Linear Return Expectations, Implications for Strategy and Execution

“The central truth of the investment business?is that investment behavior is driven by career risk.” Jeremy Grantham, founder of GMO

Asset allocation frameworks rely heavily on some variation of a portfolio construction theoretical base.? Most variations of this approach are largely based off the following assumptions.

a)????? Risks embraced, duration and volatility, have an anticipated payoff based on historic data that informs a measured exposure to chosen asset class from a selection of securities to invest in.

b)????? Correlations, a measure computed from historic data, between asset classes are deemed to be largely stable over the period for which the portfolio is constructed.

c)????? Tactical measures, adjustments in sizing and selection of themes and managers, are sufficient to maintain portfolio outcome integrity.

d)????? Risks can be contained via allocation to seemingly uncorrelated asset classes which are deemed to create portfolio offsets.

e)????? In the long term, say 10-20 years, returns are expected to revert to a historic mean and the portfolio can deliver an “above average” return by skillful agile management.

f)??????? Risk mitigation has an inherent cost to it and must be optimized to reduce the drag on long term portfolio returns.

g)?????? Diversification is the key to hedging risk, related to point (d) above on finding pairs that have a natural offset.

Statistically, this is where returns are for external mandates since Harry Markowitz pioneered the basics of this framework in the 1950s.

-????????? More than 90% of managers, across all asset classes, underperform their benchmarks post fees and taxes.

LPs (Limited Partners) cull hereto high conviction, sacrosanct models and managers after each systemic shock. Flight to safety, either to cash or asset classes ordained as relatively safe, happens with increased urgency. Drags on modelled returns from risk management, call them portfolio cushion/insurance like features, become virtuously acceptable. Rinse – Repeat - After every crisis.

At the core of such widespread underperformance by a vast majority of financial investors and managers is an implicit belief that risk adjusted returns, almost always modelled as a linear outcome, can be optimized to achieve market neutral benchmark returns while minimizing “costs” inherent in a hawkish commitment to risk containment.

Incentives are also at work which produce and perpetuate the adherence to such an approach.

-????????? LPs are averse to sitting on cash. Ability to speedily deploy cash in seemingly favorable market is an important selection criterion of managers.

-????????? Fund managers are implicitly dissuaded from being conservative about future forecasted returns.? Amongst other important criteria, the capital raising process rewards managers who forecast returns meet or beat consensus return expectations.

-????????? Size of AUM (assets under management) has perceived equivalence with superior performance and ability to manage risk. First time managers have a very tough ask seeking attention.

-????????? Discretionary mandates often carry a higher fee cost, dilution of control and governance.

-????????? In relatively volatile and uncertain times, single investment/asset deals proliferate and demonstrate confidence in timing the market to near perfection.? Or at time, rightly so, as a toe-dipping strategy.

-????????? Extreme concentration of capital seeking deployment in “favored” asset classes at the turn of every major market cycle exposes more capital to risk of a future systemic drawdown as the confidence of the mob reaches its peak.

These are extremely complicated issues and in need of a wider industry discussion and debate.? For assets that are housed predominantly in private market structures, it is much harder. ?For one, lack of comparable benchmarks other than available through self-reporting by managers or inexact industry surveys or via proxy adjustment to available comparable public market data. Illiquidity when asset classes are out of favor, gated structures which lock in capital based on “long term” commitments, mortality of underlying asset and entities as a consequence of systemic shocks and so on.

For real estate investors and managers in private markets, there are proximate measures that are increasingly on the table for discussion and being investigated for evidence.

-????????? Flexibility of geographic and intra asset class deployment creates natural hedges as growth trajectory of countries and cities, sometimes over long periods of time, can diverge longer than expected.? This approach assumes a macro expertise to pick and time such investments and to size it appropriately.

-????????? Mutually agreed mandate that allows more patient deployment of committed capital and a recognition that perceived drag on returns is preferrable to large, episodic drawdowns.

-????????? Incentive for managers to persistently mitigate risks against an acceptable basket of defined systemic adverse events. Hard to agree to, important to deliberate.

-????????? Heightened scrutiny to ensure data integrity for inputs in investment and risk models.?

-????????? Adjustments to fundamental fund assumptions should systemic events render the very premise and business model clearly untenable. Recognize – Stop – Liquidate.

At the core of long-term superior performance is an overarching focus on capital preservation[1].? Minimizing drawdowns and picking up market neutral returns is hard enough.? Taking egregious risks to generate alpha is much harder.

