Portfolio skill
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Combining asset classes
Generate alpha
Showing posts with label portfolio management. Show all posts
Showing posts with label portfolio management. Show all posts
Monday, July 20, 2015
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.
Thursday, January 29, 2015
Extraordinary Fund Manager Myopia
I answered a survey today from a major consulting firm that canvasses senior people in portfolio management and investment analysis. I won't reveal the firm's name but I will get a copy of the survey upon publication. The questions addressed investment professionals' expectations to see in the markets over the near term. I expect a bunch of bad news, unlike many pros who manage serious money.
A whole bunch of obvious risks have not deterred asset managers from seeking safe havens. Teachers' pension funds are piling into US residential real estate investments at all-time high prices. Currency arbitrageurs have not been deterred by several trading firms' blowups after the Swiss repriced their currency. Corporate earnings and P/E ratios at generational high points eventually revert to their historic means. I could go on about these things but the only people paying attention are on the fringes of the finance sector. Mainstream thinking among portfolio managers still encourages chasing yield. The Wall Street crowd assumes central bank puts under asset markets can never fail.
Geopolitical risks should compound any sane money manager's planning. Russia's diversion of reserve funds from infrastructure investment to bank backstops should signal a low-growth future. Emerging market stocks that sold dollar-denominated debt will struggle to make higher interest payments while the dollar stays strong. The enormous potential for instability in Venezuela, Argentina, and Saudi Arabia should throw cold water on any bullish case for those countries in 2015. Money managers plow ahead anyway, oblivious to contrarian cases.
The hard asset hedge crowd has enough myopia of its own. Perpetual fans of precious metals don't think about the impracticality of bullion bars in daily transactions. Stocks in the natural resource sector have cratered since 2014 and will stay low as long as currencies of hard asset producing countries stay weak. The oil sector shakeout means a lot of so-called bargain buys among junior producers will instead become bankrupt buys as major producers buy out their nonproducing assets.
Watching supposedly smart money managers make increasingly dumb bets is a fun pastime. I like it when dumb people lose millions after greed and hubris destroy their judgment. A penultimate day of reckoning awaits investment professionals who assume central banks will never lose control of currencies or yield curves. Hedge fund managers will learn the hard way how to write farewell letters to their formerly wealthy clients. I will relish bottom-fishing for cheap assets once myopic fund managers are wiped out.
A whole bunch of obvious risks have not deterred asset managers from seeking safe havens. Teachers' pension funds are piling into US residential real estate investments at all-time high prices. Currency arbitrageurs have not been deterred by several trading firms' blowups after the Swiss repriced their currency. Corporate earnings and P/E ratios at generational high points eventually revert to their historic means. I could go on about these things but the only people paying attention are on the fringes of the finance sector. Mainstream thinking among portfolio managers still encourages chasing yield. The Wall Street crowd assumes central bank puts under asset markets can never fail.
Geopolitical risks should compound any sane money manager's planning. Russia's diversion of reserve funds from infrastructure investment to bank backstops should signal a low-growth future. Emerging market stocks that sold dollar-denominated debt will struggle to make higher interest payments while the dollar stays strong. The enormous potential for instability in Venezuela, Argentina, and Saudi Arabia should throw cold water on any bullish case for those countries in 2015. Money managers plow ahead anyway, oblivious to contrarian cases.
The hard asset hedge crowd has enough myopia of its own. Perpetual fans of precious metals don't think about the impracticality of bullion bars in daily transactions. Stocks in the natural resource sector have cratered since 2014 and will stay low as long as currencies of hard asset producing countries stay weak. The oil sector shakeout means a lot of so-called bargain buys among junior producers will instead become bankrupt buys as major producers buy out their nonproducing assets.
Watching supposedly smart money managers make increasingly dumb bets is a fun pastime. I like it when dumb people lose millions after greed and hubris destroy their judgment. A penultimate day of reckoning awaits investment professionals who assume central banks will never lose control of currencies or yield curves. Hedge fund managers will learn the hard way how to write farewell letters to their formerly wealthy clients. I will relish bottom-fishing for cheap assets once myopic fund managers are wiped out.
