Thanks to all of the new subscribers since The Investment Ecosystem paywall was lifted.  This is the Fortnightly, a curated guide to good readings from around the industry, which you’ll receive every other Monday (U.S. time) if you have subscribed to email updates.

Other essays do not occur on a schedule.  The most recent posting was “The Double-Edged Sword of Manager Selection.”

The most important chart?

The title of a posting from Byrne Hobart calls this “The Most Important Chart in Finance.”

The stylized graphic illustrates “what crowding does to returns.”  The references to publication indicate that the chart comes from quantitative finance; Hobart rightly points out that the general pattern holds for qualitative strategies/fads/movements/regimes too.

Of particular interest is the “gaining popularity” phase.  (An upcoming posting will delve into the effects of popularity to a greater extent.)  As assets flow into a winning idea, the demand affects valuation and performance in a positive way.  That reinforces the emerging belief and draws even more adherents.

Eventually an inflection point is reached and the increased competition and overcrowding come home to roost.  At the bottom of the cycle, the reverse occurs.

Knowing where you are on the chart is impossible, but being aware of the forces at work is essential, which is why Hobart writes that the “picture should be printed out, framed, and hung somewhere prominent.”

Cat and mouse

Natural language processing and artificial intelligence have changed how company managers are analyzed.  Conference calls, annual reports, and other communications are parsed for indications that go beyond the words that are said or written.

Nicholas Megaw wrote an article in the Financial Times about the state of play right now, to which Matt Levine added commentary, including the emergence of this loop:

1. Executives try to trick investors.
2. Investors acquire computers that can spot the tricks.
3. Executives adapt to be able to trick those computers.
4. Investors get new computers.
5. Etc.

VC power law

Stepstone published a report that shows that “a small number of vintage years within venture capital have historically produced most of the returns for the asset class.”  The problem:

In VC, we often observe two behavioral phenomena hindering successful outcomes that are closely linked:  recency bias and the fear of missing out.  Quite simply, investors tend to allocate more heavily to the asset class during periods in which recent performance has been strongest.

That happened again in 2021, when commitments were much higher than they had been running, setting investors up for disappointment — and leaving them overexposed so that they have trouble taking advantage of the retrenchment that has subsequently occurred.

Private credit

Robin Wigglesworth captured the moment with this opener:

In a radical break from their business model of paying fines, lobbying and advising CEOs how to wreck their careers through stupid M&A deals, several banks are looking to break into the hot new phenomenon of lending money to companies.

And puts an even finer point on it to close:

History repeats itself, first as tragedy, second as farce, and third as Citi blowing itself up on the Wall Street fad of the moment.  So we’re sure this will end well.

CalPERS search

Top1000Funds.com reported that the list of applicants for the frequently vacated CIO chair at CalPERS was “55 and counting,” even though it’s early in the search.  The headhunter is quoted as saying the group “is higher quality [than last time].”

“A specially convened CIO selection sub-committee” is involved; an industry newsletter named the members of it and noted their other roles:  Principal Compliance Representative, Franchise Tax Board; Senior Environmental Scientist, California Department of Toxic Substances Control; City Council Member, Palm Springs; President, Service Employees International Union Local 521; and the California State Controller.

The last few selection processes at CalPERS would make for a good case study.

Personal trading

ProPublica published an article with the title “A Top Mutual Fund Executive Made Millions for Himself Trading the Same Stocks His Giant Fund Was Trading.”  The portfolio manager at Dodge & Cox is said to have followed requirements for advanced approval before making the trades, but the scale of the trading and its proximity to activity at Dodge & Cox raises interesting questions about what the best practices for personal trading ought to be.

Other reads

“Navigating The Information Garbage Super Highway,” Shannon O’Leary, LinkedIn.

My information consumption rules:  Go directly to primary information sources; seek out long-form writing; always search for counterpoints or a highly differentiated interpretation; never scroll headlines; and do not consume news or information you need for your day job from social media.

“Why Canadian Pension Plans Succeeded With Some of the Industry’s Largest Deals,” Alicia McElhaney, Institutional Investor.  A summary of a research paper that evaluates “four landmark transactions made by large Canadian pension funds” and how a smaller fund emulates some of their strategies.

“Schonfeld vs. Millennium: ‘Great culture, shame about the tech’,” Sarah Butcher, eFinancialCareers.

For the biggest funds, like Millennium and Citadel, technology is a differentiator in a good way.  For smaller funds, like Schonfeld, technology is also a differentiator, in less of a good way.

“The stones left unturned in the Sam Bankman-Fried trial,” Molly White, Citation Needed.  Quite a list of intriguing events yet to be explained.

