Tom Brakke – Page 22 – The Investment Ecosystem

Closet Indexers, Semantic Knots, and Quality Rules

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Looking for closet indexers

Ever since active share became a thing, a bit more than a decade ago, there has been a hunt for “closet indexers.” As reported by the Financial Times in November, the American Century Value Fund was sued by one of its investors who claimed that the fund was a closet indexer and therefore was charging inappropriate fees. Markov Processes, an independent quantitative researcher, rebutted the charges with postings in December and January.

This is an important issue for asset managers, mutual fund boards, and fiduciaries alike; it’s unlikely to go away any time soon. What constitutes closet indexing? What kind of evidence supports it or refutes it? How long is too long to hug an index, or is that never appropriate?

No matter what side of the table you sit on, you should have some beliefs that guide your actions.

Semantic knots

The Standards Board for Alternative Investments (SBAI) addresses “key areas of investment practices: disclosure, valuation, risk management, fund governance, and shareholder conduct.” Its detailed response to the Financial Conduct Authority’s discussion paper on “Sustainability Disclosure Requirements (SDR) and Investment Labels” provides some industry perspective on emerging regulatory ideas.

The tiers of labels and disclosure proposals give an indication of the difficulties of the issues to be addressed — and the semantic knots that are likely to result when trying to create a fixed frame through which to view a dynamic and evolving system. (See this piece on ESG for a few of the uncertainties that might clash with attempts to nail down labels for levels of sustainability.)

Lou Simpson

Simpson, the legendary manager of Geico’s portfolio, passed away on January 8. A posting by The Rational Walk provides some background on Simpson, a number of good links about him, and results from his first twenty-five years with the portfolio. A 1987 profile from the Washington Post provides additional perspective on the low-key but highly-successful manager.

In 2007, Jeffrey Ptak of Morningstar wrote about a visit with Simpson, which included this bit of investment philosophy:

Simpson disputed the notion that there’s a stark divide separating growth and value stocks, saying such stocks were “joined at the hip.” He reinforced that point by adding he’d always like to buy “growing businesses at value prices.”

Not low key

A couple of stories of flashier fellows — huge names in deal making in the eighties — are also enlightening. “The Debt King,” an article by Jacob Bernstein, chronicles the times (and ongoing dance) of Ron Perelman. A podcast from Ariel Levy, “The Just Enough Family,” provides an inside view of the rise and fall of Saul Steinberg’s empire.

Other reads

“Mark-to-Market Rounds — What Will Your Startup’s Strategy Be?” Tomasz Tunguz, Redpoint. Private company “rounds” are changing:

Some of our portfolio companies raise mark-to-markets annually or bi-annually as a matter of course to demonstrate strength, provide liquidity, forestall an IPO. Others leverage mark-to-markets as a defense against M&A. Still others forgo them altogether, not wanting to burden the balance sheet with excess assets. And last, some decide to negotiate the valuations lower, preferring a consistent and more modest price increase, and the confidence of knowing next year the business will be worth more, irrespective of a correction.

“A Better Bang for the Buck 3.0,” Dan Doonan and William Fornia, National Institute on Retirement Security:

This analysis finds that defined benefit (DB) pension plans offer substantial cost advantages over 401(k)-style defined contribution (DC) accounts. A typical pension has a 49 percent cost advantage as compared to a typical DC account, with the cost advantages stemming from longevity risk pooling, higher investment returns, and optimally balanced investment portfolios.

“Corporate Excess,” Roger Lowenstein, Intrinsic Value. In which GE is Exhibit A:

But there is one entitled group that is largely insulated from the market’s judgment — the hired suits who run America’s public companies. These executives have for decades preached the mantra of “pay-for-performance” but they rarely live up to it. They are overpaid when they succeed and — no other word for it — obscenely overpaid for failure.

“Should Passive Investors Be Happy Buying Equities at 100x Earnings?” Joe Wiggins, Behavioural Investment. At what point is a strategy untenable? “No approach is perfect, we must pick our poison.”

“Startup ‘Choir’ Aims to Diversify Finance Conferences With Certification,” Michael Thrasher, RIA Intel. “The technology platform and consultancy has also created a certification that conferences can earn,” for inclusion of diverse professionals as speakers.

“UBS Targets Less-Wealthy Customers With Advice by Device,” Margot Patrick, Wall Street Journal. The bank expects to wow the new customers via thought leadership:

“They are going to be getting great UBS content, great UBS intellectual capital, just delivered to them in a different way,” said Tom Naratil, president Americas at UBS. He said UBS has a global perspective and capabilities that U.S. wealth managers don’t, and “that’s our real differentiator in the U.S.”

“How Jessica Simpson Almost Lost Her Name,” Stephanie Clifford and Eliza Ronalds-Hannon, Bloomberg Businessweek. A fascinating story about brand licensing as “a financial model,” akin to other strategies of modern markets, shaped by Robert D’Loren:

“Don’t invest anything into supply chain, design, etc., and minimize marketing; just let the income streams naturally fade over time,” D’Loren says. “The key to the model being sustainable” is to keep buying new brands to replace those declining income streams.

“Asset Management Trends 2022,” OliverWyman. A quick list of ten ideas, starting with, “Macro tailwinds fade, taking the air out of managers’ sails.”

Our times

“Raising hundreds of millions of dollars from gullible investors who don’t do much due diligence is not particularly impressive anymore.” — Matt Levine.

Quality rules

Terry Smith has received a lot of attention as a result of his most recent Fundsmith annual letter. Most of it was related to his comments on Unilever, including:

A company which feels it has to define the purpose of Hellmann’s mayonnaise has in our view clearly lost the plot. The Hellmann’s brand has existed since 1913 so we would guess that by now consumers have figured out its purpose (spoiler alert — salads and sandwiches).

Smith also made the case for the kind of quality stocks that he espouses, using the MSCI World Quality Index as a proxy. Above is a longer view of that index versus the MSCI World, showing the absolute performance on top and the relative performance on the bottom. Notice the surge in 2020.

So, does quality rule? Smith makes the case that it will over any ten-year period. Are you with him, or was this long period (from the start of the index data, by chance almost coinciding with the uber-bull market) unusual?

Postings

Among the recent postings was a Sampler reposting of “Breaking Open Private Equity,” appropriately enough now open to all. Also, for paid subscribers:

“How to Use Academic Research.”

“The Goal of Explanatory Depth.”

“The Elusive Full Market Cycle.”

“Capital Market Assumptions as Explored Beliefs.”

Thank you for reading!

Published: January 24, 2022

To comment, please send an email to editor@investmentecosystem.com. Comments are for the editor and are not viewable by readers.

Capital Market Assumptions as Explored Beliefs

An online search of “capital market assumptions” (CMAs) yields a large number of hits, with the top results dominated by the latest projections from larger asset management firms and investment consultants.

In their simplest form, CMAs are comprised of the mean-variance optimization statistics that are at the heart of modern portfolio theory, which describe expectations for the returns, volatilities, and correlations of the assets to be employed.

Asset owners use those statistics in models that lead to actions outside of the investment portfolio — such as funding and benefit decisions for pension plans, or spending policy and budget choices for foundations and endowments — and which provide a framework for asset allocation policies.

