We Need Some New Terminology (Part 1)

Those outside of the investment industry — including most clients — usually don’t have the background to understand much of the jargon that is thrown at them by professionals about investments and how they work.  Bridging that communication gap is an essential skill to be covered in later postings; for now, let’s start with a very simple question:

What’s the difference between an investment advisor and an investment adviser?

Nothing, although (at least in the U.S.) the “advisor” usage is common among practitioners, while the “adviser” form is mostly the province of regulators and lawyers.  (That’s why you’ll see some of each in this posting; “advisor” is the normal usage on the site unless a publication is quoted.)

That taken care of:

What are the different kinds of investment advisors?

Oh, boy.  This got hard in a hurry.  The answers to the question will depend on whom you ask, what part of the business they are in, and the degree to which their business model is supported or threatened by proposed changes in the regulatory regime.

In a September 2021 posting, Michael Kitces provided the historical backdrop regarding the regulation of names and activities of would-be advisors — and a call to action, as you can tell from the title, “Why XYPN Is Petitioning The SEC To Implement Title Reform Under Section 208(c).”

Advisors and salespeople

The executive summary provides the basics, but Kitces offers much more in the way of details, tracing the path of regulation from before the Investment Advisers Act of 1940 to today.  The term “investment counsel” was the popular advice-giving term of the first half of the last century, to the point that the Advisers Act prohibited the use of that phrase by a person or firm unless the provision of investment advice was their principal business.

Thus, there was a “clear separation” between advisors and those who were in the business of selling product:

Which at its very core was centered on how firms marketed and held their services out to the public in the first place, with a regulatory framework that forced them to declare whether their primary or principal business was providing brokerage services (with only incidental advice), or providing investment counsel (as fiduciary advisors with no conflicted brokerage services).

This has been the playing ground for an industry tug-of-war ever since.

As brokerage firms changed their business models in response to May Day (when fixed commissions went away in 1975) and technological advances, “the use of the term ‘financial advisor’ suddenly exploded.”  Plus, the rise in popularity of financial planning added to the need for greater clarity regarding the regulatory framework for advisory services.

Then the story gets really messy.  See the Kitces piece for the blow-by-blow, but basically the SEC promulgated a rule in 1975 that was intended to clear things up, which was then vacated by a court, so the SEC responded with a different proposed rule, which never was adopted, leaving the necessary clarifications in limbo.

In 2019, Regulation Best Interest (Reg BI) was issued, which “explicitly chose not to unify the standards for investment advisers and broker-dealers as it was authorized to do under Dodd-Frank.”  (That being the 2010 Wall Street Reform and Consumer Protection Act.)  Reg BI creates a situation where a broker and an advisor are held to different standards for the same activity:

In other words, the current structure of Reg BI allows two “financial advisors” to engage in the same marketing of financial planning services, provide the same financial plan, recommend the same asset allocation recommendations, but implement with different (and in one case, more conflicted and higher cost) products.

And rather than recognizing that the delivery of advice and a comprehensive financial plan should elevate the standard of care on the recommendation of a proprietary product (because of the advice relationship of trust and confidence that has been created), instead the fact that a proprietary product would be sold at the end of the advice process allows the broker to “opt into” a lower non-RIA non-fiduciary standard of care, at the exact moment that a fiduciary standard of care is most intended and necessary to protect the investor from conflicted advice!

According to Kitces, this is an untenable situation, which has been exacerbated by the use of titles in the industry that are indicative of nothing in particular — and the proliferation of dually-registered firms, which can switch hats depending on the circumstances.  While “the founding principle of the Investment Advisers Act of 1940 was to assert a bright-line separation between sales and advice,” that often no longer exists in practice, although most clients aren’t aware that’s the case.

In response, the XY Planning Network (of which Kitces is a co-founder) petitioned the SEC for title reform and revised rules to clarify the standards that determine what constitutes the provision of investment advice — and therefore alter the dynamics of the industry as it currently exists.

About those “advisers”

Beyond the confusion around what to call and how to regulate those who provide investment services to individuals is the broader issue of what kinds of organizations are required to register as “advisers” in the United States.

To illustrate the problem, here are excerpts from the opening section of a Financial Times article, “Investment advisers surpass retail as biggest holders of US-listed ETFs”:

Investment advisers have eclipsed retail traders to become the largest owners of US exchange traded funds, highlighting how professional investors are increasingly using the vehicles to build portfolios.

Nearly two-fifths of US-listed ETFs by value are now owned by investment advisers, according to research compiled by Citigroup.  Wealth managers own 12.7 per cent, with other institutions, such as insurers and pension funds, holding a further 8.8 per cent.

Quick, what percentage is owned by the brokers and/or the registered investment advisors that are the subjects of the section above?  Are they the “wealth managers” that are referenced?  Or are they in the “investment advisers” category?

This kind of uncertainty underlies many press accounts — and industry analyses — because so many different kinds of organizations are lumped together under the rubric of “investment advisers” in the U.S. regulatory regime.

Vanguard is registered that way — or more precisely, several Vanguard entities are — as is the one-person shop on Main Street in a small town.  But size isn’t the only differentiator.

There are asset managers, who deal in individual securities and market their portfolios in a variety of vehicles (including private funds, which are their own special category).  And advisors who rarely “manage” securities themselves (although they may watch a legacy holding of a client), instead investing via those very asset managers.  And some who only do financial planning or provide consulting to institutional asset owners like pension plans and foundations.

A report from the Investment Adviser Association tries to capture the range of different entities using these four “typical profiles” that cover 85% of those registered:

You can see that even these aren’t discreet types.  (Another difficulty arises when trying to calculate the true total assets across a group of advisors or the industry as a whole, since the same asset can be double-, triple-, or quadruple-counted in the aggregate because of the levels of intermediation in the industry.)

While you can get a sense of an individual organization’s offerings from its filings (including its reported assets across certain prescribed categories), because advisors of different stripes are lumped together there isn’t a way to effectively analyze broad trends and issues.

As an example, refer back to the Financial Times article above.  Are asset managers using ETFs more, or advisory firms, or both?  It would be nice to know, since there are a variety of considerations involved, including the effect of shifts in the nature of the advice delivered, the resulting performance, and who gets what fees in the investment chain.  But that’s just one small example of what is lost in the mix when fundamentally different functions are treated as one.

Evolution and categorization

As covered in the posting on forces in the ecosystem, change is to be expected.  The evolution of the industry pressures the established order and the categorizations that have defined it.  But regulatory frameworks are slow to be updated, not the least because different industry subgroups try to protect their own points of view (and turf).

At a minimum, in trying to define and regulate the range of firms proving investment services, we need some new terminology.

Published: December 14, 2021

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Luminaries, Short Selling, and an Investment Swiss Army Knife

Welcome, new readers!  The Fortnightly is one of two categories of postings that are open to all; each edition offers a variety of ideas and links that you might find of interest.  (To sign up for a free or paid plan for the site, go here.  The Founder plan goes away at the end of the year.)

Luminaries and ideas

The CFA Institute Research Foundation released “Investment Luminaries and Their Insights,” a publication celebrating a quarter century of the Research Foundation’s Vertin Award.  The recipients of the award offer lessons learned, expectations for the future, and even some regrets.  The ideas that have animated the investment industry and profession in recent decades are on display, with references to many of the seminal works of the time.  It is an especially good overview for someone who is trying to get their arms around this fascinating, complex, and ever-evolving ecosystem.

A Swiss Army Knife?

If you go back only a handful of years, most asset owners didn’t even have “private credit” as a separate asset category in their asset allocation structure.  But it has soared in popularity.  Now, a Cambridge Associates piece calls it “The Investment Portfolio’s Swiss Army Knife.”

The firm defines private credit as “a fund that targets a high-yield or speculative-grade corporate, physical (excluding real estate), or financial asset risk in a private, lockup investment vehicle.”  One of the reasons it stayed under the radar for as long as it did is that it “is not a monolith but rather consists of several different investment strategies.”