“Advisors continue to complain about asset manager websites — time to do something about it?” Pat Allen, Lowe Group.

While a collective industry response may be too much to expect, here’s hoping this report finally lights a stick of dynamite under at least a few digital teams, including their development and design partners.

“Private Credit Fund Diligence — Six Considerations,” DiligenceVault.  Some basic points of evaluation for those wanting to get on the bandwagon.

“Why ESG Investing Has Been Such a Letdown,” Sloane Ortel, Invest Vegan.

Despite the promises of real-world impact, glossy brochures with pictures of solar panels on them, and a substantial weight of evidence indicating that these data can help mitigate financial risk if properly applied, the truth is that ESG investing often fails to deliver on its promises.

“Hard work pays off,” Joachim Klement, Klement on Investing.  A “probably quite flawed” study raises questions about how to measure true effort by fund managers — and how steadfast that effort is.

“Factor Zoo (.zip),” Alexander Swade, et. al, SSRN.

Our findings indicate that about 15 factors are enough to span the entire factor zoo.  This evidence suggests that many factors are redundant but also that merely using a handful of factors, as in common asset pricing models, is insufficient.

Valuable things a hedge fund employer can do for younger analysts, @hfreflection.  Some good ideas to help avoid the “sink or swim” approach that isn’t beneficial for analysts or firms.

“Confirmation Bias Writ Large,” Bob Seawright, The Better Letter.

In essence, the map/territory problem is confirmation bias writ large, whereby we see what we want to see, accept those desires as truth, and act accordingly.  As Annie Duke says, we’re built for false positives.

“We Now Need College Courses to Teach Young Adults How to Make Small Talk,” Tara Weiss, Wall Street Journal.  Will new entrants to the investment workforce come in even less prepared than prior generations when it comes to communication skills?

Be cautious of certainty

“Cherish those who seek the truth but beware of those who find it.”  — Attributed to Voltaire.

Flashback: The best and brightest

A 2018 posting on the original “research puzzle” blog looked back at the Vietnam War for lessons on organizations, culture, and behavior that are of value to those in the investment ecosystem.  One of them:

Don’t automatically believe what the generals tell you; they may not really know, may be conflicted for some reason, or may be putting on a show for your benefit.

The posting drew from David Halberstam’s The Best and the Brightest and Neil Sheehan’s A Bright Shining Lie.  The difference between the real story and the story told is also evident in Dispatches, Michael Herr’s gritty account of correspondents embedded with troops in the field during that war.  He wrote, “I’d never seen any point in asking generals heavy questions about anything; they were officials too, and the answers were almost always what you expected them to be.”

A core principle for those doing due diligence.

Postings

With the removal of the paywall, all 150+ postings are available to read.  One example:  “The Pull of Reciprocity in Decision Making.”

Thanks for reading.  Many happy total returns.

 

Is your organization in need of a fresh look?  Reach out about consulting and facilitation services that help you find practical yet innovative solutions to improve your chances for success.

As a reminder, all of the content on The Investment Ecosystem is now free.  Dig in.

The most recent posting, “Cooking Up the Ingredients of an Investment Recipe,” reviewed a five-part description of investment strategy that offers a self-examination process for asset managers — and a way for allocators to classify and evaluate them.  Next up is “The Double-Edged Sword of Manager Selection.”  Subscribe to get it in your inbox.

Now, on to the readings.

The fund

Few books about investment organizations have gotten the attention given to The Fund, Rob Copeland’s look at Ray Dalio and Bridgewater Associates.  It has been excerpted in a number of publications, with different eye-opening stories in each one (including the New York Times, New York, Insider, Vanity Fair, and Semafor).  There have also been many reviews and related articles, such as Robin Wigglesworth’s piece in the Financial Times.

Bridgewater’s response is in full swing — here is an Institutional Investor story — but no doubt the real action is at the firm itself and especially in meetings with its clients.  Dalio has carefully cultivated an image over time of a unique and special culture at the firm — in fact, the most unusual culture of any firm of size in the investment business.

By all accounts, the book is not much about investments, but about organizational culture, leadership, and the stories that animate the business and the flow of money within it.  It will affect the perception of the industry — or perhaps reinforce it, as it did for Mark Gimein in the New York Times Book Review:

Most of “The Fund” doesn’t feel like a book about finance.  Instead, it is about how a man of surpassing mediocrity used money to control and humiliate, and how much people abased themselves for it.  Which, come to think of it, makes it one of the better books ever written about Wall Street.

It also raise questions for the institutional investors who have built the mountain of assets at Bridgewater.  How will they find what they believe to be the truth and what will they do in response?

