Something Old, Something New
Ask a CIO: Week 2
The S&P 500 has just set a new high, and the markets continue to reflect a risk-on environment. As we discussed last week, markets are unpredictable, and that’s ok.
This week, we’re fielding questions on private credit, copy trading, and resources for more investment information.
To our new readers joining us, welcome!
Something Old
Why is everyone so excited about private credit right now?
I’ll answer this question directly, and then I’m going to go on a tangent that you didn’t ask for (but I promise to bring the tangent back around to your question).
In a nutshell, private credit as a broad collection of strategies has performed well in recent years. It’s performed well on an absolute basis, on a risk-adjusted basis (risk as defined by volatility), and on a relative basis as compared to other asset classes. As an asset class, private credit benefits from the high base rate environment – for the most part, private credit strategies are floating rate, with yields reflecting SOFR (Secured Overnight Financing Rate) plus a spread.1 Private credit has also historically exhibited low correlation to equity markets and this diversification benefit has held up in recent years in a way that isn’t true for bond investments.2
Now, for the question you didn’t ask – what even is private credit?3 Well, it’s a hodgepodge mix of wildly different types of investments with some limited, but important, commonalities. Private credit strategies include:
Corporate direct lending – senior secured loans made to privately held companies
Specialty finance – asset based loans secured by a financial asset or physical asset that generates cash flows (e.g., music royalties, equipment leases, credit card receivables, etc.)
Mezzanine debt, rebranded as capital solutions4 – flexible investments that can sit in the capital structure anywhere from senior debt to preferred equity, and often includes some equity upside participation
Distressed debt – opportunistic investments in (usually unsecured) bonds trading at typically >30% discounts to par in the secondary market5
Structured credit – primarily collateralized loan obligation vehicles and related securities, but can include certain less liquid or stressed/distressed mortgage-backed and asset-backed strategies
If you read the above and said to yourself, “what a random assortment of cats and dogs,” you would be right! But there are some commonalities. These are all debt-oriented strategies where the investments have contractual payment components, and the underlying investments have limited or no regular liquidity. In many cases, the investments are bilaterally negotiated between borrower and lender. The investments are typically made through drawdown commitment vehicles (i.e., funds that issue capital calls over a period of time), reflecting the longer duration capital needed to pursue these strategies.
Often, private credit is used interchangeably with corporate direct lending, but as you can see, it’s much broader than that. And counter to some of the hot takes you might have heard – the most common being “private credit is unproven as a new asset class” – many of the strategies in the larger private credit umbrella have been around for decades.6 At some point over the last several years, we as an investment community decided to bucket them all together. Whether that’s right or wrong, it’s been great for the asset class from a branding and recognition standpoint.
Back to your question – why is everyone so excited about private credit now? Institutional investors have been investing in various parts of the private credit market for decades. We just haven’t called these collective investments private credit until recently. Investors with more flexible investment mandates have been investing in the higher risk/higher return-seeking strategies and bucketing them under hedge funds, absolute return, or sometimes even private equity. And investors with less flexible mandates who couldn’t fit these strategies into any existing bucket often just didn’t invest in them. Now that private credit is increasingly recognized as its own bucket, it’s become easier for more investors to underwrite and fit the investments into their portfolio allocations.7
Something New (to me)
What do you think of the products that allow you to follow/copy the trades of politicians or other “experts”?
This question sent me down a rabbit hole! I admittedly have never heard of social investing or copy trading before, and now I’m fascinated. It strikes me as a bad idea from an investment standpoint, but super interesting from a game theory standpoint.
For those that are as baffled as I was by the question, a brief summary of copy trading:
Individual investors (followers) select a portfolio (leader) that they want to copy, and the brokerage platform algorithmically copies all trades made in the leader portfolio on behalf of the follower portfolio. The leader portfolio can be another user on the platform, or it could be a portfolio managed by a politician or professional fund manager – both of whom are required to make periodic public filings listing their portfolio holdings.
My initial reaction was to point out that any visibility into a portfolio based on public filings is both lagged and incomplete. For a politician, trades are reported on a 30 day to 45 day lag. For professional fund managers, 13-F filings are made quarterly on a 45 day lag. At least for professional funds, 13-F filings are also highly incomplete – these filings only capture long equity and equity-linked holdings. There is no requirement to report on short positions or non-equity positions.
The widespread holding of Lehman bankruptcy claims during the liquidation process serves as a great example of the incomplete nature of 13-Fs. For almost 10 years following Lehman’s bankruptcy, its bankruptcy claims were among the largest positions held across a swath of some of the best-known hedge funds. If you were basing your investment decisions off of 13-Fs, you wouldn’t have come close to replicating those fund returns, and you wouldn’t have even known why. Those Lehman claims were truly the gift that kept on giving, year after year.
My next thought was: who are the users jockeying to be leaders on these platforms? And why would they share their successful trading strategies?8 It turns out, these leaders could be anyone, which is remarkably egalitarian. On the other hand, it also means there’s no fiduciary duty to their followers.
