Practical analysis for investment professionals
07 June 2016

Alpha Wounds: Lack of Independent Judgment

My entire series on Alpha Wounds is intended to provide solutions that can be implemented by anyone in the investment community to improve the returns of active investment managers for the benefit of clients. This month I focus on the lack of independent judgment and due diligence among active managers.

Unfortunately, I need to rely on my own personal experience and anecdotes rather than comprehensive data to make my point. Why? The image and, therefore, expectation of active managers is that they are Sherlock Holmes-style detectives gathering facts, interviewing witnesses, and developing theories to inform their investment judgments. I’ve found, however, that this is rarely the case, and it is unseemly for investment manager emperors to admit they have no clothes.

So how is the research sausage made at most firms?

Soft Dollars

Soft dollars are indirect payments to sell-side firms as compensation for services provided. What are the typical services rendered to buy-side firms by sell-side firms? Usually these include industry conferences; access to the management teams of businesses; and research in equity, fixed income, economics, and so on. Payment takes the form of the buy-side firms placing trades with the trading desks of their sell-side counterparts. This means that the trading costs are higher, but the expense is typically borne by the buy-side firm’s clients through commissions paid rather than subtracted from the investment management firm’s own operating budget.

Attendance at industry conferences is one way to stay apprised of developments in a sector, and putting on such conferences is very expensive. So clearly value accrues to those investment managers who attend these events. Also, if buy-side managers transact a lot of business with a particular sell-side firm, they are often given private access to the management teams of major companies. One-on-one contact like this is extremely valuable, allowing investment managers the opportunity to have their assumptions confirmed or denied, and giving them access to prospective statements that then become part of their financial models.

These services are clearly valuable and would be difficult for many investment management houses to replicate on their own. But, in my opinion, the soft dollar arrangement can and does impair independent judgment. This is because trades are often directed to firms that provide access rather than to those that provide best execution. In turn, this is a drag on alpha. One example from my own career was the founder of a firm for whom I worked who suggested I direct trades to a sell-side firm in order to ensure access to initial public offerings (IPOs).

The CFA Institute Code of Ethics and Standards of Professional Conduct (“Code and Standards”) makes its point of view about the importance of independence and objectivity clear:

“Standard I(B) Professionalism — Independence and Objectivity

“Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity.”

Lack of Proprietary Research

It makes sense that buy-side firms want to pay for industry conferences and access to management. But why would a buy-side manager pay for sell-side research? After all, aren’t investment managers highly trained and intelligent detectives? Based on my experience, the answer is no. Most investment managers do not actually conduct their own proprietary research. Consequently, numerous errors in judgment are made that hurt performance and result in self-inflicted alpha wounds.

Why is this the case? One reason is that many buy-side firms are small and don’t believe they have the resources to cover the full range of businesses that a large sell-side firm and its research divisions can. This is especially true if the buy-side firm trades frequently and thus has even less time to learn the nuances of particular sectors and especially of individual companies. Low turnover managers, by contrast, can spend years studying industries and firms and thus have the bandwidth, even with small staffs, to conduct proprietary research on possible investments.

Another reason so many pay for sell-side research is that many buy-side firms believe that their competitive advantage lies mostly in asset allocation and not in company research. Why pay for a large research team when the attempt to add alpha occurs later in the process? After all, every company is really just an alpha and a series of betas waiting to be put into a multi-factor asset allocation.

Many firms also evaluate sell-side analyst quality as a proxy for overall due diligence. That is, they think they know who the best sell-side researchers are and focus their scrutinizing powers there rather than on the underlying businesses. In this way, their small scale is presumably optimized.

Lastly, many buy-side firms are overly focused on earning marginal assets under management (AUM) through marketing rather than by generating returns. So asset managers send their research analysts — and especially their portfolio managers — out on marketing missions. In this case, sell-side research subsidizes the marketing efforts for asset-accumulating buy-side firms. This works all the better if a sell-side firm is also engaged in manager search and implies that a good trading desk customer is also, therefore, a qualified candidate for inclusion in manager search efforts.

Where’s the Beef?

While these rationales for using sell-side research are logical, I consider the actual principle to be illegitimate. Why? How are these activities good for our end clients? In my opinion, they are motivated by business considerations aimed at maintaining the high margins of investment management firms. The consequence is that many investment managers cannot tell you the name of the CFO at even their largest holdings. Neither can many managers anticipate how a recession in a company’s third largest market might affect an investment’s profit margins. Nor can they tell you the details of a proxy filing or how a change in management compensation plans is likely to dilute earnings per share or drain cash from the balance sheet. And so on, ad infinitum, until you trail your benchmark, have negative alpha, even before your expense ratio is taken out, etc. Ouch!

Here is what the Code and Standards says about this situation:

“Standard V(A) Investment Analysis, Recommendations, and Actions — Diligence and Reasonable Basis

“Members and Candidates must:

“1. Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.

“2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.”

Sadly, most investment managers do not disclose what actually happens behind closed doors at their firms, so there is no way to independently verify my claim that most managers simply do not conduct their own proprietary research. But here are several anecdotes from my own career that are drawn from a large pool of such stories:

Wyoming Woes

Early in my career, I was in Gillette, Wyoming, attending an exploration and production company’s analyst day. Specifically, the company was demonstrating the benefits of its many coal-bed methane assets. During the course of the day — boy, was I naive — I asked the company’s management many pointed questions. After all, they were among the largest holdings in the fund I served as an analyst for and I wanted to understand the business better.

