Regime Change (With a Lack of Information)

Two days ago, Bloomberg published this chart within the article, “Bank Stocks Unravel in Worst Rout Since 2020 Amid Economic Woes”:

This text appeared above it:

For some investors and analysts, the slump in bank stocks is particularly confounding as the surge in U.S. Treasury yields, something that would typically help boost shares, is having limited effect.  In fact, while the 10-year Treasury yield is sitting near its highest level since 2018, its 40-day correlation with banking stocks has become the most inverted in three and a half years.

“Banks are historically strongly correlated to bond yields direction, but due to recent growth concerns have opened up a gap with yields,” JPMorgan Chase & Co. strategists including Mislav Matejka wrote in a note.

Here’s a longer look:

Context is everything.  You might draw a different conclusion from this chart than from the previous one.

Furthermore, if we really are at a pivot point of regime change, going back to late 1989 is insufficient.  But that’s all of the history there is on Bloomberg (presumably backfilled from the inception of GICs in 1999).  What did this relationship look like in the seventies?

We’re seeing a lot of correlation charts that involve fixed income these days, and much commentary about them.  At times confusingly so, since some are crafted to show the relationship with interest rates, while others use fixed income returns (producing opposite results).  Without proper context, even professionals can get turned around, to say nothing of lay people.

How about growth versus value?  Here’s the available history on Bloomberg for the Wilshire indexes:

The first thing you’re likely to notice is that extraordinary move during the dot-com boom (and bust).  Then look at the difference in the growth and value relationship by size; quite amazing.

This time we have forty years of data.  What conclusions can we draw?  Should we draw?  Will we draw?

Here’s the big enchilada — inflation and rates — again going back as far as is available (the generic ten-year is the governor of the time horizon here):

As is well advertised across the ecosystem of late, we’ve been in a one-way move in bonds for four decades.  The super-high inflation back then turned to disinflation, propelling a steady move lower in rates.  Now we have that unpleasant spike in inflation at the end — and lots of questions.

Considerations

Given the incredible size and complexity of the modern investment endeavor, we have to continually remind ourselves that we’ve been living in one regime for a long time, and that, despite the wondrous machines on our desks (and in our hands), we might lack the context to evaluate something new.  (Be especially wary of statements about something happening for the first time in history.  Many times it’s just that the view is too narrow.)

There are sources other than the normal ones that we use, providing the opportunity to scramble for some more data, but it’s hit and miss in getting at comparable information.  Plus, composition changes in data series can easily confuse the matter (think of the adjustments to the S&P sectors, for example) and alternative methodologies can result in altered takes (how do the Wilshire indexes used above compare to others formulated in different ways?).

Plus, whether charts are intraday or decades-long, we think we see patterns that may or may not be there — our conclusions can easily be spurious ones.

Whether we’re at a point of regime change or not, it’s good to remember that despite our sophistication, tools, and zettabytes of data, there is a lot that we don’t know and there are important gaps in the information we have available to us.  Being open about those shortcomings is a start.

Published: April 28, 2022

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Open Questions, Searching for Skill, and Lots of Reversals

It is great to see a number of new subscribers to the Fortnightly.  Welcome!

The rest of you may have noticed that there was an extra week between the last edition and this one, as the team took a vacation break to rest and recharge.  But we’re back at it, with one change:  You will now receive this every two weeks on Monday evenings (U.S. time).

On to the readings.

The SEC and climate change

The mere mention of climate change causes people to run to their respective corners of belief.  Yet investment organizations of all types are going to be dealing with this issue for decades — and will need to analyze the implications for asset pricing, decide whether and how to engage with efforts to combat the potential threat, and navigate the tricky waters of communications with clients and other stakeholders about it.

An evenhanded evaluation of the issues starts with quality sources of information (not all from one “side”).  A case in point is the emerging debate regarding the SEC’s proposed rules on climate-related disclosures.

One question of importance is whether the SEC is stepping leaping out of its lane.  In that regard, “The SEC’s Climate Disclosure Proposal: Critiquing the Critics,” by George Georgiev, is a worthwhile read.  The author concludes that the proposal “is firmly grounded within the traditional SEC disclosure framework that has been in place for close to nine decades,” writing that “the SEC’s Proposal is limited to disclosure — and only disclosure — on a technical topic, and the SEC has decades-long experience handling disclosures on technical topics.”

While Georgiev takes a side (he thinks that the agency’s actions are “overdue”), he provides important points to be considered in any objective discussion about the appropriateness of the proposal and its effect on investors.

Open questions

Investment practitioners sometimes disparage academics as not dealing in the real world, but the two camps each have something to offer in terms of understanding facets of the ecosystem.  Exchanges of ideas between them usually lead to better outcomes over time.

Most academic research is focused on public markets — and, in turn, most of that is equity-related — since that’s where the data is available.  Thankfully, that’s changing for the better, although slowly.

“Asset Allocation with Private Equity,” a paper by Arthur Korteweg and Mark Westerfield, takes the perspective of a limited partner investing in private equity and the associated problems regarding diversification, commitment pacing, the assessment of skill, the evaluation of performance, and the imbalance of power versus general partners.  Throughout the research, they put forth “27 open questions to help guide private equity research forward.”

The search for skill

In “Investing in Skill,” Man GLG lays out its philosophy of having “no house view” on strategy formulation by its portfolio managers, but trying “to judge skill from processes, rather than fixate on outcomes.”  Why?

A primary goal of measuring skill is to provide hard, quantitative feedback to portfolio managers to help them understand what works for them, and develop and hone their investment process.

The paper looks at how similar performance can come from much different combinations of hit rates and payoff ratios — and details the four steps in measuring skill:  choosing an appropriate benchmark, understanding the investment process, assessing investment activity, and using counterfactuals for comparison.  The final key is communicating effectively with the portfolio manager so that the feedback has maximum effect.

Also see “How ‘Skill’ is Missing From Performance Discussions,” a posting by Michael Ervolini of FactSet.

(These two pieces fit well with the ones on using feedback that were published on The Investment Ecosystem recently.  See the links further down.)

Reversals

Regime change (or at least a whiff of it) is causing notable reversals in the investment world.  First, in the stocks of pandemic winners — here’s one example of the many stories about them these days.  And areas that were long out of favor are now (finally) showing relative performance, and investors are scrambling to figure out whether the changes will last for a time or fizzle out.

There seems to be an uptick in organizational tumult as well (market stress usually amplifies organizational stress).  Among the examples:  Gabe Plotkin of Melvin Capital tried to act as if its disastrous performance should be rewarded with more favorable terms from clients, but he did a “dramatic about-face” after a couple of days.  In the normally more staid environs of the mutual fund world, Phaeacian Partners is slated for a “bizarre and unfortunate” wind down after eighteen months.  (It did last longer than CNN+.)  More to come.

Other reads

“The Story of Hetty Green: America’s First Value Investor and Financial Grandmaster,” Mark Higgins, SSRN.  While the opportunities for women were greatly restricted in her era, Green is “the true originator of the value investing philosophy and one of the greatest financial minds in all of U.S. history.”  The piece includes biographical information, historical context, and sidebars on elements of investing philosophy.

“Conflicting Incentives in the Management of 529 Plans,” Justin Balthrop and Gjergji Cici, SSRN.

States accept higher fees in return for more leeway for the program manager in setting menus and fees.  Program managers use this latitude to extract higher rents from the plan through pursuit of indirect forms of compensation such as revenue-sharing agreements with mutual fund companies they choose for managing plan assets.

“Too Much Email? Let Your Bot Answer It,” Tyler Cowen, Bloomberg.   Thoughts about the changes that will happen as we outsource more and more of the daily grind.

“Could it really be that simple?” Joachim Klement, Klement on Investing.  Looking at profit per transaction for miners as an indicator of the changing supply/demand relationship for Bitcoin.

“The SEC needs to crack down on Cathie Wood,” Max Schatzow, Citywire RIA.