An expression of beliefs

The formation of the assumptions proceeds differently based upon the size and expertise of an organization. Smaller entities typically look to an investment advisory firm, institutional consultant, or OCIO to provide CMAs, which may be put into use with relatively little examination. The largest organizations usually have the in-house expertise that allows them to build the assumptions from the ground up, using their own capabilities and tapping a variety of outside sources.

Whether home-grown or off-the-shelf or something in between, the CMAs are an expression of beliefs. As such, in draft form they should serve as a vehicle for a discussion of those beliefs, the proposed choices, and the implications of them — well before the CMAs are adopted and implemented.

Questions

Here are a few of the questions that should be asked of those who have arrived at the draft assumptions:

Are the numbers primarily forward-looking or backward-looking? Expectations are largely anchored by past experience, but future return profiles are a function of current conditions, subsequent developments, and the forecasted time horizon. The location on the forward/backward spectrum will result in different projections, sometimes quite different, regarding returns, volatilities, and correlations. Another consideration: Larger disconnects between history and forecast are more difficult to communicate to stakeholders. (Procyclical behavior is evident. See, as one example of research on the topic, “The Return Expectations of Public Pension Funds,” by Aleksandar Andonov and Joshua Rauh, which argues that “institutional investors rely on past performance in setting future return expectations, and that these expectations affect their target asset allocation policy.”)

Are the essential elements of the forecasts presented in a granular but clear fashion? CMA documents can range from the sparse to the bloated. What is most helpful for those trying to understand the choices made is to identify the component factors for each asset class and to convey them in a straightforward manner. A bare-bones presentation of the bottom line doesn’t provide enough context, while a comprehensive approach — which may provide deep detail on economic factors — is often too much information for users.

How are the uncertainties around the assumptions expressed? It is quite common for there to be too much attention to the statistics and not enough exposition of the range of possibilities. What stress tests and scenario analyses were done? Did they go beyond the standard approach of modeling some of the notable crises of the past to consider more drastic events and outcomes? Contemplating those out-there situations is the first step to being able to adapt to varying conditions going forward.

Related to that, are there developments that could cause the expectations to be wrong in substantive ways? Since deviations from plans in a positive direction aren’t really a concern; the focus is on downside surprises. While every period is fraught with uncertainty, is this one more unusual than normal? The participants in a webinar from Portfolio Management Research on “novel risks” made the case that it is. On the economic front, we are in a “yield- and return-starved world,” with a current inflation rate never before seen by many investors and sizable central bank balance sheets. Then there are pandemic, cybersecurity, and digital asset risks, all pretty new. And the big one — climate change — carries industry, regulatory, economic transition, and geopolitical risks. Put it all together and you have a situation where our existing models and analyses are lacking, and overreliance on historical information could be particularly dangerous.

Are the expectations and perceived requirements for returns affecting the objective evaluation of prospective returns in any way? The decline in expected returns, especially over the last decade, has been met by a variety of tactics. Most prominently, portfolios are riskier and less liquid. Also, there has been an increasing use of leverage, not just within alternative asset exposures, but on portfolios themselves. The shortfall from declines in expected returns can also be closed by nudging the assumptions in favorable directions, kicking the can down the road in the hope that things break in a positive way. Both internal analyses and those from an outside advisor can be subject to the dangerous tendency to make those kind of adjustments.

What are the range of expectations in a given asset class that are used by others? While the goal shouldn’t be to follow what others are doing, you can get important perspective by seeing the spread of forecasts from those who publish CMAs. One easy way to do that is by viewing the surveys of CMAs published by Horizon Actuarial Services. (As noted in the methodology sections of the reports, one issue to contend with is the lack of consistent definitions of some of the asset classes.)

How do you come up with your private equity assumptions? Take a look at this graphic from Horizon’s 2021 survey (these are ten-year CMAs):The individual asset classes have their own indicators; for example, each red triangle represents the expectations for private equity by a surveyed firm. As you can see, they are all over the place. On the horizontal scale, there are standard deviation assumptions of less than 10% out to 35%. The former must believe that the smoothed numbers reported by general partners represent the true volatility of PE, while the latter scoffs at such an approach. In terms of returns, there’s a clear outlier, miles above everyone else. Is that based on historical returns or something else?

What about venture capital? Venture isn’t mentioned in the Horizon report (so the assumption is that it is in the private equity bucket). But it presents a great example for a debate on how much current conditions should affect forward expectations. The extraordinary results of late from a number of venture investors, especially university endowments, would bias many toward keeping the forward assumptions robust, and maybe even moving them higher. But the last time venture had a cycle like this, the subsequent ten years were miserable. What do you do?

How about private credit? Not even recognized as an asset class by most asset owners just a few years ago, private credit has surged in popularity. There are a number of different strategies under that umbrella, historical information is sparse, and the size of assets employed has grown dramatically. How do you come up with a forecast?

Do the CMAs include alpha expectations? There are firms that publish CMAs which include expectations of alpha within some categories (typically alternatives); you normally have to check the footnotes to find that out. They argue that they are able to produce that kind of outperformance, so it should be included, but that’s far from a given (and alpha tends to erode over time). In any case, it muddies the waters. Such an approach shouldn’t be considered a best practice; you should forecast and use beta returns for planning purposes, and let anything above that be a pleasant surprise.

The end result

Ultimately, if you are using a mean-variance optimization (or another approach), you will need to arrive at a set of numbers to use. But the most valuable part of the endeavor may be the scrum leading up to that adoption, with its consideration of the questions above, in addition to others.

A good process should document the uncertainties and weaknesses involved with the final conclusions — there will always be many of them — along with the range of possibilities that were explored for individual issues and why specific choices were made.

Examining potential CMAs and adopting final ones can be a check-the-box exercise or it can be an enlightening journey that prepares you for what’s to come. Which description comes closer to characterizing your approach?

Published: January 20, 2022

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The Elusive Full Market Cycle

If you spend much time looking at investment policy statements of asset owners or advisory firms — or at the marketing materials of asset managers — you’ll often come across the phrase “full market cycle.” As frequently as it is used, it is almost never defined. Even academic papers sometimes employ the phrase without explanation.

A general sense of the ambiguity is reflected in a page of “Stock Basics” from FINRA:

This cyclical pattern — specifically, the pattern of strength and weakness in the stock market and the majority of stocks that trade in the stock market — recurs continually, though the schedule isn’t predictable. Sometimes, the market moves from strength to weakness and back to strength in only a few months. Other times, this movement, which is known as a full market cycle, takes years.

You will occasionally find a definition that includes some specific metrics for marking a cycle. While it doesn’t include the word “full,” this is how Campbell Harvey’s glossary defines “market cycle”:

The period between the two latest highs or lows of the S&P 500, showing net performance of a fund through both an up and a down market. A market cycle is complete when the S&P is 15% below the highest point or 15% above the lowest point (ending a down market).

That would result in more frequent market cycles than what you normally see cited, especially in the 2010s, which most people consider one long up move in U.S. stocks.

Purpose

Does the uncertainty around the use of the phrase matter? Let’s look at its supposed purpose. Here are excerpts of documents from different kinds of organizations:

Advisory firm: Our investment philosophy is to grow wealth and manage risk throughout a full market cycle.

Asset manager: The strategy seeks to outperform the Barclays US Aggregate Bond Index with a similar risk profile over a full market cycle.

