sgt. pepper’s and process

I was twelve years old when Sgt. Pepper’s Lonely Hearts Club Band came out.  I vividly remember sitting in the barbershop where I often wasted time when someone walked in with the album in his hands.  In the intervening fifty years, I’ve listened to it hundreds of times.

It made no sense to me that anyone would want to remix it (except as a way to generate sales) and I didn’t think it was worth trying to improve upon something that was so good.  I didn’t expect to ever listen to the new version.  Now I’m not so sure.

I’ve had a chance to hear several interviews with Giles Martin (the son of the legendary Beatles producer, George Martin), who did the remix.  It was fascinating to listen to him talk about the recording process then and the remake of the album now (and hear snippets from the different versions).

The amazing thing is that Martin had available to him all of the original tapes from the sessions long ago.  Not just the individual tracks – which were miraculously combined in ways to use the four-track technology of the day to produce something truly remarkable – but the voices of the Beatles as they worked on the ideas.  In addition, he had recording journals which described in minute detail what was sped up here, what was spliced there, and what was tried but discarded.

It all made me think about a different collective pursuit:  investing within an organization.

What if there were recordings of team meetings and you (as a prospective investor) could listen to them?  How much do we really know about the pieces that go into the decision making process?  About what is explored and rejected?  About what compromises are made?  About how people work together?

Usually, we know almost nothing about process.  We have apocryphal stories and that’s about it.  We hear the beautiful music of good performance and assume that the process behind it is beautiful too.  Probably not.

We don’t have those tapes and we don’t have those session notes.  If we did, we’d have a better chance of assessing what was skill and what was luck – and identifying the rare instances where someone thinks about the world in a way that others never had.

If you tried to diagram the recording process for Sgt. Pepper’s, it wouldn’t look anything like the formulaic approach that you see in a typical asset manager pitch book.  Perhaps that should tell us something about what you need to do to create a record that is unique and lasting.

scouring the universe

To state the obvious, we communicate with each other through language.  Whether we realize it or not, our words can leave many clues beyond the intended message.

That presents opportunities for those doing investment evaluations, who often rely on the statements of others (say, a CEO of a company they follow or a portfolio manager of an asset management firm they are considering hiring) as part of their work.  Careful reading or listening can lead to trails of discovery.  And, increasingly, there are tools that utilize the brute force of computing power to analyze the patterns of speech and writing of those we seek to assess.

Certainly a simple mashup of 10-Ks over time can reveal changes that otherwise might not be noticed.  More robust linguistic analyses of presentations and conference calls can be used to provide personality profiles of individuals and risk assessments of their organizations, based solely on their communications.

Such analyses provide another dimension to the mosaic of information that analysts can use.  But let’s turn the tables and look at the analysts’ own work and linguistic footprints.

For instance, take the title of this piece.  It comes from a report written about an asset manager, who is (according to the writer) busy “scouring the universe” of securities for winners.

I must admit I’m stuck on that word “scouring.”  It certainly has a strongly positive connotation.  Does that manager scour better than others?  Is he more diligent than everyone else in the pursuit of ideas?  Somehow I doubt it and I am skeptical of the writer’s ability to know whether that’s the case or not.

It’s possible the word came directly from the asset manager’s own narrative of the investment process.  That happens a great deal.  When you look at research reports on companies or asset managers, it’s often hard to sort the facts from the opinions, the cogent assessments from the promotional fluff, and the words of the entity being analyzed from those of the person doing the writing.

Language matters.  The words of others often offer unexpected hints that can be capitalized upon by a diligent investment analyst.  So can the words of the analyst in subsequently describing her opinion – how much her words mirror those of the target of the analysis and how loaded her descriptions are can reveal the degree of objectivity that has been brought to bear.

a battle for the spoils

As reported by RIABiz, there was a telling exchange during the last Charles Schwab earnings call.  An analyst “grilled [the CEO] about whether Schwab was damaging shareholder interests in an overzealous regard for the welfare of investors.”

There you have it.  That’s today’s world.

It’s not as if the conflict has gone unnoticed before.  For example, many allocators expressly avoid asset management firms that are publicly held (or that are divisions of companies that are public).  The thought is that, on balance, decisions will be made to benefit the shareholders, not the asset owners.  (While less noticeable, the same issue can exist at private firms.)

Across the investment ecosystem, a battle for the spoils is raging. 

That shouldn’t be surprising:  we are in a low-return environment and there are multitudes of providers in every corner of the business.

In the retail advisory world, where Schwab is a significant player (wearing a number of different hats), clients are pushing for lower-cost alternatives.  That has happened even though many don’t understand the total fee load that’s levied on them when you add up the take from everyone along the investment food chain.

The same process is underway in the institutional realm, where asset owners realize that they are giving away a big chunk of their returns to intermediaries.

