(Wiley Finance 072)Investment Leadership and Portfolio Management文稿

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P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordviii P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordInvestmentLeadershipandPortfolioManagementi P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordFoundedin1807,JohnWiley&Sonsistheoldestindependentpublish-ingcompanyintheUnitedStates.WithofficesinNorthAmerica,Europe,AustraliaandAsia,Wileyisgloballycommittedtodevelopingandmarketingprintandelectronicproductsandservicesforourcustomers’professionalandpersonalknowledgeandunderstanding.TheWileyFinanceseriescontainsbookswrittenspecificallyforfinanceandinvestmentprofessionalsaswellassophisticatedindividualinvestorsandtheirfinancialadvisors.Booktopicsrangefromportfoliomanagementtoe-commerce,riskmanagement,financialengineering,valuationandfi-nancialinstrumentanalysis,aswellasmuchmore.Foralistofavailabletitles,visitourWebsiteatwww.WileyFinance.com.ii P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordInvestmentLeadershipandPortfolioManagementThePathtoSuccessfulStewardshipforInvestmentFirmsBRIANSINGERGREGFEDORINCHIKBARRYMANDINACHJohnWiley&Sons,Inc.iii P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordCopyright
C2010byBrianSinger,GregFedorinchik,andBarryMandinach.Allrightsreserved.PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.PublishedsimultaneouslyinCanada.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedinanyformorbyanymeans,electronic,mechanical,photocopying,recording,scanning,orotherwise,exceptaspermittedunderSection107or108ofthe1976UnitedStatesCopyrightAct,withouteitherthepriorwrittenpermissionofthePublisher,orauthorizationthroughpaymentoftheappropriateper-copyfeetotheCopyrightClearanceCenter,Inc.,222RosewoodDrive,Danvers,MA01923,(978)750-8400,fax(976)646-8600,oronthewebatwww.copyright.com.RequeststothePublisherforpermissionshouldbeaddressedtothePermissionsDepartment,JohnWiley&Sons,Inc.,111RiverStreet,Hoboken,NJ07030,(201)748-6011,fax(201)748-6008,oronlineathttp://www.wiley.com/go/permissions.LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheirbesteffortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespecttotheaccuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimanyimpliedwarrantiesofmerchantabilityorfitnessforaparticularpurpose.Nowarrantymaybecreatedorextendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategiescontainedhereinmaynotbesuitableforyoursituation.Youshouldconsultwithaprofessionalwhereappropriate.Neitherthepublishernorauthorshallbeliableforanylossofprofitoranyothercommercialdamages,includingbutnotlimitedtospecial,incidental,consequential,orotherdamages.Forgeneralinformationonourotherproductsandservicesorfortechnicalsupport,pleasecontactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974,outsidetheUnitedStatesat(317)572-3993orfax(317)572-4002.Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappearsinprintmaynotbeavailableinelectronicbooks.FormoreinformationaboutWileyproducts,visitourwebsiteatwww.wiley.com.LibraryofCongressCataloging-in-PublicationData:Singer,Brian,1960–Investmentleadershipandportfoliomanagement:thepathtosuccessfulstewardshipforinvestmentfirms/BrianSinger,GregFedorinchik,BarryMandinach.p.cm.–(Wileyfinanceseries)Includesbibliographicalreferencesandindex.ISBN978-0-470-43540-3(cloth)1.Portfoliomanagement.2.Investments.I.Fedorinchik,Greg,1970-II.Mandinach,Barry,1956-III.Title.HG4529.5.S5562009332.6–dc222009020140PrintedintheUnitedStatesofAmerica10987654321iv P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordContentsPrefacexiAcknowledgmentsxviiCHAPTER1CharacteristicsofSuccessfulAssetManagementFirms1YouCanTaketheBoyOutoftheCulture,butYouCan’tTaketheCultureOutoftheBoy3SizeMatters,butNotintheWayMostPeopleBelieve7Governance:TheGuardianofanInvestment-DrivenFirm12FosteringCollaborativeFreedom:EverybodyisaPeer19Integrity:AnUnquestionableCharacteristicofSuccess23Conclusion25CHAPTER2BuildingaCathedral:AFrameworkforTurningtheMissionintoCollectiveAction27AFrameworkforEffectiveLeadershipandManagement28EstablishingandLivingOrganizationalValues29CreatingMissionand/orInvestmentPhilosophyStatements31StrategicGoalsandKeyPerformanceIndicators33Conclusion37CHAPTER3BuildingaMeritocracy:Understanding,Evaluating,andRewardingEmployeeContributions39Performance:ADeeperDive39Horizon:TheFallacyoftheThree-YearTrackRecord40PerformanceAnalysis:PracticallySpeaking45v P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordviCONTENTSTop-downandBottom-upApproachtoDeterminingPerformance48DesigningYourRatingSystemtoHelpMaketheDifficultDecisions51WhatDoesthePerformanceScoreReallyMean?53Criticality:ADeeperDive53MeritZones:PuttingItAllTogether57CommunicationofPerformanceandCriticality59ValuesandCompensation64Conclusion67CHAPTER4InvestmentPhilosophyandProcess:ALoftyCathedralNeedsaDeepFoundation69TheImportanceofInvestmentPhilosophyandProcessinInvestmentOrganizations69InvestmentPhilosophy:CoreBeliefs70InvestmentProcess:ControlandAnarchy73AvoidingthePitfallsofBehavioralBiases78Conclusion83CHAPTER5InvestmentProcessinanEvolvingWorld85ImplementationOverview:The“How”oftheInvestmentProcess86FundamentalValuation88MarketBehaviorandHowItChallengestheFundamentalInvestor90TeamBehavior:LessonsfortheCIOfromJellyBeansandFreud118PortfolioDesign127Conclusion129CHAPTER6CommunicationforSuperiorClientOutcomes131TheProblem:HumanNature133AClassicTale134Case1:IndividualInvestors,theImpactofPerformanceChasing137Case2:AreInstitutionalInvestorsthe“SmartMoney?”137TheRealityofInvestinginEquities139TheMathematicsofRecovery142 P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordContentsviiDilemma:InvestmentFirmorDistributionShop?143TheImportanceofCulture145SalesandMarketinginanInvestmentFirm146Conclusion149Appendix:ClientCommunicationinExtremeMarketConditions149CHAPTER7WherearetheClients’Yachts?:ReasonableFeeStructures159The“GammaTrade”161AnatomyofaBlowup167Catch22168FaultsofExistingFeeStructures170OurRecommendation:HighIntegrityFeeStructures178Conclusion186CHAPTER8FinalThoughts187CharacteristicsofGreatAssetManagementFirms188ItStartswithaSharedMissionandValues188TrueMeritocracy189AvoidingthePitfalls190ForSuccessfulClientOutcomes:Communicate,Communicate,Communicate192It’sAllaboutIncentives193Integrity193Notes195Bibliography201AbouttheAuthors205Index207 P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordviii P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordPrefacenMurfreesboro,TN,childhoodhomeofoneoftheco-authors,aweath-Ieredfarmerwalksouttogetthemorningnewspaperinherusualmorningbackpain.Maryhadforgottentotakehernightlypainkillertotreatarthritisinherbackandtheimpactofherweeklyimmunesysteminhibitorinjectionwasbeginningtowane.Regardless,shehobblesbackintotheoldwoodfarmhouseandsettlesintoaneasychair,moldedtoherbodyafteryearsofthismorningritual.Shereadsthelocalnewspaper,buildinguptheenergytomountthetractorforanotherday’slabor.MaryspotsanarticleinthenewspaperaboutaterroristattackinSouth-eastAsia.Shehasneverheardoftheterroristgroup,butsheiscertainthat“someMuslimgroup”isbehindthedevastation.MaryhatesMuslimsandissurethattheyhateherforherfundamentalistChristianbeliefs.Nobother,though,astheyareontheothersideoftheworldandMuslimsareunlikelytohaveanyinfluenceonhernarrowexistenceinthisrurallittlecorneroftheworld.Shecouldn’tbemorewrong.WhatMarydoesn’trealizeisthatbothofthedrugssheusestocontrolherdailypainwouldnothavebeenpossi-blewithoutthegenerousfinancialsupportofthoseindividualswhomsheunjustlyloathes.Conversely,thepeoplewhoproduceherpillsmayequallydislikeMaryforherbigotryandhatred;yettheyenablehertogetuponmostdaystoliveapain-freeexistence.Moreover,theirinvestmentscreatedtwosuccessfuldrugs—interestinglydevelopedbyanIsraelicompany—thatgarneredgenerousreturnssupportingunprecedentedinfrastructurebuildingaroundtheworld.Itisnotfromthebenevolenceofthebutcher,thebrewer,orthebaker,thatweexpectourdinner,butfromtheirregardtotheirowninterest.Weaddressourselves,nottotheirhumanitybutfromtheirregardtotheirowninterest.Weaddressourselves,nottotheirhumanitybuttotheirself-love,andnevertalktothemofourownnecessitiesbutoftheiradvantages...Hegenerally,indeed,neitherintendstopromotethepublicinterest,norknowshowmuchheispromotingit...Heintendsonlyhisowngain,andheisinthis,asix P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordxPREFACEinmanyothercases,ledbyaninvisiblehandtopromoteanendwhichwasnopartofhisintention.