While opportunities in other locales are briefly mentioned, the recommendation is that three kinds of U.S. institutions should be “adding private credit to portfolios.”  Given the attention and money thrown at the area of late, you’d expect that there would be some focus on the risks, but all of the risk discussion is on the attractive risk profile versus other vehicles.  It would be good to hear the other side of the story.

Short selling

How’s this for a headline:  “Tecnoglass: Cocaine Cartel Connections, Undisclosed Family Deals, And Accounting Irregularities All In One Nasdaq SPAC.”  It fronts a report from Hindenburg Research on the firm, which “manufactures and sells architectural glass, windows, and related products.”  The stock fell 45% in the two trading days since it was published.

A day after the report dropped, Bloomberg posted an article which begins:

The U.S. Justice Department has launched an expansive criminal investigation into short selling by hedge funds and research firms — thrilling legions of small investors and other skeptics of the tactics that investigative firms use to bet on stock declines.

The probe, run by the department’s fraud section with federal prosecutors in Los Angeles, is digging into the symbiotic relationships between funds and researchers, hunting for signs that they improperly coordinated trades or broke other laws to profit, according to people familiar with the matter.

Because the game is stacked against short selling, those doing that kind of work often are more thorough in their research than longs, surfacing issues that others haven’t.  Those who argue for banning short selling ignore the research showing that price discovery is improved by the presence of short sellers — and the historical evidence that there are more than a few CEOs who complained about the shorts who had something to hide.  (Beware those who “protest too much.”)  And most of the hyping of stocks is on the long side; that’s been on full display this year.

The Hindenburg report does have a soap opera feel to it, and Tecnoglass said it contained “inaccurate statements, groundless claims, character attacks, and speculation” — and increased its earnings guidance to boot.  All five Street analysts covering it have buy ratings on the stock.  Let the battle over the substance of the respective takes begin.

To the larger point, if rules are being broken, the perpetrators should be taken to task, no matter what side of the trade they are on.

Other reads

“Networks in Finance,” Net Interest, Marc Rubinstein.  The opening section of this posting (beyond that it is for subscribers only) provides an instructive look at networks past, present, and future.

“The Economics of Resilience: Capital Allocation and Investment Horizons during COVID-19,” FCLTGlobal.  The organization’s 2021 report shows the cash flows, allocations of capital, and time horizons across the players in the investment chain.

“The Book of Jargon: Environmental, Social & Governance,” Latham & Watkins.  This isn’t really a read, but a “glossary of ESG slang and terminology.”  (If you’re boning up on ESG and didn’t see the Sampler posting last week, check it out.)

“The role of income in portfolios,” Verus.  The paper has some great charts that show the income and price components of returns for several asset classes since 1985.

“Ranch Investor Found His Inefficient Market in Big Sky Country,” Bloomberg.  This interview provides an interesting look at an out-of-the-way market, with a surprise element:  “We can drive our financial returns with the environmental work we’re doing.”

“Buyouts: A Primer,” Tim Jenkinson, et al.  “This paper provides an introduction to buyouts and the academic literature about them.”  As promised, it’s a primer, providing analysis from an academic point of view rather than a provider or consultant promoting the approach.

 “DAOs, A Canon,” Future from a16z.  If you’re interested in learning about decentralized autonomous organizations, the posting has link after link after link for you to pursue.

“The Global 100,” Peregrine.  This report “provides a quantitative and qualitative window” into the market activities of the largest global asset managers.

“Digital Scurvy,” The Attention Span, by Tom Morgan of the KCP Group.  Most of us don’t handle our digital tools very well now; how will we deal with “intelligence amplifiers” and “spirit tech”?  More machine intervention is coming.

“Most expensive sales in 2001,” AbeBooks.  As of early November, the list has the fifth most expensive sale on the site as Security Analysis, by Benjamin Graham and David Dodd.  Graham would no doubt be amazed at the price of $29,000 (although an electronic image of a bored ape has fetched about a hundred times that).

Values

“If you’re not willing to accept the pain real values incur, don’t bother going to the trouble of formulating a values statement.”  — Patrick Lencioni.  (While referring to corporate values, it applies to investment values and beliefs too.  There will always be difficulties in implementation that aren’t there in the abstract.)

Central Securities

Jason Zweig’s latest column in the Wall Street Journal profiles Wilmot Kidd, the long-time manager of Central Securities.  In the top panel, you can see most of the performance since he took over management of the closed-end fund in 1974.

The chart is the maximum available on Bloomberg, which goes to show that the historical evidence at our fingertips is limited even on expensive data terminals.  This simple series starts at the end of 1980, just before the end of the last inflationary period, so we lack perspective on that front.

A relative chart (middle) always tells you more than an absolute one.  The patterns of out- and underperformance give a much better sense of when a manager adds value.  Wilmot’s path of returns is typical of those with great long-term records; they come with periods of lagging performance, sometimes long ones.

Closed-end funds don’t get much attention these days, but since the market price varies away from the underlying value of the assets, there can be opportunities created for a double-barreled effect if the securities and the premium/discount are moving in the same direction.  You can see that Central Securities (bottom) has traded in a relatively narrow range on that front, at a persistent discount to the underlying holdings.

Because there isn’t the hassle of cash flowing in and out (sometimes gushing in and out), Zweig writes that the structure “enables a closed-end fund to manage its portfolio, without having to manage its investors.”  The column discusses how Wilmot uses that freedom to add value, from having large positions (“Risk may be reduced through active and more intimate knowledge of the problems of companies in which we invest.”) to including private company investments long before that was popular.

Postings

Postings since the last Fortnightly have addressed the needs for transformative transparency in private equity and for a more robust approach to the analysis of human capital during due diligence, as well as a review of the bad bets and surprising outcomes related to Enron, now twenty years in the rearview mirror.  Visit the archives to see the full range of postings during the first two months of the site.

Published: December 12, 2021

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Who Are These People Anyway?

Experienced allocators of capital often remark that, over time, they have come to appreciate that the “people” part of the analysis of an asset manager is what matters the most.

Why, then, is so little time, money, and effort spent on trying to help those doing due diligence get better at evaluating the human capital of an organization?

Understanding individuals

Often, the “people” section of a due diligence report is focused on biography:  lists of details and/or narrative descriptions of the backgrounds of the individuals being put forth as central to the success of the strategy under review.

A kind of mental accounting occurs:  how many are from top schools, how many have been at premier organizations, how much experience do they have, etc.  And, if you say to one of them in an interview, “Tell me about yourself,” you are likely to get all of those details in response — and usually nothing about who they really are.

The goal should be to understand them as best you can, but the lack of unlimited time and the self-imposed need to prioritize investment-related questions cause little if any progress to be made in that direction.  Instead, you should strategically pursue the human dimension in your interview plan, and have the background and tactical tools at your disposal to make the effort worthwhile.

Carving out time to learn about these matters is the first step.  You can gain knowledge through training or self-education on relevant topics.  Among them are such areas as personality types, behavioral patterns (and disorders), cognitive versus social differences, and emotional intelligence.  Doing so leads to greater awareness of the human dimension that should infuse your interviews and evaluations.

Those interviews need to include questions that surface, to the degree possible, the real person, not the one that is marketed to you.  Improved interviewing techniques can yield more discoveries; it starts with the willingness to ask questions that provoke answers which reveal more about the interviewee than what the biography recounts.

Greater awareness will help you to judge the self-reporting by those whom you interview.  How open are they?  Can you foster greater openness?  How accurately are they presenting information about themselves and about their organization?

Interviews are performative encounters.  You need to judge how much impression management is going on and how accurate a picture is being painted for you.  While studies have shown that people on average aren’t good at detecting lies and deception, a broad range of uncommon questions may produce some evidence of that as a byproduct (in a way that a standard discussion about a favorite stock never would).  You may not uncover a fraud, but diagnosing a pattern of image enhancement may be an important part of the mosaic that you are seeking.

Another outcome of this pursuit is the formation of your own beliefs and preferences about individual characteristics that you think add value or detract from it.  Take narcissism.  Is that a positive or a negative quality in a portfolio manager?  In a chief investment officer?  In a CEO?  Why?