Thursday, March 20, 2014
Generating Alpha From An IP Portfolio
I suspect that some of the concepts useful in financial portfolio management also apply to managing a portfolio of intellectual property. The IP portfolio will not be as liquid as a basket of stocks or bonds, but there may be a common intellectual framework for all of these asset classes. Intellectual Asset Management refers to IP finance and valuation in ways that beg for more analysis.
Notional IP portfolio holdings must start with bottom-up valuation. Standards from USPAP, IVSC, FASB, and IFRS/IASB establish baselines for assessing IP value. WIPO's list of documents on IP valuation help build out the methodologies needed. Valuation matters for establishing an investment's entry point. I wouldn't pay a million bucks for some patent that's only worth a nickel. The "cost" method reminds me of equity valuation methods that use book value and Tobin's Q. The "income" approach is pretty much the discounted cash flow method that most equity analysts should recognize.
The illiquid nature of IP means a pure-play investment in a bunch of intangible assets would bear more resemblance to a private equity investment than a public stock. Liquid proxies for an illiquid patent portfolio do exist. These include ETFs based on the Ocean Tomo 300 Patent Index. The simplest way to measure the alpha of a pure-play IP portfolio is to compare it to that index's return over whatever holding period is relevant.
There are "unknown knowns" that pose risk management challenges to IP portfolio management. Patent quality matters. There must be some way to perform statistical analysis of an IP portfolio's quality beyond just number of filings by country or sector. WIPO's PATENTSCOPE database and the USPTO probably have enough data to make this analysis worthwhile. Managing an IP portfolio's risk should consider litigation trends within the taxonomy of patent classifications. The risk breakdown would assign different risk weights to electronics, hydraulics, or whatever to avoid overconcentration of ownership in some class subject to heavy litigation (like software). My Google searches for "patent portfolio theory" and "patent portfolio race" reveal a notable amount of theory addressing these issues. Finally, I wonder whether IP portfolio considerations should differentiate by type of IP: patent, trademark, copyright, etc. A diverse portfolio containing many IP types may achieve an optimal risk-return tradeoff, or it may be an encumbrance to the search for pure-play returns.
Investing in IP or IP-heavy companies reminds me of the "innovation premium" theory. I proposed my own metrics for an innovation premium in an Alfidi Capital blog article last year. Those metrics can be weighted differently to account for qualitative differences; i.e. "number of patents filed" can carry a smaller weight if patent quality declines. I feel like publishing a longer research report on generating alpha from an IP portfolio but I will only do so if it adds something not already covered in WIPO's literature. Good knowledge of IP valuation would make a huge difference in technology transfer from research laboratories to the marketplace. I would consider commercializing tech from a government or university lab if I understood how its valuation fit into a larger portfolio.
Full disclosure: No positions in any investment products mentioned at this time.
Notional IP portfolio holdings must start with bottom-up valuation. Standards from USPAP, IVSC, FASB, and IFRS/IASB establish baselines for assessing IP value. WIPO's list of documents on IP valuation help build out the methodologies needed. Valuation matters for establishing an investment's entry point. I wouldn't pay a million bucks for some patent that's only worth a nickel. The "cost" method reminds me of equity valuation methods that use book value and Tobin's Q. The "income" approach is pretty much the discounted cash flow method that most equity analysts should recognize.
The illiquid nature of IP means a pure-play investment in a bunch of intangible assets would bear more resemblance to a private equity investment than a public stock. Liquid proxies for an illiquid patent portfolio do exist. These include ETFs based on the Ocean Tomo 300 Patent Index. The simplest way to measure the alpha of a pure-play IP portfolio is to compare it to that index's return over whatever holding period is relevant.
There are "unknown knowns" that pose risk management challenges to IP portfolio management. Patent quality matters. There must be some way to perform statistical analysis of an IP portfolio's quality beyond just number of filings by country or sector. WIPO's PATENTSCOPE database and the USPTO probably have enough data to make this analysis worthwhile. Managing an IP portfolio's risk should consider litigation trends within the taxonomy of patent classifications. The risk breakdown would assign different risk weights to electronics, hydraulics, or whatever to avoid overconcentration of ownership in some class subject to heavy litigation (like software). My Google searches for "patent portfolio theory" and "patent portfolio race" reveal a notable amount of theory addressing these issues. Finally, I wonder whether IP portfolio considerations should differentiate by type of IP: patent, trademark, copyright, etc. A diverse portfolio containing many IP types may achieve an optimal risk-return tradeoff, or it may be an encumbrance to the search for pure-play returns.
