Investor Identity Drives Returns Through Technology and Governance - Episode Hero Image

Investor Identity Drives Returns Through Technology and Governance

Capital Allocators – Inside the Institutional Investment Industry · · Listen to Original Episode →
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TL;DR

  • Investor identity, defined by capital, people, process, and information, is the ultimate driver of institutional investor returns, dictating achievable asset allocation rather than being determined by it.
  • Technology acts as a critical enabler for institutional investors, transforming portfolio navigation from process-based human knowledge to data-driven collective intelligence, akin to GPS for personal travel.
  • Effective governance requires aligning risk budgets with governance budgets, ensuring boards possess the necessary skills, capacity, and time to oversee complex portfolios, especially in illiquid asset classes.
  • The concept of "submergence" highlights the importance of recovery shape after drawdowns, suggesting that sustainability factors, not just traditional risk metrics, are key to building resilient investment portfolios.
  • ESG investing, moving from opaque ratings to factual data, can drive lower cost of capital and improved long-term performance by providing granular insights into environmental, social, and governance factors.
  • Innovation within conservative asset owner organizations requires creating safe spaces for failure and dedicated teams to experiment, as crises often serve as powerful, albeit reactive, catalysts for change.
  • Collaboration among asset owners can effectively drive innovation in non-competitive areas like middle and back-office functions, pooling resources to develop solutions where individual firms lack capacity.

Deep Dive

Investor identity, defined by an organization's unique blend of capital, people, process, and information, is the fundamental determinant of investment returns. This framework challenges traditional views by positing that an investor's capabilities, rather than external market factors alone, dictate their asset allocation success. The implications are profound: without understanding these core capabilities, attempts to optimize portfolios or adopt new strategies, such as ESG or private market investing, are likely to falter.

The core of any investment organization's identity is its "production function": the interplay of its capital, people, process, and information. This function is significantly influenced by enabling factors like governance, culture, and technology. Governance, for instance, acts as a critical constraint, requiring a "governance budget"--the skills, capacity, and time of the board or investment committee--to be aligned with the risks an organization takes. Without this alignment, complex strategies become unmanageable. Culture, on the other hand, can foster knowledge sharing, while technology offers the potential for scale and efficiency. A significant tension exists between traditional, relationship-driven cultures and the disruptive potential of technology, which is often viewed by institutional investors as merely an operational tool rather than a strategic advantage for performance enhancement.

Technology's role is evolving from a simple operational toolkit to a sophisticated enabler of "portfolio navigation," akin to GPS for personal travel. While current adoption is nascent, comparable to early GPS systems, the future lies in data-driven insights that reveal not just what an investor owns, but also how to optimize their portfolio's trajectory. This shift from process-based decision-making, reliant on human shortcuts, to data-driven collective intelligence promises to unlock significant value. For example, by precisely modeling future cash flow needs and running sophisticated scenario analyses, investors can potentially reduce cash holdings, reroute capital to more productive alternatives, and achieve mass customization in their investment strategies. This technological enablement is crucial for long-term investors, moving beyond generic return targets to personalized destinations tied to unique liabilities and capabilities.

The concept of "submergence"--the duration of a drawdown and subsequent recovery--offers a new lens for risk management, challenging the primacy of metrics like Sharpe ratios and volatility. Traditional approaches focus on immunizing portfolios against shocks, but resilience, a concept proven in other complex systems like ecosystems and human physiology, emphasizes the ability to absorb shocks and recover stronger. This resilience is increasingly linked to sustainability factors, such as environmental footprint and employee satisfaction, which correlate with faster recovery trajectories. This provides a factual basis for ESG integration, moving beyond opaque ratings to tangible performance drivers. The application of advanced technology, such as sophisticated scenario modeling and data analytics, is key to understanding and managing submergence, enabling diversification not just by risk factors but by recovery profiles.

Ultimately, innovation within these conservative institutional investor organizations is often catalyzed by crises. However, intentional innovation requires creating "safe spaces for failure" and dedicated R&D functions, moving beyond a sole focus on efficiency. Collaborative efforts, particularly in areas like middle and back-office functions or legal frameworks, can be effective when not perceived as directly competing on alpha generation. Companies like APG and PGGM in the Netherlands exemplify this by piloting new technologies and processes. The broader implication is that by embracing technology, refining governance, and fostering a culture that values experimentation, institutional investors can achieve superior risk-adjusted returns and better fulfill their long-term obligations.

