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Chronicles of an Allocator

Chronicles: September 2020

Issue 7, September 2020

Dear Investment Professional,

Welcome to the September edition of Chronicles of an Allocator. This monthly newsletter is carefully curated to provide you with a selection of thought leadership pieces, designed to assist and inform the capital allocation process.

As we’ve said before, the relationship between public and private markets continues to shift, which has prompted investors, managers, and regulators alike to discuss the importance of access. Throughout most of this year especially, the theme of democratization continues to be at the forefront of regulators’ minds in the United States. While this discussion has been initiated in the United States, the outcome is likely to impact other areas of the world in the future. A few weeks ago, the Securities and Exchange Commission officially voted to extend the definition of an “accredited investor” from a wealth-based requirement to an education-based requirement.

While a select few now have access, CAIA Association argues that not much has changed for the end-investor and the education requirements are far from rigorous. We believe that a combination of shifting capital formation and the thrust of responsibility on the end investor for their own retirement savings brings a sense of urgency to the situation.

These pieces are a “best of” compilation of insights we believe are most relevant to you as allocators of capital. They fall under four themes: democratization of alternative investments, the current state of the industry, artificial intelligence and data science, and environmental, social and governance (ESG) issues.

Sincerely,

John L. Bowman, CFA, Senior Managing Director, Twitter, LinkedIn

Keith Black, PhD, CFA, CAIA, FDP, Managing Director Content Strategy, Twitter, LinkedIn

Guowei Jack Wu, CFA, Content Director, CAIA APAC, Twitter, LinkedIn

Aaron Filbeck, CFA, CAIA, CIPM, Associate Director, Content Development, Twitter, LinkedIn

Democratization of Alternative Investments

Shuru Law: What’s the Definition of an Accredited Investor, and Why Should I care?

This article from Rahul Keshap of Shuru Law provides a summary of the newly-revised accredited investor rule and what it means for investors and the industry.

CAIA Association: Understanding the Limitations of Liquid Alternatives

While liquid alternatives do offer similar diversification benefits as private hedge funds for retail portfolios, they are constrained in three major ways: liquidity, shorting, and leverage. Shana Sissell, CAIA, Chief Investment Officer of Spotlight Asset Group, explores each of these constraints and their impact on performance and risk.

CAIA Association: Politics, Religion, and… Private Equity?

Institutional investors have dramatically increased their allocations to private equity over the past decade. Private capital allocations remain highest in endowment portfolios, but other institutions, such as family offices and pensions, have begun to follow suit as future expected returns have looked relatively dire for public equities. However, a flood of academic debates has emerged surrounding private equity’s outperformance relative to public markets once certain return adjustments are made, notably return measurements and leverage. This piece from Aaron Filbeck, CAIA, CFA, CIPM, discusses both sides of the argument.

Institutional Investor: The Consequence of Shrinking Public Markets

The number of companies in the U.S. stock market has declined over the past few decades. Relative to history, more companies are relying on private equity to fund growth, staying private longer, or opting to avoid IPOs altogether. Specifically, the U.S. pool of micro-cap stocks - those with market values under $250 million – has shrunk by 58 % from 1998 to 2018 according to research by Syracuse University. Additionally, private companies valued at over $1 billion have been seeking late-stage funding in private markets, rather than going public through an IPO. As a result, ordinary investors are missing out on growth opportunities as these companies only are accessible to institutional and high net worth investors.

Current / Future State of the Industry

Invest Like the Best: Great Migration from Public to Private Equity

On Invest Like the Best, Patrick O’Shaunghnessy and Michael Mauboussin discuss the monumental and multi-decade shift between public to private markets. Topics discussed include the reasons for this shift, the biggest overall changes in capital markets, and the future of investing in capital markets. The discussion came as result of a recent report authored by Mauboussin, which covers many of these topics in great detail.

GIC & PGIM: Building a Better Portfolio: Balancing Performance and Liquidity

The search for higher returns and better diversification has led many institutional investors to allocate more capital to private assets. However, while private assets may potentially provide higher returns, investors still must balance these benefits with the challenge illiquidity. This paper combines insights from GIC and PGIM Institutional advisory and solutions to answer the question of what should be the right amount of private assets in a portfolio given a certain level of “liquidity risk tolerance.”

