Since a fair number of essays on this site deal with that question in one way or another, I had plenty of material from which to choose.  My answer,[2] in a nutshell:  Don’t go looking for the best analysts in rankings of those with the best statistical performance over some limited period of time.

Despite the fact that performance derbies in every corner of investment endeavor inevitably lead to performance chasing and bad decisions by individual, institutional, and professional investors alike, decision makers persist in thinking that numbers and rankings tell us something that they usually don’t.

That said, it was worth noting that Morningstar analysts showed well in this year’s WSJ derby.  Most readers probably don’t even think of Morningstar as being “on the Street,” but it has been providing equity research to its clients for more than a decade.  (I conducted due diligence on the firm’s research product over a multi-year period as a part of the Global Research Analyst Settlement.[3])

An article[4] accompanying the survey covers the basics of the Morningstar methodology, which is much different than that found at almost all of the other firms that have analysts represented.  Every approach has its weaknesses, including Morningstar’s, but the firm tries to negate the effects of one of the most prevalent and damaging research flaws:  Analysts tend to lose sight of the value of a business in the fog created by current market pricing.

To avoid that, by design Morningstar’s approach leads to a less attractive rating as a stock price moves higher and a more attractive rating as it moves lower (assuming the estimate of the fair value of the firm remains the same).  It is a value strategy, not a momentum one, which may or may not be for you, but it is clearly defined as to what it tries to do and what it doesn’t try to do.

Discipline is key, whether you are a value player or a momentum player, and Morningstar has tried to provide a structure that manifests its philosophy.  A well-executed momentum approach would do the same.  The classic problem for sell-side analysts is that they get caught without a workable framework to guide them through the ups and downs of markets.

They (and the philosophies of the firms they represent) tend to be neither value nor momentum in a disciplined way — and they can be very susceptible to a risk inherent in the growth investing philosophy.  Namely, at times when price momentum in a stock has waned and value cannot be found, the disciples of those approaches (each which has support in the academic literature) don’t play.  Growth investors and Street analysts often do.  The tendency for each group is to wait too long for their faith in a story to play out.

Don’t be charmed by rankings of analysts.  Unless you have years of information and measure analyst output in several different ways, you’ll likely come to the wrong conclusions.  Spend your time instead trying to understand how analysts and firms say they will make their decisions, monitor them to see whether they adhere to that philosophy, and decide whether their approach fits how you think about the world and want to invest.

That is how you’ll find the best analysts for what you are trying to do.

There was a fair bit of discussion about the traps that individuals can fall into and the dangers they run competing against professional investors.  I interjected that those professional investors are prone to the same behavioral errors as individuals — and that a good investment process should be designed to minimize them.

A day after that exchange I left on a trip, bringing along Fund Management: An Emotional Finance Perspective, a monograph published by the Research Foundation of CFA Institute in 2012.[2]  It speaks directly to the issues that I raised and is an eye-opener for those who think that fund managers operate apart from the emotional fray.

The authors, David Tuckett and Richard Taffler, started with a simple question:  “What is it like to be a fund manager?”  Emotionally, that is.  To find out, they conducted in-depth qualitative one-on-one interviews, which are uncommon in the study of finance.  (I admit to a bias in favor of their method, since that is at the core of how I analyze investment organizations.)

Someone who has been in the business for a while will find himself nodding in agreement at many of the passages, recognizing his own experience (and being quick to identify the behavior of others).  For example, the relative performance game that most asset managers are playing leads to a different kind of emotional framework than a manager’s client is likely to have.  The manager is insulated to a great extent from the jarring impact of large losses in absolute terms, instead having a focus on relative positioning that results in competing anxieties — caused by straying away from consensus on one hand or clinging to it on the other.  (And if the manager has a nice lead on his benchmark as the end of the performance review period approaches, he might just hit “the index key” and lock it in.)

Much of the book is about the storytelling that permeates the business and its role in the emotional life of a fund manager.  The authors quote another academic study that said that the work of fund managers is in essence “an interpretive or sense-making process,” adding that “brokers, consultants, public relations firms, journalists, economists, and just about everyone else in financial markets” are, in fact, telling stories to each other day in and day out.

These stories fall into the classical types, with epics and tragedies being dominant, the epics told by managers (to themselves and to others) about the triumph of analysis, while the tragedies involve some random outcome that would have been impossible to foresee.  Interestingly, the authors see these stories as coping mechanisms, helping professional investors make some sense of an uncertain world.  When we win, it’s an heroic effort; when we lose, the fates of market life have done us in.

Frequent players in these stories are the corporate managers that lead the companies in which portfolio managers invest.  Attempts are made to sort “good” managements from “bad,” although as relationships develop between the parties, it becomes harder to be objective.  Ultimately, the most powerful relationships can develop not with the managements, but with the investments themselves.  Fund managers fall in and out of love with these “phantastic objects” (see the explanation of that spelling on page 85) over and over again.  (In turn, investment managers can become phantastic objects themselves, gurus to adoring investors until their performance disappoints.)  All of this would sound like psychobabble if it weren’t so recognizable.

As told through the words of interviewees, the authors document the ways in which the emotional lives of investment managers in response to the task at hand lead to actions that fit neither standard financial theory or the expectations of other investors.

The monograph touches on screen watching, obsessing over performance, the disconnect between client expectations and stated beliefs, distortions from incentive structures, cycles of giddiness and despondency, the “stories” of quantitative managers, career risk, “groupfeel,” and the difficulty of doing something truly different.  That may seem like a lot, but the monograph is less than a hundred pages.  It should be read by all chief investment officers and other leaders in the industry, but I fear it will be read by very few, because it relates to the “soft” aspects of the business, which tend to be assumed away rather than acknowledged.

Even if you don’t buy the thesis of the authors, the words of the fund managers themselves can be striking.  The most memorable for me were from one who avoided the WorldCom and Enron disasters because he had “ploughed through the numbers.”  But he missed the upside before the fall and the underperformance (and pain) from not owning them when they were winners is what he remembers:  “They hurt me forever.”

Tuckett and Taffler believe that the “emotional triptych” of greed, fear, and hope thought to be the drivers of investment decisions don’t describe what’s really going on, that we are instead motivated by excitement, anxiety, and denial.  Their monograph describes an emotional finance that is rarely discussed but critically important.

As we say in my house, “There’s a lot of that going around.”

Models can’t capture reality, but they can provide a framework for examining it and for making investment decisions — yet a framework is not a formula, and you don’t need to kneel at the altar of a model to find something of value in its use.

What models don’t do is give easy answers, yet that’s what’s apparently expected of them most of the time.  A couple of examples I’ve witnessed of late:

A representative of a large pension plan explained a series of shifts into so-called alternative assets by stating that all of the moves “reduced risk in the portfolio.”  No assumptions were given and no broader examination of the meaning of “risk,” just that definitive statement, apparently because the changes led to a statistic in a model being lower than it had been before.

Another institutional investor said that a recent review had found her organization’s investment strategy to be “just about on the efficient frontier,” as if that was a place where you could set out a chaise lounge and order a margarita.  The tweaking of one little assumption would cause her to appear to be in another place altogether.

These tendencies are not limited to asset owners, of course, or any other branch of the investment tree.  Research analysts trumpet conclusions without context, be they based on the simplest arithmetic or the most complex DCF calculations.  Portfolio managers do too.

That is to be expected — if we reported and debated every assumption in every interaction, we’d never get anything done.  But the answer to that reality is not to avoid a discussion of the caveats, but to figure out how to properly communicate them, even though doing so can wreck “the illusion of certainty.”[1]  And, to deal up front with the really big assumptions that are at the core of a critical analysis.

It is especially important — and especially difficult — to do so when working with individual investors.  In a recent posting, Tadas Viskanta talked about the virtues of “sticking to a plan in the face of emotional volatility.”[2]  That’s very true — and a great financial advisor is an expert at providing the behavioral bumpers that can help a client stay on plan.  But what if the plan is based upon a questionable model or unwise assumptions?  That is the case all too often.

A financial plan that uses historical inputs without a buffer of safety invites danger and increases the chances of behavioral freakouts.  Yet, so many plans are based upon those inputs, without questions being asked about what the return assumptions ought to be,[3] how to handle the reality of migrating correlations,[4] or whether standard deviation is the embodiment of risk.  A mean-variance model that uses those inputs is not a bad tool, it’s just wielded inappropriately a lot of the time.

In defined contribution plans, the explosion of assets in target-date funds has been supported by the “comforting metaphor”[5] of a “glide path” into a well-funded retirement.  If only it were all as easy as we are led to believe.  Not only do most participants not see the complexities and pitfalls of the model — neither do many of the plan sponsors.

If we are to plug and play, let it be in an exploratory fashion, so that we can see the strengths and weaknesses of our methodologies.  Not one set of numbers into one model to get one answer, but multiple (wide-ranging) scenarios, seen through different lenses, to help us picture the undulations in the terrain that we must traverse — and to help us ask the key questions along the way.

Given the appetite for the illusion among the investing masses, a portfolio manager who is seen to wear the cloak of greatness has an easy time conjuring up a winning story.  Bill Gross would be one that could fall into that category (and he is good at talking his portfolio at times[2]), but his latest commentary casts the cloak aside and reveals the illusion.[3]

In short, Gross raises doubt about his numbers and those of other investment legends “that purport to show how much better an individual or a firm has been than the competition.”  As for greatness, “I must tell you, after 40 rather successful years, I still don’t know if I or PIMCO qualifies.”

You can say that it’s false modesty, but his point is cogent and almost never broached in investment discussions.  That is, that we may have just been through “the most attractive epoch” to manage money, one fueled by a great credit expansion (and a succession of Federal Reserve puts).  When — if — it changes will be the real test of greatness of a manager, Gross believes.

It is a remarkable commentary.  Gross pokes fun at his own image, for one thing, and also highlights PIMCO’s ability to sell volatility and earn carry as keys to its success, the emphasis probably a surprise to many of its investors and their advisors.  But, most importantly, he questions our assumptions about expertise in the financial markets.

