Noise - Chapter 12
Sources Of Noise: Associates
Briefly: Associates
Noise. Your internal and external associates are a source of noise.
Chronic. You will experience chronic noise if you fail to regulate the amount of access that you grant to your associates.
Acute. You will risk the experience of acute noise if you fail to invest in those same relationships.
An array of people provide services to you as a fund manager, and to your firm.
Internal. Some of these services might be provided by in-house people and teams, such as marketing or compliance.
External. And other services your firm might outsource, such as legal or accounting.
The amount of noise that emanates from your internal and external associates is a function of two things.
Competence. Associates who don’t know what they are doing will create noise for you. Poor hiring decisions give rise to you having to deal with associates who have low levels of competence, but these decisions may not be part of your portfolio of responsibilities as a fund manager.
Relationship. Poor relationships with even highly competent people will create noise for you. Poor quality conversations with your associates gives rise to poor relationships. Giving attention to the quality of your conversations with your associates is absolutely part of your job, even if nobody bothered to tell you.
I can almost hear you groaning. You have a massive job on your hands trying to generate alpha and/or beat your competitors, how can you possibly have anything left over for pointless chats with that guy from Compliance? Pointless chats are a form of noise and you are right to want to keep them to an absolute minimum.
Barton Biggs understood how much noise could be generated by associates. He wrote: “As an investor, you have to dominate your intellectual intake environment and not let the outside world control you. You have to be adamant that you make the choice of who accesses you and not be at the mercy of others.”
You certainly don’t want alpha-generation to become secondary to office admin, where you have a long line of people outside your door, each waiting to take a piece of your time. You need to be disciplined about controlling who has access to you, so that you are not simply available at all times to anyone who wants access. All those who clamour for your time will take it if they have half a chance and they will leave you with nothing, no time to think productively or read high-quality research.
But this is only one aspect of managing the noise that emanates from your associates. It is defensive in nature, geared to keeping chronic noise out. The obvious payoff of the defensive strategy is that the daily running costs are kept low. That looks like a solution, but it ignores the fact that noise takes multiple forms, and one type of noise can silently morph into another more dangerous type while you’re not watching.
Avoiding conversations with your associates has a positive first-order payoff because you experience less noise in the short term, whereas insufficient high quality conversational investments in key relationships has a negative second-order payoff because you ultimately experience more noise, perhaps a lot more than you think you saved.
Internal Associates
This can be illustrated by the relationship that you have with your internal associates who support you in servicing the firm’s clients. Time and energy is leached from the pursuit of alpha by you telling your story to your associates from Client Servicing so that they can retell the story on your behalf to your clients.
As a matter of simple time-arithmetic, the better you invest in these conversations, the less you will have to invest in preparing and travelling to and from your meetings with clients to deliver the story in person. But there is deeper calculus involved: the buffering that your associates can provide between you and the firm’s clients is a hedge against a more insidious form of noise than simple loss of time. The less capable your associates are at providing you with buffering, the more you will have to interact directly with your clients, which carries a set of hidden costs.
We’ll explore in more detail in the following chapter the ways in which your clients generate noise, but for now you might think about your relationship with the firm’s clients in terms of two vectors, where the flow of information in each direction has the potential to cause you disturbance if contact is too frequent or insufficiently mediated.
Incoming. Your clients are fallible human beings, subject to noise just like you are, but they probably invest less effort in the management of noise than you do. They are subject to cyclical bouts of anxiety and optimism that are inversely correlated with risk, and their emotional swings will contaminate your thinking and make you more prone to erratic decision-making. You will find yourself doing one thing in your portfolios when you really ought to be doing another.
Outgoing. Your communications to your clients, which are sometimes in response to their incoming concerns, are designed to deliver the subtextual message that you have things under control, especially when your performance is not so hot. The forcefulness of your opinion about fund positioning is positively correlated with the degree of unease that your clients express. The worse your performance, the more in control you need to sound, which means that you risk falling into the trap of becoming rigid and dogmatic when you would be better served by greater fluidity in your thinking and positioning.