Action Items

  • Create investor identity framework: Define 4 core components (capital, people, process, information) to guide strategic asset allocation and portfolio implementation.
  • Design technology adoption roadmap: Identify 3 key areas (data infrastructure, scenario modeling, optimization engines) for enhancing portfolio navigation and return potential.
  • Implement submergence analysis: Measure recovery trajectories for 5-10 asset classes to inform risk management beyond traditional volatility metrics.
  • Audit ESG data sources: Evaluate 3-5 current ESG rating providers to identify factual underpinnings versus blunt metrics for improved investment decisions.
  • Develop innovation safe spaces: Establish 2-3 pilot programs with defined failure tolerance to encourage experimentation within asset owner organizations.

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Key Quotes

"I actually think the fact that we don't have a name for this community is part of the issue that I'm trying to solve. What do we call this community of pension funds, sovereign funds, endowments, and foundations? They put the capital in capitalism is what I tell my students to try to get them excited about pension funds."

Ashby Monk highlights that the lack of a unified name for asset owners (pension funds, sovereign funds, endowments, foundations) contributes to their understudied nature. Monk suggests that understanding this community, which he refers to as "long-term investors" or "fiduciary investors," is crucial for comprehending how capital is deployed within capitalism.

"So if you want to go and do highly illiquid investing in private equity or venture capital, first thing you need to go do is look at your process and your information. Do I have a process for managing my commitments? Turns out private equity and venture capital are commitment-based investments. They draw down over time, they return capital over time. You need a strong process, really it's a strong technology component to model all that out in order to pursue a more illiquid strategy."

Monk argues that the ability to pursue illiquid strategies like private equity and venture capital is directly dependent on an organization's internal processes and technological capabilities. He emphasizes that managing the commitment-based nature of these investments requires robust systems to model capital drawdowns and returns effectively.

"So governance tends to view the technology component as kind of like an operational toolkit rather than what I think it is, which is a potential enhancement for returns. If you get your tech stack right, fundamentally transforms what you know about yourself. It's less about what you know about the world. It's great to use technology and ChatGPT to go collect knowledge on the world, but ultimately, I think the real unlock with technology will be to say, 'What do I own? What are the products I own? What are the risks I own? And how do we run scenarios against that to begin to model out my trajectory?' What we think of as portfolio navigation."

Monk observes that governance structures often perceive technology as merely an operational tool, overlooking its potential to enhance investment returns. He posits that a well-implemented technology stack can fundamentally transform an investor's self-understanding by providing deep insights into their holdings and risks, enabling sophisticated portfolio navigation.

"So I'd say we are in that phase in the kind of 1980s and 90s where we were just starting to get GPS, and it was like, 'Oh, this is fun, this GPS,' but we didn't really know what to do with it. ... So what we've witnessed in the personal navigation space is this shift from what I would describe as process-based decision-making, where we naturally look to people as owners of knowledge, and those people know shortcuts, they've been here before, they know the neighborhood, et cetera, et cetera, to this new phase where, yes, people need to drive the car, but ultimately, it's the data that comes together into this broader collective intelligence that guides us."

Monk uses the analogy of early GPS systems to describe the current state of technology in institutional investing. He explains that the industry is moving from a reliance on human knowledge and process-based decision-making to a data-driven approach, where collective intelligence derived from data guides investment decisions, much like GPS guides navigation.

"We did this paper on submergence, which is basically when a drawdown starts, a submergence is the beginning of the drawdown, the downward trip underwater, all the way back to when it gets to the high-water mark or the goal-water mark... And so we don't have great tools in the investment industry to think about the shape of recoveries. And so we have a lot of work through MPT on drawdowns, on value at risk, we do a lot of work on volatility and variance, but we don't think as much about the shape of recoveries."

Monk introduces the concept of "submergence" to describe the entire period from the start of a drawdown until an investment recovers to its previous high-water mark. He points out that the investment industry has robust tools for analyzing drawdowns and volatility but lacks adequate frameworks for understanding and measuring the shape and duration of recovery periods.

