Open Questions, Searching for Skill, and Lots of Reversals

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

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

On to the readings.

The SEC and climate change

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

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

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

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

Open questions

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

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

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

The search for skill

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

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

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

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

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

Reversals

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

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

Other reads

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

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

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

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

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

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

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

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

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

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

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

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

Around the table

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

A case study

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

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

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

Postings

Here are some of the recent postings on the site:

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

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

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

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

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