Noise - Chapter 10
Sources Of Noise: Management
Briefly: Management
Noise. The way in which your firm is managed is a source of noise.
Strategy. Poorly conceived or executed corporate strategy enables a toxic culture.
Culture. A toxic culture distracts and diverts you from generating alpha.
The job of managing an investment firm is to respond to changes in the competitive landscape, so that the firm delivers value to its stakeholders. This involves attending to two interrelated dimensions:
Strategy. Selecting the component parts that make up the business, and planning how those parts should change over time.
Culture. Creating the conditions that allow for constructive relationships between the component parts of the business.
When either of these dimensions is poorly conceived or executed by the firm’s management, it creates noise. This noise has two consequences for you as a fund manager:
Distraction. It requires that you allocate resources to non-productive activities.
Divergence. It creates pressure for you to diverge from your investment process.
Noise interferes with your ability to generate alpha. If your firm markets itself as an active manager, the absence of alpha is a serious problem. If noise is not constructively dealt with, it will invite the failure of your funds, your career, and the firm.
Strategy
Firms across the asset management industry are confronted with a number of challenges, including slowing asset flows, downward pressure on fees, and upward pressure on costs. The firms that are under the most intense pressure are:
Mid-Size Players. These firms are losing market share as the industry bifurcates into large players that operate at scale and small players that operate in a niche.
Active Also-Rans. Active managers who lack deep expertise and who are unable to generate alpha are losing market share to those managers that do outperform and to the providers of passive vehicles.
This means that mid-size active managers who are not delivering alpha have some serious strategic issues to contend with. For such firms in particular, the firm’s management needs to be clear on three key parts of the business:
Model. The business model that is most appropriate, now and in the future.
Products. The investment offerings that best fit with the chosen model.
People. The people who will best manage the firm’s chosen products.
Model
In a report on the global asset management industry, Boston Consulting Group identified four business models for delivering success in the future:
Alpha Shop. Firms with deep investment expertise in specific asset classes or investment strategies.
Beta Factory. Firms with scale and operational efficiency.
Solution Provider. Firms with skills in multi-asset portfolio construction, manager selection and monitoring.
Distribution Powerhouse. Firms with superior access to investors and product manufacturers, and which offer superior support to intermediaries.
Management needs to be clear with itself and with the rest of the firm, and with the market at large, about the firm’s model. Failure to do so creates noise and corrodes the firm’s culture, as the firm’s employees become anxious, confused and defensive when the business model is poorly articulated.
Products
The firm’s product offerings must be aligned with the firm’s business model. A failure to consciously commit to a clear business model gives rise to a product suite that is likely to include offerings that are not competitive. Misallocation of resources from competitive products to those that are not competitive will create unnecessary noise within the business.
Management needs to be clear on which products will receive scarce resources, which products will be maintained as cash cows, and which products need to be culled. Failure to do so jeopardises the survival of the firm and creates noise for the alpha-generators.
People
The type of people who are needed in a firm will depend on the model and the products. A true alpha shop requires investment professionals with deep expertise in particular asset classes or investment strategies, which is a set of skills that obviously differs from those who would best be employed in a beta factory.
Employing people without the required skills and attributes to run the firm’s products is a very costly mistake. Even if the right people are employed, the firm’s management needs to devote considerable energy to create and sustain an environment where these people can flourish. Allowing a toxic culture to take hold is an effective way to nullify good hiring decisions.
Culture
You can make a quick diagnosis of the toxicity levels in your firm’s culture using this short list of factors:
Conflicted. The firm places its own interests ahead of clients’ interests.
Reactive. The firm’s management is short-term oriented and reactive.
Political. People in the firm are territorial, manipulative, self-interested.
Conflicted
Organisational culture is not always a binary phenomenon where good is clearly distinguishable from bad. However, there are numerous examples of where there is little doubt about the degree to which a firm’s culture is toxic. The most obvious of these is where financial watchdogs find clear evidence of unethical behaviour.
Behaving with integrity is simply good business practice. Your firm exists because clients have entrusted it with the stewardship of their capital. Anything that undermines that trust, especially unethical behaviour on the part of the firm’s management or your colleagues, jeopardises the existence of the firm.