The trial

It didn’t take long for the jury to come to a verdict in the trial of Sam Bankman-Fried, adding a coda to yet another boom-to-bust chapter in market history.

Of particular note was the commentary from a partner at Sequoia (which had provided funding to FTX and which published a glowing profile of Bankman-Fried two months before everything fell apart).  Alfred Lin tweeted:

Immediately after FTX collapsed, we extensively reviewed our due diligence process and evaluated our 18-month working relationship with SBF.  We concluded that we had been deliberately misled and lied to.

He was “fried” in response.  For example, from Jamie Powell:

“due diligence”, my brother in christ it had no board of directors, no cfo, no head of risk and was incorporated in antigua and barbuda. 2 mins of googling would have got you there.

Chris Addy of Castle Hall Diligence arrived at a couple of big-picture conclusions from the whole affair:  that crypto “is not yet ready for institutional investment” and that “FTX raises profound questions around the venture capital investment model.”

(Learning how to crack the narrative of asset managers is at the heart of the Academy due diligence course.  The first step is wanting to do it.)

ODD and IDD

The Standards Board for Alternative Investments and CAIA Association have released a great report, “Striking the Right Balance: Navigating Operational and Investment Due Diligence in Institutional Investments.”  In a brief six pages, it covers the emergence of ODD in the wake of the financial crisis, as well as the challenges that developed during the “Goldilocks era” that followed.

Among the topics are FOMO-driven compromises to standards and the reliance on others for due diligence (or on the marketing spiels of managers).  Importantly, the resourcing and power imbalances between IDD and ODD — and the competition between them — take center stage, thus the theme of “striking the right balance,” in governance, process, resourcing, etc.

Total shareholder return

The latest research from Michael Mauboussin and Dan Callaghan is “Total Shareholder Return: Linking the Drivers of Total Returns to Fundamentals.”  As is usual for them, it contains a number of good exhibits, among them ones that show corporate tax rates across the decades (down, down, down); dilution by sales deciles (monotonic); changes in shares outstanding by sector (big differences); and the instructive drivers of total return for AT&T.  Also, there’s a checklist for assessing prospective returns.

Personalized investment

Broadridge released a report, “U.S. advisor-sold asset management: This time it’s personal,” full of data supporting its assertion:

Most asset managers are still approaching a 21st-century clientele with 20th-century business models.  Today’s U.S. investors demand an increasingly personalized approach to investing, reshaping product and distribution strategies across the industry.

The five themes emphasized are additional portfolio objectives of clients, a focus on holistic outcomes, evolution away from the “tax inefficiencies and non-customizable pooled format” of mutual funds, shifting capital markets, and increasing industry concentration.  There are a number of “action items” with details on what “successful managers” will do in the coming years to navigate the large advisor-sold market for investment products and services.

Drawdowns

Toby Nangle started an article in the Financial Times with this:

All the worst things about the 1970s seem to be coming back.  Inflation.  Strikes.  Really silly flared trousers.  And of course double-digit bond portfolio drawdowns.

The charts provided show that the global bond bear market of late stands out “for its magnitude and pace.”  But, as the chart above illustrates, the drawdown from a half century ago lasted a good long time, prompting the description back then of bonds as “certificates of confiscation.”  Nangle’s concluding comparison of the two periods:

So while this bear market has been a shocker, we reckon we’ll need to check back in 2034 to see whether it beats the 1970s for sheer doggedness.

Other reads

“Should CalPERS Fire Everyone And Just Buy Some ETFs?” Meb Faber.  “All the time and money spent . . . Is it just CalPERS, or is it the industry?”

“How the Fearless Fund Lawsuit Is Provoking Outrage, New DEI Strategies — and Renewed Commitment,” Michelle Celarier, Institutional Investor.

With the stakes so high, the Fearless Fund case is forcing venture capitalists and allocators alike to rethink or reshape their efforts at increasing diversity, including among the companies they invest in, the managers they hire, and their own organizations.

“Big hedge funds pay ‘silly’ money, says founder of Europe’s largest manager,” Kaye Wiggins and Harriet Agnew, Financial Times.  Paul Marshall bemoans a “kind of battery-hen farming merry-go-round,” which is “not the right way to build great businesses or even to build a great industry for our clients.”  (Plus, “surfing the guarantee.”)

“The Transformation of Labor Markets,” PGIM.

For investors, the forces reshaping global labor markets will impact wages, productivity, unemployment, economic growth, inflation and fiscal deficits — creating a new roster of winning and losing industries and countries.

“Money Managers With $100 Trillion Confront End of the Bull Market,” Silla Brush and Loukia Gyftopoulou, Bloomberg.  Big active managers “have been bleeding cash” (client assets, that is).