People offer different answers, but being able to think in depth about those kinds of questions is an advantage, even if they lead to decisions that cause you to avoid a manager with whom others find success.  You are playing the odds based upon what you know and what you believe will work over time.

Teams and organizations

Even teams or organizations that are highly dependent on one individual (or are perceived to be essentially the product of that individual) rely on collective action.  Therefore, the next step is moving from the human dimension to the social dimension.

Assessing each of the individuals who make up an organization in the manner described above — one on one — would provide great insight into the collective capabilities of the whole, but that’s impossible for all but the smallest firms.  However, a due diligence effort should be based upon that principle.

If the goal is to understand the people and how they come together, then the ideal is to interview a selection of those involved who (as a group) can provide insight into the human and social dimensions, while you are learning about the investment one too.  That group should include some at the heart of the investment process, as well as some on the periphery of it (who often provide a better perspective of the cultural workings of the organization).

For various reasons — time constraints, tradition, lack of training, the allure of investment discussions, impediments from the firm being vetted — many due diligence encounters fail to go deep on people-related factors.

Ultimately, you need to make judgments about the capabilities of the collective — be it at the team level or the organization level — and its performance.  Not performance in terms of the read-what-the-numbers-say performance, but how, why, and in what ways they succeed and fail in their goal of working together to make better decisions.

As when judging the interests and motivations of individuals, a broad base of knowledge, good interviewing skills, and a willingness to explore the social dimension in different ways allow you to unveil things that others miss.

Philosophy and choices

One go-to question for due diligence analysts to ask of key leaders in an organization takes this form:  “Why have you made the choices that you have regarding X and what is the philosophy behind it?”  X can be structure, process, incentives, or anything else — including all kinds of people-related issues.

At times, they really don’t have an answer, which ought to tell you something.  Or the professed theory doesn’t match up with the actual implementation, opening up another line of inquiry.  Plus, if you’re versed in the broader issues and principles involved, your knowledge may eclipse theirs, something that’s not common in these kinds of interactions.  It may even lead to a revealing discussion that otherwise wouldn’t have occurred.

While conversations on these topics are most frequent with the powers that be, the questions can be asked of others in slightly different form, regarding how the choices represent (or don’t represent) the broader philosophy that’s espoused internally and externally.  Those can be illuminating too.

Objective

The grade given to the “people” component of a manager research assessment is often simply drawn, without the kind of analysis that provides explanatory depth.  Going beyond that requires new avenues of learning and new investigatory techniques.

If this really is a people business, as everyone says, then getting better at evaluating people as individuals — and understanding the dynamics of how they come together in common purpose — needs to be elevated to a primary role in manager selection, so that it is properly balanced with investment concerns.

 

Several modules of the due diligence course available in the Academy deal with the issues discussed in this posting.

Published: December 8, 2021

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Breaking Open Private Equity

Last month, Gary Gensler, the chair of the U.S. Securities and Exchange Commission, gave a speech to members of the Institutional Limited Partners Association (IFPA).  At the top of the list of issues he addressed were fees and expenses:

Private funds have multiple levels of fees — among others, management fees, performance fees, and for many private equity funds, portfolio company fees.

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.

He also called out the lack of transparency regarding performance:

There’s a debate about whether private equity outperforms the public markets net of fees, or taking into account leverage and liquidity.

I’m not here to weigh in on that debate.  The point is, when people debate the fees and performance of mutual funds, they draw on a great deal of knowledge and information.  In contrast, basic facts about private funds are not as readily available — not only to the public, but even to the investors themselves.

Regardless of that overall economic debate about whether various forms of private funds outperform public markets on a risk-, liquidity-, and leverage-adjusted basis, there may be benefits to fund investors to increasing transparency of the performance metrics.

Six weeks before, a paper, “An Economic Case for Transparency in Private Equity: Data Science, Interest Alignment and Organic Finance,” was posted online.  The work of Ashby Monk, Sheridan Porter, and Rajiv Sharma, it proposes a new paradigm for reporting by the managers who serve as the general partners (GPs) of private equity funds, offering greater transparency to the asset owners who are their limited partners (LPs).  A short summary of the paper by the authors was published by CAIA, but it should be read in its entirety by those involved with private equity.

The current landscape

The authors write that “there is a pressing need to substantiate the economic case for private equity,” and they propose a framework that “uses data science technology to operationalize private equity data and institute a scientific approach to performance measurement.”  The information is intended to be “a pathway of facts through the investing value chain, allowing a comparison, at every stage, of investment options to facilitate efficient capital allocation.”

The ideas fit with the concept of “organic finance,” a philosophy “underpinned by greater information transparency between investors and the sources of investment return (base assets).”  Using that terminology, most current private asset strategies would be considered “inorganic,” since those sources of return are largely obscured, resulting in a misalignment of interests.

Surveys show that most asset owners — from those with sizable exposure to those who have just dipped their toes in the water — intend to add to their holdings.  Yet, because of the lack of good information, the authors pronounce “the economic case [for it] unclear.”

There are the well-known problems with IRR, the most-cited metric for performance evaluation, including the inane but often persuasive “since inception” numbers for legacy providers whose early wins are amplified unjustly.  More recently, the ability to game the metric has led to aggressive use of prescription lines of credit and “purposeful engineering of early outflows.”

Additional performance measures are used by GPs and LPs, but “private equity’s attempts to quantify active management remain largely deficient; the value bridge is theoretically flawed and the representativeness of the public market equivalent (PME) is conditioned on a subjectively chosen benchmark.”  All of it results in “the confusion of trustees and beneficiaries unable to connect a reported return to the portfolio valuation or their account balances,” and “creates the illusion of high returns and props up outdated investment models, effectively ossifying the industry.”

The GPs pull the levers that drive the ultimate payoffs to LPs, but also control the flow of information, which leads to a misunderstanding of the sources of return and the GP choices that shift risk in ways that benefit their interests rather than those of the LPs.  For example, it is well known that GPs are conservative in their valuation assessments in order to smooth returns, which are attractive but misleading for those in governance roles at asset owner organizations.  That incentivizes GPs “to retain data and metrics that underestimate risk in the portfolio.”

The industry practice of reporting net-of-fees returns also obscures what’s going on throughout the process — and hides questionable expense allocations by GPs.  The inability to see all of the pieces of the puzzle (from the performance on the underlying assets to GP fees and expenses) prevents LPs from making proper price-to-value determinations or assessments of GP skill.

A pathway of facts

As a remedy, the authors advocate for a new approach to create the desired “pathway of facts” by clearing away the fog that prevents LPs from proper understanding of their investments:

The goal of transparency, then, is to remove performance ambiguity and reform the model with explicit accountability to alignment and economic sustainability.

Thus, the “organic finance framework”:

In private equity, the source of investment value and risk is the operating company held by the fund.  Within an organic framework, therefore, reported data begins with accounting quantities from these companies and includes their cash flows from and to the fund.  The fund’s accounting quantities are then added to the dataset, including capital flows and commitment schedules, valuations of base assets, fees, carried interest, and holdings data.  Authorized service providers may add quantities to the dataset, e.g., an independent valuation.  Data flow describes the movement of this data through a ‘security network’ – the machines and software of authorized parties – ultimately compiling a full, multi-dimensional dataset that provides traceability between the LP and the base asset producing value and risk.

The digital flow of that organic information would be light years ahead of the current state of the art, “where much of the data from holdings are truncated and transformed by GPs into detail-poor visualizations and/or replaced with forward-looking descriptions locked in slide presentations and pdf documents.”  It would lead to reduced costs and increased accuracy — and provide a great deal of information not currently available to LPs.

Using that data, there are obvious benefits on the performance measurement front from taking the aggregation (and beautification) of the results out of the hands of GPs.  In addition, other sources of information (especially on public market equities) can be used to calculate sufficiently accurate valuation estimates to allow LPs to have rough approximations of portfolio positions.  Obsessing over such numbers on a regular basis would be counterproductive for an LP, but that context would be invaluable in assessing the changing risks and options available (especially during times of stress) across the portfolio.