"So the punchline to your question is, we often need crises to drive change because these organizations are fairly conservative and slow-moving, and they are monopolistic. But interestingly, technology is going to reveal little mini crises inside these funds, which are opportunities to make change."

Monk suggests that institutional investors, due to their conservative and monopolistic nature, often require crises to spur innovation and change. However, he posits that technology has the potential to reveal smaller, internal crises within these funds, creating opportunities for innovation and adaptation without waiting for larger market shocks.

Resources

External Resources

Books

  • "Investor Identity: The Ultimate Driver of Returns" by Ashby Monk - Mentioned as a recent paper discussing investor identity and its components.
  • "Submergence: Drawdown Plus Recovery" by Ashby Monk - Discussed as a paper examining the importance of considering the combined drawdown and recovery period in investment decisions.

Articles & Papers

  • "Investor Identity: The Ultimate Driver of Returns" (Stanford Research Initiative on Long Term Investing) - Mentioned as a recent paper discussing investor identity and its components.
  • "Submergence: Drawdown Plus Recovery" (Stanford Research Initiative on Long Term Investing) - Discussed as a paper examining the importance of considering the combined drawdown and recovery period in investment decisions.
  • Brinson paper - Referenced for the concept that asset allocation accounts for a significant percentage of performance variability.

People

  • Ashby Monk - Guest, Executive and Research Director of the Stanford Research Initiative on Long Term Investing, and Head of Research at Adaptr.
  • Gordon Clark - Mentioned in relation to best practice governance work for investment organizations.
  • Roger Urwin - Mentioned in relation to best practice governance work for investment organizations.
  • Keith Ambachtsheer - Mentioned in relation to best practice governance work for investment organizations.
  • Andrew Ang - Mentioned in relation to the development of factor-based asset allocation following the 2008 crisis.
  • Wesley - Quoted from the movie "The Princess Bride" regarding people who claim to have all the answers.
  • Henry Ford - Referenced for his parlance regarding innovation.
  • Elon Musk - Mentioned in relation to ESG ratings.
  • Mark Walker - Mentioned for his work with CalPERS on developing technology for pacing, liquidity, and cash management.
  • Swenson - Mentioned in relation to the "Swenson model" of investing.

Organizations & Institutions

  • Stanford Research Initiative on Long Term Investing - Mentioned as Ashby Monk's new platform for studying asset owners.
  • Adaptr - Mentioned as a fintech company where Ashby Monk serves as Head of Research.
  • Capital Allocators - Mentioned as the podcast host.
  • New Zealand Super Fund - Mentioned as an example of an organization with "Guardians" overseeing investments.
  • CalPERS - Mentioned for Mark Walker's work on technology for pacing, liquidity, and cash management.
  • APG - Mentioned as an organization that bought a data team from Deloitte to build internal data capabilities and for its innovation engine.
  • PGGM - Mentioned as a Dutch organization with a process-driven approach to experimenting with technology.
  • Future Fund - Mentioned as an organization that has invested heavily in technology.
  • Deloitte - Mentioned as the source from which APG acquired a data team.
  • New Zealand Super - Mentioned as an organization investing heavily in technology.
  • Australian Super - Mentioned as an organization investing heavily in technology.
  • Stanford University - Mentioned as the institution where Ashby Monk teaches a course on allocators.
  • Princeton University - Mentioned as an institution with technologists who may not be aware of pension fund technology spending.
  • Harvard University - Mentioned as an institution with technologists who may not be aware of pension fund technology spending.
  • Capital Constellation - Mentioned as a collaborative effort where LPs anchor or incubate GPs.
  • NIIF (National Investment and Infrastructure Fund) in India - Mentioned as a successful collaboration with Canadian pension plans.
  • Brookfield - Mentioned as a company focused on private equity investing in essential industries.
  • Y Combinator - Mentioned as a type of accelerator that helps GPs start their businesses.
  • The Princess Bride - Mentioned as a classic movie.

Tools & Software

  • ChatGPT - Mentioned for its joke-writing capabilities and as a tool for collecting knowledge on the world.
  • Navigator - Mentioned as software invented by Ashby Monk's former company, RCI, for navigation concepts.
  • Ways - Mentioned as a navigation app that uses GPS.
  • Google - Mentioned for indexing the planet and providing navigation assistance.

