The Champion Manager of the Year

If you evaluate asset managers and allocate assets to them, take The Basis Point Test and see how you score.

The champion manager

The 150th Open Championship concluded yesterday at St. Andrews.  As always, the awards ceremony included the announcement of “the champion golfer of the year,” one of the most recognizable phrases in all of sport.

Cameron Smith received that recognition by playing one of the greatest final rounds in major championship history.  No doubt his incredible performance will result in increased press attention, lucrative endorsement deals, and shorter odds at the betting window for coming events.  He was not an unknown before — his game is widely respected — but his “stock” has now been revalued.  That said, who knows whether the Open is a sign of even better things to come or the high point of his career?

Parallels to the investment game abound.  A portfolio manager who shoots the lights out for a period of time is sure to be featured in those publications that still make lists of the best performers in different categories for a year or even a quarter (although most of the evidence shows you’d be better off buying the laggards rather than the leaders).

There are also manager-of-the-year awards, which feed the industry’s marketing machine and lead to more assets for a manager so honored (and, in most cases, softer standards of due diligence, since the awards are viewed by many — consciously or unconsciously — as a stamp of approval).

The awards aren’t limited to managers; there are some for asset owners, fund selectors, advisory firms, etc.  We are drawn to rankings and our impressions are affected by them (or we wouldn’t pay attention).  That puts the onus on those evaluating managers and other providers to see past the aura surrounding them and judge what will endure after the magical moment has passed.

Mutual fund boards

At the end of the great paper, “Role of the Mutual Fund Director in the Oversight of the Risk Management Function,” issued by Deloitte and the Mutual Fund Directors Forum, is a footnote which includes this reminder:

The SEC has explicitly stated, “directors play a critical role in policing the potential conflicts of interest between a fund and its investment adviser” . . . indicating that “[t]o be truly effective, a fund board must be an independent force in fund affairs rather than a passive affiliate of management.”

It’s debatable whether that standard is met.  How many fund boards do independent due diligence on the firms managing the money of the funds (with the exception of details that are specifically required to be reviewed)?  Most don’t get past the manager’s narrative.

But that’s a deep topic best left for a future analysis.  What makes this piece “great” is the incredible number of questions throughout that directors “may find helpful” across four categories of risk (investment, operational, strategic, and regulatory).  While there are issues to discuss beyond the ones presented, fund directors who seek answers to those questions would be demonstrating a greater-than-average fiduciary effort.  (The same goes for other kinds of intermediaries.)

Material risk

Speaking of risk management, the CFA Institute Research Foundation has published a monograph by Richard Bookstaber and Dhruv Sharma, Managing Material Risk.  While the focus is on risk management for individuals, the ideas “extend to the range of asset owners.”

In sum, many of the standard tools for evaluating investment risk are poor reflections of the real world, and

the notion that we can optimize a portfolio is wishful thinking, as is the idea that we can look at the current situation in isolation and “set it and forget it” when it comes to portfolio construction for risk management.

Bookstaber points to

a systematic flaw in the risk models is being used to evaluate individuals’ investment portfolios:  assets erode in value more quickly than what is suggested by traditional models, and they take comparatively longer to recover.

And, “at the same time that current methods underestimate material risk in the market, they overestimate the long-term risk.”  His answer is to use agent-based modeling, which can reflect the vastly different goals and behaviors of the various market actors.  Within that framework, data on “leverage, illiquidity, concentration, and credit conditions” can better explain the cascades and contagion that occur and disrupt carefully-created plans.

Other reads

“Allocating to hybrid strategies is a multiple-choice decision,” Cara Lafond, Pensions & Investments.  The increased mixing and melding of private and public strategies within investment vehicles raises classification issues for asset owners; four options are outlined.

“Beyond Fama-French Factors: Alpha from Short-Term Signals,” David Blitz, et. al, SSRN.  The authors approach the analysis of short-term signals using different assumptions than others, and find that

a composite strategy comprising short-term reversal, short-term momentum, short-term analyst revisions, short-term risk, and monthly seasonality signals generates economically and statistically highly significant net alphas, at least when efficient trading rules are applied.

“Private Equity: Risks and Opportunities,” Frank Fabozzi, et. al, Portfolio Manager Research.  A timely recording of a panel discussion covering a wide range of research about private equity investments.

“What’s the deal with the God Bless America ETF?” Alex Steger and Alex Rosenberg, Citywire RIA.  A look at one of the latest thematic offerings, which carries the ticker symbol YALL:

Also, as was the case with the launch of Strive Asset Management a few weeks ago, you have this odd situation of a firm or fund being created with the expressed aim of being non-political and against all things mission based in finance, while being, you know, quite political and mission based.

“Defining and diligencing impact funds,” Ben Thornley and Jane Bieneman, top1000funds.  “A guide for more precise impact labeling and stronger impact management practices.”

“Capacity Constraints in Hedge Funds: The Relation Between Fund Performance and Cohort Size,” David Forsberg, et. al, Financial Analysts Journal.  The authors find that capacity concerns should not just focus on a given fund, but on the “cohort” of similar strategies, because

diseconomies of scale arise from capacity constraints related to the amount of AUM pursuing particular investment opportunities, which in turn was better identified under the cohort model as it incorporated the AUM of close competitors into the analysis.

“Trends to Watch,” DuDil.  This site specializes in identifying changes in company accounting policies that might otherwise fly under the radar.  Three trends are covered here:  changing behaviors related to employee stock compensation, companies tinkering with accounting assumptions because of inflation, and increased scrutiny from the IRS regarding transfer pricing.  (Plus, some stocks to watch.)

“The Five Distinct Signs that You Have a Toxic Workplace Culture,” Gustavo Razzetti, Fearless Culture.  And some tips on how to see them.

“Rating Morningstar’s Fund Ratings,” Jeffrey Ptak, Morningstar.  This self-analysis from the firm includes a good thumbnail of its four types of fund ratings, multi-dimensional looks at the performance of them, and “opportunities for improvement,” including:

The forward-looking Analyst Rating and Quantitative Rating have generally been successful sorting funds based on future performance versus a category average, with higher-rated funds succeeding more often than lower-rated funds, on average.  Nevertheless, Gold-, Silver-, and Bronze-rated funds have not outperformed their assigned benchmark indexes, on average.

“Agency Rule List,” Office of Information and Regulatory Affairs.  The current list of SEC proposed rules.

Coatue presentation deck, May 2022.

Big regret:  anchoring bias to the last 10 years.

A place for us

“Humans will be needed to look over the bots’ shoulders to ensure that the recommendations they make are sound.”  — From “Five New Financial Jobs of the Future” by Chris Kornelis in the Wall Street Journal.

Sector rotation

The allure of the sector rotation philosophy is based on the idea that you can catch the relative moves among them.  Easier said than  done, but this chart shows why it is an appealing concept.

A couple of years ago it was hard to give away energy stocks, especially because of the tsunami of interest in ESG factors.  On the flip side, tech could do no wrong and no price was too high for a piece of the future.  Then everything changed.

Will we take a trip back to (and below) the zero line, then slog around for years, like last time?

Postings

Recent pieces for paid subscribers:

“Finding the Right Talent.”  This posting starts not one but two series.  It is the first of four taking an investment perspective of the terrific book Talent, and it kicks off a months-long project on the nature of investment work.

“The Individualism-Collectivism Sweet Spot.”  There are certain attributes that define the culture of an organization.  Using asset management firms as an example, some thoughts about a central consideration.

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

Published: July 18, 2022

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Finding the Right Talent

A long series of postings will unfold intermittently on this site over the next several months, focusing on what the world of work might look like in the investment industry going forward.  That’s an impossibly broad topic — with no discernable endpoint — so the goal is to explore the ideas in ways that help investment professionals and organizations consider the possibilities and weigh their options.

Where to start?  The list of potential subjects is broad and deep.  Certainly there are a couple of major forces to address.   The increased automation of tasks is likely to alter traditional industry roles — and the popularity of remote and hybrid work arrangements will challenge the norms of structuring organizations, with implications for culture, investment process, and a host of other concerns.

Talent

The first few postings in the series will focus on people, specifically on the goal of finding the right people to bring into an organization, using an excellent book — Talent, written by Tyler Cowen and Daniel Gross — as thematic glue.

One of the principles of this site is that good ideas from other disciplines should be examined, debated, and (if appropriate) applied within investment organizations.  That seems obvious, but such exploration is relatively rare; energy gets devoted to the “investment” part of the description, not the “organization” part.

Therefore, on any topic, the standard questions are:  Is there something about investment organizations in general that makes them different than other entities, so that a specific idea wouldn’t apply?  Why?  How can the idea be adapted to fit the circumstances in a given situation in order to further investment and organizational goals?

