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Fundamental return attribution
The Thinking Ahead Institute (of Willis Towers Watson) has released research on “fundamental return attribution.” (The link connects to a short video describing the idea, the paper, and open-source code for use in calculation.) The goal of the approach is to separate:
Returns arising from changes in market sentiment (multiple return), the growth of the portfolio’s fundamental characteristics (growth return) and the change in those fundamental characteristics due to changes in the portfolio’s holdings (activity return).
Underpinning this framework is an assumption that the objective is to own a portfolio (a) with the largest possible current intrinsic value and/or (b) with the largest possible expected future growth in that intrinsic value.
According to the video, the goal is to “push all of the noise [of market pricing] into the market multiple piece, which leaves us with a useful signal.”
But how to arrive at good estimates of intrinsic value, a necessary first step?
Intrinsic value is, of course, unobservable and often highly subjective. That said, are there observable measures that might be used to approximate it? For example, is revenue the most meaningful proxy? Or earnings? Or book value? What about intangible assets? There is no perfect answer.
One possibility:
Some asset managers make an explicit forecast of intrinsic value as part of their investment process. In this case these estimates of intrinsic value could form the basis of the analysis. This should enable more meaningful communication between an asset owner and asset manager over time.
Such conversations should occur as a matter of course, but it’s not much of a solution, since the assessments of intrinsic value from managers are subject to bias as well as the normal imprecision.
The framework is an interesting idea worthy of further pursuit. It’s timely, coming on the heels of a period when market sentiment drove certain kinds of stocks (and the returns of certain kinds of managers) to new heights. Much of that is now being unwound, reinforcing the point that it’s necessary to separate out the impermanent drivers of performance from the true underlying levers of value.
On that topic, here’s a thought from Joe Wiggins:
In the years before the stark rotation in markets, I noticed a fund manager frequently posting on social media about the stellar returns that they had generated. Their approach was in the sweet spot of the time — companies with strong growth and quality characteristics, often with a technology element — but this was never cited as a cause of the success. Instead, the focus was on how their process and sheer hard work had directly resulted in consistent outperformance over short time periods. They were simply doing it better than other people.
This was palpable nonsense.
A difficult environment
Bridgewater released a paper, “Building a Beta Portfolio in an Environment That Looks Difficult for Assets.” An image provides the essence of the problem covered:
The really scary parts are in a section with a long and foreboding heading: “The Risk of Stagflation Is Growing; That Tends to Be the Worst Environment for Most Portfolios and the One Where the Benefit of Balance Is Greatest.” Bridgewater judges “the pressure for stagflation relative to market discounting to be the highest it’s been in about 100 years.”
Consequently, “the current environment calls for diversification in all forms,” but “the relationships between assets are changing.” Therefore, balance is recommended, since, “for most investors, not holding assets is not an option.” Plenty of charts are included.
1958?
Investors are always using the events of previous market years as analogies, but usually it’s 1987 or 2008 or the like. When was the last time someone pulled out 1958 for a comparison like that?
The Office of Financial Research does so in “Treasury Market Stress: Lessons from 1958 and Today,” a brief that highlights that
many of the vulnerabilities present in recent episodes of Treasury market illiquidity have parallels in a similar episode of stress in 1958.
Namely,
a high level of outstanding debt, dealers overloaded with Treasury securities, large positions (sometimes with minimal haircuts) funded using leverage in the repo market, a prevalence of carry trades, and sudden increases in margins.
Also, check out the government securities dealers of 1958 in comparison to the primary dealers of today. There is a much different market structure now (that includes a much greater complexity of market players beyond the dealers), but maybe there’s some of that rhyming history in the analogy.
Other reads
“The Long View: Investing in the Future,” Baillie Gifford. A first annual collection, including Moore’s Law (still going), networks, circular economies, and innovation.
“Diverse Manager Investing: Shining a Light on Potential Blind Spots,” GCM Grosvenor. “We are finding that, as LPs integrate diversity into their investment programs and into their firms, they are faced with a set of new challenges, or ‘blind spots.’ ”
“How to spot strong company management,” James Henderson, Financial Times.
Finally, we recognise that everyone makes mistakes. We do not expect a completely faultless record — but we look for honesty and timeliness when it comes to admitting mistakes.
We find that those who are most upfront about their missteps tend to rectify them more successfully than those who try to ignore or hide problems.
“The Use of Short Selling to Achieve ESG Goals,” Managed Funds Association. “Short-selling companies with large carbon footprints has the advantage of helping investors reduce their climate risk while also expressing their sustainability goals and values.”
“Crypto Hedge Funds — Where is the Value?” Markov Processes International.
What have the best funds done differently — and how certain is it that these methods will work in a shifting crypto market? Is the difference between the top and bottom funds just coming down to their exposures to specific coins, as in the Terra (LUNA) collapse?
“Why it’s better to be a small investor,” Marcus Padley, Firstlinks. Comparing advantages and disadvantages of being small versus being in the institutional “smart money” crowd.
“Down Rounds: Deal With Reality,” Brad Feld. Given the pressure in VC land, there will be all kinds of financing options presented; beware those “structures”:
Rather, when you have a choice between a financing at a lower valuation and a financing with all kinds of crazy structure to try to maintain a previous valuation, negotiate the best price you can but do a clean financing with no structure.
“The Academic Failure to Understand Rebalancing,” Michael Edesess, Portfolio for the Future. “The choice of rebalancing as an investment discipline as compared with an alternative such as buy-and-hold is simply a risk-return tradeoff — though one that is a little more subtle than most.”
“US Earnings: Do CEOs or Analysts Know Better?” Man Group. The “remarkable resilience” in earnings forecasts from analysts is in “stark contrast” to the tone from corporate leaders.
“Why Perfectionism Ruins Portfolios,” Adam Collins, Eversight Wealth.
Past performance and well-timed presentations only create the illusion of certainty about the future. Instead of a crystal ball, investment marketing is closer in nature to old-school advertising:
~ Cherry-picked data? Check.
~ Suggestion of future benefits? Check.
~ Lack of long-term evidence? Check!
All about the questions
“It’s not the answers that make you good in this business, it’s the questions you ask.” — Michael Price.
Outline of an era
Thirty-nine years ago today, the editor of this publication started working for one of the largest asset management organizations in the country. This picture is the best summary of the era that ensued.
Driven by disinflation, globalization, demographics, and the internet, interest rates stayed on a downward trajectory throughout, with each new peak lower than the last one. The Federal Reserve was slow to raise short-term rates and quick to drop them, arguably fostering the speculative environment for each new cycle — and engineering a much higher valuation structure across investment assets than has existed before.
The Fed is now facing an economic environment unlike any other during this entire period. But old habits are hard to break.
Postings
A previous posting, “The Goal of Explanatory Depth,” was brought out from behind the paywall via the Sampler category, so it is now open to all. Here’s the theme:
There is no way to “get it all” when doing due diligence. There will always be gaps in information. It is important to acknowledge them, and to avoid passing the narrative of others along as your own point of view.
Recent pieces for paid subscribers:
“Down and Dirty Due Diligence.” Two articles from more than twenty years ago offer tactics for those doing due diligence that are just as important as they were then (and yet are still somewhat rare).
“13F Filings.” The 13F disclosure rules have spawned infrastructure in the ecosystem and quarterly accounts about manager moves. Some quick takes on the rules, copycatting, and research on performance.
All of the content published by The Investment Ecosystem is available in the archives.
Published: June 20, 2022
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