Is Alpha Getting Choked by Philosophy Mismatches?

Is Alpha Getting Choked by Philosophy Mismatches?

by Jason Voss, CFA, CFA Institute

My entire series on Alpha Wounds is intended to provide solutions that can be implemented by anyone in the investment community to improve the returns of active investment managers for the benefit of clients. This month’s post focuses on choices over which the investment adviser has nearly full control. Specifically, I am talking about matching the culture of an investment management firm with its underlying investment philosophy. When culture runs counter to philosophy, even excellent fund managers are not allowed to fully execute their investment philosophies.

From Germination to Revelation

The genesis of this understanding came to me during a 2013 presentation by a fund manager who was at one point anointed “Fund Manager of the Decade” by Morningstar. I was all ears as I listened to him describe his ways and means of delivering outsized results. I am paraphrasing, but he said, “I wake up very early and digest the news from many different news sites. I check my e-mail for news alerts about the companies we own in the portfolio. I read the regulatory releases of each firm front cover to back cover. I conduct financial statement analysis and build discounted cash flow valuation models. I interview management and conduct on-site research as well as my own independent research.” And so on.

Notice something here? First, I have a sneaking suspicion that many investment managers do not do all of the above. But second — and surprisingly — there is nothing secret about the Fund Manager of the Decade’s process. In fact, if I asked each of you the cold question, “Describe to me the process of a classic value manager?” you would likely give me the same answer.

As I was listening to this fund manager, it occurred to me that, based on my own experience, a gigantic difference maker for me and my performance was having a firm culture that supported the investment philosophy. Here I am referring to the difficulty of implementing and executing an investment philosophy that is strongly in accord with the minds of its practitioners and is supported by value-added tools. When I asked the Fund Manager of the Decade about these things, he said, “Oh my God, that’s everything.”

Marketing the Philosophy

If members of the firm’s marketing department are compensated by commissions, then they also are incentivized to earn the next dollar of assets under management (AUM) without respect to whether that new customer fully supports the underlying investment philosophy. If the marketing department is working with wirehouses primarily, then, yes, you get scale in your AUM, but you get very little chance of ensuring the end investor trusts the investment managers to execute their philosophy over time. In the long run, this means that if the investment environment cuts against the grain of the philosophy, assets under management leave just as quickly as they came. In many cases, the aggrieved customer never comes back, or it is many years until they are open to the fund manager again.

What I propose as a solution is that wholesalers and other marketers of an investment firm’s products:

• Be extremely well educated about the underlying investment philosophies represented.
• Be compensated not just for securing new AUM, but for the longevity of those assets under management.
• Be supported by the management of the adviser so that marketers have the ability to turn away assets under management that are not aligned with the investment philosophy.

Governing the Philosophy

At most firms, the board of directors is not supportive of periods of under-performance from investment managers. Again, boards can be just as impatient as investors with poor performance — after all, the board works for the shareholders. Consequently, firms need to spend time educating their boards about the underlying philosophies. Additionally, when recruiting new board members, assuming the adviser has a say in such matters, it makes sense to find those who are committed to serving the best execution of the underlying investment philosophy.

It may sound as if I am advocating for boards stacked with sympathetic insiders, but I am not. What I believe is that even independent boards would like to be liberated from conversations at quarterly board meetings that do not serve the end shareholder. Instead, if the philosophy is clearly stated and the expectations of board responsibilities are well established in the board’s culture and aligned with that philosophy, then an independent board is actually more free to focus on what matters: execution of the philosophy in service to shareholders.

Caveats

Most assets under management are housed at gigantic fund houses, from BlackRock to Fidelity to Vanguard. In these cases, the opportunity to align culture with investment philosophy is more difficult, primarily because when there are more than 10 to 20 investment products, there are likely many investment philosophies represented in-house.

Also, these conversations should take place sooner rather than later in the creation of new products. For example, if you are an ace trader thinking of starting your own investment vehicle, put intelligence, wisdom, and energy into the creation of the entirety of your firm, not just in your investment process.

Summary

In conclusion, I believe that one of the drains on performance is hidden from public view: Namely, an alpha wound is self-inflicted when a quality investment manager must compete not just with other fund managers for returns, but for justification and philosophy implementation with her own marketing department and board of directors.

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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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