The authors of Talent encourage that kind of approach:

Always ask:  In which areas might this work?  Might this not work?  When does this work or not work?

Along that line, it’s worth noting that the book focuses on finding “talent with a creative spark.”  How that is interpreted — or whether it is truly valued — varies by organization.  But the concepts put forth are broadly applicable even if they aren’t directly aimed at investment organizations.

This posting will provide an overview of sorts, while subsequent ones will deal with narrower topics like the challenges and opportunities of “otherness,” the differences between virtual and in-person communication, and how the tactical aspects of interviewing highlighted by the authors apply to the craft of due diligence.

Identification and valuation

Some themes of the book:

~ The search for talent is both art and science.

~ The proper valuation of talent is critical to success.

~ Talent might be undervalued or overvalued by the market, perhaps in systematic ways.

~ Identifying and valuing talent in a changing environment requires ongoing improvements in process.

If you substitute “investments” for “talent” in each of those statements, you’ll see that the philosophy of the authors fits with the investment mindset.  Their goal is “to revise the bureaucratic approach to talent search,” in order to provide “a personal or organizational edge” in identifying and valuing talent.

There are valuable insights sprinkled throughout the book.  Early on, a group dinner discussion is described this way:  “Events like this, in which ideas are shotgunned out at a rapid pace, often provide a quick window into whether a person’s true interests lie in status or in ideas.”  Such an important distinction.

One factor that comes into play (not just at dinners but in other situations as well):

Most of us have a bias toward well-spoken and articulate storytellers.  But make sure you keep an awareness of this at the front of your mind, for it can cause you to hire glib but unsubstantial people and overlook rare creative talent.  Do not overestimate the importance of a person’s articulateness.

Being mindful of your biases is important; “don’t leap too quickly to conclusions about [a] person being ‘a weirdo’ . . . ‘weirdos’ may end up as some of your best performers.”  You want to be able to objectively judge people across various dimensions, and to recognize their abilities even when they are overlooked (and therefore misvalued) by others.

Intelligence

Invariably, if you ask someone about working in the investment world, they’ll talk about how smart everyone is.  Therefore, a chapter with the title “What is Intelligence Good For?” seems made to order.  The authors state their conclusion up front, that “intelligence is usually overrated, most of all by people who are smart.”

They cite Marc Andreessen, who agrees with that assessment and “argues that, all other factors equal, the more important qualities in a hire are drive, self-motivation, curiosity, and ethics.”  If intelligence is overrated, it’s also then overvalued.  Now add in some of that articulateness and you can see how the valuation of an individual can really get out of whack.

Analogies to the valuation of companies are appropriate.  There are “no extra gains to be had from investing by running after positive qualities but neglecting price.”  You are much better off discovering “hidden virtues.”  And should you be bidding against others, you may end up experiencing the “winner’s curse” of finding out you paid too much in your rush to capture that talent.

That is especially true when notions of intelligence are intertwined with observations of an investment track record (which is an inherently noisy measure of quality).  Intelligence is context dependent and so is performance.  If you hire someone into a new organizational environment, they may struggle to understand how to succeed within it.  Or they may encounter a much different market regime to navigate than they had before and find it difficult to adapt.  Faced with tougher circumstances, their results may suffer, and perceptions of their intelligence may decline along with them.

Personality

Also context dependent:  personality, even though most tests of it pronounce someone to be of a certain type.  While “often those claims are correct to some degree,” they miss the variability in the measured characteristics across different situations.

The authors use the common Five Factor model for illustration, and write that

if you’ve never heard of it or worked with it, it can teach you something, but at the same time, most of the practitioners who use it or cite it tend to significantly overrate its effectiveness and overlook its limitations.

It’s “marginally useful” to use that model, but you “should not obsess over” it.  Some investment firms swear by personality tests and others think they are garbage, but

there is another use of personality psychology:  namely, as a way of developing a common language so that you and your team can discuss and evaluate claims about personality.

The personalities of individuals matter in an organization.  The authors’ recommendation provides a sensible middle ground on which issues can be examined thoughtfully and with more depth than would result from a slavish adoption of a methodology or the rejection of all possible benefits of one.

In addition to the standard five factors (scales of neuroticism, extraversion, openness to experience, agreeableness, and conscientiousness), Cowen and Gross mention that “a tradition factor” comes into play in certain cultures, especially in Asia.  They also discuss other qualities, including stamina, self-improvement, dynamism, maturity, ambition, sturdiness, generativeness, and several more.

Another indicator is important for the investment realm — the number of conceptual frameworks that someone can reference and apply.  If they have a single model to which they always return, they are likely good at one kind of thing, limiting the roles that they will fit into and the environments in which they can excel.

Also:

When it comes to hiring, most of all you need a good match, not some supposed vision of candidate perfection.  So skill in spotting flaws in other people can lead to very positive matching outcomes, and that is another reason the dialectical perspective of seeing both the good and bad sides of talent is highly useful.

Your talent strategy

The book also gets into different ways of searching for talent, some of which are better suited to the world of entrepreneurs than the process that plays out for investment professionals, which is driven by biography and track record more than innovative ideas.

Nonetheless, every organization demonstrates a pattern of hiring over time, perhaps by design but maybe by happenstance.  Ideally, “your set of filters should be part of an integrated strategy”:

Whom are your filters bringing through the door?  And which strengths and drawbacks are those individuals likely to have?  Your talent search and interviewing techniques never start from a totally blank slate; they should start from an understanding of where your institution stands in the broader scheme of things, and what are the main problems you face when trying to attract talent.

Which brings us to issues to be unfurled as this series continues, including what kinds of jobs are to be filled — and what kinds of people will be needed to fill them — in the decades to come.  The challenge for those leading investment organizations is to create a “hive mind” (and desirable hive behaviors) that fosters an ability to compete at a high level, over time, in a complex adaptive system.  There are many pieces of the puzzle to be uncovered and put together.

 

All future postings in this series will be included in this index as they are published.

Published: July 14, 2022

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The Individualism-Collectivism Sweet Spot

In the posting “Creating a Culture: The Case of Credit Suisse,” Marc Rubinstein of Net Interest recounts some of the history of the investment bank and its struggles to build a cohesive organization.  That serves as a backdrop for him to consider recent “catastrophic events” for the firm (including Greensill and Archegos, cornerstones of its annus horribilus) — and issues of culture.

To provide some context within which to evaluate Credit Suisse, Rubinstein quotes from a 1985 Sloan Management Review article by David Maister about “one-firm firms”:

The characteristics of the one-firm firm system are institutional loyalty and group effort.  In contrast to many of their (often successful) competitors who emphasize individual entrepreneurialism, autonomous profit centers, internal competition and/or highly decentralized, independent activities, one-firm firms place great emphasis on firmwide coordination of decision making, group identity, cooperative teamwork, and institutional commitment.

The individual-collective dynamic is a core consideration — probably the most important consideration — in the cultural analysis of an organization.  To dig deeper using Maister’s principles, let’s narrow the focus to asset managers, even though a similar approach could be applied to other kinds of entities as well.

In doing so, the issue of scale comes into play, since it is easier to imagine a smallish, focused boutique having a common, collaborative culture than a global, multi-asset, multi-product firm having one.  But all along the size continuum, organizations face questions of structure, process, incentives, power relationships, etc. that revolve around beliefs about collectivism and individualism.

One-firm firm characteristics

Maister’s article outlined the pillars of the “system” that he saw at the heart of one-firm firms:  loyalty, downplaying stardom, teamwork and conformity, long hours and hard work, a sense of mission, and client service.  There are asset management firms that appear to match that simple summary (and Maister’s further exposition of the elements of it), but would you consider those characteristics to be the norm within the industry?  Most people would probably answer, “No.”

Which raises the questions:  Would those characteristics tend to produce asset management organizations that do a superior job of delivering performance (and fulfilling other client needs) over long periods of time?  Or is there something about the craft of asset management that makes an emphasis on the collective an inferior approach?  Is the industry culture of individualism borne of thoughtful design, resulting in better outcomes, or is it just a vestige of tradition that’s very hard to undo (and which forestalls needed improvements)?

Finding the sweet spot for a particular firm’s culture should be a matter of careful consideration, not just copying what has been done before.  A bedrock belief as to the right balance of collectivism and individualism forms the foundation for myriad other organizational decisions and behaviors (and attempts to avoid the hard debates related to it will only intensify over time if they are not clearly addressed).