The quality of conversations that you have with your associates from Client Servicing will determine how effectively they will be able to act as a buffer between you and the firm’s clients, and thereby mediate the frequency and quality of client contact. Investing time in these conversations will enable your associates to better understand your investment approach and your portfolio positioning, which means that they will be in a better position to engage with clients and keep you somewhat protected from overexposure.
If it’s not your natural game, having these conversations will feel like they chew up scarce resource, but if you don’t invest time and energy in having high quality conversations with your associates, you will invite more noise. You have to figure out how much time and energy you’re willing to allocate, which is a cost, but there is no approach that does not carry a price tag. If you focus on keeping the chronic, ongoing noise to a minimum by avoiding these conversations, you open the door to acute noise that has the potential to take you out of the game. You might like to think of this in terms of a put option: investing in conversations is the premium paid away for protection against unknowable but potentially catastrophic downside.
External Associates
The extent of potential downside might be more easily understood in the context of your external associates. Your associates can seem relatively unimportant in your heroic quest for alpha, mere pawns to be moved around your chess board, but sometimes they can be in a position of great power over you. Should this ever happen, you will be extremely relieved to have invested in your relationship, because your survival may depend upon it.
Example: Steinhardt Partners
Michael Steinhardt had a highly successful career as a hedge fund manager and gained a reputation as one of the shrewdest men on Wall Street. He was able to generate outstanding returns for his investors: $1,000 invested with him when he started his firm in 1967 would have grown to $481,000 by the time he retired in 1995, whereas $1,000 invested in the S&P over that same timeframe would have grown to $19,000.
Steinhardt describes his fund’s positioning on the eve of the crash on Black Monday in October 1987 as being “meaningfully exposed on the long side”. Like most others, the Crash of ‘87 caught him by surprise, but Steinhardt summoned the courage amidst the acute noise to buy S&P futures the day after the crash. However, before the market opened on the Tuesday, he got a call from Morgan Stanley, who were the clearing brokers for the firm’s futures trading, to let him know that they were raising the margin requirements on the Steinhardt account.
Steinhardt was long and leveraged, and intent on getting longer, but the call meant that if they did not raise enough cash to meet the margin call by close of business that day, Morgan Stanley would begin to liquidate their account. Steinhardt was at risk of losing control of his portfolio at the very worst possible time. So he picked up the phone to the firm’s prime broker, Goldman Sachs, and managed to strike an arrangement where Goldman would immediately take over Steinhardt’s futures clearing from Morgan Stanley.
He was able to avert a disaster with one phone call because of the strength of his relationship with the head of the equities division at Goldman, who was prepared to motivate to his management committee that they take on additional credit exposure in the midst of the storm. The quality of this relationship had a direct bearing on Steinhardt’s investment staying power. Had that associate relationship not been as strong, the situation would have turned out rather differently.
Poor relationships are a source of noise, and they can morph into other forms and significantly amplify market-related noise. The noise that Steinhardt experienced from the poor relationship with Morgan Stanley was latent up until the crash, there was little noise in evidence and therefore no particular need to do anything, after which that noise became manifest in the form of a margin call. Chronic people-related noise doesn’t always look like much of an issue until it’s suddenly a major problem. What saved Steinhardt on this occasion is that the souring relationship with Morgan Stanley was loosely hedged by a good enough relationship with Goldman Sachs.
You need your key relationships to be in credit for when you need to draw on that credit. You achieve this by dealing with the noise in your relationships through an ongoing series of conversations, something that requires discipline and commitment. I’ll pick this up again in Section 3.
References
Biggs, B. (2006) Hedgehogging. Hoboken, New Jersey: John Wiley & Sons, Inc.
Steinhardt, M. (2001) No bull: my life in and out of markets. New York, New York: John Wiley & Sons, Inc.