A day before his piece came out, I had read a seminal paper by Daniel Kahneman and Gary Klein called “Conditions for Intuitive Expertise.”[4]  The authors come from different points of view to ask the questions:  “What are the activities in which skilled intuitive judgment develops with experience?  What are the activities in which experience is more likely to produce overconfidence than genuine skill?”

Klein is a scholar of naturalistic decision making (NDM) and Kahneman is famous for his study of heuristics and biases (HB).  Their bodies of work seem to be at odds, and the paper effectively summarizes the points of difference and agreement.[5]  Where the NDM canon sees the ability to develop expertise, Kahneman talks of the “illusion of validity” (speaking of illusions), for “the unjustified sense of confidence” that often manifests itself in those with experience, without regard to whether the situation warrants it.

The common ground for the authors is that the degree to which expertise can be relied upon depends on the nature of the environment for decision making.  In their eyes, investment professionals face a hard reality:  “Long-term forecasting must fail because large-scale historical developments are too complex to be forecast.  The task is simply impossible.”  That plus overconfidence spells trouble, as the markets are one of those “wicked environments” where feedback is misleading, luck plays a huge role, and plenty of new errors are there for the making.

Perhaps we could learn from those in other fields whom Klein has found to show consistent skill.  They “typically resist requests to make judgments about matters that fall outside their area of competence.”  (That doesn’t happen much in the investment arena.)  And:  “People in professions marked by standard methods, clear feedback, and direct consequences for error appear to appreciate the boundaries of their expertise.”  Our profession doesn’t have those characteristics, yet all too often we don’t acknowledge or heed the boundaries that exist.

As purported mavens of the market, we operate in a wicked environment, one that fools us and allows us to fool others as to its reality, intentionally or unintentionally.[6]  Gross would have us think that an even more wicked environment might face us in the future, that what we have experienced of late is as good (or as easy) as it gets.

Whether or not that is the case, the words of these three men, two academics and a practitioner, argue for a clear-eyed view of the nature of expertise.  The environment demands it.

Ironically, the words I read had been written by John Hempton, who was the subject of one of the essays in that series.[2]  They are:  “In money management what sells is the illusion of certainty.”

I was jolted out of my previous writing plan by that phrase and the one that followed, which said that “a fund manager who tells the truth (the truth being that he may be wrong at any time) is a more-difficult sale but a better investment.”[3]  I was not at all shocked by Hempton’s statements; in fact, I realized that in one way or another they reflected a theme that I deal with all the time.

For reference, you should know that I write about and offer consulting services to many different parts of the investment ecosystem.  In a world of specialists, I am a generalist, connecting the dots across the industry for the benefit of readers and clients.

So, if “what sells is the illusion of certainty” and I’m working with an asset manager, should I encourage them to be illusionists and add to their assets under management?  To craft a narrative that brings in the assets while not fully painting the picture of what they do and what the investor might experience?  I’m sorry, I just don’t have it in me.

I remember my father (who sold financial products) telling me that if something is sold right, the client should understand what could occur across a range of scenarios.  They might be disappointed when bad things happen, but they have been prepared in advance.  That preparation makes for a harder sale, but a more honest one and a better one — the assets are stickier because they are there for the right reason.

A portfolio manager who is marketing to institutions might have a few chances a year to land a big account.  Managers are taught to stick to a script (although many have a hard time of it), a script that shines a rose-colored light on the firm.  The goal is not to educate the client — and usually not enough time is allotted to do that anyway — the goal is to win the business.

Investment advisors working with individuals are presented with the same dilemma.  Their practice management metrics will all look better if they can offer a stylized version of the investment world versus the messy one that actually exists.[4]  Who wants to talk about uncertainty when a plan can look so tidy without it?  And can a financial advisor be comfortable saying, “I don’t know,” even if that is the real answer?[5]

Therefore, those on the other side of the table — the buyers of investment services — have to bear the burden of the search for true understanding.  That means peeling off layer after layer and looking for good questions rather than pat answers.  Yet most buyers are not up to the challenge, lacking both the investment experience and the emotional fortitude to explore the dark corners of possibility on the investment horizon.

Just this week, quite by chance, I have discussed these dynamics with people that play each of the roles referenced above.  It is inescapable for me to conclude that the illusion of certainty drives many of the issues that the investment business faces today, which is why Hempton’s words hit so close to home.

If the CEOs have been unaware of this practice, they didn’t see the natural convergence of two factors.  First, “management access” has vaulted to the top of the lists of services that buy-side firms want from sell-side firms.  Second, the sell-side has always figured out a way to get paid (and paid well) for the hot product or service of the day.[2]  And, let’s just say unforced disclosure is not the firms’ strong suit.

The payments are sometimes “hard,” that is, coming from direct payments to the brokers.  At other times they are “soft,” a part of the pool of commission dollars that asset managers pay to execute trades above the normal rate — or just hidden in the overall bundle of services paid for by commissions.  (Yes, if you are a client of those asset managers, the assets being spent are yours.  They may or may not be spent wisely.[3])

The immediate reaction (United States version) is, “What about Regulation Fair Disclosure (Reg FD)?”  Among other things, its rules were intended to prevent corporate managers from selectively sharing material nonpublic information with certain favored analysts and investors.  So, if someone is paying $20,000 an hour for access, they believe that Reg FD won’t be effectively enforced and/or that CEOs leave a trail of analytical breadcrumbs to find a way out of the forest of shared knowledge to that paradise known as alpha.

(As for United Kingdom reaction to the story, how brazen is it that the practice has continued despite regulator warnings, as seen in Integrity Research’s October posting, “UK Challenges Management Access”?[4])

Having been in many one-on-one or small group meetings with CEOs (although not for a while), I understand the benefit of being able to quiz them.  How do they answer questions?  What don’t they know?  What makes them uncomfortable?

There are concrete answers that matter and numbers galore that are cited.  Those schooled in the financial models of the companies might hear a fact that seems foreign and figure out what that means for the analysis.  But often the best hints come from the words used, the body language tells, and other touchy-feely things — not exactly the strong suit of most investment analysts.

So, whether I paid a hefty fee to a broker to have access or got it for free, I’d want to have people in the room that looked at the world from different angles, to triangulate and dissect the story.  That’s pretty uncommon in my experience, given that most investment professionals are cut from the same cloth, have similar points of view, and aren’t trained in conducting interviews or observing behavior.

On the other side of the table, CEOs should eliminate the middlemen whenever possible (which is most of the time).  They should focus on meeting with investors who have the potential to be long-term shareholders, while diversifying their base of relationships in the investment community.  It is easy to have brokers make the arrangements, but what value do they add, really?  Whether they are being paid directly or just getting points that will turn into commissions down the line, they are monetizing access to managers that companies can provide for free.

The face time between managements and investors offers opportunities and risks for both sides.  As for the other guys in the room, who needs them?

This is the eleventh in a series of postings on topics related to equity research.[5]

My previous postings included a background piece about research departments at asset management firms and the rationale for analyst-run funds;[2] the complications and considerations that come from having such a fund (including the possibility of “the research-fund tail wagging the research-function dog”);[3] and a chart with commentary regarding some of the leading research-based funds.[4]

The paper by Cici and Rosenfeld begins with an introduction that says that despite the importance of analysts, “we know very little about their abilities and the role that their research plays in their respective fund families.”  The authors, of course, mean that there hasn’t been much work by academics to understand what analysts at a buy-side shop do and how good they are at it.  (One nice feature of the paper is that it references other studies of interest, but in comparison to the huge number of papers on sell-side research,[5] there haven’t been many at all that focused on the buy-siders.)

Those of us that study the research process might feel that we understand it in a qualitative way, but some of the most important skills of analysts defy measurement and it is common for the leaders of investment organizations to have trouble articulating how their analysts’ work is different or better than anyone else’s.

In considering the working paper, my standard caveats apply:  I don’t question the statistical methods or check the math.  I think about the ideas that are put forth and the conclusions that are drawn — and look for analogies and anomalies between them and my own observations.

The basic approach of the professors involved evaluating the performance of the analyst-run funds in comparison to other funds (that are not managed by analysts), both at the same fund family and elsewhere.  The bottom line was that the research funds did well in comparison.  That finding went against the expectations of “common wisdom” and the Human Capital Theory, which would argue that portfolio managers, being more experienced than analysts, should outperform them.  (The list of possible explanations offered by the authors is interesting.[6])

To further study the organizational dynamics involved, the professors also gauged how extensively portfolio managers used the ideas of analysts that were in research funds — what they called the “analyst idea utilization ratio.”  There was a great variability in that utilization, with evidence that higher-skilled managers (as defined by past performance) use the specific ideas less than do other managers, sourcing more positions in other ways, although their performance was only on par with the analyst-run funds.  Those that use the analyst ideas to a greater extent actually lag, perhaps because “they either pick the worst analyst ideas or poorly weight those ideas in their portfolios.”

Their analysis also led Cici and Rosenfeld to “believe that the quality of investment decisions undertaken by analysts in their management of analyst-run funds can be viewed as a reflection of the research capability and strength of the investment process within each corresponding mutual fund family.”

Unfortunately, as someone wrote recently, “We see performance and infer process.”[7]  So, that conclusion is too much of a reach for me.  I also have other questions, wanting more evidence on the source of the outperformance and the nature and impact of the structuring choices (many of which have changed over time) that convert the raw material of analyst recommendations into a portfolio.  Also, we need to keep in mind that the filings of these funds are infrequent, so that there is a lot of information not available.

All that said, the paper is a great example of how academic research should trigger further important work by practitioners.  Quite apart from the question of analyst-run funds, the ideas that the authors offer should inspire leaders of investment organizations to evaluate in new ways the interactions of analysts and portfolio managers — and to assess and explain the real impact of research output on investment performance.

This is the tenth posting in an ongoing series on equity research.[8]

The term has taken the business world by storm and is unavoidable as a topic of conversation among managers, technologists, and investors .  We all feel like we should have big data and do something with it.

As part of an ongoing series on equity research,[1] here are some musings about big data in that context.  Whether you think that big data is a revolution[2] or “a marketing campaign, pure and simple,”[3] there are implications for investment processes from the explosion of data.

