I ran into this Tom Toles cartoon in the archives. (For the youngsters in the crowd that might be confused by the imagery, the needle is being applied to an old-time stock ticker.)
Here’s the question for you: When was this published and why?
Citi Prime Finance issued a paper in October entitled, “Exploring the Concept and Characteristics of ‘People Alpha.’” Given the interest in getting alpha at any cost, could it be that hedge funds are actually considering going “soft” by focusing on building a strong culture?
The paper says that “hedge funds investing in superior people management outperform their peers, registering higher average investment returns than those firms that put less emphasis on these factors.” This is actually a very interesting debate, in that there are many who scoff at the notion, who say that what matters is performance, month in and month out, and that you get that by getting the best talent and paying them the most money if they perform.
Focus Consulting is in the business of building and repairing the cultures of investment firms, so it’s not a surprise that it posted the Citi paper on its website (PDF) and sent an email to its subscribers with a summary of the findings.
When I saw it, I was reminded of an October email from Russell Campbell of Your Second Opinion that was titled, “Investment Performance First, Culture Second.” Campbell questioned the assumption that culture is the necessary foundation “in investment management firms where extraordinary talent is required to compete and investment performance matters more than everyone getting along.” He compared employee ratings for mutual fund firms on Glassdoor.com with the stars the funds have earned at Morningstar — and asserted that culture, measured in that way, is not a good indicator of success.
I last met with Campbell and with Jim Ware, the head of Focus, at the 2012 CFA Institute annual conference, although not together. (The two know each other, as this interaction indicates.) I have to side with Ware on the question at hand; you can’t build a sustainable organization without paying attention to organizational behavior. If you find an investment firm that thinks it can, pull your business even if the numbers are good. It won’t last.
The debate is a very important one and the culture wars rage on, within the industry and within firms. Ware and Campbell may have different notions of “people alpha,” but the question is on the table for all of us: What environment allows an organization to meet its clients’ goals over time?
Near the beginning of the long and intricate Gödel, Escher, Bach: An Eternal Golden Braid, Douglas Hofstadter was musing on the border between non-intelligent behavior and intelligent behavior. He wrote that to have intelligence means:
to respond to situations very flexibly;
to take advantage of fortuitous circumstances;
to make sense out of ambiguous or contradictory messages;
to find similarities between situations despite differences which may separate them;
to draw distinctions between situations despite similarities which may link them;
to synthesize new concepts by taking old concepts and putting them together in new ways;
to come up with ideas which are novel.
Those lines may be from the 1970s and may have been written about how to approach the challenges of artificial intelligence, but reread them and perhaps you’ll see what I did: The job description for an ideal investment decision maker.
You may have heard about the pilot that landed a 747 at the wrong airport in Kansas the other day. He was off by nine miles.
"As he tried to sort out the situation over the radio, the pilot could be heard mixing up east and west in his notes, acknowledging he could not read his own handwriting and getting distracted from the conversation by ‘looking at something else.’"
It reminded me of an incident in 2009, in which a couple of pilots forgot to land a big plane at Minneapolis-St. Paul International Airport. They said that they lost “situational awareness,” which prompted me to write a posting with that title in which I related it to the markets:
"Two staples of the investment game, relative performance and relative valuation, play a large part in the periodic bouts of disorientation that imperil the industry and the profession. When everything is relative, it is easy to lose situational awareness."
Given the repricing of risk that we’ve seen, losing situational awareness is definitely a possibility — and, figuratively, you could end up landing at the wrong airport.
However, for those that are in the business of due diligence, such changes in the environment are actually a blessing, in that you get a better sense of how an investment organization or manager lives the stated investment beliefs — what truly is relative and what is absolute, and how the message delivered and actions witnessed compare.
We will get even more evidence the next time the trend changes, but for now we can better evaluate the pilots.
Rick Bookstaber has written a short piece that is worth your contemplation. In it, he envisions a future of less stuff: “We simply demand less in terms of the consumption of produced, brick and mortar types of goods because that is not where we are spending our lives.” Should the current trajectory continue, the economic ramifications would be extraordinary.
Trying to forecast change is plenty hard and the timing of it particularly so. That doesn’t stop investment prognosticators (for whom high season is about to arrive) from calling for this and that to occur by a certain date. But seeing the really big changes means looking out further, beyond the next bonus or incentive allocation, which is what Bookstaber, with his reference to 2025, is trying to get us to do.
As I sit in a fairly large suburban house, full of things, the message is a bit personal. (Especially since some of those things would be classified as collectibles of value, the markets for which have already eroded somewhat because of the forces Bookstaber identifies.) Combine that with being in the middle of a huge demographic cohort and the implications beyond this street address are significant.
As I work with investment organizations, one of the biggest challenges is to consider the possibilities of the future and to assess them in a risk management framework. Or should I say a risk-and-opportunity framework.
