While symptoms in investment management indicate serious problems for our profession, numerous signs are that most of us are not paying nearly enough attention to the potential value of investment counseling to our professional success on which, of course, our business depends to be successful over the long term.
Investment management is in trouble as a profession now, and prospectively as a business, because investment performance is in trouble and investment performance is at the core of both the profession and the business.
For anyone looking at the business dimensions such as profitability, growth or acquisitions, this alarm must seem quite false. After all, the business is booming. But on the professional dimensions, such as client satisfaction and loyalty, the evidence for concern is rising. The troubles are getting worse, and several of the causal factors of trouble are interrelated and reinforcing.
Eventually, if the industry falters and stumbles on the professional dimensions, the business dimensions will also be hurt. Just imagine the economic impact of a return to the low fee levels that prevailed before the general acceptance of “performance” investing!
Analytic models from other disciplines can enable open-minded observers to see developments in their own disciplines anew and perhaps more clearly. Thus, navigators and medical doctors have had experience in their searches for understanding that can be useful for investment managers and their clients who seek to understand and manage investment performance.
Consider an analytic model from medicine. When they diagnose a disease, physicians differentiate quite strictly between two very different phenomena: symptoms and signs.
As doctors know, not all symptoms are linked to disease, and many others are only indicative. Some are psychosomatic and some are ephemeral. Even when symptoms are real, our doctors can be genuinely challenged to diagnose and isolate the true cause of the illness and estimate its future pathology.
Most diagnostic work is quite difficult. Long years of hard studies and many years of professional experience are vital to your doctor's success in making the correct diagnosis. Access to such powerful diagnostic instruments as MRI scanners has been transforming medical diagnoses as doctors shift from estimation and interpolation to knowing. Technology continues to transform medicine. The great advances of science in medicine enabled Dr. Lewis Thomas to say that, by about 1960, so much scientific knowledge had been accumulated about the nature of disease that science had finally gained ascendance over iatrogenic or doctor-caused diseases such as infections caused by doctors moving from one to another patient without adequate scrubbing-up after the first patient. After 1960, that doctors' scientific knowledge had become ascendant.
Navigation at sea has gone through a similar great progression. John Harrison's invention of accurate timekeepers for use at sea enable sailors to determine their longitude. (They could already tell latitude by their sextants.) This enabled Captain James Cook to sail throughout the Pacific on his great voyages of discovery and know where he was and how to get where he intended to go. Under Mathew Fontaine Maury, sea captains of the maritime nations undertook in the mid-nineteenth century the systematic worldwide collection of data on such influential variables as water temperature, current, and wind speed and direction. The carefully collected data were plotted on charts, and their patterns were analyzed. Soon the best routes for sailing to catch the most favorable winds and currents were plotted. The happy result was that long ocean passages became both substantially shorter and more predictable and safer. (U.S. Navy charts 150 years later still carry a legend citing the innovative work of Mathew Fontaine Maury.)
Fifty years ago, radar again revolutionized navigation. Sailors could “see” the coastline and other vessels in thick fog or heavy rain or darkness. Then came SONAR for depth measurement, and then Loran. Today, global positioning satellite systems (GPS) take navigation even farther. Navigators can now locate their positions anywhere on the surface of the globe and at any level above or below the surface—with accuracy to within one square meter.
In addition to keeping sails trimmed, sea captains took responsibility for plotting optimal courses across the seas for safe passage, and eventually for on-time arrivals. In addition to relieving pains, medical doctors took responsibility for preventative medicine and for curing more and more diseases. In each case, the transformation in capability has converted the nature of expectation. We now expect doctors to diagnose a remarkable range of diseases, and we expect on-time arrivals.
The same transformation in ability to know where we are and to know how to get where we intend to go has been developing an investment management. The tools available are advancing rapidly in their ability to be specific. Just one generation ago, Longstreet Hinton, distinguished head of the Trust & Investment Division of Morgan Guaranty Trust, would respond with confidence in his warm Vicksburg, Mississippi, voice to General Motors' senior financial executive's question about how GM's large pension fund was doing, with the genial and clearly conversation-ending comment: “Everythin' is comin' along jes' fine.”
With research led by economists at the Cowles Foundation at Yale, and the Merrill Lynch Center at Chicago, comparisons to the S&P 500 became widely available by the early 1960s. The 1970s experienced A. G. Becker's ubiquitous comparisons of individual funds to dozens of other funds of similar size without, however, any regard for the important differences in asset mix, investment strategy, or objective. By the 1980s, numerous carefully defined and constructed indexes were available, and a particular fund's performance could be measured—asset class by asset class—relative to any of several benchmarks.
Today, rigorous and detailed analysis of beta, alpha, Sharpe ratios, and performance relative to virtually any specified benchmark is part of all careful studies of performance attribution. As a result, investment managers and their clients can now know exactly where a particular portfolio is positioned relative to the market. And they can know how that portfolio would be expected to perform, given any reasonable scenario of future market behavior.