Consultant: A multi-strategy fund seeks to add alpha over a full market cycle, while providing significant risk reduction through diversification of manager and investment styles.

OCIO: These investment objectives are expected to be achieved over the long term and are measured over a full market cycle.

Public pension plan: Tracking error relative to the Custom Fixed Income Benchmark is expected to be below 50 basis points on an annualized basis over a full market cycle.

“Full market cycle” is almost always used in relation to performance attributes of one kind or another. If that’s the point, then there should be a shared understanding among the parties involved regarding the meaning of the term. It rarely exists.

Reporting

Furthermore, when was the last time you saw any of those metrics reported for the period of a full market cycle (whatever that is)?

Ryan Leggio and Steven Romick of the FPA Funds wrote this (published in 2015 by Advisor Perspectives among others):

A full market cycle can be defined as a peak-to-peak period that contains a price decline of at least 15% from the previous market peak, followed by a rebound that establishes a new, higher peak. Few publications or data providers publish, let alone highlight, full market cycle returns, yet we believe understanding them can help the return of your portfolio over the long-term.

The definition is similar to the one from Harvey’s glossary, with the additional requirement that a “new, higher peak” must be attained for a new cycle to start. The second sentence gets at the need to improve industry practice.

The most recent factsheet of FPA Crescent Fund, for the period ending September 30, does indeed show market cycle performance, so the firm is living up to its views. However, the period shown for the most recent market cycle — from 2007 to the date of the factsheet — is at odds with the definition above. (A different description for a full market cycle appears in the footnotes; it excludes other declines during that period, notably the sharp one related to the pandemic.)

Other considerations

The notions of market cycles have changed over the years; some even consider those of late to be “fake” in some respect given the unprecedented actions of central banks. And the relationships between economic and market cycles look different, as do strategies that were honed during a different time — remember sector rotation?

And what of assets other than equities in the United States? One university endowment lists goals for each segment and manager of the portfolio, all to be evaluated in the context of those full market cycles, with no clarity on what that means specifically for the disparate kinds of investments. (As an exercise, how would you mark the cycles for a portfolio of sovereign bonds from different countries?) We can make this very messy if we want to delve into the nuances.

The important thing is that this notion of full market cycles has to go from being a convenient but mostly worthless concept to something that’s actually understood and used. Otherwise, it should be tossed onto the ash heap.

Published: January 18, 2022

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The Goal of Explanatory Depth

In the prologue to the audiobook Miracle and Wonder: Conversations with Paul Simon, Malcolm Gladwell asks:

When we call someone like him a musical genius, what does that mean? Can we be more specific about how experience and culture and talent and family combine to make music that endures?

We could offer similar questions about people who we think individually or collectively demonstrate investment genius. Can we be more specific about what the qualities are that earn them that designation — or even about the calculus of the personal scoresheet we use to come to that conclusion?

This topic was addressed a bit in a previous posting, “Who Are These People Anyway?” Now let’s extend it more broadly to consider the explanatory depth that is often lacking in due diligence efforts and (especially) reports and recommendations. (The need for “explanatory depth” is one of the core themes of the due diligence course in the Academy.)

Explanatory depth

For those viewing investment problems through a quantitative lens, the explanations of a manager’s efforts over time are found in the numbers. They encompass absolute, relative, and risk-adjusted performance, including many different metrics calculated from the return stream, plus factor and sector exposures from holdings analyses, as well as performance attribution, etc. The predictive power of the measures are questionable, but they are the basis on which decisions are made by many.

As examined here, however, “explanatory depth” refers to the qualitative characteristics that are ascribed to managers by those doing due diligence. You know the categories — process, culture, philosophy, leadership, people, and the like.

We can judge a due diligence effort on its examination of those dimensions, as well as the communication of the range of that analysis to others via reports and presentations. Because that transference of knowledge requires editing (you can’t and shouldn’t try to tell everything you know), there are gaps between the two. Each is important in considering the notion of explanatory depth.

Reporting the narrative?

An asset manager’s marketing collateral might say, “We are known for our collaborative culture.” If a due diligence report then states, “The manager is known for its collaborative culture” (or a paraphrase of that), has analysis been done? Maybe or maybe not.

Due diligence reports often include conclusions that fit that pattern. The reader of the report has no way of knowing whether the assessment was the opinion of the person doing the due diligence or just the narrative of the manager being passed along. Because of the need to condense information into a usable form, the statements lack context and it is unclear whose points of view are being delivered and what is behind them.

Therefore, in evaluating the quality of a due diligence effort, some testing is required. If the marketing materials of the manager are at hand, scanning them versus the recommendation report usually turns up a number of topics with common descriptions between them. Those should be probed to find out what evidence supports the assertions and what techniques were used to surface it.

If the manager’s materials aren’t available, an exploration of some of the conclusions can serve the same purpose. Ask about the manager’s narrative, the conclusions (of the due diligence analyst) that have been presented, the techniques used to come up with them, and the evidence that supports them. Doing that with a couple of those standard topics will reveal more about the nature of the investigation than the talk about investment ideas that usually dominates such interactions.

Either this stuff is important or it isn’t. If there’s not much behind the conclusions (other than that narrative), then they are being oversold as essential elements of the analysis.

Deeper levels

Hopefully, the due diligence has gone beyond the immediately available narrative in ways that surfaced more detailed information. Those managers who are best prepared will have ready answers for many basic lines of inquiry, so the narrative is not confined to the marketing materials. There is more sorting to do.

The key is getting them past the point of preparation and to the nitty-gritty of the topic at hand. Does the pattern of information support the claims that are being made? What bits of it are the product of discovery by the analyst that wouldn’t be found in the meeting notes of others who do similar work?

Explanatory depth is a difficult standard. You won’t (and can’t) understand everything about an organization, but you should be able to support the statements that you make about a manager based upon independently-surfaced information. If you opine that a manager has a collaborative culture, then that view should be your own and you should be able to explain why that is an apt description based upon the work you have done.

(A very simple example of this principle can be found on a slide from the due diligence course. On the left is an example of what a manager says about its sell discipline, which can also be found in due diligence reports about it prepared by others. Presenting that description — in quotes — along with the column on the right makes clear the manager’s narrative, as well as characterizations and conclusions about it from the investigating analyst, plus a mention of the process used to arrive at them.)

Considerations

The kind of depth being sought requires an expansive view of due diligence practice. For instance, you are unlikely to get a deep view of an organization through a single point of contact, or even through multiple contacts if they are tightly clustered in terms of responsibility. The triangulation that comes from interviewing people in different functions and at different levels provides a more complete picture.

Searching for that elusive depth takes you into areas where others don’t venture, providing a richer vein of information. It also helps you to locate boundaries that can illuminate even as they obscure, especially regarding questions that people can’t or won’t respond to, or things you aren’t allowed to observe. (No one could visit Madoff’s 17th floor to see the IBM computer from which the customer statements flowed or the people in on the “operation.” Nor could you see a Theranos blood machine in action — or audited financials for the firm, for that matter. Less dramatic examples occur with regularity; even minor matters can provide helpful clues.)

Explanatory depth takes time. That sets up a potential conflict: When deadlines are short, as in a situation where there is an upcoming closing and — based upon limited information — you have a desire to get in, what do you do?