In addition, there would be new opportunities to “rank performance, quantify outperformance, and isolate value drivers.”  That’s a two-edged sword, in that performance is often drives manager selection activity more than it should, but it is preferable to the lack of good information available today.  The paper puts too much emphasis on isolating “the outperformers,” as if that’s a panacea, but rightly points out the importance of being able to disaggregate the elements of performance in new ways that would add value to the selection process.

The level of detail surfaced through the proposed framework would also allow the ability to assess portfolio-wide targets for exposure to thematic trends — or to judge the implementation of goals regarding ESG, for example, or mission-related initiatives.

The information for risk management would also be improved.  The authors specifically call out the recent growth in the leveraged loan market, where “LPs have gained exposure to both supply and demand sides via private debt and private equity, respectively.”  They point to this “loading up of downside risk” as concerning, given that:

Falling equity prices and widening credit spreads go hand-in-hand in financial crises, increasing the likelihood that the same factors that negatively impact private debt will also negatively impact private equity, i.e. increasing correlation between assets and asset classes.

To be able to implement the organic framework, LPs would have to upgrade their systems and investment processes.  But those capabilities are needed in other asset classes too, especially related to the complexities of derivative positions (through which risk exposures can change rapidly), so the positive impact from the new approach would not be limited to private equity.

An opportunity for GPs?

It may be tempting for the industry to accept opacity as a natural, permanent, and even desirable characteristic of private market investing.  Certainly it’s the way of the world now.

The misalignments of interest that have resulted are presumed to be intentional, since the GPs are the beneficiaries of the design.  That design has been accepted and institutionalized with the tacit consent of the LPs, who are, with rare exceptions, price-takers when it comes to the terms of the partnerships.

GPs may claim that the lack of transparency is important, that the disclosure of their methods would impede their ability to deliver good performance to the LPs.  But that’s a weak argument; these are not trading strategies with short shelf lives, where alpha decays rapidly as others copy them.  The assets are unique and the operational and financing choices discrete.

Why might GPs move in the direction of increased transparency?  We are at the point where the industry wants to bring in new investors, especially by way of defined contribution plans.  The authors argue that private equity firms can foster the next leg of growth in assets by finally providing the information needed to clear away the fog and show that they add value:

It is somewhat paradoxical that it may be in pursuit of trust (and capital) of “unsophisticated” investors that transparency finally gains purchase in the private markets.

It seems unlikely, though, for this innovation to be led by the large, entrenched managers.  Instead, imagine yourself as someone with a track record at a private equity firm getting ready to start a fund on her own.  Or maybe as one of the founders of a firm that has shown some early success.  Why wouldn’t you voluntarily sell this idea (or something like it) as part of how you do business?

If it solves problems for the LPs — and you have the bona fides to be otherwise considered as a good candidate — it would allow you to offer something that others won’t.  In a very competitive business, that matters.  And even if you thought such openness would truncate your personal economics a little, a successful fund company with a little less in the way of personal economics is still a wondrous thing.

Maybe this will all start from the bottom up.  That would be preferable to a regulatory solution.  Which LPs and GPs will step up to make it happen?

Published: December 4, 2021

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Enron: Bad Bets and Surprising Outcomes

Twenty years ago tomorrow, Enron filed for bankruptcy.  After that came the most famous corporate fraud case in U.S. history and significant changes in regulation.

Much of it is chronicled in a new podcast series, Bad Bets, which features John Emshwiller and Rebecca Smith, the Wall Street Journal reporters who unravelled the story.  (Podcast episodes and transcripts are available here.)

Some of the story

The key players at Enron were Ken Lay, Jeff Skilling, and Andy Fastow.  Lay was the firm’s long-time CEO, Skilling the widely-admired innovator who had a short stint as CEO during the firm’s last year, and Fastow the CFO whose financial engineering was first lauded and then condemned.  All were ultimately convicted.

Once a “sleepy gas pipeline,” Enron made itself into a phenomenon, taking advantage of deregulation in the energy industry to become a trading powerhouse, while expanding geographically and getting into new businesses.  One of those forays, into broadband, played a major role in the unwinding of the firm, but there were many contributing factors.

Over time, the firm increasingly pushed the ethical envelope.  A famous example occurred in 1998, when stock analysts were invited to visit a sales room that had opened for a new line of business it was promoting.  But the room wasn’t ready, so Enron employees were marshalled from other areas to populate the area and look busy.  (The first episode of the podcast, “Potemkin Village,” is named in honor of that successful ruse.  Similar stunts by other companies have fooled analysts over the years.)

Fastow was good at subterfuge, cutting corners, and doing things to beat the earnings estimates and growth projections the company promoted.  He said later:

I should have been called Chief Loophole Officer.  That’s all I did every day, and we were the best at it.  The way I looked at it is whoever could best exploit those rules gives their company a competitive advantage, and it’s my job to give my company a competitive advantage.  That was my job, to find loopholes.

The big loophole for Fastow was getting the board of Enron to allow him to serve as the general partner for some private partnerships doing business with the firm — while he was its CFO.  Those partnerships were used to hide financial problems at the company and ultimately were key to its undoing.

In early 2001, Skilling took over the CEO role from Lay, who remained Chairman.  He only lasted six months before he resigned in August and Lay became CEO again.  The stock had peaked at $90 one year before, but by then had declined 55%.  Skilling’s resignation prompted the WSJ to start its investigation.

In October the company announced a big loss and Fastow was forced to resign.  (Meanwhile, Lay kept talking up the company and its stock to employees and analysts.)  A few weeks later, Enron restated its financials for the previous four years.  Another month and it was gone, less than a year after reporting annual revenues of $100 billion.

The analysts

Trying to figure out why Skilling quit, Emshwiller prepared for an interview with him.  He read the “Related Party Transaction” section of a recent SEC filing for the company:

And there I found something most unusual, something that ended up being a big deal.  Deep in the document was a reference to outside partnerships that were doing vast amounts of business with Enron, worth hundreds of millions of dollars.

Similar language was in previous filings.  Why had the partnerships not been a focus of the analysts covering the company (or the large institutions that formed the core of its investor base)?

Carol Coale, who covered Enron for Prudential, recalled an analyst event in January 2000 when Skilling announced the firm’s aggressive move into broadband, saying it was “like a cult meeting because every single person was mesmerized.  Everybody was on the same page.  Everybody was caught up in the moment, including me.”  The stock rose 26% that day.

A year later, Coale saw something else:  a flood of Enron staffers in the broadband area looking for jobs.  “I had proof, I had resumes in front of me, and folks I had talked to that were saying, ‘We think something’s amiss at Enron.’ ”  But whenever she contacted the executives at Enron, they talked her out of downgrading the stock.  Skilling even told her that she’d look foolish, because there would be some news coming out from the firm.  Coale:

I mean, what would you do if the CEO told you something like that?  I mean, I thought, “Well, okay, I don’t want to lose credibility. I don’t want to look stupid because this man is trying to save me from myself.”  So I believed him.  And at the time, I trusted him and I said, “Okay, I won’t do it now then, I’ll wait and see what your news is.”

It was, according to her, “a story stock.”  Analysts who fight a story like that — or even question it — face significant career risk.  (By the way, the promised news never came out.)

Another analyst, John Olson, said, “Ken [Lay] wanted strong buy recommendations, period.  He didn’t care about anything else when it came to Wall Street.”  And Lay pulled a deal from Merrill Lynch, Olson’s firm at the time, because he had rated the stock a hold.  Olson was gone soon thereafter.

Wall Street analysts face pressure from all sides.  CEOs are cajoling them to parrot the party line and convince their clients to buy.  In addition, while reforms have lessened the overt pressure and incentives for analysts to help their firms get investment banking business, they haven’t gone away.  And some large investors will withhold trading business if they don’t like an analyst’s rating on a favored stock.  It’s no wonder that stories outrun reality and that sell-side analysts are usually behind the curve.  They are pushed in that direction by the interests of others.

The enablers

The web of parties that fostered the Enron disaster went far beyond the analyst ranks.

