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A very toxic cocktail?
“Query: Can there be too much of an illiquid good thing?”
That inquiry animates “Alma mater over her skis,” the lead essay in the July 28 issue of Grant’s Interest Rate Observer:
Interest rates, the everything bubble, conditioned expectations, institutional forgetfulness and the wobbling secondary markets for private investment assets feature in this unfolding speculation on the latent liquidity crisis in modern endowment portfolios.
To consider the possibilities, Grant’s references Laurence Siegel’s 2008 article in the Journal of Portfolio Management, “Alternatives and Liquidity: Will Spending and Capital Calls Eat Your ‘Modern’ Portfolio?” (A draft of the published piece is available here.) The JOPM article — timely once again — concluded in this way:
In today’s markets, with many of the most popular asset classes being illiquid, investors need to devote substantial attention to liquidity so that the goal for which the asset pool was assembled can be achieved.
Siegel’s analysis showed the math that comes into play in bear markets and “catastrophic” ones by comparing a starting allocation to alternatives of 15% with one that begins at 50%. At higher levels of alternatives, the percentage of liquid assets can drop to untenable levels during difficult times.
That looked to be the likely eventuality during the financial crisis, and there were some fire sales of private assets and other maneuvers in response. But, as Grant’s notes, “A ‘V’-shaped credit recovery saved the bacon of illiquid investors far and wide.”
Advocates of private assets are quick to supply historical evidence that those investments weather downturns well (and, due to lagging prices, cushion bottom-line portfolio returns). But the few data points to date do not represent the full spectrum of future possibilities. Grant’s quotes an unnamed endowment manager:
If you have even moderately higher inflation, not much equity market return, and you’re already compromised from a liquidity standpoint, that’s a very toxic cocktail.
Evaluating systematic managers
Dimensional released a short set of recommendations on the process of “Systematically Evaluating Systematic Managers.” They include an outline of criteria to use before hiring a manager, broken down into the areas of research, design, process, and track record, as well as a section of to-dos after hiring, including judgments about premium capture, risk management, and total costs.
The firm is, of course, talking its own book:
If done well, a systematic active approach can be more reliable and less costly than a traditional active approach without sacrificing the greater diversification and easier monitoring typical of indexing.
The before- and after-hiring breakdown is a bit artificial, since most everything in either category should also be included in the other one. Taken together, all of the bullet points represent a good blueprint for analysis, even though they are topic-level lists. Layers of important details aren’t included (but there are a number of links to other materials).
When asset managers issue a this-is-how-we-should-be-graded scorecard, it can help the parties to identify common expectations. But allocators need to find the elements that are missing from that self-test — and to independently judge each attribute — so that they are free from the manager’s own conclusions.
Nuanced factors
Chenmark buys small businesses. That may seem far afield from your part of the investment ecosystem, but its latest weekly newsletter deals with a universal issue. The piece compares two companies that Chenmark had the opportunity to buy and explains why it selected the firm with a lot of hair on it rather than the one in which everything seemed perfect. The trade-offs are analogous to the choices that investors make regarding stocks, bonds, private assets, investment managers, etc. There is no absolute rule of thumb:
There are plenty of examples of businesses that are “cheap for a reason” that end up being even worse than expected, and there are certainly businesses that are worth every penny of a high valuation.
The key thing we try to remember is that in any deal, business quality, price, and the associated expected return are all highly nuanced factors that can intersect with each other in ways that can be counterintuitive.
Other reads
“What managers get right (How to get that 2nd meeting),” Shannon O’Leary, LinkedIn.
Check your ego at the door.
Understand the organization.
Articulate your special sauce.
Show up as true thought partners.
“How bonds ate the entire financial system,” Robin Wigglesworth, Financial Times. “A very short, very wild history of the market that will shape the next financial crisis.”
“The Price of Risk: With Equity Risk Premiums, Caveat Emptor!” Aswath Damodaran, Musings on Markets.
I have an obsession with equity risk premiums, which I believe lie at the center of almost every substantive debate in markets and investing.
“Private Debt Yield Decomposition,” StepStone. Starting with a “base case loan,” estimated adjustments for capital structure, loan to value, leverage, EBITDA, ownership, and covenants.
“Expanding private markets are redefining their public counterparts,” Satyajit Das, Financial Times.
The rise and rise of private equity and debt is reshaping public markets with consequences we are only beginning to understand.
“Why the Biggest Target-Date Funds Have Underperformed,” John Rekenthaler, Morningstar. Bottom line: Allocations to foreign stocks have hampered performance versus traditional balanced funds that have most or all of their assets in the U.S.
“Building portfolio resilience in the face of uncertainty,” Amanda White, Top1000Funds.com.
A group of investors came together in London to share their ideas on how to best assess risk and position their funds for both the challenges and opportunities in this increasingly demanding and puzzling market.
“The Term Structure of Machine Learning Alpha,” David Blitz, et. al, SSRN. Alpha after transaction costs for machine learning models has declined over time, but varies depending on the horizon selected.
Longer-horizon strategies select slower signals and load more on traditional asset pricing factors but still unlock unique alpha.
“The partisan portfolio divide,” Joachim Klement, Klement on Investing. The increase in political polarization is reflected in portfolios, which have become weighted according to those views — an unfortunate development.
“Ideas are Dimes a Dozen: Large Language Models for Idea Generation in Innovation,” Karan Girotra, SSRN. Two of the factors that are likely to lead to profound changes in innovation practices:
In short, the productivity race between humans and ChatGPT is not even close.
In most innovation settings, we’d rather have 10 great ideas and 90 terrible ideas than 100 ideas of average quality.
“Regression is a tool that can turn you into a fool,” Wesley Gray, Alpha Architect. “Behold, my magical alpha!”
The order of things
“Left unchecked: Organizations default to bureaucracy. People default to distraction. Both result in a lack of focus and speed.” — Shane Parrish.
A single decision
These charts are from an article in the Wall Street Journal, “AI Mania Triggers Dot-Com Bubble Flashbacks.” The ascent of Nvidia as AI has taken hold of the imagination has been stupendous, on top of big gains before that. But the specter of high fliers past makes “investors question whether the stock can live up to the hype.”
Nvidia’s price/sales is compared to Cisco’s a quarter century ago. That stock demonstrated that a super-high valuation can lead to underperformance even when earnings rise over time. (A famous quote from Scott McNealy talked about the improbable math facing the stock of Sun Microsystems when it was trading at a mere ten times sales.)
Ted Seides wrote a piece about the challenges faced by asset managers because of the “Magnificent Seven” stocks, including Nvidia, that dominate the market capitalization indexes against which managers are measured. How much of the seven you own is the “single decision” that determines how you will be judged — a no-win situation, making this a unique time:
It’s less about what to do and more about how to educate your constituents on the choices at hand and expected outcomes to come. Proper communication is necessary because the one decision will in fact determine relative performance in equities.
Posting
“Examining the Investment Memos Produced by Asset Owners” summarizes research from Addepar about the structure of institutional investment memos and provides observations about typical shortcomings within them that impede good decision making.
All of the content published by The Investment Ecosystem is available in the archives.
Thanks for reading. Many happy total returns.
Published: August 14, 2023
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