There is no right answer. It depends on the beliefs and processes of your organization, and the trade-offs it is willing to make. Your strategy may be predicated on quick responses made with less information. If so, that should be clear to all (as well as the anticipated benefits and risks of such an approach).

Just don’t dress it up as thorough due diligence — or convey the manager’s characterizations as if they were your own.

Published: January 13, 2022

To comment, please send an email to editor@investmentecosystem.com. Comments are for the editor and are not viewable by readers.

How to Use Academic Research

The proliferation of publicly-available academic research concerning investments over the last two decades has changed investment practice in many ways.

It used to be rare for working papers of academics to get much attention other than from fellow academics. The Social Science Research Network, now just SSRN, was created in 1994 and soon became the prime repository of papers across a variety of disciplines, including investments. There are other sources, but SSRN is still the dominant one.

Prior to the broader availability of those working papers, academic research was limited to peer-reviewed journals, most of which were (and still are) quite expensive. (The Financial Analysts Journal is an exception, at least for members of CFA Institute, to whom it is available for free.)

Using the research

Most papers follow a format something like this:

Abstract

Introduction

Relationship to previous research

Methodology, data, and formulae

Results

Conclusion

Bibliography

Appendices, including charts and statistical analyses

If you are a statistical maven, you may find the meat of a paper of interest (roughly, the methodology, data, formulae, results, and appendices), but you can get the essence of it by reading the abstract, introduction, and conclusion. For additional perspective, the relationship to previous research and bibliography are almost always thorough, providing avenues for further investigation.

All of it should be viewed in light of critiques of finance research from within the academic community, including:

Using statistical inference to analyze a complex adaptive system sets up challenges that are often overlooked (Bailey and López de Prado).

Economic incentives can distort both academic and practitioner finance research (Harvey).

The “file drawer problem,” where only research that shows statistical significance receives attention, is evident in both the composition of academic journals (Morey and Yadav) and conferences (Morais and Morey), giving a distorted view of the body of research that has been performed.

Much of the research output is directly related to the work of those in quantitative finance, but it also can be of value for those who have other kinds of analytical, portfolio management, and advisory roles — which is the perspective taken in looking at the examples below. Does the research pass the “smell test” of representing the world as you know it? If there is a discrepancy between your experience/beliefs and the research, what is the nature of the disconnect? Often the research can prompt new insights and a rethinking of old notions and practices, although sometimes you realize that the researcher’s assumptions, design, or data account for the disconnects.

Two other notes:

Disproportionate amounts of research are done on equity markets, mutual funds, and the United States, because that’s where the information is most complete. That’s changing at the margin, as other asset classes, vehicles, and geographies are studied, but it is still the case.

In this posting, no attempt is made to evaluate the techniques or quality of the examples of research that are provided.

Pairs trading

A pairs trading strategy is executed by going long one security and short another, in the expectation that their relative values will converge over time. Such strategies have been the subject of a fair amount of research in the past, much of it (like a paper reviewed in a 2009 piece from The Research Puzzle) related to what makes for a good pair, one of the topics addressed in “In Search of Pairs using Firm Fundamentals: Is Pairs Trading Profitable?” from Sungju Hong and Soosung Hwang.

The abstract states that “portfolios of pairs that have higher fundamental similarity outperform those that are fundamentally less similar by minimizing the non-convergence risk.” Given that many pairs trades put more emphasis on the correlation of the two assets (which can change abruptly), the research prompts questions about the nature of risk management that should be involved.

The authors provide a long list of firm characteristics that were tested and rank them in their importance in determining the similarity of two equity securities for the purposes of the analysis. But it is the broader conclusions that are striking:

Despite the outperformance of the pairs with fundamental similarities, these pairs do not show a significant alpha any more in the 2010s. As in Gatev et al. (2006), the profitability of pairs trading continues to decrease because of active arbitrage trading and the changes in trading environment and information (Green et al., 2016), and pairs trading does not seem to be profitable any more in the US market. The results indicate that temporal price deviations that can be exploited by arbitrage trading are less likely to arise, and if any, these pairs may be spurious.

Two charts provided illustrate a stark change in the overall historical pattern of returns to the strategy.

Questions:

If you are a manager who implements pairs trades, does this match your beliefs or prompt you to consider rethinking your approach?

If you are an investor, has your due diligence allowed you to understand the nature and prevalence of pairs trading among your current and prospective managers — and how they have adjusted to a less fertile environment?

How much of the change in alpha opportunity is related to the massive flows into passive investment products? Would a reversal of that trend revive the trading strategy?

Pairs trading is common in other asset classes (notably fixed income) and even for multiple-security vehicles (increasingly, ETFs); has the compression of alpha proceeded in like fashion among those strategies?

Fund size matters

A couple of “stylized facts” from the body of academic research come into play in a paper from Gelly Fu, “Small Fund Size Matters.” Namely, because investors place “a disproportionately large amount in the top performing mutual funds,” firms “have high incentives to produce outperforming funds” and align incentives for those managing funds accordingly. Plus, “mutual funds exhibit decreasing returns to scale, that is, mutual funds perform worse as they grow larger.”

Based on those assumptions, Fu studies cases where portfolio managers run more than one fund to see if the smaller funds have better performance than they otherwise would have when controlling for size and other factors. They do, but only when there is a significant difference in size among the funds managed. (The paper also looks at changes in the relative size of funds overseen by a portfolio manager as a result of fund mergers — and references research by Agarwal, et al. which finds that “managers temporarily divert their attention” to a newly-assigned funds, which often come to them because performance has been poor under a previous manager.)

Fu uses the phrases “preferential attention” and “priority funds” to describe managers’ approach, which many involved would probably dispute, although:

I examine the trading activity of priority funds using quarterly holding data and find that priority funds exhibit less herding behaviour compared to the non-priority funds, in other words, managers tend to lead the institutional crowd with their trades in the priority fund. This implies that when managers identify a good investment opportunity, they first trade on this investment with their priority fund before moving on to their non-priority funds.

Questions:

If you work at an asset management firm, does this research reflect what you have observed among managers with multiple portfolio responsibilities?

Are there practices at your firm that foster the observed performance differences, such as trade allocation policies, especially regarding IPOs?

If you are an investor, what are your opinions/operating procedures regarding portfolio managers with multiple responsibilities?

What are the incentives that exist for the asset management firms you use — and for the individual investment decision makers within them?

Selecting managers

Discerning the “why” of manager selection has been the subject of a number of analyses, among them, “Picking Partners: Manager Selection in Private Equity,” a paper by Amit Goyal, Sunil Wahal, and Deniz Yavuz. (It uses an expansive definition of “private equity,” encompassing partnerships that could more narrowly be described as “buyouts, direct lending, distressed equity, growth, infrastructure, mezzanine financing, natural resources, real estate, and venture capital.”)

The abstract summarizes the findings regarding the general partners (GPs) who manage the funds and the institutional investors who are the limited partners (LPs) within them:

In addition to chasing GPs with high prior performance, LPs have large propensities to select first-time or young GPs without a performance history. LPs also have tendencies to follow their peers’ investment decisions, to reinvest with the same GP, and to invest with GPs domiciled in the same state/country. These selection criteria, however, do not provide information material for future performance, and in the case of first-time GPs are associated with lower future performance.

