Assessing Liquid Portfolio Corrections during Covid-19 [1 of 4]

Grinding the world economy to a halt, COVID-19 has demonstrated an urgent need for better visibility into investment portfolios. Especially when it comes to the complexities of multi-asset class portfolios. Our goal with this new series is to demonstrate the strategies that modern-day investors can use to make the most of opportunities, and respond productively to challenges. This is the first of four installments:

• Assessing Liquid Portfolio Corrections
• Understanding Private Company Fundamentals
• Modeling Private Portfolio Impact
• Quantifying Cashflow Requirements

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Foreword  

It’s 3:59 AM on a moonlit night during the last week of March, Anno Domini 2020. You’re up in your home office staring at your computer screen. Asian markets are open, down hard from the previous day, marking new lows. While you're trying to chart the Nikkei drawdown since its recent peaks, your European market screen pops up, signaling their opening. The first few ticks mark another gap down, wider than Asian markets. It’s the fourth market in a row to show a drop. You had just convinced the board of trustees to approve the largest increase in exposure to Asian and European markets since the endowment was established 150 years ago. The money was successfully allocated about 2 months ago. Good timing, you say to yourself. As you absorb the numbers, the rolling news clip below catches your attention. “Global equity markets have experienced the fastest 20% drop across all recessions,” says a lead technical analyst with a very long name. You feel the pain.  

Time to react. A rush of questions pop into your mind:

How much could my public market portfolio be down by now? How will it break between the long-only and hedge fund book? What’s going to happen to my corporate credit portfolio? How is this going to impact privates? How many of the portfolio companies held by GPs will go under? What’s the impact on returns, and more importantly, capital calls?

Wait, wait, wait, you say to yourself, let’s start by forming an opinion on where this all will go. You’ve got a stack of research papers to go through on your iPad, courtesy of way too many free sell-side subscriptions. You had blocked out time on your agenda today to go through them all, but you figure you might as well do it now. Except there’s a new one popping into your inbox every 10 minutes, and they all say the same thing. You read the first paragraph of the first piece, the first sentence of the second, the title of the third. By the fourth, you just glimpse the keywords: more downside. But you also realize it doesn’t matter. You’d rather just know your exposures so you can actually see the impact of what’s happening on your portfolio. Except you don’t have the figures at hand.  

You lower your glasses, roll your hands into fists, and rub your eyes, a vain attempt at removing the chronic sleep deprivation accumulated during the second week of total lockdown. Teachers happily delegated home-schooling to you, which you try to squeeze in during the early morning. Your spouse is stuck in Morocco, where she went to perform due diligence on a real-estate deal for her employer. Most likely your spouse will be able to come back tomorrow, courtesy of an emergency repatriation flight organized by American Pride Airlines. You’re at the brink of physical collapse.  

A shiny, metallic-grey notification pops up on your smartphone. You can’t help but glance over at it. It reminds you that it’s been a month since you purchased the gorgeous e-car that’s now been sitting idle in your garage for two weeks. You picked it up on a beautiful day in early March. On the way home, it was around noon, you had opened the rooftop and let the eager sunlight inundate you with a preview of Spring. You had even put on the Ray-Bans, which you hadn’t worn in decades. You close your eyes and savored the memory of what you hoped this year could have been...  

The sound of the cat dry heaving breaks the spell. You jump out of your chair to rush across the room, but stumble on the pile of toys that didn’t get picked up the night before. By the time you’re up again and reach the couch, it’s too late. The cat is now down on the rug meowing up at you, leaving you to contemplate a wide splash of vomit on your Italian-leather couch. Great. Your clench your fists in anger, realizing the abundant sweat in your palms. Your heart races faster. Your mind is still seeing tumbling price charts. You don't know how you’ll be able to handle all of this at once, it feels impossible.

In times like these, there’s only one thing to do: call Eva. She had hired you as an intern on her trading desk about twenty years ago, and has been your investment mentor ever since. You followed in her career footsteps out of sheer admiration and became CIO of a University Endowment, like she had done many years before, relocating to Europe for the job and handing over the reins of the trading desk. “She said you’re the most capable investment professional she ever had on her desk,” the Chairman of the Board had said, who performed the reference calls with her on your first day when you took office at the endowment.  

While you were faster in decision making and quicker to take advantage of short-term opportunities, Eva was the steady hand, the North Star guiding sailors through uncertain, turbulent waters like these. You realize it’s been two years since you last spoke to her, just a quick, casual how are you. This time you’ll need her investment advice, just like in the good old days. You feel your heart slow down and a smile stretches across your face as you FaceTime her.  

Eva picks up from her home office, holding a warm cup of tea with both hands. “It’s been unusually cold over here,” she tells you as she slowly sips her tea. You see her golden retriever sleeping in the background, curled up at the bottom of her living room sofa. After a few pleasantries, you explain the problem in its most simplistic form: how can I estimate the impact of what’s going on and do the most sensible thing here?

"Do we have 20 minutes?” she asks. Bewildered that solving all of this would only take that long, she instantly picks up your emotional cue, “Not for the solution, of course, but for you to hear what I’ve done about it.” Good old Eva. Of course she’s done it already with a solid plan and flawless execution. You start to listen.  