Investment banks try to gain favor with hot companies and vie for their business.  Merrill Lynch assisted Enron in a shady deal involving barges in Africa.  One person at Merrill who objected to the deal was asked during the trial, “Why didn’t you, if you thought it was so bad, why didn’t you report it to compliance at Merrill Lynch?”

And she said, “Are you kidding?  That’s not what compliance is for.  And especially when you have the head of investment banking approving it, they weren’t going to do anything because I said it.”

The accountants, the auditors, the law firms.  Everyone was approving and abetting Enron’s moves.  (The lead Arthur Andersen partner ordered the shredding of around two tons of Enron documents when the SEC announced it had been informally investigating the company.  As a result of its actions at Enron, Arthur Andersen didn’t survive.)

And then there was the board.  Jim Timmins (the first Enron whistleblower to help the reporters, who revealed his identity on the podcast) said that the board “was very supportive of Enron management because the Enron share price had just continually ticked up through the years.”  It approved all kinds of questionable deals and arrangements, based upon the recommendation of management and all of those other enablers who checked their boxes of approval.  Tellingly, during the meeting when conflict of interest guidelines were waived in regard to the Fastow partnerships, those at the table were “more worried about the optics of the conflict than the conflict itself.”

The trajectory

This chart shows the return on Enron stock, with the absolute percentage in the top panel and the relative performance on the bottom.  (Because of the dividends the company paid along the way, neither line goes to -100%, even though the stock was worthless.)  It is easy to spot when the story went into high gear — and when it hit the wall.

Could it happen again?

Today’s environment is similar in many ways.  A technology-driven bull market has resulted in historically high valuations, and there is new-era thinking everywhere.  Large companies (to say nothing of more speculative names) that announce new initiatives can see sizable moves in their stocks.  And all of those enablers are still mostly incented to keep the stories going, not to search for flaws or ask hard questions.

There won’t be another Enron in terms of the specifics, but we’ll revisit the pattern.  A big blowup, lots of finger pointing, more regulation, and promises of “never again.”  It’s built into the structure of our system (and the nature of our selves).

Surprising outcomes

A Texas Monthly article is titled, “In Praise of . . . Enron?”  It includes quotes from people “waxing nostalgic” about their time at the firm.  New markets and technologies were spawned by Enron and many in its ranks when it went under found success elsewhere:

Enron imploded with such cosmic intensity that its legacy became irredeemably dark.  Yet Enron-born technologies and markets remain intrinsic parts of the energy, finance, and tech industries.  A diaspora of its alumni have gone on to build innovative, successful companies in renewable energy, finance, even sporting goods.  Enron also invested in developing technologies that, while they didn’t pay off at the time, demonstrated that the company possessed an insightful vision of the future.

Even more surprising is the series of lessons from what is known as “the Enron corpus.”  After seizing the emails of many high-ranking employees at the company, the Federal Energy Regulatory Commission decided to release them to the public.

A 2017 New Yorker piece details what happened when researchers got ahold of that information.  Among many other things, they have studied email-foldering behavior, the distribution of emails produced, how communication flows in a network, and deception theory (regarding how those sending disingenuous emails craft their messages versus others).

Spreadsheets were attached to many of those emails, and they have been vetted too.  Tim Harford highlighted the work of Felienne Hermans, who analyzed them.  As Harford writes of Excel, “It’s powerful, it’s flexible.  It’s ubiquitous.  It may not be the right tool, but it’s the tool that’s right there.”  So it is used for all kinds of problems, including ones for which it’s not well suited.  And Hermans found at least a quarter of those sampled had at least one calculation error — and many had extraordinary numbers of them.

These studies of emails and spreadsheets have provided unexpected insight into our work world.  They also lead into questions about the needs of organizations to understand the patterns of conduct within them versus the desire of workers to not be monitored unnecessarily.  (These ideas will come into play in an upcoming series on this site regarding the evolution of investment work environments.)

Lessons

At the conclusion of the last episode of Bad Bets, John Emshwiller says:

Perhaps if there’s one takeaway from the Enron saga, it’s that vigilance and skepticism by everyone involved are things that should always be in fashion.

Narratives can overpower analysis (and ethics).  “Vigilance and skepticism” can be viewed as hindrances to the game as it is played, instead of being recognized as essential qualities for good work.

Published: December 1, 2021

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From Crypto to Tractors to Wolves in Sheep’s Clothing

We are still in the first few weeks of The Investment Ecosystem, and already there is a nice repository of content for you to read.  A summary of recent posts is found at the end of this posting.  (Make sure to check out the ESG piece if you haven’t seen it.)

And if you’re on the free tier, now is a good time to consider the wider array of offerings.  The Founder plan goes away after December 31.

On to the readings.

Around the ecosystem

Active share, a metric that has only been around a dozen years or so, is the subject of a new Morningstar paper.  You might be able to tell the conclusion of the analysis by the title:  “Unattractive Share: A much heralded measure of active management has failed to steer investors into funds with consistently strong performance.”  The firm finds that high active share funds tend to have higher fees and higher volatility — and “failed to deliver superior net-of-fee results in any category.”

The Thinking Ahead Institute of Willis Towers Watson released its 2021 list of the world’s largest asset managers (the data is as of the end of 2020).  This was striking:

Investments is a fast changing industry:  221 names on the list of 500 largest asset managers ten years ago are absent from our latest 2020 list.  Over the past decade, there seems to be a quickening of pace of competition and consolidation, with some rebranding.

If you’re interested in getting in the weeds regarding 36+ years of developed market equity composition and returns, check out this report from @jesse_livermore.  It decomposes the fundamental results, the valuation changes, and the resulting performance for sectors and stocks over that time.  Start with the guide and definitions up front (and use the table of contents feature in your PDF reader to find your way around easily).

A Barron’s cover article called this “the weirdest time in history for finance.”  One outstanding feature is the “Tesla-financial complex” — what to some people is a car company is now another thing altogether, given “the idiosyncratic force it now exerts over the stock market.”  The Financial Times has the story.  Tesla’s outsized influence is causing contortions and distortions in the market system, and no doubt there are more strategies that we won’t know about until some fateful day.  (When retail investors are talking about estimated TSLA dealer gamma exposure, the game has changed.)

A statement from the SEC focused on “the importance of high quality independent audits and effective audit committee oversight,” saying that a good committee “facilitates communications among the board of directors, management, internal auditors and independent auditors.”  In addition, it “enhances auditor independence from management” and is “instrumental in setting the tone at the top.”  The general assumption is that having financial experts on the committee improves the quality of earnings.  That’s called into question by a paper (a portion of the title is “Wolves in Sheep’s Clothing?”), which postulates that sometimes that expertise is used to help management manipulate earnings rather than inhibit the manipulation of them.

Crypto

Notwithstanding the dip in cryptocurrencies of late (those at the Thanksgiving table must not have been convinced/convincing), all kinds of organizations are trying to figure out whether to get on the bandwagon — and some have clients giving them a shove.  Among the recent headlines:  “Popularity of crypto funds sparks growing interest from managers” (FT).  “Pension Funds Discover Cryptocurrencies” (finews).  “Crypto fever: the pressure grows on wealth managers” (FT).

As the institutional use of crypto increases, there is more and more asset allocation research that tries to put it in the traditional return, volatility, and correlation portfolio setting.  (Good luck with that.)  Here’s a Tommi Johnsen review of one paper, via Alpha Architect.

Those of a certain age were taken back in time upon hearing the news that the Staples Center in Los Angeles (where the Lakers, Clippers, Sparks, Kings play) is being renamed Crypto.com Arena.  There were those disastrous naming episodes of the past, especially during the dot-com era.  Luckily, Concinnus Financial did an analysis last year of the companies who have bought naming rights.  Some ended up bankrupt, others stalwarts.  Concinnus’ assessment was that the purchase of naming rights “generally does not align with the best interest of shareholders.”

Other good reads

“My Clearinghouse Love Letter,” Front Month.  An explanation of the role that these important market structure entities play.

“Wild Bidding Wars Erupt at Used-Tractor Auctions Across the U.S.,” Bloomberg.  There are markets in everything; here’s a fun look at one of them.