All of this puts investment firms in a difficult spot.  Do you protect the comfortable margins of a prior era or do you “anticipate where the client wants to go” as Schwab says it aims to do, even if that means disappointing shareholders (public or private)?

I will be releasing a white paper that focuses on how asset managers should respond to these pressures.  Sign up if you’d like to be among the first to receive it.

institutional and unemotional

Abby Joseph Cohen was on a panel at the Yahoo Finance All Markets Summit on February 8.  In talking about the behavior of investors, she said, “I deal mainly with clients who are large institutions – they are not emotional.”

I beg to differ.

Certainly some institutional investors are more emotional than others.  When giving presentations, Cohen comes across as very analytical and rather unemotional.  In small group meetings, she is the same way.  Perhaps her tone inspires reciprocal behavior and she draws her conclusion from those interactions.

While professional investors as a class are likely less emotional than other people when it comes to making investment decisions, they are far from “not emotional.”

If you’ve worked inside an institutional firm, you’ve witnessed emotional outbursts, and you’ve also seen people whose decision making is altered by the pressures they face, even while they maintain a brave front externally.  As @cheapbeta tweeted recently, “Watching someone you work with suffering through a bad performance period is extremely difficult.  Psychology changes.”

For perspective on these issues, I recommend reading Fund Management: An Emotional Finance Perspective from the Research Foundation of CFA Institute.  (Here’s my earlier posting on it.)  You’ll get a different and more accurate idea of what drives those big-money decision makers than you might have taken from Cohen’s remark.

The actions of analysts and portfolio managers aren’t driven entirely by the analytical process as presented in a pitch book.  They are people.  They are subject to the same foibles as everyone else.  The implications of that should be a key focus for those who design organizations and those who do due diligence on them.

taking business risk

“Investors are bailing on Jeremy Grantham once again.”  So began a January 8 article in the Wall Street Journal.

“Again” is the operative word, as we’ve been here before.  GMO, Grantham’s firm, thinks that most assets are now highly valued and, as history would suggest, will deliver decidedly subpar returns going forward as a result.

Not wanting to take undue investment risk on behalf of its clients, GMO has taken on business risk for itself instead, and assets under management have dropped noticeably.  This is not the first time that has happened, nor is it likely to be the last.  It is in the firm’s DNA to act in this fashion under these circumstances.

Whether that makes sense or not at this particular time (or whether it made sense at the point at which the firm got cautious) is up for debate, but it clearly sets GMO apart.  Most asset managers and their clients perpetuate the myth that they will be able to walk right up to the precipice, see the danger, and respond promptly by liquidating assets at their peak.  (News flash:  It doesn’t happen like that.)  Risk management is much talked about, but there’s not a lot of it in practice.

I gave Grantham a hard time when (almost three years ago) he predicted that the S&P 500 would top out at 2,250.  We’re within a couple of percent of that level right now.  Should the market turn south, Grantham would be lauded as a seer, and the money would flow back in.

Perhaps the investors – institutions and individuals alike, often guided by their consultants and advisors – who pulled money from GMO were concerned by organizational changes.  (A new CEO was hired recently, and there have been job cuts.)  But I doubt it; performance is what motivates the movement of money.

Those that fled should have foreseen this eventuality and shouldn’t have invested with GMO in the first place.  No manager philosophy could be more clear, yet that part of the analysis (which everyone purporting to do due diligence says is so important) must have been skipped by the now-departed clients.

At every level, this is a business of herding, and straying from the herd creates business risk for firms, just as it does career risk for individuals.  Most asset managers don’t dare do anything that might cost a loss of assets, no matter the market conditions or likelihood of a positive outcome.  In the long run, that attitude usually runs counter to the interests of their clients.

the big board

In Slaughterhouse-Five, Kurt Vonnegut’s landmark 1969 novel, Billy Pilgrim picks up a book by the author Kilgore Trout entitled The Big Board.

The book concerned “an Earthling man and woman who were kidnapped by extra-terrestrials.  They were put on display in a zoo on a planet called Zircon-212.”

Then:

These fictitious people in the zoo had a big board supposedly showing stock market quotations and commodity prices along one wall of their habitat, and a news ticker, and a telephone that was supposedly connected to a brokerage on Earth.  The creatures on Zircon-212 told their captives that they had invested a million dollars for them back on Earth, and that it was up to the captives to manage it so that they would be fabulously wealthy when they were returned to Earth.

The telephone and the big board and the ticker were all fakes, of course.  They were simply stimulants to make the Earthlings perform vividly for the crowds at the zoo – to make them jump up and down and cheer, or gloat, or sulk, or tear their hair, to be scared shitless or to feel as contented as babies in their mothers’ arms.

The Earthlings did very well on paper.  That was part of the rigging, of course. And religion got mixed up in it, too.  The news ticker reminded them that the President of the United States had declared National Prayer Week, and that everybody should pray.  The Earthlings had had a bad week on the market before that.  They had lost a small fortune in olive oil futures.  So they gave praying a whirl.

