Tom Brakke – Page 25 – The Investment Ecosystem

Mass Customization and Tactical Asset Allocation

Six employees of BNP Paribas Asset Management have posted a paper on SSRN, “Mass Customization of Asset Allocation.” The abstract reads, in part:

The digital transformation is creating a need for mass customization of tactical asset allocation [TAA]. Asset managers publish tactical asset allocation qualitative views regularly. However, the construction of robust portfolios from such views at large scale is often over-simplified. We propose a robust framework that enables the industrialization of highly customized tactical asset allocation portfolios from a single set of investment views. Our framework links the conviction of investment views to the consumption of risk and derives the expected returns accordingly.

Note the inclusion of “tactical” in the description that’s not found in the paper’s title. Thus, the recommendations deal with the interim adjustments to asset class weightings within a strategic asset allocation framework.

Such adjustments could be applied to hundreds or thousands or “even millions” of accounts overseen by a firm on behalf of institutional and/or individual clients. Changes are usually the province of an investment committee or asset allocation committee or a portfolio manager (or team) responsible for a product line.

Typically there is an implementation framework that captures two aspects of the decision makers’ beliefs about the prospects for each asset class — direction and conviction — in some combination of words, colors, numbers, and symbols. An appendix in the paper provides a number of examples from well-known asset management firms to demonstrate how their beliefs are communicated to others.

Those beliefs then need to be translated into action across the array of portfolios being managed. That’s where the challenge of so-called “mass customization” comes into play.

According to the authors, the views of the decision makers “should be implemented on an industrial scale and with no delay in all portfolios and mandates, even in those with the highest levels of customization. Creating a viable industrial TAA process is thus part of the asset manager’s fiduciary duty towards all its clients.”

Framework

Those interested in the specifics of the recommended framework can dive into the details provided in the paper. Here’s how the steps involved are described:

1. Construct a unique unconstrained active portfolio using an active risk budgeting approach that fully reflects the [investment committee’s] views at a given level of tracking error.

2. Calculate the implied active returns that render this unconstrained active portfolio optimal under [robust portfolio optimization] by reversing the optimization problem (reverse RPO).

3. Run the RPO with the implied active returns and the risk model as inputs while imposing portfolio constraints and defining the benchmark, the universe of financial instruments allowed and the tracking error tolerated.

There are a variety of exhibits which illustrate how the framework is applied. Notably, the authors believe that the transparency of the approach allows those involved “to explain easily the impact of constraints on tactical tilts and to gauge the extent to which their constrained portfolios reflect the [investment committee’s] views.”

Considerations

Here are some items to consider regarding tactical asset allocation practices:

As mentioned in the paper, mean-variance optimization models have important shortcomings, yet they remain the foundation of most asset allocation work throughout the industry.

Implicit in the paper’s recommendation is the belief that tactical asset allocation adds value. That may or may not be the case. Simple rebalancing might be a better solution.

Those combinations of “words, colors, numbers, and symbols” used by firms to describe the desired direction and conviction of tactical movements are less than optimal. They should be replaced by more granular numerical scales.

It is an open question as to whether those recommendations are best derived quantitatively or qualitatively or by using some advanced form of man-machine interaction.

The dimension of time wasn’t addressed in the framework. Perhaps the varying time horizons of clients are captured in the risk assessment and budgeting processes, but perhaps not (or not sufficiently).

Another point of interest comes from a sentence which was quoted earlier: “Creating a viable industrial TAA process is thus part of the asset manager’s fiduciary duty towards all its clients.” In a business of scale, the need for “industrial” activities is very real, but there are trade-offs. Some might argue that industrialization is largely for the benefit of providers rather than clients (resulting in improved margins and allowing for even more scale).

And, while firms need to do what they say they do — and to act in their clients’ best interests — having an “industrial TAA process” is not a necessary element of fiduciary duty.