There’s much there to parse. It is mostly as expected, but the conclusion regarding favoring first-time GPs is surprising. However, there are some possible explanations, each of which is addressed in more detail. It may be that the lack of access to established funds has forced organizations that are new to private equity (or have had small exposures) to ramp up their portfolio weights by targeting newer funds where they can get in. Also, the authors acknowledge that some first-time funds may not have “true rookies” at the helm, but veterans of other firms who could have been observed by LPs previously. In addition, newer kinds of investment strategies often are the province of newer kinds of firms. Or, it may be that young funds offer fee discounts to attract investors. Finally, there could be a belief “that first-time GPs may deliver superior performance.”

That last point represents a philosophy that is quite common (even among those who don’t invest in nascent firms because their governance precepts require them to wait for some performance evidence). Therefore, the conclusion that first-time funds as a class do not meet that expectation is particularly notable.

Questions:

If you are an investor, how do the findings of this study match up with your beliefs and practices?

What are your “tendencies” as to following your peers’ investment decisions, reinvesting with the same GP, and investing with GPs domiciled in the same state/country? Do you track them? Which do you think add value and which detract from it?

What are the general principles that guide your consideration of emerging managers (of any kind)?

Summary

These are but three examples of the thousands of papers that are produced every year, some of which become better known because they shine a new light on areas of investment practice and/or they receive attention from the press or leading firms.

A regular diet of academic research will help you to reconsider your assumptions and to prompt new angles of pursuit. It’s a mistake to look to the papers and articles for answers, but they can be a great source of important questions to ponder and investigate.

Published: January 11, 2022

To comment, please send an email to editor@investmentecosystem.com. Comments are for the editor and are not viewable by readers.

Misleading Numbers, Boring Meetings, and a Bad Combination

Happy New Year!

The Fortnightly is delivered to all subscribers, paid and free, and includes a range of readings and ideas for everyone. (Check out the subscription options here.)

Activists

According to a column by Jonathan Guthrie in the Financial Times, the “stakes” of activists aren’t always what they seem:

Their real exposure to gains and losses may be far lower than that of the so-called long funds that invest for pension schemes and insurers. Management and media can therefore overestimate activists’ real financial commitment — and thus the alignment of their interests with other investors.

Guthrie provides some examples where the advertised holdings of activists are misleading, but he doesn’t argue for regulatory action. Instead he concludes:

A simpler corrective would be for chief executives and long funds to be more sceptical. They should challenge activists and other sophisticated investors to state their detailed exposure to a target company with a sign-off from an investment bank. If the wheeler-dealers declined, it would be reasonable to wonder why. And we should stop throwing that silly word “stake” around.

TPG, IRR, MoM

The lede to an Institutional Investor article:

Private equity giant TPG is taking advantage of booming markets to go public next week, but critics say it is inflating the returns of its funds — and burying the bad news — in its S-1 registration statement for the IPO.

The story cites a letter by Eileen Appelbaum and Jeff Hooke to the SEC, which delves into the murky world of private equity performance reporting — and points out what they see as shortcomings and inconsistencies in the filing. It will be worth watching to see whether TPG alters the filing in any way as a result, especially given Gary Gensler’s wonderings in a November speech:

I wonder whether fund investors have enough transparency with respect to these fees. I wonder whether limited partners have the consistent, comparable information they need to make informed investment decisions.

Meetings

For a minute there, it looked as though more “knowledge workers” would be going back into the office, but for most that move has been delayed, and even rescinded for some of those who had made the transition. (What comes next in the world of work for investment professionals will be the focus of an upcoming series on this site.)

As tough as Zoom sessions can be, they are just another permutation of the meeting culture. Tyler Cowen offers his thoughts on why some (many? most?) meetings are bad. The first four points include the word “boring” and explain different factors that cause the boredom that grates on attendees.

Also, “Many meetings lack a natural close, due to insufficiently strong leadership . . . [and] do not price the scarce resource of time.”

Other

“Elizabeth Holmes and her Big 4 audit firm buddies at Theranos,” Francine McKenna, The Dig. An important angle of the story.

“Bill Foley,” Exploring Context. “How Bill Foley built several multi-billion dollar businesses and generated one of the best long-term investing track records.”

“Global Private Equity Barometer,” Coller Capital. A good set of questions to gauge what others are thinking and doing — and ask yourself what you are thinking and doing.

“An Engineer’s Hype-Free Observations on Web3 (and its Possibilities),” Dave Peck, PSL. “Fair warning: this is a long analysis of the current state of the ecosystem. It is a collection of opinions from a pragmatic builder’s perspective. It is focused away from economics and the financial mechanisms of the chains themselves.”

“Knight Diversity of Asset Managers Research Series: Industry,” Knight Foundation. The foundation’s latest piece illustrates the trends in diversity at hedge fund, mutual fund, private equity, and real estate asset managers.

“21 thoughts from 2021 I’d like to take into 2022,” Tim Urban. The opening graphic was used in a previous Fortnightly. There are many more ideas to ponder in this compilation thread.

“52 Things I Learned in 2021,” Jason Kottke. An interesting list.

Always something

“As for fads — there’ll be new ones every year. We never run out of inventory.” — Brutus, Confessions of a Stockbroker (1971).

2021 Quiz

Thanks to those who tried out the quiz that was highlighted in the last edition of the Fortnightly. It turned out that it was pretty hard, with a maximum score of only 76% and an average showing of around half of that. Here’s one of the questions:

Elon Musk was named Time’s Person of the Year for 2021. Which of these business people did not receive a similar honor in years past?

Mark Zuckerberg
Ted Turner
Steve Jobs
Andy Grove

That had the worst percentage of right answers of any question. Grove was picked by 48%, while Turner and Jobs tied for the lowest choice at 15%. The correct answer is Jobs.

A bad combination

The top panel of the chart shows the duration since the end of 1990 for two key Bloomberg U.S. bond indexes: the Aggregate (which is the most widely used as a benchmark) and the Treasury (which represents the kind of “pure” fixed income that does well during times of stress). On the bottom is the yield on those same two indexes.

The chart illustrates a key feature of so-called bond math — all else equal, as rates go down duration rises. That bad combination of higher volatility and lower yield hasn’t been much of a worry over this time period, but the bounce in inflation has investors worried.

There’s a major debate about how stocks will do if rates keep rising, but many believe that TINA is the operative principle — that when it comes to stocks, “There Is No Alternative.” (A recent Morningstar piece takes that tack: “Lower your expectations, but with bonds likely to struggle, the ‘TINA’ market for stocks continues.”)

Unfortunately, as long-duration assets, stocks also face a bad combination. The earnings yield doesn’t provide a lot of cushion and high valuations can translate into greater volatility. It’s a more complex calculus than the simple math of bonds, but there is a broader range of outcomes (including bad ones) for equity holders in a higher interest rate environment.

Postings

The slow holiday season wrapped up with a free reposting of “Ten Charts and Some Questions” and a subscriber-only essay on “Identifying Quality Across the Investment Chain.” The complete archives can be found here.

Published: January 9, 2022

To comment, please send an email to editor@investmentecosystem.com. Comments are for the editor and are not viewable by readers.

