Updating theory
Inflation changes assets
Same risk assumption
Inflation changes assets
Same risk assumption
Showing posts with label investment theory. Show all posts
Showing posts with label investment theory. Show all posts
Thursday, April 02, 2015
Modern Portfolio Theory Before Hyperinflation
Modern portfolio theory (MPT) has been around since Ike was in the White House. It's old enough to be Generation X's cranky parent, yelling at the neighborhood kids to get off the lawn. It's also old enough to deserve some improvements.
The authors of MPT and related investment strategies were old enough to have lived through the Great Depression. Images of people who lost everything from overconcentration in one stock, style, or sector made lasting impressions. MPT's emphasis on diversification is a natural result. Most investment theorists in the Anglo-West have not lived through a hyperinflating economy. Using MPT to rebalance portfolios during hyperinflation poses hidden risks.
Fixed income investments comprise a significant allocation of many MPT models in the real world. Bonds, notes, cash instruments, and other things denominated in a face amount of currency will rapidly turn worthless in a hyperinflationary economy. Ask anyone who invested in Zimbabwe, Argentina, or Venezuela in the last decade. MPT investors in those countries could be heard howling all the way across the Atlantic, if anyone listened.
Hyperinflation turns MPT inside out. Asset allocations that include hard assets are far more likely to survive a hyperinflating economy than anything with fixed income. Hard asset sectors like energy, agriculture, mining, and now infrastructure as an emerging theme will hold their worth through inflation because they produce output that can be valued in any currency. They may even experience strong valuation growth during hyperinflation as investors rush to convert the declining power of their currencies into hard goods that will retain utility. The end of hyperinflation will also end such rushed growth, but a productive farm will still be a farm. A bond won't be the same at all.
Updating MPT for a highly inflationary economy does not require adjustments in risk-return calculations. It does require the inclusion of other asset classes that do not behave like fixed income. Consider that oil drillers and metal miners have been hit particularly hard in recent months by oversupply and declining world prices. Consider also that lengthy monetary stimulus has pumped an unsustainable global bond market bubble. Rebalancing means a rotation away from overconcentration in fixed income is due any time. Underpriced hard assets are ready for any MPT-based portfolio manager with enough foresight to prepare for inflation.
The authors of MPT and related investment strategies were old enough to have lived through the Great Depression. Images of people who lost everything from overconcentration in one stock, style, or sector made lasting impressions. MPT's emphasis on diversification is a natural result. Most investment theorists in the Anglo-West have not lived through a hyperinflating economy. Using MPT to rebalance portfolios during hyperinflation poses hidden risks.
Fixed income investments comprise a significant allocation of many MPT models in the real world. Bonds, notes, cash instruments, and other things denominated in a face amount of currency will rapidly turn worthless in a hyperinflationary economy. Ask anyone who invested in Zimbabwe, Argentina, or Venezuela in the last decade. MPT investors in those countries could be heard howling all the way across the Atlantic, if anyone listened.
Hyperinflation turns MPT inside out. Asset allocations that include hard assets are far more likely to survive a hyperinflating economy than anything with fixed income. Hard asset sectors like energy, agriculture, mining, and now infrastructure as an emerging theme will hold their worth through inflation because they produce output that can be valued in any currency. They may even experience strong valuation growth during hyperinflation as investors rush to convert the declining power of their currencies into hard goods that will retain utility. The end of hyperinflation will also end such rushed growth, but a productive farm will still be a farm. A bond won't be the same at all.
Updating MPT for a highly inflationary economy does not require adjustments in risk-return calculations. It does require the inclusion of other asset classes that do not behave like fixed income. Consider that oil drillers and metal miners have been hit particularly hard in recent months by oversupply and declining world prices. Consider also that lengthy monetary stimulus has pumped an unsustainable global bond market bubble. Rebalancing means a rotation away from overconcentration in fixed income is due any time. Underpriced hard assets are ready for any MPT-based portfolio manager with enough foresight to prepare for inflation.
Sunday, March 08, 2015
Thematic Investing Train Leaves The Station
The finance sector is always ready to entertain some new theory. The latest is thematic investing, which can mean just about anything. A handful of asset managers and consultancies have think pieces telling institutional clients how to make this work. Do a Web search to read them yourselves. I poked around a number of reputable sources tracking thematic investing to see what's missing from the discussion.