Sustaining the culture

Maister identified a number of actions that he saw as standard practice for a one-firm firm seeking to sustain its culture; each is shown indented below.  Whether or not you buy into his overall philosophy, these items can serve as a scorecard for where your organization is now — or as a list of topics to revisit as part of your improvement efforts.  (The comments that follow each are in regards to the investment decision makers at asset management firms, not the broader employee base.)

Entrance requirements into the group are extremely difficult.

What are your requirements?  One of the firms cited in the article looked for SWANs:  “people who are Smart, Work hard, are Ambitious, and Nice.”  The last attribute sticks out as unusual, although some organizations do emphasize such personal qualities far more than others.

Perceptions of performance are extremely important in the hiring process at most firms, even though those perceptions can be distorted in all of the same ways as they are when outsiders try to judge an asset manager — there is a lot of noise involved and much misinterpretation, but the numbers often overrule considerations of organizational fit as candidates are being evaluated.

It’s worth noting that one risk of “extremely difficult” selection requirements arises when the attributes of a model employee are drawn too narrowly, resulting in a relatively uniform pool of talent and experience.  That can lead to strong results in environments that reward those dimensions but impede adaptability overall.

Acceptance into the group is followed by intensive job-related training, followed by team training.

This is an example of stark differences between the subjects of Maister’s piece and the typical asset management organization, where there is very little training.  What does occur happens in a haphazard fashion, a sort of training by osmosis.  If you’re lucky, you get exposed to people who are a) interested in providing needed training and b) able to do it well — but that combination is unusual.

And when it comes to “team training” or anything away from learning about a new investment something or other, it’s even more rare.  Areas like decision making, collaboration, and communication, which are critical to success, always seem less important to pursue than investment ideas.

Challenging and high-risk team assignments are given early in the individual’s career.

This varies quite a bit by firm, but often people who make it into the business can get significant responsibility pretty quickly, although in individualistic cultures they aren’t really “team assignments” per se.  But given the modest hit ratio on investment ideas, failure comes early and often.  How does the organization respond when a significant failure or pattern of failures occurs?  That’s a tell.

Individuals are constantly tested to ensure that they measure up to the elite standards of the unit.

Again, the noisy nature of asset management returns leads to flawed evaluations, but they are still the predominant measurement tool.  As a result, individuals are not pushed to expand their capabilities — and therefore aren’t “tested” in new ways.

Individuals and groups are given the autonomy to take risks normally not permissible at other firms.

Having the autonomy to make decisions is a key part of the individualistic approach, so many firms score well on this item, although “normally not permissible at other firms” is a very high — and perhaps ill-advised — bar.  What constitutes an undue risk?

Training is viewed as continuous and related to assignments.

As indicated earlier, this is an area of weakness.  Generally, training is spotty and lacks purpose.  (Having a large budget to attend conferences is not “training.”)

Individual rewards are tied directly to collective results.

This gets to the heart of the matter.

Tying compensation to collective results can cause great internal friction, as those who had a great year while the organization overall stunk it up feel like they’ve been shortchanged (even though they benefit when the tables are turned).

At the other end of the spectrum, rewarding individuals without any connection to the organization’s success can lead to active (and potentially destructive) competition that restricts the flow of information, resources, and ideas.  When that occurs, you really don’t have an organization at all.

Therefore, firms often use a combination of organization and individual performance to determine incentive compensation.  There are many different ways to do so; what’s most important is being clear about why the structure is what it is — and how it delivers benefits for clients and fosters the desired firm culture.

Such clarity will lead professionals to make active decisions about whether to join, stay, or leave your firm, reinforcing not just the compensation scheme itself but the culture you are trying to create.

Managers are seen as experts, pacesetters, and mentors (rather than as administrators).

Generally this is true in the industry, as a common goal is to minimize “bureaucracy,” but it raises questions.  In a business that prizes performance and devalues training, successful investors are often promoted into roles for which they aren’t prepared.  They might be “experts” at their corner of investing, but may not see much beyond it.  As to being “pacesetters,” they often haven’t been involved in organizational initiatives, so their pacesetting may have consisted of some smart investment selections over time.  And their ability to capably serve as “mentors” varies widely.

This brings up important questions about cultivating leadership talent from within the investment ranks versus outside of them, a topic on which there are often strong opinions.  “What it takes to be a leader here” should be well understood by all concerned.

Putting clients first

In his article, Maister pointed to five examples of his ideal:  “investment bankers Goldman Sachs, management consultants McKinsey, accountants Arthur Andersen, compensation and benefits consultants Hewitt Associates, and lawyers Latham & Watkins.”

Almost four decades later, things have changed quite a bit.  All five were private partnerships at the time.  Latham & Watkins is still an independent entity, as is McKinsey, but Hewitt went public twenty years ago and was then acquired by Aon.  Goldman Sachs also became a public company and has expanded into many new business areas that were off limits historically.  Arthur Andersen collapsed after its work for Enron and WorldCom came to light.

One aspect of Maister’s analysis deserves comment in light of past events.  “The client comes first” and similarly-themed passages appear throughout the article.  But consider the messes that felled Arthur Andersen, and the ones that Goldman Sachs and McKinsey have found themselves mired in over the last two decades.  Putting clients ahead of ethics, sound due diligence, prudent risk management, and thoughtful growth have tarnished the reputations that Maister extolled.

The desire to do what the client wants can be problematic in asset management too.  Pressure from individual clients regarding underperforming holdings (or cheerleading regarding winning ones) can distort perceptions of risk and return — and affect decision processes, as can the procyclical inflows and outflows of capital from those clients.  They can also request one-off strategies or special access that wouldn’t otherwise be considered.  It’s not always smart to put the client first, even though it’s generally a sound rule.

Who makes those kinds of choices (and how they are made) should reflect a firm’s preferences for individual and collective action.  As is also true for the other matters mentioned above (and more), finding the sweet spot is important cultural work.

Published: July 7, 2022

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Behavior, Learning, Assumptions, and Sophisticated Guesswork

The Fortnightly is an eclectic look at ideas from around the ecosystem.  It’s part of the free tier for this site.  You can sign up for it — or dive into the deep pool of original content that a paid subscription offers — here.

On to the readings.

A focus on behavior

The 2022 edition of the annual Behavioral Economics Guide offers the typical wide range of articles.  One of the great questions for investment organizations is whether and how to adopt efforts to improve decision making behavior — in an industry that is famously “hands-off” in many respects, what kinds of structuring and nudging is warranted in the pursuit of better outcomes?

Here are some of the articles that might illuminate that question:

Partnership Between Data Science and Behavioural Economics

Using a Behavioural Lens to Manage Risk in the Financial Industry

How to Introduce Behavioral Science Into Organizations and Not Perish While Trying

Applying Behavioural Economics to Firms

Behavioral Incentives and Their Influence on Employee Performance

Other entries also offer important context, and there are additional resources as well, including a very good glossary of behavioral science concepts.

An investment organization of any size ought to be investigating these ideas.  Who is doing so in yours?

Learning the business

Brent Donnelly of Spectra Markets published “How to Succeed as a Sell Side Trader,” which offers thoughtful advice on finding your personal approach, becoming the “go-to expert” in your market, the franchise value that comes with certain jobs, being a team player, the importance of client service, and much more.

If you’re not a “trader,” don’t let that stop you from reading it.  Many of the ideas apply to other corners of the investment world.  Such as:  “A trader cheering for a position that’s moved aggressively their way is the most reliable trading indicator I have ever seen.”  That applies to analysts, portfolio managers, advisors, and allocators too; when the crowing starts, it’s a red flag.

(The piece also appears on Epsilon Theory, sans the two appendices:  “Steps toward becoming an expert in your currency” and “21 ways to succeed at trading and 13 ways to fail.”)

Also:

~ Twitter has become a source for threads on investment career recommendations.  Here are two from Brett Caughran:  for a new pod shop analyst and getting a hedge fund job.

~ For some basic career path information, 300 Hours offers summaries on investment research, portfolio management, investment banking, private equity, financial planning, corporate finance, and accounting.

~ Be careful when tinkering with shared models.

Private equity assumptions

From January to April, the capital market return assumptions for private equity published by BlackRock collapsed, dropping five percentage points on a five-year horizon, three on a fifteen-year horizon, and more than two on a thirty-year horizon.  In contrast, U.S. public equity return predictions showed little change across most horizons, and expectations actually went up for the shorter ones.

Discuss.

Paired articles

Here are some pieces that fit together thematically:

Data and research.  “Research & Alt Data: A Zero Sum Game” (Michael Mayhew, Integrity Research Associates) and “5 Key Takeaways from Unbundling Uncovered USA” (Mike Carrodus, Substantive Research) cover the dynamics at play and the impact on budgets for each.