Identifying Quality Across the Investment Chain

The description for a Brandes webinar in October 2021, “Quality Shareholders: Who They Are and How Do They Add Value?” began:

By one definition, a “quality shareholder” analyzes company fundamentals, holds substantial stakes in a few for the long-term, and engages with management on specific challenges.

As noted, that’s one definition — one which does not apply broadly to the general practices of the investment management industry. Therefore, it is by no means a universal definition of a quality investment approach, but examining it raises questions for asset managers and those who evaluate them.

Companies

Philip Ordway of Anabatic Investment Partners, one of the panelists on the webinar, described “three things all companies need: Effective capital allocation, ‘good’ shareholders, and meaningful communication with stakeholders.” That spare definition emphasizes both the central role of capital allocation for company managers and the need for clarity as to purpose for all parties involved.

Ordway offered a long list of characteristics he believes are common among those managers/firms who are “adept at capital allocation.” It starts with an investing mindset, with the board and leadership “embracing” their roles as capital allocators and focusing on cash flow and per-share metrics — plus taking a long-term view and being willing to allow for autonomous decision making. Then there are the desired cultural qualities, including frugality, humility, and the willingness “to learn, adapt, be different, and look temporarily dumb.”

Just as interesting is his exposition of what not to do. That reads like a list of standard operating procedures for many CEOs, including making decisions regarding dividends and share repurchases that aren’t optimal (violating “Rule #1: Do not destroy value”), worrying about and playing to the sell-side community (and offering it “guidance”), and neglecting the power of communication to align owners and others.

By hewing to one or the other of these lists, “over time companies get the shareholders they deserve.” (For those interested in being in the first group, Ordway recommended practices for the board, executive team, and those involved in investor relations — “IR does not exist to please Wall Street, court favor with sell-side analysts, or get the stock price as high as possible” — and cited the importance of having an “owner’s manual” which lays out the operating principles for all to see, so that everyone is on the same page.)

Shareholders

Lawrence Cunningham, a professor at George Washington University, was also on the Brandes webinar. He has been analyzing what he calls “quality shareholders” for a number of years; the most comprehensive review of the work is in a 2020 book. The topics are also addressed in a paper of his.

Cunningham divides shareholders into four quadrants derived from two dimensions — their time horizon (or “vision”) for decision making and their level of conviction in position sizing. He refers to those who take a shorter-term diversified approach as transients, longer-term diversifiers as indexers, those who take concentrated positions for short periods as activists, and quality shareholders as those who invest in a concentrated way for the long term.

Using that construct, the asset management industry is dominated by the first two categories — indexers and transients. No doubt the use of the term “transients” would rankle those who find it applied to them; by process of elimination, that bucket would include a sizable majority of asset managers.

As Ordway does, the referenced paper argues the case that there is a mutual attraction between quality companies and quality shareholders. It also includes lists of companies and shareholders that meet the criteria for the respective categories, based upon research by Cunningham and others.

Others in the chain

What appears above is a pretty simple model of the world; in most instances the investment chain is more complicated than that.

The owners of an asset management firm, be they public or private entities, have expectations for returns on their ownership stakes. If the owners aren’t those involved in managing the assets (and are more interested in financial results than the investment tenets of the firm), conflicts can arise during the inevitable fallow periods that accompany any long-term strategy.

A bigger problem is that asset owners or individuals who invest with a manager might profess to understand its beliefs and intended approach, but then evaluate the manager through a performance lens in a way that is at odds with those precepts. Most asset flows (in and out) are in response to performance, making a manager’s job more difficult than it is for those who have a relatively stable pool of capital.

That is the crux of the problem, the reason why so few firms fit into Cunningham’s quality shareholder category. Their business models are predicated upon gathering assets, with the same strategy often being sold to different kinds of buyers with dissimilar interests and characteristics. In most cases there isn’t a unity of philosophy akin to the mutual attraction (albeit rare) between companies and shareholders described above.

To alter Ordway’s phrase: Over time asset managers get the investors they deserve. It’s very hard to run a concentrated portfolio with a long horizon if your investors aren’t in sync with your approach in good times and bad — and patience often runs thin.

Questions for discussion

If you are part of an asset management firm, how do you answer the questions below? (Asset owners, investment advisors, and others in the investment chain have related questions to ask themselves. Such introspection is an important part of continuous improvement.)

Into which of Cunningham’s quadrants would you place your firm?

What modifications would you make to his construct?

Considering Cunningham’s dimensions of time horizon and concentration, has there been a change in either or both in terms of your implementation over the last five years?

Should there be a change regarding either of those dimensions for you to generate better investment performance for the future?

How do you describe your investment philosophy?

What are the hard choices you have to make to implement that philosophy?

Are there any you haven’t made but should?

What percentage of your asset base invests with you because of your investment philosophy rather than other considerations?

Is there any way to better qualify potential clients given your business model?

What determines the “quality” of the companies in which you invest? Of the investors that you have?

How would the members of each of those groups answer a similar question about you?

A conversation between Cunningham and Ordway is available on MOI Global.

Published: January 4, 2022

To comment, please send an email to editor@investmentecosystem.com. Comments are for the editor and are not viewable by readers.

A 2021 Quiz, a New Understanding, and a Bunch of Apes

The first quiz from The Investment Ecosystem is now live. It is mostly a look at the wacky market year of 2021, but there are some historical questions too. See how you do; you might win a one-year subscription (or extension of your existing one) just for entering.

There are instructions at the start of the quiz that describe it more fully. The quiz will be open until January 7. To synchronize with that, the Founder subscription will remain available until then, rather than being retired after the first of the year.

Good luck!

A new understanding?

The Oliver Wyman Forum has produced a report (the first in a promised series) it calls, “A new understanding of the past, present, and future of the US equity market.” The piece reworks a number of standard equity measures, including the Capital Asset Pricing Model (to arrive at a “True North equity risk premium”) and the price/earnings ratio, based upon “perceived earnings,” which it finds more timely. Plus, there’s a “Holistic Market Model.” The author sets a high bar, promising that the work will “bring the financial community’s understanding of US markets to the next level.”

Of note: “We conclude that secular profit margins before corporate taxes are near an 80-year high, the combined corporate and investor personal tax rate is near an 80-year low, and the secular post-all-tax margins are near a 100-year high.”

ARK

It seems that something about ARK Investments could be included in every edition of the Fortnightly.

This time around, Amy Arnott of Morningstar wrote about the firm’s flagship fund in “ARKK: An Object Lesson in How Not To Invest.” To be fair, the “how not to invest” under review is not about the management of the fund but the chasing of performance by investors, which has resulted in a huge gap between the reported returns for ARKK and the estimated returns for investors. (That’s something we’ve seen many times before with other high-fliers.)

ARKK has been under pressure since it peaked in February, and is down almost 38%. In a recent note, “Innovation Stocks Are Not in A Bubble: We Believe They Are in Deep Value Territory,” Cathie Wood kept preaching the gospel that has made her famous. Originally, she wrote that ARKK “could deliver a 40% compound annual rate of return during the next five years,” but subsequently changed the language to “our strategies will triple to quintuple in value over the next five years.”

Most investors would be hard pressed to find “deep value” in the names that ARK favors and many question Wood’s statements about the capabilities of her firm (“I believe that our research on innovation is the best in the financial world”). The very first posting on The Investment Ecosystem used ARK to illustrate some universal challenges for asset managers, and addressed that last issue among others.

