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Why Firms Should Adopt the CFA Asset Manager Code

The CFA Institute Asset Manager Code is a valuable guide for asset management firms that aspire to high standards. The purpose of the Asset Manager Code is to foster a culture of ethical and professional behavior that protects the interest of investors, protects and enhances the reputation of the investment firms. It also provides a useful framework for asset management firms to provide services in a fair and professional manner with full disclosure. The Code helps asset managers gain the confidence of clients, ultimately leading to higher profits.

Broadly speaking, there are six general principles to the Code:

Managers must

Act in a professional and ethical manner at all times
Act for the benefit of clients
Act with independence and objectivity
Act with skill, competence, and diligence
Communicate with clients in a timely and accurate manner.
Uphold the applicable rules governing capital markets.

The details matter. In this article we’ll examine the key sections of the Asset Manager code.

There are six sections to the Code:

Loyalty to Clients
Investment Process and Actions
Trading
Risk Management, Compliance and Support
Performance and Valuation
Disclosures

Loyalty to Clients

A firm must prioritize clients interests ahead of firm and employees, maintain confidentiality, and refuse inappropriate gifts or business relationships.

Firms need to develop policies and procedures to ensure that client interests are paramount in all aspects of the manager-client relationship. This includes things like investment selection, transactions, monitoring and custody. Managers should avoid situations that create conflict of interest. Moreover they should implement compensation arrangements that ensure these interests are aligned, and no in conflict.

This also includes being careful to maintain client confidentiality (ie a privacy policy). This of course does not apply if information must be legally disclosed.

Asset managers also need to be careful to avoid getting into business relationships that create conflicts of interest. This can be challenging for due diligence analysts who constantly receive gifts from potential investments.

Investment Process and Actions

This requires reasonable care and judgment when making investment decisions, fair dealing, sufficient due diligence, and avoiding manipulation of securities prices and volume.

A rigorous due diligence process is part of the Asset Manager code. This means using reasonable care and prudent judgement in setting the investment policy, and having a reasonable and adequate basis for all investment decisions.

Manipulating securities market, or treating clients unfairly is a violation of this part of the code. Note that this provision doesn’t prohibit side-letter arrangements, als long as they are fairly allocated among similarly situate clients for whom the opportunity is suitable.

The CFA Institute provides additional guidance on this part of the code that pertains to the differences between managing pooled funds and separate accounts. When a pooled vehicle has a specific mandate, strategy, or style, the investors should take only investment actions that are consistent with those constraints or objectives. If there is any change in the investment style or strategy, you should inform investors before making the changes. That way clients can decide if the new strategy still fits with their objectives.

When managing separate accounts there are additional subtleties. You should evaluate and understand the client’s objectives, risk tolerance, time horizon, liquidity needs, financial constraints and unique tax, legal, and regulatory constraints that would impact the policy. Only make decisions that are suitable for clients given these circumstances.

Trading

This section includes not using material non-public info for trading purposes (regardless of local law), the prioritization of clients over the firm, the proper use of client commissions, and making sure your clients get best execution and the development policies of fair and equitable trade allocation.

Firms need to establish compliance procedures to ensure they avoid insider trading.
Additionally, they need to give priority to clients made on behalf of the client over those that benefit the Manager’s own interests.

Commissions generated from trades should only be used t o pay for investment related products or services that assist in the investment management process, not with management of the firm. This goes back to the general principle of putting clients first. Closely related, Managers need to seek best trade execution for clients. This can add a lot of value for strategies that deal in illiquid securities, or make large investments. As with everything else, the firm needs to document this with proper policies and procedures.

Risk Management, Compliance and Support

The asset manager code requires detailed policies and procedures in order to ensure compliance with the Asset Manager Code. The firm’s compliance department needs to develop extensive written policies and procedures to ensure that all activities comply with the Asset Manager Code, and with all legal and regulatory requirements.

The compliance officer should be independent from investment operations if possible. Additionally, they should report directly to the CEO or board. The compliance officer also needs to make sure all client communications are accurate and complete. Additionally, third party confirmation is essential. Maintain records for at least seven years, or as required by local law. Keeping top quality staff isn’t just good business sense, its also required by the Asset Manager Code. A disaster recovery and business continuity plan is also part of this section of the Asset Manager Code.

The firm should establish a firmwide risk management process that identifies, measures and managers the risk position of the manager. An effective risk management process will identify risk factors for individual portfolios, as well as for the manager itself. This includes, stress tests, scenario testa, and backtests.

Performance and Valuation

The asset manager code requires the use of fair market prices or commonly used valuation methods, as well as data that is accurate, relevant, timely and complete.

Managers need to present performance data that is fair, accurate, relevant , timely and complete. Its critical that managers must not misrepresent hte performance of individual portfolios or their firm. The GIPS standard provide a good standard, although its not required. MAnagers should not cherry pick performance, or take credit for performance that occurred before they took over management.

