OCIOs: History and Evaluation

Once upon a time, say fifty years ago, it was common for bank trust departments to manage assets on behalf of nonprofit organizations and other asset owners.

The investment management business really hadn’t grown up yet.  While there were some mutual fund companies and many brokerage firms, it was common for wealthy families to have their money managed by banks.  They often had long-standing and multi-faceted relationships with the firms that had helped to finance and grow their businesses.  The management of pools of money — such as pension plans and the funds of nonprofits that were the beneficiaries of their clients’ philanthropic interests — was another of the many services that the banks provided.

They were one-stop shops for managing those assets; in most cases a banks ran the entire investment portfolio, which was then comprised of blue-chip stocks and plain-vanilla bonds.

A variety of factors, including the adoption of ERISA in 1974 and an increased emphasis on performance comparisons, led to the growth of the institutional consulting industry.  Soon asset owners of all kinds were selecting investment managers with ever-narrower specialties; custodial banks kept track of everything.  Meanwhile, traditional balanced accounts started to fade away and the influence of bank trust departments in the institutional realm faded along with them.

This trend continued for decades, as portfolios became more complex and the number of managers exploded.  Even with the help of consultants, it was hard for the members of investment committees to keep up with everything.  Changing managers or adding a new strategy in the portfolio was a slow process.  It might take discussions at one or two meetings before giving the consultant direction to do a manager search — and one or two more to make a selection, usually involving an in-person beauty contest as the final step.  Assuming quarterly meetings, that’s half a year or more after the idea was first raised before the change was made.

A reversal of trend

Many investment committee members liked interacting with consultants and being involved in the selection of asset managers, but it was an inefficient process — and the readiness of the members to deal with their obligations varied widely.

Gradually (and then suddenly), all of that changed.  Today, for those asset owners who aren’t big enough to field their own in-house staff, the de facto standard is the use of an outsourced chief investment officer (OCIO).  An OCIO is today’s version of a one-stop shop, a firm that has the discretion to make all investment decisions within the parameters established in advance by the client.  In that kind of arrangement, the investment committee’s role becomes one of governance and monitoring.

(In practice, the dividing lines can vary from situation to situation, and can be complicated by legacy holdings or relationships that give the OCIO something less than free rein over the whole portfolio, but the dividing line outlined above is the essence of the OCIO concept.  As an illustration, a Russell Investments piece includes an appendix with a list of duties with “retain/delegate/partner” choices for an investment committee to consider.)

The players

As it became clear that the OCIO trend had legs, the investment industry did its thing.  Everyone wanted to get into the business, and there are now entities calling themselves OCIOs with these historical roots:  traditional consulting firms, investment banks, endowment fund spin-offs, family offices, asset managers, wealth management firms, and those bank trust departments.  Plus, there are firms that were formed specifically as OCIO providers.

In addition, the OCIO model has been adopted by all different kinds of entities, including endowments, foundations, defined benefit pension plans, defined contribution plans, insurance companies, investment advisory firms, etc.

The name is an odd one.  You’d think that an outsourced chief investment officer would be a person, when what you’re really getting is an outsourced investment function.

Some directories include the year that a firm started in the OCIO business.  If one is listed as having been at it since 1979, for example, it probably was a bank trust department.  The term “OCIO” and many of the services now offered came around much later on.

Maturation

Every OCIO provider offers marketing material explaining why the concept makes sense, usually grounded in the rationale that the complexity of markets + the speed of change + the need for access to the best asset managers on the planet = something that’s beyond the capabilities of a typical investment committee (so let us do it for you).  Every market spasm has led to further adoption of the model.

While it started as a way for smaller asset owners to upgrade their approach, larger and larger pools of assets have gone the same way.  Putting an exclamation point on the trend, BlackRock announced in June 2021 that it had been hired by British Airways for a £21.5 billion ($30.5 billion) OCIO mandate.

Evaluating OCIOs

Today, the OCIO industry looks different from what it did even a few years ago.  Here are some considerations if you are hiring an OCIO, trying to evaluate your current one, or thinking about switching to another provider.

The business models.  As mentioned above, OCIOs have come from all different parts of the ecosystem.  Each of the business models presents potential conflicts, quite varied in nature, as a simple comparison of the length and content of their respective disclosures and regulatory filings indicates.  Where the OCIO function fits within a firm and how it interacts with and draws upon other lines of business internally are important.

Capabilities.  Beyond that, the historical roots of a firm have shaped its expertise, world view, processes, and culture.  An OCIO that grew up as an institutional consultant providing advice will be different in its orientation and capabilities than a global investment bank (or a firm in any of the other categories).  Each entity brings strengths and weaknesses simply because of its history.

Clients.  Some OCIOs, by virtue of their roots or specific targeting strategies, have concentrations of certain types of clients.  The mix of clients matters, since time horizons, standards of practice, and organizational concerns vary by asset owner type.

Range of services.  OCIOs provide a range of services beyond investment management.  An asset owner needs to think about which services are important — to make those retain/delegate/partner choices — and to evaluate how to weigh the capabilities of the investment management function versus everything else.  For example, given how hard it is to generate alpha, helping a foundation or endowment to get (and maintain) a deep understanding of its financial situation and risks so that it can adopt a sustainable spending policy could be more consequential than a few basis points here or there.

Investments.  A detailed look at the pure investment part of the equation is beyond the scope of this posting, but some of the broad categories to evaluate (in addition to the organizational and business model considerations) include:  investment philosophy and beliefs; the investment team; the overall investment process; asset allocation; due diligence and manager selection; portfolio structure and implementation; and risk management.  Each element is important and for every one there is both narrative and reality.  Avoiding the allure of the former and discovering the latter is the essence of good due diligence.

Fees.  Mixed in with the business model issue is the fact that fees can be hard to figure.  One provider, Commonfund, summarizes the challenge this way:

Due to a lack of transparency and consistency across the industry, the “sticker price” for an investment manager is often misleading, resulting in many investors not knowing what their actual “all in” costs are, much less if they are paying a reasonable rate for each underlying component.

While an Institutional Investor article says:

For OCIO firms that are part of larger companies with custodian, brokerage, or investment management businesses, extra costs may arise when the OCIO division funnels assets through other lines of business.

Performance.  Investment committees (and governing boards and other stakeholders) obsess over comparative performance, despite the fact that every asset owner is different and effort should be focused on finding the structure, strategy, and portfolio composition that meet its specific goals over a long time horizon.  In essence, that’s what an OCIO is supposed to do.  But a lack of comparability with other organizations is frustrating to many, so now there is an index (with sub-indexes) that track OCIO performance.  It’s hard to argue with having more information with which to make decisions, but history demonstrates that the availability of such information mostly leads to short-sightedness and poor decision making.

OCIO search consultants.  Not surprisingly, there are now scores of search consultants ready to help asset owners to parse the complexity and provide advice about the range of OCIO providers.  (Disclosure:  The editor of this site has acted in that capacity.)  As with every other link in the principal-agent chain, the consultants bring the possibility of needed expertise (at a cost), but they come with their own business models, biases, and (often) an unwillingness to buck the tendency to overweight performance in the selection process, since that is the most obvious and easiest thing to sell.

Time horizon

Starting about three years after an OCIO has been selected, other providers will contact the asset owner and/or search consultant to see how things are going with the organization that was selected.

Granted, it’s possible that there isn’t an organizational fit and that the asset owner will want to make a change on that basis.  But other OCIOs know that it’s likely that people will get itchy if performance isn’t what they think it should be.  They are expecting asset owners to play the three-to-five year cycle that almost everyone has used when selecting and evaluating asset managers (and which has been shown in study after study to be counterproductive).

You should go into a relationship with an OCIO with a time horizon of a decade or more.  These should be long-term affairs.  That doesn’t mean that changes can’t be made before then, but having the proper mindset at the beginning provides the needed perspective for the selection process — and saves you from unnecessary hassle and cost by avoiding unwarranted performance concerns thereafter.  If you did your homework on the OCIO up front and it is doing what you asked of it, there is no need to react to the short-term noise of performance, which flops back and forth over time.

It’s not as if you’ll magically find a better OCIO anyway.  They are more alike than different, and if you select a new one that has had good performance you might become a client just in time to see that revert.

Plus, the costs of replacing an OCIO can be significant, especially if you have been investing in private assets.  One search consultant, Alpha Capital Management, has laid out those issues in “OCIO 2.0? Don’t Forget Your Bags.”

Going deeper

Investment committees that employ an OCIO have the freedom to concentrate on the activities with the most impact rather than the trivial ones.  The typical meeting fare (performance information, along with economic and market reviews and outlooks) doesn’t prepare you for your ultimate responsibilities — and all those pages and pages of details in the quarterly reports provide documentation but not enlightenment.

