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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