Investing in IP or IP-heavy companies reminds me of the "innovation premium" theory. I proposed my own metrics for an innovation premium in an Alfidi Capital blog article last year. Those metrics can be weighted differently to account for qualitative differences; i.e. "number of patents filed" can carry a smaller weight if patent quality declines. I feel like publishing a longer research report on generating alpha from an IP portfolio but I will only do so if it adds something not already covered in WIPO's literature. Good knowledge of IP valuation would make a huge difference in technology transfer from research laboratories to the marketplace. I would consider commercializing tech from a government or university lab if I understood how its valuation fit into a larger portfolio.
Full disclosure: No positions in any investment products mentioned at this time.
Tuesday, November 12, 2013
Get Rid Of The Yale Endowment Model
Investment managers become enamored with faddish theories from time to time. Theories that promise to outperform the stock market's broad benchmarks always work until they don't work anymore. It's time to retire one theoretical model that doesn't work anymore - the Yale endowment model from David Swensen.
I can boil this model's argument down to one pithy sentence: Put one third of a portfolio into the most illiquid, highly leveraged products imaginable, provided those products are based on mathematical formulas that have no relationship to reality. That worked in the era up until the last housing crisis, when every marginal dollar of debt added to the economy added more than one dollar of additional GDP. The US economy passed that tipping point and every dollar of additional debt is a burden upon corporate earnings.
The Yale model cannot account for the underperformance of the hedge fund sector over the past decade yet advocates hedge fund investment simply because it is not correlated to equities or bonds. It also endorses private equity allocations at a time when VC funds are in a long-term trend of underperformance. Leveraged buyouts are based on the premise that debt-driven restructuring can unlock buried value. That was fine when average corporate earnings were under their historical norm of 6% of GDP. Earnings are now almost twice that figure. They will revert to their mean at some point and companies undergoing a leveraged restructuring will turn in disappointing results to their private equity owners.
The model's logic doesn't even pass a test of internal consistency. Mr. Swensen's books on portfolio theory argue that more intermediaries between a client and their money provide incrementally less value. The Yale model implies that hiring more sub-managers for private equity and hedge fund investments adds value, which contradicts any inclination to minimize intermediaries. Mr. Spock from Star Trek would say that's illogical. Fictional aliens don't manage money, but if they did I think they'd put a Vulcan nerve pinch on anyone who insisted that ten levels of sub-managers deliver ten times the value of one.
My final beef with the Yale model is its inability to detect fraud. Remember Bernie Madoff? He made off with a bunch of cash for his Ponzi scheme because institutions trusted their funds-of-funds managers to perform due diligence on sub-managers like him. They did no such thing. Trusting additional layers of money managers increases the possibility that one will be a phony.
The Yale model ignores the effectiveness of the shareholder activist model that used to work well enough for institutional investors. Maybe CalPERS and other institutions got lazy after the 1990s and decided to contract out their original thinking to sub-managers who did little thinking. The Yale model gave them all convenient philosophical cover to take their eyes off the ball. Today's economic climate demands attentive money managers. They cannot afford to hang onto the Yale model.
I can boil this model's argument down to one pithy sentence: Put one third of a portfolio into the most illiquid, highly leveraged products imaginable, provided those products are based on mathematical formulas that have no relationship to reality. That worked in the era up until the last housing crisis, when every marginal dollar of debt added to the economy added more than one dollar of additional GDP. The US economy passed that tipping point and every dollar of additional debt is a burden upon corporate earnings.
The Yale model cannot account for the underperformance of the hedge fund sector over the past decade yet advocates hedge fund investment simply because it is not correlated to equities or bonds. It also endorses private equity allocations at a time when VC funds are in a long-term trend of underperformance. Leveraged buyouts are based on the premise that debt-driven restructuring can unlock buried value. That was fine when average corporate earnings were under their historical norm of 6% of GDP. Earnings are now almost twice that figure. They will revert to their mean at some point and companies undergoing a leveraged restructuring will turn in disappointing results to their private equity owners.