—AdamSmithThesepartiesdon’tknowandperhapscan’tstandeachother,yettheydependon,benefitfrom,andsupporteachotheronadailybasis.Howcanthishappen?AREWESETTINGAGOODEXAMPLEFOROURCHILDREN?Tounderstandhowthishappenseverysecondofeveryday,consideracommonmisperceptionthatwassoeloquentlyportrayedinTomWolfe’sTheBonfireoftheVanities(RandomHouse,2001).ShermanMcCoy,aself-styled“MasteroftheUniverse”bondtraderonWallStreet,isaskedbyhisdaughter,Campbell,whathedoesforaliving.Thequestionispromptedbythefactthatseven-year-oldCampbell’sfriend’sdadproducestangiblethingsathisprintingbusinessandCampbellwantstotellherfriendwhatherdaddydoes.Afterseveralfailedattemptstoexplainwhathedoes,Sherman’swifeJudyexplainsthat,“Daddydoesn’tbuildroadsorhospitals,andthathedoesn’thelpbuildthem.”Rather,Judyexplains,“Justimaginethatabondisasliceofcake,andyoudidn’tbakethecake,buteverytimeyouhandsomebodyasliceofthecakeatinylittlebitcomesoff,likealittlecrumb,andyoukeepthat....Imaginelittlecrumbs,butlotsoflittlecrumbs.Ifyoupassaroundenoughslicesofcake,prettysoonyouhaveenoughcrumbstomakeagiganticcake.”(p.239)Havingequatedthegainsfrombondtradingtogatheringmillionsof“goldencrumbs,”Judyhasimplied,inquitememorablemanner,thatShermandoesn’tproduceanythingtangible.Shermanisportrayedasaparasiteontheeffortsofothers.WhileTomWolfeprovidedawonderfulstory(andaNewYorkTimesbestseller),hehasshreddedthecontributionofinvesting.Thecriticalroleofaninvestoristolocatethebestandcheapestcakesintheworldandmakethemavailabletotheindividualswhowantcakesthemost.Forprovidingthisservice,theygetaverysmallpieceofthecakes—thecrumbs.Mostlikely,theconsumerandbakerdon’tknowandwillneverknoweachother.Infact,theconsumermayhatethebakerandthebakermay,likewise,despisetheconsumer,yettheymerrilycometoeachother’sservice.Mary,ourruralfarmer,benefitsfromthecontinuouseffortsofinvestorsaroundtheworld.Investorsevaluateeveryinvestmentopportunity,every P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordPrefacexirequestformoneytobuildabusiness,researchadrug,developanewman-ufacturingprocess,andsoon.Whengoodopportunitiesareidentified,theyplacecapitalintheseopportunities.Thesesameinvestorsbeseechentitiesthathavecapitaltoentrustitwiththemtomakegooddecisionsregard-ingwhichopportunitiestosupport.Investorsserveasstewardsofsociety’swealth.Thatsaid,investorsarenotdoingnot-for-profitsocialwork.Find-ingopportunitiesthatmaybeprofitableisincrediblydifficult,andsuccessfulinvestorsgetandshouldgetpaidalotofmoney.However,theyshouldbesuccessfultobepaidhandsomely,anditisdifficulttodistinguishsuccessfromrandomlypositiveoutcomes.Anotherimportantconsiderationforinvestmentmanagersisthefactthatactuallydeliveringsuccessfulperformanceoutcomestoclientsrequiresmorethanjustimprovingtheefficiencyoftheglobalallocationofcapital,andgeneratingvalue-addedinvestmentperformance.Itrequiressuccessfulcommunicationwithclientsthathelpsthemovercomethenaturalhumanbiasesthatoftenleadtopoorinvestmentoutcomes.Succeedinginthisen-deavorisoneofthegreatestchallengesinthisbusiness,andonethatrequiresadditionalattentionandgreatexecution.Itisforthesereasonsthatwehavedecidedtowritethisbook.Aftercollectivelyaccumulatingnearly70yearsofexperience,wefeelaneedtodocumentthecharacteristicsoffirmsthatareandarelikelytobesuccessfulstewardsofclientcapitalandthebehaviorsofthesefirms’leadersandtheirinvestmentteams.OVERVIEWOFTHEBOOKThebookisatop-downanalysisofsuccessfulstrategies,structures,andactionsthatcreateanenvironmentforgeneratingstronginvestmentper-formanceand,mostimportant,fordeliveringrewardinginvestoroutcomes.Additionally,wediscussvariousaspectsoftheframeworkthatwehavefoundusefulinthisregardsothatreaderscanexaminerealapplicationsoftheideas.Eachchaptercanstandonitsownandcanbereadinisolation;however,thechaptersarebestreadinsequence.Thebookbeginswithadiscussionofthedifferencesbetweeninvestmentfirmsandproductfirms.Bothtypesoffirmshavetheirplaceintheindustry,buttheyaremotivatedbydifferentmeansandtodifferentends.ThebulkofChapter1focusesonthecharacteristicsthatarefoundinsuccessfulfirmsofbothtypes,andincludesdiscussionontheimportanceofculture,leadership,integrity,andthegovernancethatmustbeinplacetosustaininvestmentsuccessandsuperiorinvestoroutcomes. P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordxiiPREFACEChapter2discusses“BuildingaCathedral,”withafocusonorgani-zationalmission,cultures,andvalues.Itaddressessomeofthepracticalconsiderationsrequiredforlivingorganizationalvalues,settingmissionandgoalsandmeasuringorganizationalsuccess.Wedrawuponourownexpe-riencesanddiscusswhatwehavefoundtobesuccessfulandunsuccessful.Thesuccessfulaspectsofourexperiencewillbedelineatedindetailfortheusefulapplicationofseniormanagersinotherinvestmentfirms.Chapter3dealswithsomeofthemostimportantpracticalconsider-ationsindevelopingameritocraticinvestmentprocessthatrewardsindi-vidualcontributionsappropriately.Wearguethatfartoomuchattentionispaidtolastyear’sperformanceresultsindeterminingthecompensationofinvestmentprofessionals.Weoutlineanddiscussourviewsonthetwoprimarycomponentsofemployeecompensation,namely,performanceandcriticality.Welayoutanapproachthatwehavesuccessfullyemployedformanagingthecompensationprocessandforencouragingindividualdevel-opmentwithakeyfocusontransparency.Together,Chapters4and5discusstheimportanceofinvestmentphi-losophyandprocess.Thealignmentofthetwoempowersindividualswhilesettingclearboundariestohelpgoverntheactionsofinvestmentprofes-sionals.Thesechaptersexploreavarietyofissuesrelatedtofundamentallydriveninvestmentphilosophiesandprocesses.Theyalsodescribeanumberofthemostimportantbehavioralbiasesthatservetoconfoundgoodinvest-mentdecisionmaking.Marketbehavioranalysiscancontributesignificantlytosuccessfulexecutionofinvestmentdecision-makingprocesses.InChapter5wealsocovertheoriesofevolutionandrecentlypopularizednotionsof“blackswan”taileventsandtheirapplicationtoinvesting.Chapter6demonstratestheimportanceofcommunicationforsuperiorinvestoroutcomes,realizingthatasuccessfulinvestmentprocessisequalpartsinvestingandcommunication.Ourexperiencehastaughtusthatgen-eratingsuperiorinvestmentperformanceisextremelydifficultbutachievableforthehighestqualityfirms.However,actuallydeliveringsuperiorinvestoroutcomesraisesadditionalchallengesthatmostoftheinvestmentindustrycannotachieve.Sound,consistent,andtransparentcommunicationwithin-vestorsisthehighestsuccessstrategyforachievingsuperioroutcomesandhelpinginvestorsavoidthepitfallsofperformancechasingandothervalue-destroyingbehaviors.Chapter7discussesincentivestructuresandfeemodelsforassetman-agementfirms,challengingsomeofthepervasivemodelsintheindustrytoday.Someofthegreatwealthdestructionofourtimecanbetracedbacktothebasicculpritofflawedincentivestructures.Whiletheauthorsmaydisagreeontheintentofvariousfeeandincentivestructures,weallagreethatbetteralternativesexistthanthestatusquo. P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordPrefacexiiiChapter8,thefinalchapterofthebook,representsadistillationandsummaryofmanyofthemostimportantconceptsthatwebelievearepre-sentedhere.Ifyouhavealimitedtime,andtendtopreferCliffNotesoverfulltexts,youmaywanttostartwithChapter8.Interviewsandsurveysofnumbersofindividualscoveringhundredsofdifferentinvestmentfirmsformthebasisformuchoftheconclusionsreached.Further,wehaveallhadtheopportunitytoworkforanum-berofbothsuccessfulandultimatelyunsuccessfulventures,spanninglargefirmsandsmallfirms,publicfirmsandprivatefirms,aswellasourownentrepreneurialventures.Throughoutthebook,theimportanceofcultureandintegritycannotbeoverstated.Thegreatestvulnerabilitytosuccessfulinvestmentfirms,teams,andprocessesisweakeningorunderminedcultureandintegrity.Thisisapointthatwillberaisedagainandagain.BRIANSINGER