Cathie Wood’s repeated performance predictions are reckless, harmful to retail investors, anti-competitive, and should be pursued by the Securities and Exchange Commission for violating the Investment Advisers Act of 1940.

“Putin’s Invasion Reminds Us That We Live in a Finite World,” Jeremy Grantham, GMO.  “Cowboy economics” and our reluctance “to address very long-term issues.”

“Barclays ETN debacle seen as unlikely to ‘end the gravy train’,” Steve Johnson, Financial Times.  A look at the exchanged traded note sausage factory in the wake of the crazy Barclays episode.  From Morningstar’s Ben Johnson:

The house almost always wins.  [The Barclays episode] is a rare example of the house losing, because someone on the door forgot what they were doing and handed out too many chips.

“The 3-D Fiduciary,” Ravi Venkataraman, Investment Adviser Association.  An active manager argues that in a new environment which demands a third dimension of investment evaluation, “only active management inherently has the complete set of tools to evaluate and implement what is necessary to address this dynamic new world of investor expectations.”

“Is There Any OCIO Model That Is Conflict Free?” Alicia McElhaney, Institutional Investor.  The hot market for OCIO services has led to increasing scale — and the concerns that historically come with it.

Around the table

“The aim of argument, or of discussion, should not be victory, but progress.” — Joseph Joubert.

A case study

Three months ago, Jeff Ptak of Morningstar tweeted, “Not often you see a long/short fund make (a) a big bet that (b) pays off.”  Shortly thereafter, it announced a soft close, which nonetheless allows for the further accumulation of assets, including from “investors that purchase shares through financial advisors and/or financial consultants that had clients invested in the Fund prior to its closure.”  As the bottom panel of the chart shows, asset growth has continued since the March 1 effective date (some due to appreciation).

You can learn more about the Invenomic Fund, run by a firm of the same name, here.  How to analyze it?  From a performance standpoint, the fact sheet shows two benchmarks, the S&P 1500 (used for the relative performance above) and the Morningstar Long/Short category average (a better fit, but not available to show on the chart).

Without the restrictions on fund flows, you would expect assets to be piling up even faster now.  (Hot performance, more than three years old, and long/short when people are a bit nervous about beta.)  Lots of analytical questions and due diligence challenges on this one; a very good case study in the making.

Postings

Here are some of the recent postings on the site:

“Reposting: We Need Some New Terminology.”  This is a combined republication, now available to all in front of the paywall, of two earlier postings that dealt with shortcomings in labeling regarding different kinds of “investment advisors” — and the confusing world of “passive” and “indexed” strategies.

“What Will Define the Portfolios of Tomorrow?”  Two white papers present visions of the future. Asset owners need to weigh the various ideas to decide which ones will move their organizations — and their portfolios — forward.

“Building an Organization Oriented to Improvement.”  In this first of two related postings, a Mauboussin and Callahan report serves as the framework for examining longstanding areas of weakness for asset management firms.

“Angles of Discovery for Due Diligence.”  How can outside research on uncommon topics provide insight for the manager selection process?  This is the second take on the Mauboussin/Callahan report.

Follow us on Twitter to see the Charts of the Day and more.

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

Published: April 25, 2022

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Angles of Discovery for Due Diligence

The previous posting, “Building an Organization Oriented to Improvement,” summarized a recent essay from Michael Mauboussin and Dan Callahan in order to question whether the kind of ideas expressed within it are being applied by asset management firms.

This time, we will consider how the same ideas can be used by those doing due diligence to gain greater insight into the organizations that they analyze.  Such avenues of inquiry offer the opportunity for explanatory depth beyond the narratives provided by the firms.

(Many of the ideas presented here are expanded upon in the Investment Ecosystem Academy course on due diligence and manager selection.  The need for “explanatory depth” is one of the core concepts within it; “look both ways” is another tenet of the training.)

Look both ways

While investment organizations across the spectrum differ from each other in fundamental ways — asset managers are not like asset owners or investment advisory firms, and even within those categories there are recognizable subsets — many of the principles that can be used to analyze them are remarkably consistent.

Take the categories of evaluation that were the historical “4Ps” of philosophy, people, process, and performance.  All of them are relevant no matter where you go or what kind of organization you’re looking at.  Many of the finer points in those categories and others apply universally too.

So “look both ways” is a reminder that insights that allow for a more intensive look at asset managers also open doors to evaluating your own organization.  Therefore, the piece by Mauboussin and Callahan can first be used in that way, to examine your practices and consider opportunities to get better over time.

An uncomfortable topic

Since a large part of a due diligence analyst’s job is to crack open the narrative of an asset manager and determine what’s real and what’s not, one goal should be to accumulate topics and techniques that facilitate that effort.

A fruitful line of inquiry involves asking about what things need improvement.  It is surprising how often people struggle with questions like that, even senior people, who are most expert at reciting the narrative and are often reluctant to share anything that seems negative.  For example, they tend to be protective of the investment process as advertised, using the industry catchphrase of “consistent and repeatable” to describe it, when words like learning, evolving, and improving would represent the qualities that are likely to win over time.

Their inability (or unwillingness) to identify concrete areas for improvement indicates one or more of these dynamics at work:  a) they haven’t really thought about it much; b) they genuinely don’t believe that the organization needs to improve; c) there is a cultural aversion to talking about shortcomings within the organization; and/or d) they don’t want to be open with investors about what they need to do to get better (not a great foundation for a long-term partnership).

Whether an interviewee is cooperative or intransigent in response to general (and more detailed follow-up) questions on potential areas for needed improvement, there are opportunities to unearth unusual insights about a firm by asking them.  The fact that those exchanges may be uncomfortable are an indication of their value.

Angles of discovery

That brings us back to the ideas put forth by Mauboussin and Callahan.  They show ways in which feedback can be used in organizations guided by an ethos of continuous improvement, providing a convenient set of variations on a theme for engaging with an asset management firm.

The suggestions below also apply broadly to the use of other sources of information — from within the investment world and outside of it — that can be used to reveal aspects of an organization that otherwise tend to remain hidden.  The Mauboussin/Callahan piece is a particularly good example of how it can work.

Like any organization, an asset management firm makes choices, large and small, that define it.  Many of them happened years ago, while others (especially investment decisions) occur on an ongoing basis.  Much of the engagement with those doing due diligence on the firm focuses on what the manager has done (and what it intends to do):  Here’s the philosophy, here’s the structure, here’s the people, here’s the process.

Much more important in getting to the heart of the matter are the why questions along each dimension — and that’s where the advantage can swing in favor of someone doing due diligence, if they are more well versed in those topics than those they are interviewing.

Consider just a few of them referenced in the last posting:  forecasting, training, team composition, and environment/culture.  It is not at all difficult to build a base of knowledge to be able to ask revealing questions (in search of that explanatory depth) in any of those areas.  Asking why or why not questions about well-researched organizational topics can lead to a dialog that takes you beyond the narrative descriptions on which most due diligence reports are based.

The items on the Mauboussin/Callahan list can be used that way, allowing you to move past the rote topics to more fertile ground, where there usually aren’t pat answers at the ready.

But, to take it a step further, imagine showing up for a due diligence meeting and saying, “I know your meetings with allocators aren’t usually like this, but I’d like to spend the time today talking about how improvement happens in your organization.  That will help me to understand how your firm got to this place and how you might grow and adapt over the coming decade or more of our relationship together.”  Such an approach would result in more differentiated insights than come out of the typical manager meeting.

Another good time to use outside ideas like this is in those boring quarterly update calls where not much is said of value.  Instead, they should be seen as opportunities to expand your knowledge of the firm.  Exploring uncovered ground and introducing new concepts is a good way to do that.

Your scorecard

In the previous posting, asset managers were asked to complete a scorecard on where they are on the various means of improvement that were discussed.  Now it’s time for those of you doing due diligence to fill out your own report card.

