Monday, November 27th, 2017
busy dying

We face a new era of asset management.  Passive investment strategies ”“ and factor-based systematic ones ”“ have been gaining market share, putting pressure on traditional active management organizations.

You've seen the headlines, proclaiming that “winter is coming” for active management or that it faces an “existential crisis.”  In response, many firms have come out with white papers in defense of active management.  They come in two varieties.

The first kind looks at the historical cycles in the performance of active management, urging investors not to jump ship just before active starts to outperform once again.  Usually there are charts that show the correlation and dispersion of individual stocks and industry sectors — and a review of macroeconomic and market environments to show when active management has performed the best.

That's all interesting and informative, but it ignores a couple of major issues:

~ The cumulative performance of active management doesn't look very good over time.  Even when the conditions have been favorable, many active managers haven't done particularly well.  The it's-just-where-we-are-in-the-cycle argument doesn't hold up.

~ There has been a general compression of alpha over time across many different segments of the asset management business, as professional investors have in essence become the market, squeezing out most of the amateurs on whose mistakes they capitalized.

The second type of white paper gets specific about the particular approach of the firm that publishes it, trying to show why that firm is better than its competitors.  Lower fees, lower turnover, higher active share, and higher levels of portfolio manager ownership of products are among the characteristics that are highlighted in these analyses.

You can't blame them for putting their best foot forward, hoping that their version of active management is seen as one that can continue to work well even as others fail.  Who wouldn't do that?

But both of those kinds of advocacy papers ”“ the general and the specific ”“ suffer from the same problem:  they define active management as what it has been rather than what it could be or should be.

Perhaps the firms that produce the papers are busy remaking themselves behind the scenes, but I doubt it.  The typical investment management organization is quite resistant to change.

Why is that?

Those with good performance are in the enviable situation of having a track record that they can sell, undoubtedly presented with the mantra that a “consistent and repeatable process” produced it.  The amazingly profitable business model of an asset management firm then leads to golden eggs for those involved.

Who would want to give that up by disrupting what you have going?

And, in many cases, even those managers who have been struggling are reluctant to change much ”“ remember, they too have been promising a consistent and repeatable process.  The industry business model is so good that they may be doing fine despite their lagging numbers.  Not as many golden eggs, but enough not to want to make drastic changes either and entail the risk of losing them all.

To paraphrase Bob Dylan, “Organizations not busy being born are busy dying.”Bob Dylan | Here are the lyrics to “It's Alright, Ma (I'm Only Bleeding).”  A lot of investment organizations don't realize that they are in the latter category.  They are busy dying.

It's time to set aside the allure of the current business model and established ways.  A makeover is in order.

We can start with the notion that “consistent and repeatable” is the holy grail of process.  The market is a complex adaptive system, eager to chew up anyone that thinks that yesterday's answer will be tomorrow's.  Continuous improvement is required, not sticking with what has worked.

But that's just scratching the surface.  Active management firms need to undergo a redesign process.  That doesn't mean that everything has to be changed, but everything needs to be subject to change.

You can start with the roles of investment decision makers and the structure of organizations.  They look the same as they have for decades.  Given the technological breakthroughs that we have seen and the ones on the horizon, those old constructs are outmoded.

And no longer can asset management organizations afford to skimp on the development of the human capital that is their lifeblood.  At most firms, a “fixed mindset” (focused on perceived ability in terms of investment acumen) drives decisions, not a “growth mindset,” which is geared toward learning and potential.Mindset | Here is a short description of the two.  Training is traditionally weakthe research puzzle | Much of it is haphazard “training by osmosis.” and leaders often become leaders whether they have the requisite skills or not.

Everyone says that culture matters, but “culture” is often a dirty word in the business (except when you’re marketing).  “Give me some incentives and leave me alone” is in the DNA of many organizations, which can easily turn into misaligned incentives and misguided decision making — not a foundation for long-term, sustainable performance.

And then there's the proverbial elephant in the room:  fees.  Most active managers charge too much, clinging to historic fee structures that are out of sync with the benefits delivered.

The body of research shows that professional investors by and large still do better than the crowd before fees, even if that pre-fee alpha has been declining over time.

The problem is that the fees eat up that alpha.  The benefits of active management have accrued to active managers, not to asset owners.  And, when you add on the fees of the other intermediaries in the value chain, it might as well be described as a lack-of-value chain.  Either active management has to get better or fees need to go down.

In fact, both are required.

For any given organization, a radical remake may be called for, or just a touch-up here or there.  The risk is being too timid in approach or too narrow in scope.  The times demand action.

Another reason that it’s hard to change is that clients don’t understand it and in fact discourage it through their manager selection processes.  So asset managers have to learn how to bring clients along with them for this ride of improvement.  And consultants, investment advisors, and asset owners need to realize that they should want to partner with firms that are preparing for the future, not ones that are clinging to the past.

The worst thing that could happen now is for active management to outperform for a time and give the impression that the danger was transitory.  It isn’t.  Don’t wait around to read a death notice in the paper and realize it’s too late to be reborn.

If you would like to have a conversation with me about your organization and ideas for improvement, you can schedule one by clicking the link on this arrow.Schedule a call | Half-hour times are available for free consultations.