Academic validation is the main missing link. The academic research on focus investing validates a very selective approach to investing in a small portfolio of actively selected stocks, provided those stocks have strong fundamentals and are held for the long term. Books covering Warren Buffett's methodology support this conclusion but it's worth mentioning that Buffett himself is genetically unique. No other human investor or human-created selection screen has been able to duplicate his performance. Ten years is the minimum for a long-term holding but active investors pursuing thematic investing usually don't have that kind of patience.
Whether an average investor can outperform a broad market simply by starting with a pure macro idea is questionable. Investors awaiting hard evidence need only look at the poor track records of most hedge funds and sector-specific mutual funds to see the problems facing theme investing. The longer think pieces I've read on thematic investing emphasize wishy-washy concepts like hunches, feelings, and inclinations. Those are poor reasons to pick stocks. Thematic investing appeals to some of the lamest institutional investors, specifically sovereign wealth funds and pension plans, who fell for the Swensen-Yale investing model when it was hot.
Plenty of macro ideas are just plain bad. "Globalization" is a very broad theme implying multinational corporations are best suited to handle it. The trouble is that multinationals are often tied to the regulatory environment of their home countries. Here's one I won't try: the "food-water-energy security nexus." It matters to geopolitical strategists who try to predict conflict flashpoints. It matters less to corporations that play it primarily by mitigating its risk.
Thematic investing is not for everyone. Investors are welcome to pick their favorite sectors provided they know a sector inside and out. Sector market leaders have pricing power and the sectors themselves have barriers to entry (like switching costs) that deter competitors. Those are components of a Buffet-style durable competitive advantage. The dearth of competent investment managers means the mediocre majority will fall back on weak top-down selection strategies. Thematic investing is gaining speed with people who don't know where they're going.
Academic validation is the main missing link. The academic research on focus investing validates a very selective approach to investing in a small portfolio of actively selected stocks, provided those stocks have strong fundamentals and are held for the long term. Books covering Warren Buffett's methodology support this conclusion but it's worth mentioning that Buffett himself is genetically unique. No other human investor or human-created selection screen has been able to duplicate his performance. Ten years is the minimum for a long-term holding but active investors pursuing thematic investing usually don't have that kind of patience.
Whether an average investor can outperform a broad market simply by starting with a pure macro idea is questionable. Investors awaiting hard evidence need only look at the poor track records of most hedge funds and sector-specific mutual funds to see the problems facing theme investing. The longer think pieces I've read on thematic investing emphasize wishy-washy concepts like hunches, feelings, and inclinations. Those are poor reasons to pick stocks. Thematic investing appeals to some of the lamest institutional investors, specifically sovereign wealth funds and pension plans, who fell for the Swensen-Yale investing model when it was hot.
Plenty of macro ideas are just plain bad. "Globalization" is a very broad theme implying multinational corporations are best suited to handle it. The trouble is that multinationals are often tied to the regulatory environment of their home countries. Here's one I won't try: the "food-water-energy security nexus." It matters to geopolitical strategists who try to predict conflict flashpoints. It matters less to corporations that play it primarily by mitigating its risk.
Thematic investing is not for everyone. Investors are welcome to pick their favorite sectors provided they know a sector inside and out. Sector market leaders have pricing power and the sectors themselves have barriers to entry (like switching costs) that deter competitors. Those are components of a Buffet-style durable competitive advantage. The dearth of competent investment managers means the mediocre majority will fall back on weak top-down selection strategies. Thematic investing is gaining speed with people who don't know where they're going.
Wednesday, May 21, 2014
The Haiku of Finance for 05/21/14
Growth investing fad
Comes and goes with bubble times
Praise lack of earnings
Comes and goes with bubble times
Praise lack of earnings
Monday, February 03, 2014
Choosing Between Meritocracy And Topocracy
Topocracy is a counterpoint to the meritocratic distribution of rewards within an economic network. This isn't some mere theoretical description of how economies behave as their structures mature. It's a description of reality as plutocratic regimes become entrenched in modern economies.