The paper is a good example of the dance between theory and practice, as well as the push and pull in the industry between customization and industrialization. There are a wide range of circumstances among the individuals and families served by investment advisors. When considering solutions regarding tactical asset allocation (or any other investment function), implementation should be practical while being theoretically sound — and efficient yet personal.

Published: October 25, 2021

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The Problem of Overconfidence in Investment Practice

“Overconfidence is the mother of all psychological biases.”

That sentence opens a short posting by Don Moore, a Berkley professor who wrote a book that explains “what confidence is, when it can be helpful, and when it can be destructive in our lives.” The quote also reveals a problem at the heart of many interactions among investment actors.

A paper from Broyhill Asset Management begins with this observation: “Absolute certainty does not exist in the wild. Yet, on Wall Street, overconfidence is pervasive.” The piece offers the definitions of certainty and uncertainty from Jason Zweig’s wonderful book, The Devil’s Financial Dictionary, before using the words of Richard Feynman to illustrate the appropriate (but rare) approach to a complex adaptive system like the one we inhabit.

Ian Toner of Verus wrote that our work “requires us to focus on skepticism: skepticism about markets, skepticism about counterparties, skepticism about investment claims, and skepticism about models.” He expanded on each of those angles of doubt. One reminder: “The pay available in the investment industry means that some of the brightest minds of our generation are devoted to creating compelling stories around no more than adequate investment products.”

Faking it

Given the ongoing trial of Elizabeth Holmes, as well as the bizarre happenings at Ozy Media, there have been many recent articles about the boundaries of the famous venture capital mantra, “Fake it till you make it.”

Of Holmes, one story said, “One of her strongest arguments may be that the only thing she was guilty of was optimism.” In a column about Ozy, Matt Levine wrote, “Here’s the thing about being a private company. You can sort of … say stuff.” The bar is lower than for public companies (although there are many examples of faking it in that realm too). One of the tailwinds for the SPAC boom in the last year is that you can sort of say stuff in marketing those transactions as well; the rules about making predictions are much more lenient than the ones for IPOs.

The broader issue

Bending the truth (or breaking it) is not limited to Silicon Valley or other venture hot spots. Confidence is something that is prized and sought out in the investment world. No one would say that they are looking for overconfidence — that mother of all biases — but that’s the end product much of the time. Confidence is the oil that lubricates decision making. Those who provide it tend to win the day, overshadowing those who seek to give a balanced, objective view of the possibilities.

A few examples:

A sell-side analyst, even one who is positive on a stock, gets less of a hearing with a buy-side portfolio manager (and his firm less of the trading flow) than an effective cheerleader who relentlessly promotes an idea.

Representatives of an asset management firm that talk with great confidence about their strategy are more likely to win business versus their competitors that speak frankly about the normal ebb and flow of both beta and alpha that should be expected. (Not surprisingly, that’s the case when those making the decision are volunteer trustees, but it is also true for professional allocators. They’re human too.)

When dealing with prospects, investment advisors are more likely to sell a vision of the future using comforting average statistics from the past rather than talking about fat tails, the wildness of markets, and the broad range of potential outcomes.

Even within organizations, it can be hard to be heard if you’re providing a balanced view. For example, recommendation reports for stocks and strategies and managers are written in ways that, as the old Johnny Mercer song goes, “accentuate the positive, eliminate the negative.” Or at least minimize the negatives, or stress how each one is “mitigated.”

We’re drawn to overconfidence — and then we end up being disappointed when reality intervenes.

Avoidance ideas

The tendency toward overconfidence is ingrained in us and designed into our relationships and organizations. Combating it is difficult.

Within your own organization, it comes down to the formation of beliefs about the problem, creating processes to shape the change, and having leaders that will drive the transformation so that someday it becomes an accepted part of the culture.