“Thinking Broadly: Improving Active Performance Via Systematic Extensions,” Acadian.

Systematic extension strategies . . . have been underutilized for years (Figure 1) due to hazy perceptions of their underperformance around the Global Financial Crisis (GFC) and a blurry leeriness of risks associated with shorting.

“Sandy Gottesman: A Whale of a Value Investor and Philanthropist,” James Russell Kelly, article in Financial History (within the “publications panel at the bottom of the page).  On “The Buffett Group” and how it evolved, and the career of the founder of First Manhattan.

“11 Signs to Avoid Management Meltdowns,” Todd Wenning, Flyover Stocks.  Indicators of ethical collapse and factors that impede “management’s ability to make rational, ethical, and thoughtful decisions.”

“Blacklisted ‘woke’ firms like BlackRock and State Street still have a lock on AUM in oil states . . .,” Oisin Breen, RIABiz.

Perhaps not surprisingly, pension fund managers are leading the backlash against the backlash.

“Large Language Models Understand and Can be Enhanced by Emotional Stimuli,” Cheng Li, et. al, arXiv.  Can an “EmotionPrompt” improve the relative performance of LLMs?

Mutual fund performance, Jeffrey Ptak, @syouth1.  A series of revealing charts, with this conclusion:

In summary, with only a third of active U.S. stock funds beating their index before fees over the average 10-year period and with the average fund outperforming by just 0.26% p.a. (excluding dead funds), one thing seems pretty clear: Active U.S. stock funds charge too much.

Change

“In times of change, learners inherit the earth, while the learned find themselves beautifully equipped to deal with a world that no longer exists.” — Eric Hoffer.

Flashback: The Tao Jones

In 1983, Bennett Goodspeed of Inferential Focus wrote The Tao Jones Averages: A Guide to Whole-Brained Investing.  A 2010 review of it from the original “research puzzle” blog includes this:

While it’s tempting to view the book as gauzy Eastern philosophy with no practical application, its central message is that a good investment process is one of balance, and that the lopsided approach practiced by most organizations and individuals is doomed to fail.

In sync with the Eric Hoffer quote above, the last two pages of the book include a section called “The Warmth of the Herd,” which begins this way:

Wall Street has a bias in favor of logical, left-brained thinking.  Consequently, the right-brained sensing needed to decipher changing conditions tends to be ignored or overridden by reason.  As a result, the collective wisdom is often surprised.

Postings

Check out the archives (the paywall is no more) and search some of the categories.  You’ll find evergreen postings of interest.  Here’s one from January 2022:  “The Goal of Explanatory Depth.”

Thanks for reading.  Many happy total returns.

The paywall on The Investment Ecosystem has been blown up.  All of the postings from the first two years of this site are now free (and all future writings will be as well).

If you have been a subscriber, you should have received an email about the change.  If you haven’t been one, now is the time to sign up to receive emails of postings or to visit the archives to see what you’ve been missing.  It’s all free all the time.

The most recent essay, “When Analysts Throw in the Towel,” looks at the social and psychological pressures that affect sell-side analysts (and other investment decision makers) when things go against them.

A new “flashback” section will now appear at the end of Fortnightly postings (like this one, which features a 2008 Howard Marks memo).

On to the readings.

AI all over

We’re coming up on the one-year anniversary of the introduction of ChatGPT to the broader world, which jumpstarted the current fervor over artificial intelligence.

“Productivity, Democracy, Power, and Truth: The Influence of AI on Markets and Investing,” a report by Inigo Fraser Jenkins and Alla Harmsworth of AllianceBernstein, is big in scope, as the title suggests.  It asks (at the end), “How can strategic asset allocation adjust to the potential for somewhat higher real growth (both earnings and GDP) but also higher long-term uncertainty?”  With higher equity exposure, higher inflation expectations, and a higher risk level overall.  (Also of note, the report includes predictions about changes in how analysts will work and think.)

Around the ecosystem:  Texas Teachers “believes AI can differentiate the fund;” J.P. Morgan Asset Management wants AI to “co-pilot” with portfolio managers, not boss them around; Angelo Calvello thinks recommendation engines will change wealth management; trading desks are gauging the risks and opportunities amid concerns about reliability; and Citywire Selector asks ChatGPT whether it will take over fund selection from humans.  Additionally, meetings are about to get weird.

Portfolio management in PE

A revealing paper, “Portfolio Management in Private Equity,” from Gregory Brown, et. al, looks at a little-explored area of a very popular asset class, revealing important patterns for investors.  According to the authors, “In spite of the centrality of the issue we study in this paper, almost no work to date has studied the GP’s investment decision through the lens of portfolio construction.”  Some of their conclusions:

The largest investments in PE funds typically have the lowest returns on average, but are also the least risky.