It worked.  Olive oil went up.

In the subsequent decades, we have learned much about behavioral finance, but we still “jump up and down and cheer, or gloat, or sulk, or tear [our] hair, to be scared shitless or to feel as contented as babies in [our] mothers’ arms.”

Whether on Earth or Zircon-212, we are prone to such things.  Today we are celebrating new highs in the U.S. equity indices.  One day, we will give praying a whirl once again.

During a time of much consternation about active management, one of the big questions is whether we can understand the emotional component of what we do enough to add value in new ways.

humility and curiosity

I recently watched a TEDxSaltLakeCity talk given by Kevin Jones, a surgeon who cares for patients with sarcoma.  After my experience being treated for cancer last year, I feel like I have a greater understanding of Jones’ premise:  “Medicine is science.  Medicine is knowledge in process.”

The numbers were on my side all along, but, as Jones said, “Neither the individual or the physician knows where in [a] population the individual will land.”  As it happened, I was on the right side of the distribution, with very positive outcomes for almost every aspect of my treatment.  Except . . . .

I had participated in an immunotherapy trial and it appears that my supercharged immune system kicked off a rare side effect (one that probably isn’t too serious).  While we are early on in the immunotherapy revolution, thousands of people have taken the drug I was on, and only a handful appear to have had that complication.  That makes me more of a player in the “knowledge in process” game than I had anticipated.

But enough about me. 

What really interested me in Jones’ talk were the analogies that could be drawn to the business of investing.  He said that the “two most important values for any science [are] humility and curiosity.”  Investing is certainly less a science than medicine (despite all of the attempts to make it one), but the principle still applies.

As indicated in Jones’ stories of doctors talking to patients, confidence in the face of uncertainty can be comforting, but it’s also dangerous.  Setting up unrealistic expectations is an easy way out of difficult discussions about possible outcomes, yet that seems to be the standard fare in the investment industry.  We can run ten thousand trials based upon historical observations, but it doesn’t give us the future.  Pat answers are the province of marketing, not analysis.

Jones said, “I encourage you to seek humility and curiosity in your physicians.”  Similarly, I encourage you to seek humility and curiosity in your asset managers and investment advisors.  Those qualities are indications that they are ready to learn, not to tell you everything they already think they know.

the zero-sum game

In a brief but very influential 1991 article (“The Arithmetic of Active Management,” published in the Financial Analysts Journal), William Sharpe wrote that “the return on the average actively managed dollar must equal the market return.”

In a recent paper, Lasse Heje Pedersen of AQR challenges that assertion by noting that Sharpe’s arithmetic did not account for the addition and subtraction of holdings in the market portfolio itself.  Those changes “are large enough that active managers can potentially add noticeable returns relative to passive investors.”  That’s definitely an important distinction to consider, quite amazingly arriving as it does a quarter century later.

Setting that aside, it seems to me that Sharpe’s piece is most commonly misrepresented by those who apply the notion that “active management is a zero-sum game” in ways that don’t necessarily apply.  You see such assertions with great regularity in written material and hear them at most every conference where active versus passive is discussed.  For example, someone will say, “As we know, mutual fund management is a zero-sum game and therefore . . . .”

Sharpe tried to head that notion off at the pass in the original article, but his caveats are widely ignored.  His definition of “active” included everything that wasn’t “passive” (that is, holding the market portfolio), and he specifically pointed out that certain classes of active investors could outperform other classes of active investors and, indeed, passive ones.

He wrote that institutional asset managers could as a class outperform individual investors, each of which are included in his definition of “active.”  Pedersen picks up on that point by stating that “the most obvious reason that ‘informed active managers’ can outperform in aggregate is that they trade against ‘non-informational investors’ who are motivated by liquidity needs, institutional constraints, hedging, or are influenced by behavioral biases.”  (And then there are central banks – motivated by something else entirely – who have become leaders of a sort in the active corps of investors.)

It can be true that, in practice, the average pre-fee return for mutual fund managers is roughly equal to the passive return on similar categories of assets, but that is not a matter of arithmetic and is not preordained.  Nor is it true for all hedge fund managers or those who manage money for institutions or any other subset of the total.

There have been and will be categories of investors whose returns are greater than their fees for significant periods of time.  That’s an important part of the ongoing evolution of The Investment Ecosystem™; the places where value-added activity occurs within Sharpe’s broad definition of active investors changes over time.  The outsized returns eventually get worn away in any one category, as the history of mutual funds and hedge funds have shown.  Understanding how and why one type of investor has an advantage over another one during a particular stage of the ongoing evolution is key to assessing the character of the ecosystem as a whole and the opportunities that can be found within it.

The notion of investing as a zero-sum game is a worthwhile construct, but be careful of it being put forth in situations where it doesn’t apply.