| Areté Quarterly Q219 |
Business update
One of the things I think about almost everyday is how to best serve investors in this investment environment. Another thing I think about almost everyday is how to do so in a way that is socially useful.
I've written many times about the challenges of this investment environment dominated by low rates, low expected returns, and high levels of policy intervention. In a sense, this is only partly a challenge because short-term interests can be served simply by completely ignoring risk.
Such a course of action, however, only enables the worst tendencies of investors and therefore does not serve long-term interests or provide any function of value. It's like a doctor who tells patients to keep on smoking, drinking, and overeating, and not to worry about exercising.
The challenge is being exacerbated by the reaction function of major investment groups. In the absence of immediate threats, many groups of investors are migrating to investment options that primarily serve short-term interests. They may (or may not) be a touch better than overpriced actively managed funds, but they also fall far short of what can objectively be considered good value.
For example, many mainstream investors have flocked to passively managed funds for the benefit of lower management fees. Many younger investors are expressing a great deal of interest in "impact" funds whereby their investments can have a positive effect on society. Many institutions, such as pension funds, are increasing allocations to riskier investments such as private equity, real estate and other alternatives in order to boost returns. Technology worshipers think technology can solve all problems and naturally migrate to offerings that incorporate new technology.
Each of these groups provides a clear pocket of demand for certain types of investment services and therefore also creates clear opportunities for providers to make money. I would argue, however, that most of these opportunities do a much better job of pandering to specific interests than they do of really helping investors improve their long-term welfare.
Take passive funds, for instance. I don't think there is anything inherently wrong with passive funds and they serve some investors well. But I also think they are wildly over-marketed. With such a prominent focus on low fees, there is far too little scrutiny of the underlying assets. Sometimes those assets are hugely overvalued and sometimes they do not provide the intended exposure. As an analyst, I am frequently shocked by the quantity of truly awful investments that are included in major indexes. I can't in good conscience recommend many of these things to my friends and family.
Impact investing and ESG (environmental, social, governance) criteria are also currently hot investment themes that I believe have a great deal of potential to hurt investors. Way back in business school I did a research project on what was then called socially responsible investing. My conclusion was that ESG considerations should figure into a company's discount rate. In other words, every stock involves a series of tradeoffs. Typically, companies with good governance and environmental records have lower discount rates and therefore higher valuations. All of these factors must be considered holistically.
Many ESG efforts miss a couple of hugely important points. For one, to the degree ESG efforts are prioritized at the expense of investment merits, they are not really investments at all but rather allocation decisions. Any such process would therefore be inappropriate for people whose primary intent is to derive adequate returns in order to fund some long term goal like retirement.
In addition, ESG considerations are often complex and involve many different factors and many shades of gray. Overly simplistic evaluations can miss important nuances. For example, it can be counterproductive to ban all major oil companies from portfolios if one's goal is to promote sustainable energy. What if one or more of those companies rigorously adhere to environmental standards and are progressive about transforming to more sustainable energy forms over time? Such a company could be a valuable ally for the cause and should not be rejected out of hand.
As it turns out, exchange-traded funds (ETFs) are almost perfect vehicles by which to cater to investors with very targeted interests such as ESG (but also countless others). That emphatically does not make them good investments though. Hester Peirce, a commissioner at the US Securities and Exchange Commission, expressed his general concern about specialized ETFs in the Financial Times: “I feel investors are getting misled — and I think it’s a sign of our times where we get all fired up about stuff without really thinking about what’s behind it.” I couldn't agree more.
Another trend has been for pension plans to ride further and further out on the risk curve by increasing allocations to private equity and other alternative investments. Unfortunately this has nothing to do with discovering an under-appreciated investment niche. Far from it. All evidence suggests that private equity returns are coming down and very close to that of public stocks, although with far greater risk. What is not coming down are management fees for private equity. As a result, it is extremely hard to make the case that the explosion in private equity funds under management is serving the long-term interests of investors more than it is lining the pockets of private equity managers.
Finally, there has also been a trend in the development of technology-infused investment products and services. These are targeted at technology worshipers who believe technology is the solution to all of the world's problems. They include apps that facilitate tracking your portfolio on your mobile phone to automated recommendation criteria for investment ideas. More often than not, these services are manifestations of cool (or simply widely available) technological functionality far more than they are thoughtful applications to solve real investment problems. While such offerings often improve convenience, mobility, and efficiency, they rarely improve investors' long-term welfare.