Managers take their biggest bets on their “safest ideas” instead of “best ideas.”

Returns within a typical PE fund increase monotonically as the investment size rank increases through the fifth largest investment made by a PE fund.

Funds start with higher-return deals.  That is, the earlier deals in the fund are of higher return and higher risk.

Funds with high-performing deals early in the fund’s life generally experience lower returns in later deals.

These results are consistent with the idea that GPs, motivated by career concerns and the incentives of limited partner agreements, approach fund investment through the lens of portfolio formation.

Given the standard marketing cycles, the changing portfolio composition as a fund ages is especially of note.

ESG

Kroll released its first “ESG and Global Investor Returns Study.”  It covers a lot of ground, but performance drives interest and “proofiness” in the industry, so the return calculations are likely to get the most attention.

The results above are for the respective MSCI ESG categories.  The colors indicate the three groupings (leader, average, grouping) used in most of the exhibits in the document, rather than the full spectrum of ratings as shown.

Advocates will no doubt use these numbers in debates with those who oppose any sort of ESG investing — at investment committee meetings, legislative hearings, etc.  But it’s a relatively short time period, there are sector mix effects to consider (and methodology to understand), and the number of companies included in the analysis doubled from 2013 to 2021.  Plus, this was a period when ESG was becoming more popular, so investor flows into highly-rated companies; reversion could mean that things look different over time.  Use with care.

The techno-optimist

Marc Andreessen got a lot of reaction to “The Techno-Optimist Manifesto,” an article which takes talking your book to a whole new level.  Among the many rebuttals are those from Ezra Klein and The Rational Walk.

Byron Wien

Wien passed away at ninety years of age.  He was widely known for his annual list of “Ten Surprises” of prospective developments unexpected by professional investors — and in later years for his twenty life lessons.

Other reads

“ETFantasmagoria,” Robin Wigglesworth, FT Alphaville.  On the explosive growth of ETFs, including “new-gen” ones far from their “passive roots,” and some thoughts about how their use will continue to evolve in more complex ways.

“CDPQ’s two-way street of efficient external manager relations,” Amanda White, Top1000funds.com.

It is important for our team to understand the knowledge gaps of the organisation, and while we better understand these knowledge gaps we work with partners and funds to see how they can help us fill those gaps.

“The art of keeping it simple, by JPMorgan’s Jan Loeys,” Bryce Elder, FT Alphaville.  An uncommon point of view for a strategist who works within a part of the industry that is paid for complexity.

“2024 Examination Priorities,” Securities and Exchange Commission.  The SEC’s playbook across the range of entities it monitors.  One interesting priority:

Adherence to contractual requirements regarding limited partnership advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.

“Sharing Names and Sharing Information,” Omri Even-Tov, et. al, SSRN.  Do CEOs offer more information to analysts who share their name, especially if it’s uncommon?  Fascinating conclusions.

“Diverse Managers Are Stuck. Can Changes to Seeding and Anchoring Deals Help?” Julie Segal, Institutional Investor.

Existing diverse manager and emerging manager programs were two of the least helpful sources, in part because they take a check-the-box strategy to due diligence and their requirements often make some problems worse, including working capital.

“Wind of Change: A Favorable Environment for Hedge Funds,” Zhe Shen, TIFF.  A much different view than that expressed by Michael Rosen of Angeles in the last edition of the Fortnightly.

“We are All Quants. The New Era of Systematic Investing,” Campbell Harvey, Research Affiliates.

The machine, obviously, does not have direct behavioral biases and will not fall prey to human emotion.  Indeed, the best algorithmic strategies will observe, learn from, and profit from others’ emotional choices.

“Reality Of Working At A Hedge Fund — An Insider’s Guide,” Buyside Hustle.  Myths and realities for those trying to get their foot in the door.

“Heterogenous Discount Rates and Optimal Portfolio Diversification,” Theia Finance Labs.

The market portfolio only represents the optimal portfolio in the particular case that the investor’s discount rate is identical to that of the market, i.e. that discount functions are homogenous.

“Private credit returns are great (if you believe the marks)” Robin Wigglesworth, FT Alphaville.  Subtitle:  “A rolling loan gathers no loss.”

It’s a social science

“All investing is behavioral, psychological, social, etc.  So a lot of big investing mistakes are not because investors don’t understand finance — it’s because finance is all they understand.” — Morgan Housel.