P1:a/bP2:c/dQC:e/fT1:gfmJWBT154-SingerAugust28,200921:20Printer:CourierWestfordAcknowledgmentsnumberofindividualshavecontributeddirectlyandindirectlytothisAwork.TheauthorswouldliketogivethankstoAlexMcCarthy,AprilPowell,EdouardSenechal,andBradShade,allofwhomprovidededitorialinputaswellassweatlaboratvariousstagesinthisprocess.Theirhardworkhelpedpushthisworktoitscompletion.WealsoneedtoprovidespecialrecognitiontoJosephMaccone.Joewasabitofalatecomertotheproject,thoughweendeduppleadingforhishelptobringthebooktofruition.Intheend,heputinenoughworkonChapter6tobeconsideredaco-author.Wealsoneedtothankourfamiliesforputtingupwithusthroughthispastyear.ThisisespeciallytrueofLinda,Margo,andAndySinger,whoputupwithmorethantheusualnumberofrantsfromBrian.AndofcourseHilary,Tom,andTedFedorinchik—whowillhavebeenthankfullyeithertoosleepdeprivedthemselvesortooyoungtorememberthisperiodoffatherhoodinabsentia.Wealsowouldliketothankthehundredsofindividualswhotookpartinconversations,interviews,andtheotherlifeexperiencesthatshapedourviewsonanumberofthesetopics.xiv P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCHAPTER1CharacteristicsofSuccessfulAssetManagementFirmsenerallyspeaking,employeesandclientsofassetmanagementfirmsareGlookingforrewarding,long-termrelationshipswithsuperiororganiza-tions.Whilenewspapersandothermediaoutletsprovidefrequent,oftendaily,scorecardsofassetmanagerinvestmentperformance,determiningsu-periorityisdifficult,requiringalongperiodofanalysis.Whatdoesitmeantobesuperior?Identifying,understandingandimplementingthecharacteristicsofsuperiorinvestmentmanagementfirmsisthekeyobjectiveofthisbook.Throughoutthisbookwewillrelateanumberofobservations,somegeneralandsomeveryspecificaboutvariousinvestmentmanagementfirms.Wewillpointtoqualitiesofthesefirmsthatwe,orthoseweinterviewed,identifiedaspositiveorgenerallynegativeordisadvantageous.Wearenothowevermakingrecommendationsfororagainstinvestingwiththesefirms.Theduediligencerequiredtomakesuchrecommendationsisbeyondthescopeofthisbook.Wewillsimplyusethesefirmsasexamplestoidentifyanddiscussthequalitiesthatourresearchhasidentifiedasimportantforsuccess.Everyinvestmentfirmperformstwobasicfunctions:thebusinessfunc-tion(marketingandclientrelations)andtheinvestmentfunction.Were-fertofirmsthatfocusmostenergyonthebusinessfunctiongenerallyas“product-driven”andthosethatfocusmostenergyontheinvestmentfunc-tiongenerallyas“investment-driven.”Thesetwofunctionsoftenoperateatcrosspurposes.Superiorinvestmentperformancetendstoattractassetsfromclientsseekingattractivereturns.Thisinturnmayencourageproductproliferationthatfeedsthebusinessbeastbutunderminesthesustainabil-ityofinvestmentperformance.Averysmallnumberoffirmsarebuiltonafoundationthatharmonizesthetwofunctions.Vanguardisaproduct-drivenfirmwithalow-costbusinessmodel.Itdeliverssuperiorinvestmentperfor-mancebydistributing“passive”investmentvehiclesandavoidingthehigh1 P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford2INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTfeesofactivelymanagedvehicles.Wesay“passive”inquotations,becausetheoverwhelmingmajorityofpassivevehiclesarebenchmarkedagainstac-tiveindexes.Itmightbemoreappropriatetocallthisactivity“indexfund”investing.Decidingwhichindexfundtoinvestinisanactivedecision.How-ever,onceinvestedinanindexfund,thefunditselfemploysarule-basedactivestrategy.Therulesmayincludecapitalization,creditratingorstyletilt,amongothers.Unlesstheindexcomprisestheentirecapitalmarket,itisactive.Regardless,followingmarketnomenclature,weuse“passive”and“active”inthemorepedestriansense.Passivestrategiesarethosewithcloseadherencetoanybenchmarkorindex.Activestrategies,bymostdefinitions,arethosethattakepositionsdifferentfromsuchanindexwiththegoalofproducinganattractiverisk/returnprofilerelativetotheindex.Superiorinvestmentperformancethroughactivemanagementis,onaverage,notcompensated.Afterfees,activemanagement,ingeneral,isneg-ativelycompensated.Further,theskillrequiredtoaddvaluethroughactiveinvestingisveryhardtoidentify.Finally,findingtheskilledmanagerswhodoexistisadauntingtask.Vanguardisasaferalternativeforthosewithouttheknowledge,experience,orresources—thevastmajorityofinvestors—toidentifyinvestmentskill.Thisisnottosaythatindexfundscomewithoutrisk.Understandingthebasicriskcharacteristicsofvariousassetclassesandindexfunds,orrelyingonanexperiencedadvisor,remainsaprereq-uisitetoinvestinginanyinvestmentvehicle,activeorpassive.DespitethefactthatwecharacterizeVanguardasaproduct-drivenfirm,John(Jack)Bogle,Vanguard’sfounder,speakstotheimportanceofclientoutcomesbyadmonishingtheindustrytoprioritizestewardshipoversalesmanship.Hedeservescreditforundertakingthisimportantendeavorandexecutingwithexcellence.CapitalGroupisanactive,investment-drivenfirmwhosebusinessmodelrevolvesaroundthedeliveryofsuperiorlong-termclientoutcomes.AsCharlesEllispointsoutinCapital:TheStoryofLongTermInvestmentExcellence,“CapitalGroup,especiallytheAmericanFundsmutualfundsubsidiary,putssoundinvestingwellaheadofsalesormarketingineverybusinessdecision.”1CharleygoessofarastosaythatCapitalispaternalisticinitsrelationshipwithclientsandpotentialclients.Ifaninvestmentproductisverysalable,butnotinthebestinterestofpotentialinvestors,thenCapitalwillnotselltheproduct.Capitalhasearnedareputationofoperatinginthebestinterestofcurrentandprospectiveclients.Whydosomeinvestment-drivenandproduct-drivenfirmsprovidesuc-cessfullong-termemployeeandclientrelationshipswhileothersdonot?Itisimpossibletoprovidearecipeforsuccess,butitispossibletoiden-tifycertaincharacteristicsofsuccessfulfirms.Weidentifyfivecriticalas-pectsofassetmanagementfirmsthatwebelievesignificantlyinfluence