10 Open Questions for All Professional Investors

10 Open Questions for All Professional Investors

By Paul Kovarsky, CFA and Sloane Ortel Posted In: Drivers of Value, Economics, Investment Topics, Leadership, Management & Communication Skills, Performance Measurement & Evaluation, Portfolio Management

The investment profession has some pretty intense open questions.

Think about it. Over the past 18 months, the explosive rise and fall of crypto assets caused many of us to wonder anew about the very nature of money. Why wouldn’t accepted wisdom about how to manage it be worthy of similar scrutiny?

So what are the big questions? Here are 10 that we came up with as well as some literature that may help answer them.

1. What’s after alpha?

Strong relative performance does not always deliver clients a compelling result. Many investment firms are retooling themselves to charge for services in a way that is linked to overall client outcomes, as distinct from the performance of a given portfolio against a benchmark. How can these outcomes be measured?

“Alternative Performance Measures” (CFA Institute)Risk Profiling and Tolerance: Insights for the Private Wealth Manager (CFA Institute Research Foundation)“New Vistas in Risk Profiling” (CFA Institute Research Foundation)

2. Are firms managing too much money?

Investment opportunities are scarce, so it stands to reason that funds organized to pursue them have limited capacity. When should principals draw the line? How can clients ensure these decisions are made in their best interests?

“Alpha and the Capacity for Hedge Funds to Increase Assets” (CFA Institute Refresher Readings)“Flows, Price Pressure, and Hedge Fund Returns” (Financial Analysts Journal)“Capacity of Smart Beta Strategies: A Transaction Cost Perspective” (Columbia Business School Research Paper)

3. Why does the equity risk premium exist?

Equities tend to outperform other asset classes over long time periods. Why is that, exactly? The CFA Institute Research Foundation is in the habit of rethinking the equity risk premium every 10 years, so you can assume there isn’t a simple answer.

Laurence B. Siegel completed an excellent contextual review of the academic literature.Don’t miss Elroy Dimson’s review of 112 years’ worth of market data.

4. Can passive funds stay passive?

The world’s largest investment titans are unified in the nature of their most popular offerings, which transmute an index designed for benchmarking into a vehicle available for investment. How can these firms respond to agitation from activist shareholders without straying from their pass-through promise, incurring significant diligence costs, and risking their client relationships?

Rakhi Kumar explored “10 Trends in Asset Stewardship.” (Enterprising Investor)Vicente Cuñat, Mireia Gine, and Maria Guadalupe examined the abnormal returns associated with the passage of shareholder-sponsored governance proposals. Their findings are summarized in CFA Digest.Marco Becht, Julian Franks, Jeremy Grant, and Hannes F. Wagner surveyed the returns to hedge fund activism. CFA Digest provides a synopsis.

5. What explains the low-volatility anomaly?

Equities with low market betas have historically delivered much greater performance than would be suggested by the capital asset pricing model (CAPM). Is that a shortcoming of the CAPM, the result of a hidden duration effect in these (primarily dividend-paying) shares, or an exploitable consequence of investor behavior?

“Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly” (Financial Analysts Journal)“The Low-Volatility Anomaly: Market Evidence on Systematic Risk vs. Mispricing” (Financial Analysts Journal)“Low Volatility Investing 2.0” (CFA Institute)

6. Is buying low enough of a margin of safety?

You are a committed value investor who withstood the temptation of investing in an overvalued market. Is a margin of safety enough, or does it need to be supplemented with the right structuring and incentives to ensure all stakeholders have real skin in the game?

Seth A. Klarman and Jason Zweig discuss the opportunities for patient investors. (Financial Analysts Journal)“Distressed Credit Investing: Opportunities after Another Credit Bubble” (CFA Institute)“Tail Risk: Who’s Afraid of King Kong?” (Enterprising Investor)

7. What’s the best way to deliver excess alpha to your clients?

Great ideas are often left uninvested because opportunity sets are dynamic while client mandates are static. How should firms evolve their client relationships to deliver the fruits of their research before they spoil?

“New Equity Funds: Marketing and Performance” (Financial Analysts Journal)“Is it Possible to Produce an Innovative Financial Product?” (Enterprising Investor)Investment Firm of the Future (CFA Institute)

8. Is leverage good or bad?

Imagine you are a long-term investor, and we are in the midst of a financial shock that has sent asset prices plummeting. Does a fiduciary relationship to your asset pool prevent you from buying equities on margin or compel you to?

“A Shortfall Approach to the Creditor’s Decision: How Much Leverage Can a Firm Support?” (Financial Analysts Journal)“Speculative Leverage: A False Cure for Pension Woes” (Financial Analysts Journal; with comments from Clifford Asness, Ralph Goldsticker, CFA, and Rodney N. Sullivan, CFA)“Is Leverage Good or Bad?” (Enterprising Investor)

9. What are the drivers of successful turnarounds?

You’re ready to enter a company as the rescue investor. Is it most important to get the right entry price, achieve operational improvements, or alter its capital structure?

“Measuring the Moat” (Credit Suisse)“Why Capital Structure Matters” (Milken Institute)“Investing in Distressed Situations: A Market Survey” (Financial Analysts Journal)

10. Is private equity an addiction or a salvation?

Many asset owners have come to rely on investments in private equity to meet their return targets. Is that wise? Or are they better off doing the hard work to adjust the expectations of their beneficiaries downward?

“Private Equity Recommitment Strategies for Institutional Investors” (Financial Analysts Journal)“The Seven Kinds of Asset Owner Institutions” (Enterprising Investor)“Luis Viceira: Activism, Indexing, and the Investment Management Workshop (IMW)” (Enterprising Investor)

These queries are not easily answered. Which is why CFA Institute and Harvard Business School have been working together since 1968 to convene senior professionals to explore such critical questions. Close to 100 decision makers from 30 countries/territories attended our Investment Management Workshop in June 2018. We managed to get seats in the back. The depth of observation multiplied with each case discussion.

Bad news though: We can’t share the most trenchant takeaways.

The group operates under the Chatham House Rule, which enables open discussion by ensuring that the identity and affiliation of each participant is kept confidential. The beauty of participant-based learning is that each person present learns something a little different and teaches something else in turn. There is never just one set of answers, and the primary takeaway is an enhanced capacity to reason in community despite inherent uncertainty.

If such a capability sounds like it might be useful to you, the Investment Management Workshop will be held again 23–27 June 2019.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer

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