Contrast the Arrow-Debreau model of supply-demand equilibrium with the Sonnenschein–Mantel–Debreu theorem that individual rationality does not necessarily lead to macroeconomic rationality. This is not intuitive; Kantian reasoning tempts us to believe that rational actors everywhere would construct a rational world even without a deliberate attempt to do so. The lack of rationality in humans, such as with the inability to apply Bayes' Theorem or game theory in thinking, begs theoreticians to construct explanations that account for non-rational economic actions. This leads academics to the study of the tension between topocracy and meritocracy in a world where a perfect Arrow-Debreau equilibrium does not always hold for every commodity.
Serious students of these topics are welcome to peruse "To Each According to its Degree: The Meritocracy and Topocracy of Embedded Markets" from Scientific Reports. One doesn't need an understanding of advanced mathematics to comprehend the study's implications. Social networks have costs, and those costs channel rewards to economic actors favored by "nodes" of connectivity regardless of whether they produce things of value. A plutocratic society skews these reward channels upward through manipulation of the legal and political systems. Increasing income inequality is the result. Economic advantage is locked into the most robust social networks. Members of lower social classes find themselves locked out of opportunities to join social networks that channel excess economic rewards upward to the ruling elite.
The choice between meritocracy and topocracy is never completely mutually exclusive. Economies have always been inseparable from social networks. Only the complete disintermediation of all production, all consumption, and all knowledge from social connections would theoretically eliminate the possibility of topocratic rewards skewed to those of high connections and status. The greatest promise of additive manufacturing (3D printers allowing anyone to design and produce), automation (the possibility of production anywhere, anytime), and MOOCs (free education and knowledge) is the potential to confine topocracy to a very small portion of the economy. The convergence of those three forces can unleash a meritocratic economy that bypasses plutocratic social nodes.
Contrast the Arrow-Debreau model of supply-demand equilibrium with the Sonnenschein–Mantel–Debreu theorem that individual rationality does not necessarily lead to macroeconomic rationality. This is not intuitive; Kantian reasoning tempts us to believe that rational actors everywhere would construct a rational world even without a deliberate attempt to do so. The lack of rationality in humans, such as with the inability to apply Bayes' Theorem or game theory in thinking, begs theoreticians to construct explanations that account for non-rational economic actions. This leads academics to the study of the tension between topocracy and meritocracy in a world where a perfect Arrow-Debreau equilibrium does not always hold for every commodity.
Serious students of these topics are welcome to peruse "To Each According to its Degree: The Meritocracy and Topocracy of Embedded Markets" from Scientific Reports. One doesn't need an understanding of advanced mathematics to comprehend the study's implications. Social networks have costs, and those costs channel rewards to economic actors favored by "nodes" of connectivity regardless of whether they produce things of value. A plutocratic society skews these reward channels upward through manipulation of the legal and political systems. Increasing income inequality is the result. Economic advantage is locked into the most robust social networks. Members of lower social classes find themselves locked out of opportunities to join social networks that channel excess economic rewards upward to the ruling elite.
The choice between meritocracy and topocracy is never completely mutually exclusive. Economies have always been inseparable from social networks. Only the complete disintermediation of all production, all consumption, and all knowledge from social connections would theoretically eliminate the possibility of topocratic rewards skewed to those of high connections and status. The greatest promise of additive manufacturing (3D printers allowing anyone to design and produce), automation (the possibility of production anywhere, anytime), and MOOCs (free education and knowledge) is the potential to confine topocracy to a very small portion of the economy. The convergence of those three forces can unleash a meritocratic economy that bypasses plutocratic social nodes.
Monday, September 02, 2013
Adapting Portfolio Theory To Social Capital
Today I attended an awesome seminar on the research behind the Bay Area Impact Investing Initiative. A diverse bunch of finance types gathered at the East Bay Community Foundation to hear the principals behind BAIII discuss work that is very relevant to the social capital movement. I don't have time this week to attend SOCAP13 at Fort Mason so this seminar will have to tide me over until next time.
