Michael S. Falk, CFA, will be moderating the panel, “Asset Owner Perspectives: Positioning Investment Portfolios for the Future,” with Dhvani Shah, CFA, and Peter Lindley, on Wednesday, 30 September 2020, from 2 to 3 pm EDT.
“The enemy of great is good.” — Jim Collins
Many businesses are fine with “good enough.” They aren’t willing to go the extra mile to make themselves great. With the rise of index funds and exchange-traded funds (ETFs), however, good enough is no longer an option for active investment management firms. Survival requires that they make the leap from good to great.
The question is how.
At Focus Consulting Group, we examine everything investment management firms do, from their investment philosophy and process and execution (PPE), to their culture and strategic planning, and beyond. On PPE projects, we observe investment teams over several days, seeing how they work and make decisions. How do they generate ideas? How do they vet them? What are their investment processes? How are the teams composed? How are decisions made? And, how do they pursue continuous improvement?
What we typically find are firms whose processes and capabilities are already pretty good, but that have some room for improvement.
When I began this work several years ago, this wasn’t what I expected. I expected a broad distribution of managers — some that do a lot well, others that need help in lots of areas, and many falling somewhere in between. Instead, for the most part, investment managers concentrate their efforts and talents on one or two aspects and leave others largely unexamined. For example, many firms do good research and buy pretty well, generating a solid “batting average” at the security level, but their portfolio construction and turnover habits may come up short.
Ultimately, the investment management process can be broken down into five distinct components, each of which can and should be evaluated and improved.
1. Team Structure
Although the term “diversity” has become en vogue in many corporations in recent years, we find it a bit too generic to be useful. Teams should seek cognitive diversity so they can approach complex problems — i.e., forecasting the future — from a wide variety of perspectives. An Enneagram Assessment of each team member is our preferred method of measuring cognitive diversity.
Diverse teams reduce the potential for blind spots and have higher collective intelligence (CI). CI is further expanded through gender diversity. Keep in mind that diversity still requires alignment, so make sure the team is in sync on the investment philosophy — what will win — and the means of accomplishing it.
2. Decision Rights
Decision governance is an often overlooked feature of the investment process. Who gets what say in decisions? Effective decision governance is less about a single best practice and more about leveraging higher CI and clarity on how decisions will be made. With clarity, teammates avoid becoming “sideways” with each other. It is up to the chief investment officer or portfolio manager to define this clarity.
Clear decision rights lay out who is responsible for what and help achieve buy-in from those involved in the process. Such clarity creates the structure and trust necessary for teammates to be open and honest with one another and ultimately improves team decisions. The size of the decision-making body has some bearing on decision quality as well: We’ve found the optimal size to be four to six diverse people.
3. Investment Philosophy and Buy Discipline
What distinguishes investment managers from one another? Some of the best have an elegant yet simple philosophy. Others may have a unique approach to idea generation, modeling, or valuation. Some stand out for their top-notch execution or patience. Whatever their value add, all teams focus on what they believe gives them their edge (when they believe they have an edge).
This philosophy is represented by the buy discipline. This often correlates with manager skills around buying securities. In the case of US equities, there are about 3,600 public companies at the moment. Firms have different philosophies on where to focus and are typically defined by market cap or style, such as large-cap growth or small-cap value.
Of course, every investor must whittle down the total universe to only those that fit with their philosophy. These securities can be distilled through experience or, more constructively, through screens designed to identify those with the characteristics that correspond to the chosen philosophy.
If you manage a 60-stock portfolio and average 33% annual turnover, then you need about 20 new ideas each year. If you have a big team, filling that pipeline may not be an issue. On a smaller team, idea generation may pose a bigger challenge. Either way, not every proposed idea will make it into the portfolio. You may need far more than 100 ideas to get down to the 20. So make sure the team respects its productivity needs.
A critical part of the buy discipline — getting names into the portfolio — is the counterargument. Why shouldn’t we invest in this? We recommend designating one team member to play devil’s advocate (DA) for each pitched idea. Keep in mind, decision meetings work best when participants have all the relevant material at least 48-hours in advance, and that a good DA is someone the idea pitcher knows is both skilled and tasked with blocking the buy. This keeps the pitcher from taking offense.
The DA role should rotate among team numbers for two reasons: Nobody should be painted as always being THAT skeptical and because playing DA builds analytical skills.
Of course, all of this whittling down produces a wonderful trail of data. Investors naturally look at how their portfolios perform, but it’s also worth tracking the performance of the securities not bought. The first lesson is that if the screening process is reliable, its output should be monotonic: That is, the top decile results should outperform the second decile and so on for your key factor. This analysis can help identify weaknesses in your screening process. There is also tremendous value in assessing the performance of each filter in the funneling process.
How did the investable universe perform? How did the firm’s screen output perform relative to the investable universe and the actual firm’s portfolio? How did the names researched but not chosen perform? How did the names that passed the screen but were not chosen to research perform?
These questions merit answers and the answers are both attainable and help teams get better. These reviews are improvement techniques.
4. Size-and-Sell Processes
Once an investment decision — to buy — is made, the investment team makes a number of other choices, ranging from the target portfolio allocations to benchmark-relative weighting considerations and, ultimately, selling decisions. Each of these choices produces a stream of data that should be analyzed. Is your team buying well and sizing poorly? Is it chronically early or always late? How have its sell decisions performed in terms of both losers and winners?
In short, investment operations produce all sorts of harvestable data that can be analyzed for potential sources of alpha. An, if data science isn’t a strength at your firm, build it or buy/rent it from a service provider. Yes, these types of vendors do exist.
5. Ongoing Assessment and Improvement
Most investment operations appreciate the importance of continuous learning. However, they tend to direct those efforts outward, toward companies, industries, market behaviors, monetary policy, etc. They spend much less time looking inward to improve their operations. This oversight gives an advantage to those that do incorporate ongoing self-assessments using their own data and build systematic learnings by tracking differentiated process portfolios. For example, you could track an equal-weighted version of your actual portfolio to learn how your active sizing influences results.
Arguably the best way to learn is for the team to gather— after sells — to conduct a post-mortem on what was learned or could have been learned. This requires decision tracking. Over time, the buy rationales and key decision comments need to be saved for review at the post-mortem session — an annual day of learning, for example — to prevent hindsight bias from distorting the potential learnings.
Evidence-Based Investing — How Much Evidence Do You Have?
One of the great ironies of the investment business is that it is full of intelligent and creative business analysts who rarely focus their analytical skills on their own teams. Nothing lulls a team into complacency like decent profitability. But amid the growth of indexing and the ever-changing nature of today’s dynamic market, good enough is no longer good enough.
Each aspect of your investment process deserves your full commitment. Strengthening them — and committing to continuous improvement — is how investment managers go from good to great.
Your clients are counting on you — and so is the ongoing relevance of the active management industry. So don’t delay.
For more from Michael S. Falk, CFA, don’t miss Let’s All Learn How to Fish . . . . to Sustain Long-Term Economic Growth, published by the CFA Institute Research Foundation.
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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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