Most definitions of big data include “the three Vs” of volume, velocity, and variety.  Truth be told, that construct is now twelve years old, having originated at the META Group, since bought by Gartner.[4]  So, we’ve been dealing with these concepts for a while, but now the buzzwords are in widespread use.

There are a range of issues here for investment organizations.  Compliance and risk management can be improved by better organizing and analyzing the disparate data sources already at hand — although some more prosaic steps, like attacking spreadsheet errors,[5] might provide more bang for the buck.

The major big-data front in the equity realm has been high-frequency trading, with less feverish quantitative strategies also resting on predictive analytics.  The approaches of two decades ago were similar to today’s, it’s just that the dials for the three Vs have been turned up.  Let’s look elsewhere though.

If there is promise in using big data to gain economic advantage, equity investors should be investigating which firms can actually capture that advantage.  Cutting through the stories will be hard work (see Hewlett-Packard and Autonomy) and parsing the hype versus the reality will be reminiscent of the work on other such management fads and fancies over the years.

For those that actively manage portfolios in a qualitative manner, the big-data question remains the same as it has been for some time.  To what extent is your decision making data-driven?  (Or, to what extent should it be?)  Many firms allow great flexibility in how analysts and portfolio managers ultimately decide what to do after chewing through the data that is tossed around them.  But bits and bytes of information don’t make a process.

To take advantage of the opportunities, firms should not only rethink existing roles,[6] but the entirety of the investment function.  Structurally, data scientists and decision scientists may be mixed in with stock jockeys, making for a cultural clash.  The “how” of decision processes should morph if we truly are entering a different information environment.

As always, the leaders of investment organizations will determine whether the promise of all of this will be captured and the alpha revealed.  Which firms will be bold enough to lead after sniffing out these changes in the wind:

There will be more research firms that produce higher-frequency observations than the monthly and quarterly economic and corporate reports that we rely upon now.  There will be new partnerships that involve complementary sharing of information.  There will be investment organizations that purchase or team up with data aggregators and analyzers that seem far removed from the workings of the markets.  All of this will also bring new questions about privacy boundaries and regulatory constraints — and insider trading allegations too.  Perhaps some retailer will understand the gold mine of information it has accumulated and in essence create an internal investment fund to capitalize on it.  (I have no idea of the legal implications of that, but we should think expansively about the availability and use of data, since consumers seem willing to sign their information away at the drop of a hat.)

Consider a Bloomberg terminal today.  It can report a vast array of data, and it relays searches and graphs and favorites and messages from all over the investment ecosystem.  I haven’t read my Bloomberg agreement lately, so I can’t recite its policies.  For my purpose today, I don’t really care.  Imagine all of it was yours — the facts, the connections, and the behavioral clues.  What could you do with it?

I won’t argue that simple and sound techniques from years gone by are destined for the scrap heap as a result of changes in the information environment.  But “research” is bound to get bigger, providing opportunity and risk for those pioneers who try to capture the frontier, as well as those who stay behind.

If you are betting on something, there’s an odds board that shows your chances, even if you can’t see it.  At a racetrack, it’s easy to tell the long shots from the favorites by looking at the board.  If you’re wagering on football, the line on the game includes some implicit odds.  You can find out how the deck is stacked against you in blackjack depending on the rules of the house — and you can look up the odds for the lottery game you are playing.

What about your odds when buying a stock?  It’s a multifaceted question, the answers to which will depend on the “security analysis religion”[2] to which you belong.

Let’s say the foundation of your approach is to assess a company’s position qualitatively.  You judge its “moat” — the sustainability of its competitive advantage (if it has one) — and you evaluate the factors that will hurt its chances of success and those that will make it more likely.  At some point, you boil it all down into a financial forecast, putting numbers to the factors and coming out with a map of the past and a model of the future.

But the stock is for sale at a price and you have to decide whether to buy it or to sell it.  Enter valuation, which is nothing more than an odds board to help you think about that decision.

Recently I was at a meeting and a director of research (who also is an active analyst) said that he had come to the conclusion that valuation doesn’t matter.  Basically his point was that fundamentals will win out and overwhelm any valuation structure.  But that’s true for only a tiny fraction of very special companies (and we don’t know in advance which ones they will be).

All else being equal, the lower the valuation, the better your odds of success.  That doesn’t mean that you are sure to lose when something is highly valued, rather that your likelihood of winning is lower or that the expectations of winning are baked in, so that you can lose even when the company wins.

There are many different valuation metrics.  We could list them all, from the conservative, like normalized historical GAAP earnings, to those liberal interpretations of forward earnings minus whatever bits of unpleasantness analysts will agree to leave out of a company’s metrics.  They can be based on dividends or enterprise value or (if you’ll remember) eyeballs.

The valuation odds board is electronic these days and you can see all of those ratios change second by second if you’d like.  How to put them together into a decision framework is up to you, with the first choice you face being whether to go with the winds of relative valuation or to stick with some absolute standards.

But you’ll notice that the title of this posting is plural — there’s another odds board that many investors look at and quite a number of them rely on it almost completely.  It doesn’t have an agreed-upon title like “valuation.”  Some would call it “supply and demand” and some “investor behavior,” but we’re talking about signals related to price and other technical indicators.

The messages of the two boards often are in opposition to each other.  It pays to know who you are, so that you stick to your methodology and don’t run back and forth to the board that gives you the most appealing read at any point in time.  Or that if you use both boards (as many investors do), you do so in a disciplined and thoughtful way.  Part of that is focusing on the much different time horizons that are implicit in the odds that you think you see.

So, how do you like your chances?

If you are a sell-side analyst, you listen to an earnings call, work on your model, do a report for publication in the morning, maybe get a little sleep, and get up to start communicating to the members of your firm, your clients, and — if you have a certain stature — a television audience.  You probably have a junior analyst or even a team to help you, but there’s plenty to do.  And if more than one firm reports in an afternoon, you do it all twice or three times, perhaps without the sleep.

Or maybe you are a buy-side analyst, let’s say for a hedge fund that is known to trade heavily.  The news comes fast and furious:  Reports from the company (and spin from the company) and opinions from all corners.  You are fielding the mess of it, plus trying to analyze the developments and communicate effectively about them and your point of view.[2]

In either of those positions — or if you are a portfolio manager dealing with a broad range of current and potential investments — it might seem that speed is always of the essence, even though in today’s world you’re not likely to add much value through speed.  You are propelled along at the pace of the business, whether that results in good decisions or not.

For the leaders of investment organizations, those realities raise a question:  Does your strategy really require you to play the game as everyone else does, to run at the same speed at which the market runs?  The chances are parts of your process are vestiges of a time gone by.  Rethinking them could be liberating and fruitful.

To consider an even more important question, let’s say you are a director of research, with a staff of qualified analysts.  They have different areas of coverage, but essentially identical job descriptions and goals.  Thus, you have a lot of analytical horsepower, but it all operates at the same speed and pretty much in the same way.

Which is bad, not good.

The structure is principally built for one kind of person, who operates in a particular fashion and attempts in all ways to stay in sync with the market.  Yet some of the most brilliant investors frame analyses in unique ways and operate at different speeds than the rest of us.  You probably either force them to conform or, more likely, you don’t hire them in the first place.

How much better it would be if your research strategy resulted not in a sameness of roles and activity, but a differentiation of them in ways that took full advantage of the talent available and met the true needs of your firm.  That person that operates a different speed, who is frustrating you now, may be the key to your future.[3]

Please note:  The third member of the “research puzzle” family, a mini-blog with shorter updates, was recently introduced.[4]

Meeting with a client recently on risk management issues, I said that “risk management is forward-looking and creative, not backward-looking and statistical.”  The latter has its place and can inform the former, but that standard approach often ends up strangling risk management rather than energizing it.

Then I heard that a major investment firm had gutted its risk management function because a change in regulators for it meant fewer hoops to jump through and therefore some costs to be saved.

Today I saw a list of “top fears” of institutional investors for the coming year;[1] you can assume that they’ll be the main focus of stress tests, scenario analyses, and other risk management processes for those investors.  However, it’s just as likely that “risk,” however you define it, will show up in a different corner altogether.

It might not seem an easy transition from these “macro” examples to the next posting in a series on equity research[2] but the same principles apply in equity analysis too — and the same behavioral tendencies trip us up.

We like to fight the last war, since its lessons are fresh in our minds.  We gravitate toward risks that are well identified, be they for the global economy or a stock, since we will undoubtedly be asked about them by clients and co-workers, and it is nice to have thoughtful answers.  Even having identified them, however, we aren’t very good about evaluating them and talking about them in concrete ways rather than as generalized concerns.

Consider two places where a list of risks for a stock would be found.  An IPO prospectus features a kitchen-sink approach, listing everything possible to avoid legal issues later on.  Reading the list, it is easy to think, “yeah, yeah, yeah,” and not pay much attention to the risks.

In contrast to that, most buy-side and sell-side reports have remarkably brief expositions of relevant risks, duly filtered and narrowed and in concert with the analyst’s thesis.  As an exercise, take the last ten blow-ups in your sphere of analysis and see how many times the catalyst for the decline had been identified and examined in advance in the reports produced by leading analysts.  (Don’t count binary events like an FDA approval.)

It is often something seemingly out of the blue that gets you, but is that really the case?  We ask analysts to perform a wide range of functions[3] and to consider an amazing array of inputs.  It is no surprise that it all gets boiled down in a hurry to a few key factors, typically those that are dominating the conversation among analysts, portfolio managers, clients, and even the media.

Often left out of the discussion are topics like accounting risk (analysts go with the flow more than make waves regarding questionable accounting treatments), governance risk, and guidance risk.  Among other types of overlooked risks, they show up disproportionally versus the amount of time spent on them by analysts.  In practice, they are perfunctory risks; in actuality they are potentially significant ones.

For an investment organization, trying to effectively communicate about the risk of an idea is not easy.  Analysts become advocates for their ideas, not educators about the risks inherent in them, or even very good judges of those risks.  Little if any time is allocated to original research aimed at identifying risks unseen (or improperly assessed) by others.

In a world of sameness when it comes to the process of analysis, here is an area where differentiation is possible but difficult.  Those searching for alpha should welcome the challenge.

According to the SEC,[1] “Insider trading is illegal when a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading.”