P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms3superiorityandsuccess:1.Strongculture2.Limitedsizeandcomplexity3.Cleargovernanceofthebusinessandinvestmentfunctions4.First-rate(non-hierarchical)investmentleadership5.IntegrityWesurveyedinvestors,spokewithindustryleaders,anddrewuponourcollectiveexperienceswithmultipleproduct-andinvestment-drivenfirmstoassesstheimportanceofeachcharacteristicindeterminingsuperiorityandsuccess.Eachiscoveredindetailbelow.Thischapter,andmuchofthebook,arguesthatunifyingcultureamongateamofindividualsfromdiversebackgroundsandeducationsisindispens-abletothelong-term,sustainablesuccessofassetmanagementorganiza-tions.Duetoitsimportance,webeginwithadiscussionofcultureandfollowwithamajorchallengetoitssurvivability—theallureofsize—andtocriticalcontributorstoitssustenance:stronggovernance,capableleadership,andintegrity.YOUCANTAKETHEBOYOUTOFTHECULTURE,BUTYOUCAN’TTAKETHECULTUREOUTOFTHEBOYThecultureofafirmisdefinedbythetotalsetofsharedandsociallytransmit-tedattitudes,values,aspirations,behaviorsandpracticesofitsemployees.Superiorassetmanagementfirms,whetherproduct-drivenorinvestment-driven,exudestrongandpositivecultures.Considertwoverydifferentfirms,bothwithstrongandlong-standingcultures.Vanguard’scultureisonethatincludescost-consciousnessandclientoutcomes.ItsInternethomepagestates,“Investmentcostscount:Keepmoreofwhatyouearn.TheaveragemutualfundchargessixtimesasmuchasVanguarddoes.”Vanguard’sdesiretodeliverstrongclientoutcomesisenshrinedinitsstructure;mutualfundclientsareownersofthefirm.JackBogleespousestheinterestsofVanguard’sclientsthroughthedeliv-eryofarangeoflow-costinvestmentvehicles.Jackisnotedforhisfrugality.WhenanindividualjoinsVanguard,thereisnoquestionofthefirm’sstrongculture.Prospectiveemployeesknowthatiftheyarehired,theyareunlikelytobejettingaroundtheworldinprivatejetsorvacationingonyachtsanytimeinthenearfuture.Someshrugofftheimportanceofastrongandpositivecultureashavingnoplaceinthehardened,individualistworldofinvestmentprofessionals. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford4INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTThissentimentisunwise.Whilecultureinvolvesmuchmorethanjustle-galbehavior,theU.S.legalsystemdoesnotsupportthebravadooftheseinvestmentprofessionals.TheU.S.DepartmentofJusticesays,“Acorpo-rationisdirectedbyitsmanagementandmanagementisresponsibleforacorporatecultureinwhichcriminalconductiseitherdiscouragedortacitlyencouraged.”2Theguidelinesfordeterminingculpabilitydirectjudgestoevaluatewhetherthecultureencouragesethicalconduct.Theupperechelonofassetmanagementfirmsshouldnotbecavalierabouttheculturesthattheypromote.Cowardiceasksthequestion–isitsafe?Expediencyasksthequestion–isitpolitic?Vanityasksthequestion–isitpopular?Andtherecomesatimewhenonemusttakeapositionthatisneither,safe,orpolitic,norpopular;butonemusttakeitbecauseitisright.—Dr.MartinLutherKing,Jr.Astrongculturedoesnotarisefromjusttheencouragementoflegalbehavior;itcomprisespositivevalues,attitudes,andperformance.However,thebackboneofastrongcultureinanyorganizationisitsvalues.In1963,ThomasJ.WatsonJr.,theformerCEOofIBM,wroteofthefirm’scorevalues(beliefs)inthebookletABusinessandItsBeliefs:Ibelievetherealdifferencebetweensuccessandfailureinacor-porationcanveryoftenbetracedtothequestionofhowwelltheorganizationbringsoutthegreatenergiesandtalentsofitspeople.Whatdoesitdotohelpthesepeoplefindcommoncausewitheachother?...Andhowcanitsustainthiscommoncauseandsendofdirectionthroughthemanychangeswhichtakeplacefromonegen-erationtoanother?...[Ithinktheanswerlies]inthepowerofwhatwecallbeliefsandtheappealthesebeliefshaveforitspeople....Ifirmlybelievethatanyorganization,inordertosurviveandachievesuccess,musthaveasoundsetofbeliefsonwhichitpremisesallitspoliciesandactions.Next,Ibelievethatthemostimportantsinglefactorincorporatesuccessisfaithfuladherencetothosebeliefs.3Ifvaluesaresoimportant,whydotheyseemtobethesame,oratleastverysimilar,formostfirms?Moreover,firmsoflimitedintegrityoftenespousepositivevalueswhileostensiblyfunctioningfreefromtheirinfluence.Thisisnomoreclearlydemonstratedthanbyreviewingthevaluesofthenowdefunctfirm,EnronCorporation.Enroncollapsedafteralong-termpatternofunethicalandillegalbehaviorwasuncovered.Figure1.1displaysEnron’svalues. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms5CommunicationWehaveanobligationtocommunicate.Here,wetakethetimetotalkwithoneanother...andtolisten.Webelievethatinformationismeanttomoveandthatinformationmovespeople.RespectWetreatothersaswewouldliketobetreatedourselves.Wedonottolerateabusiveordisrespectfultreatment.IntegrityWeworkwithcustomersandprospectsopenly,honestlyandsincerely.Whenwesaywewilldosomething,wewilldoit;whenwesaywecannotorwillnotdosomething,thenwewillnotdoit.ExcellenceWearesatisfiedwithnothinglessthattheverybestineverythingwedo.Wewillcontinuetoraisethebarforeveryone.Thegreatfunherewillbeforallofustodiscoverjusthowgoodwecanreallybe.FIGURE1.1EnronCorporation’sStatementofCorporateValuesSource:www.enron.com(circa1999)Includingtheword“integrity”inEnron’svalueswouldbecomicalhaditsbehaviorsnotdestroyedthelivesofsomanyemployeesandinvestors.Thefirmcollapsedundertheweightofexecutivefraudandconspiracy.IntegrityisavaluethatEnronstated,butnotonethatitlived.Whileillegalbehaviorsarerare,valuesaremoreoftenstatedthanlived.Weobservethatmanyassetmanagementfirmscreateanddisplayasetofvaluesbecauseitisagoodmarketingtoolratherthananytruesetofguidingprinciples.Onedifferencebetweenfirmswithstrongandpositiveculturesandotherfirmsisthefactthattheiremployeeslivethevaluesthatthefirmsdisplay.CaseStudy:Culture,aHouseBuiltontheValuesFoundationIfahomebuilderstartsfromscratch,virtuallyanymaterialscanbeacquiredandused.Eskimosinfrigidenvironmentsuseiceandsnow.NativeAmer-icansusednaturalcavesandcliffsorwoodandanimalskins.Similarly,thecultureofanewfirmcanbedeterminedattheoutsetandestablishedbyitsinitialandfoundingemployees.BillHewlettandDavidPackardstartedHewlettPackardwithaclearsetofvalues,theHPWay.TheHPWayemergedfrom“deepconvictionsaboutthewaybusinessshouldbebuilt....[Theseconvictionsare]heldindependentofthecurrentmanage-mentfashionsoftheday.”4 P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford6INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTIfaconstructionprojectisarenovation,thenthebuilderisconstrainedbytheexistingstructure,characteristics,andmaterials.Similarly,themate-rialsforgrowingafirm,itspeople,mustbeconsistentwithwhatisalreadyinplace.Onceafirmisestablished,thecumulativediscussionsandactionsofeveryemployeeconstituteasharedsetofvaluesandaculturethatdictatesrecruitment,hiring,evaluation,andterminationdecisions.Afirm’svaluesarenotthefirm’sculture;theyareasmallaspectoftheculturebutarguablythemostcritical.Valuescompriseasmallsetofguidingprinciplesoftheorganization.CapitalGroup,notedforitsstrongcultureandsuperiormutualfundperformanceforexample,hasaculturethatarisesfromitsvalues.TheInternethomepageforCapitalGroupstatesthatitoffers“challengingopportunitiesinahighlycollaborative,respectful,state-of-the-artenvironment.”5JobcandidatesaretoldthatCapitalGroupseeksindividualswithspecificcharacteristicscommontoallitsemployees:integrity,collaboration,respect,curiosity,accountability,detail-orientation,andhumility.AndtheSurveySays...Totestourhypothesisthatfirmswithstrongandpositiveculturesprovidesuperiorclientoutcomes,wesegmentedallfirmsintoeithertheinvestment-drivenortheproduct-drivencategoryandqueriedinvestmentprofessionalsfromaroundtheworldthroughsurveysandinterviewsregardingsuperiorityofthefirmswithintheirrespectivecategories.Investment-drivenfirmsarethosewithrealizedgenerallystronginvestmentperformanceandahighpotentialforsustainable,superiorinvestmentperformance.Product-drivenfirmshavehighclientsatisfactionbasedonofferingfeaturesotherthanbutnotexcludinginvestmentperformance.Thenon-investmentfeaturesbehindproduct-drivenfirmsarelowfees,clientservice,advice,diversification,andbreadth.Wewerenotsurprisedtofindthatourqueriesconfirmedthehypothe-sis.Superiorfirms,whetherinvestment-orproduct-driven,generallypossessstrongandpositiveculturesthatsupporttheirmissions.Infact,ofthefirmscoveredinourresearch,culturewasthemostconsistentandimportantdifferentiatorofthequalityofafirm.Ofcoursesomefirmswithstrongculturesfailandotherswithweakculturesthriveforaperiodoftime.How-ever,itappearsthatastrongpositivecultureisanecessary,ifnotsufficient,characteristicoflong-termsuperiorityofassetmanagementfirms.Theanec-dotalevidencefromourinterviewssuggeststhatthesefirms’leadershipteamswereabletodevelopsharedvaluesandculturewhilealsomaintainingandencouragingtheindividualityoftheteam’smembers.Ourfindingsarenotuniqueandshouldnotsurprisereadersfamiliarwithextantliterature.InHighPerformingInvestmentTeams,JimWare