“Paradoxes of Life,” Sahil Bloom, The Curiosity Chronicle.  Wonderful, short takes on “20+ powerful paradoxes on growth, business, investing, and life.”  Also, look at the visual summary of them by Sachin Ramje.

R.I.P., Peter Marcus.  The obituary for the long-time steel analyst said that he “spent his entire life visiting steel plants in the unglamorous outskirts of every continent.”  He is quoted as having said, “I’m a juggler of ideas and a seeker of patterns.”

Quote

“Research is formalized curiosity.  It is poking and prying with a purpose.” — Zora Neale Hurston.

Twenty years of returns

A New York Times article two weeks ago said that returns in India have been “luring investors from home and abroad.”  It has outdistanced the three other Asian indexes show above over the last two decades.  (These are total returns for a yen-based investor.  The S&P 500 would rank third in this group on that basis, at 446%.)

Recent postings

The most recent posting, “The ESG Juggernaut and Points of Pushback,” is must reading given the importance of that topic across every kind of investment organization.  Other postings cover a novel approach to portfolio construction using ensemble methods, the problem with distribution yield, a look at the reinvention of an old media company, and the importance of taking time to read books (including some good lists of them).  The archives of the site are found here.

Published: November 28, 2021

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The ESG Juggernaut and Points of Pushback

ESG is dominating the investment business.

According to Bloomberg’s count of headlines from all of the news sources it monitors, the monthly total of those including “ESG” is up ten times since January 2018.  Google searches are up by a factor of five over the same period.

Your inbox is flooded with articles and papers from asset management firms, academics, industry organizations, consulting and advisory firms, etc.  And, there’s another flood going on, of money into products that carry the ESG label or promise to operate within the precepts it represents.

On this site, we’ll be part of that deluge and will aim to provide content that makes sense of it all.  This posting is a start.

Beliefs

Investment beliefs form the foundation of the philosophies, principles, and processes that lead to decisions in portfolios.  They interact with organizational beliefs (the how of culture and structural choices) and mission beliefs.

For example, the mission beliefs for institutional asset owners include economic targets like meeting pension promises, delivering a desired portion of an operating budget, or maintaining the purchasing power of a portfolio for perpetuity.  But the broader mission of an organization (or the interests of some of its stakeholders) can be at odds with the investments held in the portfolio.  In part, the march to ESG reflects changes in the balance between investment and mission beliefs by asset owners.  (Individuals have been making similar choices.)

No matter where you are on the spectrum of beliefs regarding ESG, informed and engaged debate about it are essential.  The ideas below are intended to sharpen that debate.  If you are a skeptic regarding ESG, the points surfaced may feel like vindication, but that’s not the purpose of providing them here; it’s to suggest a platform for further analysis and discussion.

If you are a proponent of ESG, consider Charlie Munger’s famous dictum:  “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”  These are arguments that you will need to understand deeply to effectively communicate with others about how ESG should inform investment decisions.

Seven myths

Below you’ll find “Seven Myths of ESG,” based upon a paper released by the Stanford Corporate Governance Research Initiative.  Each of the myths appears in italics.

We agree on the purpose of ESG.  The authors point out that “little consensus exists about what ESG is and the problem ESG investment is expected to solve.”  They outline three broad philosophies:  one for which “ESG investment is offered as a solution that reduces long-term risk,” another where the goal is “to find an equitable balance between investor and societal interests,” and the last, which “sidesteps the economic implications of the decision and is essentially a normative (values-based) argument.”  As a starting point:

The distinction between these viewpoints is very important because without agreement on the fundamental problem that ESG is addressing, corporations, investors, and stakeholders will not be able to agree on what ESG activities to pursue, how much to invest in them, and what outcomes to expect.

ESG is value-increasing.  In a business obsessed by bottom-line performance, everyone wants to know whether ESG leads to better or worse performance.  According to the authors, “the evidence is extremely mixed and very dependent on the setting.”

Early research in this area almost always showed lagging performance for “social investing” of various kinds.  But in recent years, the trend has changed and the authors’ conclusion is that “ESG investing has on average been indistinguishable from conventional investing.”  (Some other analyses show ESG outperforming.  An important question left unanswered is whether the huge asset flows of late into ESG have produced a relative price effect that is transitory.)  At the corporate level, there is uncertainty too, leading to this:  “In summary, we do not know the financial impact of ESG.”

We can tell whether a claimed ESG activity is actually ESG.  Some examples are provided which illustrate that advertised ESG efforts by companies may just be “standard business decisions to maximize shareholder value.”  Such “greenwashing” is also an issue at investment firms that promote their vehicles “as sustainable without engaging in a rigorous process to evaluate ESG quality.”  Of broad concern:  “A deep body of research demonstrates the economic damage of greenwashing.”

One of the footnotes provides this reminder to those charged with evaluating companies (or doing due diligence on investment managers) regarding their ESG efforts:

It is almost certainly the case that companies promote their positive ESG attributes while burying their negative attributes.  ESG ratings developed by third-party rating agencies rely heavily on this selective disclosure.

A company’s ESG agenda is well-defined and board-driven.  Speaking of beliefs and related actions, not much is understood about how companies are making decisions about ESG.  The evidence is hard to pin down, but “most companies appear to develop ESG priorities and investment in reaction to internal and external pressure.”  The authors cite another Stanford study that “companies are highly reactive to advocacy by a range of constituents and most respond to social and environmental pressure by taking some form of action.”

G (governance) belongs in ESG.  Some excerpts:

A puzzling aspect of ESG is why governance is included as a third pillar, alongside the environment and social issues.

A company can have good governance quality and be strictly focused on shareholder maximization.  Alternatively, a company can have good governance quality and adopt a stakeholder-centric view that balances profit with other societal objectives.

The need for governance quality is universal among organizations.

ESG ratings accurately measure ESG quality.  There are an ever-increasing number of providers of ESG ratings.  “Unfortunately, the ratings assigned by these providers have an unproven correlation with performance and are also not correlated with one another.”  One analysis of three ESG ratings providers demonstrated that the “methodologies differ in most every relevant aspect:  input metrics, how metrics are evaluated relative to peers and the industry, how missing data is treated, and the treatment of specific companies.”

“The number of input variables is daunting.”  Here is MSCI’s framework, which is included in an appendix in the paper:

The authors’ take:  “Rigorous measurement of each dimension constitutes a significant research challenge.  Measuring all of them accurately and combining them into an overall composite ESG score that is predictive of outcomes is likely not possible.”

Mandatory disclosure will solve the problem.  There will likely be calls for increasing disclosure requirements, but while “the output of this effort might increase information quality at the margin, the cost of doing so will not be trivial.”  For example, twenty years on, there are uncertainties regarding the costs and benefits of Sarbanes-Oxley, which mandated greater corporate disclosure.

Divest or engage?

Another paper, “The Impact of Impact Investing,” investigates the question:  Is divestment from low-quality ESG firms effective?

It attempts an evaluation of “the quantitative impact of ESG divestitures.”  The abstract ends:

We conclude that current ESG divesture strategies have had little impact and will likely have little impact in the future.  Our results suggest that to have impact, instead of divesting, socially conscious investors should invest and exercise their rights of control to change corporate policy.

(An article from Knowledge@Wharton gives a very good overview of the the paper.)

This gets at an important distinction in the ESG debate.  Is it better to improve the worst companies on any of the dimensions at play or to favor the best companies?  Those are completely different approaches, illustrating the challenges that exist at the intersection of investment and mission beliefs.

Divestment feels right, but it ignores the fact that it likely has very little effect.  Engagement has the potential to lead to positive change — genuine impact, the stated goal — but, realistically, can one owner, even a sizable one, make that happen given how corporate governance works?

In fact, avoiding investing in something — let’s use fossil fuel as an example — doesn’t mean it is going away.  As the title of a Matt Levine piece said earlier this year, “Someone Is Going to Drill the Oil.”  He explores the gap between economic and non-economic frameworks for thinking about the issues, and quotes from a Financial Times article about “the investors cashing in on Big Oil’s push to net zero”:

Yet despite the intense spotlight on the energy sector, there are potential buyers for these assets — from smaller private players such as Ineos, independent operators who are backed by private equity, opaque energy traders and state oil companies.