Which brings us to “the mosaic theory.”  What do you see here?

There really is something there, but you’d have to be amazingly good or amazingly lucky to discern it.  Perhaps with a few more tiles filled in you could do it.

Building an investment picture bit by bit is what the mosaic theory is all about.  An investor can assemble information from different public and private sources to make a decision — as long as the general principle laid out by the SEC statement above is not violated.

There are endless debates about the definition of “materiality” and other issues, and differences of opinion about where the lines are (or should be) drawn.  While there is no doubt that enforcement has been stepped up, regulators have said that they are are not trying to revoke the mosaic theory.[2]

So, for an investor, it comes down to how you do what you do.  If you go looking for trouble, it’s easy to find it.  If you are trying to dance as close to the line as you can — or purposefully dance over it — then you’re playing a dangerous game.  A more sensible foundation for a long-lasting approach is to hew to the laws and intelligent standards of practice, such as those from the CFA Institute.[3]

However, the “new mosaic” of the title does not refer to that mosaic theory at all, since I don’t think all that much has changed in regards to it.  The new mosaic is that which an investor or firm can create through the use of different sources, ideas, inputs, and people that can breathe life into the process of equity analysis.

Consider the image above again, not in terms of a legal theory, but as a visual representation of your investment process.  The chances are that you color in the same tiles each time that you face a decision; they create an image in a way that you are used to seeing it.

But what about all the other tiles that you ignore, that never get colored in?  They could very well change that picture in ways that you don’t expect.  And what about the frame that you have created for your process?  What artificial boundaries have you crafted for your approach?

Your investment mosaic should not be predictable or similar to those of others in the crowd.  You should see in one tile left untouched by others the image of alpha that it might help to create.

This is the fifth in a series of postings on equity research.[4]

A great recent example of this is John Hempton’s writing on Focus Media Holding (FMCN).  Hempton is the chief investment officer for Bronte Capital, a small firm based in Australia.  An affiliate is registered in the United States, so you can read its Form ADV, Part 2 to find out more about it.[2]  Bronte is short FMCN.

On its own, that fact skews the assessment of Hempton and Bronte.  There are many investors who equate short sellers with nefarious activities, convinced that they are a blight on the capital markets.

I am not in that camp.  First of all, it is a legal activity.  But, more importantly, in my three decades in this business I have seen many more trading abuses by long investors than shorts — and much more promotion of stocks from a bullish stance than a bearish one.  Investors are fleeced on a regular basis by managements, analysts, newsletter writers, and bloggers hyping stocks.  Action going the other way is really quite rare in comparison.

Hempton has written nineteen postings on FMCN (which appeared on his blog, also “Bronte Capital”[3]), seventeen in a flurry a couple of months ago and two recently.  They concern a proposed transaction in which Carlyle and other investment groups would take FMCN private in the biggest such deal ever in China.

I read all of the postings and all of the comments on them, as well as some other sources on Focus Media.  Hempton claims to be “obsessed” by the proposed deal; I am fascinated by it and by his work.  He describes the debate over the stock as a battle between “rat-bag shorts” and a “who’s who of Asian business,” with the latter destined to win, resulting in a “done deal.”  But.

In his postings, Hempton starts to pick away at unusual items and incongruities, all the while acknowledging possible explanations and ways in which his theories could be wrong.  In fact, one great aspect of the writings is his exposition of multiple interpretations of what appears on the record, both supportive of his case and not.  That is unusual in the world of analysis, where drawing a conclusion is prized and envisioning outcomes — actually the more important activity — is generally not.

The FMCN story as told by Hempton includes questions about the reasonableness of the firm’s operating metrics, its huge writedowns, and its transactions involving subsidiaries bought and then given back (with oddly matching values and suspicious connections between the sellers/recipients).  Has the firm been booking fake profits and taking periodic writedowns to offset them?  Is it being looted?  Is it a pawn in a game of Chinese corruption?  Or did those things occur and FMCN subsequently went “legit”?  Or none of the above?

I don’t know.  Hempton thinks there is enough uncertainty to put on a short that amounts to an asymmetric bet.  If the deal goes through, there’s modest upside in the stock (a loss for Bronte), but if it doesn’t and anything looks fishy about the company, the stock could collapse, generating a nice percentage profit.  (Given Bronte’s stated methodology, FMCN is likely around a one percent short in a portfolio dominated by long positions in large cap value stocks.)

For my purposes here, whether Hempton’s suspicions prove to be correct is almost beside the point.  To read his posts is to witness the due diligence process as it ought to be.  Digging, asking questions, digging some more, cycling back around, finding obscure information, and considering the possibilities in favor of or opposed to a thesis.

The comments on the blog postings are interesting both in content and what they represent regarding new ways of open collaboration on serious investment topics.  By and large, there are very few of the garbage comments that clutter so many finance sites.  Instead, you see a reasonable dialog, with some mediocre comments, some insightful ones, and some real nuggets of information along the way.  Hempton actively seeks out opinions and alternative ideas from readers to help him in his research.

If I was still teaching MBA students about investments, I’d stop what we were doing and spend a couple of weeks on all the angles of Hempton’s postings:  the company analysis, the interested parties, the research process, and the implications of new channels for information.  But most of all I’d want them to witness the insatiable curiosity and intense focus that are evident in Hempton’s work.

Those are qualities that every investment professional ought to possess.

The fact that he turned out to be “right” cements Silver’s legacy, at least until he gets a major call “wrong” in the future, at which point we will hear a chorus of told-you-so catcalls.  Thankfully, Silver has always been consistent in talking about his methods; his goal is to analyze the odds, not to carry a political torch or overstate the application of his findings.

The debate reminded me of some key issues in investment decision making, thus the inclusion of this posting in my ongoing series on equity research.[1]

It is an easy analogy to draw between Silver’s work and quantitative methods for investment decision making.  In each case, the historical record is parsed and judgments are made on the basis of the data at hand.  There have been stocks selected and portfolios managed in that way for decades, and the approach forms the foundation of many algorithmic investment activities today.  By definition, quantitative investment works best when things stay the same and worst when real change is afoot.

For the purposes of rhetorical contrast, “fundamental” investors are often portrayed as those who invest on a hunch rather than the data.  That’s not a fair characterization, as many investors who make decisions qualitatively have a mastery of the numbers as well as the other factors that they consider.  Unfortunately, when fundamental investors go wrong, they often make errors like the anti-Silver crowd did this election cycle.

Conservative pollsters and pundits convinced themselves that 2008 was an anomaly, that the intensity of support for Obama that year could not be replicated, that it was bad data that could be thrown out of an analysis.  Certainly that was one possibility, but it was not treated as a possibility but as a foundational belief and was clung to by the believers in spite of contravening evidence.

Another problem was that the political echo chamber yielded reinforcement rather than enlightenment, as it always does.  “Thought leaders” get wedded to their predictions and anchored by their conflicts of interest.  They don’t abandon their positions until the facts disprove them (at which time it is too late) and even then mostly rationalize their errors rather than admit them.

As the returns started to come in, a telling report appeared on a live blog from the New York Times.  With the evidence mounting that Romney would lose, those at his election party didn’t want to see the coverage being broadcast on CNN:  “Every time the network is turned on, audience members at the Boston Convention Center chant for a change of channel.  ‘Fox! Fox! Fox!’ they yell.”  As if that could have helped.

It all reminded me of countless times I have seen investment managers (including me) fall in love with a thesis and a position even as facts and numbers started to pile up in opposition.  Rather than embracing the new evidence and digging for more that might disprove your views, it’s easiest to listen to those that think like you do (perhaps a conflicted sell-side analyst) or those who are unlikely to give you the whole picture (such as company management).  You start to engage in magical thinking and to see what you want to see.

There was lots of talk about the effect of momentum leading up to the election. In the investment world, momentum can lead to exaggerated moves in investment vehicles, as participants chase relative performance.

But that’s not the case in most political races.  Absent an extraordinary development, relatively few voters are being fought over and momentum runs into a natural and substantial wall.  That said, momentum did shift in Romney’s favor for a time.  However, Silver was among the first to note that his momentum had stopped and reversed, and did so well in advance of the election, while Romney’s advocates proclaimed even until the fateful evening that it would carry him over the top.  It was contrived momentum, without substance underneath.

Investment decision makers need to understand the power and limitations of each type of analysis:  quantitative, qualitative, and momentum-driven.  In the market, each has its day in the sun and each its day in the doghouse.  But the real trick is to allow one to inform the other, to combine them in ways that match your investment beliefs,[2] and to be clear about the nature of your methods and the kinds of errors you are likely to make.

If you want to be more of an advocate than an analyst and put forward theories without much in the way of factual foundation, go right ahead.  Just let those that believe in you know that your odds are long and the cost of failure might be very high.

When I evaluate a research organization or an analyst, I start with that construct, so it makes sense to include some thoughts about it in the series on equity research of which this is the second installment.[1]

For the “analysis” part of the equation, the necessary components for an analyst’s consideration can be fairly described as “anything and everything.”  To many, it boils down to “picking good stocks” (and avoiding bad ones).  It’s not unusual for an organization to have that as the effective bottom line of an analyst’s performance review.

But what does that mean in practice?  There are myriad ways to measure research “performance” — and what we really want to get at is the process behind the apparent success or failure (since it often is, of course, a matter of luck, good or bad).

As I wrote in a 2010 posting about “those darn analysts,”[2] we ask analysts to perform a wide variety of chores and — especially at bigger shops — serve a wide range of masters.  Sorting out the value added by analysts is exceedingly difficult and beauty (or lack thereof) appears differently in the eyes of different beholders of that research work.

This presents a real challenge for an analyst, a director of research, or a chief investment officer.  For all concerned, it is easier to create an orthodox research approach rather than an innovative one, despite the fact that almost by definition alpha accrues to those who approach the research puzzle from an odd angle.

Future postings in this series will deal with a variety of pertinent analytical and organizational issues, so let’s turn to the “communication” part of the equation.

I have written a number of postings about the importance of communications ability in the investment world, including one of my “letters to a young analyst,”[3] in which I said that “I saw more [analysts] fail because they couldn’t communicate well than because they didn’t have the analytical chops for the job.”