P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms7identifieskeyfactorsthathelpthebestfirmsattract,retain,andmoti-vatetoptalent.Amongthesefactorsare1)leadershipcredibilityandtrustand2)organizationalcultureandpurpose.Furtherdownthelististotalcompensation.6Jimobservesthatvaluesmotivatebehaviorsthatinturndriveresults.Thesevaluesandbehaviorsaremanifestationsofculture.BlakeGrossman,CEOofBarclaysGlobalInvestors,observedinapre-sentationatthe2008CFAInstituteAnnualConferencethatinnovationsuccessfactorsatassetmanagementfirmsincludecultureandevangelism.ReadersarewelladvisedtoregardBlake’sobservations.Hehasbuiltanorganizationthatattractsandretainstalentandcontinuestoinnovateprod-uctsthattargetclientneeds.BarclaysGlobalInvestorshasbeenasuccessstoryunderBlake’sleadership.TheAmericanFundssubsidiaryofCapitalGrouphasalonghistoryofstronginvestmentperformanceandsuperiorclientservice.Itsculturehasremainedconsistentsincethebeginning:Weareprotectiveofthewaywedobusiness.Formorethan75years,wehaveremainedsingle-mindedinourdesiretodorightbyourinvestorswithoutcompromisingourdesiretodorightbyourassociates.Weinvestinourassociatesusingthesamethoughtful,deliberateapproachweusetoinvestincompanies.7ThelegacyandheritageofAmericanFundsisclear,butperhapsin-vestorsshouldbegintobeconcerned.TheCapitalGrouphomepageex-plicitlystatesthatAmericanFundsis“oneofthethreelargestmutualfundfamiliesintheU.S.”8NeithersizenorgrowthisafoundationalvalueoftheAmericanFundsunitthatgeneratedalonghistoryofsuperiorinvestmentperformanceandclientoutcomes.Sizeisoftenanirresistiblesiren’ssongthatdrawsmanyassetmanagementfirmsawayfromtheirfoundingandsuccessfulcultures.HasthisallurebecometoostrongforAmericanFunds?TheCapitalGuardianandCapitalInternationalinstitutionalsub-sidiariesofCapitalGroupdefinetheirmissionsassuperiorinvestmentper-formance.UnliketheAmericanFundssubsidiary,however,theycuriouslydonotmentionclientresults.PerhapsthisisonereasonwhythesuccessofCapitalGuardianandCapitalInternationalhavebeenlimitedandvaried,especiallyrelativetothemutualfundunit.SIZEMATTERS,BUTNOTINTHEWAYMOSTPEOPLEBELIEVEWhileitisnotdifficulttoidentifytheincentivesthatdriveassetmanagementfirmstogrowbeyondtheiroptimalsizeforsuperiorperformance,itis P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford8INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTdifficulttodiscernwhetheranassetmanagementfirmhasgrownbeyonditsoptimalsize.Considertwo$25billionassetmanagementfirms,onewithasinglecapabilitythatis$25billionandonewith250differentcapabilitieseachwithabout$100millioninassets.Bothfirmsmanagethesameamountofmoney,buttheformercanmanageasimple,liquidstrategywithoutmuchdistractionasthereisonlyonesetofinvestmentcharacteristicsandallclientsreceiveidenticalperformanceandveryclosetoidenticalserviceandcommunication.Thelattersuffersfrommyriaddistractionsthatincludemultipleinvestmentobjectives,variedclientcommunications,untoldhoursofcontractnegotiationsandbackofficechaos.Sizeisdeterminednotonlybytheassetsundermanagement,butalsothenumberofdifferentcapabilitiesthefirmmanages.ReturningtotheAmericanFundsexample,theyhavegrowntohavequitealargeassetbase,buthavedonesowithrelativelyfewcapabilities.Similarly,Dodge&Coxdeliveredsuperiorinvestmentperformanceasitgrewtobelargeonalimitedsetofcapabilities.Duringthecreditcrisisof2007and2008,however,DodgeandCoxstumbled.Perhapsitgrewtoolargeinassetsundermanagement(AuM)despitealimitedsetofcapabilities.Perhapsthisisnothingmorethantheinevitablestumbleincurredbyallbuttheluckiestoftrulysuperioractiveinvestmentmanagersandfirms.AmericanFundsandDodge&Coxareexamplesofinvestment-drivenfirmsthatmayhaveexpandedbeyondtheviablesizeformaintaininginvestmentsuperiority.Bylimitingthenumberofcapabilitiesthattheymanage,bothfirmshavebeenabletosustaintremendousAuMgrowth.But,allgoodthingsmustcometoanend,andtheirgrowthrateshavepotentiallygiventhemtoomuchofagoodthing.Vanguard,ontheotherhand,seemstobeabletogrowfarbeyondthesizeofotherassetmanagementfirmsinbothAuMandnumberofcapabilities.UnlikeAmericanFundsandDodge&Cox,Vanguardisaproduct-drivenfirm.Itusessizetomaintainorlowercosts,asabenefittoitsclients.PerhapsthereexistsaviablelimittoVanguard’sgrowth,butfornowitseemstoknownoboundsinthegrowthofitslow-cost,passivebusiness.AsinTechnology,SmallisGoodSizemattersforinvestment-drivenfirms,butitdoessoviatheconfluenceofAuMandthenumberofcapabilities.Product-drivenfirms,especiallythoseofthepassivevariety,cangrowtobeverylargeinbothAuMandcapa-bilitieswithoutcompromisingclientoutcomes.OurresearchconfirmsthehypothesisthatassetmanagementfirmswithalargenumberofcapabilitiesandhighAuMareeitherproduct-drivenfirmsorinvestment-drivenfirmsthathaveevolved,despitetheinevitableprotestations,intoproduct-driven P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms9firms.Unlikethosethatstartassuperiorproduct-drivenfirms,largeinvestment-drivenfirmsstruggletogeneratesuperiorclientoutcomes.Asinvestment-drivenfirmsgrow,theybecomeproduct-drivenandultimatelyprovidepoorinvestmentperformanceandsubstandardclientservice.CharleyEllisconfirmsthistobe“themajorproblemthatconfronts,andoftenconfounds,mostinvestmentmanagementorganizations:Investmentsuccessleadstoassetgrowththateventuallyoverloadstheorganization’scapacitytoproducesuperiorinvestmentresults.”9However,totalassetsun-dermanagementseemslessofaninvestmentperformanceinhibitorthanthenumberofcapabilities.Currently,mostdiversifiedinvestment-drivenfirmsinexcessof$25to$30billionfinditdifficulttomaintaintheirinvestmentedge.Overtime,withcapitalmarketgrowth,tradingplatformimprovement,andtradingsimplificationbymoresophisticatedderivatives,thesizelimitforsuperiorinvestmentperformancewillgrow.Foramulti-assetinvestmentfirm,thesefactorsshouldleadtogrowthofthesizelimitbyabout7percentto9percentperannum.In2009,thecapseemstobearound$25billion.Ifcapitalmarketsgrowatanormalrate,thenin2015thiscapwillgrowtosomethingontheorderof$40billion.Ofcourse,thisisageneralization.Thesizelimitthatbeginstoerodeperformanceofafirmisdependentonthefirm’sstructureandapproach,itsinvestmentprocess,complexityandtheliquidityofitspositionsandstrategies.ComplexityisthetrueAchillesheelofsize.Afirm’sAuMcangrow,but,bylimitingthenumberofcapabilities,aninvestment-drivenfirmcanoftenretainfocusandexpandbeyondthelimitsoffirmsthatallowproductproliferation.Thesamecanbesaidofpensionplans,endowment,founda-tions,sovereignwealthfunds,individuals,andothermultimanagerinvest-mentstructures.Asthenumberofmanagersincrease,complexitygrowsandinvestmentfocusoftendiminishes.Perversely,whenmanagerresearchteamsidentifyasuperiorinvestmentfirmwithastrongculture,theyoftendirectsuchaflowoffundstothatfirmthattheysowtheseedsoftheirowndemise—thefirmgrowsbeyonditsoptimalsize.Perhapsthatiswhyinvestmentawards,consultantbuylists,and5-starMorningstarratings,areoftenseenaskissesofdeathforinvestment-drivenfirms.Figure1.2providesconfirmationfromtheperspectiveofthemultiman-agerenvironmentofmanagerresearchteams.Asthenumberofinvestmentmanagersincreases,distractionasmeasuredbyadditionalman-hoursspentpermanagerincreases.Theresultislessfocusoneachinvestmentmanager.10Theconstraintisnotthenumberofpeopleemployedbythemultiman-agerinvestmentfirm.Complexitydiminishesthefiduciarytimespentonmanagerresearchandselectionasthenumberofmanagersgrows.Increas-inginvestmentstaffandindefinitelyexpandingback-officecapacityisnotan