The Active Equity Renaissance: Renaissance Investment Management Firms
Throughout The Active Equity Renaissance series, we have pointed out the obvious need to overturn modern portfolio theory (MPT) and replace it with something better.
How have we done this? By describing the broken 1970s model of portfolio management, enumerating what we call The Cult of Emotion, and declaring the fall of MPT.
But what should replace MPT? We first proposed new frontiers of risk assessment, then new behavioral portfolio management concepts, and last what we call Renaissance Portfolio Management.
Active management is in our DNA and our history, so we recognize that what we are calling for is a radical rethink of the industry. It will not happen overnight, but with some smarts, willpower, and time, we believe The Active Equity Renaissance can be launched.
Renaissance investment management firms, built on our concept of Renaissance Portfolio Management, will be critical to inspiring and propelling this new era of active equity.
Structure Investment Management Firms
Several years ago, we attended a conference presentation by a top-ranked fund manager. The subject? The secrets of his success. What were those secrets? Financial statement analysis, valuation, discussions with management, independent verification of company data (i.e., “channel checks”), on-site visits with company management, and so on.
Chances are that not one of these “secrets” strike you as secret, right? Every fundamental manager ought to be doing them. But when asked about how he managed his relationship to his wholesalers to ensure that they sold his fund to end clients correctly and how he managed his relationship with his board of directors to ensure the same end, he said, “Well that’s everything, isn’t it?”
While we don’t think it is “everything,” how an investment management firm structures itself is a critical issue. After all, what good are superior fundamental analysis, security selection, and portfolio management if wholesaler compensation is misaligned with the strategy? What good is superior analysis if the board does not understand the strategy and obstructs delivering outperformance? IT departments, too, need to support, not hinder, ace portfolio management.
Yet, all too often the creation and continued growth of a firm are done ad hoc and haphazardly once the original strategy delivers outstanding results and starts to attract sizable assets under management (AUM).
Investment management firms must ensure that their firm structure supports the firm’s investment strategies.
Aligning Tools and Strategy with Minds
How a firm hires research analysts tends to be arbitrary. New hires are often brought in based on their credentials: Ivy League educations, bulge-bracket employment, and well-regarded asset management pedigrees. Lovely. Underwriting standards is important, but so is hiring quality minds.
This begs the question: What is a quality mind? One that sees the world as it is, and not what it wants it to be. It is a mind that can sense its own thinking and control its own function. These attributes exist outside of the normal underwriting criteria.
How do you interview for such a person? The interviewer needs a quality mind, too. Investment management firms should involve the portfolio management staff in the hiring process early on. What sort of people should they look for? Those who are tirelessly in “learning” mode and have voracious curiosity, people who have self-correcting mechanisms that ensure they are evaluating the performance of their minds relative to reality and independent of the calculation of rates of return. Analysts and portfolio managers make many more decisions each day than appear in the portfolio as buys/shorts. These quality minds are also naturally inclined to center themselves on delivering their clients’ desired outcomes.
Once these quality minds are hired, investment management firms must give them the freedom to develop tools and strategies that support how they perceive the world.
Of course, we recognize that renaissance minds are rare, and there are probably too many firms currently managing money.
Promotion Is Sometimes a Demotion
Renaissance Investment Management Firms need to promote people based on how well they execute their jobs, not based on some arbitrary hierarchy that incentivizes propelling them up to the next “rung” on the ladder. For example, if a research analyst is best suited to work as a research analyst delivering 92nd percentile quality, why promote them to portfolio manager just to move them up the org chart or to give them a raise? Instead, just give them a raise. In fact, expanding a successful manager’s scope of duties may actually hurt subsequent performance.
Why not structure compensation and benefits to reward excellence? In our vision, an exceptional research analyst could make more than an almost exceptional portfolio manager. Indeed, the typical analyst provides greater stock-picking benefits to a fund than the typical portfolio manager. Of course, if people are evaluated correctly, then only those qualified as portfolio managers would be portfolio managers. Aligning minds and quality with work-type is key.
This is true of other employees critical to investment management performance, too. Marketers of firm products need to be promoted and compensated for delivering the correct investors to the firm, rather than just a quantity of investors to the firm. Imagine marketer pay that is based on the longevity of a vintage of money. Say a marketer brings $50 million to an investment manager with a value orientation. Then the marketer ought to receive more long-term compensation for bringing in investors who stick around for long periods of time, or increase their flows to the investment manager in down market periods, or who do not sell in the face of an equity market decline.
Fund Complexes Are Just That
The fund complex is the toughest modern investment error to unwind. What is the fund complex? The collection of gigantic and often publicly traded investment firms.
Why is the fund complex a problem? Because firms are managed at the firm level. That means that individual investment management portfolios are simply assets in a larger portfolio. From the perspective of the firm and its shareholders, this may make sense. After all, a firm with 50-plus portfolios can probably deliver more consistent earnings-per-share growth. But for an individual shareholder in an individual fund, this usually means that they receive vanilla products that deliver with sour performance.
Why? Implicit in the fund complex business model is the assumption that a proportion of a firm’s actively managed funds will be “outperformers” at any given time. The marketing department hypes these products to spur incremental earnings growth by attracting new AUM. Other products are offered as means to an asset allocation end:
“You bought us for the Superstar Fund, but intelligent investors also allocate assets to fixed income and to some cash. To ease your record-keeping burden and to keep all of your funds with us, we will offer you incentives (breakpoints) to purchase our other (mediocre) products.”
The Renaissance Investment Management Firm
The best firms are privately owned. They offer a collection of active funds, each consistently pursuing a unique, high-conviction equity strategy. They compensate analysts and managers based on superior performance. They do not expand their responsibilities based on that performance. Their sales efforts focus on providing the greatest value to investors, not on growing AUM.
Put simply, the goal of the renaissance investment management firm is to deliver the best possible investment performance, not on scaling for scaling’s sake.
At the 70th CFA Institute Annual Conference, which will be held 21–24 May 2017, C. Thomas Howard will discuss ways that active equity mutual funds can be evaluated through behavioral concepts during his presentation, “The Behavioral Financial Analyst.”
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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.
Image credit: ©Getty Images/FilippoBacci