Some recent headlines:  “Private Equity Funds, Sensing Profit in Tumult, Are Propping Up Oil.”  “Hedge funds cash in as green investors dump energy stocks.”  “Long smog . . . and short ESG.”

We are seeing in real time a transition in the ownership of assets.  As one of the co-authors of “The Impact of Impact Investing” said:

If you sell stocks in a dirty company, somebody else will buy them.  That person clearly doesn’t care about the ESG aspect of it, making it less likely that investor pressure could force changes in the company.  The question in that case is, have you done something good?

Much more to do

Does your organization have clarity about where it stands on these cornerstone issues?  Do your actions reflect those choices?  Do your clients and/or stakeholders understand your beliefs and why you hold them?

There is much more work to be done.  Don’t let the need to do it get washed away in the flood.

Published: November 26, 2021

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Don’t Forget Books

You have more than enough to read:  emails and websites and research reports and dispatches from The Investment Ecosystem.  But don’t forget books.

Longer reads take you into the nooks and crannies of an idea.  You can try to do that online, but given all of the dead ends and weak material found there, that is hard work.  The nuggets are elusive.  A good book lays them out for you and provides a narrative structure to tie them together.

What to read?  Here are some good lists of books for you to consider.

Barry Ritholtz wrote about “the four intriguing thematic plots that seem to show up the most in finance”:

Greed blinded by arrogance.

Everything you believe is wrong.

Greed leading to fraud.

Michael Lewis books.

Ritholtz provides examples of each.  The second grouping illustrates the range of ways that innovators diverge from common thinking, referencing books about the polar opposite developments of passive investing and whatever Renaissance Technologies does to produce those hard-to-fathom returns.  Plus the revolution of behavioral economics and finance.

As noted, “Only one author gets his own category, and that is Michael Lewis, the poet laureate of American finance.”  Starting with his inside look at the Salomon Brothers trading floor, he has delivered time and again.

Letters to a Young Analyst, an ebook authored by the editor of this site, highlighted others in the investment realm that are “consistently good in terms of the quality of the material, the quality of the writing, and the importance of the issues addressed:  Peter Bernstein (economics and finance), Michael Mauboussin (decision making), James Grant (markets and financial history), Charles Ellis (investment policy, the investment industry, and the profession), Benjamin Graham (security analysis).”

Some of them show up in a fun posting from Ben Carlson, “TL;DR: The Best Finance Books in One Sentence.”

While reading the high points of the canon provides a good base of knowledge for any investment professional, a broader spectrum of reading yields unexpected insights from other disciplines, to say nothing of the joy and growth that can come from a good book.

One broader list to review comes from Broyhill Asset Management.  (Included in this 2021 edition of its “book club” are links to five previous offerings.)  It covers a wide swath, from Anne Lamott’s book on writing, Bird by Bird — and others on creativity — to stories about famous businesses of the day, including Netflix, Twitter, Amazon, etc.  There are also recommendations for remote learning opportunities.  It is put together in an engaging fashion, with lots of thoughtful commentary and a great variety of books to consider.

The “BCG Reading List 2021” offers short summaries about both big, hairy issues (the pandemic, climate change, the common good) and how organizations are recreating themselves.

Morgan Housel is known for his observations on the investment world and his clear and engaging communication.  It’s instructive to see what kinds of books he writes about.  Consider “23 Books That Changed My Life,” or “A Few Good Books.”  The breadth of his reading is likely a key to his success.  That’s a lesson for all of us.

But who has the time to read books?  We all do.  The payoff for the time spent is much greater than the surfing and shallow diving that consumes much of our days.  If you’re struggling to get started, try “Just Twenty-Five Pages a Day,” from Farnam Street.  It works.

Future postings on The Investment Ecosystem will feature in-depth looks at discoveries made by reading (new and old) books.

Published: November 24, 2021

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An Application of Ensemble Methods to Portfolio Construction

A 2018 white paper “Ensemble Active Management,” boldly promised in its subtitle “The Next Evolution in Investment Management.”  It was produced by the EAM Research Consortium, although there’s no information online about that group and the web address for it (found elsewhere) is not in service.

Most of what has been written about the concept since then has come from one of that paper’s co-authors, Alexey Panchekha, via the news and research page of Turing Technology (he is its president) and postings for CFA Institute’s Enterprising Investor.

Ensemble models

Booz Allen Hamilton’s The Field Guide to Data Science provides an accessible introduction to a wide range of analytical methods.  Here are some excerpts from its summary of ensemble models:

An ensemble takes the predictions of many individual models and combines them to make a single prediction.

Ensembles overcome individual weaknesses to make predictions with more accuracy than their constituent models.  If one model over fits the data, it is balanced by a different model that under fits the data.  If one subset is skewed by outlier values, another subset is included without them.  If one method is unstable to noisy inputs, it is bolstered by another method that is more robust.

Without delving deeper into the details, let’s shift back to the strategy at hand.

Ensemble active management

The premise of “ensemble active management” (EAM) stems from research showing that the highest conviction bets (relative to index weights) drive the alpha of an equity portfolio.  The remainder of the holdings (often aggregating to a majority of the fund) serve as a “beta anchor.”

In EAM, a portfolio is formed from a group of underlying funds using these guidelines, set out in one of the Enterprising Investor articles:

All of the managers must share the same investment objective, such as beating a standard index like the S&P 500.

Most of the fund managers need to demonstrate better-than-random stock-selection skill for at least their highest conviction picks.

Ideally, there should be at least 10 underlying funds.  [This sentence was hyperlinked to an academic paper by Eugene Pinksy.]

The investment processes must be independent.  This is critical.  Diversification at the predictive engine level is how Ensemble Methods solve the Bias–Variance Conflict.

From those overweight positions, EAM determines the “predictive engine” of each fund.  That analysis is used to drive the algorithm by which a fifty-stock “best-idea-centric” portfolio is created based upon the preferences displayed by the underlying managers.

(To support the creation and ongoing adjustment of the portfolio, Turing replicates the underlying funds during periods between releases of portfolio data, using changes in the values of the funds and their component securities.)

Breaking it down

On a conceptual level, EAM fits with both the ever-broadening use of ensemble methods across a variety of disciplines, as well as qualitative work on the importance of diverse inputs to decision making processes.

To further examine the ideas behind it (or to potentially extend them into new applications, or to consider investing in an EAM portfolio) would require more information beyond that which is publicly available.  What follows are some suggested angles of approach.

Another Turing document lists this as a first step in the process (emphasis from the original):

An institutional investor or investment manager selects 12‐15 proven investment managers, using their own insights into manager selection.  The underlying strategies should reflect the same investment mandate (e.g., large core), but should be diversified regarding firms and approach.

There’s that word “proven,” tossed around throughout the ecosystem but rarely defined.  What is its meaning here?  As stated before, what’s important is “better-than-random stock-selection skill.”  Over what period of time and in what ways is that determined?  Given that performance analyses trip up more allocation choices than anything else, why would having “an institutional investor or investment manager . . . using their own insights into manager selection” be the best place to start?

The same problem besets the choice of “independent” investment processes, the importance of which is stressed throughout the various documents.  Every manager will tell you that they are different, but many are superficially different at best.  What are the characteristics that determine the degree of difference from one to another, and are those determined qualitatively or quantitatively?

Beyond this are the details of implementation from day to day, bringing up issues of how proprietary the methods are and how transparent everything will be to outside investors (which will probably vary from provider to provider).  At a minimum, there should be more clarity regarding the points at which and the ways in which ensemble models are used.

Indications of performance

The initial paper was based upon research analyzing a small number of funds (37) to randomly create 30,000 clusters of ten funds each.  The backtested performance numbers were quite remarkable, showing strong performance against both the benchmark (the S&P 500) and category (Large Cap Blend) of those funds — in terms of the frequency of outperformance over rolling periods and the amount of excess returns.