P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford10INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENT30025020015010050InvestmentManHoursperAnnum002468101214NumberofInvestmentManagersFIGURE1.2ApplicationtoInvestmentManagementStructuresSource:WatsonWyattGlobalAssetStudySurvey,1999.option.Asaroughguide,ourresearchandexperiencesuggeststhatabout15to25capabilitiesisthemaximumforatypicalmultimanagerinvestment-drivenorganization.Tobeeffectiveonalargerscaleispossible,butitre-quiresresourcesdedicatedandspecializedbydiscipline.However,formostmultimanagerfirms25capabilitiesisthepointtheorganizationbeginstomigrateintoahigh-cost,product-drivenoperation.Again,thisnumberisageneralization.Withmultimanagerfirmsthecapabilitylimitisdependentontheskill,experience,history,process,andstrategiesemployedbythefirm.Afewinstitutionallyfocused,investment-drivenfirmshavedemonstratedtheabilitytoconsistentlydeliversuccessfulclientoutcomesbycoveringmorethan25capabilities,buttheyaretheexception,nottherule.Thedividinglineofsizebetweeninvestmentandproduct-drivenfirmsisfuzzy.Firmswithinarelativelywidesizeandcapabilityrangecanbeeitherinvestmentorproductoriented.WefindthatfirmswithfewcapabilitiesandlessAuMwillgenerallybeinvestment-drivenfirmswiththepotentialtodeliversuperiorinvestmentperformance.Ourresearchledtoamatrixthatcanhelpguideclientsindistinguishingbetweeninvestment-drivenandproduct-drivenorganizations.Figure1.3portraysthesizeandcapabilitycharacteristicsofinvestment-drivenandproduct-drivenfirms.Thedemarcationlinesarenotpreciseandfirmsbetweenthedashedlinescanbeeitherinvestment-orproduct-driven.Generallyspeaking,superiorproduct-drivenfirmscanbeaboutanysize, P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms11100Likely75Product-Driven50AmbiguousSize(AUM,Billions)Likely25Investment-Driven00102030Size(NumberofCapabilities)FIGURE1.3Investment-drivenvs.Product-drivenfirmsfromsmallstart-uptoVanguard-likebehemoth.ThusFigure1.3appliestoinvestment-drivenfirmsthatevolveintoproduct-drivenfirmsastheygrow.NoticethatthecapabilityconstraintismuchmorerestrictivethanthatofAuM.CaseStudy:TheTrojanHorseofClient-CentricityInthemid-1990s,GaryBrinsonsoldBrinsonPartnerstoSwissBankCor-poration(SBC).Atthetime,thefirmhadlessthan$50billioninassetsandalimitednumberofcapabilities.Garywastheguardianofastrongandpositiveinvestmentcultureandanundeniableculturebuilttodeliversupe-riorclientoutcomes.Severalyearsaftertheacquisition,inthesummerof1999,GaryaskedPeterWuffli,SBC’sCFO,totakeoverasCEOoftheassetmanagementdivision.Muchtohiscredit,PeterallowedtheculturethatwasBrinsonPartnerstoremainintact.AfurthercombinationwithUnionBankofSwitzerlandandtheexistenceof“TheThreeTribes”—BrinsonPartners,Phillips&DrewandtheSwitzerland-basedemployeesofthecom-binedfirm—createdstressesthatcouldnotbecontained.Capabilitiesbegantoproliferateasthetemptationofrevenuegrowthoverwhelmedtheinvest-mentfocus.Shareholders’demandsforshort-termAuMandrevenuegrowthobligedtheshifttoaproduct-drivenorganization. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford12INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTButthepressuresontheassetmanagementdivisionwerestrongerthanthoseobligedbyshareholderdemands.UBS,afterthecombinationwithSwissBank,adoptedaone-bankmodelthatwasclientcentric.Thiscametomeanthattheprivatebankdivision,becauseofitsrevenuegeneratingpower,dictatedthecultureoftheentirebank,andawiderangeinvestmentproductwascreatedandsoldinthenameofclient-centricity.Theassetmanagementdivision,whichsuppliedproducttotheprivatebankingdivisionaswellasin-stitutionalclients,couldnotcontaintheculturalspreadoftheprivatebank.Thesoldierswerelooseinsidethewalls.Client-centricitynolongermeantthequestforsuperiorclientoutcomes;itbecameathinveilforthesatisfactionofclientdesireratherthanclientneed.Salesmanshipsupersededstewardship.TheassetmanagementdivisionofUBSgrewfrom3percentofthebank’sincomeinthelate1990stoabout10percentatthetimeofthecreditcrisis,butmuchliketheinvestmentbank,itbecamea“client-centric”productcreatorforprivatebankdistribution.Theculturesofthetwolargestinde-pendentinvestmentboutiquesthathadexistedwithinUBSwerefusedto-gether.BrinsonPartners,thefundamentalvalue-oriented,investment-drivenU.S.subsidiaryandPhillips&DrewitscounterpartintheUnitedKing-dom,becameasignificantsupplierofproducttoUBS’sprivatebank.Astheassetmanagementdivisiongrewtomorethan$800billiontheprevi-ouslystronginvestmentculturescollapsed.Throughnofaultofanybodyinassetmanagement,itwassimplyimpossibletosustaintheindependentinvestmentculturesthathadpreviouslybredsuccess.Itwassimplyask-ingtoomuchtolimitAuMgrowthagainstthepressuresofproduct-drivenclient-centricityandevermoreshareholdervalue—ormorepreciselyper-haps,quarterlyshareholdervalue.Thelong-termsuperiorinvestmentperformanceofBrinsonPartnersandPhillips&Drewwerethreatenedontwofronts:weakeningcultureandrapidgrowth.Noleadershipteamcouldholdbacktheprivatebank’sculturaldeluge.Superiorclientoutcomesweretrumpedbyshareholderdemandsformorevalue(intheformofarisingstockprice)andtheprivatebank’sculturalinfluence.Onlyagovernancestructureandleadershipteamthatpreventedthemergerinthefirstplacecouldhavepreventedthedecline.InthecaseofBrinsonPartners,Garywasthegovernancestructureandtheleadershipteam.Hesawthefloodwaterscominganddecideditwastimetoheadforhigherground.GOVERNANCE:THEGUARDIANOFANINVESTMENT-DRIVENFIRMThereisnowaytopreventaninvestment-drivenfirmfrombecomingaproduct-drivenfirm,buttherearewaystolimitthepossibility.Thissection P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms13beginswithanexaminationofafirm’smissionstatementbeforemovingontoconsiderationofCEOandCIOauthoritiesandresponsibilities,aswellasboardofdirectorscomposition,andincentives.Weprovidepracticalrecommendationsforagovernancemodelthatsustainsagrowingfirm’sinvestmentfocusfromonegenerationofleadershiptothenext.MissionStatementThearticulatedmissionofafirmisimportanttobothcultureandgover-nance.Top-performingfirmsuseittoinspireasenseofpossibilityandtocreateorganizationalalignment.Thebestfirmsuseitasthefoundationoforganizationalplanning,byaskinghoweachindividualandeachteamintheorganizationspecificallycontributetotheacheivementofthemission.Forinvestment-drivenfirms,themissionplaysanevenmorecriticalroleinmaintaingtheintegrityofthefirm’sapproach.Themissionstatementisthefirstlineofdefenseagainstthedeteriorationofaninvestment-drivenorganization.Themissionstatementisaclearar-ticulationofwhyafirmexists.Foraninvestment-drivenassetmanagementfirm,themissionstatementclearlystatesthatthefirm’sfocusissuperiorinvestmentperformance.Itwillincludephraseslike“superiorinvestmentperformance”and“thepremierinvestmentfirm.”Themissionstatementsoffirmsthatourresearchidentifiedasthehighestqualityfromthestandpointofculturesharestrikingsimilaritiesintheirfocusonstrivingforexcellence.Whilenotallmissionstatementsareclearlyidentifiedassuch,thefirm’smissionisclearlyunderstoodbyitsemployeesandsupportedbythefirm’semployeeandclientcommunications.GREATFIRMSSEEKEXCELLENCEINDELIVERINGTHEIRVALUEPROPOSITIONTOCLIENTSAnumberoffirmsinoursurveywereidentifedasbestinclasswithrespecttotheirpercievedfocusonperformanceexcellence.Someex-cerptsoftheirmissionprioritiesareshownbelow:
“Ourinvestmentteamsaresingularlyfocusedonprovidingtoptierinvestmentperformance.”-AdamsStreetPartners(Continued) P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford14INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTGREATFIRMSSEEKEXCELLENCEINDELIVERINGTHEIRVALUEPROPOSITIONTOCLIENTS(Continued)