How often do you incorporate ideas into your process that would be considered uncommon topics in due diligence but which can provide you with deeper insight into the organizations you are trying to understand?

What are the impediments to incorporating angles of discovery like that into your work?

If you look at the twelve facets of process improvement identified by Mauboussin and Callahan, how much do you know about what the firms you cover think about the possibilities around each and what they actually do in practice?

Published: April 24, 2022

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Building an Organization Oriented to Improvement

For more than a quarter century, Michael Mauboussin has been producing research on decision making and investment process.  Dan Callahan has been his co-author on articles for much of the last decade.  Their latest essay is “Feedback: Information as a Basis for Improvement,” which fits neatly with The Investment Ecosystem’s goal of “continuous improvement for investment professionals and organizations.”

That piece will be used to look at investment practice from two points of view.  First, here, in regard to the world of asset management — and subsequently in a Due Diligence category posting that looks at the issues from the other side of the table.

Disconnects

Despite the widespread popularity of Mauboussin’s work among investment professionals, many of the ideas and principles presented therein don’t result in actual implementation within organizations.

Furthermore, it’s perplexing that investment professionals — who are so open to new companies, strategies, and vehicles from an investing standpoint — can be anything but innovative when it comes to organizational design, investment process, and the like.  That sort of bounded creativity stands in stark contrast to Mauboussin’s approach, which seeks to apply insights from other disciplines in order to improve investment decision making.

Those disconnects are on full display in “Feedback.”  The authors aggregate a dozen “facets of process improvement” in three categories:  people, organizations, and feedback during process execution.

People

This section opens with a fairly innocuous summary:

If you want to build an excellent, repeatable process you need to start with having the right people.  You then need to train them to be effective, figure out how you should deploy their skills, and institute a policy of practice.

If, as the authors then suggest, the “first step is to identify the skills that can lead to success,” do asset management firms routinely examine them in detail, and do they analyze potential hires on that basis?  In large part, no.  Specifically regarding those with some years of experience, previous performance is more heavily weighted than it should be (given the inherent imprecision in performance as a measure of skill, as well as the often overlooked importance of the candidate’s previous environment in producing it).

The authors use the characteristics of good forecasters found in Superforecasting, the book by Philip Tetlock and Dan Gardner, to illustrate the kind of skills inventory that firms should be using — a list that is particularly appropriate given the importance of forecasting in so many investment roles and the lack of effort put forth to try to improve the results from that activity.

They also delve into the differences between intelligence quotient (IQ) and rationality quotient (RQ), noting that “how people think is more important than raw measures of intelligence.”  That leads to an examination of the differences between “fluid rationality” and “crystalized rationality” — including what can be tested for (and what can’t), as well as in what categories improvement is most likely (and where it isn’t).

Can training provide that improvement?  If so, how?  The report addresses ways to improve forecasting skills; to identify and institutionalize standards for analytical concepts that are prone to sloppy definition and application; and to assess “which aspects of investment process can be addressed systematically and which must be in the realm of judgment.”  Also worth noting are the leverage effects that come from training on effective communication skills and data visualization techniques.

Given the nature of the investment realm, “it is easy to get drawn into a pattern of all playing and no practicing.”  But how can one “practice” this craft?  With the computing power and gamification techniques of the day, you’d think that advanced simulations could be developed to both hone desired skills and provide exposure to a range of possible scenarios to experience.  In the meantime, the authors offer some more prosaic options.

The section closes with this (an apt segue into the next topic):

There is a lot of opportunity to improve coaching in the investment business . . . it starts by professionals acknowledging that there is room to improve.

Organizations

Many of the shortcomings in the areas noted above can be traced to the culture of the industry as a whole and asset management in particular.  “Values and norms are influenced by governing objectives, incentives, teamwork, and the overall organizational environment,” so examinations of those come next.

Asset management firms “have tension between two potential objectives,” one related to the goal of producing long-term returns for their clients and the other focused on the financial success of the firm and its employees.  Most often, that tug of war leads to playing the game as it is currently being played; the industry is marked by similarity rather than differentiation and inertia instead of innovation.

Incentives can play an important role, but “effective incentives are very difficult to design, and incentives by themselves rarely promote the proper behaviors.”  In fact, many firms cling to incentive structures that reflect the noise of the market — and most equate the performance of an individual to the “numbers” that appear to represent their worth.  That leads to a not-so-merry-go-round of hopes that the results will be better next time, instead of an orientation for improvement grounded in the need for feedback on the fundamental drivers of long-term value-added.

Over time, there has been a massive increase in the proportion of assets that are managed by teams versus individuals — at least superficially, since it’s unclear how many are in fact what could be called real teams.  Usually lacking in their construction are careful consideration of the importance of collective (and multifaceted) intelligence on a team, the elements that lead to team success, and the kinds of training that are helpful.  Yet those factors likely are more important than traditional drivers of team composition (previous areas of experience and track records).

The “environment,” or culture if you will, of an organization is the soil in which everything grows.  It should be “committed to ongoing learning,” should “welcome different points of view,” should audit the decision-making process in ways that lead to specific and ongoing improvement, and should engender an atmosphere of equanimity:

All organizations go through ups and downs, so removing peaks and valleys is essential.  A focus on proper process with a long-term view contributes to this attitude.

Feedback during process execution

The final section includes some specific feedback techniques to improve investment processes:

Providing feedback to fundamental investors is inherently difficult because the process to make decisions is often poorly defined and the outcome, the rise and fall of asset prices, is noisy in the short run.  One way to solve this problem is to break down decisions into measurable components.  But it all starts with documenting decisions and how they are made.  Without a record of what you expect to happen, it is difficult to measure the accuracy of your predictions.

That means identifying in advance the “variant perception, a well-founded view that the market has not priced properly” which is motivating a particular decision.  Using a “linchpin analysis” to flesh out that variant perception can help to reveal the weaknesses of the proposition, and it also serves as a roadmap for the decision process that can be evaluated after the fact.

One specific way to track the accuracy of predictions about probabilistic events is called the Brier score.  Is it widely used?  Not at all:

Most investment organizations have the raw material to keep Brier scores but fail to do so.  Part of it is that keeping track of decisions requires some discipline.  But the bigger issue is that when we are wrong, we generally cope by crafting a story to explain what happened in a way that avoids making us look bad.  We are poor at predicting but great at explaining the past.

The same can be said for other pieces of what could be called a process attribution.  The information is there to analyze whether the individual components of that process diagram in the pitch book actually add value, but very few managers perform such analyses and fewer still reveal what they have found.

Many aspects of process feedback have gotten easier; there are more opportunities for “a machine giving feedback in order to improve a human’s game.”  What’s lacking, though, is the commitment to identify the feedback loops that are important, to communicate how they can help to move the organization forward over time, and to clear away the cultural impediments that inhibit progress.

Your scorecard

If you work at an asset management firm — and especially if you are in a leadership role — take the time to walk through the items mentioned above in some detail and grade your organization.  What are you doing and what are you not doing to build the kind of feedback culture that yields the ongoing improvements that you will need to compete in the future?

For those of you that evaluate asset managers, stay tuned for the next posting, which deals with the implications of all of this for your efforts to separate the wheat from the chaff.

Published: April 22, 2022

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What Will Define the Portfolios of Tomorrow?

What came to be known as “modern art” had its beginnings around a century and a half ago.  The Oxford English Dictionary has a definition for “modern” as “of or relating to the present and recent times, as opposed to the remote past.”  That’s a strange term to apply to art, which is ever-changing, but it stuck.  Many of the most popular pieces in the Museum of Modern Art aren’t modern.

Modern portfolio theory suffers from some of the same burdens.  It is now seventy years old — and investment practice has changed dramatically during that time.  The principles of MPT have been widely adopted over that time, even as its shortcomings in application have been noted.  That has led to various “post-modern” theories and approaches to augment or replace MPT.

At the same time, industry participants are (always) trying to anticipate the environments to come — and the strategies that will work.  Two recent white papers serve as examples.