Flashback: Marks in 2008

In thinking about 2008, the mind goes to September, when Lehman failed and other major firms were on the brink — and parts of the bond market seized up.  But things had been building beforehand, as shown by the title of a piece by Howard Marks on March 18 of that year:  “The Tide Goes Out.”

He detailed parts of the “virtuous circle” of booms and then wrote:

With things working increasingly well and investors becoming more and more excited, processes like this one seem destined to go on forever.  Of course, they cannot.  But people forget that, satisfying one of the key prerequisites for a cycle that goes to excess.  Overestimating the longevity of up legs and down legs is one of the mistakes that investors insist on repeating.

On the other side of the cycle, “Unquestioning euphoria gives way to full-blown depression.”

More than fifteen years later, it is worth rereading.  Among the topics covered:  “What’s an asset’s price?” (a question being asked about many private holdings today); when things that “should happens” turn into things that “should have happened”; how safe assets become unsafe with leverage; the problem with copying the previous success of others as conditions change; and those “high reported IRRs” — are they skill or luck or just “well-timed risk taking”?

Postings

As mentioned before, all prior postings are now open, so check out the archives and search some of the categories.  For example, if you’re interested in how investment organizations work, you’ll find a wealth of insights in this series.

Thanks for reading.  Many happy total returns.

This edition of the Fortnightly is a week late (we took the show on the road for a bit), but it has a full load of great reads for you from around the investment ecosystem.  Back on schedule; you’ll see the next version in two weeks.

NAV loans

The opening line of a posting from Ted Seides speaks to an evergreen investment industry experience:

Financial market participants tend to stretch at the end of a cycle in ways that look silly in retrospect.

The topic is NAV loans, via which private equity sponsors borrow against their funds, a practice that is suddenly in vogue given changed circumstances in the industry.  The title of the piece asks, “Canary or the Gold Mine?”

Given that first sentence, you think the answer must be “canary,” but then Seides relates some examples that make you think he’s going to come down on the “gold mine” side.  Before choosing, he puts forth both the “pro” and the “con” arguments, making the case that NAV loans might work out well in some cases and be disastrous in others.  That said, Seides comes down on the side of listening to the canary; he echoes the words of Ana Marshall of the Hewlett Foundation that “anyone hearing about a NAV loan should shout out a warning from the mountaintop.”  Attention must be paid.

For more on this topic, see a Financial Times article which reported that the Institutional Limited Partners Association is drafting recommendations that “call for the industry to provide justification for the loans and more disclosure of their costs and risks to investors.”  And a Bloomberg piece throws shade on NAV loans and other borrowing tactics that are becoming more prevalent by referring to them as “backroom financing.”

Due diligence

Hilary Wiek of PitchBook has issued a report, “An LP’s Guide to Manager Selection,” which delves into some of the nuances of due diligence and manager selection in private strategies.  She follows the industry preference for “the Ps,” offering six of them as the foundation of her approach — people, philosophy, process, portfolio construction, performance, and pricing — while adding a seventh, potpourri, that allows her to include some other important points.

The report is full of good questions to pose to general partners, including some that are “culturally delicate to ask.”  Wiek stresses that “all [of a manager’s] responses must form a holistically coherent picture” and gives some examples of ways in which they often don’t.  Each of the seven sections includes helpful perspective for the diligence quest.

In the end, it is critical to remember that “there is no one right answer to any of the areas of due diligence” and that “it is the allocator’s fiduciary duty to perform its own due diligence, even if it seems like smarter investors have already done so.”

CEO rewards

FCLTGlobal published “The CEO Shareholder: Straightforward Rewards for Long-term Performance.”  According to the paper:

Companies need to reward leaders who create long-term value, but focusing on short-term returns as the primary metric in remuneration keeps companies stuck in short-term behaviors.

It argues that total shareholder return — which has been institutionalized as the primary approach to incentivizing CEOs (and others at a firm) over the last few decades — is a poor way to align the interests of managers with those of investors.  The organization’s theory of “remuneration design” is explained in the body of the report; a five-part “toolkit” at the end provides a nice summary of the practical application of it.

Charles Feeney

A remarkable life, making money and giving it away.

Other reads

“Generative AI: Overview, Economic Impact, and Applications in Asset Management,” Martin Luk, SSRN.  The table of contents to this long piece offers codes for the sections to indicate “must-read,” “read if you can,” and “helpful to read.”

“Investing Is a Science, an Art, and a Practice,” David Booth, Dimensional.

Financial economics is a social science.  Unlike math, which demands proofs and delivers exact answers, research in finance yields insights.  These insights allow room for interpretation.  And putting theory into practice requires judgment.  In many ways, it’s similar to medical science.