Instead, you should spend almost all of the available time in your meetings on education regarding:

The evolving dynamics as both your organization’s circumstances and market conditions change over the years, which may require asset allocation adjustments;

Topics where committee members don’t have the necessary experience to understand the implications of the risks the organization is taking; and

Going deeper into the OCIO’s organization and capabilities; otherwise, over time, the interactions become routine rather than revelatory — and your understanding of the firm narrows rather than broadens.

Then you will be prepared to make the big decisions when they need to be made.

Published: March 14, 2022

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The Best of Times, the Worst of Times, and Adversarial Collaboration

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The evil empire

In the two weeks since the last edition of the Fortnightly, the world has been turned upside down.  The economic framework that was in place since the Cold War has been ripped apart by countries and companies in response to Russia’s invasion of the Ukraine.  The long-term repercussions on investment markets remain to be seen, including whether investing with bad guys will become less popular overall.

For now, we can mourn the end of an era when we believed that the Russians would play nice to be a part of the economic world order.  And we can marvel at the spirit of the Ukrainian people who are standing up to an oppressive power.

Culture

The Thinking Ahead Institute has issued a white paper, “Culture — the organisational superpower.”  Specifically, it looks at asset owners, but also addresses asset manager organizations.

The governance structure is a key determinant of culture:

Asset owner boards can have a wide variety of representation and a mix of capabilities, but generally the lay characteristics combine a focus on the member with domain knowledge that is uneven.  This results in most boards having a culture with high levels of integrity but with certain cautiousness and conservatism.  The generalisation is that there are typically low levels of innovation and risk tolerance, which is often mirrored in the asset owner executive team they oversee.

Another impediment is the lack of innovation in the industry:

While cultural norms differ across segments of the industry, it is apparent from our research that true innovation in the investment industry is rare.

Investment organisations find it hard to apply innovation to the business and operating models, in contrast to applying it within portfolios.

Among the sections of the paper is one on “superteams,” which includes tips “to build exceptional performance” and to improve meetings, as well as “ten tough questions” for superteams to pose.

Adversarial collaboration

Daniel Kahneman’s Edge lecture on “adversarial collaboration” is available in written, video, and audio forms.  While focused on academic resource and discourse, much of it is applicable to investment debate and decision making.

He says, “To a good first approximation, people simply don’t change their minds about anything that matters.”  Belief is social; we have our tribes and our reasons come from our beliefs:

The power of reasons is an illusion.  The belief will not change when the reasons are defeated.  The causality is reversed.  People believe the reasons because they believe in the conclusion.

Kahneman explains why he came to favor adversarial collaboration rather than what he calls “angry science.”  His work with Gary Klein on intuition — a topic of much interest in investment circles — resulted in the paper “A Failure to Disagree,” even though they approached the question from opposite points of view.  (They concluded that investment markets are an environment in which intuition is unlikely to be successful on a regular basis.)

Best of times, worst of times

Joe Wiggins wrote a posting for Behavioural Investment called, “There Has Never Been a Better or Worse Time to Be an Investor.”

He listed five areas where “investors now seem unequivocally better off”:  cost, control, transparency, choice, and information.  But then he said that if you “consider the same categories through a behavioural lens, a different picture emerges.”

For example, we have the ability to see what is happening in a portfolio “whenever and wherever we wish,” but that transparency often leads to worse choices rather than better ones.

Resources

Commonfund has a new portal for fiduciary education called Commonfund Institute Online.  According to the press release, the ten on-demand courses currently available offer downloadable slide decks, course-specific reading materials, and instructor-led videos and webinars.  There will also be live courses.

Top1000funds.com has introduced the Asset Owner Directory.  Each of the largest asset owners has a page (here’s Japan’s GPIF) which provides information on it, links to its websites and annual reports, and a complete archive of stories that have been published about it on the site.

Other reads

“First Principles: The Building Blocks of True Knowledge,” Farnam Street.  “Reasoning by first principles removes the impurity of assumptions and conventions.”

“The Agency of Greenwashing,” Gianfranco Gianfrate, EDHEC-Risk Institute.

Firms make incomplete, misleading or false environmental claims with the aim of avoiding loss of legitimacy or reputational damages, thus increasing information asymmetries between themselves and their stakeholders.  This study has three main objectives.  First, it proposes a new metric for greenwashing.  Second, it explores how corporate governance characteristics affect greenwashing.  Third, it investigates the relationship between greenwashing and firm value.

“Due Diligence — Get On The Ground,” Ian Cassel, MicroCapClub.  Read everything, utilize your network, talk to people on the ground (but not just one), and get on the ground yourself.

“Abu Dhabi wealth fund bets on scientific approach using quant experts,” Andrew England, Financial Times.

The fund, which is estimated to manage about $700bn, has over the past two years been building a “research and development lab and factory” in the hope that a scientific approach will make it more nimble and better able to identify and take advantage of market anomalies.

“Retirement Plan Landscape Report,” Morningstar.  “The Apparent Stability of the U.S. Retirement System Masks Its True Deep Fragility,” among other sections.  

“Vanguard finds robos are no threat to advisors,” Paulo Costa and Jane Henshaw, Vanguard.

Breaking down advice into discrete components, we found that investors prefer that parts of portfolio management and functional tasks be automated and that human advisors excel at delivering emotional outcomes.  Overall, our results provide evidence that human advisors should leverage technology to scale their business while strengthening their uniquely human value proposition to address investors’ emotional needs.

“Deep Waves: The Quiet Undertow of Intangible Assets,” Kim Catechis and Lukasz Labedzki, Franklin Templeton.  “At this point, 90% of the capitalization of the S&P 500 Index is accounted for by intangibles, a huge jump from 36% in 1985.”

“Death of an asset management salesman,” Chris Delahunt, Citywire.   “Unquestionably, sales has — almost always — held the whip hand within asset management firms.”

“Eponymous Laws Part I: Laws of the Internet,” Secretum Secretorum.  Including Danth’s Law:  “If you have to insist that you’ve won an internet argument, you’ve probably lost badly.”

Inspiration

“Whatever inspiration is, it’s born from a continuous ‘I don’t know.’ ”

— Wisława Szymborska

The BRICs

Jim O’Neill of Goldman Sachs came up with the acronym BRIC in 2001 to summarize the power of the emerging economic of Brazil, Russia, India, and China.  It became one of those concepts that catches fire among investors.

 

In 2005, MSCI created the BRIC Index, with backtested data from the beginning of 2001.  It was onward and upward both in absolute terms (top panel) and versus two mainstay indexes (at bottom), right up to the vertical line.  That marks the debut of the iShares MSCI BRIC ETF (BKF), which tracks the index.  It has been downhill relative to those indexes ever since.

Russia was about 7% of the index at the end of 2021.  Who knows what it should be today.  Maybe zero.

Postings

Two recent pieces:

“The Star Analyst Years.”  The first in an occasional series on the huge changes in the investment business during the 1990s and 2000s looks at the upheaval in investment research and the people at the center of it.

“Decisions with Other People’s Money.”  What factors can lead the risk-taking of portfolio managers to be out of sync — or in conflict — with that expected by their clients?

All of the content published by The Investment Ecosystem is available in the archives.  Also, follow us on Twitter — and consider a paid subscription so you don’t miss any of the insights on the site.

Published: March 7, 2022

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The Star Analyst Years

This is the first in an occasional series about the decades of the 1990s and 2000s, when so much about the investment business changed.

In the early 1980s, inflation and interest rates were sky high and stocks were in the doldrums.  In the years that followed, the forces of disinflation, globalization, the internet, and the democratization of finance led to a boom on Wall Street.

During that time, sell-side analysts became household names.  Before then, to the extent that anyone outside of the investment world even knew about those analysts, they were mostly thought to be numbers nerds, poring over financial statements to analyze companies for investment.

That image would change as the bull market grew stronger.  While most analysts would still be anonymous to the public, some of them would become famous, wield great influence, and have paydays that were extraordinary.  Not just because of those forces providing the tailwinds for higher prices, but because of new ways of doing business on the Street.

Three analysts — Mary Meeker, Jack Grubman, and Henry Blodget — came to typify the era.

Changes in the game

In his book, Blood on the Street, Charles Gasparino tells the story of that time through the careers of those analysts.  They were the biggest names and most prominent examples of how investment banking came to dominate research.  At the height of their powers, Meeker was at Morgan Stanley, Blodget at Merrill Lynch, and Grubman at Salomon Smith Barney, but all of the major firms tried to cash in on the bonanza, cutting corners in the process.

It’s not that there wasn’t pressure on research from banking before that, but the balance of power was such that conflicts were more limited.  Sometimes an analyst would be brought “over the wall” — the so-called “Chinese wall” that kept investment banking and research apart — but over time that wall started to crumble.  Firms saw that research could drive investment banking business (where the really big money was, leading initial public offerings or advising on mergers).  The way to win that business was to have a star analyst who would promote the stocks of companies who would be generating those big fees — those already public and those who were going to be doing an IPO.  They all wanted the blessing of the hottest analysts around.