The five marks

The intent of the first, CAIA Association’s “Portfolio for the Future” (a phrase it has trademarked), is indicated by the subtitle, “A practitioner’s guide to the five essential marks of effective capital allocation.”

It starts with a short “Funeral for the Past” prelude, which summarizes the astonishing growth of the “alternative” (another term which needs a refresh) investment industry over time.  Bill Kelly of CAIA writes, “The opportunity for alpha is not gone, but the low-hanging fruit has long been harvested, and the path toward higher absolute returns has gotten far more nuanced.”

The core of the paper is the exposition of those five marks that CAIA thinks will define successful portfolios and organizations going forward, namely:  broadly diversified, less liquid, rooted in a fiduciary mindset, actively engaged, and dependent on operational alpha.  The sections about each are authored by industry participants, as noted below.

Broadly diversified (Mark Anson, Commonfund).  Anson focuses on what he calls the “Beta Continuum,” which lists ten different types of beta across a spectrum from “systematic risk premiums” to “active returns.”   (More terminology upgrades are needed here too.)

What about cryptocurrency beta?  How should you think about that in an allocation analysis?  Anson puts it in an MPT context:

At this level of risk, Bitcoin fails to work within any mean/variance structure that is typically associated with the allocation of an institutional portfolio across beta markets.

While the section deals with some of the issues of the blurred lines between alpha and beta, other big issues deserved to be included, like the increased correlations that show up at times of crisis — and the faux-diversification that is caused by the infrequent and smoothed pricing of private vehicles (and which is still being used by some as a marketing lever).

Less liquid (Andrea Auerbach, Cambridge Associates).  The private markets allow asset owners to “embed exposure to greater portions of economies in a way that is simply not possible via the public markets,” given the more diverse set of companies and vehicles that are available.

While Auerbach notes some of the changes that have happened over time, she says that “the return expectation of private equity has not wavered since I first set foot in this arena in 1991,” which seems to validate concerns that expectations may be too rosy given today’s environment.  If, as CAIA’s John Bowman states elsewhere, “we are in the twilight of a four-decade economic super wave,” then there should be a greater focus on what will happen if we get into the kind of sustained challenging environment that we haven’t witnessed yet.  High hopes and high allocations could shake the patience that Auerbach counsels.

Rooted in a fiduciary mindset (Roger Urwin, Willis Towers Watson).  Urwin summarizes the challenges:

Investment is an agency business with massive commercial pressures, so we should not be surprised by our industry’s shortcomings and blemishes.  I would cite three major issues where industry failings are reasonably widespread:

Weaknesses in the value proposition where the value created does not match the fees charged.

Misalignments in the values of asset management firms with their clients.

Communications that fall short in accuracy and honesty.

He references a book about organizations (not just investment ones) that finds that they gravitate to:

the wrong sort of leadership . . ., an addiction to shallow branding, inauthentic communications, thoughtless attachment to conventional rules, and overly upbeat cultures.  The problems the researchers point out are that these factors seem to work positively in the short-term and only fall short in the longer-term.

That summary hits home in the investment ecosystem too, especially when you factor in the noisy signal of performance and the inferences about an organization that stem from it.

Actively engaged (Ann Simpson, Franklin Templeton).  The “takeaway” at the start of this piece:

The scale of capital flowing into sustainable investments, the broadening of support for shareholder activism, and the growing demand for rigorous standards to combat greenwashing are all evidence of a new “visible hand” in financial markets.

Simpson makes the case for activism, writing that “the common interest between savers, investors, companies, and wider society lies in ensuring that shared prosperity is sustainable.”  That won’t stop the debates about the pros and cons of that “visible hand.”

(This is an area that has been addressed previously on this site in “The ESG Juggernaut and Points of Pushback,” in the posting on Aswath Damodaran, and in several issues of the Fortnightly.  Upcoming are essays on proxy voting and climate change that will investigate related implications for investment practice.)

Dependent on operational alpha (Ashby Monk, Stanford Research Initiative on Long-Term Investing).  Monk differentiates between the structural advantages that some asset owners have and cultivated advantages, which are “based on the deployment of an investor’s limited resources and the intelligent investment of those resources.”

Investors “use four key production inputs to generate investment returns:  capital, people, process, and information.”  The “environmental enablers” that are used to improve them are governance, culture, and technology.  “Operational alpha” is the goal — “the efficient and effective implementation of a chosen investment model.”  It “requires a capacity for innovation, as it means changing the inputs to improve.”

Interwoven themes

John Bowman provides a summary to the CAIA offering by focusing on themes touched on by the other authors and from CAIA’s “research and conversations with investors.”  They include an ongoing blending of previous categories, including the emergence of “lifecycle equity investing” (across the various stages of private investment and into publicly-traded exposures), and a move away from “traditional” and “alternative” descriptions to focus on the underlying attributes of the different vehicles that are available.

He also says that “the liquidity of an asset is neither good nor bad — it merely reflects the ease of converting the asset or security into cash,” and that “the preoccupation with liquidity has led us to convert highly complex, leverage-unconstrained, eccentric strategies into regulated, retail vehicles,” with predictably poor results.

The “new 40” is another unfortunate construct, according to Bowman, who thinks that the rigid structure of the once-common and simple 60/40 model should not be replaced by any set way of conceptualizing what a portfolio should look like.

The latest postmodernism

The other white paper concerns “The Postmodern Portfolio.”  That “crypto allocation thesis” comes from Grayscale.  (Its “suite of single asset and diversified funds offer investors comprehensive exposure to the digital asset market.”)

The firm argues that we are in “a macro environment where money supply growth and negative real rates have created a dynamic where not taking risks is actually one of the biggest risks.”

Capital market assumptions (CMAs) are the inputs to traditional MPT analyses.  Grayscale talks in terms of Long Term Crypto Market Assumptions (LTCMAs), and includes some numbers to plug into the model:

Our LTCMAs call for crypto asset expected returns (5Y: 24.6%, 7Y: 26.6%, 10Y: 24.1%, 15Y: 20.2%, 20Y: 18.0%, 25Y: 16.6%, 30Y: 15.5%) to outpace all global asset classes over nearly the next three decades.

Speaking of 60/40, Grayscale promotes a “Global 60/40+Crypto Portfolio,” noting that portfolios “with 1%, 3%, and 5% Crypto Basket exposure over the last three years would have resulted in increasingly higher returns, with modestly higher volatility and maximum drawdowns, but with higher Sharpe Ratios.”

It is interesting that the MPT framework is used throughout the paper — a mashup of old theory and new vehicles that clashes with Mark Anson’s view above that “Bitcoin fails to work” in MPT.  In any case, the same old MPT problems exist:  it’s just a model and it’s sensitive to the assumptions used.  Unrealistic expectations render it meaningless.

The “add a little crypto” thesis has been gaining traction, with some asset owners seeing asymmetric possibilities — not fearing the effect of a small position going bad when compared to dreams of a parabolic move higher.  In the crypto community, it has become a matter of faith that big investors will approach things in that way, providing a self-fulfilling prophesy from the piling on that could result when 1% or 3% or 5% of the enormous base of institutional assets goes into crypto.

Preparing for tomorrow

The two papers are different in many ways.  One comes from a firm with a clear book to talk, while the other was issued by an industry organization (although some would argue that CAIA and the authors it used are also representing their own interests).  The Grayscale approach is quantitative (but clearly based upon hazy beliefs about the future), while the CAIA theses are qualitative in nature.

However, they are similar in that they don’t depart much from the general assumptions of the present; they are mostly extensions of ideas that are on the table already.

That may be the right foundation.  After all, changes usually take place at the margin rather than coming out of the blue.  Asset owners need to weigh the various ideas to decide which ones will move their organizations — and their portfolios — forward.

Published: April 11, 2022

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Pendulums, Ingrained Organizational Habits, and Spiritual Alignment

Thank you for reading — and for passing along your comments and suggestions.

