Thursday, May 23rd, 2019
mind the gaps

According to Wikipedia, “mind the gap” is “an audible or visual warning phrase issued to rail passengers to take caution while crossing the horizontal, and in some cases vertical, spatial gap between the train door and the station platform.”  If you’ve visited London, you’ve undoubtedly had the phrase imprinted on your brain for some time, given its ubiquity there.

Fittingly, attending and speaking at the CFA Institute Annual Conference in London last week got me thinking about all kinds of gaps.

Sessions throughout the event — the theme of which was “disruption” — dealt with some of the biggest gaps that we face today.  Climate change, sustainability, and ESG were a heavy focus throughout (including being addressed by Prince Charles in his video message to the attendeesYouTube | Here is that message.).  Geopolitical issues and demographic trends got attention too.

A decade after the financial crisis, there remains a large trust gap.  Markets may be up, but many people see the investment industry as part of a rigged system (always getting its take, no matter the outcomes for clients, and periodically putting the whole system in danger).  And capitalism, at least the form of it that we have now, is being questioned, even by some of those who have profited the most.

The conference started with Roger Ibbotson talking about Popularity: A Bridge between Classical and Behavioral Finance, a monograph from the CFA Institute Research Foundation that he co-authored.CFA Institute Research Foundation | You can access it here.  The gap to be addressed in this case is obvious from the title.  As Ibbotson said, “Assets are bundles of characteristics,” and we have preferences for characteristics that go beyond those covered by classical finance.  PAPM (Popularity Asset Pricing Model) may not dislodge CAPM during this generation, but its assumptions are closer to the nature of the real world.

I led one of the “extended sessions” at the conference, which are longer, allowing for a deeper dive than a typical slot.  My talk was on due diligence and manager selection, including finding the gaps between what a firm says it does and what it actually does (and what it could do).the research puzzle | I wrote an earlier piece on finding the gaps in a manager’s process and organization.

Over the last several years, manager research topics have become a much bigger part of my writingWritings from Tom Brakke | You can sign up for notifications here. and trainingtjb research | You can find out more on the training page of my website. activities.  I backed into them by accident.  Providing consulting to organizations on both sides of the process, I came to the conclusion that the current standards of practice aren’t what they should be.

One of the problems is that the typical approach is far too narrow.  For starters, as an industry we have beaten performance analysis to death.  We slice and dice numbers to the nth degree (and provide page after page of metrics as “evidence”), all the while ignoring the lack of significance of it and refusing to recognize the performance chasing that has been built into the selection process.

Another problem is too much investment analysis.  How can that be?  As investment professionals, we like nothing more than talking with others about investment ideas, but if the goal is to select organizations and individuals that can make good investment decisions over a protracted period, much of that time ends up being wasted.  Properly sizing the investment component of analysis is a challenge for novice and experienced analysts alike.

Conversely, there are a couple of areas where value can be added that are largely overlooked.  The first is organizational analysis.  There is very little work done on the structure, culture, and human capital of organizations in most manager research efforts, yet the organization is the platform for success.  The gaps in this area are chasms, not cracks.

A second field of opportunity is the broad category of intelligence analysis, including innovations and improvements in the processes of investigation and decision making.  The state of the art needs to move beyond the compilation of performance histories and narratives of managers to a more thorough and multifaceted examination of them.  And much more time needs to be devoted to judging the quality of the individual decisions that are made and the evaluation and selection framework itself.  Again, this is woefully lacking, even in many large organizations.

In addition to the CFA conference, I also attended Behavioral Alpha,Behavioral Alpha | The next event is in November in New York. a half-day event put on by Essentia Analytics.Essentia Analytics | Essentia offers a “behavioral analytics service that answers the questions that really matter about how you make your best (and worst) investment decisions.”  That firm’s work tries to close the behavioral gaps that can inhibit the performance of portfolio managers by tracking their decisions and providing feedback and nudges.the research puzzle | This may seem like the overlords from my last posting (“watching you”) at work, but it’s more about self-improvement, using agreed-upon approaches to improve decision making.

The first session focused on patterns in the lifecycle of alpha (at the security level) that are common in their studies of portfolio managers.  There are four main profiles:  the coaster, the hopeless romantic, the round tripper, and (the one we all want to be) the linear accumulator, for whom the alpha mountain keeps growing over time.  Unfortunately, if you look across all of the data that Essentia has, the aggregate pattern looks like that of a round tripper.  Professionals tend to build alpha early and then give it back.  (Essentia will be publishing a white paper on this topic in the coming months.)

The remainder of the event included a panel that discussed how behavioral tools are being used currently in investment organizations (and how they could be used), and a cognitive neuroscientist who talked about the challenges that we face in trying to make unbiased decisions.  One sobering moment:  the room full of analytical people learned that analytical people are even more likely than others to twist data to fit their prior beliefs.  None of this is easy, even for those who are used to being the smartest person in the room.

The biggest gap of all may be cultural.  Every investment organization ought to be focused on continuous improvement and becoming a decision factory first and foremost, but strong egos and established norms get in the way of that.  Investment expertise is seen as trumping all; those who need coaching or training or feedback on their decision making (read:  all of us) are generally resistant to it and the leaders of organizations are reluctant to fiddle with the way things have always been.

Mind the gaps and work to close them.  Every day and on each frontier.  That’s how long-term excellence is built.