As the day wound down, we retreated to the Gillette airport for lunch — which was not exactly five-star back in the day — when the chief investment officer of a major pension fund blithely said to me, “You asked a lot of good questions today. It sounds as if you do your own proprietary research, and I wondered if . . . ” I confess I don’t remember any details of the conversation beyond this moment because I was flabbergasted. That I was singled out for doing my own proprietary research blew my mind and made me wonder what exactly this better-resourced CIO did at his firm?! I assumed this must actually be a normal sort of distinction, so I kept my mouth shut. But I remember being crestfallen. Why? As a budding research analyst who aggressively pursued my career and tried so hard to gain the skills of a detective, I was shocked.

But wait, there is more!

Buy-Side Bull

For several years, I had an intellectual stalker, a fellow buy-side analyst who apparently could not do her job. I met this analyst at a sell-side industry conference. Over lunch we had a nice chat and exchanged business cards. Thus commenced a period of several years during which she called me on occasion and asked me to share details of my financial models as well as my opinion about other businesses.

Again, I was naive in the early days of my career and thought that this level of collegiality must be normal. Yet, there was no reciprocity. She did not share her opinions about the companies she tracked. I engaged in the phone calls because our firm was already vested in these positions, and I figured if her firm wanted to bid up for these assets that could only benefit our investors. After several more of these one-sided conversations, however, I rightly refused to share my knowledge and information any longer. I am still appalled at the audacity and ask myself how she got away with this behavior. I can only conclude that she got away with it because people allowed her to, or maybe it was normal practice for her firm. Or something.

Washington Whitewash

The final anecdote comes from after my retirement from investment management in 2005. I was in Washington state with my stepdaughter doing the prospective college tour. I knew that there was an investment manager looking to hire a portfolio manager and I thought I would see if I could sit for an interview while I was up there. I was curious to see if my skills still warranted a bid.

Before placing a call to the recruiter, I investigated the investment manager to see if it was among those that do their own proprietary research. Its website bragged heartily about the proprietary research the firm did and its Morningstar write-up boasted of the same. I therefore went into the interview excited by the possibility of talking with a fellow detective.

One of the questions asked of me during the interview was how I spent my days as a fund manager. My answer was that I dedicated the overwhelming amount of my time reading the news. During earnings season, I listened to dozens of conference calls. I also spent lots of time updating models to reflect new data and new assumptions. Rarely, maybe three or four times per year, I would dig in deep and conduct a full-fledged analysis on a new and intriguing business by reading annual and quarterly reports as well as the proxy. I would build a financial model, I would talk with management, and even go visit the company in person.

At the close of the interview, I asked my interviewer how she spent her days as a portfolio manager for this firm. She talked for about five minutes about the marketing activities in which she was engaged, but did not once mention any research. I found that very odd and asked, “What about the proprietary research?” She looked at me, puzzled. I filled in the blank with, “The story that I read about on the website.” To which she replied, “Oh that. That is our founder’s trading model. The way it works is that we do a qualitative review of the sell-side research we read. For all of the companies where there is a change in rating, we put it into our trading model and it helps to rebalance our portfolios.”

I don’t think this is what clients expect when they read about the diligent efforts made by the company’s research staff that, by its own admission, spends most of its time doing marketing. Egads!


  • If you are an investment consultant, ask to see examples of the proprietary research claimed by an investment manager. Also, ask them questions: For example, who is the chief financial officer of one of their holdings chosen at random?
  • If you are a pension consultant, calculate the growth in a portfolio that results from returns and from marketing. If marketing growth far outstrips returns growth, make sure to have a conversation with portfolio managers to assess how they are spending their time.
  • If you are a portfolio manager or a research analyst, learn how to conduct your own proprietary research. Dare to do the hard work required!
  • Reduce your turnover. Turnover does not just have commissions costs (alpha drag), it also is a drag on intellectual capital because you cannot possibly hope to know and understand all the companies or assets in your portfolio.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: [email protected]

11 thoughts on “Alpha Wounds: Lack of Independent Judgment”

  1. Jason , exactly my experience as a fund manager . My colleagues used to be puzzled that I would spend time reading an annual report rather than meet a hot shot sell side analyst who had come to meet us at office. But I was the only one to miss so many such meetings to work on my own models and read enough annual reports(that it used to terrify my assistant, who wondered what kind of impression, I was making on others in the organisation). It cant be a coincidence that I found exactly what you are saying( relying on sell side rating changes) happening with majority of my other colleagues in the industry. Thanks for the refresher

    1. Hello Dinesh,

      I really appreciate your sharing your story. I am certain that many others have similar ones to relate. I think that the lack of due diligence on the part of active managers is one of the sources of decline of trust in our industry. Clients don’t know that there is a lack of research, but they do know what a loss of capital feels like : (

      Yours, in service,


  2. Jeff says:


    I’m curious: what percentage of time does “overwhelming” translates into when it comes to reading the news?

    For my own private research, it’s become abundantly clear how important it is to read to develop the mosaic. Half of the battle seems to be weeding out the noise from the material. I suppose only through practice over time does this become easier. It’s encouraging to learn from your experience and understand that it’s all part of the process!

    1. Hi Jeff,

      I would say that is a 7-9 hour day that all but 1.5 to 2.0 hours was spent reading. In other words, a ton.

      Thanks for taking the time to comment!


  3. Najim says:


    Appreciate your insight. Very informative post, especially for someone on the outside of the industry looking in.

    Do you think PMs in the micro/small-cap space have more incentive to do their own research, since one can argue there are significantly more inefficiencies in this space than markets higher upstream?


    1. Hello Najim,

      Yes, I think wherever there is poor data gathering, or low amounts of data gathering that there are always opportunities for investment managers. You rightly point out that the smaller company space provides incentives for people to roll up their sleeves, conduct adequate due diligence, and capture the benefits of their information discounting.

      Thanks for taking the time out of your day to comment!

      Yours, in service,


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