You are probably familiar with all of the standard recommendations on how to attack the problem of overconfidence, including the use of devil’s advocates, red team/blue team exercises, pre-mortems, post-mortems, etc. Ultimately, you need to build an environment where people feel free to surface disagreements and disconfirming evidence — and to remind each other of the uncertainties that lurk — in order to pierce the veil of overconfidence. To quote Feynman, “Doubt is not a fearful thing, but a thing of great value.”

While none of that is easy, it pales in comparison to the challenges faced when there is business on the line and your competitors are willing to feed a prospect’s desire for overconfidence.

While it does little good in the near term, one alternative is to position your approach as one free from the typical bluff and bluster. Just as a few companies have managed to play a different investor relations game than others — plain-spoken, focused on the long term, and intended to foster a base of quality shareholders who understand what the management team is trying to do — investment firms can take a similar tack.

Building that kind of a brand takes time, one that necessarily encompasses all of the communication channels of a firm and that infuses interaction after interaction into the future. Doing so can provide true differentiation from your competitors, something that is very rare. With effort, what is an apparent disadvantage can become a competitive advantage.

There’s one other card that can be played. While there’s no way to filter clients in publicly-available vehicles, you can do so with separately-managed accounts or partnerships or advisory relationships. No one wants to turn away paying clients, but selectively doing so may be the best policy (and could even create some scarcity demand).

The appetite for narratives brimming with confidence puts individual professionals in tough situations. There are temptations to stretch the truth or to leave out considerations that shouldn’t be left out. Taking the road less traveled will provide more stable ground on which to build a lasting relationship that fosters good decision making going forward.

Published: October 23, 2021

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Education, Sleuthing, Visualization, and More

There will be a broad mix of approaches taken in the Learning Curve category of postings. This first one is an echo of the Letters to a Young Analyst quarterly newsletters; that ebook and its newletters were the inspiration for Learning Curve. (Buyers of the book now receive a two-month subscription to The Investment Ecosystem rather than the newsletters.)

Enjoy the links.

Education

Verdad shared the curriculum it provides those in its internship program. It contains summaries of and links to foundational research that has shaped the investment world. A great resource.

An updated edition of Expectations Investing, the influential book by Michael Mauboussin and Alfred Rappaport, has just been released. Included on the site for the book are some online tutorials that you might find of benefit.

If you’re working within one asset class, you might not be too familiar with other ones. Sampling them on a regular basis will help you spot opportunities and connections, and to prepare for other roles in the future. But where to start? One stop for short explainers is the “sector in brief” collection from consulting firm bfinance.

Analysis

The ecosystem is always changing, as are the tactics of thoughtful analysts, amateur and professional. Gavin Baker tweeted about the “awesome sleuthing from someone on r/wallstreetbets” concerning the discovery of an active site link at Amazon related to Affirm in mid-August. The news of the relationship between the two firms hit fifteen days later.

How can you deal with information overload (from Reddit and everything else)? Commentary from AIM13.

All of the presentations from VALUEx Vail over the years can be found online. The gathering was started by Vitaliy Katsenelson in 2011. While the decade has been challenging on a relative basis for value investors, you might find the slide decks instructive.

Visualization is a powerful tool. How well can you tell a story with just a few words and a number of pictures? Take a look at this piece from Polen Capital, “Could Software be a Safer Investment than Consumer Staples?” A minimalist approach can often get the point across more effectively than a detailed one. (Although the messy product graphic in Figure 8 was a mistake; it pales in comparison to the simplicity and effectiveness of the other images.)

With the software packages that are now available, you can select from a number of different kinds of graphics to tell a story. (We’ll get into some examples, good and bad, in future postings.) To illustrate the point, here’s an article from Flourish, “One dataset, ten visualizations.”

Careers

The Financial Times recently hosted a webinar, “The next generation of asset managers: Securing your dream job in financial services,” which is available on demand. The panelists (all women, a rarity in the investment world) described a changing landscape for the investment talent. The requirements for hiring are changing, especially for entry-level positions, and the skills needed for many positions are broadening out from investment ones to include other capabilities. The future of work — including new arrangements hastened by the pandemic, plus the ongoing displacement of many job functions as machines take over the repetitive parts of investment duties — will bring challenges, for sure, but opportunities for those who can adjust.