Example: Strong Capital Management
Strong Capital Management was a US-based mutual fund company with $40 billion under management. In 2003, the US Securities and Exchange Commission found that the firm had allowed and engaged in undisclosed frequent trading in its mutual funds, in violation of the firm’s fiduciary responsibility to its investors. The SEC levied fines of $140 million and barred the firm’s founder, Richard Strong, from the securities industry for life.
Strong Capital Management was one of four mutual fund companies that allowed a hedge fund, Canary Capital Partners, to make preferential trades in its stable of mutual funds. The practice, known as mutual fund timing, occurred where the mutual fund company would allow certain favoured parties to switch between the firm’s funds, with information that was not available to other investors or by taking advantage of stale prices.
The mutual fund companies benefited from this arrangement by either being paid directly for this option, or indirectly by earning management fees on the incremental assets under management. The cost was borne directly by the funds’ ordinary investors and indirectly by the fund managers in the form of diluted returns.
Within a year of this scandal becoming public, Strong Capital Management ceased to exist. The firm’s holding company was forced to put itself up for sale, and was acquired by Wells Fargo at the end of 2004.
If your firm is involved in irregular behaviour, you have ethical responsibilities that are clearly set out in documents such as the CFA Code of Ethics. You are obliged to do the right thing to ensure that your clients’ interests come before those of your firm and its employees.
But accepting this obligation, as you must, also means that some of your scarce resources will be diverted away from pursuing alpha for your clients. The consequences of colleagues’ unethical behaviour are manifold and uniformly bad, possibly the least of which is that it quite simply makes your job harder. The ethical noise that you experience is directly proportionate to your firm’s tolerance of conflicts of interest.
Reactive
A less obvious, but altogether more prevalent, form of cultural toxicity is when a firm’s management team allows itself to focus on short-term results at the expense of longer term considerations. There is, of course, considerable pressure exerted on your firm’s senior managers by assorted stakeholders to deliver now rather than later.
When a major client expresses dissatisfaction over the investment returns that you have generated, your boss is going to feel some serious heat about the potential hole that the departure of this client will create in the firm’s income statement. Naturally enough, your boss would like to retain this client and the most obvious way to do so would be for you to generate better investment returns. And so your boss, if he or she is unskillful, will react to the pressure that they are experiencing by transferring this noise to you. When your boss puts pressure on you to quickly improve your investment performance, it ironically makes the generation of alpha even more difficult and less likely.
If you have been diligent about sticking to a well-designed process that happens to be going through a fallow patch, your boss’ pressure will be an invitation, if not an outright command, to do something different, which is most likely to take the form of a divergence from your investment process. A period of poor performance will always test your resolve, and when your boss heaps additional pressure on you during this time, it will undermine that resolve. If you cave under this pressure and abandon your process, and if your decisions work out well, then you may retain your client in the short term and you may get your boss off your back for a bit. But the second-order consequences are that you will have undermined your team’s process-design and process-discipline, and you will also have undermined your clients’ faith in your steadfastness. And, of course, if you abandon your process and you’re wrong, your client will fire your firm and your reputation will be shot.
Barton Biggs, who founded hedge fund firm Traxis Partners after leaving his position as global investment strategist at Morgan Stanley in 2003, said about the conflict between investment considerations and business considerations: “In my view, you are not going to produce an exceptional long-term record if you let business considerations dominate good investment decision making.”
Another way in which management’s reactivity can create noise for you is where the firm tries to attract assets by offering whatever products seem hot at a point in time, without due consideration for the firm’s longer-term strategy. Your firm’s management is required to innovate and attract assets, but it can go about this in a way that creates significant noise for you as a fund manager, and it can put the business at risk of failure.
When the firm’s business development strategy is to launch a product for every hot area of the market it will have a number of possible negative consequences. The firm will have to build out its infrastructure to support the new products, which will increase the firm’s operational leverage and make the business more vulnerable to outflows. It can take time to get products ready for market, and any time lag pushes the launch date closer to the inflection point in demand. Hot products attract hot money, so rapid outflows are going to happen when the area cools.
You will be directly affected by this kind of reactive approach to business development. Unless your firm’s management hires people with the right skills to manage the new products, it is you and your team who are going to be stretched thin to do the managing, possibly with a new process, as well as the marketing, probably spending valuable time on the road. And much of this effort could turn out to be less than useful if demand for the hot area wanes and the product loses assets.