Decision making

Redington packs a lot into just a few pages in “Three Steps to Better Decision-Making,” starting with seventeen investment governance principles. #14 is highlighted: “Monitoring the quality of your decision-making can be as important as monitoring the financial performance of your investments.” That sets up the three steps: defining a good decision, building a “CheckLog,” and reviewing outcomes. The numerous questions throughout are reminders of how challenging good decision making can be — and how important a careful, structured process is to getting you where you want to go.

Resources

Given the proliferation of free and paid sources online, finding the good ones is an ongoing challenge. Thankfully, Edwin Dorsey of The Bear Cave compiled “A Hedge Fund Analyst Christmas List.” Don’t let the title hold you back; you don’t need to be an analyst or work at a hedge fund to find some nuggets that will be helpful in your particular node of the ecosystem.

Other good reads

“The Inside Story of How Bob Maynard Simplified PERSI’s Portfolio,” Alicia McElhaney, Institutional Investor. A summary of the chief investment officer’s philosophy in advance of his September retirement: “We want to be simple. We want to be transparent. We want to be focused. And we want to be patient.”

“Africa 2021: A continent of opportunity,” Invesco. An overview of 54 countries in charts and stats.

“Do Mutual Funds Increase Disclosure Complexity to Hide Fees?” Elisabetta Basilico, Alpha Architect. A review of a paper that answers the question with a “Yes.” (Related: “Fund Critic Birdthistle to Take Reins at SEC’s Division of Investment Management.”)

“A Quant Investor Uses A.I. to Track Down Corporate Greenwashing,” Liam Vaughan, Bloomberg Businessweek. There has been a spate of ESG-pushback articles of late (including ours); this one looks at an effort at Acadian Asset Management to make money trading on the difference between what firms do and what they say they do.

“Resilience and the Stockdale Paradox,” Paul Kedrosky and Eric Norlin, SK Ventures. Looking at “the full house of data” and seeing the need for resilience — “of society finding new ways to adapt and even thrive in a more volatile world” — as a big theme of venture going forward.

“Private equity groups spend $42bn buying companies from themselves,” Kay Wiggins, Financial Times. What should we think of the expanded use of continuation funds and the potential conflicts that are involved?

“2021 Recap of the Recaps,” Chris Perry, Media Genius from Weber Shandwick. In a meta year, here’s a meta list.

Reminder

“The secret of success is constancy to purpose.” — Benjamin Disraeli.

Apes on the move

Had you seen a Wall Street Journal headline a year ago titled, “Inside AMC’s Crazy, Bonkers, Upside-Down Year of Apes, Memes and Shorts,” you might have been left perplexed. You still may be (even before you consider the Bored Ape Yacht Club and the like.) In addition to offering some corporate history, the piece describes a bonkers environment, with shareholders rolling the dice and CEO Adam Aron doing everything he could to fuel the frenzy.

A posting from Doomberg, “No Planet for the Apes,” took the CEO to task: “Aron’s behavior has been downright shameless and gimmicky,” instead of “doing the serious work of capturing profits.”

After being privately held for a time, AMC once again came public in 2013. The chart shows the total return after that, with the absolute performance on the top and relative performance in the middle. The stock peaked at $62.55 on June 2, when it had increased 2,850% year to date, taking it from being an extreme laggard to a solid outperformer since the IPO. The next day, AMC sold additional stock, which is now down 54% from the top.

Aron’s own activity in the stock is shown in the bottom panel of the chart; he’s sold more than 90% of his holdings in the last two months.

Postings

It has been a quiet end of the year in terms of subscriber postings, but there are many new ones on deck. See part one of “We Need Some New Terminology,” ten interesting charts, and a tale of the wining and dining in the investment business from years gone by.

Check out the archives of all of the postings and follow The Investment Ecosystem on Twitter.

Happy New Year!

Published: December 28, 2021

To comment, please send an email to editor@investmentecosystem.com. Comments are for the editor and are not viewable by readers.

Ten Charts and Some Questions

It’s the end of the year, a time to look back. There is also that annual ritual of forecasting this and that. You won’t find any of that kind of activity here, but there are some questions to be asked.

Interest rates

Central bank actions affect economic activity and asset prices, and the U.S. Federal Reserve has the most global sway, so it makes sense to start there. Here is the Fed funds rate since the early seventies, along with the ten-year yield. The dotted line shows the average expected funds rate over the “longer run” by the members of the Fed (according to the most recent “Summary of Economic Projections.”)

What do you think they mean by the “longer run”?

Is 2.5% a reasonable expectation of short-term rates over that time?

Would a higher or lower forecast change your investment approach? How?

Correlation

The ten-year yield reappears at the bottom of this chart, with the top panel showing its 26-week correlation with the S&P 500. You can’t miss the correlation regime change (at least in hindsight). Since yields move inversely to prices, this shows that the prices of bonds and stocks tended to move together during the first half of the chart — and in opposite directions during the second half.

Why?

What do you expect to be the average correlation between them to be over the next decade?

Again, why?

Bitcoin

There is much debate about whether we are on the cusp of cryptocurrencies “going institutional.” On the provider side, some firms are actively involved in developing products and positioning themselves for the “gold rush” (ironic name, see the next chart) that they foresee. Some asset owners have dipped a toe in as well.

The chart shows the history of Bitcoin and the S&P 500 during the last few years, with each panel featuring one of the three elements common to the mean-variance optimization (MVO) approach to asset allocation. (The upper thrusts of Bitcoin have been cut off in the return panel because they diminish everything else, including the downside periods.)

What methodology would you use (or are you using) to decide your exposure to cryptocurrencies (not just Bitcoin)?

If forced to use MVO, what would your single-point estimates be for Bitcoin’s expected return, volatility, and correlation?

Commodities

Inflation has reared its ugly head for the first time in a good long while. That has spawned interest in inflation-protected bonds and various “real assets,” including commodities. On that front, here is the performance for the S&P GSCI sectors for 2021. The index is heavily weighted to energy, so the total return on the whole index is up over 38%.

You’ll note that precious metals have been going nowhere. But they had held up better than everything else during the first six months of the pandemic, while most other commodities, especially energy, got crunched.

Is the current bout of inflation transitory?

Commodities were once a popular diversifier, until the financial crisis, when they were more correlated that expected. Would/do you invest in them now?

Are precious metals an inflation hedge?

China

There are many different strands of concern about China today, including changing regulations for Chinese companies, both in that country and around the world. But let’s stick with the property companies, since real estate and associated debt often figure into financial crises.

The three companies shown above are under pressure and making headlines. The returns on their stocks are charted in the top panel and bond prices for representative dollar bond issues for each appear below them.

What are your general views about investing in China given its economic and political system — and the changes that have occurred of late?

Are you more of the mind that any weakness in Chinese stocks should be bought, or that any strength should be sold?

Who provides you with the best advice on investing in China, and how do they add value versus others?

Japan

Notable among the various bubbles of the last half-century is that of the Japanese equity market (with its ripple effects on bonds, currencies, and real estate around the world). This chart shows the size of that bubble (these are all relative returns) for yen, pound, and dollar investors.

Japan now represents around six percent of most global indexes and is not much of a topic of conversation, with all of that excitement decades in the rear view mirror. But in a piece in the most recent GMO quarterly letter, John Thorndike of the firm argues that Japan’s fundamental performance has equaled that of the United States over the last decade, while it has not enjoyed a similar surge in valuation as a result.

