Wednesday, June 24th, 2015
the flow of ideas

How do ideas flow within investment organizations?  That question has fascinated me for years.

There has been relatively little research done on the topic.  Yet, understanding how ideas migrate at asset managers, advisory firms, institutional investors, research firms, etc. is critical in evaluating their prospects for success.  Having worked with each of those kinds of entities on organizational improvement, I know the importance of the effective communication of ideas — and the difficulty of understanding how it really happens.

Those trying to make judgments from outside face a tougher task.  What evidence is available to you?  What inferences can you make?

For an example, see the first draft of a working paper by Gjergji Cici, Stefan Jaspersen, and Alexander Kempf.  It is titled “Speed of Information Diffusion within Fund Families.”SSRN | The version I read was posted in February 2015.  As of this writing, the authors are receiving feedback on it and will be refining it going forward.  (I previously reviewed Cici’s research on buy-side analysts,the research puzzle | The analysis looked at the performance of analyst-run funds in comparison to other funds. gave him feedback on his ideas for the information diffusion paper while the research was being conducted, and talked to him about it after it was released.)

The authors’ thesis is that the speed at which specific securities propagate from one fund to another within fund families is an indication of the general characteristics of information diffusion within the firm managing the funds.  Using the available data, they conclude that mutual funds have “significantly better performance when information is transmitted faster within their corresponding families.”  The firms that are characterized as having a high rate of diffusion (defined as ones where new positions spread quickly to other portfolios) outperform those with low rates of diffusion.

(In order to isolate manager skill, the authors calculated alpha based upon gross returns, but they also reported the net-return numbers.  The positive alpha in the gross calculations turned negative after adjusting for fees.  Those results fit with the evidence in most other studies, which have shown that the alpha produced by active management is typically captured by asset managers, not their clients.)

Some thoughts about the research:

~ It uses quarterly filings, so it can’t be finely tuned in a way that would be advantageous to further explore the theories put forth.

~ According to the authors, “A concern is that our measure is not capturing information diffusion but other family characteristics that positively affect performance.”  That is an important caveat.

~ It’s possible that the proposed reason for additional funds buying a position after one fund led the way isn’t due to the communication of value-creating information throughout the organization, but something else.  Among the possibilities:  Peer pressure, incentive systems that promote in-house competitions, and follow-the-leader tendencies (when a chief investment officer or acknowledged star tends to initiate most new ideas in the organization).

Given those considerations, do the performance results in the research “have implications for the organizational structure of mutual fund families”?  That may be a stretch, but it is exactly the kind of question that the leaders of investment organizations should be asking themselves (but rarely do).

If you had management responsibility for a mutual fund complex, you could see daily how position exposures change across all of the funds.  Using that data and other evidence, you could gain a better appreciation for the information networks (those found on organizational charts and the hidden ones that are sometimes more powerful) and behavioral webs of influence that affect security selection.

You could think about whether the broad incorporation of an idea in a range of portfolios (which is viewed as a positive in the working paper) might lead to a problematic conformity that actually increases investment and business risks at the complex, or leads to a blurring of the lines between funds that are supposed to have different mandates.

A core hypothesis of the paper is that making information flow more freely throughout an organization will lead to better overall performance.  Even if one doubts that the authors’ methodology delivers support for that hypothesis, it deserves consideration.

Why?  Some asset management firms promote the sharing of information and try to break down impediments to it.  But others don’t think about it very much or specifically try to limit the flow of information.  That might sound illogical, but there are many well-known organizations that do not operate on the theory of interdependence that is assumed by the authors.

It seems to me that those involved in manager selection should have their own theories about what works and what doesn’t work — and they should ask the leaders of asset management firms to connect the structures and policies that they employ to the philosophies that they espouse.

The linkage between organizational behavior and investment performance is largely unexplored.  The authors of the working paper provide food for thought for those looking for the “why” of performance rather than a passel of statistics about it.