Indexes.  Dueling headlines in the Financial Times:  “Index regulation is tricky but necessary” (by Alex Matturri, the former chief executive of S&P Dow Jones Indices) and “Worries about the dominance of big three index trackers are wrong” (from Charley Ellis, the founder of Greenwich Associates).

Ethics.  An Apple lawyer in “a role that involved managing the company’s compliance efforts to avoid employee insider trading” pled guilty to insider trading, while 49 EY employees cheated on CPA ethics exams.

Other reads

“Pension Funds Plunge Into Riskier Bets — Just as Markets Are Struggling,” Dion Rabouin and Heather Gillers, Wall Street Journal.

The funds can try to fill the gap by the politically difficult task of demanding more in yearly contributions from governments and from workers themselves, a move that often meets with pushback from public-employee unions.  Or they can adopt a potentially higher-yielding — but riskier — investment strategy.

“Collaboration Is a Key Skill. So Why Aren’t We Teaching It?” Deb Mashek, MIT Sloan Management Review.  “What is surprising . . . is how little professional development people reported receiving on how to build healthy and productive collaborative relationships at work.”

“Night Moves: Is the Overnight Drift the Grandmother of All Market Anomalies?” Victor Haghani, et. al, SSRN.  In contrast to institutions, retail investors tend to buy on the open and sell on the close, and:

Our research on the overnight effect in single name stocks suggests that the hypothesis of retail trading likely goes a long way toward explaining the phenomenon at both the level of the overall stock market, and that of individual stocks.

“New Business Boom and Bust: How Capitalism Experiments,” Michael Mauboussin and Dan Callahan, Counterpoint Global.  The entrance and exit of companies in a new industry.  (By the way, how do so many asset management firms manage to hang on?)

“Divergent Interests: Interest Rate Sensitivity in the Cross-Section of Stock Returns,” D.E. Shaw.

We believe that sector and style factor portfolios, as well as my commercial equity benchmarks, may have more active exposure to interest rates than many investors appreciate.

“When 9 is the Perfect Number,” Rusty O’Kelley, et. al, Harvard Law School Forum on Corporate Governance.  “To develop the most effective board possible, board leaders should look to assemble a group of directors who, as a collective group, always demonstrate seven behaviors,” and “without going to extremes that can be problematic,” display two other ones as well.

“Researchers Set Out to Determine How Much Endowments Invest With Diverse Managers.  Most Refused to Participate.” Jessica Hamlin, Institutional Investor.

Specifically, the research examines the extent to which the wealthiest 25 public and 25 private U.S. colleges and universities invest their endowment assets with firms owned by women and people of color.

“Activist Short Selling,” Market Sentiment.  A look at the performance of four of the short-sellers whose picks often move prices.  (You may be surprised.)

“Chaos is a Ladder,” Josh Brown, The Reformed Broker.

Everyone hates rules and regulations until it’s too late.

“Creating Visual Deliverables That Clearly Communicate Financial Planning Concepts,”  Nerd’s Eye View.  “Communication is one of the most important skills for a financial advisor.”  A look at learning styles, types of illustrations (by content and purpose), and resources to consider.

“Extroverts, Your Colleagues Wish You Would Just Shut Up and Listen,” Pamela Reynolds, Working Knowledge.

But there’s a down side to being the life of the party, according to new research:  People often assume their extroverted colleagues are poor listeners.

Sophisticated guesswork

“Private market valuations are set by a process of sophisticated guesswork based only partly on the value of comparable listed businesses.” — Kaye Wiggins.

Echo

It’s unusual, maybe even unheard of, for a company to be a “poster child” for excess in two different eras.  Perhaps bitcoin will rally to new heights and MicroStrategy will avoid that fate; founder Michael Saylor has bet the company on that eventuality.

The peaks in return for each cycle are synchronized here, showing that the dot-com-era ride was even wilder than the bitcoin one so far.  (The earlier heyday was followed by Saylor and others settling accounting fraud charges with the SEC.)

Postings

Recent pieces for paid subscribers:

“Performance Results and Measures of Greatness.”  This posting serves as a coda to the earlier series about Bill Gross and Pimco, focusing on evidence of performance and other factors that contributed to the legacy they produced.

“Switching Hats from Entrepreneur to Investor.”   Some of the personal qualities and decision making skills that lead business owners to success can work against them as they deploy their assets into other investments.

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

Published: July 4, 2022

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Switching Hats from Entrepreneur to Investor

A successful relationship between a client and her investment advisor starts with a meeting of the minds between the two — and there are a variety of hurdles that need to be cleared.

In most cases, there is an imbalance in investment knowledge that can be tough to reconcile.  Industry jargon is a barrier; even long-term clients might not really understand the terms that they hear a couple of times a year from their advisor.  Plus, the reports and emails that they receive more frequently than that from the advisor’s firm can be stuffed with lingo and concepts that aren’t exactly client-friendly.

Overall, the investment industry struggles with the problem of the curse of knowledge.  Certainly there are advisors and others who are expert translators of complex ideas into words that others can understand, but it is distressing how frequently investment professionals fail to mold their language to fit the readiness of their audience.

There are also issues of mindset and behavior to be bridged with clients, since the investment world is one in which seemingly logical choices can be counterproductive.

It’s common to divide clients into categories based upon their assets, but these issues transcend those distinctions.  For example, a posting from Jeff Bauer of Cambridge Associates, “While Great Entrepreneurs Leap, Great Investors Plan,” stresses that even clients who are considered to be successful and sophisticated might need to reorient their thinking.

Method and measures of success

Bauer uses a five-point “framework for investment success.”  The principles that likely made an entrepreneur thrive — “prioritizing short timeframes, divesting from underperformers, and anchoring to absolute performance metrics” — are a poor fit when it comes to investments.

Since “an entrepreneur’s instinct often is to invest in what is working best,” it feels natural to pick asset managers that are doing so at any point in time.  But that’s a losing strategy, not a winning one.

That said, to varying degrees, such an approach remains ingrained at most advisory firms (other than those that use passive exposures).  Very few can show a record of selection that isn’t dominated by procyclical behavior.

In fact, many advisory firms catering to ultra-high-net-worth clients market their access to the “very best” managers.  That framing makes it likely that they will be less patient with managers than they should be, since tension builds if performance disappoints and the premise (promise?) is called into question.  It’s easiest to move on to the next manager (also then promoted as being superb in every respect).

It is much harder work to educate clients about the unreliability of performance as an indicator of future results; to show them how frequently and for how long even the best managers can underpeform (as Bauer does); and to counsel patience, especially with a client that expects superior results:

Successful business owners are often stars in their fields.  Their businesses grew and amassed capital, turning performance goals into achievements, and achievements into future expectations.

Bauer argues that it is critical to get clients to avoid obsessing over the individual components of a portfolio and to understand how they all work together, but “the natural inclination to painstakingly analyze the performance of each individual line item can be hard to resist.”

Concentration

Entrepreneurs are used to having all or most of their eggs in one basket.  If they sell their business, they may be prone to concentrating the proceeds in relatively few other investments, even though the elements of information and control that they previously had are no longer available to them.  Even if they are investing in an industry that they know well, they are playing a quite different game than they had before.

In other cases, an entrepreneur may retain a significant ownership position but start diversifying into other investments.  That means addressing a series of questions about the relationship among those investments, what the overall risk exposures should be, and what “the vision for the portfolio” is.

The private realm

Private capital strategies are a natural area for investment by entrepreneurs.  Private equity and venture capital are appealing because the underlying companies can be reflective of the entrepreneur’s own journey.  Plus, they are viewed as sexy asset classes and have had strong performance (as shown by an eye-popping chart provided by Bauer, which ironically serves to whet the appetite to chase that performance despite the earlier caution about doing so).

The article stresses the importance of manager selection in private strategies, but it doesn’t adequately paint a picture of the risks overall.  The environment has been nearly perfect for private equity and venture capital, but there are plenty of reasons to believe that things will be much tougher going forward, even for those “very best” managers.

Bauer highlights some unique advantages for entrepreneurs in the private arena, given that their “industry knowledge, business acumen, and professional networks all can help to magnify an investor’s attractiveness to private investment GPs,” providing points of access and co-investment opportunities that might not be available to others.

Planning and executing

One of the sections of the posting is “Know and Account for Your Limitations.”  Bauer writes that “delegating wealth management responsibilities can be a less intuitive and more challenging proposition” for someone experienced in finding and leveraging good people in the course of their business.  There are a wide range of experts and firms who can be tapped, and they are adept at marketing their wares (and especially interested in gaining new clients with sizable assets).  Sorting through them can be time consuming and difficult.

Bauer ends with an echo of his title:

As owners consider how best to invest their hard-earned capital, they should recognize that, while great entrepreneurs may leap, great investors plan.