The analysts got involved in more and more aspects of the banking business.  During the hectic years of the dot-com bubble, Blodget told Merrill Lynch that he was having a hard time producing research on the rapidly expanding stable of companies, despite working very long hours.  He estimated that banking-related activities were taking up 85% of his time.  Meeker’s self-evaluation from 1999 illustrates the emphasis on dealmaking in her job.

As the roles of the analysts kept expanding, it seemed like they were everywhere, selling the promise of a changing world to companies and investors alike.

Here’s Gasparino on Meeker’s involvement in the famous (and famously disastrous) AOL Time Warner merger:

She was one of the key players in pitching the deal to TimeWarner’s board of directors, giving a rousing speech that heralded the vision of AOL’s CEO, Steve Case, a man she compared to legendary Time Inc. founder Henry Luce.

Analysts became sounding boards for CEOs — for the companies that they were supposed to be objectively analyzing.  They would travel together on “road shows” to see institutional investors (some of whom got preferential treatment and better information).  Research reports often would be sent to companies in advance, supposedly for fact checking, but with banking business on the line, it amounted to approval.  Plus, the investment banks engaged in “spinning” — awarding shares in other hot IPOs to CEOs to line their pockets and curry favor with them.  (Gasparino wrote that Goldman Sachs “perfected the practice.”)

The conferences put on by the analysts were described as rock concerts, where they were the stars along with the CEOs that they lauded.  Their every recommendation seemed to move the prices of stocks — with the research reports often accompanied by catchy titles (such as Meeker’s “Yahoo, Yippee, Cowabunga . . .”), new-fangled metrics, and bold predictions, like Blodget’s fabled $400 price target on Amazon.com.

The press

The attention received by the analysts drove the banking business (and stock trading), so the firms tried to get them all the press they could.  Grubman, Blodget, Meeker, and others received fawning coverage from CNBC, an ever-expanding number of market-related magazines trying to cash in on the bull market, and the major newspapers.

Grubman got the front-page treatment from the Wall Street Journal, in a piece titled “The Jack of All Trades; For Salomon, Grubman Is a Big Telecom Rainmaker.”  Meeker was on the cover of Barron’s as the “Queen of the Net” (and was profiled in the New Yorker).  Blodget was all over financial television — some eighty times in 1999 alone.

But then came the year 2000, when the air went out of the bubble and the coverage started to change.

The May 15 issue of BusinessWeek had a cover story on Grubman: “The Power Broker: From his Wall Street perch, Jack Grubman is reshaping telecom and stirring up controversy.”  Gasparino wrote that the magazine “scored a major scoop by exposing Grubman as a fabulist, a man who would make up almost any story, concoct almost any lie to get ahead.”  In many respects, his backstory wasn’t as had been advertised.

The article was also one of the first public reveals of the real workings of Wall Street.  When asked about whether he was objective enough in his research, Grubman said, “What used to be a conflict is now a synergy,” disparaging those who clung to the old ways as “uninformed,” lacking his inside knowledge.

As time went on and the stocks kept going down, the press got worse.  At the end of the year, the headline on a Gretchen Morgenson column in the New York Times asked, “How Did So Many Get It So Wrong?”  She wrote that “investing veterans say that the quality of Wall Street research has sunk to new lows . . . the result of shifting economics in the brokerage business that have pushed many researchers to put their firms’ relationships with the companies they follow ahead of investors.”

That was a view that was getting increased attention from the regulatory authorities (who had been asleep on the job) and the investing public.  The brokers who did whatever the star analysts of their firm had told them to do tired of dealing with clients that had large losses.  They turned on the analysts, just like the media turned on them, in a replay of the age-old cycle of adulation and revulsion of prophets — from GOAT to goat.

In May 2001, Fortune did a spread on the conflicts in investment research.  Meeker was on the cover, which read, “Can We Ever Trust Wall Street Again?”

In November, the iconic stipple drawings of the three faces of the boom and bust appeared in the the Wall Street Journal together.  The article, “Rock Stars of Wall Street Lose Luster Amid Slump,” read like a eulogy:

They were the rock stars of Wall Street — but now they’re out of tune, and in some cases, out of gigs.

Big-name stock-research analysts have always been well-known among the legions of professional Wall Street investors, but in the past few years, they have also become celebrities.  They were paid princely sums.  They were regulars on TV and on magazine covers.  Followers hung on their every word.

No more.

Grubman

Of the three analysts, Grubman comes off the worst in Gasparino’s book and in the other accounts of the times.  His relationships with many of the firms he covered went beyond even the loosened norms of the day, especially in regards to WorldCom.  The stock was a huge success at first, but ultimately a colossal failure, ending up in bankruptcy, with CEO Bernie Ebbers going to jail.  Grubman was a master promoter of it, but not a master analyst of it.

He made so much money for his firm that he could get by with things that others couldn’t.  His wife was able to open an investment account at another firm, which was otherwise prohibited.  He finagled Wall Street legend Sandy Weill into making a million-dollar donation to the 92nd Street Y so that Grubman’s twins could go to preschool there.  In exchange, Grubman upgraded AT&T stock (which he hadn’t liked) in advance of a deal; Weill sat on its board.

Investigations by the regulators included discovery of thousands of emails from Wall Street firms.  They illustrated the conflicts in the business model, and included examples of contrasting opinions from analysts about firms that they followed:  glowing public statements and private disparagements.  An embarrassment of a different kind was revealed when Grubman’s emails included salacious entreaties from an institutional investor who had a romantic interest in him, who fed his ego and his animus toward other analysts (one in particular).

The settlement

The last third of Gasparino’s book deals with the regulatory back-and-forth that culminated in the Global Settlement.  It was an agreement between five regulatory bodies and ten investment banks over conflicts of interest in investment research.  (Two additional firms were added at a later date.)  In addition, it included settlements with two analysts, Grubman and Blodget.  They paid fines and disgorged some previous earnings — and were permanently barred from associating with a broker, dealer, or investment advisor.  (Meeker was not charged and stayed at Morgan Stanley until 2010.)

Every frothy era on Wall Street seems to be marked by excesses that are then addressed by new rules, with the violators promising that it will never happen again.  And it might not, at least not in the same way, but the cycle is bound to repeat.  It always does.

In the wake of the reinforced standards brought on by the settlement, many top analysts decamped to hedge funds and other organizations.  There are influential analysts with sway on the Street today, but it’s nothing like it had been.

Conflicts continue to exist.  While the pressure isn’t as overt as it once was, investment bankers and company CEOs are still interested in seeing positive ratings on stocks.  After the settlement, firms modestly increased the number of sell recommendations (from almost zero during the boom years), but they have declined again after that bump.

Despite everything that happened, the research business is still biased toward promoting stocks.  That’s what makes the world go ’round.

Published: March 6, 2022

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Decisions with Other People’s Money

The investment industry is driven by the need for intermediation.  Individuals and organizations seek to invest funds and feel like they lack the expertise or time to do so on their own.

That intermediation sets up potential principal-agent problems, where the interests of a client and the professional(s) she has hired are not aligned.

Academic research

A good survey of the applicable research, The Principal-Agent Problem in Finance, was published in 2014 by the CFA Institute Research Foundation.  The author, Sunit Shah, described the main areas of study and provided summaries or excerpts from many of the notable publications on the topic.

Much of the focus regarding asset management firms relates to fee structures:

[I]f an investor’s incentives are not aligned with those of the manager, the manager often has both an incentive to act counter to the investor’s best interests and the ability to do so undetected.  Given the magnitude of payment generally involved in asset management contracts, misaligned incentives have significant potential to override a manager’s fiduciary responsibility to his or her clients.  Structuring such contracts optimally is, therefore, of the utmost importance.

A section regarding compensation for asset managers says that:

The optimal contract balances the trade-off between the motivations in the equity-like compensation of the management fee and those in the option-like compensation of the incentive fee.

However, when it comes to contracts, most investors are price-takers.  There is some haggling on the level of fees — with larger asset owners being able to get better terms — but fee structures have been resilient.  “Optimal” contracts remain a pipe dream, despite a good deal of focus on the shortcomings of current approaches.

The research regarding incentives primarily pertains to the asset management firms as a whole rather than the incentives for individuals within them, which are often quite diverse; those incentives vary depending on the respective roles of the employees.

Because that detailed information is not publicly available, there has been little examination of the effect of incentive structures on decision making by individuals — although those within asset management firms can attest to behaviors they have witnessed that have been induced by them.

Experimental studies

One way that academics are trying to get a sense of the impact of incentives is through experimental studies; experiments are created to judge behavioral responses to certain conditions.