Whether your firm’s management reacts defensively to retain shaky assets or reacts offensively to attract hot money, that reactivity is going to create noise for you, which makes it harder to generate alpha.
Political
In a 1995 speech at Harvard University, Charlie Munger said, “Perhaps the most important rule in management is ‘Get the incentives right.’” One of the levers that your firm’s management possesses to encourage the right behaviour is the firm’s incentive structure. However, when management has not developed clarity on the firm’s strategy, it is unlikely to use this valuable lever with any great skill. If management is fuzzy about the firm’s business model and its products, it will not have any clarity on what behaviours it wants to reward.
The incentive structure of the firm will have a major influence on the nature of the politics within the firm. A good way to trigger psychosis in an otherwise sane person is to randomise the delivery of rewards and punishments, and this is a certain recipe for turning an investment team into a frenzied shark tank. Every investment team is made up of competitive and ambitious people, and there will always be an undercurrent of jockeying for the top spots in the team. There is a degree of internal competition which can be very healthy, but which can quite easily tip over into destructive behaviour, where climbing the greasy pole becomes more important than making a contribution to the generation of alpha for the firm’s clients.
When you undergo a period of underperformance, this represents an opportunity for one of your colleagues to expand their territory in the firm at your expense. A collection of ambitious and competitive individuals can make for a combustible environment, which can erupt into a major conflagration if the firm’s incentive structure does not reward collaboration and support between members of the team. A poorly conceived system of rewards will politicise the firm. And in a political shop you can choose to play or you will be played. Either way, it’s going to divert time and attention away from doing constructive work on behalf of your clients.
In the same speech at Harvard, Munger also said, “I have often heard Warren Buffett wisely say, ‘The world is not driven by greed, but by envy.’” This is a deep insight for those who devise incentive structures, because it highlights the primacy of relative rewards over absolute rewards. When you decide whether you are pleased by your annual bonus you will choose a reference point with which to make the assessment. The closer that reference point is to you, the greater its meaning. You will not compare your earnings to those of a schoolteacher or a doctor, or even your own previous bank balance; you will compare your bonus to someone in your industry, in your position, and even better, in your firm. The economics of envy suggests that you will have won the game if you got more than the guy at the next desk, the flipside of which is that if he got 8 beans and you got 6, it will feel like you got -2 and not 6. Often, the management of investment firms say that they value teamwork but what they reward is the winning of an internal competition. If the firm’s incentive scheme encourages internal competition, this invites the members of the team to lose sight of who the real competition is. This is a very costly error in a highly competitive field.
It would seem that the answer to questions of incentive structure is to simply reward investment performance. It certainly makes the calculation seem easy, but it ignores a very sticky problem: it is difficult to disentangle luck from skill. Investment performance will always be a function of both of those variables. The performance-outcome paradox is that, for some proportion of time, a well-designed process that is followed with skill and discipline will deliver poor investment performance. Conversely, for some period of time, unskilled but lucky fund managers will outperform. Therefore, a poorly designed incentive structure could inadvertently reward self-interest, rashness and luck, while punishing cooperation, discipline and skill. Such a structure is likely to lead to a politicised team submerged in noise, where the individuals’ future behaviour is neither expected nor desired.
The firm’s managers would be well-advised to design an incentive structure that rewards the right behaviours and attributes, those that are most likely to result in above-average results for the firm’s clients. The incentive structure needs to be aligned with the firm’s strategy and culture, and may even be one of the key means for bringing about alignment between strategy and culture.
References
Boston Consulting Group (2017) The innovator’s advantage.
Article in Fortune on 24 November 2003 by Andy Serwer & Joseph Nocera: ‘Up against the wall. Dick Strong runs his mutual fund firm with a raging passion. And passion can get you into a lot of trouble.’
Biggs, B. (2006) Hedgehogging. Hoboken, New Jersey: John Wiley & Sons, Inc.
Munger, J. (1995). The psychology of human misjudgment. Transcript of a speech given at Harvard University.
Mauboussin, M. (2012) The success equation: untangling skill and luck in business, sports, and investing. Boston: Harvard Business Review Press.