“Doing this will improve and accelerate your analysis,” Stephen Clapham, Behind the Balance Sheet.  Analysts, when was the last time you read an audit report?

“Hedge funds do not offer value to pension funds and other investors,” Michael Rosen, Angeles.

There is no combination of stocks and high-yield bonds that did not outperform hedge funds.

Fees are simply too high a hurdle for hedge fund managers to offer an attractive return to investors.

“10 Quotes That Shaped My Investment Philosophy,” Barry Ritholtz, The Big Picture.  Only one of these is specifically about investments, yet they represent a solid philosophical foundation for investing.

“The Business of Annual Letters,” Byrne Hobart, Capital Gains.

A company has a story to tell that’s best told in the form of a serialized short-term company history with near-future speculative fiction elements.  But all of those stories come to an end sooner or later.

“Politics rivals profits for portfolio influence, says Bridgewater co-CIO,” Aleks Vickovich, Top1000funds.com.  This was written before the recent events in the Middle East; even now, are politics more import than profits?  Over what time horizon?

“Adapting to Growing Private Markets: A Playbook for Practice Success,” Asher Cheses and Daniil Shapiro, Cerulli.  “Advisors can use alternative investments to differentiate practices and attract, consolidate, and retain client assets.”  (Note that the belief that a “lack of correlation to public markets” is given as a selling point.)

“The paradox of private credit,” Jared Gross, J.P. Morgan Asset Management.  (Also see:  “Insurance Companies Binged on Private Credit. Moody’s Is a Little Worried About It.”)

Private credit has “grown up” in a period of low interest rates, inexpensive leverage and limited defaults but must now adapt to an environment of high rates, costly leverage and rising credit risk.

“The alpha of ugliness,” Robin Wigglesworth, Financial Times.  Thoughts on some academic papers comparing the looks of portfolio managers and analysts with their performance.  (Maybe AI tweaks can help the prettier among us come across as “ugly beta nerds.”)

Topics of interest

“Great minds discuss ideas; average minds discuss events; small minds discuss people.” — Eleanor Roosevelt.

Factors over time

In “Trends and Cycles of Style Factors in the 20th and 21st Centuries,” an article in the Journal of Portfolio Management, Andrew Ang looks at the “time-varying trends” of the most widely-accepted style factors (size, value, quality, momentum and low volatility).

Ang uses the breakpoint of 2001 as the dividing line between the centuries of the title and finds significant differences in the returns, variabilities, and Sharpe ratios of the factors from one time period to another.  Potential causes of the changes are mentioned but not explored by the author, including “macro variables,” “constraints that induce investors to act in certain ways,” and “investor behavior biases.”  (The effects of popularity would seem to be ripe for analysis too.)

The image above shows the different behavior of late in the value factor on which so many investors have relied — a deeper and longer drawdown than those witnessed in previous history is causing debates about the nature of historical evidence and how to interpret it.

Postings

All of the content published by The Investment Ecosystem is available in the archives.

Thanks for reading.  Many happy total returns.

Welcome to the Fortnightly, a digest of interesting reads from around the investment ecosystem.

Buying businesses

Some stock market investors are buying stocks, while others are buying businesses.  Time horizons differ and the rationale for a purchase can vary from a trading strategy to getting exposure to a factor to holding that business forever as if you were the sole owner.

Private equity funds are clearly buying businesses, although their holding periods are rather short compared to true long-term owners.  There are also multi-decade and perpetual funds with very long horizons.

Everyone in the buying-businesses line of work needs to do due diligence and faces the challenge of sorting through the information that’s provided, as well as discovering the critical bits that aren’t.  A big company probably has a well-crafted narrative (so “cracking the narrative” is a high-value skill, as it is when analyzing asset managers).  Smaller firms usually aren’t as polished and organized, presenting a different sort of puzzle.

Permanent Equity, which invests thirty-year committed funds in small to midsized companies, recently made public its due diligence process, including a seventy-page document full of details.  Chief Investment Officer Tim Hanson explained the reasons for sharing its approach.

The craft of due diligence involves more than a checklist, since there needs to be discovery of a range of attributes that don’t fit neatly between the lines, that aren’t anticipated by buyers or willingly shared by sellers.  But the thoughtfulness and depth of the Permanent Equity approach ought to serve it well in the marketplace and should be considered by others who evaluate organizations.

On a related note, “search funds” have become popular of late.  See, for example, “MBAs Are Spurning McKinsey to Buy Small Companies” by Matthew Boyle of Bloomberg.  But the dream and the reality of running companies are sometimes far apart.  Some of the disconnects are covered in “Check Your Strategy and Capital Allocation Aspirations,” from Trish Higgins and A.J. Wasserstein.

