Thursday, February 25th, 2010
structured myopia

When I was teaching MBA finance students, I included a class on the sociology of investing.  Seeing it on the syllabus did not cause a stir of excitement throughout the lecture room, since the goals of many there were to a) learn how to find ten-baggers and b) get a job.  Nevertheless, it should be part of “the core” for would-be investors.

An innate sense of where the crowd is going is critical to success, so that’s “the sociology of investing” that gets most of the attention.  Relatively little scrutiny is given to how investment firms work and how investment decisions are made within them.  A great posting yesterday on the blog socializing financesocializing finance | The blog has several authors; this posting was written by Daniel Beunza. speaks to one of the themes I have been preaching for years:  Firms are often structured in ways that make no sense given how markets work.  The posting highlights some nascent efforts to integrate trading desks across asset classes at large brokerage firms, but the principles that underlie the need to do so should be applied even more broadly.

Specialization dominates the investment decision making process.  There are remarkably few generalists in the business and, within firms, little sharing of information across asset classes — or even within them if there’s no incentive to do so.  I once asked a famous strategist how much his equity people talk to those in fixed income.  He said, “I can’t even get the growth guys to talk to the value people.”

Awhile back, I wrote about “where we draw the lines.”the research puzzle | This posting used the Morningstar style grid as a jumping-off point to examine the analytical structures we create. The “lines” of our organizations, like our analytical boundaries, are convenient, but they inhibit our ability to sense market opportunities and to seize them.  The most rigid appear between asset classes — and they are reinforced by consultants, advisors, media, etc., looking for simple descriptive boxes — but there are many others that lurk as well.  And they are cemented in place by the misguided belief that incentives should flow to individuals or teams or groups or divisions based overwhelmingly or exclusively upon their unique contributions.

Where those lines are depends on the past and the personality of the firm in question.  One of the most common hierarchical equations amounts to “equity > fixed income,” although it depends on a firm’s history, assets, and who is in charge as to whether that’s specifically in play.  No matter, it serves as a wonderful example of the principles that I am trying to illustrate.

It is normally the case that fixed income and equity operations are quite separate at most firms.  Those in research, trading, and portfolio management jobs are charged with doing their business and are compensated accordingly.  That might make sense if the market was kind enough to act like one didn’t matter to the other, but that’s never been the case and the financial innovations of the last couple of decades have only intensified the interdependence.  The flow of information between the two groups of specialists should be continual and substantive, but that rarely happens.

The ironic thing in the equation that I gave above is that, when push comes to shove, you are often better off paying attention to the developments in the bond market.  I remember clearly an interview ten years ago, during which a star equity analyst explained to CNBC that her positive view on made sense, despite her firm’s debt analyst having issued warnings on the company.  She said that equity analysts look forward and fixed income analysts look backward.  You may recall that Amazon got crushed.

Recently I saw an online commentary that boiled down to, “Who cares about Greece?”  I tweeted a response that said that “the credit market is always the canary.”Twitter | I have a few updates a day, mostly links to interesting articles I find. A litany of all of the examples over the last few decades where the first signs of trouble showed up in areas of the market that would be classified as “fixed income” would be very long indeed.  As if more proof was needed, the financial crisis was Exhibit A.  Equity investors ignored the rumblings for months and paid for it dearly.

Myopia is the enemy of the investor.  Structured myopia makes no sense whatsoever, for the individual investor or for the biggest firms in the world, but you find it everywhere.