We often miss the impact of the really big disruptions, even as we see the evidence accumulating. It is hard to properly evaluate glacial change, even when we have started to watch its progression.
It is only when a chunk of the glacier cleaves and the resulting waves swamp our observation boat that we really start to pay attention.
The last issue of The Prudent Fiduciary Digest (you can sign up for the free newsletter or see back issues here) included a section on “unseen risks” of a financial shock coming from the asset management industry. It was triggered by a report from the Office of Financial Research (OFR) that examines the potential repercussions from herding, reaching for yield, leverage, inter-connectivity, and redemption risk among those firms. (My take was that asset owners should think carefully about those issues as a part of their risk management process.)
Predictably, this has not gone over well with the asset management industry, which doesn’t like the bad publicity and fears regulation. An article in Pensions & Investments mentions BlackRock and PIMCO as the two firms most likely to come under scrutiny — and which could be labeled “systematically significant,” leading to regulation by the Federal Reserve.
In the story, one firm (Federated) calls the report “misleading and inaccurate,” while a representative of SIFMA acknowledges that the systemic role of the asset management industry is not well understood.
As would be expected, the Investment Company Institute (the industry’s trade and lobbying arm) took aim at the OFR analysis in a letter to the SEC: “Unfortunately, the OFR Study does not meet the standards we would expect for such an important undertaking.”
The ICI offers a spirited defense of the industry with some good points, but its continued emphasis on “registered funds” (its members) as if they exist in a vacuum misses the big picture. Legal issues, agency status, and historical experience are all important, but they do not tell the whole story.
The letter accuses the OFR of being “results driven,” and that’s a very real concern in any study. But the ICI doesn’t seem to understand what risk management is all about. You must look forward and judge emerging risks and, yes, think about what can and could happen. (See page four.)
Many of the managers of registered funds have non-registered entities and if you pretend that doesn’t affect how they make decisions across their firms — as the ICI appears to — you haven’t been watching carefully enough. Understanding the behavioral flows is critical and “herding, reaching for yield, leverage, inter-connectivity, and redemption risk” can be amplified across different kinds of funds, to the detriment of clients in each and the system as a whole.
The ICI cites “independent board oversight” as being a critical factor in differentiating registered funds from other investment vehicles. There is some bit of truth to that, but don’t swallow it all: Mutual fund boards are very susceptible to advisory firm “capture.”
Let the debate continue, but don’t expect an industry group to properly assess the risks that the industry presents.
Today’s title comes from an August posting by James Picerno on The Capital Spectator. He stated that “the momentum factor has become more pronounced in the 21st century.”
I recently wrote: “It seems to me that the battle between momentum and mean reversion is one of the defining factors in today’s investment world. Many ‘adaptive’ strategies are momentum in nature, while mean reversion is to many the chief gravitational force around.”
Picerno does a good job of thinking about the “mixed bag of implications” that come from this change in market behavior — and the need to consider whether your investment approach should change because of that evolution.
When working with an investment organization, one of the key “tells” for me is where it is on the spectrum between momentum and mean reversion, whether it has adjusted its approach, and whether it has effectively communicated its new strategy and the “new world” it is designed to address. As Picerno says, there are no easy or right answers, but you should know why you’re doing what you’re doing.
The real test of a firm’s (or an individual’s) position and resolve will come when the “good” momentum that has been dominating the markets is replaced by its evil cousin.
An October 24 posting on Institutional Investor’s Alpha highlighted the success of Scott Ferguson in launching Sachem Head Capital Management ($800 million in less than four months kind of success). Ferguson is described as a “protégé of Pershing Square Capital Management’s William Ackman,” for whom he served as an analyst.
The fundraising “highlights how popular activist strategies have become this year.” It is certainly easier to raise money when a strategy is popular — especially when you are considered a protégé of a successful investor (although Ackman has taken his hits this year).
But it would be interesting to see a protégé scoreboard. How often do big capital raises awarded in large part because of the reputation (the coattails, if you will) of another investor result in successful outcomes for investors? Sometimes it happens that way, but there have been a lot of notable failures.
Ferguson “spent most of his time generating ideas and doing analysis” at Pershing Square. I presume he was and will be very good at that. But now he needs to lead an organization, one immediately in the spotlight and one which is expected to succeed right out of the gate. That’s a different to-do list, and many analytical stars become organizational failures.
Protégés are hard to assess until they have been out on their own for a while, although, as in Ferguson’s case, they sometimes start with the great advantage of not having to fight for a critical mass of assets like most other new managers do. You wonder, though, what percentage of those assets came in with any detailed understanding of the structures, strategies, and organizational plans that will determine Sachem Head Capital’s success or failure — versus the percentage that pulled the trigger based upon reputation and the results of another organization altogether.