Each of these investor groups is looking for something better. Each is has its own idea of what makes the investment option better. Cost. Societal impact. Higher returns. Efficiency. Each of these is a good thing by itself. But that is the whole problem. Each of these investment options must be considered as a package of tradeoffs and none of the highlighted qualities should be judged in abstraction of other important considerations. Investors who focus on one criterion simply make profitable targets for providers who do not care about their long-term welfare.
The one thing that I have not seen happen yet to any great degree is for investors to demand structurally better investment services rather than just marginally better ones. By that I mean something like research-intensive active management at a fair price. I mean service providers that genuinely want to help their clients get ahead through the exercise of investing. I mean investment industry leaders that are not only paragons of excellence, but also excellent role models.
In general, I absolutely believe that the future of investment services is the ongoing development of knowledge and clever application of technology. These things can produce superior long term results in forms that can be truly useful. Conversely, many of today’s offerings have no good reason to exist in their current form.
All of that said, I have seen a handful of providers explore similar paths to what I have done with Areté. Some asset managers are expanding their business model by increasing the distribution of their research. Other industry professionals are increasingly marketing more directly to advisors and individual investors. Ultimately, the job is still about knowledge development and management. What is changing is the audience who finds that knowledge valuable.
In the meantime, I am continuing to do the things that I believe build knowledge and add value. I am continuing to develop and refine my valuation model. Most recently I have been updating the model to compare operating lease assets, which are now required to be reported, to the estimates that I have been using all along. I am also continuing to update my technology roadmap. Most recently I have been exploring ways in which machine learning and other forms of artificial intelligence can be incorporated into my research process.
Finally, I am also in the process of relocating to Philadelphia. In my efforts to find ways to expand the reach of my valuation work, market insights and research development, I am excited about the prospects of being part of a broader investment community. If you have any ideas of people I should talk to, I would very much appreciate hearing about it.
Thanks for your interest and take care!
David Robertson, CFA
CEO, Portfolio Manager
One of the things I think about almost everyday is how to best serve investors in this investment environment. Another thing I think about almost everyday is how to do so in a way that is socially useful.
I've written many times about the challenges of this investment environment dominated by low rates, low expected returns, and high levels of policy intervention. In a sense, this is only partly a challenge because short-term interests can be served simply by completely ignoring risk.
Such a course of action, however, only enables the worst tendencies of investors and therefore does not serve long-term interests or provide any function of value. It's like a doctor who tells patients to keep on smoking, drinking, and overeating, and not to worry about exercising.
The challenge is being exacerbated by the reaction function of major investment groups. In the absence of immediate threats, many groups of investors are migrating to investment options that primarily serve short-term interests. They may (or may not) be a touch better than overpriced actively managed funds, but they also fall far short of what can objectively be considered good value.
For example, many mainstream investors have flocked to passively managed funds for the benefit of lower management fees. Many younger investors are expressing a great deal of interest in "impact" funds whereby their investments can have a positive effect on society. Many institutions, such as pension funds, are increasing allocations to riskier investments such as private equity, real estate and other alternatives in order to boost returns. Technology worshipers think technology can solve all problems and naturally migrate to offerings that incorporate new technology.
Each of these groups provides a clear pocket of demand for certain types of investment services and therefore also creates clear opportunities for providers to make money. I would argue, however, that most of these opportunities do a much better job of pandering to specific interests than they do of really helping investors improve their long-term welfare.
Take passive funds, for instance. I don't think there is anything inherently wrong with passive funds and they serve some investors well. But I also think they are wildly over-marketed. With such a prominent focus on low fees, there is far too little scrutiny of the underlying assets. Sometimes those assets are hugely overvalued and sometimes they do not provide the intended exposure. As an analyst, I am frequently shocked by the quantity of truly awful investments that are included in major indexes. I can't in good conscience recommend many of these things to my friends and family.
Impact investing and ESG (environmental, social, governance) criteria are also currently hot investment themes that I believe have a great deal of potential to hurt investors. Way back in business school I did a research project on what was then called socially responsible investing. My conclusion was that ESG considerations should figure into a company's discount rate. In other words, every stock involves a series of tradeoffs. Typically, companies with good governance and environmental records have lower discount rates and therefore higher valuations. All of these factors must be considered holistically.