Bogle’s legacy

Portfolio Manager Research has made available the Spring 2022 issue of the Journal of Beta Investment Strategies, which is dedicated to Jack Bogle, the Vanguard founder who has been called the man who “may have saved ordinary Americans more money than any man in history.”

Several investment luminaries authored pieces for the issue, which also includes articles on the evolution of indexing and current topics of interest.

Ironically, as he was being celebrated in that journal, Bloomberg published a piece with the title, “Vanguard Stumbles In Pivot From Cult of Jack Bogle.”  The subheading put a finer point on it:  “For diehard fans of the company’s founder, what’s at stake is the very soul of the $8 trillion mutual-fund giant.”

Success has bred competition.  And the need for growth (or perceived need for growth) has taken the organization into areas that seem distinctly non-Bogle, while technology and service issues have frustrated the long-time faithful.

Bogle’s personal legacy isn’t at risk, but (despite the money pouring in) Vanguard seems like it is trying to figure out what it wants to be.  That used to be clear.

Communication

A couple of notable reports were released that emphasized the importance of communication for investment professionals.

The Financial Planning Association released a comprehensive study, “Developing and Maintaining Client Trust and Commitment in a Rapidly Changing Environment.”  Unfortunately, it is presented in seven separate reports; for ease of use, it would have been beneficial to have it all in one document.

The “summary and recommendations” chapter is worth a look-through, if only to demonstrate the size of the gaps between how planners assess their communication skills on various dimensions versus how clients do so.  For example, take the statement, “Planner communicates recommendations in terms clients can understand.”  The percent who “somewhat agreed” to “strongly agreed” with that?  Planners, 84%; clients, 51%.  (Other attributes showed even larger differences.)

Michael Mauboussin and Dan Callahan have written another good essay, “Feedback: Information as a Basis for Improvement.”  Stay tuned for a more in-depth review of the piece to be published in the next couple of weeks.  For now, here is one of the comments within it regarding communication:

Effective communication skills are also an important aspect of investment analysis and can be improved via training.

Every investment role can be summed up in this way:  analysis plus communication.  The lack of emphasis on the latter is a major failing in the investment industry.

The pendulum

Howard Marks’ recent memo starts by saying he’s “strongly interested in — you might say obsessed with — the concept of the pendulum.”  In this case, he is applying that obsession to international affairs.  At first, regarding the downside of the economic entangling of European countries and Russia:

Security doesn’t seem to have received much consideration in the deliberations that led to Germany’s energy dependency on Russia.

The other topic of the memo is outsourcing.  The pendulum has swung very far in that regard (and for very long), but the weakness in global supply chains is now evident.

Both of these issues “are marked by inadequate supply of an essential good demanded by countries or companies that permitted themselves to become reliant on others.”

Speaking of pendulums, a Packy McCormick posting includes a section on the spectacular track record of the Medallion Fund run by Renaissance Technologies.  “So how does RenTech do it?”  McCormick cites this quote from Kresimir Penavic of Renaissance:

What you’re really modeling is human behavior . . .  Humans are most predictable in times of high stress — they act instinctively and panic.  Our entire premise was that human actors will react the way humans did in the past . . . we learned to take advantage.

A due diligence question

Activist investor Trian Fund Management has been agitating for change at Janus Henderson.  Now a new CEO has been named, which apparently led to the chief investment officer leaving too.  If you’re one of the many clients of the firm around the world, does any of that alter how you think about the prospective returns you will get as a client (not as an investor in Janus Henderson’s stock) over the next decade?  In what ways?

Other reads

“The 10X10 Report,” Russell Investments.  This consists of a series of three reports that pair the opinions of “10 of the world’s leading institutional investors,” with those of “10 of the world’s leading asset managers” on different topics.

“Venture capitalists pass on board seats to secure deals in hot crypto start ups,” Miles Kruppa, Financial Times.  The CEO said that Paradigm, which led the round of funding, did not require a board seat:  “There was a deep level of trust between the two teams.  There was a lot of spiritual alignment in what we wanted to do.”

“How will you reframe the future of advice if today’s client is changing?” Jan Bellens, et. al, EY.  “Experience shows that ingrained organizational habits can represent the greatest barrier to achieving genuine transformation in the wealth industry.”

“The Ends vs. the Means: Both Matter,” T.J. Kistner and Reed Burns, Segal Marco Advisors.  This includes some simple visuals that reinforce the point that thinking of an asset manager as “first quartile” (or “bottom quartile,” for that matter) leads to unrealistic expectations.

“Debiasing and Alpha,” Drew Dickson, Albert Bridge Capital.  “So, in our evaluation of value-added and team contribution, if someone isn’t shooting their free throws underhanded, or striking out often enough, they aren’t following the process.  They aren’t engaged with our philosophy.”

“Big Stock Sales Are Supposed to Be Secret. The Numbers Indicate They Aren’t,” Liz Hoffman, et. al, Wall Street Journal.  All of the sudden, block trading is getting a lot of attention.  Will this turn into a big scandal?

“Purchase Price Allocations for Asset and Wealth Manager Transactions,” Zachary Milam, Mercer Capital.  What are the accounting issues involved in all of these RIA combinations (especially for the publicly-traded acquirers)?

“Providence Pension Mulls Issuing $515 Million in Bonds, Following POB Trend,” Anna Gordon, Chief Investment Officer.  Reminder:  “Borrowing money to invest it in the stock market is not actually an arbitrage opportunity.”

“March 2022 Active Management Environment,” Verus.  The consultant’s visualizations provide a quick look at different strategy universes in return-vs-standard-deviation space.

“Ned Johnson (1930-2022),” Jason Zweig, Wall Street Journal.  The title section of this newsletter is “How Should Kids Learn to Invest?” (which is worth reading), but further down is a wonderful remembrance of the Fidelity leader, including, “I first met Ned Johnson when I was nine years old.”

Creativity isn’t sanctioned

“Orville Wright did not have a pilot’s license.” — Gordon MacKenzie, in Orbiting the Giant Hairball.

Breaking even

There is a regime-shift feeling in the air.  It wasn’t that long ago that central bankers were begging for inflation.  It seems that they got their wish and now don’t know what to do.

The market’s inflation predictions are shown in the chart, derived from the relationship between regular Treasury notes and inflation-protected ones.  The dashed lines show the previous highs in expectations, going back to the start of 2007.

The ten-year breakeven hasn’t moved as much, as you would expect.  Where that goes from here will have a lot to say about what kind of regime we are really in.

Postings and tweets

Two recent postings for paid subscribers:

“Questions about the Dominance of Indexed Strategies.”  A profound change has taken place in many portfolios that are supposed to produce alpha, from a focus on finding the best individual holdings to an environment in which many are “agnostic to security-level information.”

“Steppingstones and Clues for Further Research.”  A Morningstar analyst’s downgrade of Fidelity Contrafund provides an opportunity to see the value of visualizations in determining good avenues for due diligence research.

“The Star Analyst Years” is out from behind the paywall and open to all.  “OCIOs: History and Evaluation” is now available on LinkedIn.

Also, follow us on Twitter.  Among the recent Chart of the Day entries there are the two-pronged pain in fixed income, divergent performance in emerging market regions, the ARKK and non-profitable technology braid, and four starkly different oil futures curves occurring in less than two years.

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

Check out the new Course Plus Coaching option for the Advanced Due Diligence and Manager Selection course in the Academy.

Published: April 4, 2022

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Steppingstones and Clues for Further Research

Morningstar downgraded Fidelity Contrafund.  Slightly.

The former is the most powerful independent mutual fund research firm and the latter is a very large fund (with a highly-respected portfolio manager) from a legendary mutual fund company.  So it got some attention.

The Morningstar article by Robby Greengold announcing the change was short and almost apologetic in tone, opening with the statement that the fund “remains excellent” and referencing the “masterful leadership of Will Danoff,” who has been the portfolio manager since 1990.