He lays out the components of a “family enterprise review” to provide the foundation for “building, maintaining, and enhancing a large, diversified investment portfolio over time.”  Even in summary form, there is a lot there, all of it preceding the “policy setting” that will guide investment going forward.

As one of the concluding paragraphs indicates, all of this represents a departure in approach for many entrepreneurs:

Creating and maximizing a business enterprise’s potential involves different attitudes, behaviors, and skills than are required to realize an investment portfolio’s full potential.  Certainly, both successful business leadership and portfolio management depend on many similar traits, including conviction, expertise, hard work, and teamwork.  But to be successful as an investor over the long run also can require some fundamental adjustments in mindset and direction.

Published: June 30, 2022

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Performance Results and Measures of Greatness

This posting serves as a coda to the earlier series about The Bond King, a book by Mary Childs about Bill Gross and Pimco.  The previous chapters:

“Cult and Culture in the Bond Kingdom.”  The key personalities and organizational dynamics.

“Hunting for Edges that Others Didn’t See.”  Tools, tactics, and structural alpha.

“Challenges and Quandaries in Manager Research.”  Questions for manager research analysts based upon the Gross/Pimco story.

Performance

Any discussion of the performance of a fund involves complications, but let’s start with a simple chart of Pimco Total Return since its inception:

The return in the top panel is the relative performance of the institutional shares (PTTRX), which have been in existence the longest.  At the bottom are the total assets across all share classes.

Gross managed the fund from its beginning until that vertical line signaling his departure.  As you can see, the performance and assets were mostly up and to the right.

Some of the zigs and zags in the lines are illuminated by the happenings described in Childs’s book, particularly the strong performance (and growth in assets) coming out of the financial crisis — and the noticeably sharp bout of underperformance during 2011.

That was attributable to a significant, misguided bet against Treasuries. As was his style, Gross had widely promoted it.  But, wrote Childs, “Five months after he made it, Gross’s bold call was publicly, exceptionally wrong.”

Among the complications when considering performance is what the benchmark ought to be.  A long-standing issue with many of the leading bond funds is that they didn’t match up very well with the Bloomberg Aggregate (and its variously-named predecessors), yet it is the standard by which they have been measured.  The funds took on more risk than the index — by overweighting certain areas and investing in vehicles that weren’t in the index — which paid off given the bond-friendly environment that lasted for decades.

Notions of alpha

In 2019, Richard Dewey and Aaron Brown published a paper entitled “Bill Gross’ Alpha: The King Versus the Oracle.”  The “oracle” referenced in the subtitle was Warren Buffett.

The authors explained that determining the alpha delivered by Gross is different than doing so for an equity portfolio, because “fixed-income securities have much higher correlations with each other than equities, [making] alpha 4.5 times as hard to measure for Gross than Buffett.”

Using the Bloomberg Credit Index rather than the Aggregate, they found that Total Return “generated 1.33% per year of alpha, with a t-statistic of 3.76” during the time Gross managed it, although analyses by others show less robust results.

The paper is worth reading for its general points about the difficulties of judging alpha when it comes to bond portfolios.  For starters, the publicly-available information on portfolio holdings is usually incomplete.  Furthermore, the attributes of an index of bonds change over time in ways that stock indexes don’t — and the prices used (for an index and for a portfolio to be judged against it) “necessarily contain a mix of opinion and observation of arms-length transactions.”

Gross to Janus

After leaving Pimco just before he was pushed out, Gross moved to Janus to manage an unconstrained fund that had been started just four months before.  Here’s that fund (shown in a similar fashion to the chart above; it is now named the Janus Henderson Absolute Return Income Opportunities Fund):

The good performance did not carry over to his new firm, at least in terms of this benchmark comparison.  Gross did attract some assets, although the Wall Street Journal reported that half of the $1.4 billion of assets in the fund after Gross had been at the helm for a year were his own.  The underperformance of the fund in 2018 triggered strong outflows, and Gross retired for good in February of 2019.

The Total Return ETF

It was big news in 2012 when Pimco started an ETF with the same strategy as its widely-popular Total Return mutual fund.  (The original ticker, TRXT, was changed to the more iconic BOND after a month, and the Total Return name was changed to Active Bond in 2017.)  An interesting part of the book details the desire to have the ETF come out of the gate quickly.

This chart shows how successful the tactics were (there is more on that in the second posting in this series) by plotting the relative performance versus AGG (its natural competitor as the ETF that tracks its index) and the two main classes of the mutual fund.  After the sharp early rise, BOND has had minor changes versus each of them from then until now.

Gross in his own words

The monthly “Investment Outlook” pieces by Gross that drew so much attention from market participants have been removed by Pimco and Janus, but he has made many of them available online.  He has also written a book, which he rushed out shortly before The Bond King was published.

An article, “Consistent Alpha Generation through Structure,” was written by Gross for the Financial Analysts Journal in 2005.  While the phrase “structural alpha” didn’t appear within it, he detailed some of the elements of that concept.

They included “the use of financial futures or future-related investments and the successful placement of the residual cash into higher-yielding, slightly longer-dated investments,” which could add “20 bps a year without even breathing hard.”  Additionally, there were various categories of “selling of unlevered volatility,” including a greater use of mortgages (capturing the mispricing of the prepayment options embedded within them; 10 bps a year), options on Treasury futures and swaps (5-10 bps), and overweighting the front end of the yield curve versus an index (the value added from that was not specified).

At the root of those structural opportunities was that there are market participants who,

because of their inherent character or the role they play, provide profits to structural investors taking the other side of the bet.

Measures of greatness

Gross built Pimco and managed its lead portfolio during an unusual time in the markets.  The environment for bonds was benign, except early on in Gross’s career, before the Total Return Fund came into existence.  So was he a product of the times or a unique talent?

Both.

An important reminder, however, is that despite the fact that Gross is seen as the owner of the track record, the returns were the product of an organization, not one person.  The results at Janus may be evidence of what happens when you take the man out of the ecosystem.

That said, it in no way diminishes his accomplishments.  In their paper cited earlier, Richard Dewey and Aaron Brown said this of Gross:

He acquired investors and leverage, he ran his fund efficiently, he stuck with his high-risk principles even when they were going through bad periods, and he communicated so that his investors not only stuck with him, but gave him the funds to build the largest bond fund in the world.

Along the way, he and his firm changed how markets and the investment industry were structured, as others adopted the methods they pioneered.

That’s quite a legacy.  The Bond King is an important book, because it goes behind the scenes at Pimco, revealing plenty of drama even as it prompts questions for the asset managers of tomorrow (and those who evaluate them) regarding the best ways to build portfolios and organizations that succeed.

Published: June 25, 2022

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Sorting the Drivers of Return from the Palpable Nonsense

Welcome to the Fortnightly, a good source for thoughtful commentary from throughout the ecosystem.  (Subscribe.)

Fundamental return attribution

The Thinking Ahead Institute (of Willis Towers Watson) has released research on “fundamental return attribution.”  (The link connects to a short video describing the idea, the paper, and open-source code for use in calculation.)  The goal of the approach is to separate:

Returns arising from changes in market sentiment (multiple return), the growth of the portfolio’s fundamental characteristics (growth return) and the change in those fundamental characteristics due to changes in the portfolio’s holdings (activity return).

Underpinning this framework is an assumption that the objective is to own a portfolio (a) with the largest possible current intrinsic value and/or (b) with the largest possible expected future growth in that intrinsic value.

According to the video, the goal is to “push all of the noise [of market pricing] into the market multiple piece, which leaves us with a useful signal.”

But how to arrive at good estimates of intrinsic value, a necessary first step?

Intrinsic value is, of course, unobservable and often highly subjective.  That said, are there observable measures that might be used to approximate it?  For example, is revenue the most meaningful proxy?  Or earnings?  Or book value?  What about intangible assets?  There is no perfect answer.

One possibility:

Some asset managers make an explicit forecast of intrinsic value as part of their investment process.  In this case these estimates of intrinsic value could form the basis of the analysis.  This should enable more meaningful communication between an asset owner and asset manager over time.

Such conversations should occur as a matter of course, but it’s not much of a solution, since the assessments of intrinsic value from managers are subject to bias as well as the normal imprecision.

The framework is an interesting idea worthy of further pursuit.  It’s timely, coming on the heels of a period when market sentiment drove certain kinds of stocks (and the returns of certain kinds of managers) to new heights.  Much of that is now being unwound, reinforcing the point that it’s necessary to separate out the impermanent drivers of performance from the true underlying levers of value.