Some securities can be hard to value. The code requires Managers to use fair market prices to value client holdings and apply, in good faith, methods to determine the fair value of any securities for which no independent third party market quotation is available. Management fees are generally calculated based on asset valuation, so this has the potential to crate a major conflict of interests. The best practices is to transfer responsibility to an independent third party. For pooled funds with independent directors, best practices is to have independent directors review valuation.

Disclosures

Disclosure is a theme that runs through all sections of the Asset Manager Code . Firms must provide ongoing , timely communications with clients. These communications must be truthful, accurate, complete, and understandable. Moreover these communications must include all material facts regarding the firm, personnel, investments, and the investment process.

Key guidance for disclosure:

Communicate with clients on an ongoing and timely basis. Managers should establish lines of communication that fit with their situation.
Ensure that disclousrs are truthful, accurate, complete and understandable and a re presented in a format that communicates effectively.
Include any material facts when making disclourures or providing information to clients regarding htemselves, their personnel, investments, or the investment process.
Things that require disclosing include
- Conflicts of interest from relationships with brokers or other entities, other client accounts, fee structures or other matters
- Regulatory or disciplinary actions against the manager.
- Thei investment proces , including information regarding lock up periods, strategies, risk factors, and use of derivatives and leverage
- Management fees and other investment costs charged to investors, including what costs are included and methodologies for determining fees and costs.
- The amount of any soft or bundled commissions, the goods and or services received, and how they benefit client
- Performance of clients investments on regular basis. The CFA Institute recommends at least quarterly when possible, and within 30 days after th end of the quarter
- Valuation methods used – must be specific, not boilerplate
- Shareholder voting policies
- Trade allocation policies
- Results of the fund audits.
- Significant personnel changes
- Risk management processes.

By adopting this code, firms demonstrate their commitment to ethical behavior and the protection of investor interests.

Four Structuring Options for Retail Cryptocurrency Funds

Blockchain and cryptocurrency are major growth areas. According to Northern Trust:

According to Fidelity, one-third of institutional investors now hold digital assets such as Bitcoin,3 and 47% see digital assets as having a place in their portfolios.4 Given this data, it’s clear that their acceptance of cryptocurrency has come a long way in the last decade. As they embrace the idea of investing in cryptocurrency, pure-play crypto hedge funds and hedge funds who offer crypto funds are sure to see greater demand – and potentially already have.
The total AuM of global crypto hedge funds roughly doubled from 2018 to 2019.5 Family offices are leading the way in this movement, making up 48% of crypto hedge fund investors, while high net worth individuals make up 42%, indicating untapped opportunity to bring other classes of institutional investors – such as pension plans and foundations and endowments – into the fold.

In a previous post, we covered the Key Benefits and Challenges of Blockchain Technology. In this post we’re going to cover fund structuring options for asset managers focused on retail investors. A 2018 article in The Review of Securities and Commodities Regulation is a great place to start.

The caveat to this post is that regulatory issues surrounding blockchain, digital assets, an cryptocurrency are fast moving. Therefore, before getting ready to launch a fund, you should look for regulatory updates, and engage with appropriate legal counsel. Nonetheless Here is a quick overview of the options that you have.

Open End Fund

There are a still a number of outstanding issues that the SEC believes need to be addressed before anyone can launch an open end crypto fund (ie a mutual fund or an ETF). However there are many commentators who believe that the SEC will change its views in the near future. Moreover, many other countries including Canada, Sweden, and Switzerland, have already approved cryptocurrency ETFs.

Closed End Fund

In the US, closed end funds face many of the same hurdles that open end funds face when getting approved for cryptocurrency investment. Quoting from the article:

In light of the SEC’s concerns regarding exchange trading, a cryptocurrency fund, including a Closed-End Fund, may consider foregoing the listing and trading of its shares on an exchange. As an alternative, a Closed-End Fund could provide periodic liquidity to shareholders either by making periodic tender offers pursuant to Exchange Act tender offer rules (“Tender Offer Fund”) or could elect to operate as an interval fund under Investment Company Act Rule 23c-3 (“Interval Fund”). Importantly, although generally prohibited under Regulation M of the Exchange Act, a Closed-End Fund – whether a Tender Offer Fund or an Interval Fund – is permitted to continuously offer and redeem its shares simultaneously.13 Without this permission, a Closed-End Fund would either not be able to take in new capital or would not be able to offer shareholders liquidity.