Eva shifts her cup to the side and starts a screen share to walk you through her portfolio. “Before we start, do you subscribe to Novus?” she asks. Novus, yes, the name rings a bell. Of course, the 4Cs, the hedge fund gurus. You tell Eva you had a demo five years ago, but didn’t think it was relevant for you given how many private investments you have, with hedge funds being a minority of the portfolio. “Well…” Eva replies, “not so long ago you told me the iPod was the hottest gadget one could have. Ever. Then the iPhone, the iPad, and the Apple Watch came along. How much do you think they’ve evolved in the past few years?" You know she’s right, and you feel you should have kept in touch with the Novus rep who set up the demo with you all those years ago.  

“There are four things we’ll do, all within Novus,” Eva declares. “First, I’ll show you how to assess the damage inflicted to your liquid portfolio by the recent market corrections. Second, we’ll maneuver Novus to go into your illiquid portfolio and measure the aggregate fundamentals of the portfolio companies held by your GPs, assessing their profitability and cash burn. Third, we’ll reflect how changes in fundamentals translate into cashflow projection changes. And fourth, we’ll assess whether your allocations should change to meet your new cashflow scenarios.”

You wonder if it’s possible for all of that to happen within one system. You feel your body tense with skepticism. You’ve tried multiple times in the past to live the one-system dream, even hired Amanda—who was so good with computers she could make Excel dance—to stitch things together. And it always failed, a solid vision crumbling under 404 errors and heavy-load, clunky macros. Meanwhile, Amanda left you because “your tech stack is archaic and your tech budget despicable.” There goes the millennial judgmental verbosity. You hate to admit it, but Amanda was right. You feel you’ll come to the same conclusion once you hear what Eva has to say. You sit back and listen, and let the tension go, as the blue components of the Novus platform slowly appear on your screen…

Assessing Liquid Portfolio Corrections

“For what we’re doing today, I’ll show you my liquid portfolio broken down by transparency level,” Eva says, as she shows you the aggregation tree depicted in Figure 1.  

“Keep in mind that for board reporting, I typically show an alternative tree where manager allocations are grouped by developed market vs. emerging market managers, as this is the asset allocation framework,” glossing over the alternative view in Figure 2.  

You interject and ask if Novus can support multiple views.

“Of course, let me go on. Going back to the transparency level, as you can see, I’ve got:

• Three activist managers, for which I receive zero transparency, at least as provided by them,
• Four long-only managers, for which I use Morningstar’s quarterly holdings as proxy,
• Five long-only managers who are sending me monthly holdings weights, and  
• Ten managed accounts, where I have daily position-level transparency by default.”

Before she can continue, the thousands of questions that are running through your mind come flowing out of your mouth.

“How do you handle multiple formats, the asynchronous frequencies, the different taxonomies? And most importantly, who’s running the whole thing, you can’t possibly have hired armies of…”

You silence yourself as Eva raises her hand to stop you.

"It’s all Novus! They give it an odd name—data management—and frankly they do a poor job at selling the value proposition, but it’s been a life changer for us. Novus organizes electronic feeds with data providers like Morningstar and combines them with the data coming from the managers we invest into. They take care of all the data challenges and build a clean investment book of record (IBOR), inclusive of history and maintenance over time.”  

“And what do they do where you know nothing, like for your three activist managers?” you object.  

"That’s where they use their Best Available functionality, which lets you combine the data sources of your choosing (or recommended by Novus) to provide a position-level proxy for your manager. For example, since the activist managers in my portfolio are all US, Novus showed me we can explain 85% of their performance via 13(f) filings,” and she glosses over Figure 3, where contribution by position is made visible for all securities held by one of the managers in her activist portfolio.  

“I’ll spare you the details, but I’ll conclude that, aggregating all this, Novus gave us the insight that 80% of our portfolio is made of mega-caps, which held better during the correction. Novus showed that if you proxied that with the DJ Style US Growth Large Cap, which went down 13% during the quarter, you’d be down 10.4%. Call it 10% to make it simple. Adding Novus’ simulated performance of all holdings, we discovered that security selection added 5 percentage points of alpha. All in all, we estimated that we’re down about 5%. Novus estimates have typically landed within a ±15% range historically.”  

“See?” you rush to interject again, “It’s never perfect. Besides, managers that don’t give you full transparency typically trade a lot, so you may be missing a ton of performance simply because Novus doesn’t have perfect data…”

Eva smiles, as if she caught someone falling victim to a beginner’s fallacy.

“You’re missing the point. It’s not about being perfect here. The point is that with a few clicks, I can predict 80% of my performance, be on top of my portfolio data, and make the most of the transparency provided by managers and publicly available sources, especially because they are combined intelligently. And, by the way, I can flip this to the board of trustees in a split second. How long would it take you to be where I am?”

Touché. Eva has a point. And yes, you realize your criticism came out of pride rather than logic—as an investor, you know you often have a hard time letting go. Meanwhile, Eva is reading your mind and is moving on.

“And of course by the time we get to the hedge fund book you’ll argue that you can’t do much with limited transparency, and that there are cases where even if you had it, not much could be gained, like with your favorite global macro managers. However, Novus allows for proxy exposure with market equivalents, adjusts for net and gross, and of course, in the most complex cases, pulls the Best Available feature to create a position-level proxy via an optimal combination of sources.”

By now you’re silent.  

“Ok so now you know you’re down 17.7%,” Eva says, pointing at the number on the Novus screen where performance estimates by manager are rolled up in the liquid portfolio, “Even if you’re positive about equity markets moving forward given the extent of central bank support, you need to assume you’ve got 20% less cash to meet your capital calls. Which makes me think…shall we hop over to privates?”

Up Next…

• Understanding Private Company Fundamentals