Many LPs are a tad fortunate, such as fiduciaries of defined contribution mandated schemes.? A target return inherent in such mandates to meet actuarial needs for their beneficiaries calls for heightened risk management.?? Large AUMs surprisingly also encourage spectacular write offs in seemingly “small and non-material” parts of the portfolio, and adds additional pressure to chase shiny new investment themes when markets normalize.

The quote below is attributed to a major pension plan who recently reported having written off approximately $750 MN of manager reported value in a venture funded, education related start up.? Italics in the quote are mine for emphasis purposes.

“The asset was well supported by a range of major global investors,” …. “However, the impact of the Covid pandemic, volatile macroeconomic conditions, rising interest rates and increasing competition combined to create a very challenging environment for?the?company.”

“well supported by a range of major global investors”

Affinity biases are rampant, the very foundation of communities, racial and ethnic identities and national landscapes. In its pervasiveness, it is also inescapable.

In clubs of “like minded” investors, who seek to influence governance and other necessary oversight responsibilities, the practice of borrowing underwriting rigor and expertise from co-investors who have a track record fit enough to be considered experts in the invested securities is long prevalent. ?LPs of all ilk have used this ruse in allocating capital.

“volatile macroeconomic conditions, rising interest rates and increasing competition combined to create a very challenging environment for?the?company”

?A once in a century event such as the pandemic, and subsequent flood of capital to resuscitate the global economy was a harbinger of the inflationary bout.

?“for the company” - Concentration risk in an entity than a thematic exposure through a diversified strategy and a belief that in a world awash with money chasing similar investment thesis it at all was surprising that the company faced increasing competition?

“the higher risk-return profile “ ,,”characteristic of the asset class,”

Higher risk - increased chances of losses, so maybe the write off was, at a portfolio level – anticipated in a basket of this or other similar higher risk investments and hence entirely par for course.

Another report quotes a senior executive of one of the largest pension plans as, paraphrased, emphasis is again mine

“to meet return targets, it has revamped its balancing strategy while diversifying its active management across more, but smaller, external mandates, particularly in equities” and goes on to state “If a manager add value to their benchmark 2 out of 3 years, we get a win two thirds of the time.? If we have 100 managers who can win two out of three[2], and of them make completely independent decisions on their portfolios, the chances of years where we will perform below benchmarks becomes very low”

And the implicit faith in the newly developed Midas touch from active internal management rises to the crest “if we don’t rebalance properly, we tend to miss the benchmark return. ?Between 2016-2019, the reason why the fund underperformed was basically that the balance was not sufficient enough”

Obvious red herrings and when the ink dries on this strategy, a strong possibility that the outcome may not pretty.? Assumptions that 2 of 3 managers through active management can lift the boat, active diversification through a wide pool of managers when statistically less than 10% outperform benchmarks, and so on.

So, is a tilt and increasing preference for private markets an implicit acknowledgement that active management works best in relative illiquid strategies where it is difficult to execute a long term buy and hold passive approach?

Do mark-to-mark accounting rules, applied with a fair degree of discretion in private market investment vehicles, create a calmer approach to building long term outperformance?

Is an open-end fund/vehicle in private assets the best structure to remove idiosyncratic and market infused volatility inherent in working with a limited time frame?

And so on.? Lots of interesting challenges and questions.? Most can be resolved to a high degree of acceptable minimum standards industry wide. It will take an objective admission from investors that unanticipated deleterious impact of realized volatility is inescapable if capital allocations, structure, and time frames are not aligned.

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?(views expressed are personal opinions and does not constitute investment advice)

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[1] Constituents of the compared indexed returns for last 20 years; ETFs - VNQ, VOO, VT, IYR, ACWX, 10 Year Treasury notes and an income distribution focused global public REITs ETF (current weight approx 65% to a US REIT basket), AWP (https://www.abrdnawp.com/)

[2] https://www.chicagobooth.edu/review/why-active-managers-have-trouble-keeping-up-with-the-pack

https://www.spglobal.com/spdji/en/documents/research/research-degrees-of-difficulty-indications-of-active-success.pdf

?Recommended reading on risk management and probabilistic thinking:

A) Safe Haven by Mark Spitznagel (https://www.amazon.com/Safe-Haven-Investing-Financial-Storms/dp/1119401798)

B) Thinking in Bets by Annie Duke (https://www.amazon.sg/Thinking-Bets-Making-Smarter-Decisions/dp/0735216355)