GMO’s value bent has become decidedly unfashionable as valuations have marched higher. Does that affect how you think about their recommendation?

The firm defines “fundamentals” as “an average of sales, gross profits, smoothed earnings, book value, and GMO’s Economic Book Value.” Are you suspicious of a firm that approaches something in a different fashion or intrigued by it?

When was the last time you looked at Japan as an opportunity?

Leverage

As markets go higher and strategies continue to work, leverage is built into the system. You know some of it is there but hard to see/track, but let’s stick with an obvious case. This fund is up huge versus the S&P 500 and even against the high-flying NASDAQ 100. Leverage can be a beautiful thing.

What percentage of the holders know what they are getting? The sponsor’s website provides the boilerplate about the unpredictability of the results on levered products, including that “returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.”

Assets have been flooding into all kinds of leveraged products of late and new frontiers are being colonized. Witness the Leverage Shares 5x Long US Tech 100 ETP, with the clever ticker of 5QQQ.

What are your exposures to vehicles with embedded leverage?

Which ones can you quantify with certainty?

Where would an unwinding of leverage in the system cause secondary effects on investments that you view as unlevered?

Speculations

It’s been a party, alright. Here are four areas where speculation has been evident, along with the Goldman Sachs Hedge Fund VIP “bucket” and the S&P 500 shown for comparison. For the most part, the juicy stuff is down from the frenzy early in the year, although SPACs took a noticeable leg up on news of the Trump deal in October.

Do you view this period as the last speculative gasp of a strong market, an unusual but transitory interlude, or a fundamental change in the nature of market activity?

With a two-year time horizon and unlimited funds, which of these six choices would you short?

Which would you buy?

Margins

Given all of the talk about inflation — and with expectations of higher employee and input costs, as well as the need to temper just-in-time inventory practices that strained supplies during the pandemic — you might think that corporate margins would be under pressure. So far, they have done quite the opposite, hitting new highs. (Other markets around the world have had similar increases in margins for the companies in their benchmark indexes, but most not to this extent.) These are trailing margins, so perhaps they will soften, but that isn’t evident in company projections or analyst estimates yet.

Is this just temporary or will inflation continue to work to the benefit of companies this time around?

Will a more aggressive anti-trust regulatory environment change the long-term trend in margins?

Manager selection

Three mainstays of manager selection are performance, personality, and (increasingly) fees. This one has them all. Pimco has been the subadvisor on this Harbor fund since its inception in the late 1980s. The relative performance illustrates that it was riskier than its index, with intermittent drops during risk-off periods, including at the very beginning. But the performance crept higher over time as that extra risk paid off during an era of financial assets.

The bottom panel shows a strong period of asset growth for the fund from 2006 to 2011, which was then reversed when Bill Gross was deposed at Pimco and no longer managed the fund.

After three-plus decades, Harbor is now replacing Pimco as the subadvisor. Bloomberg reported that “the impetus for replacing Pimco began after Chicago-based Harbor Capital did an internal study that showed core plus fund managers were taking an ever larger bite out of the yield their portfolios produced.” The fee will fall from 43 to 30 basis points.

Would you have made the same decision as Harbor did?

Where in the investment chain within which you operate are fees taking too big a bite out of (conservatively estimated) expected returns?

Published: December 23, 2021

To comment, please send an email to editor@investmentecosystem.com. Comments are for the editor and are not viewable by readers.

Lutèce, Antoine’s, Arnaud’s — and Denny’s

Postings in this category recount experiences and impressions from
throughout the ecosystem. Submissions are welcome, and can be
fact or fiction, using your real name or anonymously.

Two weeks ago, the New York Times published an obituary for Ralph Ablon. The summary read, “After expanding a family scrap metal business into a hodgepodge of some 55 companies, he then successfully focused on the service economy.” He was called “a pioneer of conglomerates.”

In July 1984, as an analyst with one year of experience, I flew to New York City to meet with Ablon at the offices of Ogden, the company he had been running for more than two decades. Working for the third largest money manager in the country meant that I could have that access. But, given my naïveté, I likely believed everything I was told. Over time, I would learn to crack the narratives of those I interviewed (or at least try to), but then it wasn’t a fair fight.

After a while, we decamped to Lutèce, then widely considered to be the best restaurant in America. It became apparent that Ablon was a good customer — or maybe they treated everyone that way; I wasn’t used to that level of service.

By 1984, the shine had come off of conglomerates, which had gained popularity in the 1960s. Charles Bluhdorn of Gulf and Western had died suddenly the year before, marking the end of its sprawl, and other firms were trying to slim down and focus.

With some exceptions, conglomerates have been viewed suspiciously over the last four decades. General Electric was lauded during Jack Welch’s two-decade tenure as CEO (now seen as a time of masterful earnings management), but the firm has been dismantled piece by piece in the subsequent twenty years. Berkshire Hathaway has managed to retain its conglomerate form (albeit with a leaner headquarters structure), although that may change when Warren Buffett and Charlie Munger are gone.

In any case, in the mid-eighties, Ogden’s many businesses were organized into services, marine and modular construction, industrial products, and food products. As noted in Ablon’s obituary, the company was starting a pivot to services, but at the same time it was getting into the business of building and running waste-to-energy plants.

And the company was still building ships. Shortly after my New York visit, I was invited to go to New Orleans to see Ogden’s Avondale Shipyards. I was one of a group of analysts in attendance.

The night before we went to the shipyard, we dined at Antoine’s, which had been (and still is) in the family of the founder since 1840, making it the oldest restaurant in the city. Then there was some ship building to see the next day, after which we went to Arnaud’s, another high spot of New Orleans cuisine, even though the restaurant was a youngster by comparison to Antoine’s; it was founded in 1918.

In talking to others, I found out that Ogden had a reputation for wining and dining analysts, and we were fulfilling our part of the relationship. It wasn’t my first exposure to such activities — brokers started offering dinners, concert and play tickets, and golf dates soon after I started in the business. But I didn’t understand the human tendency toward reciprocation, which leads (often subconsciously) to providing favors in return.

That second evening in New Orleans continued with a visit to Pat O’Briens, where I vaguely remember standing and singing along to “New York, New York” with some analysts from that very city. An even dimmer memory is a trip to a venue at the top of a hotel quite a bit later that night.

I woke up the next morning to a knock on my hotel door from the housekeeper. A glance at the clock told me I had already missed my flight back to the Twin Cities.

Ironically, I was supposed to play in a broker golf event that afternoon, with a dinner at the club afterwards. Of course, I never made it. Instead, I ended up at Denny’s with my wife (who wasn’t real happy with me at that moment) and our young children.

Wherever you are in the ecosystem, there are people whose job it is to curry favor with you. The best of them also try to give you good information and a fair deal.

I can’t say where Ralph Ablon was on that score, since I didn’t cover conglomerates for very long, so I was only with him once. When I saw that he had died at 105, I realized that at the time of our meeting he was the age I am right now.

By the way, I never again was at Lutèce (now gone), nor have I been back to Antoine’s, Arnaud’s, or Denny’s.

By Tom Brakke, the editor of this site.

Published: December 16, 2021

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