May 24, 2017
The Family Office Alpha Report by Witherspoon Partners, May Jun 2017
Boats Against the Current
By Keith Danko
“So we beat on, boats against the current, borne back ceaselessly into the past.”
F. Scott Fitzgerald’s statement on the human propensity to look back and be confined by the past, the last line in The Great Gatsby, has meaning in many different contexts—including institutional investors’ allocation strategies. Investors seem to be constantly battling against the current, orienting themselves toward the past rather than the future. In today’s investing environment, looking backwards generally equates to being over-focused on the importance of liquidity, and on other attributes that are not forward-looking. Rather than operating on rewind, looking at the wake form behind the boat, today it is important to look ahead toward the horizon.
At a recent conference, Marc Lasry, CEO of Avenue Capital Group, remarked in a keynote Q&A that investors are focusing too much on, and paying too much for, liquidity. In his view the spread between the returns available on liquid assets and investments that require a minimum two-year holding period has never been wider. He essentially admonished people to worry less about daily, weekly, or monthly liquidity, and rather to focus on finding talented managers, and to be more willing to lock up money for a few years with them. He noted the recent negative return rates on cash and bonds in Europe and Japan, labeling the idea that investors there were willing to pay someone several basis points just to have their cash held as irrational. Fearful investors loath to tie their money up for even as little as two years cannot hope to accomplish much, and the opportunity cost in his view is massive. He urged investors to take more risk and allocate to less liquid investments for better returns.
This overemphasis on liquidity is a symptom of a backward-looking investment mentality. While this can be a byproduct of any historical market cycle, in today’s case it clearly remains part of a reaction to the global financial crisis. While liquidity is always of value, the excessive leverage that was a severe cause of the crisis is a factor that is now minimized.
Understandably, investors may be suffering from the “once bitten twice shy” syndrome, trying to avoid or eliminate what may have gotten them into trouble before. Given the capabilities and pervasiveness of quantitative research, deep analysis of the past is easier now than ever. Ironically that deep analysis can create justification to find comfort in a low-performing status quo, instead of helping to find higher return possibilities where any added risk pays off disproportionately. It would behoove investors to dismiss old investment paradigms and look ahead.
In a recent Pensions & Investments feature, the obsession with liquidity was examined along with the hesitation many direct contribution (DC) plans have when considering an allocation to illiquids, despite the evident benefits of diversification and higher returns. The fixation of needing a mark-to-market and meeting daily valuation, daily liquidity and other criteria is common with some of the pension plans, but some of the larger DC plans that have the staff and scale are finding ways around the calls for valuations. One option is allocating pro rata shares of projected income and appreciation of the underlying asset. In another approach, a large state plan with a 43% allocation to illiquids instead uses monthly valuations in a unitized version of the pension plan.
Keeping a forward-looking approach to investing is not just important for investors. It is also paramount for managers when marketing themselves to explain what they will do going forward, and not orient or define themselves based on past metrics. Investors need to be presented with reasons to be focused on the future, and with how they can make money going forward.
In our experience, many managers fail to do this, which unfortunately makes connecting with investors especially difficult. Unconsciously, many managers actually present themselves as backward-looking. While highlighting a past track record is important, defining a strategy based on yesterday’s events, values, or dynamics has little value to an investor. In our consulting work this is the main issue we find with managers: convincing them to understand that demonstrating to investors how they will produce benefit for the investors going forward is what matters in winning allocations. This is true whether the investor fully grasps the concept or not.
Most managers and operating partners would be better served identifying exactly what qualities and attributes they possess that make them unique and differentiated from the rest of the pack. Often, managers believe that they are presenting qualities that make them differentiated from other managers, when in fact these qualities are prerequisites. Any attributes like “solid track record,” “experienced team,” and “uncorrelated returns,” if lacking, would generally preclude the firm from being in competition for business to begin with. Investors would benefit as well, understanding in a more concise, direct way if and how that manager may be useful in his/her portfolio.
In a perfect world, investors should be seeking those forward-looking managers who are unique, differentiated, and who offer value for today’s environment, not yesterday’s. Unfortunately, managers are not always conveying this message when they market themselves. Ideally, they should take the driver’s seat and proactively embrace such messaging, as it will ultimately help them navigate toward more allocations.
(Photo: Newport harbor by Phoebe Outerbridge)