On that topic, here’s a thought from Joe Wiggins:

In the years before the stark rotation in markets, I noticed a fund manager frequently posting on social media about the stellar returns that they had generated.  Their approach was in the sweet spot of the time — companies with strong growth and quality characteristics, often with a technology element — but this was never cited as a cause of the success.  Instead, the focus was on how their process and sheer hard work had directly resulted in consistent outperformance over short time periods.  They were simply doing it better than other people.

This was palpable nonsense.

A difficult environment

Bridgewater released a paper, “Building a Beta Portfolio in an Environment That Looks Difficult for Assets.”  An image provides the essence of the problem covered:The really scary parts are in a section with a long and foreboding heading:  “The Risk of Stagflation Is Growing; That Tends to Be the Worst Environment for Most Portfolios and the One Where the Benefit of Balance Is Greatest.”  Bridgewater judges “the pressure for stagflation relative to market discounting to be the highest it’s been in about 100 years.”

Consequently, “the current environment calls for diversification in all forms,” but “the relationships between assets are changing.”  Therefore, balance is recommended, since, “for most investors, not holding assets is not an option.”  Plenty of charts are included.

1958?

Investors are always using the events of previous market years as analogies, but usually it’s 1987 or 2008 or the like.  When was the last time someone pulled out 1958 for a comparison like that?

The Office of Financial Research does so in “Treasury Market Stress: Lessons from 1958 and Today,” a brief that highlights that

many of the vulnerabilities present in recent episodes of Treasury market illiquidity have parallels in a similar episode of stress in 1958.

Namely,

a high level of outstanding debt, dealers overloaded with Treasury securities, large positions (sometimes with minimal haircuts) funded using leverage in the repo market, a prevalence of carry trades, and sudden increases in margins.

Also, check out the government securities dealers of 1958 in comparison to the primary dealers of today.  There is a much different market structure now (that includes a much greater complexity of market players beyond the dealers), but maybe there’s some of that rhyming history in the analogy.

Other reads

“The Long View: Investing in the Future,” Baillie Gifford.  A first annual collection, including Moore’s Law (still going), networks, circular economies, and innovation.

“Diverse Manager Investing: Shining a Light on Potential Blind Spots,” GCM Grosvenor.  “We are finding that, as LPs integrate diversity into their investment programs and into their firms, they are faced with a set of new challenges, or ‘blind spots.’ ”

“How to spot strong company management,” James Henderson, Financial Times.

Finally, we recognise that everyone makes mistakes. We do not expect a completely faultless record — but we look for honesty and timeliness when it comes to admitting mistakes.

We find that those who are most upfront about their missteps tend to rectify them more successfully than those who try to ignore or hide problems.

“The Use of Short Selling to Achieve ESG Goals,” Managed Funds Association.  “Short-selling companies with large carbon footprints has the advantage of helping investors reduce their climate risk while also expressing their sustainability goals and values.”

“Crypto Hedge Funds — Where is the Value?” Markov Processes International.

What have the best funds done differently — and how certain is it that these methods will work in a shifting crypto market?  Is the difference between the top and bottom funds just coming down to their exposures to specific coins, as in the Terra (LUNA) collapse?

“Why it’s better to be a small investor,” Marcus Padley, Firstlinks.  Comparing advantages and disadvantages of being small versus being in the institutional “smart money” crowd.

“Down Rounds: Deal With Reality,” Brad Feld.  Given the pressure in VC land, there will be all kinds of financing options presented; beware those “structures”:

Rather, when you have a choice between a financing at a lower valuation and a financing with all kinds of crazy structure to try to maintain a previous valuation, negotiate the best price you can but do a clean financing with no structure.

“The Academic Failure to Understand Rebalancing,” Michael Edesess, Portfolio for the Future.  “The choice of rebalancing as an investment discipline as compared with an alternative such as buy-and-hold is simply a risk-return tradeoff — though one that is a little more subtle than most.”

“US Earnings: Do CEOs or Analysts Know Better?” Man Group.  The “remarkable resilience” in earnings forecasts from analysts is in “stark contrast” to the tone from corporate leaders.

“Why Perfectionism Ruins Portfolios,” Adam Collins, Eversight Wealth.

Past performance and well-timed presentations only create the illusion of certainty about the future.  Instead of a crystal ball, investment marketing is closer in nature to old-school advertising:

~ Cherry-picked data?  Check.

~ Suggestion of future benefits?  Check.

~ Lack of long-term evidence?  Check!

All about the questions

“It’s not the answers that make you good in this business, it’s the questions you ask.”  — Michael Price.

Outline of an era

Thirty-nine years ago today, the editor of this publication started working for one of the largest asset management organizations in the country.  This picture is the best summary of the era that ensued.

Driven by disinflation, globalization, demographics, and the internet, interest rates stayed on a downward trajectory throughout, with each new peak lower than the last one.  The Federal Reserve was slow to raise short-term rates and quick to drop them, arguably fostering the speculative environment for each new cycle — and engineering a much higher valuation structure across investment assets than has existed before.

The Fed is now facing an economic environment unlike any other during this entire period.  But old habits are hard to break.

Postings

A previous posting, “The Goal of Explanatory Depth,” was brought out from behind the paywall via the Sampler category, so it is now open to all.  Here’s the theme:

There is no way to “get it all” when doing due diligence. There will always be gaps in information. It is important to acknowledge them, and to avoid passing the narrative of others along as your own point of view.

Recent pieces for paid subscribers:

“Down and Dirty Due Diligence.”  Two articles from more than twenty years ago offer tactics for those doing due diligence that are just as important as they were then (and yet are still somewhat rare).

“13F Filings.”  The 13F disclosure rules have spawned infrastructure in the ecosystem and quarterly accounts about manager moves. Some quick takes on the rules, copycatting, and research on performance.

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

Published: June 20, 2022

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Four for Friday ~ 13F Filings

Forty-five days after the end of each calendar quarter, the holdings of entities subject to Section 13(f) of the Securities Exchange Act of 1934 have their holdings reported to the public, which they had submitted on Form 13F.  (Sources differ on using 13f or 13F, for the rule and the form; when quoted, they are provided as found, and 13F is otherwise used generically.)

In response to the reports, there are stories in the financial press about who did what during the previous quarter.  At the same time, a number of market players spring into action, including database and data analytics firms that track and parse the information, replicators who try to match the profiles of leading investors, quant firms who ingest the information into their models for individual stocks, and competitors of the reporting firms, who look for ideas to investigate.

Therefore, it is a good example of how a single rule can spawn all sorts of structures and activities throughout the ecosystem.  Future changes in the rule are likely — some prompted by the lack of disclosure of the large positions at Archegos in advance of its blowup — creating ripple effects.  (As a “Four for Friday” posting, this is not an in-depth look at the implications, but a survey of a few ideas and readings for your consideration.)

A good place to start

David Kwon, a PhD candidate at Yale, has posted an update of his dissertation on SSRN, “The Differential Effects of the 13f Disclosure Rule on Institutional Investors.”  It is long and thorough.  The first half delves deeply into the rule and the various entities and portfolio holdings to which it does and doesn’t apply.

Because “the degree of portfolio transparency varies both across and within institution categories” (only about 15% of institutional assets are reported), “the 13f rule creates a discriminatory environment where institutions of similar size, similar type, and facing the same economic exposure can face differential disclosure treatment.”

The abstract leads with the main research question, analyzed in the second half:

The 13f rule, which requires institutions to disclose mainly stock investments, has recently generated significant debate about disclosure costs.  Some have expressed concern that copycatting (and frontrunning) activities from outside investors can harm disclosing investors’ returns, while others argue that copycatting is non-existent due to the 13f reporting delay, and that even if copycatting did exist, it would benefit disclosing investors’ returns.  Do copycats harm disclosing investors?

Kwon’s conclusion is that

the likely source of the confusion as to whether disclosure is costly is the fact that copycatting activities can either be beneficial or harmful to copied investors’ returns over time, depending on the ownership horizon of the copied investor.

Coupled with the differential reporting requirements,

the 13f rule is likely disincentivizing long-term investments in public stocks in favor of short-term investments in stocks as well as investments in instruments that are not disclosed on 13fs.

The dissertation is full of interesting exhibits, and serves as a useful introduction to the topic, a general reference work on it, and research specific to the question of copycatting.

Other research

There have been many analyses of the investment strategies related to disclosures (and non-disclosures) in response to the 13F rule.

The authors of the paper “Systematic 13F Hedge Fund Alpha” studied a Novus database that identified hedge funds that had demonstrated “a longer-term view on equity.”  Therefore, the funds analyzed represented a subset of a subset of organizations that are subject to the rule.