But as time has gone on, the fund has “beaten its peers and the S&P 500 by narrower margins than before and has consistently lagged the Russell 1000 Growth Index, which is a more relevant index given the fund’s performance patterns, emphasis of high-growth stocks, and investment philosophy.”  The S&P 500 is the fund’s stated benchmark.

The main concern is the sheer size of the fund; “its colossal asset base is a substantial disadvantage.”

Here’s a look at the assets and relative performance for the fund (FCNTX) from the start of Danoff’s tenure:

Interestingly, the performance versus the two indexes has been identical over that long period of time, but the patterns are much different.  Since 2009, performance has been slightly up versus the S&P and in a persistent downtrend versus the Russell.

The assets are around $125 billion, but Greengold cites a total twice that much, telling CityWire that the larger figure includes funds that Danoff manages or co-manages in a similar style.  Not mentioned is the fact that other Fidelity funds also have stakes in many of the same companies; it’s that even larger scale that comes into play if a Fidelity analyst sours on a company.  Or if other portfolio managers are piggybacking on Danoff’s decisions.  (It happens.)

As the investment industry has industrialized, scale has become a factor (as addressed in other postings, like this one).  At what point does scale impede performance?  One thing is for sure:  asset management firms are unreliable narrators in regard to their estimates of strategy capacity.

The Morningstar downgrade was from Gold to Silver (Bronze, Neutral, and Negative are the rungs below them).  As with stock analysts, those covering investment managers are most comfortable changing their opinion gradually, especially in high-profile situations.  If scale is really a problem in this case, a bigger jump down is warranted.

The downgrade might not matter much to the fund, since flows are most sensitive to Morningstar’s star ratings — which are backward-looking measures of performance — not the analyst ratings, which are intended to be forward-looking opinions about future return potential.  (Contrafund currently has three stars.)  Plus, long-term taxable investors will be wary about selling, in order to avoid paying capital gains taxes, unless the performance deteriorates or Danoff leaves.

Contrafund would make a good case study, just on the few factors mentioned above.  But due diligence needs to go well beyond that, deep into the qualitative context for those numbers.  (That’s at the core of the online course on that topic in the Academy).

One interesting question is how decision making evolves over time, in response to changes in market environments and in the risk profile of a portfolio manager due to aging, life events, and personal world view.  (Some thoughts along those lines were included in a previous posting, “Decisions with Other People’s Money.”)

What follows are some portfolio-level looks at monthly readings of some Contrafund exposures and how they have changed since the fall of 2005:

Here are the portfolio weights in three sectors; the red line in each shows Contrafund’s exposure and the other line is the S&P 500’s (note the different scales in each panel).  At the top is technology, which has become an ever-larger portion of the market basket.  You can see that there were a couple of periods of pronounced overweighting in the portfolio.

Energy has taken an opposite course in popularity, and the persistent underweighting is not surprising in this kind of fund (but would a prolonged energy crisis change that approach?).  At the bottom is the financial sector.  A huge relative bet was cut before the financial crisis — there must be a story there — with only modest cycles of movement around the market weight since then.

The Apple exposure is fascinating.  The top panel shows the incredible run the stock has had, swamping the returns on the S&P and, to a lesser extent, other big tech stocks.  The red line in the middle shows the huge bet the fund had during the stock’s big move from 2009 to 2012.  Then the stock was market weighted for several years before becoming a persistent underweight during the latest upswing.

The problem with a chart with just portfolio weights is you can’t tell what came from the movement of the market and what resulted from the decision of the portfolio manager.  That is clear in the bottom panel.  The gargantuan position was sold down with regularity, until going flat for the last few years.  Price/earnings ratios can be tough to compare, especially when there are a lot of cyclical stocks involved — or ones that don’t ever have any earnings — but that’s not a huge problem here.  The top panel shows that Contrafund has been consistently above the S&P in terms of P/E (these are quarterly observations).  The ratio of the two is at the bottom.  There has been a fairly large contraction of late.

These kinds of charts are best used not to come to conclusions but as the impetus for forming good questions for further research.  They aren’t presented here to put forward any point other than that longitudinal information can provide important steppingstones for the analytical process — and good visualizations often reveal clues otherwise buried in a pile of numbers.

Published: April 1, 2022

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Questions about the Dominance of Indexed Strategies

The growth in indexed strategies over the last three decades has been staggering — in terms of the number of vehicles, the size of the asset pool, and the influence on investment practice.  Along with that growth have come concerns about the effects on the pricing of securities in relation to their underlying fundamentals.

As explored in “We Need Some New Terminology (Part 2),” the words “index” and “passive” are used in varied and imprecise ways.  In this posting, “indexed” denotes any strategy that is constructed in regards to an index, no matter how broad or narrow it is.  ETFs are the vehicle of the moment in terms of attention, but many mutual funds, collective investment trusts, structured products, etc. also fall into that category.

A number of citations below reference articles from — and an online conference hosted by — Alpha Architect, which will hereafter be referred to as “AA.”

The sideshow or the main event?

In a 2017 article, Wes Gray of AA summarized the abstract of a paper, “Can ETFs Increase Market Fragility? Effect of Information Linkages in ETF Markets” (Ayan Bhattacharya and Maureen O’Hara), in this way:

In English, typically market prices are established on the underlying assets and the ETF vehicle simply reflects these values.  However, this assumes the ETF vehicle is the sideshow and the underlying stocks are the main event.  But what happens when the ETF is the main event and the underlying assets become more of the sideshow?  Now the supply/demand dynamics of the ETF vehicle, which may or may not be related to the fundamental values of the underlying assets in the ETF basket, can create manufactured noise, and thus more volatility and instability in the underlying assets.  These effects are especially important for the harder-to-trade assets where arbitrage is costly and the supply/demand dynamics from the ETF market are more likely to be based on noise.

While the description references ETFs, the context applies to all indexed strategies:  Have they gone from being the sideshow to being the main event?

Much academic research is being focused on the question.  For example, this is from an abstract for a paper, “Is There a Dark Side to Exchange Traded Funds? An Information Perspective” (Doron Israeli, et. al):

Our tests show an increase in ETF ownership is associated with:  (1) higher trading costs (bid-ask spreads and market liquidity); (2) an increase in “stock return synchronicity”; (3) a decline in “future earnings response coefficients”; and (4) a decline in the number of analysts covering the firm.  Collectively, our findings support the view that increased ETF ownership can lead to higher trading costs and lower benefits from information acquisition.  This combination results in less informative security prices for the underlying firms.

The materials for the online AA conference, “Democratize Quant,” include those for a presentation by Marco Sammon on his paper, “Passive Ownership and Price Informativeness.”  Sammon looked at the changed dynamics surrounding earnings releases and concluded that “average price informativeness [has] declined over the past 30 years and passive ownership is negatively correlated with price informativeness.”  (His slides provide an accessible overview of the thesis.)

Mike Green served as the discussant for the paper, saying that the debate is moving from “Is there an effect?” to “How is there an effect?”  He thinks that the total exposure to indexed strategies is higher than commonly estimated — and he worries that there might be a nonlinear effect on pricing as the percentage gets even higher.

Price pressure and the effects of popularity

In another of the AA conference sessions, Sam Hartzmark presented fascinating research on his paper (with David Solomon) titled “Predictable Price Pressure.”  It revealed the oddity that despite investors knowing well in advance the aggregate amount of dividends to be paid on a given day, the price performance of the market varies in response to the size of those flows, something that doesn’t make sense within the frame of efficient market theory.

This points to a broader question from Wes Gray’s review of the paper:

If there are massive flows into an investment category (e.g., ESG, junior gold miners, market-cap-based passive indexes, etc.) that aren’t tied to fundamentals, the EMH theory predicts no price change.  The alternative hypothesis, let’s call it the “price pressure hypothesis,” would suggest that prices will change because providing liquidity and arbitrage capital is costly.