It is the culture of the business to not worry much about communications skill, thinking that a good analysis or good numbers will be heard and will win out.  For example, it is mystifying to me that multi-billion-dollar hedge funds send out investor letters that look like they were done by (business, not design) undergraduates.  I stated so in a tweet recently and got a response[4] that said, “It’s data that matters, not how pretty you can make the chart.”

But it is how clear you can make the chart, the report, or the presentation.  What surprises me about many investment organizations is that they don’t understand the importance of the communications side of what they do.  It’s not that their work isn’t pretty (although much of it is amateurish and ugly), it’s that it’s not effective.

Whether it is within an organization or with clients, how you present your information matters a great deal, whether it is an image, a report, a speech, or an elevator pitch.  To point to a recent example outside of investments, consider the first presidential debate.

President Obama looked to have an insurmountable lead; the race was his to lose, but he flubbed the first debate and it is very close coming down to the wire.  Why?  Try to find anything anywhere about a substantive answer that turned the tide.  It was entirely related to his communication style and the impression that he gave rather than what he said.

If you think that’s not the case in investments, you are fooling yourself — and leaving out one half of the formula for success.

While the speech focused primarily on equity sell-side research, the revolution in information and competition is important for investment firms of all types.  For this, the start of a series[2] about the state of equity research in 2012, a look back at that presentation provides a nice entry point to some of the topics at hand.

The summary text of the presentation is available online[3] and includes links to additional material.  (Since I’m quoting myself, I have left quotes out of this posting, even if I use the same words.)

The talk was about the intersection of a few important ideas:

Good research isn’t just found on the Street.  Sell-side research is no longer the only game in town.  It’s cheap or free to get information these days and it’s cheap or free to disseminate ideas, as the thriving community of investors on Twitter and in the finance blogosphere demonstrate.

The quality of the work ranges, as you can imagine, from excellent to laughable, but it’s no longer the case that you can assume that what’s widely available is not “professional grade.”  Very often it is written by seasoned professionals.

The Street also faces competition from hundreds of independent research firms, the below-the-radar (but very well financed) research offerings of Bloomberg Industries, and lone wolfs like Carson Block that can move the market more than any sell-side analyst.[4]

The research report as we know it is a relic.  Over the last couple of decades, we’ve had a communications revolution, digitization has destroyed entire industries, the investment business has new players, there are more research providers with new channels of distribution, and investment information has gotten more democratic and more social.

What has happened to sell-side research reports during that time?  Nothing much.  How is that possible?

Regulation can be used as an excuse for the lack of progress, and there is a little something to that excuse, but it’s pretty flimsy.  The reports are “frozen in time,”[5] in concept and structure, with worse graphics and production standards than when I entered the business almost thirty years ago.  Surely someone will rethink this tired model.  (OK, I’ve done that part; now someone has to be willing to be bold.)

The focus of sell-side research is all wrong.  When institutional investors are surveyed about what they want from the Street, “the big three” of recommendations, estimates, and target prices come out near the bottom.  Yet those are the things that the research product is built upon.  More than five hundred academic studies have parsed those three activities — and the forecasts are the focus of media attention and investor derision.  Sell-side analysts spend too much of their time creating and defending relatively unimportant single-point numbers and ratings rather than building and conveying unique ways of considering opportunities.

Some questions.  To the firms that produce the research:

Who is your audience?

How do you add value?  How can you add value?

What’s the purpose of research in your business model?  What will it be five years from now, given the changing ecosystem?

How can you stay relevant?

You might keep in mind that the customers of your research are for the most part wholly unsuited to the task of imagining what research will be or should be.  They’ll respond to a helpful new way of presenting information when it’s shown to them or find value in a remaking of the traditional roles of an analyst, but they’ll not see the need for it before you step out from the faceless crowd on the Street with some real alternatives.

You must differentiate your work and create research that represents the unique nature of your firm and your approach, not something that is a fill-in-the-box exercise.  It must help clients to make good investment decisions and be positioned to reflect and take advantage of the changing information flows of our world.

The firms that succeed going forward will need to be bold to compete in a different world.  There are big changes going on — and sell-side research can no longer avoid them.

Rose noted that Davis’ music is played in the dining room, but not in the kitchen.  Humm said, “The kitchen, I think, has its own music.  And when I’m in the kitchen, based on the sounds, I know if we are having a good night or if we are struggling.”

There are certain rhythms of activity that just seem right.  With your eyes closed, you could probably get a sense of how the members of a basketball team are playing together.  Or whether a man shingling a roof is in a groove.  You can certainly tell if the members of a musical group are in touch with each other, no matter if they are playing jazz or classical or country.

For those of us that work in offices and make decisions for a living, the nature of our conversations can say much about whether we are being productive or destructive.[2]  Quite apart from the content, the sounds of a meeting indicate whether much is being accomplished at all and whether it is just a forum for broadcasting opinions and emotions or one for making effective decisions.

The electronic age changed the vibrations of our working lives.  Information comes to us individually and many of us can choose a relative isolation from others if we want.  Think of a row of computer programmers, side by side, each with headphones blocking out everything else.

When it comes to the investment world, some of the sounds have changed dramatically.  The ticker machines clacking away are long gone, but back in the day there were market players who listened to their noise to understand how the market was changing.  Early in my career, the “broad tape” machine spit out the news, a bell ringing for the big stories.

Of course, the sounds of the New York Stock Exchange and other venues are nothing like they once were.  That guy on the floor that used to give you color doesn’t see (or hear) fear and greed manifested in the way he once did.  There are exceptions; some of the commodity pits are still plenty lively, but the machines have taken over by and large.  They are silent and so fast that we couldn’t divine the music even if we could hear it.

Trading rooms have changed too.  There are lots of empty desks where there used to be traders and generally fewer calls with fewer people.  Testosterone is still on full display at times, but in general the dynamics aren’t the same.  The human element of trading has been altered and a certain sense of the moment has been lost.

In previous postings on this site, I have used the image of a table[3] to set up pieces about how members of a group interact to make investment decisions.  One industry veteran told me he felt the construct was outdated, because so many investment decisions are made virtually these days.

Wherever you look, it’s harder to find the “kitchen” now — where it all happens, in an investment sense — or to hear in the activity there the things we used to be able to hear.  I get a sense that the changes matter more than most of us think.

I recently met with an industry veteran for the first time.  We talked about a wide range of things, including what topic I might explore in a presentation to a large meeting of advisors.  While driving home the next day, I was mulling over a number of investment process issues of a completely different nature.  On each front I felt stymied, with no clue as to how to proceed.

Upon arriving home, I saw an investment magazine in the day’s mail.  The cover — actually one of those advertisement paste-on covers featuring an earnest-looking CEO — instantaneously triggered an idea for the speech and some critical perspective on the investment process puzzle I was considering, even though it really didn’t have anything to do with either one.

How does that happen?  The best answer is probably, “I don’t know,”[1] but we do know quite a bit about creativity and what kinds of activities promote it.

A confession:  I’m an anomaly among investment professionals.  I often describe myself as “a creative person in an uncreative business” and “a generalist in an industry of specialists.”  Those characteristics differentiate my consulting approach and result in the eclectic mix from all over the investment ecosystem that you see on my websites.

The day after the “aha!” moment described above, I headed to New Orleans to attend a Council on Foundations conference as a volunteer investment committee member for a community foundation.

Innovation was a persistent theme of the conference; even in the non-profit world “changing business models” is a hot topic.  One session was led by Evelyn Huang of Stanford,[2] who focused on the process for “design thinking.”

The interactive session got attendees away from their electronic devices, the only thing that appeared to be capable of doing so.  Huang stressed — and the exercise demonstrated — that alternating “focusing” and “flaring” stages throughout a design process is an important part of its success.  (As I wrote in “the cave and the flow,”[3] we have similar needs for balance in our personal information diets as well.)

It is with all this creativity on my mind that I went into the exhibition hall that is a staple of conferences of this type.  There were a number of vendors of investment services there (basically, asset managers and consultants) and I talked to as many as I could.  Generally, they were selling stability, longevity, performance, and orthodox investment theory rather than innovation, although there was a bit of cognitive dissonance, since reaching for yield/risk is very much in evidence.  (FYI, community foundations on average now have larger holdings in “alternatives” than in fixed income.)

The unfortunate fellow at the Vanguard booth had to listen to me lay down a challenge to the industry.  I had recently read about how Vanguard had helped to defeat the SEC’s money market fund reforms.  (The last edition of research puzzle pix[4] shows the woes of that industry and serves as something of a preamble to this posting.)  While noting that it wasn’t his “department,” I told the Vanguard representative that the industry’s approach right now seems to be to fight everything while not trying very hard to solve the problems that exist.

That’s definitely true in the world of investment banking and seems to be the norm in most other areas of the business too.  Certainly it’s the case among the big mutual fund firms.  There are some disruptive forces about, especially the rise of low-cost ETFs, but the industry’s motto could be “to preserve and protect” — its business models and its profits, that is.

But there are huge problems to address.  And some firms will address them.  Which ones will they be?

Not those who try to “create” by back-testing.  Not those trying to match profit margins that remained unrealistically high for far too long.  Not those afraid to call a spade a spade when it comes to the shortfalls between industry promises and industry results.

At one level, it’s quite simple.  After a session at the conference on the hot topic of “impact investing,” I talked with someone who has made some of those investments at her foundation for twenty-five years.  She explained that at the beginning they had no idea what to call it, no perceived rules about how to do it, and no other organizations to benchmark against.  They just saw certain needs and filled them, creating along the way.

Take that common sense approach, add in some design thinking, get the right people around the table, keep your eye on your clients’ needs rather than your own, and disrupt this industry.  There are trillions for the taking.

Such a simple question — and so hard for most market participants to answer.  Go ahead, take a shot at making a list of your beliefs and see what you end up with.

Perhaps you’ll start with your take on market efficiency and your thoughts about passive versus active management.  That’s a logical place to begin, given how many decisions hinge on that one divide.  Perhaps you see efficiency in some areas and the opportunity to add value in others.  For the latter situations, how do you expect to add that value?  On and on we could go with the questions, from the macro to the micro, sketching the framework upon which your choices will be made.