An example is “Delegated Investment Decisions and Rankings,” by Michael Kirchler, Florian Lindner, and Utz Weitzel.  The abstract reads (in part):

Two aspects of social context are central to the finance industry.  First, financial professionals usually make investment decisions on behalf of third parties.   Second, social competition, in the form of performance rankings, is pervasive.   Therefore, we investigate professionals’ risk-taking behavior under social competition when investing for others.

It fits with other work detailed in “Investing Other People’s Money,” from Sascha Füllbrunn, Ola Kvaløy, and Wolfgang Luhan, a chapter in the upcoming Handbook of Experimental Finance.  That piece “aims to consider and summarize the existing experimental evidence on investment decisions taken for others.”

The concept of experimental finance will turn some readers off, since there is a debate about whether the results of such experiments are applicable to decision making in the real world.  (For example, some foundational elements of behavioral finance have been challenged on that basis.)  And the small stakes at play in the experiments seem laughable in comparison to the compensation available to real money managers.

Nevertheless, many of the questions asked in the studies are worthy of consideration by the leaders of asset management organizations who would like to think about whether actions taken by portfolio managers fit with the expectations of those “other people” whose money they manage.

Social distance

One question of interest is the degree of contact that exists between a principal and an agent, and how that affects decision making.  While some professionals (such as investment advisors) might have fairly regular contact with their clients, asset managers are often at great remove from the owners of the assets they manage.

Do their decision processes (and therefore the resulting portfolios) differ based upon the degree of interaction with clients, even when the same investment guidelines are in force?  For example, does managing an institutional separate account portfolio for which the portfolio manager has periodic review meetings directly with the client — or a mutual fund subadvisory relationship with a similar degree of interaction — lead to different choices than if there is no interpersonal communication with a client?

In other words, is there a “social distance effect”?  Given the way that investments are often marketed — selling what is billed as the same strategy, within different kinds of vehicles to different kinds of clients who have different levels of access — the discrepancies among them may give clues to whether the extent of communication is a factor in portfolio composition.  (Since some vehicles may have cash flows in or out and others not, that can provide further insights as to preferences at the margin by a portfolio manager.)

Incentive structures

Across those vehicles said to be using the same strategy, there might be a mix of incentive structures.  When that’s the case, what can be learned by studying the choices made in the respective portfolios?

Comparisons between strategies that aren’t advertised as being the same (but which have a manager in common) can provide evidence as to relative choices as well.  Which of those choices make sense based upon the actual differences in mandates — and which stem from incentives or unrelated preferences (such as favoring one portfolio over another for some reason)?

Risk choices

In seeking to evaluate decision making on behalf of others, academicians face a problem:

“Most theoretical and empirical work on incentives focuses on effort choices . . . while investment management is about risk choices.”  (Füllbrunn, et al.)

Therefore, studies about managing other people’s money try to compare the riskiness of choices made by investment professionals for themselves versus those made for others.  The body of evidence is mixed — and fragmentary.

There have been empirical studies that looked at how life events affect performance, and in a previous posting, Paul Marshall was quoted as saying that “the reddest flags for underperformance . . . are problems in people’s personal lives — the three Ds of death, divorce and disease.”

Age is another factor — how does risk-taking change over time?  Does that scrappy young manager become less scrappy?  How about wealth?  There are those who keep playing the game the same way even though they have a lot of chips, some who feel free to take even more risk, and others who start to take risk management more seriously than they had before.

And then there is this:

The central truth of the investment business is that investment behavior is driven by career risk.  In the professional investment business we are all agents, managing other people’s money.  The prime directive, as Keynes knew so well, is first and last to keep your job.  To do this, he explained that you must never, ever be wrong on your own.  To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing.

That is the start of an oft-quoted 2012 piece from Jeremy Grantham of GMO, whose firm has been on the wrong side of the herding effect more than once (and for long periods), resulting in substantial declines in assets under management (thus proving the point).

Clients

To return to the notion of proximity to clients:  They often are their own worst enemies and can exert pressure on portfolio managers at just the wrong time.

Their expectations might be out of whack because the marketing effort to win their business misrepresented what they would get — or they just didn’t understand it.  As a result, a mutual fund shareholder may decide to sell if a fund is underperforming, while an asset owner may put a firm on a “watch list,” as if to signal to the manager that they should try harder.

Whether the pressure comes from outflows or suasion, a manager may feel compelled to respond to it.  There are two sides to the cycle, of course; a portfolio manager gets lauded and encouraged to keep up what he is doing when things are going well, and then is pressed to change when the the flip side occurs.  Each phase of client pressure spawns procyclical behavior rather than clear-eyed assessments.

According to Füllbrunn, et al., “Traditional assumptions in economics . . . do not allow for other-regarding preferences.”  They also don’t account for the fact that those preferences migrate, making all of this even more difficult to figure out.

To analyze — or not?

If the goal of an asset management firm is to provide attractive performance that meets the expectations of its clients, then the impediments to that happening should be top of mind for the leaders of an organization.

Given the near-universal pull of increased assets under management, marketing-induced expectation gaps likely have the biggest impact.  But which of the other factors mentioned above are important determinants of inconsistent approaches by portfolio managers?

The information needed to examine the question is buried within asset management firms themselves.  For example, think of those large multi-product firms that have been around for a time; they are sitting on a mountain of behavioral information.

But they may be uninterested in it.  Philosophically, many leaders think that portfolio managers should be left alone to live and die on their performance — as long as they don’t violate mandate parameters.

Other firms are more proactive in evaluating speculative questions like these, trying to determine whether there are factors that are interfering with investment judgment when decisions are being made.

Which do you think is the right approach?  Why?

Published: February 27, 2022

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Less-Private Funds, A Really Long Bond, and Molecules Wanted

As promised, you can now get daily charts of interest from The Investment Ecosystem Twitter feed, if you follow such things.  And make sure to share the Fortnightly with others!

Less-private funds

It seems that every issue could have something about new rulemaking by the Securities and Exchange Commission.  Proposed adjustments to the private fund reporting requirement, which had been telegraphed, have now been released.  You can read the three-page fact sheet or the 236-page proposed rules.

Of course, there were plenty of articles about the proposed changes.  One in the Financial Times was headlined, “Investment industry welcomes SEC efforts to reform private equity fees.”  It summarized the positives for investors that the changes in transparency would bring, but not everyone saw the need:

The American Investment Council, the lobbying body that represents the private equity industry, said its members were already “working closely” with investors.

Eyes on venture capital

The high-flyers of the stock market have been wobbly of late, raising concerns about venture capital.  It is coming off of a dramatic period that in many ways eclipses the craziness of the dot-com era.

It’s an opportune time for Abraham Thomas to write a Substack posting (only his second),  “Minsky Moments in Venture Capital.”  He starts by reviewing Minsky cycles and the illusion of safety that they engender before the fateful moment starts the cycle spinning in the opposite direction.

As Thomas notes, “venture capital seems an unlikely candidate for Minsky dynamics to take hold.”  The conditions don’t appear to apply.

But, “Startups are marked up faster than ever.  Rounds are closed faster than ever.  Funds are deployed faster than ever.”  Maybe the compressed timelines are the key consideration:

Does the compression of timelines in venture change the distribution of terminal outcomes for venture-backed companies?

On that question, the jury is still out.  It’s not obvious to me that accelerated markups change the power-law dynamics of venture portfolios.  Markups change the journey of a business, but do they change the destination?

If the answer is yes, then there’s no Minsky dynamic at play; what we’re seeing is a rational evolution of the venture industry.  Maybe startups are truly less risky now; maybe the market truly has matured.  More capital, lower returns, safer investments.

If the answer is no, then venture is very possibly in a Minsky boom, and we’re just waiting for the moment when it turns into a Minsky bust.

(Speaking of busts, CB Insights has updated its list of “Startup Failure Post-Mortems.”  Which is your favorite of the “397 goodbye letters and investigative takedowns” that are included?  Quibi?  Quantopian?  Quixey?)

The NMS Exchange 

Each year, NMS Management publishes an “Investment Bulletin for the Endowment & Foundation Community,” featuring articles on a variety of topics from practitioners working within those types of organizations.

The latest edition includes these stories:

Is China VC Now “Uninvestable” . . . or Primed for the Intrepid?

Should Institutions Invest in Crypto?

Investing in Change: Racial Equity in Financial Services

Team Building in Sweatpants: Setting Culture in a World of Remote Work

Mentoring: A Responsibility to the Investment Industry

The Inflation Snowball

Studying the effect of emotions on culture

Wharton professor Sigal Barsade passed away on February 6.  An obituary in the New York Times said she studied “how emotions, not just behavior and decision making, shape a workplace culture, and in turn how they affect an organization’s performance.”  Barsade identified the importance of organizations assessing their emotional environments — and individuals finding a culture that suits them:  “Being in the wrong place can take an emotional toll.”  An article about her in the Wall Street Journal emphasized the importance of “emotional contagion” in the workplace, ending with Barsade’s belief that “emotions aren’t noise, they’re data.”

