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In the realm of Institutional Investment Consulting, the art of asset allocation takes center stage, leveraging indices and historical data to forecast future returns across diverse asset classes. If my memory serves me correctly from CFA level II studies, long-term returns are close to 80% asset allocation decision vs manager selection.

While the traditional 60% U.S. equity and 40% U.S. bonds allocation was once prevalent, the landscape has evolved with the inclusion of international equity/bond, alternatives (hedge funds, venture capital, private equity etc.). This is based on The Modern Portfolio Theory (MPT) which refers to an investment theory that allows investors to assemble an asset portfolio that maximizes expected return for a given level of risk. Over the long term, 15 to 20 years steady return with compound interest could be meaningful for a pension fund. The diversification’s goal is to lower portfolio correlation of an additional investment from the overall portfolio of an institutional fund.

This has led to heightening the importance of an Investment Consultant. Consultants also have a Fiduciary responsibility, and they usually serve public pension, corporate 401K, foundation, and endowment funds. However, not all of the funds have the same end goal. Notably, the rise of alternative assets, exemplified by the Yale Endowment’s significant allocation toward it, is one example of the reshaped the investment landscape.

Quantitative analysis like asset allocation, Montecarlo simulation, peer asset classes performance, tracking error, Sharpe ratio, even downside standard deviation and other performance ratios are used to evaluate portfolio managers ability to outperform the index. We have to remember that this is not a marathon but a long-term performance race.

Qualitative analysis is also conducted by institutional investment consultants usually in person, mostly to research the fund’s philosophy, process, performance, fees and more. On the portfolio managers’ side, fund’s portfolio manager, fund sales and/or portfolio specialists are interviewed several times and evaluated in addition to the performance, fees are not too high, analyst turnover and if the Fund is implementing the process and the due diligence that the portfolio manager claim. As mentioned earlier, if the correlation against other existing pension fund portfolios is similar, there is no diversification benefits. The whole point is to pick the best managers for that asset class that benefits the client’s overall portfolio.

Despite all, the above deep-down research, over the last decade, the emergence of ETFs (exchange traded funds), similar to index funds, experienced inflows of assets. Investors have shifted away from active management to passive. Index-driven funds track the indices, and they charge a much lower cost. Some charge 1 to 2 basis points. Low fees coupled with market tracking performance, have driven asset inflow to index-driven funds. Using our S&P 500 Index as an example, there isn’t any if at all tracking error at all. Investors not only pay much smaller fees but also don’t have to worry about underperforming the market. Index Funds with enormous AUM like Vanguard and BlackRock are prime examples of EFTs/Index Funds. If active investing over the last so many years have outperformed (net of fees), there may be less asset inflows to the ETFs. A study showed that and an active managers vs ETFs over a longer period, very few active managers outperform.

How do ETFs make profit then?

If it costs more for ETFs or Index Funds to on-board clients and other fees associated with it, how do they make a profit? The biggest profit for them comes from the security lending division. As mentioned earlier hedge funds have increased in number and assets and like a custodial bankhold these stocks for the index funds. These hedge funds borrow stocks from the index funds via investment banksto short (naked shorting is illegal in many countries) andlike a bank, they pay interest. I have seen interest as highas 20%+ to borrow one stock. At times, investment banks deliberately go out to the market at times to buy a basket of stocks, just to lend to hedge funds. Hedge fund managers must have the guts to borrow and short something for 20% interest. Hence, a few alternative asset managers that have good track records outperform in most cases and often, ones that do are closed for new investors.




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