That framework will look different depending upon where you are in the investment ecosystem.  A do-it-yourself investor is able to define his beliefs and act upon them directly, although most individuals are not adequately prepared to do so.

Those that work with financial advisors need to think about the interaction between an advisor’s belief system and their own — as well as the issues that can arise when one person is being paid for the advice and another is paying for it.  Incentives can sometimes swamp beliefs and the fear of losing business (or losing face) can distort decision making.

Shifting gears, let’s say that you are an employee of an organization that manages hundreds of billions of dollars.  What are the organization’s beliefs?  What are yours?  How temporal are they?  Are they formed by the rapid growth in assets of the latest hot product — or the most recent area of strong relative performance — or are there more permanent underpinnings?

Perhaps you are a fiduciary that’s responsible for working with others to select firms to manage assets for a pension plan or an endowment.  What are your beliefs (and those of the other decision makers individually and as a group) and how do they ultimately translate into the individual purchases and sales that determine performance?

As a consultant on investment process, it’s usually not too hard for me to locate a wedge issue that is evidence of a gap between stated beliefs and their application.  I have also written about this topic in a variety of ways over the years.  That’s why I was interested to see articles in Pensions & Investments about a survey it did in conjunction with Oxford University.[1]

In the print edition of July 23, the article was titled, “Having belief set is the key to future returns.”  The headline was not a statement of fact, but of the opinions (beliefs, if you will) of the survey respondents.  There was no proof offered.

And in my consulting, I don’t offer one either.  But I agree wholeheartedly that an exploration of beliefs is a necessary precursor to improving an investment decision process.

Notice that I used the word “exploration” rather than “statement.”  It is the consideration of the key issues that should inform beliefs, not a statement of beliefs that should close off debate about them.  Knowing where to stand your ground is important, but beliefs that are treated as immutable can sometimes lead to bad returns rather than good ones.

So, yes, it’s always good to hear a clear statement of beliefs and be able to see how they translate into specific decisions that resonate with them.  But tell me about the ways in which your beliefs collide and intersect, how they migrate over time and why, and what circumstances would call for a change in those beliefs (or a diversification of them) rather than a rote affirmation of those of the past.

If you can do that, you’ll be better prepared for the inevitable tests ahead.

I suppose you might find it hard to believe that the “good stuff” was academic research by three sociologists.[2]  The researchers had participants in their study rate the quality of songs that they previously had not heard.  The bottom line:  Their judgments were distinctly different depending on whether they received information about how others had already rated a particular song.

So, let’s see:  Politics, music, sociology — are investments in there anywhere?  Yes, indeed.

The opinions of investors are malleable too.  It is easy to be swayed by the “social feedback” (as Frank describes it) that you receive.  As with the participants in the study who rated music, our perspectives on investment possibilities often change based upon what we know about how others view them.

That can happen even when we have a only generalized view of an investment’s popularity, such as the aggregated rating on a stock by top analysts or its level of activity on an online investment idea site.  Let’s say you’re an endowment officer; will your percentage allocation in alternatives be affected by that typical of your peers?  And aren’t market-weighted benchmarks like the S&P 500 a popularity contest of their own, with the votes of the market setting the weights — and investors often jiggering their exposures in response?

Those are all averages, and they have the power to frame your decision making in subtle and not-so-subtle ways.  Even more powerful are the opinions of those you have come to trust, through personal contact or observation.

That analyst that recommended a stock which became a ten-bagger for you?  Every word he says will effect your decision process for a long time to come.  The person you’ve been reading at that online site who seems to have everything wired?  She becomes the first one you read each morning.  The heads of the Harvard and Yale endowments?  They are the ones on stage at conferences and you’re in the audience; guess how your alternatives exposure is likely to gravitate in response to a presentation about theirs.

I’m not saying that you shouldn’t seek out those with expertise, but it is very tricky business to objectively judge real expertise and to properly size it in your investment process (so as not to let the opinions of others overwhelm the facts at hand or your own careful analysis of them).  As the research on musical taste demonstrates, the starting point of your assessment is often influenced by others in ways that you don’t understand.

That presents a significant challenge for individual investors, and for investment organizations too.[3]  No one is immune from the negative effects of social feedback when they make decisions, so an investment process should be designed to minimize those kinds of errors.

Does yours?

In no time the inner secrets of their neighbors became known to them.  Then the Westcotts realized that there were differences between the lives that they saw in elevators or at parties or at lunch and those that played out behind closed doors.

Their radio was tuned to one apartment at a time.  What if you had an “enormous radio” of your own, which allowed you to listen in on the interactions of the players in the financial markets?  Who would you want to dial up?

I know I’d want to hear the give and take between the Masters of the Universe and their Muppets, although I fear it would be too much like the Westcotts listening to Mr. Osborn beating his wife in 16-C.

Overhearing sales pitches for investment products and services would be very frustrating, in that I’d be yelling at the radio all of the facts being conveniently left out and the questions that should be asked of the person making the pitch.

What I’d most like to witness?  The decision making discussions at investment firms, since that is the subject of much of my consulting and writing.  That portfolio manager that’s talking on CNBC now — what did he say to his analysts this morning?  And, by the way, is he just a figurehead that’s good on television and someone else is really running the show?

Which firms rely on the Street for their ideas?  Which do truly original research?  How are decisions made?  If you look at the investment process as outlined in the pitch book or product brochure, how closely does it match what you’ve learned by eavesdropping?

Alas, we don’t have such a radio.  Instead we must try to figure out what’s going on behind closed doors ourselves.  That is the essence of investment analysis and due diligence.  A story may sound wonderful, the numbers may look good, and an advocate may inspire trust, but you should never take any of them at face value.

The best personal attributes that you can have are a healthy skepticism and an inquisitive inclination.  That will help you pick away at the truth and avoid the version of it that is publicly on display.

It was other people’s money I was talking about.  Today there is a fascination with the real billionaires — those that have that much on their own.  Yes, there have always been rich folks and we’ve been increasingly putting them on lists since Forbes got into the act.  Once the fortunes got into the billions, however, we had a new and powerful name for those few that attained that goal.

We don’t use tycoon or financier or industrialist much any more (well, we haven’t had that many industrialists lately, except in emerging economies), but billionaire has become the description du jour.  To prove the point, keep track of the number of times that the word “billionaire” is used during the next week to describe someone in a business or investment story.  In newspapers and blog postings, on television and radio, in research reports, wherever.  Then ask yourself why it was used in each case and what impact it had on your interpretation of the story.

Let’s take one recent example.  InvestmentNews published an article that began, “Billionaire Ken Fisher . . . .”[1]  It went on to describe the fact that Fisher’s firm has been buying equities in China (via an ETF), thinking that efforts to stimulate growth will result in China doing better than “global equities.”

So, what is the purpose of “billionaire” in that story?  I would, for example, be interested in Fisher’s history as it relates to investment in China, but that’s not referenced.  I did find out that he was a billionaire though.

What does that tell me about his investment prowess?  Fisher is a controversial figure in the money management business and I could give you facts that make him look good and facts that make him look bad — and we could examine the nature of his track record and when he does best and when he does worst.  But he didn’t become a billionaire because of his investing.  He is a marketing machine and that machine is designed to attract other people’s money, because managing other people’s money is one of the ways you get to be a billionaire.

By and large, the hedge fund billionaires that you read about got rich off of the two-and-twenty (or higher) that they charge clients, even if their investment records swamped Fisher’s.  While hedge funds are derided as “compensation schemes,” some other billionaires got theirs mostly through the magic of stock option grants bestowed on them by boards of directors.  A few billionaires had one incredible idea many years ago and haven’t needed another.  Others inherited their billions.

While there are stories where it is warranted, it has become standard practice for lazy journalists to use the billionaire description virtually all the time it can be applied.  And my guess is that there are lots of investors who think it matters when a billionaire says or does something, even when it doesn’t.

Perhaps I should give a prize to the person who counts the most uses of the word during the next week, or provides the most egregious example.  Unfortunately, I don’t have billions and billions or I’d peel you off a few.

For insight, it’s hard to beat a world-class museum.  You come face to face with beauty one minute and brutal reality the next.  Your perspectives are altered and your beliefs are challenged.  You see the sweep of history — the connections across time reveal themselves and the true innovations seem mysterious and remarkable.  You think about notions of quality and the nature of genius, of art and craft, of inspiration and perspiration.

Other than its general lack of beauty, a careful observer could talk in a similar fashion about the workings of the investment world.  And while I didn’t go to the Institute to make analogies between what I saw there and my vocation, they kept showing up even as I was enjoying the art for its own sake.

Most of the ancient objects in a museum get very little attention from visitors.  Yet they represent the cultural foundations on which everything else developed — and they speak to the human condition and the persistence of our behavioral urges.  Not too many people spend much time studying financial history either.  Perhaps that’s why we repeat the mistakes of the past.

How thoughtful are we in our assessment of art or our assessment of investments?  Is our analysis superficial and brief, or do we develop a more robust understanding?  I was gazing at American Gothic, Grant Wood’s iconic painting, when a young woman approached with her cell phone, framed the image in the display, took a picture, and walked away.  She didn’t look at the painting itself even for a second.   Sometimes we do the same thing with investments, considering them only through the view finder of an “expert,” and fixing our beliefs forever in response.

The Impressionists draw crowds at the Art Institute, especially the famous Sunday Afternoon . . . by Seurat.  Nearby, the collection of Haystacks by Monet (at six, the largest number in one place) reminded me of how our own impressions are formed through comparison.  Like selecting a manager for an investment mandate, we can spend lots of time looking at the little differences from one painting to another, but if we know that one work is thought to be the best among the twenty-five or so versions of haystacks that Monet painted, the chances are we will tend to agree.  Too bad.

There is a new modern wing at the museum.  How long is “modern” modern?  We have a similar question in investment theory.  Modern portfolio theory seems decidedly not modern right now, just like much of the art that carries that name.  We can’t resist categorizing things, be they paintings or investment strategies, and some of the names aren’t really applicable.  (Think of the range of things we call “hedge funds.”)  Really, what we are after is good art, good theory, and good practice — and the ability to know rubbish when we see it.