Their approach focuses on assessments of conviction and consensus, and shows “economically meaningful and statistically significant risk-adjusted returns.”  However, the conclusion offered illustrates that there’s a marketing angle involved, something common in practitioner-based research:

Thus, we show that in constructing a 13F strategy, one must think about the ‘who’ just as much as the ‘how’ to be able to systematically extract statistically significant hedge fund alpha in a point-in-time way.  This, however, relies strongly on being able to identify the ‘who’ accurately, which is difficult to do without a reliable data provider.

The paper references the approach of “Best Ideas,” research from Miguel Anton, et. al, first published in 2009 and updated thereafter, most recently last year.  They argued that the “conviction” holdings of institutional investors do the heavy lifting in performance terms, and concluded that “the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers.”

One interesting angle regarding the 13F rule is the ability for filers to request “confidential treatment,” delaying disclosure.  An article by Vikas Agarwal, et. al, in the Journal of Finance (and the earlier working paper) showed that “the evidence supports private information and the associated price impact as the dominant motives for confidentiality.”

Tiger Cubs

Over time, the so-called Tiger Cubs have been the subject of many press accounts based upon their quarterly 13F filings (even though as they have gotten more deeply involved in private investing, the reported holdings account for a smaller percentage of assets under management).

Up until six months ago, the coverage was glowing — for example, in a 2019 piece from WhaleWisdom Alpha.  The aforementioned Novus includes an aggregation of the Cubs on its data platform (in addition to tracking them individually); this posting from it looks at how the Cubs did during the first part of the pandemic.  The story includes a link to the platform which shows attributes of the group through the end of 2021.

Things have changed completely in 2022.  Now the quarterly filings are fodder of a different kind, as a May story from Bloomberg indicates:  “Tiger Cubs Ditched Tech Losers, Buying Others That Did Worse.”  Two days ago, the 13F holdings in Carvana were used to show one of Tiger Global’s biggest failures of late:

Beware “performance” claims

Because of all of the things that are left out, don’t mistake the information gleaned from 13F filings as performance, says David Spaulding in an issue of his firm’s “Performance Perspectives.”  Reporting holdings is not reporting performance — and many of the stories you read may offer numbers and conclusions that are off base.

Published: June 17, 2022

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Down and Dirty Due Diligence

The title for this posting comes from two articles in the Journal of Private Equity, the first appearing in 1998 and the second in 2001.  They were written by a pseudonymous author, Allan Smithee (paying homage to those in the film industry who had used similar names).

Private equity and the investment world in general have changed markedly in the last quarter century, but the articles are a reminder that patterns repeat, especially those involving human behavior (and therefore organizational behavior and investor behavior).

Smithee described his approach in the 1998 piece:

I don’t carry a badge or a gun.  I carry an unhealthy dose of cynicism.

I treat everything as a hair-brained scheme that must be proven otherwise.  I trust no one’s convictions to be honest or competent.  Credentials mean nothing.  Facts?  What facts?  Faulty misguided assumptions are masquerading as facts.

The examples that he provided were regarding company due diligence of the kind that is done for private equity (and venture capital, etc.), but the lessons apply to the investigation of asset managers as well.  Being “boondoggled by [an] orchestrated demo” of a new product is similar to being boondoggled by a pretty summary of an unpretty investment process — or by a theatrical investment committee meeting without the true theater that can play out within a real one.

Smithee wrote of the president of a firm who “had crossed the Rubicon of objectivity” regarding its prospects, noting that “sometimes the will to believe becomes the belief itself.”  The same thing can happen to those charged with doing due diligence.  One of his lessons to avoid the slippery slope of belief:

Never, ever be intimidated by anyone, anywhere, anytime.  Never be so intimidated by someone’s credentials and convictions that you fail to question and verify their claims.  Respect everyone, be intimidated by no one.

Another:  “Don’t let anything pass by your eyes and ears that doesn’t make sense.”  Instead, you need to “look for the loose thread and yank it.”  You don’t know what’s going to matter, so you should “challenge everything that doesn’t fit.”  Those whom you question:

will either learn to tell you the truth, decide there are dumber investors available and quit talking to you, or you will decide there are more intelligent, honest managers and quit talking to them.

Columbo on the case

Smithee used the TV detective Columbo to suggest effective ways to approach interviewing, writing that “little is served by presenting a capable image.”  Columbo turned his unassuming manner, frumpy appearance, and willingness to appear confused into assets.

The subjects of due diligence are more knowledgeable about technical matters than those doing the investigations, so it’s a mistake to try to impress them in meetings:

If I went into a project with a big head, I might worry about looking stupid by questioning a fundamental fact or asking for a down-to-earth explanation that everyone else might see as obvious or trite.  I might want to avoid potential embarrassment.  But, I am not going to the target company to show the managers how smart and successful I am.

There is no reason to tell them much, if anything, about my own credentials and experience.  There is no reason to present a capable image in either dress or speech.

In my experience, the exact opposite image can be useful.  If you appear helpless and confused, it is amazing how much people will want to help you.

Tactics

The first article closed with ten “down and dirty tactics” for onsite visits.  Here are a few of them.

Smithee said that you shouldn’t challenge “the honchos” in an initial meeting (although that may not be the best approach in situations where there won’t be a series of such meetings).  His rationale:  “Feeding their ego will make them feel comfortable and will increase your access.  Get out of the executive suite silently skeptical and talk to the staff.  They know what is really doing on.”

He repeatedly stressed the importance of interacting with the staff:

Why is it that employees say the darndest things?  Why would they tell you something that is not in the best interest of their company?  Lots of reasons:

~ They may not know what management has told you.

~ They may assume you have already been told.

~ They haven’t been coached on what to say, how to say it, or what data to provide.

~ No one may have asked for their opinion before, including management.  Now they have someone to talk to, and you’re the lucky one.

~ They may assume it is a done deal, so why shouldn’t they talk to you?

~ They want to get off on the right foot with the new owner.

While the last couple apply to situations where a change in control is the endpoint of the due diligence work, the broader principle applies in any situation.  The best information often comes from those who aren’t on the interview lists of due diligence analysts.

When evaluating an operating company, you should “speak with the engineers and technical people.  They don’t know how to lie, they’re too analytical.”  (And they are not fluent in the narrative.)

Like Columbo, you should “make the fog your best friend”:

Never tell anyone you are skeptical and doubting.  Explain it as confusion.  “I’m way over my head on this assignment.  Sorry, I’m such a bother.  I really appreciate your patience with me.”  People will try to help you.  Give them enough rope to hang themselves.

Narrative framing

As in his first article, Smithee’s second piece used examples (with fake names) of due diligence projects that he had worked on.  Many emphasized the narrative-creation activities of those he investigated.  In one case, he was impressed with the initial information he saw, “even allowing for investment banker-inspired spin and presentation mastery” — a discount that should always be applied to those carefully crafted narratives.

He wrote that investment bankers “have several functions”:

~ To keep you focused on the trees rather than the forest (or vice versa, if need be).

~ To keep you from getting too close to reality by presenting you with pretty, edited, and slanted information bundled in a way that’s a real task to untangle.

~ To control where you go and who you see.

~ To keep you away from people who might slip up and give you the real story.

~ To eliminate impromptu questions and answers.

Some asset management firms are experts at doing the same sorts of things; evaluating the degree to which those barriers are being erected and creating strategies to break through them are fundamental skills in due diligence.

Also, he stressed avoiding the written-questions trap:

I hate putting questions in writing because it gives the respondent too much time to spin a fudged answer.  It allows the seller the opportunity to get everyone on board as to what the story is.  Getting one-on-one with the target managers and asking the same questions of each [doesn’t happen in a group meeting].  The one who had the best spiel would offer an answer and no one else would say anything contradictory.

Other lessons

“Feigned stupidity, which I talked about so much in my first article, goes only so far.”  Eventually, you have to be willing to press the issues, to ask the uncomfortable questions, and to make sure that you get all of the information that you have been promised.

“Don’t let others manage the process, but it’s OK if they think they are.”  This is one of the most-violated precepts in due diligence practice.  Those to be evaluated should never control the agenda.

“Don’t be shy of walking away.”  This should be a bedrock principle, although walking away from a business deal is easier than walking away from a meeting with an investment manager that your firm expects to cover for years to come.

Due diligence analysts can benefit from investment knowledge and technical expertise, but they are hollow without the kind of mindset and tactics that Smithee espouses.  (That’s why the Investment Ecosystem Academy due diligence course and customized training for organizations take a similar approach — and identify important topics where an analyst’s expertise can exceed that of the people being interviewed.)