Other reads

“Underestimating the Red Queen: Measuring Growth and Maintenance Investments,” Michael Mauboussin and Dan Callahan, Counterpoint Global.  “This topic is important because you can anticipate a company’s growth only if you understand how much capital the company spends on growth versus maintenance.”

“Delegated Risk-Taking,” Tim Kroencke and Carolina Salva, SSRN.  In some countries, defined contribution plans look like this:  “i) the contributions of the beneficiaries are pooled and professionally managed, ii) the individuals cannot choose the financial intermediary, or the investment strategy and risk profile, and iii) financial risks may be born by the individuals.”  Studying that structure in Switzerland:  “Our results suggest that delegated risk-taking results in portfolios of risky assets that are difficult to reconcile with classic financial theory.”

“Do Performance Fees Truly Align Hedge Fund Manager Interests with Allocator Interests?” Jonathan Cornish, Portfolio for the Future.  “Performance fees represent a ‘heads I win, tails you lose’ proposition for managers.”

“Asset Allocators Are Mired in Bureaucracy — But They Don’t Have to Be,” Christopher Schelling, Institutional Investor.  Thoughts on governance, leadership, investment process, and decision making.

“The hidden leverage of stock-based compensation,” Jamie Powell, Financial Times.  Another generation discovers the consequences when the stock option flywheel unwinds.

“Back to Earth or Temporary Setback? Revisiting the FANGAM Stocks,” Aswath Damodaran, Musings on Markets.  An update of the market leaders, including one-line valuation stories.  (A video is at the bottom of the posting should you prefer that.)

“Analytics transformation in wealth management,” Anutosh Banerjee, et. al, McKinsey.  “Wealth managers are finding success with two approaches (serving “clients across the wealth continuum on a flat-fee advisory basis” and embracing “personalization aligned to client life stages and goals”) [that are] “achievable only with advanced capabilities in data and analytics.”

“Are Cryptoassets Tulips or Dot-coms?” Douglas Elliott, Oliver Wyman Forum.  Which camp are you in:  the Dismissive, the Active Opponents, the Pragmatists, or the Supporters?

“2021 Investment Management Fee Study,” Callan.  A look at fees across the main traditional manager categories, showing the trend in the ranges of published fees and actual fees, along with the degree of manager concentration (of the total fees) in each category.

“The ten best books for thinking clearly about statistics,” Tim Harford.  The author of The Data Detective highlights some other books to check out.

Molecules wanted

“This is a molecule crisis.  We’re out of everything.  I don’t care if it’s oil, gas, copper, aluminum, you name it, we’re out of it.” — Jeff Currie, global head of commodities research for Goldman Sachs.

A (really) long bond

On June 30 of last year, the Republic of Austria sold a hundred-year bond.  The yield is less than a half percent higher now than it was at issue, but look what’s happened to the price — down over 30%, and 47% from its peak fourteen months ago.  The current duration is 62, and if rates rise to 2.5% over the next year, the bond will decline from around 74 to 40.  (We’ll provide an update when we’re halfway to 2120.)

Postings

Two recent essays:

“We Need Some New Terminology (Part 2).”  The first chapter of this two-part series dealt with the confusing names for investment advisors — and the significant differences among firms that fit under that regulatory description (at least in the U.S.).  This edition tackles an even tougher semantic challenge:  What is passive investing?

“When Does Scale Impede Returns (and When Doesn’t It)?”  The general belief is that big is bad when it comes to returns; is that the case?  Some examples to consider.

All of the content published by The Investment Ecosystem is available in the archives.

Published: February 20, 2022

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When Does Scale Impede Returns (and When Doesn’t It)?

It is generally believed that performance deteriorates as the size of assets under management increases.  Most research supports that belief.

Is that painting with too broad a brush?  There are always outliers.  Some large pools of money can outperform for a time (although there is the eternal problem of trying to figure out whether a period under review provides any real evidence or just noise).  And being small in size is not a panacea.

There is no doubt that size matters, but what is the net effect of the particular advantages and disadvantages of being large (or being small)?  We are dependent on blunt size-versus-performance comparisons because organizational attributes aren’t tracked in any kind of a systematic way, so conclusions about most attributes other than size are impractical.

Pension plans

The effect of size on the performance of institutional asset owners, specifically pension plans, is the subject of a paper from CEM Benchmarking, “A Case for Scale: How the world’s largest institutional investors leverage scale to deliver real outperformance.”

The results are based upon the analysis of the plans (public and private) in CEM’s database, over five hundred in all, with assets totaling around $15 trillion.  According to the paper, the largest funds outperform smaller ones, “while taking less active risk.”

Among the findings:

→ Active management produces gross value added versus passive, which increases with the size of the plan.

→ Gross value added in public markets doesn’t vary according to the size of a plan; the benefits come from lower costs due to internalization of the investment function and/or bargaining power with external managers.

→ The bulk of the gross value added comes from private market exposures.

→ Net value added in private assets is a function of scale and the degree of internalization of the investment activity.

Charts showing the gross value added, cost, and net value added illustrate the benefits of internalization in private equity and real estate.  Even with a lower gross value added on internally-managed assets, the net value added is greater than that for external funds and fund-of-funds.  (In fact, the net value added is negative for each of those fund structures.)

In addition to lower costs, “a second advantage that can be gained by internalizing PE and RE is the ability to exert control over the use of leverage,” instead of having those decisions in the hands of outside managers.

A webinar about the paper featured Rashay Jethalal of CEM and Bert Clark, president and CEO of Investment Management Corporation of Ontario (IMCO); it was moderated by Jim Leech, the former head of the Ontario Teachers’ Pension Plan.  As you might expect given the participants (and the fact that the session was hosted by Canadian Club Toronto), many good things were said about the so-called Canadian Model of pension governance.

Millennium Management

Switching to the asset manager side of the ledger, a Financial Times newsletter included this about Israel Englander’s Millennium Management, gleaning information from the hedge fund’s most recent investor letter:

Over the past decade, Millennium’s multi-strategy fund has delivered annualised gains of 11.17 per cent a year.  In the previous 10-year period — when the fund was roughly four times smaller — it returned 10.96 per cent a year.  And its Sharpe ratio — a measure of return adjusting for risk — has also improved from 2.65 in the earlier period to 2.78 over the past 10 years.

This means that, as Millennium grew its asset base, returns have actually gotten better.  Englander writes:

“We believe that these numbers demonstrate that, as in most industries, scale is a benefit, not a cost. While we have no intention of growing for the sake of growth, on balance, we think continued scale will lead to benefits that exceed costs.”

The FT summarized the firm in this way:  “Millennium employs 278 trading teams, diversified across asset classes, investment strategies and geographies.”  It is by no means the only fund organized in that fashion, but it is worth considering whether certain ways of structuring and operating a fund can allow for greater scale and still not face a decline in performance.  (That said, a minor increase in Sharpe ratio over ten years yields more narrative power than statistical proof.)

Considering scale

These are two examples, regarding different kinds of organizations, where the general principle of size impeding returns is brought into question.  The exercise could be extended into other parts of the ecosystem.

For instance, the growth in assets managed by OCIOs has been dramatic.  That’s an aggregation strategy of sorts, but one that offers a more expensive kind of intermediation than the traditional consulting models that most OCIO clients used to use.  There are obvious benefits from the new structure, but it’s unclear whether the net results are better than they would otherwise have been.

Some OCIOs have gotten very large indeed, so if there are benefits to scale, their clients should see them in terms of relative performance over time.  But is that popular model the right one for smaller asset owners to use?

IMCO, mentioned above, is in the process of aggregating the assets of smaller Ontario pension plans to try to capture the advantages of scale identified by CEM.  Couldn’t small foundations and endowments and other pools band together to do something similar?  There are hurdles, of course, but if internalization of the investment function makes sense, why hire OCIOs (who use outside managers and charge their own fees) to do that?  Wouldn’t some sort of “mutualization” make more sense?

A few questions to ponder:

Should general principles about the effect of scale be rethought?

What evidence should be used to evaluate the possibilities?

Are there structural aspects of organizations that are critical in understanding the dynamics between size and (long-term) performance? If so, what are they?

What new cooperative investment ventures for asset owners will come onto the scene in the next few years?

 

The Assets module of the Academy due diligence course considers issues regarding flows, scale, and capacity at asset managers.

Published: February 17, 2022

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We Need Some New Terminology (Part 2)

The first part of this look at fuzzy terminology in the investment industry covered the ambiguities around the word “advisor.”  Now let’s turn to another confusing description, this time in regard to an investment strategy.

What is “passive investing”?