Rest in peace

Michael Falk accomplished a great deal in a little more than a half century. Among his contributions to the investment profession was a monograph for the CFA Institute Research Foundation, “Let’s All Learn How to Fish . . . to Sustain Long-Term Economic Growth.” In 2019, he reflected on the goals of that book — and the diagnosis of ALS that would take his life.

Published: October 20, 2021

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The Allure and Anchoring of Targeted Returns

First and foremost, the expectations that investors form about the future performance of asset classes, strategies, and asset managers are grounded in the historical record.

Beyond that, firms providing investment products market their wares in a variety of ways to take advantage of those expectations (and associated hopes and fears). For example, “targeted returns” and similar concepts are common frames used to influence both individual and institutional clients and prospects.

It might happen in a straightforward way, with the goal or the benchmark or even the name of the product indicating the stated target. In other cases, targets aren’t featured in the marketing materials but come out during presentations or due diligence interactions.

Some examples

The Putnam Absolute Return fund series gained quite a bit of attention when it debuted in 2009. Would you like 100, 300, 500, or 700 basis points above a risk-free rate? Just pick the fund that’s right for you.

It didn’t work out that way. As the subtitle to a 2018 John Rekenthaler piece said, “Absolute return is an aspiration, not a realistic investment objective.”

The chart below shows another example, the Invesco Global Targeted Returns Fund.

A marketing tagline for it: “Delivering a smoother investment journey by accessing a broader set of ideas, asset classes and investment styles.” Its stated goal gets to the targeted-return part, “The Fund aims to achieve a positive total return in all market conditions over a rolling 3 year period.” And the target benchmark is even more specific, “The Fund targets a gross return of 5% per annum above UK 3 month LIBOR over a rolling 3 year period.”

As you can see, good returns in the first years brought in a trove of assets, but the initial three-year trailing number has never been topped, and subsequent ones have been languishing in negative territory for the last few years. The assets that flowed in then flowed out, all in all a quite common pattern. Early success, later disappointment.

A more calamitous set of results hit the Allianz Structured Alpha products. As is often the case with product lines among larger firms, the “Structured Alpha” brand was extended in a variety of ways to different kinds of vehicles and permutations of the strategy, which came undone in response to market volatility caused by the onset of the pandemic.

Most notably, there was the failure of a couple of the “1000” version hedge funds, which targeted returns of ten percent above risk-free assets, wiping out the investors. Other strategies, “Structured Alpha 250, 350, and 500 . . . lost about 33, 56, and 75 percent respectively by the end of March [2020].” It all has produced a mess for Allianz and a painful lesson for those who believed the story.

Narrative creation

Of broader consequence than specific examples like those cited above is the process by which return expectations are formed and relied upon without much pushback. Managers are in the narrative-creation business as much as the asset-management business, and building an attractive return story (or risk-return story) is a key goal. A firm may boldly state a target or be coy in its approach, but in the end it wants to get its message across and to anchor investor expectations in a way that is beneficial to it.

In public-market situations, allocators normally form an assumption about the amount of alpha a manager can provide versus a relevant benchmark. That’s usually based upon historical performance — and tends to be too optimistic. In private markets, the expectations are more likely to be put forth as an estimate of absolute returns going forward.

The people who have done the due diligence write reports and give presentations and provide recommendations regarding a manager and its strategy. If an investment is made, the return expectations that they have formed and communicated (which tend to hew closely to the manager’s narrative) will be listed in spreadsheets and committee reports on into the future.

Breaking down the target

Thorough deconstructions of return targets are not very common. In most cases, managers don’t voluntarily get into the components of their targets, and allocators don’t push them on it.

That’s why it is good to do so.