Previous postings from The Investment Ecosystem (including this one) have stressed the importance of “popularity,” as outlined in the book, Popularity: A Bridge between Classical and Behavioral Finance.  Investment flows affect the performance of securities and strategies (a factor which is often overlooked during the asset manager selection process).  The interesting thing about the analysis of Hartzmark and Solomon is that they extended the concept beyond the strategy level by looking at aggregate dividends and the performance of the overall market.

Taken as a group, indexed strategies are definitely popular — hugely popular.  If the “price pressure hypothesis” is valid at all, the size of the asset pool and the enormity of the ongoing flows pose important questions for participants in all corners of the ecosystem.

Indexed investors

With the advent of ETFs, the use of indexed strategies has gone far beyond the core base of investors in traditional passive mutual funds, who looked for broad market exposure that mimicked the market.  Now, high-frequency trading firms, hedge funds, long-only asset managers, institutional asset owners, and individuals are using indexed products in all sorts of ways.

For instance, articles in Pensions&Investments and Top1000Funds.com have reported how the Municipal Employees’ Retirement System of Michigan has “found exchange-traded funds to be the optimal vehicle for quarterly rebalancing and tactical shifts across global equity and fixed income,” although the details make that description seem quite understated.  One piece says that a third of the assets of the plan is in ETFs; the other says it’s one half.  (The headline on a different P&I article:  “ETF usage gaining foothold among U.S. pension funds.”)

Another headline — this time on an iShares-sponsored posting in Institutional Investor — asks, “Why is the IWM Small-Cap ETF a Cornerstone for Institutional Portfolios?”  It stresses “the potential for incremental return offered by ETF securities lending,” as well as exposure to smaller companies.  (A month after that appeared, a very similar argument was made for the large-cap iShares products.  Given the unlimited range of indexed vehicles these days, there is no end to the potential supply of similar articles pushing their inclusion in portfolios.)

Asset managers use ETFs too.  A study, “ETF use among actively managed mutual fund portfolios” (D. Eli Sherrill, et. al), was reviewed by Tommi Johnsen for AA.  The research examined the relative results of benchmark ETFs (those that mimic the performance benchmark of a fund) versus non-benchmark ETFs, regarding liquidity, returns, and risk.

We could go on.  In the investment advisory world, there are all sorts of indexed applications that go beyond the acquisition of beta.  Advisors sometimes invest in individual specialty ETFs on behalf of their clients, but they also utilize separately-managed accounts and model portfolios, many of which now consist of ETF strategies rather than the individual securities of yore.

Questions

What kinds of investment (in terms of vehicles, tactics, investor types, etc.) in indexed strategies tend to add value?  Which ones tend to detract from value?

The available evidence regarding this question is mixed and limited.  One paper, “Blessing or Curse? Institutional Investment in Leveraged ETFs” (Luke DeVault, et. al), states that:

Empirical tests suggest that institutional holders of leveraged ETFs predict weak portfolio performance in aggregate, consistent with manager hubris, especially among the set of institutional managers most likely to lack management skill.

A reversion of the popularity — and therefore performance — of thematic and sector strategies seems particularly common.  Here’s an exhibit from “Competition for Attention in the ETF Space” (Itzhak Ben-David, et. al):

In what ways are the indexed strategies that your organization employs (or is thinking of employing) inherently “better” than ones created of individual securities?  In what ways are they “worse”?

A simple exercise among those involved in the investment process seems warranted, given how indexed strategies are taking over.  What evidence can be marshalled in support of those characterizations?  It is likely that more and more questions will be asked along that line.

What is the probability that the performance attributes of the strategies you use have been goosed by the popularity of and flows into them?

What are the big-picture ramifications of the tremendous changes in market composition, strategies, and attitudes regarding the use of preset packages of securities versus securities themselves?

Where do you think we are at on this migratory path?  What are your game plans for some likely (and unlikely) scenarios in terms of changes in market behavior and the implications for your organization’s investment outcomes?

At what point (if any) will this all have gone too far?

A 2019 article in the Financial Analysts Journal, “The Revenge of the Stock Pickers” (Hailey Lynch, et. al) stated:

When an exchange-traded fund (ETF) trades heavily around a theme, correlations among its constituents increase significantly.  Even some securities that have little or negative exposure to the theme itself begin to trade in lock-step with other ETF constituents.  In other words, because ETF investors are agnostic to security-level information, they often “throw the baby out with the bathwater.”

It was titled — perhaps over-optimistically given subsequent evidence — “The Revenge of the Stock Pickers.”

Are investors, by virtue of their expanding use of indexed strategies, becoming increasingly “agnostic to security-level information”?  That would generally seem to be the case, making all of these questions among the most important ones that an organization can be asking itself.

Published: March 28, 2022

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Unpredictable People, Leverage, and Walking the Talk

If you’re new to The Investment Ecosystem, this regular feature is one of the free offerings, featuring a variety of interesting reads about the investment world.  It is included in all of the subscription plans; try out the monthly or yearly plans to get the full range of content.

Walking the talk

FCLTGlobal has released a paper, “Walking the Talk: Valuing a Multi-Stakeholder Strategy.”  The main body of it starts in this way:

The term stakeholder can be unnecessarily polarizing.  This publication uses the term primarily to talk about groups that have a direct means of influencing a company (e.g., regulators, lenders and creditors, and shareholders) or play a direct role in ensuring the success of the business (e.g., customers, suppliers, and workforces).  The leaders of businesses that outperform in the long term know instinctively that attention to their key constituents is central to their success.

The core argument is that a multi-stakeholder approach leads to better financial results over time — even if a shareholder-centric emphasis might do so in the short term.  (The methodology for the simple exhibits that are provided is in the appendix.)

This is how it ends:

The landscape of corporate expectations is ever changing; responsible long-term companies develop processes to consistently evolve their approach to remain responsive to key stakeholders while also staying true to their corporate purpose — ultimately delivering superior value over time.

Leveraged loans

The latest edition of Verdad’s weekly newsletter is called “The Loan Engine.”  It begins, “The Federal Reserve Bank of New York is out with a staff report warning of the dangers in leveraged loan funds,” noting that they have become a popular place to be of late.

But:

Our research suggests that much of this lending is, in fact, riskier than high-yield bond lending, despite being senior secured.  A rule to remember in lending is that the best borrowers borrow long, fixed, and unsecured.  The worst borrowers borrow short, floating rate, and secured.  And in this case, the main driver of leveraged loan growth is private equity using loans to fund buyouts.  Senior secured leveraged loans help private equity firms maximize the amount of leverage for the lowest cost.

Given the money that’s been gushing into private equity over the last few years, we’ll see what credit quality looks like when we have a recession that lasts longer than a quarter.

You can look at the return profile of leveraged loans in an IE chart of the day tweet from last week.  Also, some overdue news:  “Old-School Leveraged Loan Market Is a Step Closer to Ditching Faxes.”

Direct lending

To continue with the lending theme, Cliffwater has done a great job of summarizing the fees and expenses involved in direct lending via a clear and straightforward report, “Private Fund Fees and Expenses for Direct Lending.”  It is available here, along with other good information.  (Just select the “Private Debt” filter.)

Hanging out your editorial shingle

The emergence of Substack and other platforms has led to an explosion of investment content (and other content too).  In a recent series of tweets, 10-K Diver offers a quick overview of the landscape.  It may or may not be your ticket to stardom — that has certainly happened for others — but at a minimum putting your words “in print” is a valuable process no matter what else comes of it.

Other reads

“Remembering Michael Price, a Legendary Value Investor,” Meryl Witmer, MarketWatch.  “Rely on primary sources, dig deep, and don’t use sell-side reports.”

“ESG, Impact, and Greenwashing in PE and VC,” Anikka Villegas, PitchBook.  A look at three types of ESG investors:  purists, pragmatists, and pluralists — and what greenwashing looks like to them.  Also, two kinds of impact.