R. Paul Herman from HIP Investor elaborated on the five "HIP" factors that he uses to describe previously unquantified drivers of corporate valuation. Human capital has heretofore been an off-balance sheet intangible asset that financial models have ignored. Endogenizing this asset into a financial model adds depth to a balanced scorecard managerial approach. Incorporating environmental, social, and corporate governance (ESG) factors into corporate management is a new approach to mitigating risk. Asset management firms are now publishing ESG reports and corporate managers are plotting projects and business units on a 2x2 human capital matrix. We've all seen BCG's growth-share matrix, so just picture one with profit on the y-axis and a human capital scale on the x-axis. I learned from Mr. Herman that Infosys tracks its human capital according to a formula from a 40-year old Harvard Business Review article. I'll bet that reference is the Lev and Schwartz model for the present value of future earnings referenced under human resource accounting.
The HIP theory has some surprising implications. I've noticed that lots of investing styles - growth, GARP, sector rotation - all claim to outperform benchmarks at some point. Mr. Herman's research reveals that even "vice" portfolios of investments in cigarettes and gambling can outperform market benchmarks, but sustainable ESG portfolios can also outperform with reduced risk. His findings indicate that more diverse corporate boards of directors are associated with higher ROE and lower volatility, and that unsustainable companies have more volatile share prices.
Lauryn Agnew from Seal Cove Financial discussed her work on attracting institutional assets to social capital investments. Modern portfolio theory is limited by its emphasis on historical measures of risk, like tracking error and volatility. She wants to educate investment managers on how ESG criteria mitigate future risk. Institutions are starting to come around. The Federal Reserve Bank of San Francisco held its Impact Investing in the Bay Area conference this past May. Get the conference report and read the working paper.
Ms. Agnew's focus stems from her work with the governance of local non-profit institutions. These investors want to align their fiduciary duties with the social benefit mission of their endowments. Institutional trustees have had to live with tradeoffs between impact and investment returns up until now. Her starting point for identifying locally-based public corporations was the Bloomberg Bay Area Index. She then matched the ESG scores for portfolio candidate stocks to criteria defined by a given non-profit's mission, and then ranked the stocks for optimal fit. Several iterations of sample portfolios revealed which combinations of local concentration and ESG score minimized tracking error.
The Bay Area Council's Family of Funds has sought double bottom line impacts for several years. Enthusiasm for ESG investing is not limited to the Bay Area. The California Economic Summit's Capital Action Team is pushing triple bottom line results all over the Golden State. The California Financial Opportunities Roundtable has outlined solutions for growing local businesses. The Community Reinvestment Act encourages the formation of investment companies that implement its principles. Community development financial institutions (CDFI) certified by the US Treasury's CDFI Fund can use equity equivalent investments to give non-profits lower capital costs.
Private sector thought leaders in ESG analysis are few and far between. Changemaker Capital Partners is driving impact private equity investing. Collaborative Economics is helping to seed the civic ecosystem with "innovation brokers" who can drive multidisciplinary change. I've done similar work as a knowledge management professional but I had no idea there was a term for an emerging field. The Stanford Social Innovation Review and Ceres publish leading edge think pieces on sustainability and ESG. The Global Environmental Management Initiative (GEMI) is taking this subject's tools worldwide. Now I've got some high-quality sources for future blog articles.
I'll close out this intense, multidisciplinary discussion with my own proposed social capital innovation. I see a massive disruption opportunity in sustainability for a business development company (BDC) that is chartered to provide capital to small and medium enterprises meeting ESG criteria. I believe such an entity that is majority owned by investment professionals from traditionally disadvantaged demographics (women, ethnic minorities, disabled military veterans) could register in the Altura Capital Emerging Manager Database and qualify for capital from institutions with a mandate to diversify their sub-managers. Such a business may also qualify as an SBA-designated Small Business Investment Company (SBIC), giving it additional advantages. Domiciling this enterprise in a HUBZone would be the crowning glory in a pitch for local investment. I do not know whether this ESG / BDC / SBIC plan is workable but I am very willing to work with other finance professionals who want to explore it and give it a shot. We won't know until we try. Maybe some ambitious innovation broker from 85 Broads or the Wall Street Warfighters Foundation is willing to help me make this happen.
Full disclosure: No positions in any securities, funds, or enterprises mentioned at this time.