Investopedia, the most popular online source of definitions for investment terms, summarizes it in this way:

Passive investing is an investment strategy to maximize returns by minimizing buying and selling.  Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.

An entry in Campbell Harvey’s glossary reads, “Buying a well diversified portfolio to represent a broad-based market index without attempting to search out mispriced securities.”  But there are other definitions, including one that links directly to “indexing,” which is defined as:

A passive instrument strategy calling for construction of a portfolio of stocks designed to track the total return performance of an index of stocks.

The most recent fact book from the Investment Company Institute echoes that, describing passively managed portfolios as those “in which the adviser seeks to track the performance of a selected benchmark or index.”

In these and other definitions, “passive” and “indexed” are used interchangeably, an approach that is the norm for many media outlets and investment organizations.

A little history

Early on in “the index revolution,” the idea of “tracking an index” meant “tracking the market,” with the market being the S&P 500, viewed as the best gauge of the performance of U.S. stocks, even though it included a relatively small percentage of them.

In 1991, William Sharpe argued, in “The Arithmetic of Active Management,” that the indexes used should be broader than the S&P, while putting a stake in the ground regarding those definitions:

A passive investor always holds every security from the market, with each represented in the same manner as in the market.

An active investor is one who is not passive.

Subsequent developments would take things in the opposite direction, toward narrower and narrower indexes — and a much different application of the terminology.

The Investopedia entry referenced above mentions minimizing transactions and long-term holding periods as a tenet of passive investing.  The original concept behind the name was all about owning the market and not trying to buy or sell in an attempt to outperform.  Also implicit in the approach was the market-capitalization weighting framework referenced by Sharpe.

Over time, that total package (which in turn resulted in much lower costs for an investor) became the passive side of the active-versus-passive debate that has been raging ever since.

Today, the “passive” mantra has been co-opted and applied to strategies very far afield from the original intent.  While just a few indexes were in existence fifty years ago, now there are thousands of them, with more created every day.  Very few could be described as broad-based, and as index providers have sliced and diced the investable markets into ever-finer pieces, the trading of those pieces has increased dramatically.

The ETF pivot point

For the first twenty years or so of their existence, index funds (retail and institutional) mostly followed the original principles.  The pivot point came in 1993, with the debut of what is now called the SPDR S&P 500 ETF Trust.  It replicated the same popular index, but it could be traded intraday on an exchange.  (There went the no-transaction part of the idea.)

As interest in the ETF structure built over time, sector ETFs came on the scene, as well as ETFs based upon other indexes that had become widely used for the analysis of active manager performance.  Eventually, indexes were created just to be able to create ETFs.  Index-based investment vehicles had morphed from a way to play long-term market potential to an engine for generating revenues for brokers and asset management firms.

Despite all of the changes, we’re still using the old words to describe vehicles that look nothing like the old vehicles.  For example, if you see statistics from Morningstar about active and passive strategies, it considers “passive” to be anything that is based on an underlying index.  Thus, the latest fund fee study from the firm has an equal-weighted passive average fee well above where you might expect if you were using the lens of the traditional passive approach:

An excellent paper, “Competition for Attention in the ETF Space,” lays out today’s environment:

The interplay between investors’ demand and providers’ incentives has shaped the evolution of exchange-traded funds (ETFs).  While early ETFs offered diversification at low cost, later ETFs track niche portfolios and charge high fees.  Strikingly, over their first five years, specialized ETFs lose about 30% in risk-adjusted terms.  This underperformance cannot be explained by high fees or hedging demand.  Rather, it is driven by the overvaluation of the underlying stocks.  Overall, providers appear to cater to investors’ extrapolative beliefs by issuing specialized ETFs that track attention-grabbing themes.

An earlier version of the paper said that “financial innovation in the ETF space follows two paths:  broad-based products that cater to cost-conscious investors and expensive specialized ETFs that compete for the attention of unsophisticated investors.”

That’s where we are.  Many people and institutions implement the original form of passive investment — and many call what they do by the same name, even though it is unlike it in every respect but one.  The only thing the two approaches have in common is the tracking of an “index,” which isn’t even a meaningful distinction any more, now that indexes create little worlds of their own rather than capturing the overall characteristics of a market.

So what?

A central tenet of The Investment Ecosystem is that we operate in a complex adaptive system that is always evolving.  But categories often don’t keep up with the developments, and a term that used to mean one thing can now mean another.  That’s not a huge problem if everyone is on the same page, but we’re not.

Obviously, it’s unrealistic to expect that the industry will shift to some more nuanced approach any time soon.  But that doesn’t prevent your organization from doing so.

The purpose is not to come up with some sort of degrees-of-purity scale based upon the original concept of passive investing (unless that fits with your investment beliefs), but to have a framework for understanding.

The process of evaluation may lead you to make changes on the investment front, but the main goal is to examine how you communicate what you do — and how you use the words “passive” and “active.”

You might find them in your newsletters or on your website.  They may even be ingrained into your client portfolio reports.  What do they mean in those contexts — to you and to your clients?

Look around.  Some firms promote “passive” approaches — taking advantage of the salience of that term — when the strategies they offer involve layers of active choices.  Others try to hew to an ideal like Sharpe’s — and a few off them tie themselves in knots over some of the sticky implementation questions that arise when trying to reach that goal.

The education of clients is a core responsibility.  Markets are uncertain enough on their own; don’t make them more so by using inexact descriptions just because everyone else does.  Simple explanations that enlighten should be part of the mission.

Published: February 12, 2022

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From the Supreme Court to the Plant Manager

A new feature of The Investment Ecosystem will be starting later this week on Twitter:  A chart of the day.  Asset classes, investment managers, securities, maybe even some economics.  From all around the world.

Follow the feed now and you’ll be all set.  Please use the charts as you wish and send along any requests.

Defined contribution plans

From a January 24 Bloomberg Law article:

The U.S. Supreme Court revived a lawsuit against Northwestern University Monday in a decision that may breathe new life into dozens of lawsuits across the country that take aim at retirement plans with poorly performing investments and excessive recordkeeping fees.

It reports that there have been “about 150 lawsuits filed in federal court over the past two years” regarding the role of fiduciaries in selecting options within defined contribution plans.  An earlier article stated, “A sharp spike in lawsuits over retirement plan fees has wreaked havoc on the market for fiduciary liability insurance.”

The ruling has plan sponsors and lawyers trying to grasp its implications, and no doubt those firms who provide independent evaluations of plan investment choices are inundated with business.

One law firm, Bradley, summarized the Court’s (unanimous, with one recusal) opinion in this way:

So there are two guardrails to steer between.  On the one side, fiduciaries cannot select a menu of higher and lower-cost investment options and forget to evaluate them, regularly and individually.  On the other side, fiduciaries have a range of reasonable choices they can make using a prudent process.  The width of the space between is difficult to gauge.

Of great interest is how this will be interpreted by lower courts in regard to performance evaluations of investment options that don’t have higher-than-normal fees.  If investments on a sponsor’s menu that underperform for a few years are deemed to be evidence of fiduciary failure, that will be a sign that things have gone too far.

The elusive edge

Charlie Henneman and Preston McSwain had a wide-ranging interview with Richard Ennis.  Among the many topics covered (the title of the posting is “Does the Endowment Model Measure Up?”) was manager research.  Ennis:

At EnnisKnupp, we had about 30 people in our manager research group.

I spent a lot of time and resources trying to figure out how to identify superior investment managers — ones that had an edge.

I would constantly ask managers what they believe their edge or advantage over the competition was.  Consistently, they would say that it was their education, technology, access to better information, process, or a combination of these.

When pushing them, though, as to how they were really different than what all the other managers were telling me, nine out of ten times they would fold.

If you’ve been reading the content of The Investment Ecosystem these first few months, this dynamic is familiar to you.  Those doing due diligence need to have the tactics to get the explanatory depth that’s needed.  Likewise, managers need to be able to identify true differences — not spout the same old lines — and to explain how any advertised edge will stay sharp in the face of market forces out to make it dull.

Thinking about things

David Spaulding of the Spaulding Group opens a recent newsletter with a quote from Benjamin Dreyer:

And that’s often the problem, isn’t it?  In writing and in so many things:  that we accept things we’re taught without thinking about them at all.

Spaulding’s expertise is performance measurement and he cites things that are accepted in that realm “perhaps without thinking of them.”  He lists six rules that don’t make sense to him in the Global Investment Performance Standards (some of which he’s been advocating against for decades).

The specifics may or may not be of interest to you (although Spaulding provides easy to understand examples), but the moral is what’s important:  just because something is a standard or a norm doesn’t mean it makes sense or shouldn’t change.

Other reads

“Workshop Note: Reality Tunnels,” Frederik Gieschen, Neckar’s Insecurity Analysis.  “If you’re trying to connect with someone, keep in mind that you have no idea what show is playing on their chosen channel.”  (Plus some other interesting topics, including culture.)

