Underperformance, egos, and asset management’s most obvious structural flaw.

Reported by Elizabeth Pfeuti
CIO Magazine, 11th September 2015

“I’d like you to underperform your benchmark by a consistent 200 basis points for
the next six months.”

Imagine making this statement at your next fund manager meeting. It’s likely that those sitting across the table would look at you quizzically and ask you to repeat the instruction.

You’d say again—stressing this time—that you’d like your manager to underperform their benchmark by 200 basis points for the next six months. After all, if they are as skilful as they (and their fees) would have you believe, this should be no problem.

It’s probable that your manager would start reeling off the quarters of outperformance they’ve had and assure you that these returns are a better indicator of skill.

“OK, great,” you would counter. “Can I accompany you to your next training session? When this week are you analysing your performance? Who is responsible for pouring over your daily trade data and who poses the tough questions on your selling discipline?”

Cue more quizzical looks.

“Because,” you would then say, “if your returns are down to skill rather than luck, I want the best coaching team available—like Serena Williams, Lewis Hamilton, or the New York Yankees employ. We can’t afford for you to lose your edge.”

At this point, very few fund managers would throw open their office door and lead you to the nerve centre where all this happens. Most of them would smile nervously and ask if you’d like to hit the bar or have a round of golf instead.

Egos and mediocrity are the problem. If your fund manager maintains you are remunerating him for his superior skill, but refuses to take advice or training to maintain or improve his performance, he might find that luck soon runs out.

And do you want your assets to crash out of the major leagues with him?

“She can improve a lot. Her game at the net can improve and the transition from the baseline to the net can be improved a lot. Her swing volley can be better; she sometimes is hesitating to move forward… it’s just to name a few.”

This is Serena Williams’ coach, Patrick Mouratoglou, discussing how she could improve her game. It was not when she was struggling to perform a season or two ago, but in a CNN interview in March of this year after she had just won the Australian Open. She went on to win the French Open and Wimbledon, and is poised to take the Grand Slam at the US Open.

“Serena Williams’ game involves roughly 85% skill and 15% luck,” says Lawrence Evans, co-founder of Salomon Partners, a fund management coaching and performance analysis firm. “Being a fund manager involves 90% skill and 10% luck.”

Williams has an undeniable gift for tennis, but instead of relying on her natural ability, she is driven to excel. She trains at least five days a week and whether she has just slammed her opponent 6-0, 6-0, or been slammed herself, she returns to the training court the next day to work.

Very few people are natural fund managers. Securities selection is not a skill we are born with, most people believe. It is something we work at. With that in mind, how many of these investors—who rely more on skill than luck—can boast a regime like Williams’? Very few. And unfortunately for investors, there is usually just one thing to blame: Ego.

“Our industry puts too much emphasis on people believing they are geniuses or have some kind of sixth sense. That is all rubbish,” says Fredrik Martinsson, righthand man to the CIO at Danish pension ATP. “There are some brilliant people, but what makes them is the interconnection between protocol and details—their process.”

For Martinsson, there are four important P’s: people, protocol, process, and a platform from which to conduct it all. “The most important P is people,” he says, “but only if they are devoted to the others.”

The cult of “star fund managers” is not only unhelpful, but rarely actually true, according to Morningstar’s UK Director of Manager Research Jeremy Beckwith. “There is a small number of managers who have been around 10 years [at the same fund] and really good firms are hard to find,” he says. “We give positive ratings to fewer than 10% of firms.”

No firm is consistently brilliant, according to Beckwith, but the underlying factors of people and process are key to being better than average. “The process gives the outcome,” says Evans at Salomon, who also should be credited with the question in this article’s opening. He and his partners, including former Goldman Sachs Asset Management international business head and behavioural finance expert Paul Craven, pose exactly this question to leading international fund managers.

The answers they receive indicate whether they are dealing with someone who wants to be the best or someone who believes they have already hit their groove and are happy with it.

“We meet a lot of rock stars,” says Evans, “but we have found that having a massive ego is not a trait of a genuinely skilled investor. We have pitched to managers with huge egos and have been asked to leave, but we are lucky to coach some of the best portfolio managers in the business.”

Evans believes a “folklore of finance” says success should be measured by the alpha created—and that needs to change. “Are you meeting your clients’ objectives on a long-term basis?” should be at the heart of every decision a manager makes, says Evans. Despite many outwardly saying this is the case, actions speak louder than words.

Beckwith has spent years meeting fund managers and evaluating their performance. Yet few people have delivered and shown real skill. Those who do have similar characteristics. “They are passionate and single-minded about investing,” he says. “They show humility and realise that at least one-third of their decisions are going to be wrong. The successful ones want to learn when they are wrong and when to cut their losses.”