In an out-of-the-way part of the modern galleries is The Old Guitarist from Picasso’s “blue period.” His greatness was in part based upon his ability to adapt and to redefine his art, like Warren Buffett, who went from deep value to brand franchises and beyond.  Contrast that with the way that much of the investment industry is built upon an adherence to an investment approach rather than the continual adaptation of it.

As befits Chicago, there are remnants of elaborate buildings by Louis Sullivan and Frank Lloyd Wright in the museum, including a reconstruction of Sullivan’s original Chicago Stock Exchange trading room (usually empty), the perfect place to contemplate how trading has changed over the years.  Today’s exchanges are emptying out too.

Frankly, the galleries of the Art Institute don’t fit very well together architecturally; neither do today’s markets for securities and investment services.  But instead of museum volunteers to guide them, investors must rely on gatekeepers that have more complex motivations.  There are no guarantees that someone with CFA behind their name will do better by you than anyone else.  But the organization that confers the designation has education and ethics at its core, as the annual conference demonstrated.

That is a canvas upon which beautiful art can be made.

An index of all of the postings about the CFA annual conference includes descriptions of and links to each one.[2]

“Our industry has forgotten what it takes to maintain the trust of clients, regulators, and the public as a whole,” he said.  As a result, “Our profession has lost much of its good standing and public respect.”  Alas, it has been “a failure of self-control” that has caused the damage.

So now what?  According to Rogers, the CFA Institute intends to be a bolder voice for reform of the investment industry.  He said that finance came to be thought of as an end in itself, to the detriment of the industry, its professionals, and society.

As advocates, the CFA Institute and other interested organizations can only do so much.  Rogers’ message was primarily one of personal responsibility, that the profession is “at a fork in the road” because professionals have been standing by as the industry has done its thing, rather than standing up for the principles that the CFA was founded upon.  Shortly after his speech, all CFA members around the world received an email with fifty ways to restore trust, culled from suggestions sent by charterholders themselves.

Look at the list[2] and think how you’d grade the investment industry today, point by point.  It’s a list of ideas, not a cohesive narrative, but it reminds us that it is within firms that the ethical battles must be won, professional by professional.  We need openness instead of opacity, fees that are reasonable for the services provided (and the value added), client interests that come before a firm’s interests, and an absolute commitment to ethical behavior.

Of course there are many great firms and upstanding professionals.  But despite the fact that you can do business the right way and still end up incredibly rich over time, the allure of the quick score is irresistible for many.

The night before Rogers’ speech, Heather Brilliant, the chair of the CFA Society of Chicago, quoted Albert Einstein:  “Relativity applies to physics, not ethics.”  However, the business runs to a large extent on relativity — relative performance, relative valuation, and endless games of follow the leader, chasing what’s hot until it’s not and cutting ethical corners in the process.  “Everything is relative”[3] could be the industry’s motto.  Somewhere along the way, ethics became relative like everything else.

This is a unique business, with ethical challenges everywhere you look.  In fact, in 2007 the CFA Institute published a monograph on the topic, The Psychology of Ethics in the Finance and Investment Industry.[4]  A few months later, you didn’t need to read the book to know that something was very wrong about the way the industry operates.

But what has really happened since then?  By and large, the industry has fought reform at every turn, arguing that new regulations are onerous but demonstrating no resolve to change the way business is conducted on its own.  Investment professionals are faced with a dilemma; to build a better industry we must tear down some of what passes as the way of the world, even at our own firms.

To quote Rogers, “Now is the time for action.”  I couldn’t agree more.

See more postings about the conference.[5]

The first was a plenary session that featured Harold Bradley of the Kauffman Foundation, Bill Hambrecht of WR Hambrecht, and Duncan Niederauer of NYSE Euronext.  It was titled, “Has Innovation Helped or Hurt the Integrity of Markets?”

Niederauer had his PR hat firmly on throughout the session, urging attendees to “take a balanced view of accomplishments and pitfalls,” and chastising critics of the industry, saying, “Quit being negative; we’re trying to solve problems.”  By and large, he gave a defense of the status quo — other than warning about the growing share of dark pools.  In other words, he talked his book, and did not address issues related to the upheavals caused by new business models at the exchanges.

As Hambrecht noted, the changes in the industry have led to much lower transaction costs, at least in equities.  (You can still get mauled trying to sell a muni, for example.)   That’s the one shining benefit that gets pointed to as evidence of progress.  But at what cost in other ways?

Hambrecht summarized my point of view when he said, “Much of what we call financial services innovation is dealer bookmaking.”  That’s where the action has been.  Bradley stated it this way:  “The foundation of the business relies on prop trading.”  He also expressed concern about the explosion in the notional value of OTC derivatives that has resulted.  Certainly, the game of cat-and-mouse with the regulators will continue, but sometimes it seems like the regulators are the mice.  As always, those with the most power to change market structure for the better are on the buy-side, and Niederauer believes that they will “have a lot more to say” going forward, but it really hasn’t happened to date.

Partially because of the JOBS Act, Hambrecht thinks that there will be a shift away from technology as the driving force of change in the business, to “content.”  He sees a flowering of research information ahead.  (I am less sanguine, for a variety of reasons.  By the way, I wish that the conference had been held this month so that I could hear Hambrecht talk about the Facebook IPO.)

While that panel didn’t provide much in the way of fireworks, that was not true of one at a breakout session regarding high-frequency trading held later the same day.  The panelists were Kevin Callahan of AX Trading Network, Manoj Narang of Tradeworx, and Joe Saluzzi of Themis Trading.  Narang and Saluzzi squared off repeatedly about the benefits and detriments of HFT.

Narang believes that firms like his provide the liquidity that is the lifeblood of the market, saying that “without HFT, there is no market,” that they are the “natural counterparties . . . trying to take the other side of your trade.”  Saluzzi sees not liquidity providers, but liquidity takers, and decried abuses by HFT firms.  Narang acknowledged some “inadvertent [quote] spamming behavior,” but Saluzzi scoffed at that characterization.

All the panelists agreed that Rule 611 regarding “locked markets”[1] is problematic and needs to be reviewed, which is saying something, since there wasn’t much agreement on anything else.

As far as I’m concerned, the bottom line was expressed by Callahan, who said, “The buy-side needs to wake up.”  He thinks it’s time for those investors to have “a holistic view toward trading costs” and realize that “they have a choice” regarding the market structure in which they operate.  On a trade level, Saluzzi sees the VWAP orders and other algorithmic trades from institutions being “picked off all day long.”  But, as Callahan indicated, the larger question is whether those buy-side firms will take the lead in dealing with the pressing issues of market structure that have resulted from “innovation.”

Yes, it’s hard for me to use that word in this context without the quotation marks.  They call it “innovation,” but in the investment business, that usually just means that “we figured out how to make some more money for a while.”  True innovation involves a rethinking that adds value over time, not just speeding things up to clip basis points for today — and in a business where we are stewards of the capital of others, it should lead to benefits for the many rather than for the few.  As an industry, we’ve failed to make that happen.

Other postings about the CFA annual conference.[2]

One of the best breakout sessions at the CFA annual conference featured Brian Uzzi, a professor from Northwestern.  It was in a slot at the end of the day and the title indicated it was about using “social networks to build your business.”  That’s a well-worn topic that didn’t seem very promising, but I decided to hang out in the back of the room to see if there was anything worthwhile.  There was.

Uzzi talked about network dynamics, opening with the differences between the networks of Paul Revere and William Dawes, the theory of six degrees of separation, the nature of high school dating networks (and corporate boards of directors[1]), and the contagion of both diseases and ideas.  In today’s world, investment professionals ought to understand how networks function, since the principles feed into the sociology of markets and organizations — and the investment decision process.

Seeing Uzzi’s presentation, I was reminded of a series of postings I did from Defrag 2008, including one called “the social urge.”[2]  In it, I talked about a presentation by Paul Pedrazzi of Oracle, in which he looked at the different characteristics of people in a network.  As I wrote then, “one prerequisite for social networks to be successful in the enterprise is for them to encompass and incorporate the abilities of a wide variety of people, not just those for whom the inclination to use the networks is natural.  Otherwise, they are at great risk of become nothing more than echo chambers.”

Yet, as Uzzi noted, echo chambers are in fact what many of our networks become.  Whether it’s our personal networks or business ones or (certainly) political groupings, we tend to cluster, creating “a myopic view of the world” with a “common information set.”  If you were to design a network for optimal information sharing and decision making, it would look nothing like what most of ours do.

And that’s true for investment organizations.  For the most part, information gathering is a free-for-all, which often means that when it comes to decision making, common sources get magnified and unique inputs get marginalized or not used at all.  The “tried and true” becomes tired and narrow, without us even realizing it.

What if you could observe and map the flow of information and ideas that you use?  Where are the gaps and where are the echo chambers?  And where is the “structured myopia”?[3]

In addition to talking about the nature of networks, Uzzi explained some of his current research regarding “emotional activation and trading.”[4]  He says that “short-lived psychological states” interpreted from the messages of traders can predict subsequent behavior.

Given the flurry of interest in “the Twitter hedge fund,”[5] that’s not a new concept, but these types of analyses are in their infancy.  The headlines going forward will likely focus on the “beating the market with algos” meme, while I see the power of the research being applied to organizational decision making.

Since it’s the first Saturday in June, tens of thousands of candidates are taking the CFA exam today — and the parade of newly-minted finance graduates continues on stages across the land.  I would say to each:  Understanding the sociology of the investment business is as important as anything else that you have learned to date (except ethics).  You’re probably tired of studying, but if you don’t know much about network dynamics, now is the time to learn.

This is the tenth in a wide-ranging series on the CFA annual conference.[6]

Today’s title came from a phone conversation that I had with someone a few months ago that concerned the process of communicating about an investment firm and what it does.  I said that I’d had some success at new business pitches and review meetings simply because I was “marginally less oblivious than most portfolio managers.”  Good relative performance, if you will.