This progress brings us to the central contemporary challenge. The tools of analysis now available to both managers and clients are so good that they convert the challenge from answering “Where are we now?” to asking instead, “Where do we want to be and exactly how do we plan to get there?” Since clients can now get what they ask for, explicit and exact definition of a manager's intention is all the more important today in evaluating the manager's actual achievements.
Investment managers and their clients need to differentiate between the investment equivalents of medicine's symptoms and signs and act always on the enduring, objective data. In defining and understanding investment objectives and in evaluating investment performance, investment managers and their clients need to know how to discriminate between data that convey real information and data that are only noise.
If clients focus on symptoms, managers may be tempted to manage the symptoms. The most common way managers manage the symptoms is by changing the period over which performance data are reported and discussed. (In ice hockey, every defense player soon learns the great lesson about covering skillful forwards: Don't watch the eyes or the head or the puck or the stick—or even the hands. Watch the hips, because skaters have to go where their hips go.) Dominance of performance data, as we all know, is very powerful when skillfully manipulated. (Examples are sadly abundant in reports of mutual fund “performance” in advertisements. In the early 1970s when pollution was fast becoming a public concern, the jets taking off from LaGuardia came under pressure to stop dumping the thick exhaust spewing out of their engines, seen as a blatant disregard of the public. The problem was quickly solved by chemistry—no more black exhaust smoke. Yet the real polluting was not eliminated at all because the chemicals that were added to make the exhaust invisible actually increased the pollution. But the symptom was “solved,” and consumers stopped protesting because they thought they'd won, when actually they'd lost.)
Of course, symptoms are inherently evident, or they wouldn't be symptoms at all, but they are not necessarily useful information. When we discuss performance, we must ask the classic vaudeville question: “Compared to what?” We now know it's crucial to specify the relevant peer group or standard and compare results to that standard. Being ahead of or behind the S&P 500—which 25 years ago was an attention-grabbing major revelation—is now recognized as nothing more than an artifact. The real question is whether the manager is ahead of or behind the specific agreed upon benchmark.
Good investment performance is not simply having favorable outcomes; it's at least as important to have achieved those results in a deliberate, predictable, repeatable way so the favorable outcome is expectable in the future. That's why conformance to intention is at least as important as performance. As the great sports coaches tell their teams: “Plan your play, and play your plan.”
Conformance means diligently playing with the investment manager's known field of competence, adhering to the manager's chosen discipline, and conscientiously avoiding what tennis players call unforced errors which cause players to lose to opponents whose playing is more steady and consistent. Conformance also helps eliminate the vagueness that so often confuses the discussion at investment review meetings. Conformance obliges managers and clients to focus on developing and specifying investment objectives and investment policies.
Fund executives' informed evaluations of an investment manager's ability to produce expectable and predictable operational investment results depend upon collecting and using large enough or long enough samples for statistical validity. (An equal concern is with appraisal periods that are too long, such as mutual funds that create their “performance records” before their assets ballooned.) Realistically, quarterly and annual performance results are only very small samples from the continuous process of managing portfolios over the long, long term. Small samples are notoriously unreliable. (My favorite illustration is the story of the English anthropologist returning from his eighteenth-century expedition to study the natives of America. At the Royal Society's annual dinner at London's Mansion House, he rose and began his personal report with the solemn declaration that, “In North America, all Indians always walk in a single file.” (Pause.) “At least the one I saw did.”)
As any Bayesian statistician would gladly explain, hyperactive clients who make decisions to hire and fire managers on short-interval performance data are taking a big risk of sampling error. Too many fund executives and investment consultants appear to compromise the validity of their performance data by relying on periods of time that are far too short.
Experience confirms the concern. For all too many funds and for all too many consultants, the average manager they fire outperforms the average manager they hire as a replacement. It's all about the dangers of underestimating the powerful tendency toward regression to the mean. The “data” most investors use to evaluate investment managers are not sufficiently robust—and so are not very helpful. Institutional investors know from experience, and the data confirm the same or worse for individual investors in mutual funds. Recent years' performance simply does not accurately or reliably predict future performance.
The secret for success in evaluating investment managers is for fund executives (and their consultants) to be careful not to pay too much attention to symptoms, useful as they can sometimes be and instead, to focus on signs and the real causes of underperformance.
In evaluating investment managers, here are some of the serious symptoms we all know to watch for:
It really makes no difference whether the manager's results are more or less favorable than the benchmark: If the manager is out of zone, that's what matters. For a driver, being off the road on the left is as bad as off the road on the right, just as too far is as bad as too short in a game of ring toss. The agreement between manager and client has been broken. Infidelity is infidelity.
Wise clients note that investment performance, like learning languages or negotiating peace agreements, does not come in smooth, steady, consistent increments, but in irregular surges, followed by periods with no visible gains. Similarly, the stock market makes more than 80% of its gains in fewer than 20% of its trading days. And most superior managers achieve the great majority of their superiority over benchmark performance with a small minority of their investments during just a few quarters.