Separate from the legal issues, closed end funds have a lot of economic advantages over open end funds for cryptocurrency investments. Check out: Closed End Funds Are A Better Solution For Digital Assets

33 Act/ETP Structure

Grayscale Bitcoin Trust reportedly attempted to register as an ETP, but was unable to do so. However, it was able to conduct an offering under a registration exemption under Rule 506(c) of Regulation D promulgated under the Securities Act of 1933. This process has proven much easier than using a 40 act structure(ie an open end fund or a closed end fund). However 33 Act companies often don’t have the same level of investment protection.

Commodity Pool

Given the growth of the cryptocurrency derivatives market, its likely some fund sponsors will come up with commodity pool structures that offer cryptocurrency exposure. These funds would be required to register with the CFTC as commodity pool operators, but would avoid some SEC complications.

Key Considerations Regardless of Structure

Regardless of fund structure, there are several issues a firm needs to concern. A key challenging is to find the right service providers to be partners in the strategy. Northern Trust, in a recent post suggested there should be three key considerations: (1) Previous experience servicing crypto strategies (2) Assistance with investor transparency and (3) Risk averse custody optoins.

4 Types of Institutional Investors

Broadly speaking there are four types of asset owners. Each has different purposes and constraints. Additionally each has a different strategy for allocating to alternative investments. This post summarizes the four different types of institutional investors.

Endowments and Foundations
Pension Funds
Sovereign Wealth Funds
Family Offices

Endowments and Foundations

Endowments are funds established to raise charitable contributions, and support the activities off a non profit organization. University endowments are probably the most common example. They receive donations from alumni, and use the investment income to support university operations. Notably some of the most prestigious colleges also have the largest endowments. Endowments vary widely in size.

Endowments are known for their pioneering approach to alternative investments. Indeed the most robust research backed method for investing in alternatives is called “the endowment model. “ Endowments have light regulations, and exceptionally long time horizons, so they can theoretically invest in anything.

Foundations are similar to endowments, in that they depend on charitable contributions from supporters. Typically foundations are used to fund grants and charitable work. Like endowments, foundations have long time horizons and are able to invest in a wide variety of asset classes.

However, there is an important difference between endowments and foundations: Due to tax regulations, foundations are typically required to distribute a minimum percentage of their assets each year. The need to make regular distributions impacts asset allocation decisions.

Although endowments and foundations serve different purposes, and fall under different tax rules, they often have similar investment policies.

Pension Funds

Pension funds are one of the most common types of institutional investor. exist to provide retirement benefits for specific groups. The organization that sets up a pension fund is called a plan sponsor. The plan sponsor might be a corporation, nonprofit, or government entity.

There are four types of pension funds.

National Pension Funds

National Pension Funds provide basic retirement services to citizens of a country. The most famous example is the US Social Security Other economically important examples include South Kora’s National Pension Service, and the Central Provident Fund of Singapore. In some cases, national pension funds operate similarly to sovereign wealth funds. National Pension funds have massive scale and long term time horizons. As a result, they are able to invest in a wide range of alternative investments.

Private Defined Benefit Funds

Private defined benefit funds are another important type of institutional investor. They are set up to provide prespecified benefits to employees of private businesses. Benefits provided are typically based on years of service, salary etc. The plan sponsor is responsible for asset allocation. Private defined benefit funds are long term investors, although not as long term as national pension funds. Private defined benefit funds are able to invest in a wide variety of alternative asset classes.

For a variety of reasons, private defined benefit funds are becoming less common.

Private Defined Contribution Funds

Private defined contribution funds are now more common than defined benefits funds. With defined contribution funds, contributions are deposited into accounts linked to each beneficiary. Upon retirement, the employee gets the amount in the account. The employee is ultimately responsible for managing the plan and bears all the risk. The plan sponsor decides what investments are available for beneficiaries to select. Uneven payout timing of alternative investments, illiquidity, and governemnt regulations typically prevent these funds from offering a wide variety of alternative investments. Additionally, most participants typically fall below the income threshold. Defined contribution funds are typically able to invest in real estate and liquid alternatives though.

Individually Managed Accounts

Individually managed accounts the same as private savings plans. Asset allocation is directed entirely by employee. Examples include Roth IRAs and Traditional IRAs in the united states. These funds enjoy certain tax advantages. However these tax advantages come with additional regulatory scrutiny Consequently there are limits on the alternative asset exposure people can get in individually managed accounts. Private placements are normally not available. One big issue that often comes up is custody. Fortunately, a lot of companies are coming up with custody solutions and are generally working to make it easier for investors to access alternative investments in their individual retirement accounts. Consequently, investors can access precision metals, bitcoin, and certain alternative investments in their individual retirement accounts.

Sovereign Wealth Funds

National governments set up sovereign wealth funds (SWFs) to save and build on the country’s current income, in order to benefit future generations. They are similar to national pension funds in that they are government run, but unlike with national pension funds, they have a broader range of purposes than just providing retirement income.