As for why anyone would share their portfolios, apparently followers pay these leaders to copy their portfolios. So in theory, a successful leader could earn more from their followers’ subscription payments than from actual investment success. If nothing else, gathering followers is probably a more certain path to earnings. That sets the stage for some odd incentives.
My last thought was, could this effectively create a legal form of front running? If a leader had a large enough follower base, could they purchase a bunch of short dated call options on a thinly traded stock, then buy the stock in their portfolio, wait for the followers to copy the trade and push up the price, then monetize? And do the inverse on the sell side? I imagine the more widely adopted copy trading becomes, the more likely the front running risk. And since the leader trades first, that portfolio would likely look successful based on the price action that results from the trades that follow.
Just for fun, let’s play the scenario out further. I’ll use the S&P 500 index and the rise of passive investing as an extreme example of broad based portfolio copying.
Each quarter, the S&P 500 Index is rebalanced, which includes adding or removing companies from the index. Passive funds algorithmically replicate the changes in the S&P 500 Index after each rebalancing. The sheer volume of purchases and sales associated with each S&P 500 rebalancing has the potential to move stock prices (and that is exactly what has happened for years). Professional fund managers and bank proprietary trading desks recognized the market impact of index rebalancing and poured resources and research into predicting what rebalances would occur each quarter. These professional traders then traded based on these anticipated index changes. These index rebalancing strategies have ultimately netted hedge funds and banks billions of dollars each year.
The S&P 500 index rebalancing profits were generated based on expectations in changes to the benchmark (the index rules are clear, so there is a fair bit of certainty in the predictions). Imagine someone knowing with perfect certainty how billions of dollars are going to be traded. There is an advantage to knowing what others will do, and the bigger the advantage, the larger the incentive to profit from that advantage. So many possibilities to exploit!
That said, this copy trading phenomenon doesn’t currently seem large enough to worry about getting front run. The more likely downside to following a leader is far more boring – leaders aren’t fiduciaries and don’t have to take appropriate risks, so follower beware.
Something Borrowed
What podcasts or websites would you recommend for newer investors to check out on their own time?
There are any number of websites to help someone learn about basic concepts or investment terminology (e.g. Investopedia) – I’m assuming if you’ve found your way here, you’re looking for something more. The following folks are a sampling of industry voices that institutional investors are reading or listening to:
Eye On the Market – commentary by Michael Cembalest at JPMorgan
Money Stuff – opinion column by Matt Levine at Bloomberg
Capital Allocators – podcast by Ted Seides
Invest Like the Best – podcast by Patrick O’Shaughnessy
Masters in Business – podcast by Barry Ritholtz
If you’re interested in taking a deeper dive, at my prior institution, we assigned the following reading to help bring our interns and new analysts up to speed. It’s a mix of specific investment insights and broader reflections on major recent market events.
Pioneering Portfolio Management, by David Swensen
All About Hedge Funds, by Ezra Zask
Private Equity Primer – TIFF Investment Management
The Most Important Thing Illuminated, by Howard Marks and Paul Johnson
When Genius Failed, by Roger Lowenstein
The Big Short, by Michael Lewis
Too Big to Fail, by Andrew Ross Sorkin
There’s nothing quite like good old-fashioned books. And if you find yourself with questions while reading or listening to any of the above, send them on over: askacio@ivyinvest.co!
Until next week,
Wendy
SOFR replaced LIBOR (London Interbank Offered Rate) in January 2022, driven in no small part due to the LIBOR fixing scandals among major banks, a classic case study in misaligned incentives (financial markets are full of them).
In 2022, equity markets and bond markets fell in tandem, rendering the traditional 60/40 stock/bond split useless from a diversification standpoint. A lot has already been written about this breakdown in historical correlations, so I’ll keep it brief – rapid rate hikes are bad for fixed rate bonds because bond yields don’t change once they’re set. Floating rate investments, on the other hand, reset yields periodically (frequency of resets varies) and so benefit from rising rates.
Last week I noted that equities are a fancy term for stocks. Credit is not a fancy term for bonds. Bonds are a very specific type of credit instrument, but the credit market expands far beyond bonds.
I’m being a little facetious here, and I actually really like this area of the private credit market right now.
Discounts exist for a reason, aka the companies that issued the debt trading at distressed prices are at risk of default or bankruptcy. In the investment world, corporate bankruptcies are bad for equity holders, but can be great for debt holders.
I spoke recently with a long-time CIO that mentioned investing in what today would be considered private credit back in the 1980s. Large E&F portfolios were investing in mezz and special sits funds in the 1990s.
Not all private credit strategies are equally compelling, and manager selection is really important. Credit markets in general are less transparent and more complex, and let’s just say that institutional memory, experience, and expertise are not equally distributed across market participants.
My perspective on the secrecy around successful trading strategies is also skewed by how closely guarded any successful trading strategy is in the professional investment world. Matt Levine wrote a couple of great notes recently on the Jane Street lawsuit against Millenium for copying a trading strategy. It’s a comical example of how seriously firms guard their trading strategies.