For public-market strategies, diagrams and descriptions of a manager process are standard fare in pitch books and RFPs, and performance attribution is available on request, but those two sources of information don’t fit together. What’s needed is a process attribution; imagine one of those waterfall charts that illustrates the value added or subtracted by each step in the manager’s narrative of its process. Then you’d have something from which to go deeper.

With it, you could better judge the relative strengths and weakness of the manager’s advertised approach and (if you had historical information) observe the ebb and flow of the component parts. You could think through the range of possible outcomes, examine the wearing away of perceived or actual edges, and see risks that otherwise get glossed over.

Private market vehicles can be even more complex (and less transparent), but the same principles apply. How can the raw material of the strategy, whatever it is, be turned into the hoped-for return? How realistic is that return target and what levers need to be pulled (and to work) for it to be achieved?

How can you segment and evaluate the different parts of the waterfall? You might find multiple ways to do so, improving your understanding of the projections.

Take private equity as an example. The use of subscription lines has altered the signals that allocators could get from IRR calculations, especially in the early years of a fund, therefore affecting the assessment of a general partner’s current vehicle and — given the pull of the interim results that are reported — the selection process for subsequent (or competing) ones. Multiples are now significantly higher than they have been historically, and the private equity industry is much different today than it was even ten years ago. How have your expectations changed as a result? What should the pieces of the general model look like under those changed circumstances and how should it be adapted in specific cases?

One of the main hurdles in the due diligence process is the lack of explanatory depth. The narratives created by managers regarding people and culture and process and many other things are hard to see through but easy to pass along to others. The same goes for return targets.

Tactics to crack the narratives of managers vary from attribute to attribute. When it comes to returns, try to build them from the ground up on your own. Then ask managers how their estimates come together. You might find that it is a constructive way to engage with them and to sharpen your own expectations.

For a deeper dive into narratives, explanatory depth, process attribution, and other related concepts, see the Advanced Due Diligence and Manager Selection course in the Academy.

Published: October 19, 2021

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A Case Study in Three Dimensions of Asset Manager Practice

In February 2020, Bloomberg published an article, “Cathie Wood, the Best Investor You’ve Never Heard Of.” Not any more.

She is now the most well-known portfolio manager around, called everything from “Money Tree” to “The Godmother” to “Momma Cathie” to “the Tom Brady of asset management.”

There are many fascinating aspects of the story of ARK Investment Management, Wood’s firm. Rather than tackling a number of them, this posting looks at issues related to investment research and decision making at ARK, but they also pertain to the industry as a whole.

Experience

In 1977, Barton Biggs wrote an investment strategy memo for the institutional clients of Morgan Stanley, in which one of the themes was how hard it is for portfolio managers to keep an open mind. Experience can be a great benefit, he said, but “the problem is that in accumulating experience, [the manager] also acquires prejudices against industries and stocks because he has lost money in them.” He continued:

Unless a money manager understands and compensates for this natural inclination to develop prejudices, these biases can block and impair his ability to receive and respond to new investment ideas . . . he should not permit the accumulated scar tissue to block his perception.

But that is easier said than done. And so, new generations often come to the fore during times of change:

Remember the Great Winfield in The Money Game who found himself unable to participate in a speculative junk market because his memory was getting in the way. He had heard all the stories before and he remembers how the stocks died when the market went down. “Now you know and I know,” he says to Adam Smith, “that one day the orchestra will stop playing and the wind will rattle through the broken windowpanes, and the anticipation of this freezes us. We are too old for this market. The best players in this kind of market have not passed their twenty-ninth birthday.”

The Great Winfield’s very sensible solution was to go out and hire some kids to give him the fresh perspective, to get the feel, of a “kid’s market.” “The strength of my kids,” he says, “is that they are too young to remember anything bad, and they are making so much money they feel invincible.”

Another excerpt that Biggs quoted from The Money Game included a swipe at the old ways of a veteran, “You can’t make any money with your questions like that. . . . Tell him, Johnny. Johnny the Kid is into the science stuff.”