OVer the past few decades , SWFs have become a major economic force because of their sca. The rise of SWFS has been tied to emerging economies that have large natural resource endowments. Typically SWFs grow when commodities are high. In other cases, such as with China, they are funded by large trade surpluses that give countries with huge amounts of foreign currency.

SWFS have broad investment mandates and long term investment horizons. However, depending on the politics of the particular country, there may be limitations on what they are allowed to invest in. Typically they invest a portion of their funds in alternative assets.

Family Offices

Family offices are organizations dedicated to the management of a pool of capital owned by a wealthy individual or family. Basically they are private wealth advisory firms. Family office is a broad, diverse category. In some cases they are spun off from operating companies, in other cases they are funded by legacy wealth. The goals and investments mandates of family offices vary widely. Sometimes they are focused on maintaining a standard of living. Other times they are focused on providing benefits for future generations, or on philanthropic activities. There are typically differences between the goals and strategies of first, second, and third generation family offices.

Family offices have long time horizons and large scale, so they are often able to invest in a broad range of alternative asset classes.

For more details, check out Alternative Investments: An Allocators Approach

Complexity and Misaligned Incentives

Why are some investments complex and opaque? In Opacity and Financial Markets, the Yuki Satoidentifies a possible nefarious reason: principal agent problems. Investment managers have incentives to obscure the true extent and sources of return variability. Complex investments can justify higher fees. Therefore, the investment management industry has an incentive to manufacture complex investments out of simple investments through financial engineering.

On the other hand, the Sato also points out that complex investments can also be useful for investors. Complexity and opacity are sometimes the unintended consequences of new investments designed to create improved risk management techniques. Creating a new investment opportunity that allows investors to better manage risk, or in academic jargon, select payoffs in a way that maximizes expected utility, is known as “completing the market”.

So complexity is not necessarily good or bad by itself. Yet complex investments do require heightened due diligence. In particular investors need to be on the lookout for misaligned incentives when allocating to complex alternative investments.

3 Complexity Case Studies

Alternative Investments: An Allocator’s Approach summarizes three case studies where investment complexity served a useful market completion purpose, but also led to misaligned incentives between investors and investment managers and salespeople. All three cases involve financially engineered fixed income products.

The first example is Treasury Strips in the 1980s. Treasury bond investors suffered massive losses when interest rates rose in the late 1970s. US Treasury Strips are zero coupon securities created by parsing a non-callable US treasury note or bond into a set of securities with maturities corresponding to each of the promised coupon and principal payments.

These synthetically created zero coupon bonds have different characteristics than traditional treasury investments. They were useful for investors looking to match cash flow needs. However, there were also downsides. They didn’t offer the traditional relation between yields, coupons, and prices that made it easy for retail investors to judge the value of a bond. Brokers were able to get large bid ask spreads, and circumvent fee limitations by charging on the face value of the bonds, rather than the nominal value. Brokers also encouraged investors to roll strips as interest rates declined ,generating massive commissions and fees. The misaligned incentives and increased fees worked against the advantages of zero coupon bonds.

Collateralized Mortgage Obligations (CMOs) have a similar story as Treasury Strips. They took a security offering a long string of cash flows, and parsed them into different sets of products that offered targeted maturity exposures. In 1994, rising interest rates caused CMOs subject to extension risk to experience massive losses(up to 80%). Often the investors in these products did not understand the complexities, or realize the interest rate risks they were taking.

The third case study is residential mortgage backed securities during the 2000s. Unlike CMOs and Treassury Strips, RMBS had significant credit risk. They provided investors with cheap diversification and risk management in the years leading up to the crisis. However, the complexity in the products camouflaged the inherent risks. When the financial crisis came, RMBS investors experienced substantial losses.

Five Steps to Implementing an ESG Strategy

Environmental, Social and Governance (ESG) investing is on the rise. The Chartered Alternative Investment Analyst Program has made ESG topics an important part of the analyst curriculum. This reflects the fact that understanding ESG issues is essential for alternative investment professionals. This article outlines five steps firms can take to create an ESG strategy from scratch.

Asset managers and investors need to have an ESG strategy. Approximately 76% of institutional investors incorporate ESG into their investment decisions. ESG can lead to increased risk adjusted returns, redacted reputational risks. Additionally ESG can help an investment organization address stakeholder concerns. Moreover, ESG, done right, is just plain good for the planet.

Many investors don’t know where to start. Fortunately this article outlines five simple steps asset managers can take to implement ESG into their investment process.

Here are the five steps investors can follow.

Articulate Mission and Values

The goal of the first step is to clarify and build consensus regarding the mission and values of the program, expressed in part as the identification of key areas to target

Create Impact Themes or Theses

This step starts at the broadest levels, such as environmental, social, governance or other issues, but then it drills down to specific themes or issues. These themes might be broad categories of issues that share common features, or might be extremely diversified. It all depends on the mission and values of the organization implementing an ESG program. Materiality in this step can be used to identify priorities between missions. This help form the social target of the program. Some common steps in this process include incorporating targets of social programs into an investment policy.