Two ways

The latest memo from Howard Marks looks at two routes to success — fewer losers or more winners.  As he has before, Marks uses the image below to illustrate general investing principles, equities, fixed income, and the stylistic choices of avoiding losses or going for winners.

But Marks is “convinced the potential to improve on that through skill does exist in some markets and some people,” that alpha lies in “the ability to alter the shape of the distributions in the graph above so they’re not symmetrical,” as shown here:

Now we just need to find those markets and those people (and not confuse the random noise of performance with an ability to bend the distributions on an ongoing basis).

Anniversaries

It’s that time of year.  In the last couple of weeks we’ve “celebrated” the 25th anniversary of the collapse of Long-Term Capital Management (LTCM) and the 15th anniversary of the Lehman bankruptcy.

Looks back at LTCM include a posting from Marc Rubinstein (the pre-paywall section has the basics) and a Bloomberg article by Sonali Basak that includes an interview with Victor Haghani — and a reminder that the event marked the institutionalization of “the Fed put.”

That put was very much in evidence ten years later.  But what has changed since the financial crisis?  Mark Rzepczynski offered his opinions about what has changed (and what hasn’t), including that “The Fed has created the foundation for a new financial crisis.”

Other reads

“Honey, the Fed Shrunk the Equity Premium: Asset Allocation in a Higher-Rate World,” AQR.

Where “cash-plus” strategies charge performance fees, they should be on returns above a cash benchmark, just as long-only managers should be evaluated against an appropriate market benchmark.

“The Research and Development Factor,” Larry Swedroe, Alpha Architect.  “The empirical evidence demonstrates that the R&D premium remains an anomaly in all models.”

“Panel: The RIA industry is headed into a war for talent,” Daniel Gil, Citywire RIA.

A prolonged shortage of financial advisors may push hiring competition among RIAs into an all-out industry war which could sharply drive up costs to recruit and retain employees.

“The China paradox: underrepresented or too dominant in emerging market equities?” Marc Bindschädler, Vontobel.  Given uncertainties about China’s future — and its “dominant but also underrepresented” weighting in market indexes — consider five possible “patterns of investor response.”

“An oral history of the fear index.” Robin Wigglesworth, Financial Times.

“Democratising volatility trading” is something that sounds cute in an options exchange pit or Goldman Sachs trading floor, but perhaps there are just some things that shouldn’t be democratised?

“How Andy Golden Reinvented the Endowment Model for Princeton,” Alicia McElhaney, Institutional Investor.  “One team, one dream” — with an “odd and secret and unstable” decision process for what goes into the portfolio.

“Using AI in an earnings call,” Joachim Klement, Klement on Investing.

What the research found was that executives tend to hide behind boilerplate answers more when they are delivering bad news.  If they are discussing problems at their business, they obviously don’t want to go into too much detail about how bad the situation really is.

“Investment Advisers: Assessing Risks, Scoping Examinations, and Requesting Documents,” Securities and Exchange Commission.  Which firms get examined, what areas are in focus, and the (pile of) documents that are usually requested at the start.

“Thematic Analysis: Emerging Risks in Private Finance,” International Organization of Securities Commissions.

Private finance has largely grown in a period of accommodative macro-financial conditions.  This has now changed.  The sector may be tested in the medium to long term and could respond in ways that uncover hidden risks.  It is evident that private and public markets are intertwined to the degree that any one market event could have implications across both markets and, potentially, the broader financial system.

“The Real-Life Inspiration Behind The Bonfire of the Vanities,” Joseph Mysak, Bloomberg.  Cutting the cake and keeping the crumbs.

Narrow perspectives

“If everyone is thinking alike, then no one is thinking.” — Ben Franklin.  (See also Alfred Sloan.)

Uncommon levels

These charts were posted on LinkedIn (top and bottom) by Brian McAuley of Sitka Pacific Capital Management.  They offer historical context for the management of portfolios (and the behavior of clients regarding investment products of various stripes).

Is this a permanent change in the economic and market regime that started in the early eighties?  That’s the big question of the day, along with the corollary:  Which businesses, instruments, and strategies are untenable if that’s the case?

Postings

“The Paradox of Manager Selection Practices in a Changed World.”  The persistence of performance by the managers of alternative investments has declined over time, so the heuristics of the past don’t apply, and different ideas and questions become more important in manager selection.

“Becoming a Learning Organization.”  Lessons from seventy years of the CIA’s efforts to study the intelligence process and build up a fund of knowledge to help it learn from its successes and failures.

All of the content published by The Investment Ecosystem is available in the archives.

Thanks for reading.  Many happy total returns.