Alas, in the end, as Biggs wrote, “They buried the kids and their science stuff.”

This comes to mind because the ARK research function has been characterized as Wood and a bunch of kids. You can judge for yourself by looking at the “research/investing” tab of the team page of the firm’s website — and by watching the video that’s linked at the top of the page. ARK has been perfectly structured for the environment that we have been in. The question is what will happen in the environments to come; will this cycle end like other ones have?

Research focus

Wood believes that most investment firms are ill-equipped to deal with this new era, because they structure their research efforts based upon old industry categories and on notions of importance that are grounded in current market capitalization.

Instead, she is an advocate for a thematic approach, moving research resources to areas where disruptive innovation is taking place. An analyst in that video on the website said, “We’re trying to figure out the macro trends of technology over the next five to ten years, and that’s much more exciting than maybe working out the minutiae of the next quarter or so.”

It’s true that investment organizations are frequently hamstrung (or even strangled) by entrenched categorization schemes. The reality is that alpha is often found by those snooping between the lines and finding the ill-fitting ideas, or by those going boldly at times when others are only timidly considering a possible foray. There’s nothing timid about ARK’s approach.

By hiring people with relatively little in the way of financial experience, but with what she believes is expertise in the emerging trends of the day, Wood is touching on two key issues.

The first concerns the organization of research analysts within a firm. Fundamental investment analysts (whether specialists or generalists) mostly follow industry norms — and the templates of their firms — when studying companies and recommending their securities.

Very few asset management firms have experts in individual fields who are there to provide advice that feeds the investment process without themselves being traditional analysts. Most organizations have trouble figuring out how to make that happen. Instead, if they are looking for specialized expertise outside of the standard channels of investment information, they opt to take people with industry experience and make them analysts (almost always a misuse of their talents) or to use expert networks and other contacts for that insight.

The second question that could be asked: “What mix of industry knowledge, trendspotting, innovation, and financial experience on a team makes for the best results?”

ARK has come in for some heat because other industry participants question the quality and depth of its research and the specific claims that it makes about the prospects for the companies in which it invests. (As an example, here is ARK’s March report on Tesla and a Twitter thread from Christopher Bloomstran regarding it, in which he said, “The fantasy involved is simply spectacular.”)

Around the table

Bloomberg Businessweek featured Wood on its cover in late May. It was titled simply: “The Believer.” The related story supports that characterization, although anyone who has watched Wood already knew of her steadfast belief in a particular vision of the future. One person was quoted as saying, “You listen to her and you go, ‘Wow. Either she’s right or she really thinks she’s right’.”

That raises the issue of whether people in the firm can stand up to Wood and engage in a way that leads to better decisions, or if the keeper of the vision will always win out — a cultural dynamic that has led to the decline and fall of many firms.

The article talks about a weekly investment ideas meeting that includes analysts and outside experts, “part business school seminar and part free-form bull session.” Who those outside experts are and whether they hold contrary views would determine whether there’s more exploration or theology at play. One who has been attending for a time was quoted as saying, “The lovely thing about it is you don’t have to talk the party line. You can say things that are heretical.”

An ARK employee said, “Cathie believes in a circle table as opposed to a rectangular table. She wants everyone around the table offering their ideas.” Anyone who has vetted investment organizations has heard something like that before; sometimes it’s true but often it isn’t.

No doubt the “circle table” was a metaphor, but the ARK video shows Wood at the center of long rectangular table, the focus of those seated around it, just as she is the focus of everything related to the firm. Whether she can lead a sustainable organization that is multidimensional remains to be seen.

These considerations — the role of experience, the structure of research activities, and the balance between firmly-held beliefs and the openness to other voices — are by no means limited to ARK; they should be of concern for every asset manager (and, therefore, for those who allocate capital to them). But as the archetypal firm of this era, the spotlight will be on the future choices that ARK makes regarding them.

Published: October 15, 2021

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