Develop Impact Investment Policy

The third step is to develop an impact investment policy. This will specify the method by which the ESG related targets will be included in the portfolio construction and investment management processes. The CAIA textbook shows a chart with three axes : Return, Risk, and Impact. The closer any point on the graph is to each of the labels, the more that label represents a high priority. The shaded area represents target combinations of risk, return and impact.

Generate and Evaluate Deal Flow

The fourth step is to generate and evaluate deal flow. Target graphs can be used to depict the valuation of individual assets. ESG ratings and materiality analysis are used in the step to asset hotel likely impact of various investments

Portfolio Construction and Management

Portfolio construction and management is the fifth and final step. Top down asset allocation decisions should reflect the fact that different asset classes have different ESG opportunities, in addition to different risk and return tradeoffs. One example is timber, which is low risk, low return, and will have an impact factor that depends a lot on the specific sustainable practices used. The portfolio construction starts with optimizing the top down tradeoff, between the goals of hi return, low risk, and high impact, and the opportunities available in each asset class. Finally there is a bottom aspect part where the firm selects and weighs individual investment opportunities, analyzing the tradeoffs between risk, return, and impact.

How Funds of Hedge Funds Add Value

Funds of hedge funds have no shortage of critics. The common concern that analysts have about funds of funds is the extra layer of fees. Hedge funds already charge high fees. Adding a funds of funds manager on top increases the return hurdle necessary to beat the market. Some people are skeptical that funds of hedge funds add any value when compared to a randomly selected group of hedge funds. There is a wide dispersion in performance among hedge funds. Do funds of funds help you gain access to the best opportunities?

Researchers have studied this very question and identified three different ways that funds of funds managers can add value. First strategic allocation can provide static beta benefits. Second, tactical allocation can add dynamic beta benefits. Finally, fund selection can add alpha to a hedge fund portfolio.

This graphic demonstrates how Strategic Asset Allocation, Tactical Asset Allocation,and Fund Selection add value beyond a random selection of hedge funds:

Let’s examine each of these value add approaches individually.

Strategic Asset Allocation

Strategic asset allocation of a fund of hedge funds reflects the long-term bets made by the
portfolio manager. Strategic asset allocation is a crucial step in the investment process. It adds the most value over the long term. Perhaps more importantly, it also builds resilience in the portfolio that will pay off when investors need it most. With proper strategic asset allocation, a hedge fund investor can get through a downturn while avoiding large losses.

Research from the EDHEC Risk Institute found statistically significant evidence of value add from strategic asset allocation under stressed market conditions from 2007-2009. The top 7.77% of hedge funds were able to add 3.50% annually.

Tactical Asset Allocation

While fund managers only rarely make strategic asset allocation shifts, they might frequently make tactical allocation shifts. Unfortunately, there is little evidence that most funds of hedge funds managers add value through tactical asset allocation. There are exceptions, however. Some managers are able to identify short term trends, and access the funds most capable of exploiting those trends.

Fund Selection

One barrier to hedge fund investing for firms with smaller staffs is the due diligence requirements. Consequently, they might turn to a fund of funds manager to help with due diligence on individual hedge funds. Indeed, fund selection is where its possible to truly add alpha.

However, Alternative Investments: An Allocators Approach notes that fund selection is a “double edged sword”. In normal markets, ~93% of fund of hedge funds had an annual positive outperformance of 3.9% over the neutral portfolio. However in stressed market conditions, only 48.4% of funds of hedge funds added value of 4.18% annually.

So ultimately, an allocator can benefit from a funds of funds approach. However, they need to make sure to find the right funds of hedge funds manager.

Portfolio Composition with Illiquid Private Assets

This post is part 2 of a 2 part series. Click here to read the first post.

Managing the tradeoff between liquidity and performance is a central challenge for allocators and investment professionals. Building a Better Portfolio: Balancing Performance & Liquidity is a great resource for allocators and investors looking to systematically meet this challenge. In a previous post we summarized the five components of an asset allocation model that incorporates private market assets. In this post we’ll discuss a few more highlights from the paper.

A good private asset commitment strategy must balance several investment objectives. These include performance, risk and liquidity. Over the years academics and practitioners have developed a variety of models and heuristics to balance these objectives.

In How Large Should Your Commitment to Private Equity Really Be? Researchers propose a simple rule of thumb. Simply commit the capital allocated to private assets each year. This is a deterministic rule, and it does not make use of any currently available information. The goal is to build and maintain a desired allocation to the targeted asset class. Other possible methods include basing the allocation decision on the amount of uncalled capital, cash, NAV and recent distributions. The idea is to consistently commit a fraction of overall capital.