Many ESG efforts miss a couple of hugely important points. For one, to the degree ESG efforts are prioritized at the expense of investment merits, they are not really investments at all but rather allocation decisions. Any such process would therefore be inappropriate for people whose primary intent is to derive adequate returns in order to fund some long term goal like retirement.
In addition, ESG considerations are often complex and involve many different factors and many shades of gray. Overly simplistic evaluations can miss important nuances. For example, it can be counterproductive to ban all major oil companies from portfolios if one's goal is to promote sustainable energy. What if one or more of those companies rigorously adhere to environmental standards and are progressive about transforming to more sustainable energy forms over time? Such a company could be a valuable ally for the cause and should not be rejected out of hand.
As it turns out, exchange-traded funds (ETFs) are almost perfect vehicles by which to cater to investors with very targeted interests such as ESG (but also countless others). That emphatically does not make them good investments though. Hester Peirce, a commissioner at the US Securities and Exchange Commission, expressed his general concern about specialized ETFs in the Financial Times: “I feel investors are getting misled — and I think it’s a sign of our times where we get all fired up about stuff without really thinking about what’s behind it.” I couldn't agree more.
Another trend has been for pension plans to ride further and further out on the risk curve by increasing allocations to private equity and other alternative investments. Unfortunately this has nothing to do with discovering an under-appreciated investment niche. Far from it. All evidence suggests that private equity returns are coming down and very close to that of public stocks, although with far greater risk. What is not coming down are management fees for private equity. As a result, it is extremely hard to make the case that the explosion in private equity funds under management is serving the long-term interests of investors more than it is lining the pockets of private equity managers.
Finally, there has also been a trend in the development of technology-infused investment products and services. These are targeted at technology worshipers who believe technology is the solution to all of the world's problems. They include apps that facilitate tracking your portfolio on your mobile phone to automated recommendation criteria for investment ideas. More often than not, these services are manifestations of cool (or simply widely available) technological functionality far more than they are thoughtful applications to solve real investment problems. While such offerings often improve convenience, mobility, and efficiency, they rarely improve investors' long-term welfare.
Each of these investor groups is looking for something better. Each is has its own idea of what makes the investment option better. Cost. Societal impact. Higher returns. Efficiency. Each of these is a good thing by itself. But that is the whole problem. Each of these investment options must be considered as a package of tradeoffs and none of the highlighted qualities should be judged in abstraction of other important considerations. Investors who focus on one criterion simply make profitable targets for providers who do not care about their long-term welfare.
The one thing that I have not seen happen yet to any great degree is for investors to demand structurally better investment services rather than just marginally better ones. By that I mean something like research-intensive active management at a fair price. I mean service providers that genuinely want to help their clients get ahead through the exercise of investing. I mean investment industry leaders that are not only paragons of excellence, but also excellent role models.
In general, I absolutely believe that the future of investment services is the ongoing development of knowledge and clever application of technology. These things can produce superior long term results in forms that can be truly useful. Conversely, many of today’s offerings have no good reason to exist in their current form.
All of that said, I have seen a handful of providers explore similar paths to what I have done with Areté. Some asset managers are expanding their business model by increasing the distribution of their research. Other industry professionals are increasingly marketing more directly to advisors and individual investors. Ultimately, the job is still about knowledge development and management. What is changing is the audience who finds that knowledge valuable.
In the meantime, I am continuing to do the things that I believe build knowledge and add value. I am continuing to develop and refine my valuation model. Most recently I have been updating the model to compare operating lease assets, which are now required to be reported, to the estimates that I have been using all along. I am also continuing to update my technology roadmap. Most recently I have been exploring ways in which machine learning and other forms of artificial intelligence can be incorporated into my research process.
Finally, I am also in the process of relocating to Philadelphia. In my efforts to find ways to expand the reach of my valuation work, market insights and research development, I am excited about the prospects of being part of a broader investment community. If you have any ideas of people I should talk to, I would very much appreciate hearing about it.
Thanks for your interest and take care!
David Robertson, CFA
CEO, Portfolio Manager
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