The Prudent Fiduciary Digest #53

The Prudent Fiduciary Digest

October 11, 2018

When markets get a little wobbly, it is a challenge to stay focused on the important items on the agenda. Near-term performance reports and economic/market predictions chew up time and add little or no value. Hopefully you can avoid that myopia.

(If you want to get away and "sharpen the saw," my next workshop is in November.)

On to the readings.

Hedge funds

Hedge funds get lots of attention (and assets) from institutional investors. But what is a "hedge fund"? A two-page explainer from the Lookout Mountain Hedge Fund Review provides some history and points out the muddy definitions provided by alternative investment organizations and investment consultants alike. It also offers a more precise description, which excludes many of the vehicles to which the term is currently applied. That ought to tell you something.

The definitional challenges are compounded by an evolution in how the funds are marketed. They were first positioned as hedged vehicles, then return-maximizing ones, before the most recent positioning as the source of risk-adjusted performance. The changes have fogged the perceptions of investors as to the purpose of the funds.

An unrelenting bull market over the last decade has made for tough comparisons, and an archaic fee structure, in which managers can be attractively rewarded for mediocre or even poor performance, has led to much wringing of hands and some notable impacts on individual funds. For example, see the Bloomberg article on "The Incredible Shrinking Hedge Fund."

That said, institutional asset owners still have very large holdings in these funds. A J.P. Morgan survey provides extensive information on the how and why for those investments, among other information.

The industry understands that it has a perception problem, so there are any number of published defenses of the worth of hedge funds, such as a paper from the Alternative Investment Management Association (AIMA) and Aberdeen Standard, which begins with a chapter on "delivering for investors" and ends with one entitled, "Why Be Optimistic About Hedge Funds?" Also, there is a piece from Steben which seeks to bust the common myths (as it sees them) about hedge funds.

From the standpoint of where we are in the cycle and what that means for hedge funds, there are analyses from Fidante Partners, on performance during the late stage of business cycles, and from Pavilion, on performance during periods of rising rates. (As always with pieces like these, take them with a grain of salt. The periods studied are few in number and we face an ever-changing market environment.)

Quantitative investing

There has been a significant increase in the use of quantitative investment strategies over the last decade. These are differentiated from traditional (frequently called "fundamental") approaches, where humans make specific, individual decisions about what to buy and what to sell. In quantitative investing, people are involved in the conceptualization, coding, and testing of strategies, which are then systematically implemented.

To get a sense of the different varieties of quantitative investing that are available, check out Bloomberg's "quicktake" summary. Several kinds of strategies are outlined briefly, showing "how it's done" and "why it makes money," along with the typical holding period, an example of its implementations, and firms that use it.

Those more academically inclined might have an interest in the literature review from CFA Institute Research Foundation, "The Current State of Quantitative Equity Investing."

A paper from Man FRM, "How to Pick a Quantitative Hedge Fund," provides a framework for a "good quantitative fund" (I'm sure modeled after itself).

I think there are many questions about the move to quantitative strategies that haven't been properly addressed by investment fiduciaries, including the nature of due diligence, transparency (or lack thereof), and issues of fiduciary responsibility. I wrote a posting about these "quant questions."

Climate change

Shortly after I started writing in 2008, I published a blog about climate change and the implications for investment analysis. It has also been a topic in four of these newsletters over the years.

With the publication of the latest UN report on the threat, asset owners can expect to be dealing with questions about climate change for a long time to come. Making investments for perpetuity – or for long-lasting pension plans – requires having a view of the range of possible outcomes and dealing with questions about the responsibility of asset owners to take action.

There are already starting to be winners and losers among different industries and geographies. A changing climate helps some and hurts others. The insurance industry, for one, is scrambling to understand the potential effects, as indicated in this Wall Street Journal article. (If your asset managers can't answer questions about the possible implications, that may be an indication that their time horizon is too short or that their "risk management" is limited to the evaluation of past risks rather than new ones.)

Three readings of interest:

~ "An Investor Framework for Addressing the Impact of Climate Change," Callan.

~ "Measuring Transition Risk in Fund Portfolios," Morningstar.

~ "The Global Fossil Fuel Divestment and Clean Energy Investment Movement," Arabella Advisors.

The issue of climate change will increasingly be the subject of discussion among members of investment committees and boards of directors and the stakeholders who they represent.

Classification changes

"The extent to which asset management depends on classification is remarkable." That quote opened a recent Financial Times article. I couldn't agree more. It is something we explore in the workshops I lead.

Investment decisions are made within accepted constructs, be they asset classes or industry sectors or whatever. Behavior is driven by those somewhat arbitrary groupings of investments, which grow out of date as economies and markets change.

A recent modification is a case in point. The Global Industry Classification Standard (GICS) groupings were altered last month, adjusting the composition of categories related to the popular sectors of internet services, e-commerce, and communications. A short summary from Rocaton talks about some of the implications.

Right now, asset managers are trying to figure out whether to adjust their strategies as a result. They also will be modifying attribution analyses regarding their historical holdings and performance. All of this will be confusing for consultants and asset owners who are focused on those details.

Questions

Here are some questions you might ask at your next meeting:

~ How do we define "hedge funds"? What is their role in our portfolio and how likely are they to add value in that regard going forward?

~ Do we understand the quantitative strategies that we use as deeply as we should?

~ What are the investment issues for our portoflio related to climate change? What are the mission-related ones, if any?

~ What are the implications of the GICS changes for our managers? Do we have any parts of our own classification scheme that are out of date?