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Credit Investing | How long will the current credit cycle continue? For today's investors, Oaktree Capital have released a worth-viewing series of videos interviews between Howard Marks and other Oaktree Portfolio Managers. Credit investing is ultimately about taking risks at the right points, in the right structures and the right opportunities for the return reward. It is possible that interest rates might not rise enough to end this credit cycle, although it is clear that credit spreads have become too low for certain investors to take on more risk to meet their return targets. It might not be possible to time where we are in the cycle; therefore, it is worth listening to Howard Marks' comments that: "[One] of the most important things for people to realise is that these phenomena, like the credit market, are not mechanical and they don't work like finely honed machines - they are really driven by psychology and it's important to realise that psychology tends to go to excess." Tread with caution, as the easy money might have already been made.
Investment Process | A killer question to ask a fund manager is: "Who is the most important person in your team?" Team collaboration in portfolio management is generally seen as a good thing. Asset owners and their advisors typically value a team-based investment process, despite fears of 'group-think' or 'herd-instincts'. New research by Harvard Business School associate professor Ethan Bernstein and colleagues suggests that 'always teamwork' may not be always effective. Modern communication methods mean that collaboration is more frequent. But what they found was when high performers interact with low performers constantly, there was little to learn from them, because low performers mostly just copied high performers' solutions, and high performers likely ignored them. Most interesting is that they found occasional collaboration can be a big help; in other words, less intense collaboration may be helpful when it comes to solving complex problems. As the academics note, when high performers interacted with low performers intermittently, they were able to learn something from them that helped them achieve greater solutions to the problem. Maybe the killer question to ask a fund manager is not about teamwork at all; but "What do you think contributes to effective collaboration?"
ESG | This 2Q 2018 paper entitled 'Lost in Translation: In Search of Authenticity in ESG Integration' suggests that ESG integration has lost its meaning. Ulrika Hasselgren and her co-authors write: "When ESG integration is disconnected from the investment process - when it is hijacked by screening, scoring, overlaying, filtering or any other form of framework or tool - something vital is lost in translation." This sentence requires careful consideration given that ESG is becoming 'mainstream'. The nature of language is such that people never say exactly what they mean. While the use of the word 'hijacked' can be debated (it might help the marketing of the authors' employers active investment offering), it does deal with the main problem at hand: have the pressures felt by asset owners and asset managers to be 'ESG savvy' meant there has been insufficient questioning of what is good ESG behaviour (security selection) and integration (portfolio construction). Maybe the biggest risk of ESG investing is the potential of misunderstandings when asset owners do not get the outcome they expected. While the paper encourages "a sincere search for authenticity in ESG integration", it provides no details how this can be achieve. Agree or disagree with ESG investing - but just remember that it is the investors who must decide. An old saying holds that markets are ruled by either greed or fear. Some have made money from ESG investing. Other have lost money. Better ESG investing deserves a richer debate.
ETFs | Today, with lots of capital concentrated in a few securities, active investors are more engaged in the debate on the virtues of passive investing. They are making a better distinction between good and bad passive investing. This short article (June 2018) written by Transtrend (a CTA manager that has been around for ages) is a good example of thoughts on the impact of index tracking or how passive investing could self destruct. The authors are surely right when they state: "Markets are not a train that one can hop on and hop off without impacting its timetable. All trading activity has market impact. In fact, market impact is the only force that drives prices." The article demonstrates how index tracking affects an index and how, in theory at least, index tracking could not only deteriorate the index, but also give the tool to some index trackers to outperform in the process. The proof is only theoretical and is yet to be demonstrated with market data. I hope someone will attempt this analysis. There has been a lot of debates regarding active versus passive investing and sometimes it is necessary to simplify and emphasise to get a grip on a dynamic. By doing so, this article is key in understanding how the rise of index hugging will affect markets and can help investors determine whether or not an index is worth tracking. In short, the fewer trackers, the more attractive the index.
Oaktree Capital's Howard Marks offers a wealth of knowledge and wisdom about active management, passive investing, and quants/AI in his latest memo, entitled 'Investing Without People.' In this current up-cycle, his comments on the actions of market participants are insightful. Let me quote: "When everyone decides to refrain from performing the functions of analysis, price discovery, and capital allocation, the appropriateness of market prices can go out of the window..." The potential for disappointment rises when people invest more in certain stocks than others; think of FAANGs, factor crowding, and the feedback loop as a result of passive investing. In short, overvaluation followed by abrupt reversals. Indeed, too strict a focus on short-term relative returns of active funds, and abandoning those having short-term performance challenges, can needlessly reduce potential longer-term excess returns for investors. A truly active and differentiated fund will have spells of underperformance blips. Investors will be better served by a more realistic consideration of the pros and cons of active investing. And here is the killer quote: "quantitative investing's emphasis on profiting from short-term dislocations leaves a lot more to be mined. So much of investing these days considers only the short run that I think there's a great scope for superior active investors to make value-additive decisions concerning the long run."
Computers prioritise efficiency over judgment. But, as David Iben (CIO of Kopernik Global Advisors) writes in his latest commentary (June 2018): "...in investing, a field that is famously a blend of science and art, isn't judgment what really matters?" In short, there is uncertainty. Investment returns are highly uncertain and irregular. Computers might help investors find patterns or signs of 'irrational' exuberance or despondency. But, as Iben writes, 'In a weird paradox, computers have allowed mankind to formulate and embrace more theories, which in turn, have caused increased use of computers, which unfortunately, due to the inherent fallacies embedded within, have had spurious consequences." He adds, "The less time people spend doing active research, the easier it is for the remaining practitioners of the trade; the greater the prospective returns will be." Though simple in principle, true active management is difficult to follow in practice. Machine learning will not make truly talented investors redundant. Although AI is suffused with hype, it will be better than humans at specific tasks. Crucially, to quote Iben again, we need to keep remembering to break away from any "servitude to misguided ivory tower theory, behavioural heuristics, ill-conceived formulas, fiat money, and other 'false Gods'."