Forces in the Ecosystem

The topics to be covered by The Investment Ecosystem will range from the common to the arcane.  No doubt there will be ideas that move to the forefront down the road that aren’t even on the proverbial radar screen yet.

That said, certain themes that form the backdrop for the analyses of today’s investment developments are likely to be with us throughout the (hopefully long) life of this endeavor.   Here are some of the persistent forces that drive the ecosystem, which you’ll see appear in ways large and small in the years to come.

Segmentation

We have a natural need to categorize, creating segments for easier analysis and communication.  Not that those divisions always add clarity or that we live in a world of universal definitions.

No matter if you’re trying to sort out asset classes or strategies or organizations, imprecision and disconnects among different categorization schemes abound.  Why?  We inhabit a complex landscape, causing some of us to see the dividing lines in different places than others — and those lines move over time as the ecosystem changes.

Take “hedge funds.”  Once fairly homogeneous, the vehicles that fall under that general term now encompass a wide range of strategies that are often totally unrelated to each other.  A given fund can be put in quite disparate “buckets” of categorization by similar asset owners.  And the firms that manage the funds can vary markedly in size and form.  (However, some elements show more commonality, including legal structure, liquidity terms, and incentives.)

Despite the challenges, categorizing actors within the ecosystem aids in both micro and macro analyses.  On the micro front, segmentation allows us to compare and contrast counterparties and strategies within reasonable boundaries (and, in doing so, provides us with feedback for the ongoing updating of our categorization framework).

In addition, finely-drawn segments have attributes and tendencies that can inform macro analysis of the workings of the whole ecosystem.  Efficient market theory assumes that participants are rational decision makers operating without constraints, but one benefit of segmentation is seeing how unrealistic that is.  Legal, behavioral, and normative constraints abound, and vary considerably.

Aggregation

A fallback position of those arguing for efficiency is that the aggregated activity of market participants overwhelms those constraints, resulting in an efficiency that fits their theory.  But even if markets can be described as quite efficient much of the time, sizable dislocations occur more frequently than the theory would predict.

Nevertheless, aggregation is a powerful force, often working in the direction of efficiency, leading to a compression of opportunities in previously fruitful areas.  All the while, greater scale is built into strategies and organizations, which can lead to instability under conditions of stress.

Migration

Despite our proclivity for categorization, ideas don’t confine themselves to individual segments.  They get passed around the ecosystem.

The prevailing movement tends to be from “institutional” to “retail,” with one of the best examples being the propagation of alternative strategies over the last quarter century.  The endowment model of investing — at least the part of it expressed in a proliferation of new asset class exposures — has spread from a narrow group of adherents to become implemented far and wide.

A different kind of migration happened just before that movement got going (and contributed to it), when hedge funds went through a period of “institutionalization,” evolving from being the province of smallish managers serving private investors to a dynamic part of the industry full of influential players.

Another major migration was occurring in parallel to these changes — the march of indexation.  Viewed as opposing developments, they also fed each other in various ways, including via allocation strategies that featured a cheap core of passive exposures surrounded by expensive, complex, and opaque vehicles.

These are big examples, trends that have dominated the industry for years.  But they started small — and there are many others to explore and track and experiment with going forward.  The shifts never stop.

Popularity

The ecosystem is a social place.  Fashion and social pressure play significant roles in decision making.  Collective actions alter the price of assets, and the forces of migration and aggregation amplify the trends.

Gauging popularity and acting on assessments about it is tricky business.  While it’s very evident that private equity is extremely popular right now, the wind continues to be at its back.  Surveys show still-increasing interest among institutional asset owners, and individual investors are clamoring for a bite of the apple, including in their defined contribution plans.

That momentum is supported by the accumulated buildup of implementation infrastructure among both managers and investors — and the reluctance to lean away from a powerful trend.  Until something shakes devotion like that, it tends to intensify.

At the same time, if higher prices are paid for the same economic outcomes, popularity sows the seeds of diminishing future returns.  (A good exposition of that idea can be found in a book, Popularity: A Bridge between Classical and Behavioral Finance, from the CFA Institute Research Foundation.)

ESG is among the most fascinating examples of these principles at work today.  The popularity of the ideas behind those three letters (especially the “E”) has dramatically altered organizations and strategies and the pricing of some assets, all within a relatively short period of time.  (There will be more to come about the broad impact of these developments in future postings.)

Order and disorder

At every level and in every node — and across the ecosystem as a whole — there are movements of order and disorder.

Much of the time, we operate in a pretty-well-ordered world.  That allows for the implementation of practices and the selling of ideas and products within an accepted context.  But in a complex adaptive system, increasing order and rigidity give way to bouts of disorder — and reordering.

The triggers for the changes can come from all sorts of places.  Economic and social developments are the most prominent; despite increasing financialization, the causation arrow runs primarily in one direction.  The largest disruptions start outside the investment ecosystem, which is tuned to the environment that has been in place.

But destabilizing forces can come from within as well.  Innovation (another force worth mentioning) sometimes builds in complexities and risks that lie in wait, only to surface at an inopportune time.

Regulatory actions are important factors too:  intended to create greater order, they often cause ripple effects of disorder (and sometimes quite unexpected consequences).

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All of these forces are constantly at work, altering opportunities and risks in the prices of assets and the fortunes of market players.  The ever-shifting landscape presents a map of possibilities for investment organizations and professionals to explore.