Another slightly more advanced framework is known as the Nevins commitment model.

Nevins Commitment Model

The Nevins Commitment model comes from a paper in the Journal of Alternative Investments: A Portfolio Management Approach to Determining Private Equity Commitments.

This model uses four parameters.

Rate of capital calls
Rate of Distribution
Rate of Return on Public Assets
Rate of Return on private assets

Since it requires input from external data sources, its a bit more advanced than simple rules of thumb. Nonetheless, it is much simpler to implement than more complex allocation models.

Three important questions for private asset investors

An asset allocator that makes commitments to private assets needs to balance many competing demands. As they build their process, they should always keep three questions in mind:

How to formulate a private asset commitment strategy to manage private asset exposure and the uncertainty in timing and magnitude of their cash flows over time?
What should be the desired allocations (public vs. private, public passive vs. public active) given the investor’s liquidity risk tolerance?
How would various market scenarios impact the portfolio’s liquidity and performance?

Click here to read the GIC and PGIM paper that develops a framework for answering these questions.

Running Cash Flow Simulations

Best practices for allocators involve running simulations to see how various commitment strategies impact cash flows. By stress testing “:worst case scenarios” an investor can position the portfolio in a way that avoids a situation where they are forced to sell good assets at a discount to meet liquidity demands, while still allocating enough to illiquid assets to achieve desired returns.

Alternative investments are an important part of any asset allocation strategy. Used wisely, they can enhance returns and reduce risk. A key part of using alternative investments wisely involves balancing the tradeoff between liquidity and performance.

See also:
Closed end interval funds are a fund structure designed to force an elegant compromise between two extremes of liquidity structures. This fund structure can be used for a wide variety of strategies, and is becoming increasingly popular with both mass affluent and institutional investors.

Asset-Allocation-for-Private-Investments

Five Components of an Asset Allocation Framework

Traditional portfolio management techniques such as mean-variance optimization or risk parity don’t capture the reality faced by an allocator building a portfolio that includes alternative investments. These traditional methods focus on return variability and drawdowns, while treating liquidity risk as a secondary considerations.

Yet in reality, liquidity risk is of critical importance. In fact, while return variability and drawdowns are generally transitory, liquidity risk can cause permanent damage to a portfolio.

There is a tradeoff between performance and liquidity in asset allocation. At one extreme, holding illiquid but high performing assets might give investors little room to maneuver and meet liquidity demands. In a downside scenario, these illiquid assets would ultimately hurt performance because the allocator would need to sell them prematurely at a discount to meet cash needs. At the other extreme, an all liquid portfolio might not generate the high enough returns. Handling this tradeoff is the central challenge for allocators and alternative investment professionals.

GIC and PGIM produced a joint research paper that develops a framework for systematically handling this tradeoff. The paper develops a cash flow-driven asset allocation framework to help investors formulate private asset commitment strategies, determined desired allocations to private funds, and understand how various market scenarios would impact liquidity and performance of their portfolio.

Most research in this area generally falls into two buckets: cash flow prediction models, and private asset commitment strategies. GIC and PGIM integrate these strategies.

Visualizing the role of private investments

This flow chart explains the framework for allocating to private investments.

This asset allocation framework has five major components

Market simulation model
Private Asset Cash Flow Model
LP Commitment Strategy Model
Investor’s Portfolio Structure
Liquidity and Performance Analysis

The first three steps involve asset modelling. To begin with the researchers simulated the risk and returns of a multi-asset portfolio, including private and public markets. They used the Takahashi and Alexander Model to capture empirical relations between cash flows and public market performance. This framework is also flexible, because it allows investors to input their own public capital market assumptions. This is the first step in the framework- the Market Simulation Model.

The second step, Private Asset Cash Flow Model is closely related to the first step. The framework allows the investors to input their views on private markets and estimate their skills and how they might impact expected returns. A cash flow model that is responsive to underlying capital market conditions allows an allocator to perform stress tests, and tailor liquidity analysis to their estimates for future market scenarios.

The third step involves applying an LP commitment strategy. There are two options. The first is a Cash flow Matching strategy. This involves building a private asset portfolio whose periodic net cash flows are close to zero. So distributions received in each quarter should fund capital calls in the next quarter. A benefit of this strategy is the fact that it can insulate the rest of the portfolio(ie the publicly traded portfolio), from private asset investment activity. This strategy also has limitations In particular it leads to volatile commitment patterns, and since it may result in skipping commitments over multiple periods can make it hard to diversify by fund vintage. Additionally the strategy has no control over how NAV will grow as a percent of overall portfolio. This strategy is also not possible if an allocator is starting a new private capital investment program from scratch, it can only make commitments once distributions have started to arrive.