I have used the phrase since and those hearing it usually smile knowingly.  Jamie Ziegler, the founder of AUM Partners, did so when I related the story to her at the CFA annual conference after her session on “Best Practices in Client Communications.”  Her message was that “emotional intelligence is the foundation of superior client communications skills.”  Unfortunately, that’s not the strong suit of most investment professionals, yet they are often thrown into situations where they are expected to communicate well.

Leading up to Ziegler’s presentation, I had been in three conversations with people at the conference about the nature of investment organizations and how they tended to fall into two camps — those that came across as curious and those that appeared to be primarily defensive in character.  So it was an interesting coincidence when Ziegler used those two words to describe those individuals who are effective communicators and those who are not.  Openness and honesty engender trust.  That’s the first lesson to learn.

Ziegler covered plenty of tips for improving communications (truly listening is a hard one for most of us), but firms need to also make assessments about who can be successful at carrying a heavy burden of communication and who can’t.  Too often, investment professionals are put in situations and given messages to deliver that are bound to lead to failure.  Sometimes you have to reinvent the communications construct to succeed.

Just as the methods of communication may need to be adjusted, so must the content itself.  Several speakers talked about how clients and prospects now expect different information.  Mellody Hobson of Ariel Investment said that “there’s no question the relationships with clients have changed.”  They are now more risk averse, honing in on this statistic and that, and asking for “a detailed discussion of your risk management.”  New items are expected to be found in pitch books and review books — and different topics need to be addressed in the meetings where they are presented.

The author Sebastian Mallaby said that the “conversations between hedge funds and their clients aren’t what they should be,” that there isn’t enough transparency and that the “right” things often aren’t discussed.  Ashvin Chhabra of the Institute for Advanced Study talked about the need to frame investment decisions with individuals in completely different ways, including recognizing that “you can’t asset allocate your way to another part of the wealth distribution.”

The “what” of the conversation is changing, in no small part because of the amazing market events of this millennium.  Unfortunately, communications can become more reactive than they should be, resulting in a backward-looking agenda that leaves important matters unaddressed.  Finding the right balance is critical.

More importantly, across the years issues will come and they will go.  But those that know how to communicate effectively have an advantage.  And often all it takes is to be marginally less oblivious than everyone else.

This is the ninth in a series[1] on the CFA annual conference.  Up next is a look at the power of networked conversations.

I wish I had thought of that line, but I didn’t.  Hugh MacLeod did.[1]  He is a cartoonist with an unlikely mission, “changing business for the better.”

Ever since I saw that quote from MacLeod I have been repeating it to clients, because I think it perfectly sums up the challenges that many of them face.  Investment organizations — whether they be businesses per se or other kinds of institutions that make investment decisions — need to have the right people involved in those organizational conversations, the right issues addressed, and the dialogue should meander in constructive rather than destructive ways.

Attending the CFA annual conference got me thinking more about the nature of those conversations, since there were quite a few presentations that touched on the theme in one way or another, surprisingly so for an investment conference.  But such a gathering spawns a series of conversations of its own, with people you planned to meet, those that you’ve known online but not in person, and the ones you happen to sit next to on a bus or at a table.  So, to borrow a phrase, a conference is only as good as its conversations, including the ones spawned by the particular topics and speakers chosen by the organizers.

One breakout session featured Kim Redding of Brookfield Investment Management and Jim Ware of Focus Consulting Group, who has helped Redding evaluate Brookfield’s culture.  The topic of their discussion was the interplay of personalities at Brookfield and investment firms in general.  You might think that would be uninteresting to a bunch of investment professionals, but the room was full and there were heads nodding throughout.  I think all of us had seen that investment performance can be easily damaged if no one cares about how people work together and what their conversations entail.

The fear, of course, is that you get too much structure, too much process, and too much culture, since investment people are famously reticent about all of those things.  For his part, Redding is an advocate of understanding the personalities at his firm and carries the Myers-Briggs profiles and other information about his team around with him — as a reminder of how each makes decisions and how best he can communicate with them.

Redding showed the audience that information.  He was somewhat of an outlier from the typical investment person (I can relate), so he processes ideas much differently than many members of his team.  That kind of situation can lead to key players talking past each other and getting frustrated enough that it could end up in open warfare or a cessation in the ongoing discourse that needs to occur.

As Ware’s work has shown, investment organizations tend to have extremely unbalanced distributions of personality types.  I think that’s a direct result of the dominant human relations philosophy in the industry:  Hire smart people (that think like we do) and let them make decisions.

But research into decision making has demonstrated the weakness of such an approach.  There is strength through interaction, specifically interaction with others who don’t address problems in the same way that you do.

Just as it’s easy to hug performance benchmarks too closely, it’s easy to adopt industry norms for what an investment organization should look like.  In a business where competition is fierce and alpha is precious, it might just be that having different people, structures, processes, and conversations than other organizations will be the key to success going forward.  Maybe now is the time to start talking about it.

Thus begins a “mini series” within the series[2] of postings on the CFA annual conference.  Stay tuned for more thoughts about conversations with prospects, clients, networked contacts, and conference attendees.

Starting out, Sandor talked about what makes for a “good derivative.”  As befits his key role in the development of financial futures,[1] his answer was straightforward:  “Transparent, regulated, and centrally cleared.”  And bad ones are “opaque, unregulated, and have insufficient capital” backing them up.  It’s hard to argue with those characterizations, given that all the real calamities have come from the latter.  But that’s where the money is too, so the problem doesn’t seem to go away.

Sandor’s main topic concerned another kind of “good derivative,” however.  He was the founder of the Chicago Climate Exchange (CCX) and related entities, “the world’s first and North America’s only voluntary, legally binding greenhouse gas cap-and-trade system.”  The CCX closed in 2010, a fact much celebrated by those in opposition to the concept, as any online search for information about the exchange will demonstrate.

When Sandor sees problems, he wants to figure out how markets can solve them, and he recited a list of the benefits of markets during his talk.  But the problems are getting knottier and there is political opposition from both ends of the spectrum when it comes to addressing environmental problems with market-based solutions.  “The left wing hated us as capitalists and the right wing because we were nutty environmentalists,” said Sandor about his experience with CCX.[2]

In a cost-benefit sense, the cap-and-trade system was a rousing success, according to Sandor:  $3 billion in costs and $120 billion in benefits a year, including 32,000 lives saved, which he thinks never could be seen because of the smoke from the political rhetoric.  “We aren’t thinking like we used to,” he said, citing the $2-3 trillion in costs in response to a $500,000 mission sponsored by al-Qaeda (another perspective that’s likely to make him unpopular with some).

He sees using markets in innovative ways to deal with potential environmental threats as placing cheap bets to protect future generations.  But that takes a consideration of probabilities and possible outcomes — something I wrote about on this site four years ago, regarding “warming up the models”[3] of analysis — not certainty about what will happen, which is the state of the discourse today.

Our approach tends to be reactive rather than proactive, throwing money at problems rather than thinking creatively in advance about what might happen.  That goes for investment professionals as well as government officials.  For example, Sandor asks, in the wake of events like Katrina and Fukushima, “Does anybody think that $500 billion of property and casualty capital is enough?”

While it wasn’t a focus of his presentation, Sandor thinks market-based remedies are needed to solve the water allocation and usage issues that are coming at us faster than we care to believe.  He sees “good derivatives” that can help us solve our problems — and named his book accordingly.[4]

As long as we are thinking about the future, I wonder whether these issues will be front and center at the CFA conference ten years from now or all but forgotten.  I’ll take a cheap bet on the expectation that this topic is here to stay.

This is the sixth in a series[5] of postings on the CFA annual conference.

Daniel Kahneman and Eugene Fama appeared a day apart at the conference and were obviously worlds apart in their theories of economic decision making.  Fama is the dean of rationality and empiricism, while Kahneman sees the economic world in a behavioral context.  Both were entertaining and obviously brilliant.  One was left wondering what would have happened had they gone mano a mano.

As it was, the contrasting ideas of the two men were the backdrop for many of the conference sessions, even the ones that occurred before their presentations.  But it wasn’t just a battle of those two heavyweights that set the tone for the conference — it was their dances in turn with a third, the investment management industry itself.

One long-standing debate is that of active versus passive investment strategies, and Fama wasted no time in proclaiming the futility of active management in front of a sea of active managers.  Many that were in attendance manage growth stocks, but Fama told them that there’s a negative premium for growth:  “If you like growth companies, you take a lower expected return.”  He also questioned other popular industry ideas, saying that the current fascination with low-volatility strategies is actually based upon decades-old knowledge and when asked about risk parity asset allocation, he said he’d never heard of it, but that the concept sounded “stupid.”

Fama commented that “it’s hard to think of anything more valuable than having someone get you to think differently” and “you don’t know what’s going to surprise you next year or even next week,” yet most of his answers (during the session and in his publications) make finance sound like settled science.  When it comes to behavioral finance, he thinks that it is very good at the micro level but that it offers no insight to aggregate economic activity.

In contrast to Fama, who sees an overarching theory of finance, Kahneman comes at things from the ground up.  Much of his talk related to concepts explained in depth in his book, Thinking, Fast and Slow, which is about how we make decisions.  For practitioners, Kahneman’s talk was full of useful information, including the importance (and risks of) storytelling in decision making, our willingness to ignore key information if it suits us, and the overconfidence that seems to never go away, despite ample evidence that it should.  Those findings (and others) from Kahneman have direct impact for people who work in investment organizations and who deal with clients.

By definition, active managers think that they can beat the odds and outperform over time.  If so, Kahneman’s work should provoke more than a “gee, that’s interesting” response — it should aid the drawing of the blueprint for a successful investment firm.[1]  His potential impact on the industry is significant, but given how hard it is to change the culture and processes of a firm, I think that change will be a long time coming.

Listening to Fama and Kahneman, I thought of a useful exercise for investment managers:  Try to explain your strategy in reference to Fama’s view of the world and your decision process in light of Kahneman’s observations of human behavior.  If you can do that, you are a giant step on the way to defining the set of beliefs that you embrace, the nature of the choices you will make, and the likelihood that you’ll be able to add value for your clients.

As disparate as the two men are, like all good thinkers they provide reference points by which you can determine where you are.

This is the fourth in a series of postings about the 2012 CFA annual conference.[2]