The first live portfolio started in late 2018 and Turing reports that currently there are 78 strategies in “the industry,” across a number of different kinds of vehicles, covering every part of the style box.  The early numbers are compelling as well, although greater clarity is needed regarding the different kinds of portfolio and how the information is combined — and net-of-fees numbers should be reported in a straightforward manner.

But given that the first of these portfolios is reaching its three-year anniversary (and therefore qualifies for the artificial and ineffective age requirement imposed by many investors), you can bet that the marketing engines are revving up right now.

Considerations for asset managers

It is ironic that many of the materials regarding EAM dwell (accurately) on the inability of active managers to beat their benchmarks, while relying on those same managers for the raw material that fuels EAM.  That highlights the portfolio construction practices that proponents of the approach think is at the heart of the active management underperformance problem.

Many managers offer high conviction portfolios and, for some, that is all they offer.  If such portfolios come out of a unified investment process, are they likely to outperform or underperform something that taps a more diverse set of investment approaches, as EAM promises to do?

“Platform” firms, where separate pods operate independently, fit one part of the EAM formula; would an allocation algorithm work better in terms of allocating money among the pods than qualitative decisions do?

How about those picking subadvisors for multi-manager vehicles?  Would they be better off adopting the EAM methodology?  It seems made to order for them, especially since many subadvised vehicles have struggled to add value.

Or imagine a situation where a firm decides to seed a number of in-house strategies, not with the goal of marketing them or aggregating them into a fund, but to use as the information engines of the algorithm.  (You’d have to get the incentives and the sizing of those pools right, since you’d want the individuals doing the investing to be appropriately aligned, even though they are ultimately providing the signals for a different purpose.)  Maybe this kind of approach will spawn new structures; you can see shades of it in some current ones.

Another example:  An EAM piece suggested that an asset owner could pay managers “for their list of holdings and weights, apply ensemble methods to the combined list of securities from [a group of] active managers, and trade the resulting EAM portfolio themselves.”  Many asset managers sell model portfolios already; to what extent are they being used in this way?  What are the implications going forward?  Will we see more asset-light firms?  Will we still call them “managers”?  What happens if you remove the asset gathering function from the business that produces the ideas?

For large, multiproduct organizations, other possibilities exist.  The components of multiple in-house investment processes could provide a more granular level of signals to feed an ensemble approach.  The kind of component reporting that would be required is atypical at most firms but provides possibilities for the future.

Considerations for others

For those analyzing, hiring, and firing asset managers, the principles regarding alpha engines and beta anchors — foundational for EAM — offer a template to review your investment beliefs and potentially redesign the evaluation of managers and the execution of your strategy.

Someday, you will likely be considering whether to invest in an EAM-like strategy, but the tenets that underlie it also can be addressed by restructuring selection and portfolio construction practices that result in beta (really, beta minus fees) becoming dominant when active management is the stated goal.

In general, the materials released regarding EAM have been promotional in nature, par for the course in the business and not unexpected given the apparent performance in backtests and early live results.  The challenge will be to dig into the details, poke holes in that narrative, and create a map of likely risks across a broader sweep of time.

Research and development

Some of the above might be interpreted as saying that the emergence of EAM as a force is a fait accompli.  Not in the least.

But it is a good means by which to get at some larger points.

Every investment organization, large or small, ought to have an R&D function dedicated to continuous improvement, focused on new methods internally and the emerging environment externally.  Choices have to be made, especially when resources are tight, but not evaluating ideas outside your current state is untenable as a long-term strategy.

In this situation, there are general and specific questions to ask, no matter if you work for an asset manager or any other kind of organization.  Where are you at in your thinking about the use of machine learning and other techniques to change your processes in the future?  What new internal structures for investment organizations (and external competition among them) might result?  You may be very far down that road or not even started; how you address the idea of EAM (or any other possibility) will depend on that backdrop.

Then, take the ensemble idea itself (not EAM) and consider how it can be used within your organization and the strategies that you employ.  It is, on its own, a very powerful concept to apply within the investment realm.

Of course, there’s the notion of EAM itself.  Bob Tull, a member of Turing’s advisory board asked some questions:

What if Ensemble Active Management is shown to be a superior means of delivering active management?

What if EAM portfolios are strong enough to re‐open the active vs. passive debate?

What if EAM‐powered active ETFs are readily available to the investing public?

If EAM gets traction in the industry and eventually becomes hard to ignore (a progression we’ve seen many times before), what are the implications for your organization?

The industry picture

Intense exploration is occurring in the industry regarding ensemble methods, machine learning, and other data science techniques.  A number of strategies utilizing them are already available, but it’s safe to predict that many more offerings are on their way.  We will see applications across asset classes and types of organizations, addressing a wide variety of problems.

Some examples can be observed in working papers and in published articles.  For instance, see “Machine Learning for Stock Selection,” from a 2019 edition of the Financial Analysts Journal.  In addition, there are books on the topics, such as Marcos López de Prado’s Machine Learning for Asset Managers (Cambridge University Press, 2020).

Usually, when alpha is to be found via such methods, the practitioners who discover it are interested in keeping it to themselves.  Therefore, the state of practice across the industry is a mosaic at best and an evolving one at that.  For example, while you don’t hear ensemble methods referenced as part of the narratives of traditional money managers now, that will be coming.  Below the radar, though, those techniques are already in production at firms that don’t broadcast their tactics.

So, there may be other EAM-like concepts of note that haven’t been publicized.  Interestingly, the approach comports with the theory behind TOPS, the “Trade-Optimised Portfolio System” of Marshall Wace, which harvests high-conviction ideas in a different way.  TOPS has been used by the firm for two decades and was referenced in an earlier posting on The Investment Ecosystem.

As you can see, there are many potential layers of inquiry and analysis related to EAM.  It may or may not become the next big thing, but examining it now and watching its progress can inform your approach to your current practices — and your plan for investigating the broader spectrum of possibilities to come.

Published: November 22, 2021

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A New Business Model for Old Media

It used to be that there were few things more wonderful than owning a dominant newspaper franchise.  The bigger the market the better, but the business model worked in both big cities and small towns.

Here are the results for the New York Times from 1995 through today:

Revenues and earnings are both lower than they were at the start of 1995.  That dip down in net income in 2006 was a recognition of the impairment of goodwill and other intangible assets.  There was a lot of impairment going on.

The bottom panel shows that the stock was able to keep up with a strong market in the late nineties and really tack on the relative performance during the following bear market.  Then the bottom dropped out.

We all know why, but this is stunning nonetheless:

It starts a few years earlier than the first chart, showing that during the initial decade of the internet age, revenue continued to grow and the business model stayed intact.  Then, unrelenting decline.  From the peak, the drop was more than 91%.

In 2011, Page One was released.  The acclaimed documentary about the Times showed the transformation of the industry through the travails of the paper and through the views of its media reporters, including the legendary David Carr.  (Highly recommended.)

But eventually things started to improve.  Buried by the scope of the stock decline in the first chart in this posting is the fact that NYT has outperformed the market by 40% during the last four years.  It had been 100%, but the stock has been weak on a relative basis since March.

The firm has managed to stabilize its business model:

It has stayed profitable the last several years — and look at that subscriber growth!  Granted, they are mostly digital subscribers, but still.  The “Old Gray Lady” has put on some new clothes.

President Trump used to talk about “the failing New York Times,” but it has been anything but that, finding its footing in a difficult environment.

The decline of print journalism has implications for society as a whole, and the landscape remains bleak, with many newspapers just trying to hang on.  And Alden Global is gutting the newsrooms of the many papers it has bought, wringing as much cash flow as possible out of the firms before they die.  There are a few signs of hope, including some benevolent owners taking over storied franchises, new nonprofit models cropping up, and inspiring stories like that of the Storm Lake Times.

In 2009, The Atlantic published an article, “End Times,” with this subhead:  “Can America’s paper of record survive the death of newsprint?  Can journalism?”  So far, the answer to the first question is “yes.”

Published: November 18, 2021

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