We have all been told that it’s good to be right. However, most important is to know whether you were right for the right reasons, or right for the wrong reasons. Luck is very easy to spot and impossible to control—just hit the roulette wheel to find that out. Skill is a different matter.

“We ask a fund manager: ‘How do you define skill?’” says Evans. “For the majority, ‘the return’ is the answer. We ask: ‘Is it something you can control?’ most fund managers say ‘yes’—but it isn’t. The return is the outcome. The skill is the process. Fund managers get themselves into knots with this question.” Even the best fund managers in the world win no more than 60% of the time, according to Evans. “There’s a lot more luck involved than managers admit—and a lot of it comes down to money. You can’t charge fees if you’re basing your outcomes on luck.”

Former sportsperson-turned-CIO Larissa Benbow draws many parallels between the worlds of sport and finance, and identifies problems with the latter. “What tends to happen in the investment community is that the industry becomes too focused on the output (performance) and they start to ignore the inputs,” says Benbow. She represented Great Britain on the international softball stage before taking charge of a £10 billion corporate pension at high street bank HBOS. She left the bank in 2015 and is about to announce her next investment role.

“When this happens, performance often suffers, leading to fund managers looking for shortcuts to get it back on track—or they look for a fall guy to blame.”

The fall guy can be anything from the market, to central bank actions, to poor liquidity, to other investors. Can you remember the last time you heard Rory McIlroy blaming anything other than himself for failing to make the cut?

“In sports, if you want to be and remain the best—and improve—you have coaching and take advice,” says ATP’s Martinsson. “In our industry the same rules don’t seem to apply. The concept of training is new and some are sceptical.” Additionally, the majority of investors do not want to reveal what they are doing to someone else—for whatever reasons—says the Dane.

“Believing that the learning or developing stops or is reduced upon taking the role as fund manager is naïve,” says Benbow. “It now becomes more critical than ever; and if they believe this is not the case all they need to do is reflect on where Serena might be without her coaches. Sure, she might be a good tennis player, but would she be the record-setting champion she has become? Doubtful.”

If a fund manager was playing Williams at Wimbledon, who would be in the supporters’ box? The player’s manager would be the fund house’s CEO; the accountant would be its CFO; physical therapist and personal trainer would be covered by the COO, with investors making up the family and friends cheering and being filmed by TV crews. This just leaves the position of coach, which is pivotal to Williams’ success. It would be empty for most fund managers.

That tide may just be about to turn—at least for the managers who want to consistently see their name engraved on the trophy. “They realise that if you want to be number one, you can’t do it on your own,” says Evans. “You need a sounding board, coach, and teacher rather than just waking up and making trades.”

It all starts with data. 

“In sport, no elite athlete competes or trains without analysis and someone tracking their improvements,” says Rick Di Mascio, fund manager-turned-analyst at Inalytics. “As soon as they step off the court, pitch, or ground, their stats are waiting for them. It’s inconceivable that anyone could compete without a coaching programme.”

At Inalytics, Di Mascio has put together a programme with Shane Sutton, technical director of British Cycling, to apply to fund management. Sutton was instrumental in reshaping the Great British cycling team to become a world leader on the international stage.

Both Inalytics and Salomon Partners, although with different approaches, focus on the same method: collecting data, analysing and learning from it, then working with a coach to update and maintain an edge. “We have 1,000 portfolios and millions of investment decisions to look through,” says Di Mascio.

A key point here is that those doing the coaching are not—and never were—individually at the top of their game. Sutton contributed to the Great Britain team that won 26 Olympic medals, but won none himself.

“Why do the top four tennis players all have dedicated trainers?” says Martinsson. “They have the best backhands and forehands in the business—who is a trainer who has not won as many titles as them to tell them how to play?”

It doesn’t matter, Martinsson argues.

The Folklore of Finance

State Street has an independent think tank called the Center for Applied Research (CAR). Their research is well worth following. Recently they have written an outstanding paper called “The Folklore of Finance”. The report discusses how the traditional beliefs, biases and human behaviours are sabotaging our industry. There are some excellent conclusions and tangible action points that are very much in line with Salomon Partners’ industry views. It is a very good read.


“Getting Lucky”

Howard Marks’ must-read article “Getting Lucky” discusses a variety of thought provoking issues. One of the concepts that resonated with us was the concept of markets being structurally efficient, but periodically cyclically inefficient.

Marks goes on to state “Markets will be permanently efficient when investors are permanently objective and unemotional. In other words, never. Unless that unlikely day comes, skill and luck will both continue to play very important roles.”

Keep developing skill!