The second LP commitment strategy is called Target NAV. With this strategy the allocator tries to achieve target NAV as a percentage of the overall portfolio. This strategy divides the private portfolio into three pools of capital- (1) “in the ground” asset also known as the NAV, (2) Committed but uncalled capital, and (3) uncommited capital which is to be allocated to private assets, and distributions from prior commitments that have not yet been committed to new commitments. An advantage of this strategy is that it treats the private allocation of a self contained portfolio. A drawback of this strategy is that it doesn’t balance cash flows, and might require frequent interactions with other parts of the portfolio in order to absorb or free up capital for private market related cash flows.

The fourth component of the asset allocation framework is Portfolio Structure. The framework sorts assets by transactability- that is the ease and cost of selling. There are three types of investments, two liquid, and one illiquid. Liquid investments include Liquid passive and liquid active, which are actively managed inpursuit of alpha. . The third category is simply private market investments. This diagram shows how there is a “waterfall” for sourcing liquidity:

A liquidity event occurs whenever an investor needs to move down the waterfall to find lqiudiity. A large liquidity demand could produce a cascade.

The fifth component of the asset allocation framework is Liquidity and Performance analysis.
There are four categories of liquidity demands. Quoting from the paper:

GP Capital Calls: An obligation that an LP must fulfill based on total initial committed capital amounts, but the timing and amount of each capital call are not under the LP’s control;
Rebalancing: Shift portfolio allocation between public stocks and public bonds at quarter ends to maintain policy or target weights;
Dry Powder Creation: A tactical move into higher beta assets (i.e., stocks) during market downturns (i.e., at the end of each month if the public equity market experiences a large drawdown) to provide market support or to take advantage of the market dislocation;
Dry Powder Reversal: When a market recovery occurs (i.e., when a drawdown is less than -5% following a recovery in the equity market) there is a need to adjust public stocks and bonds back to their initial relative target weights.

The paper also has a case study that illustrates how commitments strategy and portfolio structure interact to determine expected performance. Click here to access the research paper.

In a subsequent post, we’ll follow up with more on portfolio construction with illiquid private assets.

Key Benefits and Challenges of Blockchain

This is part II of a two part series. Click here to read the first part.

Blockchain has many benefits that will impact a lot of industries. For the financial service industry, the key potential benefit is the ability to impact post trade settlement. On the other hand, there are multiple technical, business, and regulatory challenges that the industry still needs to overcome. By understanding these benefits and challenges, an investment professional can better identify potentially profitable investments in the blockchain space, and better implement blockchain technology into their business operations.

Post Trade Settlement

One of the most important potential benefits of Blockchain technology is the possibility of reducing the post trade settlement period. Settlement periods are the time between the execution of a trade, and the performance of all duties necessary to satisfy all parties obligations. With current technology this often takes several days. Title to most financial assets can only be settled against payment when banks are open for business. That is a relatively limited time window in a globalized world. One way to solve this would be to have one blockchain accounting for ownership of money, and another that accounts for ownership of securities. Assuming the buyer has sufficient funds and the seller has sufficient shares(or other securities), then settlement could occur any time of day in a matter of seconds with full certainty and legal certainty.

Faster payments

Closely related to faster post trade settlement is faster payments. A digital ledger system with digital identities for all parties involved can make foreign exchange transactions process faster, for example.

Blockchain is far from perfect however. There are several technical and business challenges posed by blockchain technology. Here are a few challenges outlined in the article:

Achieving consensus. Blockchain requires consensus among a blockchain’s network’s members. Since the ledger is distributed among all participants in the blockchain, any change in the protocol must be approved by all. A potential solution would be to give one or a few participants authority to make changes binding on the entire network. However blockchains purists would point out that this is not really a trustless solution. There is a tradeoff between the amount of consensus needed and the speed at which things can be completed.

Technical and Business Challenges

Standardization. There are many different blockchain designs. This can cause major issues in implementation by businesses. There are many different international and regional organizations working to establish technical standards. IRonically, the proliferation of standard setters might slow down the process of standardization.

Interoperability . Closely related to the issue of standardization is the issue of interoperability. There are so many different blockchain network systems that it can be hard to get them to operate together.

Scalability is another important issue. IT can be hard to make a truly permissionless system scale up. The race takes a large amount of computing power, which slows down the processing of transactions. In any cases these networks require a lot of computing power.

Efficiency. There is a tradeoff between efficiency and being truly trustless. A complex computational system to confirm transactions is less efficient than a system relying on the discretion of permissioning nodes, but offers advantages in that not everyone needs to agree to trust certain parties.