Websites & Online Resources

  • alphasense.com - Mentioned as the website for AlphaSense, a research platform.
  • srsacquiom.com - Mentioned as the website for SRS Acquiom, a company focused on M&A processes.
  • capitalallocators.com - Mentioned as the website for the Capital Allocators podcast.

Other Resources

  • ESG (Environmental, Social, and Governance) - Discussed in relation to ratings, data, and long-term risk management.
  • ESG ratings - Discussed as being difficult to understand and potentially misleading, compared to Big Macs.
  • Credit ratings - Used as an analogy for ESG ratings, highlighting the difference in associated probabilities of default.
  • Nielsen ratings - Used as an analogy for traditional knowledge-based information versus data-driven insights.
  • Drawdowns - Discussed as a fact of life in investing, with a focus on recovery shapes.
  • Value at Risk (VaR) - Mentioned as a tool used in risk management.
  • Volatility - Mentioned as a metric used in risk management.
  • Variance - Mentioned as a metric used in risk management.
  • Sharpe Ratio - Discussed as a potentially distorting tool for understanding risk, especially in negative return environments.
  • Information Ratio - Mentioned as a metric used in investment communication.
  • Capital Market Assumptions (CMAs) - Mentioned as tools used for projections.
  • Monte Carlo simulation - Mentioned as a type of modeling tool.
  • The Yale Model - Referenced as a strategy involving investment in alternative assets.
  • The Canadian Model - Described as a model requiring talented people, strong delegation frameworks, and overseas offices for information gathering.
  • The Endowment Model - Contrasted with the tech model, suggesting it is akin to Yale's strategy.
  • The Tech Model - Proposed as a new model for asset owners, potentially enabling less cash holdings and higher returns.
  • Business Process Automation (BPA) - Mentioned as a focus for a sovereign fund in the Middle East.
  • Prudent Person Rule - Mentioned in the context of collaboration in investment decisions.
  • IP (Intellectual Property) - Mentioned in the context of collaboration and the fear of leaking proprietary information.
  • GP (General Partner) - Mentioned in the context of Capital Constellation and anchoring/incubating GPs.
  • LP (Limited Partner) - Mentioned in the context of Capital Constellation and asset owners.
  • Liability Driven Investing (LDI) - Mentioned as an outcome of the 2001-2003 crisis.
  • Asset Liability Modeling (ALM) - Mentioned as an outcome of the 2001-2003 crisis.
  • Factor-based asset allocation - Mentioned as an outcome of the 2008 crisis.
  • Net Zero Commitment - Mentioned as a common encumbrance on capital for asset owners.
  • Fiduciary - Mentioned in the context of pension employees discussing spending.
  • Risk Budget - Mentioned as a concept similar to a governance budget.
  • Governance Budget - Mentioned as a concept that needs to align with a risk budget.
  • Private Equity - Mentioned as an illiquid investment strategy.
  • Venture Capital - Mentioned as an illiquid investment strategy.
  • Hedge Funds - Mentioned as an investment strategy.
  • Fund-to-funds - Mentioned as an investment strategy.
  • Consultants - Mentioned in the context of investment organization governance.
  • Delegation Frameworks - Mentioned as a component of governance.
  • Dashboards - Mentioned as a technology tool for boards to monitor portfolios.
  • Knowledge Tools - Mentioned as tools to capture tacit knowledge.
  • Data Infrastructure - Discussed as a necessary component for companies to benefit from data collection.
  • Cost of Capital - Mentioned as a potential benefit of improved data and ESG practices.
  • Resilience - Discussed as a philosophy for investment ecosystems, similar to human and military resilience.
  • Sustainability Factors - Mentioned as factors associated with recovery trajectories in investments.
  • Employee Satisfaction - Mentioned as a sustainability factor.
  • Environmental Footprint - Mentioned as a sustainability factor.
  • Portfolio Navigation - Discussed as a concept enabled by technology, moving beyond just knowing what you own.
  • Scenario Tools - Mentioned as sophisticated tools for modeling portfolios into the future.
  • Diversification - Discussed in relation to risk factors, volatility, and submergence profiles.

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