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The equity risk premium
“Because it is not directly observable, the equity risk premium (ERP) is one of the great mysteries of finance.” That’s the first sentence of the preface to “Revisiting the Equity Risk Premium,” a monograph from CFA Institute Research Foundation, which covers presentations from eleven participants in a forum on the topic, interactions among the group prompted by those presentations, and discussions about related ideas.
While the publication was just released, the forum took place in late 2021. Therefore, the significant economic and market changes of 2022 were not a factor in the discourse; it would have been interesting to see if those developments would have altered the perspectives.
A few bits and pieces from some of the participants:
~ Is a 4% equity risk premium estimate “somewhat of a ‘goldilocks’ number that comfortably fits with a variety of investor hopes and institutional structures?” (Brett Hammond and Martin Leibowitz)
~ “The signal-to-noise ratio in finance is truly awful.” (Thomas Phillips)
~ “There’s a wedge between any individual’s experience and the market’s collective experience [over an extended period of time].” (Larry Siegel)
~ Investors who have very concentrated portfolios “are ex ante idiots. Ex post, we laud some of them.” (Cliff Asness)
Among the many other ideas explored are the CAPE ratio, regression to the mean (or not), extrapolating valuation changes, momentum, bubbles, “American exceptionalism,” disappearing small cap and value premia, and the friction among realistic real returns, spending policies, and the behavioral needs of investment committees and the institutions that they represent.
Falls (slow and fast)
On June 7, the Financial Times published an article, “How Crispin Odey evaded sexual assault allegations for decades.” A week later, an FT headline referenced “Odey Asset Management’s fight for survival.” The next day, another one proclaimed that the firm was “to be broken up.”
Amazingly, after Odey was found not guilty in a 2021 sexual assault case — the judge told him “he could leave the courtroom with his ‘good character intact’ and congratulated him on reaching his sixties ‘without a stain on your character’ — his Odey-ous behavior continued. He also threatened the Financial Conduct Authority over an investigation into his conduct, arguing it “was unlawful and that the regulator had failed to clearly demonstrate how allegations of sexual misconduct risked harming the integrity of financial markets.”
The investment risk-taking for which Odey was known — big gains and big losses — was reflected in his personal behavior as well. Investors looked the other way for years, not valuing the “key-man risk,” and then it all came tumbling down in days, valuing it in the extreme. That’s a pattern we’ve seen before, if not with the volatility upon which Odey thrived.
Obligatory AI section
Among the surfeit of AI-related material clogging inboxes, here are a few that might be of interest to you:
~ “The economic potential of generative AI,” from McKinsey, is a big-picture piece about the productivity effects of AI that is getting quoted extensively in other places.
~ “Generative Artificial Intelligence and Corporate Boards: Cautions and Considerations,” from Mayer Brown, focuses on regulatory positioning and risk management considerations for firms.
~ “AI Canon,” from Andreessen Horowitz, offers a huge set of links to materials from “gentle introductions” to deep dives.
~ “Hedge fund Two Sigma also doesn’t buy the ChatGPT hype,” from eFinancialCareers: “What’s really changed is that the awareness has occurred.”
~ “Computer-driven trading firms fret over risks AI poses to their profits,” from the Financial Times:
AI-generated news and images could pose a big problem for hedge funds and ultrafast proprietary trading firms that use complex algorithms to comb vast amounts of news and social media for market-moving signals that they can then rapidly trade.
~ “Stop Pushing the Same Old Investment Advice,” from Angelo Calvello (for Institutional Investor) argues that active managers aren’t taking AI seriously enough:
New regime or not, it is disingenuous to assume that active managers using the same well-worn investment methods (factor-based or otherwise) will now be able to generate alpha when the evidence shows these methods, used in various market regimes, have for at least the past 20 years consistently failed to beat their benchmarks net of fees, let alone to generate alpha.
Other reads
“As Continuation Funds Plague LPs, Investors Search for a Solution,” Alicia McElhaney, Institutional Investor.
“What has happened over the last few years has been a shift in the balance of power between GPs and LPs,” said Mike Gould, an investment office director at Lehigh University. “The alignment that was there much more in the beginning has now shifted in favor of the GPs.”
“Rise of the Allocators: Multi-manager Strategies for Alternative Investing,” bfinance. A look at four multi-manager fund types, including general descriptions, pros and cons, conflicts of interest, costs, and case studies.
“What’s Culture Got to Do with It?” Tom Reader (London School of Economics), William Blair.
When things go well, we attribute it to a quality associated with us. But when things don’t go well, we attribute it to an external quality. That’s true of individuals, teams, and institutions.
“How Investing Personality Types Frame Your Money Perspective,” Portfolio Charts. A thoughtful framework based on four motivations (“What most influences your choices”) and four methods (“How you best understand investing”).
“Cheap Capital,” Matthew Crow, Mercer Capital.
In the post-ZIRP environment, many RIA models are hitting a wall of market resistance, opening up space for new ideas. Some of those ideas will look a lot like the same wine in more presentable bottles — some will genuinely be new.
“Blindfolded Monkey Fees,” Ted Caldwell, Lookout Mountain. “In many cases, investors never receive the performance for which they paid performance fees.”
“Lina Khan Is Upending One of Wall Street’s Favorite Trades,” Yiqin Shen, Bloomberg.
Faced with the changing landscape, these funds are switching up their playbook. Some are unwinding struggling positions altogether, others are focusing more on trading swings in spreads as deal prospects fluctuate, or are scaling into wagers more slowly. And then there are those who pounce on troubled transactions with a view that they’ll eventually close and produce fat returns.
“Four Facts About ESG Beliefs and Investor Portfolios,” Stefano Giglio, et. al, SSRN. A large survey of retail investors shows “substantial heterogeneity” regarding the use and expected returns of ESG investments.
“A Simple Framework for Structured Products,” Madeline Hume, Morningstar. Complexity and high fees make these products a minefield for investors, unless they have the capability to analyze the embedded optionality in a particular offering.
Evaluation or extrapolation?
“If you look at the highest performing private equity programmes, many of those have extremely high proportions of their private equity portfolio in venture. So bearing that in mind, CalPERS should be participating more in venture.” — Anton Orlich, CalPERS.
Migrating returns
Following on a pair of reports on Return on Invested Capital (ROIC) six months ago, Michael Mauboussin and Dan Callaghan have issued another one, “ROIC and the Investment Process: ROICs, How They Change, and Shareholder Returns.”
The graphic is from a section on the movement of ROICs over time and the relationship to total shareholder return (TSR). Using a series of three-year periods over more than three decades, the authors illustrate that “the most common outcome for a company within a starting quintile [of ROIC] is to end up in the same quintile.” But the stay-put percentages range from 29% to 48% depending on the quintile, so there is a lot of movement too. A static forecast doesn’t represent the likely distribution of ROICs, as shown above for one of those three-year periods.
Posting
The current series on culture and the social aspects of the investment world continued with “Social Forces and Sell-Side Analysts.” That posting reviews a paper that explores the web of relationships in which those analysts work, which is usually not addressed in research on their recommendations and estimates.
All of the content published by The Investment Ecosystem is available in the archives.
Thanks for reading. Many happy total returns.
Published: June 19, 2023
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