Published: June 13, 2022

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Crypto, Valuation Uncertainty, and the End of Free Money

In upcoming months, paid subscribers will receive postings that focus on the future of work in the investment world.  Changes in technology, demographics, and employee preferences will transform every organization.  New practices will be needed to compete effectively.

The postings will examine the implications of those changes and provide ideas that will help you to navigate them.  The content on the site won’t be exclusively devoted to related topics; it will be interspersed with the broad range of material that readers have come to expect.

(If you’re not a paid subscriber already, please consider a monthly and yearly plan.  It’s a small price to pay given the importance of your mission.)

Meanwhile, our “interesting times” continue in the markets, as reflected in this edition’s readings.

Crypto questions

Campbell Harvey is the lead author (with six others) of “An Investor’s Guide to Crypto,” a report which provides a tidy overview of the major investment considerations regarding cryptocurrencies.

They divide the “investible universe” into six categories.  (So-called stablecoins were left out, for reasons explained; the paper appears to have been completed prior to the Terra/Luna lunacy during May.)

A section titled “The Challenges of Valuing Crypotocurrencies” examines “some popular approaches to valuing cryptocurrencies such as bitcoin.  None of these approaches are satisfactory.”  They include Metcalfe’s Law, Bitcoin as “digital gold,” value in relationship to mining cost, a flow-versus-stock analysis, and relative value approaches.

The next part looks at performance and risk characteristics — and how crypto might be used in a portfolio.  The lack of historical data is a problem, but some conclusions can be drawn, including that

in normal times bitcoin has limited correlation to other assets often used as multi-asset portfolio building blocks.  However, as we move further into the left tail of the return distribution, the correlation with some of the naturally riskier assets rises dramatically.

One odd aspect of it all is that custodial and regulatory issues are backwards from those for most alternative investments:  “For cryptocurrencies . . . retail investors have easy access, and it is professional asset managers that face substantial hurdles.”

Elsewhere:

PGIM has released a white paper, “Cryptocurrency Investing: Powerful Diversifier or Portfolio Kryptonite?”  It sees “no compelling case for direct ownership of cryptocurrencies as a meaningful share of an institutional portfolio,” but argues that “there are attractive institutional investment opportunities in the broader crypto ecosystem.”

A paper on “How the Cryptocurrency Market is Connected to the Financial Market.”

In a New Yorker column, John Cassidy wrote that “ever since big money got in on the crypto game — venture-capital firms, hedge funds, and, lately, some of the big Wall Street banks themselves — there has been a great deal of expensively produced puffery and flimflam surrounding the entire industry.”

Valuation uncertainty

Everyone’s trying to figure out valuation and how much overshoot might have occurred during the last few years.

“Are Stocks Undervalued Yet?” asks the Wall Street Journal.  The article by Mark Hulbert has this conclusion for a subhead:  “Eight valuation models suggest that even after recent declines, the stock market isn’t a good value.”  Seven of them are just 2-16% off of their historic highs; the lone exception, P/E ratio, is around 60%, but that benefits from margins that are, yes, historically high themselves.

(One of the models is the “Buffett indicator.”  A recent study corroborates that it “explains a large fraction of ten-year return variation for the majority of countries outside the United States.”)

A different view is put forth by Dave Sekera of Morningstar, who thinks that stocks “are trading at a rarely seen discount.”  The firm has a disciplined process that focuses on price-to-fair-value, a much better approach than using target prices.  Here’s some history of that measure:

The big question is whether the Morningstar analysts’ fair-value models have unrealistic expectations about margins, growth rates, and discount rates given a much different macro landscape now than has been seen in a very long time.

In the realm of private assets, where valuation marks are a quarterly affair, it’s not so much a question of whether today’s price is a good one but what today’s price should be.

Jeffrey Diehl of Adams Street published a posting on “The Impact of Public Market Dislocations on Private Markets.”  He put a stake in the ground regarding valuation:  “Based on what we have seen in past market cycles, we estimate our private holdings will likely decline by about 60% of the fall in public markets.”  (Since most down moves have been short, the quarterly marks never quite catch up.  A lengthier retrenchment might show a different pattern.)

Compare that to a Bloomberg article about D1 Capital Partners, which said that its public securities holdings were down 44% so far this year, while its private ones were only off 8%.  It feels like there are a lot of shoes yet to drop.

Free money

The legendary venture capital firm Sequoia put together a presentation for the founders of its portfolio companies titled “Adapting to Endure.”  It captures the abrupt change in attitude that is reflected in valuation uncertainty in VC land and real cutbacks among the unicorn crowd and those that thought they were on track for that status.

The message is clear; “the removal of free money” changes the calculus.  (Cue a song from a stagflationary era long ago.)

Other reads

“Diversity Matters: The Role of Gender Diversity on US Active Equity Fund Performance,” Stephen Lawrence, SSRN.

Maximizing gender diversity in active equity investment teams correlates with as much as a 38.9 basis point improvement in fund performance after controlling for characteristics of the fund and its investments as well as other dimensions of diversity.

Quality and diversity of education are strong indicators of fund outperformance but cannot explain the unique benefit that gender diversity brings to a team.

“Everything old is new again: The FT reports EY may spin off its audit arm,” Francine McKenna, The Dig.  “We’ve seen this song and dance before,” says the subtitle.  “Wanna bet which entity gets out from under all the bad vibes of Wirecard, Luckin, NMC, and all the independence issues pending at EY US?”

“Bull Market Rhymes,” Howard Marks, Oaktree.

Does it really matter whether the S&P 500 is down 19.9% or 20.1%?  I prefer the old-school definition of a bear market: nerve-racking.

“Growth Traps Snap Shut,” Ben Inker, GMO.  A “quick refresher” on the less-talked-about cousins of value traps, which includes this chart of how far expectations got out of whack this cycle:

“A Pension Fund That Lost Billions in Allianz Funds’ Collapse Is Now Pointing Fingers,” David Voreacos and Neil Weinberg, Bloomberg.  An asset owner and a consulting firm argue about who didn’t fulfill their duties regarding a very large, disastrous bet.

“Understanding,” Tim Quast, Modern IR.  “The sellside is so yesterday.”  Today, investor relations professionals need to “go where the money is, by becoming what it wants.”

“Bond trading 3.0,” Robin Wigglesworth, Financial Times.

Fixed income is now in one of those classic flywheels beloved by consultancies, where more electronic trading begets more adoption, liquidity and innovation, and in turn even more electronic trading.

“Value Investing Is Not All About Tech,” Cliff Asness, AQR.  “Perhaps not surprising, when investors are willing to pay a relative ton for the ‘hot’ industries, they are also in the mood to pay a relative ton for the ‘hot’ companies within each industry.”

“Asset Managers Say Your DDQ is 50%+ Duplicative,” Castle Hall.

At present, we have a smorgasbord of different questionnaires and templates by asset class which materially hinders efforts to create a consistent diligence process for all plan assets.

“Private Equity Headhunters: Pathway Providers or Unethical Gatekeepers?” Brian DeChesare, Mergers & Inquisitions.  Tips on navigating the hiring process.

Powers of selection

“In a world that changes more swiftly than we can perceive there is always the danger that our powers of selection will be mistaken and that the vision we serve will come to nothing.” — John Cheever.  (He was referring to fiction, but it applies to our business of uncertainty as well.)

Slashed expectations

Shopify is one of those stocks that had extraordinary gains which is now deep down the back side of the mountain.  The top panel shows the stock price, as well as the consensus target price.  From the peak, the stock is down 78%.  The bottom panel shows the sharp rise and fall of earnings expectations.

All of that makes for interesting timing for a shareholder vote on whether to preserve Shopify founder Tobi Lutke’s voting power.  Advisory firms ISS and Glass Lewis are opposed, and CalPERS is voting against the proposal; Bloomberg has the story.

Postings

Here are links to three postings of late.  The first is a long-form look at one of the most important topics there is:

“Revisiting Beliefs about Private Equity.”  Despite the popularity of private equity, beliefs about its performance attributes vary dramatically, while the investment characteristics of the holdings are much different than in the past.  That calls for a reassessment.

The other two are the first of a new format called “Four for Friday,” which feature several angles on a theme.

“More on Private Equity” was a natural follow-on to the piece above, including items on certainty versus uncertainty, access and analysis, the impact of a large class of investors, and PE investments in RIAs.

“The Role of Sell-Side Analysts” covered a famous phrase — “Great quarter, guys” — plus robot analysts, non-deal roadshows, and the mix of “investing” and “the game” in sell-side roles.

Follow us on Twitter to see the Charts of the Day, which range from investment strategies (like the Freedom 100 Emerging Markets) to individual securities (what a move in this energy bond) to asset classes (how long did it take for stocks to out-return corporate bonds?).

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

Published: June 6, 2022

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