So, too much attention to the current performance numbers or to passing symptoms can be very misleading. (That's what political powerhouse Mark Hanna had in mind when dismissing a contemporary politician by saying, “He had his ear so close to the ground it was full of grasshoppers!”) If the symptoms persist, however, they will in aggregate be equivalent to signs.
In investment management, some of the signs are external or environmental, and some are internal to individual managers. As the period over which results are measured is extended, more managers will fall short, and the persistence and magnitude of the average shortfall will be greater.
Without dwelling on the sobering realities, here are some of the signs that indicate not a universal inevitability but an increasingly high probability that increasing numbers of clients will see their managers produce results that fall short of the overall market. (Note that the larger the manager, the more numerous the clients and the greater the probability of underperformance. As a result, the experience of clients, on average, will be worse than the experience of managers.)
Consider that in a single generation the market has been transformed. The market now reflects the well-informed judgment of professionals. The old 10:90 ratio of institutional trading versus individual trading has been completely turned upside down. Today, institutions control 90% of NYSE public trading. This is why market makers have grown more cautious and more disciplined about risk management and hedging with derivatives. And with 50% of all New York Stock exchange transactions executed by the 50 largest and most active professional investors, the natural spreads in the stock market are getting tighter and tighter.
The margin for error has steadily become smaller and is still shrinking; the penalties for error are greater, and they hit faster. With institutions dominating the market, the market becomes more and more efficient. So, errors in pricing and in valuation are fewer and briefer in duration because more and more information is known faster and faster to more and more active investors.
Extensive, expert, and well-crafted as it is, the dominating information and analysis coming from Wall Street is shared so broadly and so rapidly that within hours of its discovery, most research has already become the “ultimate value-free commodity” because everyone knows it, it is already in the market price.
Managers with high turnover are particularly affected by tighter markets, so playing the “money game” is less rewarding, and staying out of harm's way is increasingly important. As we're all advised when playing poker: “If after 20 minutes you don't know who the game sucker is, chances are you are.”
As the years go by, active funds have become less and less likely to be rewarded by getting a jump ahead of competitor funds just by acting more quickly on fast-breaking information when so many institutional investors know what can be known and are equally swift to take action.
Hugging the index leads managers to overdiversify portfolios, and hold too many different stocks to be able to have superior insight or make better decisions than their peers who now dominate market activity and prices. In addition, dutifully matching the index can make portfolio managers replicate the index willy-nilly. When a few very large companies' stocks selling at very high price/earnings multiples dominate the overall index (as was the case in 2000), this infuses extraordinary unintended price speculation into the index.
Excessive activity runs up the annual operating expense of executing transactions. Not only does this impose significant frictional costs on portfolio results (plus short-term taxes on taxable funds), but it also raises the specter that institutional investors are scrambling to outwit or outguess the other institutional investors who all share most of the same information and dominate the quick response price-setting of the stock market.
Who would argue that such a quick-on-the-trigger activity is investing—and not speculation? And if it is speculation, it's a risky kind of speculation: not on corporate developments, but on the probable market reactions of other institutions as they anticipate each other. The transaction costs of high-turnover portfolio operations can easily exceed the net benefits of all that activity, the recognized cause of the Loser's Game.
Fees and costs have doubled over the past 30 years for mutual funds and institutional funds. In a 15% annual rate of return “cornucopia market” environment, the steady increase in the rates charged by investment managers may not have been given particular notice, but if annual returns were to fade to an average of 6–8%, who would not notice the large fraction of that average return going as fees to the managers?
The real costs of portfolio management will be better understood when clients learn to compare fees not to asset managed or even to total returns, but to incremental, risk-adjusted returns. Very few managers add so much value over a decade that their fees on this basis are under 50%. For most managers, their real fees on real value-added are in excess of 100%.
The aggregation of these several signs leaves little mystery as to the general trend of the investment management industry. While varying considerably from firm to firm, the overall trend is toward both increasing difficulty for investment managers and increasing disappointment for clients.
The investment management profession needs to recognize the risk of courting an inevitable shortfall in results and client dissatisfaction, by continuing to claim to clients that “our mission is to achieve superior operational performance,” which a majority of managers over and over again confirm to do. We can and should be concentrating on the classic, but all too neglected mission of astute investment counseling—where we can surely succeed with major benefit for our clients.
Investment counseling on long-term goals and appropriate investment policy and asset mix is our true professional calling. When the right goals and objectives have been defined for each particular investor, and appropriate investing policies have been worked out, operational implementation via indexing is both inexpensive and achievable and beneficial.
The genius of this past generation has, ironically, transformed the challenge for investment managers and their clients from finding ways to “beat the market” to learning to accept market realities as a given and to make the best of this by making explicit the important choices about long-term objectives and asset mix.
Those who accept the challenge and the opportunity will be shifting from the craft of money management to the profession of investment counseling, and from nearly inevitable losing to assured winning.
Source: The Journal of Portfolio Management, Summer, 2002.