“Options Market Structure 101,” Front Month.  An overview of what happens to Joe Retail’s options order.

“Last Sane Man on Wall Street,” Andrew Rice, New York.  An excellent profile of Nathan Anderson of Hindenburg Research.

“Intelligo Risk Barometer 2022: Pre-Investment Risk Indicators and Insights,” Intelligo.  One firm’s approach to background checks, with some interesting statistics from its evaluations.

“Succession in the Context of Nepotism,” Rosemont.  “Several firms have navigated the nepotism gauntlet well, and the beneficiaries — the spouse, child, cousin, etc. — tended to have the following in common: they work as hard or harder than anyone else, are every bit as qualified as any other candidate, and bring a prove-it attitude to work every day — this isn’t the University of Entitlement.”  (Also see the excellent article about Fidelity by Justin Baer of the Wall Street Journal.)

“Analyst information and investor reaction, not a match made in heaven,” Joachim Klement, Klement on Investing.  “Analyst forecasts vary in accuracy and quality over the cycle, but it seems that investors pay attention to analysts at exactly the wrong time when analyst forecasts are most unreliable.”

“A Probabilistic View of Private Equity Returns – An Allocators Perspective,” Chris Keller, Portfolio for the Future.  “Let me cut to the chase, 2x is not a high probability outcome when investing in private equity.”

“Observations from Examinations of Private Fund Advisers,” Securities and Exchange Commission.   An update of a previous SEC risk alert, this one detailing additional compliance issues it has found in examinations:  “(A) failure to act consistently with disclosures; (B) use of misleading disclosures regarding performance and marketing; (C) due diligence failures relating to investments or service providers; and (D) use of potentially misleading ‘hedge clauses.’ ”

“The moral calculations of a billionaire,” Eli Saslow, Washington Post.  At 78, Leon Cooperman is at his desk for more hours every day than most everyone else; much earlier in life “he’d come to see the act of making money less as a personal necessity than as a serious game he could play and win.”  Fascinating.

The plant manager

“The toughest job in PPG right now is a plant manager.  They wake up in the morning, check their phone to see how many people call off sick, then they get to work.  They go through the dock area to see how many trucks didn’t get picked up, and then they go to the receiving area and then find out what didn’t come in that was supposed to.  And then they move it into the plant and the supply chain people are telling me that they’re going to have to make smaller batches, because of lack of raw materials.”  — From the PPG Industries earnings call, highlighted by John Authers of Bloomberg.

A divergence of opinions

In the posting referenced in the section below, Aswath Damodaran talks about why he tackles valuations on IPOs and companies where there are wide differences in opinions.  Tesla is a stark example; here are the current high, median, average, and low target prices today, according to Bloomberg.  Place your bets.

Postings

Two recent postings:

“Addressing the Culture Gap.”  Observations from a book about culture and what makes for team success — and from an asset manager’s point of view.

“The Teacher.”  Advice from Damodaran on what it takes to value companies, along with his reasons for bucking some of the investment industry trends of the day.

All of the content of The Investment Ecosystem is available in the archives.

Published: February 6, 2022

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The Teacher

Aswath Damodaran is often called “the dean of valuation,” but his reach extends beyond that narrow definition to books about corporate finance, investment philosophies (and fables), and risk management.

In addition, Damodaran openly shares his opinions, research, datasets, and even class materials and sessions.  His website offers a rich vein of learning opportunities, including his blog, Musings on Markets.  If that’s not enough, check out his YouTube channel of almost nine hundred videos.

In December 2021, Frank Fabozzi interviewed Damodaran for Portfolio Manager Research; the quotes below come from that conversation.

Teaching

As is evident from his body of work, Damodaran loves to teach.  In fact, he says, “Teaching is my passion — I happen to teach finance,” and he believes that there is “no more prestigious job in the world, a job that makes more of a difference, than being a teacher.”  If he wasn’t teaching at a university (NYU), he would be happy doing so in a high school somewhere.

“Teaching is stagecraft,” he says, emphasizing the need to be able to tell stories well.  He thinks that also comes into play in doing valuation work; finding a fit between the numbers and the story is an important part of the process.  (This topic is covered in his book Narrative and Numbers: The Value of Stories in Business; a summary of it can be found here.)

Embrace uncertainty

“There is no right answer” when it comes to valuation — or the path of markets going forward.  In coming up with a valuation, “you’re wrong 100% of the time . . . but I’m OK with that.”  In his teaching, Damodaran eschews the use of case studies.  With tens of thousands of public companies around the world, he thinks that learning results from examining them “in real time, with real numbers,” so that you have to “live with the uncertainty.”

One major trap is that of aiming for too much precision; “sometimes you need to give up on precision to be accurate.”  You’re dealing with the future, so there’s no formula.  Trying to hone every number can actually get you further from the truth, all the while increasing confidence in that false precision.  You need to learn to be pragmatic rather than dogmatic in your approach.

That also involves the willingness to be wrong, and to say “the three most important words in investing:  I was wrong.”  Don’t be the type of analyst or portfolio manager who can’t admit that, who is always looking for something or someone to blame.

Go where it’s darkest

If you want to learn, “go where it’s darkest, go where there’s chaos and uncertainty,” because “markets make far more mistakes in the midst of chaos than in the midst of stability.”  He publishes IPO valuations and assessments of volatile companies like Tesla, where the range of opinions is extremely wide; in that case, from those who think “that Elon Musk is a scam artist” to those who think he heads “the greatest company ever.”  By assessing value somewhere in the middle, Damodaran “gets blowback from both sides.”  If it’s not just name-calling, he values the feedback, because that’s how his valuations get better.

Don’t accept the party line

To tell the story of a company, you need to understand what it does.  That doesn’t come from looking at historical financials and projecting them out — from or doing Google searches.  “You have to talk to people.”  Damodaran learned the most about Uber from Uber drivers.

In fact, he thinks “you’re not going to learn anything by talking to management,” and he has never once reached out to any firms when doing his work.  They are going to give you the party line and, depending on your role, you may be “constrained about what you say and how nice you have to be.”  Access is overrated.

Be different

Damodaran is independent in his thinking and speaks clearly about his views.  Here are some of them that stand apart from the conventional wisdom of the day.

Disclosures.  “We’re drowning in disclosures.”  A 10-K today is five times the length of those thirty years ago — and less informative.  (See Damodaran’s video showing the twelve pages of the 200-page P&G filing that he used to do his valuation.)  The entire risk section is “absolute nonsense,” just a long list of things thrown together.  He points a finger at the accountants and lawyers who argue for increased disclosures (and directly benefit when those disclosures are required or become common practice).

Buffett.  While Damodaran expresses admiration for Warren Buffett, he has a problem with the people that follow Buffett and “take everything he says as gospel.”  It resembles a never-questioning cult.

Sustainability.  One of the tenets of Damodaran’s work is an attention to the life cycle of a company and the expectation that it will “act its age.”  He compares a relatively young company to a teenager — it may be full of stories and expected promise, but amidst the progress there will be questionable behavior as it grows into maturity.  He resists the notion of “sustainability” as inevitably good, because “many companies should be liquidated.”  An aging company pining for its youth is likely to make boneheaded decisions.  “Accept your age and act appropriately.”

ESG.  No holds barred here:  “The entire thing is a scam,” with lots of people making money off of the concept and no real benefit being seen.  He mentioned several of the issues identified in the earlier “seven myths” posting, and challenged the notion that companies that received high ESG ratings are “less risky.”  Nor will they provide better returns, since you are constraining your opportunities.  He thinks that values-based investment decisions ought to be made by individuals, not CEOs (just as they have been in years past).  And we should quit ducking the hard political and personal decisions when it comes to environmental policies; getting to where we need to be is going to cause some pain, and outsourcing that through the “E” of ESG is wrong-headed.  We need “laws and regulations aimed at the public good.”

No one way

While different groups of investors believe that they have the one true religion, no approach has a monopoly on successful investing.  A variety of ways can work (although they often “work” at different times).

The important thing is to match up who you are with a philosophy that makes sense for you.  Damodaran describes himself as a value investor, but defines it differently than many who claim that moniker, being willing to invest in disparate companies at every stage of the life cycle, looking for those that have a worth that exceeds their price.  If the traditional value investor is “valuing the investments that are already made” and the traditional growth investor is valuing those “yet to be made,” they both care about value, just in different ways.  He is willing to look across that semantic breakdown — and other ones — to find value wherever it is.

Advice

As an accompaniment to the interview, here is some advice that Damodaran offers to his students (it also serves as the start of the “Other Voices” section of Letters to a Young Analyst):

Don’t mistake luck for skill:  Most investment success stories are due to luck, not skill.  My most successful investment ever was in Apple in 1997 and it was driven more by pity (for Apple) than by some sense of intrinsic value.