The model's logic doesn't even pass a test of internal consistency. Mr. Swensen's books on portfolio theory argue that more intermediaries between a client and their money provide incrementally less value. The Yale model implies that hiring more sub-managers for private equity and hedge fund investments adds value, which contradicts any inclination to minimize intermediaries. Mr. Spock from Star Trek would say that's illogical. Fictional aliens don't manage money, but if they did I think they'd put a Vulcan nerve pinch on anyone who insisted that ten levels of sub-managers deliver ten times the value of one.
My final beef with the Yale model is its inability to detect fraud. Remember Bernie Madoff? He made off with a bunch of cash for his Ponzi scheme because institutions trusted their funds-of-funds managers to perform due diligence on sub-managers like him. They did no such thing. Trusting additional layers of money managers increases the possibility that one will be a phony.
The Yale model ignores the effectiveness of the shareholder activist model that used to work well enough for institutional investors. Maybe CalPERS and other institutions got lazy after the 1990s and decided to contract out their original thinking to sub-managers who did little thinking. The Yale model gave them all convenient philosophical cover to take their eyes off the ball. Today's economic climate demands attentive money managers. They cannot afford to hang onto the Yale model.
Tuesday, September 17, 2013
Forgetting FX Invest West Coast 2013
I attended last year's FX Invest West Coast thinking I could benefit from the thinking of serious currency investors. The main thing I learned last year is that much of this finance sub-sector is driven by quant philosophies that have little to do with finding value in the real world. I tried to register several times this year but never got a final confirmation to attend. Maybe someone who attended last year took offense at what I wrote about stupid quant people wasting their time with Rube Goldberg trading mechanisms. I stayed away today but here's my blind-item critique of the FX Invest West Coast 2013 agenda. I have no idea what they actually said, or if they even showed up, because I wasn't there. My comments below refer to publicly available information that relates to the topics of the scheduled program items.
CalPERS had something to say as an opener. My blog article of what CalPERS had to say last year really laid into them so I can't imagine what they could have said today. CalPERS lost my respect ever since they switched from activist investing in undervalued companies to doubling-down on illiquid, leveraged products.
FRBNY spoke on PVP settlement and replacement cost. The New York Fed has all you need to know about their payment versus payment best practices in a 2010 white paper. The standard definition of replacement cost means little in currency investing unless it applies the BIS best practices for reducing foreign exchange settlement risk.
BlackRock was supposed to say something about currency beta and whether active or passive investing in currency matters. I just shake my head whenever somebody uses beta to measure anything other than a single security that belongs to a broad index. IMHO anyone who uses active strategies in currency is merely gambling, not investing. Currency is cash, and cash is for passive holdings until it finds an active use in some other asset.
A bunch of panels discussed BRIC currencies, ECB policies, and electronic trading platforms. Folks, I've discussed all of those things on my blog and no so-called "expert" can hold a candle to my level of thinking. I haven't blogged about swap execution facilities (SEFs) but I don't use them. I suspect that the wide use of SEFs will eventually reduce the alpha that active currency managers can generate by allowing more traders to arbitrage away pricing anomalies. It will be just like Reg D destroying the alpha available to managed futures traders. Kiss those big bonuses goodbye, quants.
The Indian rupee (INR) has done badly this year. No kidding. Quants need to stop trying to day-trade this currency and start looking at India's macroeconomic fundamentals. India's central bank is considering radical plans to play games with its gold reserves in an attempt to stabilize the rupee and India's current account deficits. Raising short-term interest rates is the right thing to do. You'd think quants would see that as a buy-and-hold opportunity, but quants don't think that way.
One speaker showed an interest in discussing emerging market currencies as an inflation hedge. I've discussed that on my blog but I only like currencies from countries with low debt-to-GDP ratios and a strong rule of law. Throwing emerging currencies into the mix just won't do it for me. You'll end up owning currencies from Argentina, Venezuela, and other places where demagogues confiscate wealth and hyperinflate the economy. No thanks. I would have been squirming in my seat if I had to listen to a formal talk on the glory of EM currencies.