Immutability. Once a transaction is added to the blockchain it can’t be reversed. Fat finger trades can be fatal in this case. What if a regulator requires a transaction to be reversed? It’s not possible on the blockchain. In practice, erroneous transactions can be reversed in financial markets. If you move to blockchain you need to do without this capability.

Blockchain Applications: Benefits and Challenges

Blockchain is in the news a lot these days. Yet the technology is in the early stages of development, and the blockchain industry is full of charlatans and unjustified hype. It might be hard for a traditional alternative investment professional to get up to speed. Fortunately the Chicago Federal Reserve put out a basic introduction, which is also being used by the CAIA Level II Curriculum. Here are a few of the highlights that all alternative investment professionals need to know.

In Part 1, we’ll cover the following topics:

How a simple distributed ledger works.
How transactions are added to a blockchain
How the blockchain consensus mechanism works. The differences between permissioned and permissionless networks.

A distributed ledger is simply a special kind of database that exists across several locations or among multiple participants, i.e. it is a way of mutualizing database infrastructure. It can be public or private, permissioned or permissionless. In its simplest form, each user can read and write from the database, and each user’s copy is automatically updated to reflect an agreed upon consensus.

A distributed ledger is not necessarily completely decentralized, but it will be more distributed than a typical relational database.

According to the Fed’s explainer:

Relational databases are centralized, with a master copy controlled by a central authority. Users sharing a database must trust the central authority to keep the records accurate and maintain the technological infrastructure necessary to prevent data loss from equipment failure or cyberattacks. This central authority represents a single point of failure; if the central authority fails, the database is lost. Users who do not trust one another must maintain separate databases that they periodically reconcile.

This chart shows a basic distributed ledger setup:

How a transaction works:

When a member of a blockchain network engages in a transaction, they submit the transaction to the network… The submission of the new transaction changes the state of the ledger (which is now in conflict with the state of other copies of the ledger. Once the new transaction is discovered by the network, the consensus breaks, forcing other operators to either validate and update their records with the latest change or reject the new addition to the ledger…. A consensus mechanism then confirms the submitted transaction as valid. There are various methods of achieving consensus on a blockchain, as we discuss below. At this point, it is simply important to understand that a blockchain database must have a mechanism through which participants agree to a change in the state of the ledger. Once consensus is achieved, all ledgers are updated to reflect the new state

Adding Transactions to the Blockchain

The key elements of a blockchain include its distributed nature, its immutable character, and its agreed upon consensus mechanism.

This chart shows how a transaction is added to a blockchain:

Permissioned vs Permissionless Networks

A permissionless open network is open to anyone who wants to transact. All users can see all transaction records. New transactions are added via cryptographic methods. Permissionless networks do not require central authority. This avoids central points of failure.

However financial markets might require a permissioned network for three reasons. First there are trusted intermediaries who assist with transactions. Second, complete transparency isn’t necessarily desirable. Third, regulatory requirements might conflict with a completely permissionless network. Therefore blockchain applications in finance are more likely to use permissioned networks. “Permissioned blockchains allow certain members to control the confirmation of transactions. These permissioning members (consensus authorities) can exert control in various ways depending upon the network design. They could be responsible for explicitly approving transactions. Another option would be to designate the permissioning members as the sole members of the network able to participate in a cryptographic consensus mechanism.

There is controversy in the blockchain industry over whether permissioned or permissionless networks are better:

Some argue that a permissioned blockchain removes “a major benefit of the blockchain system: the system works between parties that do not need to trust each other. If the concept is to implement permissioned distributed ledgers between trusted [parties] … why would you use blockchain technology when more efficient alternatives are available?”5 However, permissioned blockchains retain many key features and benefits of permissionless blockchains, including the decentralized storage of the database and the (near) real-time reconciliation of all copies of the database. They also alleviate some of the problems posed by the permissionless system, including its need for substantial computing resources to confirm transactions.

How a Consensus Mechanism Works

Consensus mechanisms are necessary to add blocks to a blockchain database. The specific way a consensus mechanism works varies depending on the design of the blockchain. If it’s permissioned, then it might require approval of a central authority. If it’s permissionless, then it might require some cryptographic confirmation. For example, the bitcoin blockchain uses a proof of work consensus mechanism.

On the bitcoin blockchain, individuals known as miners compile submitted transactions into blocks. They confirm that those spending bitcoins mine each transaction received those bitcoins from some earlier transaction recorded on the blockchain and race to solve a difficult computer problem; the first miner to solve the problem confirms their block and adds it to the blockchain. The miner is awarded a certain number of bitcoins in return. Because every user on the blockchain has access to the entire ledger, users can confirm for themselves that the latest block of transactions added to the chain records valid transactions, that is, that the users spending bitcoins in the latest round of transactions received them in some earlier transaction and have not yet spent them.

In part 2 of this post will examine post trade settlement, and other key things to implementation considerations for blockchain.

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