McKinsey: Preparing for Private Equity Exits in the COVID-19 Era

Exits have slowed down due to market uncertainties caused by COVID-19. McKinsey shares four insights on how founders and sponsors are using this extra holding period to create value for shareholders: investing in growth areas, capturing value or signalling its potential, hard pivots, and strategic planning for a changed future.

CAIA Association: Putting 2020 Into Perspective - Diversification May Work Better Than You Think

The ability of a diversified portfolio, especially long-only, to provide relief during market turbulence has come under attack in recent years with many saying that diversification disappears altogether when investors need it most. Rodney Sullivan, CAIA, CFA, Editor of The Journal of Alternative Investments, examines the historical performance of diversified portfolios during multiple stress periods. In his words, “the death of diversification is greatly exaggerated.”

Artificial Intelligence and Data Science

CAIA Association & State Street: Making Sense of Machine Learning

In a poll taken during this webinar, allocators expressed a preference to invest in a more understandable, low Sharpe ratio strategy than in an opaque black box machine learning strategy with a much higher Sharpe ratio. Efforts to understand how machine learning models work can improve transparency and allow investors to feel more comfortable with making investments in these strategies. The "making sense of machine learning" paper and webinar explain the computation of the “fingerprint” for a given machine learning model’s linear, nonlinear, and interaction effects that drive its predictions — and ultimately its investment performance.

McKinsey & Co.: How Jobs Are Changing as Automation and Digitization Take Hold

This article displays a powerful graphic on how job functions are changing in an increasingly technologized world. This visual coincides with a recent McKinsey article on how technology is impacting careers in operations.

Institutional Investor: AI Powered Hedge Funds Outperformed

In a recent three-year period, hedge funds using artificial intelligence tools had a total return of 34%, far beyond the 12% return of the total hedge fund industry. Using alternative data sources and non-linear technologies, these funds can react to, and even predict, changes in market environments. As assets in AI-driven hedge funds continue to grow, fund launches may expand further due to a greater availability of alternative data sources and open-source AI and machine learning tools.

FDP Institute: Factor and Asset Allocation, The Role of Networks and LASSO

The asset management industry is increasingly using machine learning and predictive models, but these techniques are prone to over-fitting and false discoveries. LASSO regressions, network theory, and predictive models are powerful tools that can be used to build factor and asset allocation models, but it is imperative that investors make the appropriate adjustments for Sharpe ratios and t-statistics to get an accurate view of likely performance issues before the models are implemented.

Environmental, Social, & Governance

GIIN: The Impact investing Market in the COVID-19 Context

In this first brief, Global Impact Investing Network (GIIN) share their findings on how to build resilience against future crisis for impact investors. From their primary research sourced from 97 investors, they identified four key topics. First, how the social and environmental needs are changing as the COVID-19 pandemic spreads. Second, how impact investors' objectives and targets have evolved to reflect the new realities. Third, where lies the impact investment capital available to respond to COVID-19 crisis. Fourth, the challenges facing impact investors' portfolio and the limiting factors for capital deployment.

Metlife: Real Estate: Investors Demand Meaningful ESG Progress

ESG principles are playing an increasingly influential role in real estate. While there are various common industry certificates, such as ENERGY START or LEED in the US or BREEAM internationally, MetLife believes it is important to set even more aggressive goals. This paper shares a step by step approach to upgrade the environmental aspect of a real estate portfolio.

CAIA Association: European Green Deal - Towards A Zero-Carbon Urban Environment

Recent developments in the European Green Deal (EGD) have important implications for EU real estate investors and developers. Christos Angelis, CAIA, Director of Masterdam, begins a multi-part series on the role of national governments and local authorities on the asset class.

PRI: Strategic Asset Allocation – The New Frontier for Responsible Investment

While the body of literature surrounding ESG issues at the asset class level continues to grow, little has been done in the way of building a framework for asset owners building strategic asset allocations. In this article, PRI provides multiple case studies mean to show how sustainability issues can be integrated into the portfolio management process.

Capital Allocators: Kim Lew – Diversity, Equity, and Inclusion

The guest of this episode of Capital Allocators with Ted Seides is Kim Lew, CEO of Columbia Investment Management Company and former Chief Investment Officer of Carnegie Corporation. On the topic of conscious and subconscious bias, the discussion covers Kim’s childhood and early career experience with conscious and subconscious bias and her career as an allocator and the challenges and opportunities afforded by diversity across investment teams, manager selection, and running a fund.

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All posts are the opinion of the contributor. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the contributor's employer.