The one topic I might have liked would have been currencies as alternatives to bonds. My currency ETFs are paying me a better yield than my US dollar cash holdings. Like I said above, only low debts and strong rule of law matter in finding currencies to use as hedges or income alternatives. Once hyperinflation destroys the US dollar, my currency ETFs will enable me to buy US dollar assets cheaply. Currency is cash, and foreign currency in a hyperinflated economy enables wealth accumulation.
This FX Invest West Coast conference is still in progress as I'm writing this article. I didn't miss much besides free food and coffee. It may be just as well that I sit this conference out if they can't have me as a speaker. I would probably offend everyone in the room with my strongly held belief in the limited portfolio role for currency strategies. Currency is cash, and cash is productive in only limited ways: investing in assets or paying expenses. Currency can also hedge cash exposures but those exposures must be committed to something serious. I have lots of cash sitting in my portfolio because not many assets in the capital markets are attractively priced and I have very few expenses to pay. I'm too cheap and too smart to be of use to many of the numbskulls in the professional currency investing circuit. It's their loss and they'll never know it.
CalPERS had something to say as an opener. My blog article of what CalPERS had to say last year really laid into them so I can't imagine what they could have said today. CalPERS lost my respect ever since they switched from activist investing in undervalued companies to doubling-down on illiquid, leveraged products.
FRBNY spoke on PVP settlement and replacement cost. The New York Fed has all you need to know about their payment versus payment best practices in a 2010 white paper. The standard definition of replacement cost means little in currency investing unless it applies the BIS best practices for reducing foreign exchange settlement risk.
BlackRock was supposed to say something about currency beta and whether active or passive investing in currency matters. I just shake my head whenever somebody uses beta to measure anything other than a single security that belongs to a broad index. IMHO anyone who uses active strategies in currency is merely gambling, not investing. Currency is cash, and cash is for passive holdings until it finds an active use in some other asset.
A bunch of panels discussed BRIC currencies, ECB policies, and electronic trading platforms. Folks, I've discussed all of those things on my blog and no so-called "expert" can hold a candle to my level of thinking. I haven't blogged about swap execution facilities (SEFs) but I don't use them. I suspect that the wide use of SEFs will eventually reduce the alpha that active currency managers can generate by allowing more traders to arbitrage away pricing anomalies. It will be just like Reg D destroying the alpha available to managed futures traders. Kiss those big bonuses goodbye, quants.
The Indian rupee (INR) has done badly this year. No kidding. Quants need to stop trying to day-trade this currency and start looking at India's macroeconomic fundamentals. India's central bank is considering radical plans to play games with its gold reserves in an attempt to stabilize the rupee and India's current account deficits. Raising short-term interest rates is the right thing to do. You'd think quants would see that as a buy-and-hold opportunity, but quants don't think that way.
One speaker showed an interest in discussing emerging market currencies as an inflation hedge. I've discussed that on my blog but I only like currencies from countries with low debt-to-GDP ratios and a strong rule of law. Throwing emerging currencies into the mix just won't do it for me. You'll end up owning currencies from Argentina, Venezuela, and other places where demagogues confiscate wealth and hyperinflate the economy. No thanks. I would have been squirming in my seat if I had to listen to a formal talk on the glory of EM currencies.
The one topic I might have liked would have been currencies as alternatives to bonds. My currency ETFs are paying me a better yield than my US dollar cash holdings. Like I said above, only low debts and strong rule of law matter in finding currencies to use as hedges or income alternatives. Once hyperinflation destroys the US dollar, my currency ETFs will enable me to buy US dollar assets cheaply. Currency is cash, and foreign currency in a hyperinflated economy enables wealth accumulation.
This FX Invest West Coast conference is still in progress as I'm writing this article. I didn't miss much besides free food and coffee. It may be just as well that I sit this conference out if they can't have me as a speaker. I would probably offend everyone in the room with my strongly held belief in the limited portfolio role for currency strategies. Currency is cash, and cash is productive in only limited ways: investing in assets or paying expenses. Currency can also hedge cash exposures but those exposures must be committed to something serious. I have lots of cash sitting in my portfolio because not many assets in the capital markets are attractively priced and I have very few expenses to pay. I'm too cheap and too smart to be of use to many of the numbskulls in the professional currency investing circuit. It's their loss and they'll never know it.
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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