“Creating A Financial Planning Residency Program To Develop The Next Generation Of Advisors,” Carolyn McClanahan and Joey Loss, Nerd’s Eye View.  Reimagining advisor education using the medical education model.

“Do Investors Understand the Long-Term? Crystallizing what it means to be a long-term investor,” Jakob Thomä, et. al, 2° Investing Initiative.  This short paper offers three premises:

1) Everyone thinks that being a long-term investor is a good thing.

2) Asset managers and asset owners think they are long-term investors, but they don’t agree with each other on what that means.

3) Investors are not long-term investors according to their own definitions.

“Investor Relations 4.0: Transforming Investor Relations for the Digital Age,” DiligenceVault.  An argument for moving to a next-generation IR function.  (This is IR from managers to allocators, although the same principle applies from companies to managers.)

“Portfolio Construction in the Context of a Global Private Markets Platform,” Michael Taylor, Adams Street.  “Active portfolio construction [using co-investments] is a powerful tool to manage risk exposure while achieving portfolio level objectives.”

“SEC takes its finger out of the dike with investigation of Big 4 auditors’ conflicts,” Francine McKenna, The Dig.  “Is the regulator ready for the flood of findings, fines, and sanctions that might jeopardize the viability of more than one firm?”

“Leverage: Friend or foe?” Sarah Rundell, Top1000funds.com.  Large asset owners are using leverage at the portfolio level.

“Block trading probe of Wall Street banks and hedge funds may cast large net,” Todd Ehret, Reuters.  “The probe into practices surrounding such trades could be extensive and far-reaching, involving potentially hundreds of individuals and dozens of firms.”

“A Fool and His Gold,” Doomberg.  The meme stock craziness just went to a whole new level.

“Inside the bubble,” Seth Godin, Seth’s Blog.  “Whenever there’s a speculative bubble going on (or a cultural one, for that matter) life inside the bubble seems rational and normal.”

Unpredictable people

“The numbers we use are an abstraction of reality, not reality itself, which is full of unpredictable people.”  — Mike Lipper

The 60:40 stalwart

This chart begins ten years ago, in January 2012.  The total return of a 60:40 mix (rebalanced monthly) has never been below zero — and there haven’t been too many down months.  The last bar is March month-to-date.

With inflation on a tear and rates rising, we’ll see if equities catch a cold, resulting in both parts of the portfolio struggling.  That hasn’t happened very often during this period.

Postings

Two recent postings:

“OCIOs: History and Evaluation.”  In many ways, outsourced chief investment officers are a return to the distant past.  Here’s some history regarding OCIOs, comments on the current environment, and considerations for those interested in this hot industry trend.

“Two Sides of Ambivalence.”  Confidence is highly prized in the investment world, even though the essence of the endeavor involves uncertainty.  Perhaps there is an unappreciated superpower worth discovering.

All of the content published by The Investment Ecosystem is available in the archives.  Also, follow us on Twitter — and consider a paid subscription so you don’t miss any of the insights on the site.

Published: March 21, 2022

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Two Sides of Ambivalence

The Hidden Brain podcast probes “the unconscious patterns that drive human behavior, shape our choices, and direct our relationships.”  An episode, “The Benefits of Mixed Emotions,” features Naomi Rothman, who “explores how ambivalence changes the way we think and how it changes the way others see us.”

As noted in an earlier posting, an attitude of confidence about one’s ideas is much prized in the investment world.  That easily spills into overconfidence, which we can define as a level of confidence that is unwarranted by the balance of information that is available.  Displaying ambivalence is generally a no-no.

A penalty for ambivalence

Rothman says that “people tend to have negative perceptions of those who are ambivalent, those who are expressing that they feel tension and conflict about something.”  In some studies, doctors who admit that they are weighing two possible diagnoses “were rated as more indecisive, as less well informed, as lower in job performance — and people were less likely to say that they would follow their advice.”

It’s not a great leap to see that similar factors are at play in other realms of expertise.

In fact, research shows that “leaders who show their ambivalence in earnings calls — CEOs, CFOs — receive more skepticism from the analysts and the marketplace.”  They face a “scrutiny penalty” (which on average is larger for women executives).

Skepticism of those who display ambivalence is the default reaction in most corners of the investment ecosystem.  Which is weird.  Given that markets are uncertain places, shouldn’t the desire for certainty be viewed with suspicion, as something unnatural and ill-fitting for the task at hand?

Benefits of ambivalence

Most people are drawn to leaders and experts who express unrelenting confidence and optimism.  But a one-sided world view can lead to a toxic positivity where dissension is unwelcome and shortcomings aren’t addressed, resulting in a narrowing perspective that obscures opportunities.

Conversely, those who freely express their ambivalence — and the need to consider the dissonant evidence that exists — create an environment for better decision making.  Their openness to new ideas and a variety of perspectives signals to others that divergent thinking is an essential activity.  The results:  more exploration, more learning, increased interaction with others who might have valuable information and insights — and better outcomes.

Two sides

This is a paradox.  People tend to be turned off by those who are willing admit their ambivalence, even though there are powerful benefits to doing just that.  Two sides of one coin.

Two more sides:  Rothman’s work is grounded in the study of “emotional ambivalence.”  We might also think about something we could call “analytical ambivalence.”  The latter is borne of the range of evidence that is surfaced as a result of any thorough analytical effort; there are always pluses and minuses.

That analytical ambivalence feeds the emotional ambivalence, which can also be affected by the memory of prior decisions and experiences, the cultural environment of an organization, and market conditions.  Too often, it’s all kept inside, hidden from others.

Implications for due diligence

The “people” and “culture” sections of most due diligence analyses come up short in regard to topics like these.  (To use the terminology of the Academy course, they lack explanatory depth.)

Some relevant questions regarding your due diligence work:

Is the willingness to express ambivalence — to talk openly about the uncertainties of any idea or strategy — a good marker on which to judge an investment professional or organization?

If so, what tactics do you use to reveal it?

What is your preference?  Do you favor people and organizations who are highly confident in their positions, or would you rather have them be open about the uncertainties that exist (and their own doubts and concerns)?

Looking back at your past work, have you addressed this dimension in your analyses?  Why or why not?

How would you place the people/organizations that you have analyzed and recommended on a spectrum — in terms of their (avowed) uncertainty or certainty about their beliefs and decisions?  (Take out a piece of paper and consider the best ways to plot them and see what the distribution shows.)

Implications for manager selection

As you sell your ideas to others in your organization, the same dynamic comes into play.  Are you allowed to talk about the uncertainties that you have regarding a given manager, strategy, or organization — or would giving a balanced view of the pros and cons mean that your recommendation would be discarded in search of a more “perfect” candidate, one for which you don’t have any ambivalence?  (Translation:  You hide any ambivalence you have.)

Such cultural impediments mean that the benefits of sharing that ambivalence — analytical and emotional — aren’t captured.  The selection of a manager starts without the proper context, without the whole story, without an emphasis on the uncertainties.  This especially happens with “world class” or “top quartile” managers, even though their organizations are messy too if you bother to look closely.

As a result, disappointments are more common than need be, simply because the going-in expectations are too high.  That is a key reason for the revolving door of manager selection.

Permanent uncertainty

Shankar Vedantam, the host of Hidden Brain, often asks the researchers who are his guests on the podcast to relate stories from their own experience that illustrate the findings of their work.  He did so to good effect with Rothman.

Of special interest were her observations about her father, who by nature was a model for the virtues of ambivalence that she ended up studying.  He was “uncomfortable with premature certainty,” always wanting to learn more about something prior to passing judgment and being open to, even seeking out, disconfirming evidence.

The reality for investment professionals is that real certainty is unachievable, even when our confidence level rises to the point that we confuse the two.  Decisions need to be made, even though we remain in a state of permanent uncertainty.

A willingness to embrace that uncertainty — and to talk openly with others about the ambivalence it engenders — is an unappreciated superpower worth discovering.

Published: March 20, 2022

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