R. Paul Herman from HIP Investor elaborated on the five "HIP" factors that he uses to describe previously unquantified drivers of corporate valuation. Human capital has heretofore been an off-balance sheet intangible asset that financial models have ignored. Endogenizing this asset into a financial model adds depth to a balanced scorecard managerial approach. Incorporating environmental, social, and corporate governance (ESG) factors into corporate management is a new approach to mitigating risk. Asset management firms are now publishing ESG reports and corporate managers are plotting projects and business units on a 2x2 human capital matrix. We've all seen BCG's growth-share matrix, so just picture one with profit on the y-axis and a human capital scale on the x-axis. I learned from Mr. Herman that Infosys tracks its human capital according to a formula from a 40-year old Harvard Business Review article. I'll bet that reference is the Lev and Schwartz model for the present value of future earnings referenced under human resource accounting.
The HIP theory has some surprising implications. I've noticed that lots of investing styles - growth, GARP, sector rotation - all claim to outperform benchmarks at some point. Mr. Herman's research reveals that even "vice" portfolios of investments in cigarettes and gambling can outperform market benchmarks, but sustainable ESG portfolios can also outperform with reduced risk. His findings indicate that more diverse corporate boards of directors are associated with higher ROE and lower volatility, and that unsustainable companies have more volatile share prices.
Lauryn Agnew from Seal Cove Financial discussed her work on attracting institutional assets to social capital investments. Modern portfolio theory is limited by its emphasis on historical measures of risk, like tracking error and volatility. She wants to educate investment managers on how ESG criteria mitigate future risk. Institutions are starting to come around. The Federal Reserve Bank of San Francisco held its Impact Investing in the Bay Area conference this past May. Get the conference report and read the working paper.
Ms. Agnew's focus stems from her work with the governance of local non-profit institutions. These investors want to align their fiduciary duties with the social benefit mission of their endowments. Institutional trustees have had to live with tradeoffs between impact and investment returns up until now. Her starting point for identifying locally-based public corporations was the Bloomberg Bay Area Index. She then matched the ESG scores for portfolio candidate stocks to criteria defined by a given non-profit's mission, and then ranked the stocks for optimal fit. Several iterations of sample portfolios revealed which combinations of local concentration and ESG score minimized tracking error.
The Bay Area Council's Family of Funds has sought double bottom line impacts for several years. Enthusiasm for ESG investing is not limited to the Bay Area. The California Economic Summit's Capital Action Team is pushing triple bottom line results all over the Golden State. The California Financial Opportunities Roundtable has outlined solutions for growing local businesses. The Community Reinvestment Act encourages the formation of investment companies that implement its principles. Community development financial institutions (CDFI) certified by the US Treasury's CDFI Fund can use equity equivalent investments to give non-profits lower capital costs.
Private sector thought leaders in ESG analysis are few and far between. Changemaker Capital Partners is driving impact private equity investing. Collaborative Economics is helping to seed the civic ecosystem with "innovation brokers" who can drive multidisciplinary change. I've done similar work as a knowledge management professional but I had no idea there was a term for an emerging field. The Stanford Social Innovation Review and Ceres publish leading edge think pieces on sustainability and ESG. The Global Environmental Management Initiative (GEMI) is taking this subject's tools worldwide. Now I've got some high-quality sources for future blog articles.
I'll close out this intense, multidisciplinary discussion with my own proposed social capital innovation. I see a massive disruption opportunity in sustainability for a business development company (BDC) that is chartered to provide capital to small and medium enterprises meeting ESG criteria. I believe such an entity that is majority owned by investment professionals from traditionally disadvantaged demographics (women, ethnic minorities, disabled military veterans) could register in the Altura Capital Emerging Manager Database and qualify for capital from institutions with a mandate to diversify their sub-managers. Such a business may also qualify as an SBA-designated Small Business Investment Company (SBIC), giving it additional advantages. Domiciling this enterprise in a HUBZone would be the crowning glory in a pitch for local investment. I do not know whether this ESG / BDC / SBIC plan is workable but I am very willing to work with other finance professionals who want to explore it and give it a shot. We won't know until we try. Maybe some ambitious innovation broker from 85 Broads or the Wall Street Warfighters Foundation is willing to help me make this happen.
Full disclosure: No positions in any securities, funds, or enterprises mentioned at this time.
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