Experience means little:  All too often, older analysts try to intimidate younger analysts by pointing to their long experience in markets.  Unfortunately, there are so many paths that stock markets can follow, most of which we will never get to see over our lifetimes, that experience means close to nothing in markets and can often lead analysts down the wrong path.

Respect the market:  The valuation of companies and active portfolio management are driven by the belief that markets make mistakes.  While you may subscribe to that view, you should also respect markets.  Thus, if you find that a stock is under- or overvalued, start off with the presumption that you are wrong and the market is right and search for the reasons why.

Pay heed to first principles:  You will be told, especially during periods of crisis and euphoria, that first principles don’t matter anymore and that there have been paradigm shifts.  My advice is for you to pay particular attention to first principles, especially in those periods.

To thine own self be true:  Markets are about money and money can twist human beings into pretzels.  If there is enough money at stake, you will find ways to do things that you should not be doing and to justify those actions intellectually.  Listen to your conscience and learn to walk away.

Finally, Damodaran says at the end of the interview, “Don’t expect [a CFA or MBA] to magically change your skill set.  It’s the start of a process.”  Keep learning and questioning and challenging.  “If you get comfortable, you’re in danger.”

Published: February 2, 2022

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Addressing the Culture Gap

An enduring question:  To what degree do ideas, theories, and principles regarding organizations apply to investment organizations?

Granted, there are many different kinds of investment organizations, but any leader ought to be able to address the question in a thoughtful manner.  (As should those charged with evaluating organizations from the outside.)

The common factor for the disparate entities in the ecosystem is the nature of investing — an uncertain and noisy endeavor that regularly leads to results that can be misinterpreted even by people with years of experience.  Assessments of organizational attributes like culture are heavily skewed by historical performance.  The general rule:

We see performance and infer __________ (fill in the blank).

As with other topics, seeking explanatory depth regarding organizational culture involves exploring a range of perspectives about it beyond the investment realm — and then comparing those ideas to the conventional wisdom, common practice, and unique conditions within the industry.  That first part, getting an outside view of the concepts, is usually overlooked.

The Culture Code

In 2018, Daniel Coyle published The Culture Code, a book with the subtitle, “The Secrets of Highly Successful Groups.”  He came to believe that the cultures of those groups were based upon three main skills.  They are building safety, to “generate bonds of belonging and identity”; sharing vulnerability, because “habits of mutual risk drive trusting cooperation”; and establishing purpose by creating “shared goals and values.”

How much does that sound like a stereotypical investment organization?  Some would read the description and say that those skills aren’t what makes a difference in generating investment performance — and some would even say that an emphasis on them would be counterproductive — while others think that those characteristics do lead to high-performing, sustainable organizations.  Coyle’s simple premise provides a quick litmus test for beliefs, as well as a guide to explore individual cultures more deeply.

Early in the book, Coyle discusses the use of sociometers by researchers to track the patterns of interactions in a wide variety of work environments:

In each study, they discovered the same pattern:  It’s possible to predict performance by ignoring all the informational content in the exchange and focusing on a handful of belonging cues.

Again, that seems unlikely to apply to a bunch of investment professionals, doesn’t it?  Another conclusion comes from an analysis of a large number of technology start-ups, which found three basic models at work:

The star model focused on finding and hiring the brightest people.  The professional model focused on building the group around specific skill sets.  The commitment model, on the other hand, focused on developing a group with shared values and strong emotional bonds.

While that’s still not a direct match, we begin to see connections to the investment world.  When it comes to hiring investment talent, the star and professional models rule the day.  But, in this study at least, “the commitment model consistently led to the highest rates of success.”  By undervaluing the traits and acts that lead to cohesion, is it possible that we are limiting the capabilities of those in our organizations in ways that contribute to underperformance?

Real courage

Too soft for you?  Try the chapter on SEAL Team Six, where the story of that unit’s success is told mostly through the experiences of Dave Cooper.  The chapter ends this way:

“When we talk about courage, we think it’s going against an enemy with a machine gun,” Cooper says.  “The real courage is seeing the truth and speaking the truth to each other.  People never want to be the person who says, ‘Wait a second, what’s really going on here?’  But inside the squadron, that is the culture, and that’s why we’re successful.”

Yes, there are plenty of investment people who are willing to say what they think at the drop of a hat.  That’s not the “real courage” being described here, which includes the willingness to not only say what you think but to devote yourself to helping to make the change happen, first with yourself.  That involves being vulnerable, admitting your shortcomings, and putting the team above yourself.  To live and die for each other.

Elements of culture

A culture is made of many pieces.  Simple statements and compelling stories about purpose matter, but actions speak much louder than words.  In building a culture, Coyle says, “you must first have a target,” and your in-group relationships should be at the top of your prioritization list:

This reflects the truth that many successful organizations realize:  Their greatest project is building and sustaining the group itself.  If they get their own relationships right, everything else will follow.

This needs to be done in the context of “the type of skills you want your group to perform”:

High-proficiency environments help a group deliver a well-defined, reliable performance, while high-creativity environments help a group create something new.  This distinction is important because it highlights the two basic challenges facing any group:  consistency and innovation.

Thus we come to a critical juncture.  The majority of investment organizations are out of whack across these dimensions, favoring proficiency and (apparent) consistency over creativity in methods and a commitment to organizational innovation.  That imbalance leads to a deterioration of performance over time.  (More on that further down.)

New ways of work

Coyle’s book will be revisited in an upcoming series on virtual, hybrid, and other models of work in the investment world.  Reading about the power of in-person interactions in its pages when it was published must have triggered different ideas than it does today (in the wake of our forced experiment regarding remote work and the changes in employees preferences that have resulted).

An asset manager’s perspective

“Why Do Money Managers Fail?” is the title of a July 2022 paper by Paul Black of WCM Investment Management.  It has deservedly received quite a bit of attention.

There are two ways that it can be viewed.  First, it serves as a part of the firm’s narrative about its history and culture.  Plus, since it attacks the notion that asset growth harms the ability of a manager to produce returns, the paper sets up a defense against those who would express that concern about WCM.

More importantly, Black gets to the heart of some important issues.  For example, here’s the beginning of a sidebar titled “An Industry That Penalizes Change”:

Our industry too often worships at the alter of process, process, process.  “Don’t change the process!”  I find it bizarre:  money management may be the only business where changing your process or belief system — because you’ve learned from your mistakes and want to get better — is frowned upon.  Where else are you penalized for growing your knowledge base and making necessary improvements?

Bravo!  Black calls out the most intractable fallacy about the business, which is trumpeted by asset managers and allocators alike.

The main topic is culture.  “One of the great mysteries of my life is the fact that culture plays such an underappreciated role in the durability of one of the world’s most people-driven businesses,” especially since, when managers fail, “the primary culprit almost always relates to people and culture.”

He refers to “the silent killers” of institutional bureaucracy, cynical factions, ulterior motives, and “the failure to create a second generation.”  The essence of Black’s prescription:

I believe that all these unhealthy culture issues can be alleviated through focus on three big actions:  (1) make sure your people know they matter, (2) make sure your people know that you, as leaders, care about them, and (3) foster an environment where your people care about each other.

It could have come straight out of Coyle’s book.  Black admits, “It’s easy to talk a good game about caring and candor, but the reality is that doing it well is exhausting.”

And most organizations don’t put in that effort:

Sadly, this type of people work is exceedingly rare in the industry, largely because there are horrendous starting conditions.  Most of the individuals attracted to investment management are exceptionally intelligent, have achieved a great deal academically, and (when successful) are highly compensated.  Naturally, this bolsters the human ego, which makes it difficult for people to exhibit vulnerability about their mistakes and areas in which they need to improve.  There is also a lack of trust in most firms.  People worry that exposing their own shortcomings will alter their career trajectories.  And they have a hard time separating themselves from their ideas.  Any challenge against a recommendation can be perceived as a personal attack.

Road maps

Organizational improvement has to start from where you are.  Changing a culture can be slow and torturous work, especially if there are difficult people involved, but staying put is a recipe for failure.

(One of the advantages available to a new firm is the ability to create a culture from a blank slate, although almost all are too busy with other things to prioritize it, so they just replicate environments they’ve known before.)

Evaluating your own culture is hard, but understanding that of others is even more challenging, because you can’t see most of what you’d need to see to do the work.  Still, due diligence analysts frequently make statements about an organization’s culture that aren’t based upon any real insights; the conclusions are summaries of the narratives that have been offered to them.

As an industry, we are mostly in the dark ages on topics related to culture.  It’s time to seek outside perspectives, to ask the hard questions, and to make bold choices.

 

The Advanced Due Diligence and Manager Selection online course includes a module that addresses additional ideas for allocators about culture and how to analyze it in an asset management firm.

Published: January 26, 2022

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