The Academy course on due diligence and manager selection is on sale (that’s rare). Customized training for teams is available too. Check it out; only through September 6.
On to the readings, which highlight some of the recent happenings and writings in the ecosystem.
Taking procyclical risks
You might expect asset managers to lean against periods of excessive risk. “Are fund managers rewarded for taking cyclical risks?” a paper by Ellen Ryan, supports the conclusion by others that managers are, on the contrary, incented to lean into those risks by the asymmetric nature of the performance derby. A summary of the conclusions:
First, we confirm the presence of asymmetries in the flow-performance relationship for equity, government bond, corporate bond and high yield funds in the euro area. This suggests that the flow-performance relationship typically rewards risk-taking across all asset classes. Second, we examine how these asymmetries interact with the wider market environment. We show that for equity funds the asymmetry of the flow-performance relationship is stronger in times when market prices are rising and when equity funds are receiving net inflows on aggregate. Thus this type of incentive could give rise to a coordinated increase in equity fund risk appetite during periods of market exuberance.
If “performance relative to peers plays a greater role in determining which funds receive inflows during periods of market exuberance than it does outflows during a crisis,” why wouldn’t a manager dance (hard) until the music stops?
It all reads like a travelogue of the last few years, including:
This type of behaviour may be particularly problematic during periods of accommodative monetary policy, where an extended period of rising asset prices results in a build-up of risk among funds.
The disclaimer on the cover says that the paper “should not be reported as representing the views of the European Central Bank,” but comparisons to “bank-driven credit booms” and references to “policy implications” make it hard to avoid inferences about future debates regarding the systemic effects of concordant procyclical decision making by asset managers.
Another J curve
On the eve of the coronavirus pandemic, Vanguard published “The Idea Multiplier: An acceleration in innovation is coming.” The firm couldn’t have foreseen the forced innovation that would follow because of that extraordinary event.
Now, a follow-on piece, “How America innovates,” leads with the expectation that the U.S. economy will experience “its fastest level of productivity growth in decades over the next several years.” It includes the notion of a “productivity J curve,” which results because the effects of significant changes in technology are slower to arrive than expected — and then show up with great force. That idea might help explain the lingering economic productivity puzzle.
Remote work is used as an example of the J curve. The technology was in waiting, not widely adopted due to the dominance of existing practices. Then the pandemic spawned a rapid conversion, triggering both increased productivity and debates about the old way versus the new way.
The ideas put forth in the two reports are worthy of consideration; we’ll see if the optimistic conclusions of Vanguard come true.
Hedge funds
A survey about hedge funds from SEI, “Back to the future,” says that “competitive pressure and institutional gatekeepers will continue to steer the industry toward innovation and operational excellence.”
As always with two-sided surveys of investors and managers, the gaps in responses between the groups are of most interest. In some cases they are wide indeed. For example, more than 80% of managers think that investors are mostly or completely satisfied with the hedge fund fee structure and expense attribution, but less than 40% of investors actually are.
As for those gatekeepers, their role is essentially described as passing the manager’s narrative on to an investor. (If you believe that’s the way things should work, sign up for the due diligence course referenced above right away.)
Speaking of hedge funds, Julian Robertson passed away last week. In addition to his tremendous track record, he was instrumental in the institutionalization of the business — and was the person most responsible for the focus on “pedigree” among gatekeepers.
Backlashes
The ESG backlash has started hitting the fortunes of investment firms, as indicated by “Texas accuses BlackRock of energy company boycott in ESG clampdown,” “Florida State Board bans ESG considerations in managing pension plan,” and other headlines.
That is triggering a backlash to the backlash, as investment firms fight back, arguing that all relevant factors should be considered in making investment decisions, and that a prohibition on evaluating certain kinds of risks does not fit with the precepts of fiduciary duty.
This is going to get messy for both sides.
Other reads
“The Uphill Battle Women Still Face in High Finance,” Benn Eifert, Noahpinion.
I care about this because I see the injustice of brilliant, talented women friends struggling in ways I never had to. I see it drain them. The field I have played this game on is wildly skewed. Much of the best talent in the industry is pointlessly deterred by misogyny.
“Organizing your mental kitchen for information FOMO (Building A Second Brain),” Frederik Gieschen, Neckar’s Minds of the Market. Thoughts about personal knowledge management and strategies for dealing with the overwhelming amount of information. “Capture now, organize later.”
“And when we disagree . . .,” Seth Godin. “The hallmark of a resilient, productive and sustainable culture is that disagreements aren’t risky.”
“Capital Group: the slow-moving giant in dangerous waters,” Brooke Masters, Financial Times.
In a sea full of predators, Capital is like a whale shark: slow-moving, friendly and enormous. Its collaborative culture, low fees and dedication to active stock picking make it a well-respected outlier in the increasingly cut-throat world of asset management.
“Value, Growth and the True Exposures in Your Portfolio,” Maarten Nederlof and Jeffrey Clark, Neuberger Berman. “Assess the ‘flavor’ of available value managers carefully, and choose or diversify among them intentionally.”
“Unblurring the Boundary Between Philanthropy and Impact Investing for Families,” Nick Rees, Cambridge Associates. The first of two postings; the second is “Implementing a Sustainable and Impact Investing Strategy — A Family Perspective.”
“Advisory Firm Paths to Side-By-Side Management and Mutual Fund Performance,” Jongwan Bae, et. al, SSRN. There are differences in side-by-side performance (managing both mutual funds and hedge funds) depending on the origin of the firm’s business.
These patterns suggest there are adviser-level incentives to deliver strong mutual fund performance (which attracts capital from new investors) and manager-level incentives to favor hedge funds (which increases compensation).
“Evolving Our Definition of Diverse Managers,” Commonfund. “This turned out to be no easy exercise.”
“U.S. Public Plan Asset Allocation Report,” Nasdaq (eVestment). A good summary of exposures and trends within public plans.
“Can you tell a fake ETF from a real ETF?” Alex Steger and Alex Rosenberg, Citywire RIA. It’s hard keeping up with all of the new flavors being created — here’s a short, fun quiz to see if you can tell the difference between the made-up ETFs and those found in portfolios.
47 years ago
“In setting realistic investment objectives, trustees should be aware that the likelihood of any professional manager producing consistently superior performance, relative to that expected at any level of risk, is small — especially in the case of large pools of capital.” — John McDonald, “Investment Objectives: Diversification, Risk and Exposure to Surprise,” Financial Analysts Journal, 1975.
Postings
The latest Sampler posting (freely available to all) is “Two Sides of Organizational Improvement.” It combines two pieces, previously only available to paid subscribers, concerning an essay from Michael Mauboussin and Dan Callahan about continuous improvement. The first part focuses on asset managers and the second on those that do due diligence on them.
Two “Four for Friday” postings filled out a light late-summer calendar, regarding:
Mutual fund boards ~ questions of independence, new rules, performance evaluations, and board assessments.
The investment advisory world ~ the future of advice, dual-registered firms, portfolio gaps, and a “cutting edge technology in applied behavioral finance.”
All of the content published by The Investment Ecosystem is available in the archives.
Thanks for reading. Many happy total returns.
Published: August 29, 2022
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