“Myoverridingobjectiveisexcellence...I’lldowhateverittakestomakethecompanygreat.”-BridgewaterInvestments
“Weseethefirm’smissionasthefollowing,inorderofimportance:1.)Todeliversuperiorinvestmentperformanceandadvicetoourclients.”-GMOLLCWhilethesearejustafewexamples,whatweseeisaprimaryfocusongeneratingsuperiorinvestmentperformance.Thebestfirmsgettheiremployeesalignedbehindthemissionofperformanceexcellence.Theyusethemissionstatementtoinspireasenseofpossibilityandpride.WewilltalkingreaterdepthaboutmissionstatementsinChapter2.Atthisjunctureitisworthfollowingashorttangenttocontemplatethepre-cisewordingofthemissionand,moreimportantly,monitoringthemissionstatementforchangesthatsignalculturalshifts.Themissionstatementshouldbeofferedasthefirstandforemostmar-ketingstatementofaninvestment-drivenfirm.Missionstatementpromi-nenceaffirmsthesupremeinvestmentfocusofthemanagerandtheemploy-ees.Clientsshouldseekandconfirmtheirmissionalignmenttoamanager’sbeforepursuinganyothermanagerinformation.Consistencyofmanagerandclientmissionstatementsforestallsfutureproblems.Hodgson,Breban,Ford,StreatfieldandUrwinsimilarlyrecommendthattheclientoritsproxy,investmentconsultantsintheirarticle,compre-hendtheassetmanager’smissionandgovernancestructure.11Theinsightisimportant,butoftentheexecutionfallsfarshortofthemark.Frequently,assetmanageralignmentisconsideredafterthemanagerpassesvariousconsultantorclientdeterminedscreens,primarilythethree-yearinvestmentperformancescreen.Alignmentofmissionsshouldbedeterminedbeforescreensofperformanceareconsidered.Moreimportant,aprominentmissionstatementismoredifficulttododgeormodifythananinconspicuousornonexistentmissionstatement.Asinvestmentprofessionals,wehavespentmanydayswranglingovermissionstatementwordingwithbusinessmanagementcolleagues.Wefindthatsuchwranglingisoftenthebeginningoftheend—especiallywhenitcontemplatesdilutionofthefocusoninvestmentexcellence.Ininvestment-drivenfirms,morphingofthemissionstatementisoftenmotivatedbyastrengthening P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms15businessfunctionasAuMgrows.Themissionstatementbecomesmodifiedinamannerthatallowstheinvestmentprofessionalsandbusinessfunctiontoclaimcongruence.Oftenthechangesaresubtle.Thephrase“thepre-mierinvestmentfirm”maybesubstitutedwith“apremierinvestmentfirm.”Investmentexcellencemaybedilutedthroughaddingemphasistopopu-larphraseslike“client-centric”tothemissionstatement.Thereisnothingwrongwithbeingclient-centric,butsuchachangeinthemissionstatementisapotentialsignalofmorenefariousforcesworkinginthebackground.BoardCompositionIfthemissionstatementisafirstlineofdefenseofaninvestmentadvisoryfirm,boardcompositionisthenextbarricadepreventinganinvestmentfirmfrombecomingaproductfirmacrossleadershiptenures.Bestpracticesforboardcompositionsuggestassemblingmostlyindependentdirectorsinordertoprotectshareholderinterests;butwhileanindependentboardisgoodforownerprotection,itmaynotbeappropriateforaninvestmentfirm.Amongthestakeholdersofaninvestmentfirmarenotonlytheowners,whoareoftentheinvestmentandbusinessprofessionalsthemselves,butalsotheclients.Investmentfirmboardsshouldbedesignedtoprotectthecriticalinterestsofownersandclients,bothofwhomwanttoretainaninvestment-drivenculture.Inaninvestmentorganization,unlikeapubliclylistedcompany,man-agementhasafiduciaryresponsibilitytoactinthebestinterestofitsprimarystakeholder,theclient.Managementisnotandshouldnotbeprioritizingtheinterestsofshareholders.Practicallyspeaking,thesupremacyofclientinterestsmeansthatinvestment-drivenassetmanagementfirmsshouldnotbelistedfirmsordivisionsoflistedfirms.Otherwise,theprimacyofclientoutcomeswouldbethreatenedandultimatelydiminished.Inthecaseofmanypubliclyregisteredmutualfundsandevenpri-vatelystructuredinvestmentfundsoroffshorecorporations,thereareinfactboardsofdirectorswhosestatedobjectiveisensuringthatinvestorsaretreatedappropriatelyandthattheinvestmentmanagerisactinginawaythatmaximizesresultsforallinvestors.Infact,theseboardshavetheabilitytoterminatetheinvestmentmanagementfirm(oradvisor)tothefund.How-ever,inpractice,weseeveryfewinstancesinwhichthisactuallyhappens.Intheworldofhedgefunds,weevenseeanumberofprofessionalfirmswhospecializeincarryingoutthesedirectorialduties.Thesearefirmsthatexistandareorganizedprimarilytosupplydirectorstotheboardsofhedgefunds.Thesefirmsexemplifyacommonprincipal-agentconflict.Thesedirectorsarehiredbytheprincipalsoftheadvisingfirms.Further,someindividualsareknowntobedirectorsrepresenting100differentboardsormore. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford16INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENT2008–2009CASESTUDY:INVESTORSUNITETODRIVEDIRECTORACCOUNTABILITYInthehedgefundfalloutof2008and2009,weexpecttoseetheissueofboardindependencegainincreasingattentioninthehedgefundindustry.Theindependenceofandincentivesofboardmemberswillandshouldbehighlyscrutinized.Institutionalinvestorsandcapitalallocatorsareinapositiontohelppushneededchangeinthisareaandtoholddirectorsmoreaccountable.Oneinstanceweareawareofdemonstratesacaseofpositivechange,andhowinstitutionalinvestorscanhelpdrivethispositivechange.Theadvisortoacertaininvestmentfund,organizedasanoffshorelimitedliabilitycorporation,claimedthattheywerecommitedtowork-ingwiththeirinvestors,andultimatelydoingwhatevertheirinvestorswantedforthefund.Throughaperiodofverychallengingperfor-mance,theadvisorcontinuedtoclingtoalosinginvestmentstrategyandsuspendedtheabilityofitsinvestorstoredeemfromthefund,whilecontinuallydestroyinginvestmentvalue.Theadvisorcontinuedtotakeitsmanagementfeeduringthisperiodofsuspendedredemp-tions.Agroupofthefund’sinvestorsunitedandbroughtaplantotheadvisortotrytorealignincentivesandpushforchange.Thisincludedanorderlytimelineforawindingdownofthefundandafeethatwasbasedonapercentageofcapitalthatwasreturnedtoinvestors(asopposedtoaregularmanagementfeechargedonassetsunderman-agementeachquarter).Theadvisorbalkedatthesuggestionsoftheinvestorgroup.Theinvestorgroupcomprisedaboutone-thirdofthefund’sin-vestorbase.Theyaskedtheadvisortocallashareholdermeetingtodiscusstheplanwithotherinvestors.Thiscallforashareholdermeet-ingwasalsostalledandultimatelyrejectedbytheadvisor.So,whilethefirmhadanindependentboardofdirectors,theadvisoritselfwouldnottaketheinvestorgroup’srecommendationforashareholdermeet-ingtotheboard.Ultimately,thegroupcontactedtheboardmembersdirectlyandatfirsthadasimilarresult.Thedirectors,despitehavingconfirmationofthedesireofatleastathirdofthefundtodoso,wereunresponsivetotherequest.Eventuallytheinvestorgroupwasabletogettheshareholdermeetingcalled,butonlybyusingtheircollec-tivecloutandapplyingpressuretothefirmthatsuppliedtheadvisor’sboardofdirectors. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms17Wewouldnotbesuprisedtoseeamoreorganizedapproachtothesetypesofsituationsasaresultofrecentexperiences.Thereisanop-portunityforindustryassociationsorperhapsorganizationslikeproxyvotingservicestoformalizeprocessessuchastheseforidentifyingandcoordinatingactivitiesamongcollectiveshareholdergroups.Giventheinherentprinciple-agentconflictsofexistingboardstructures,thismaypresentthebestviablesolutiontoprotectinginvestorinterests.CorporationsandLimitedLiabilityCompanies(LLCs)canhaveboardswithgovernanceauthority.Intheory,clientrepresentationontheseboardswouldprotecttheirinterests.Inpractice,clientswouldspurnthelegallia-bilityofboardmembership.LimitedPartnerships(LPs)donothaveboardswithgovernanceauthority.Thegeneralpartner(s)managethepartnershipalongthelinesofacorporateboard.Thus,directclientinvolvementongoverningboardsisdifficultandunlikely.AcommonoccurrencetodayisforinvestmentfirmstocreateanAdvi-soryBoard.Thesetypicallyincludeinsidersandclients,alongwithbig-nameacademicsandinvestors.Thisstructuregivestheappearanceofenhancedclientprotection,butitgenerallydoesnotprotectclientinterests.Unfortu-nately,theAdvisoryBoardconceptismoreoftenthannotaboutappearancesandmotivatedbymarketing—cleverandcomforting,butultimatelyineffec-tual.AdvisoryBoardsaregood,butcareshouldbetakentodiscernitsroleasagoverningversuspromotionalentity.Weconcludethesethoughtsaboutboardsbysayingthatundoubtedly,appropriatelystructuredboardswithtrueindependencecanhelptoprotectinvestorinterests.However,wemustalsonotethatexperiencehastaughtusthataligningclientandmanagerinterestsisnotnecessarilybestaccom-plishedthroughboardcomposition,butratherthroughsignificantmanagerco-investment.Whenmanagershavesignificantpersonalcapitalinvestedalongsideclients,itcanbeapowerfuldriverofincentivealignment.Wewillreflectthroughoutthisbookontheimportanceofincentivealignment.CEOandCIOAuthoritiesWefoundastrongpreferenceamongthoseweinterviewedonthetopicofCEOandCIOauthorities.Simplystated:Firmsthataresuccessful,especiallyacrossmultipleleadershipgenerations,delegateCEOandCIOtitlesandauthoritiestoasingleindividual.InmanycasesthereisnoCEOtitle,withtheCIOtakingonbothsetsofauthorities.Acriticalseparationisthatof P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford18INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTCIOandChiefOperatingOfficer(COO).TheCOOhasauthorityoverandresponsibilityformanagingtheaffairsoftheinvestmentbusiness.TheCIOfocusoninvestmentprocessandstrategy,aswellaspolicymattersthatcouldthreatenthefirm’sinvestmentfocus.Investment-drivenfirmstendtohaveasingleofficerwithauthorityoverexecutiveandinvestmentactivities.Sincesuccessfulfirmsaretypicallysmallandsimple,thereisnoneedforseparation.Product-drivenfirms,ontheotherhand,tendtobelargerandmorecomplex,requiringtheseparationoftheCEOandCIOtitlesandauthorities.Separationoftheseauthoritiesprovidesyetanothersignofaproduct-drivenfirm.Evenifthefirmissmallandhasstronginvestmentperformance,itissusceptibletoshiftingawayfromitsinvestmentkernel.IfforsomereasontheCEOandCIOresponsibilitiesareseparated,legaldocumentationensuringthedefactoalignmentofCEOandCIOauthori-tieswiththeinvestment-drivenmissionisappropriate.Unfortunately,theseincentivesareverydifficulttocraftwithoutoverlyconstraininggovernancedocuments.FirmswithseparateCEOandCIOtitlescanbeextremelysuc-cessfuloverasinglegenerationofleadership.FirmslikeArrowstreetCapitalhavealignmentofobjectives,desiresandvalues,butArrowstreetCapital’spowerfulandwellarticulatedmissionreflecttheguidingprinciplesoftheCEOandCIO.IncentivesTheconfluenceofmissionstatementandvalues,boardcomposition,andCEO/CIOauthoritiesarethegovernancebackboneofinvestment-drivenor-ganizations.GivenaclearmissionstatementandunambiguouslyarticulatedCEO/CIOauthorities,theboardmustacttoincentivizecongruentmanage-mentbehaviors.TheCEO/CIOisresponsibleandmustberemuneratedforsuperiorlong-terminvestmentperformance,superiorclientoutcomes,andguardingthemissionandvalues.IftheCEO/CIObeginstoactinaman-nerthatisincongruous,thentheboardshouldreduceremunerationand,ifactionsarenotrealigned,begintheprocessoffindingareplacement.Laterchapterselaborateonhowtodefinesuperiorinvestmentperfor-manceandclientoutcomes,anddiscussreinforcementofandbarrierstodesiredoutcomes.Briefly,though,investmentperformancecanbeachievedbyaninvestment-drivenorganizationthatobjectivelyevaluatesandrewardsitsemployees.Chapters2and3provideastraightforwardsetoftoolsforcreatingappropriateincentivesforallmanagementandstaff.Theboardin-centivizestheCEO/CIO,andtheManagementCommittee,usingthesetools,incentivizesallotheremployees,includingthemselves. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms19FOSTERINGCOLLABORATIVEFREEDOM:EVERYBODYISAPEERIntheassetmanagementcommunity,aswithmanyindustries,professionalsarepromotedtomanagementpositionsbasedontheirinvestmentorassetgatheringsuccess.Asaresult,thehighestlevelsoftheseorganizationsarerifewithindividualsdevoidofleadershipormanagementskills.Wehavepersonallywitnessedcountlessexamplesofthis.Thebestinvestmentpro-fessionalsareoftenpromotedintosupervisoryorleadershiprolesdespitenoexperienceoraptitudeforleadership.Similarly,wehaveseenindivid-ualswithstrongsalesandclientserviceskillspromotedtoleadbusinessfunctions,devoidoftherequiredleadershipskills.Promotingthewrongindividualsintotheseleadershippositionsisoneofthemostcommonandpotentiallynegativedriversoffirmperformance.Thesedecisionsoncemadearedifficulttoundueanddeservemuchattentionandplanning.Ourexpe-riencesuggeststhatthefallout,moreoftenthannot,isthateitherarrogantcoercionmasqueradesasleadershiporanarchiccomplaisanceprecludesde-cisionmaking.Theleadershipspectrumrangesfromhubristiccontroltodetachedanarchy,withcontrolbeingmorecommon.AccordingtoGaryHamel,“Command-and-controlsystemsreflectadeepmistrustofemployees’com-mitmentandcompetence.”12WebelievethatHamelistoostronginmakingthisconclusion.Thecontrolleadershipstyleresultsincompliance,butdoessoattheexpenseofcreativityandpeerengagementandcontribution.Militaryleadership,whereindividualsmustactinconcertortheythreateneachotherandthebroadcampaign,requiresafirmleadershiphierarchyandunquestionedcompliancewithleadershiprequests.Suchahierarchydoesnotprecludeflexibility,butconstrainsittooccurwithinpre-ciseparameters.Additionally,processesorteamswhereindividualsfillpre-ciseroles—withflexibility,innovation,andcreativityoflimitedvalue—areamendabletocommand-and-controlleadershipstyles.ConsidertheleadershipofRossPerot,thefounderofElectronicDataSystems(EDS),whostartedthefirminthe1960sandeventuallylefttheor-ganizationin1986.EDSprovidedtechnologicalanddatamanagementout-sourcingforfirmsthatneededtoorganizeout-of-controlsystems.Control-basedleadershipwaseffectiveforEDS’sassignments.Thecontrolenviron-mentisanecdotallysupportedbythestrictdresscode,includingnofacialhair.TheAssociatedPress(AP)reportedin1997onthelooseningofalastvestigeofPerot’sleadershipstyle.EDSrelaxeditsdresscodetoallowpantsuitsforwomen.Thisaspectofthefirm’sstrongculturesurvivedfor10yearsafterPerot’sdeparture. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford20INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTManyofEDS’searlyemployees,consistentwiththefirm’scultureandPerot’scommand-and-controlleadershipstyle,camefromthemilitary,specificallythebattlefieldsofVietnam.Theseemployees,andsubsequentemployees,functioninamilitary-likeenvironment.Somuchsothatinthelate1970sEDSundertookamilitarycampaign.In1978,twoEDSemployeesweretakenhostageinTehran,Iran.TheU.S.andIrangovernmentsfailedtoactonbehalfofthehostages,soPerotandhisleadershipteamlaunchedoperationHOTFOOT(HelpOurTwoFriendsOutOfTehran).PerotrecruitedretiredU.S.ArmyGreenBeretArthurD.“Bull”Simonstocommandarescuemission.PerotslippedintoIran,posingasanewscourier,andinformedthehostagesofanimpendingrescuemission.EDSemployeeswererecruitedforthemission,andthetwohostagesweresuc-cessfullyliberated.AccordingtoGlennJohnson,amemberoftherescueteam,theteamexecutedthemissionbecauseitwassomethingthatneededtobedone.Clearly,command-and-controlleadershipcanbesuccessfulforteamswithaprecisemissionandclearroles.Leadershipdisengagement,attheotherendofthespectrum,isspawnedfromeitherfearorcomplacencyandnurturedinapowervacuum.Theresultisanarchyandanorganizationincapableofmakingdecisionsatalllevels.Anarchyisnotintentional.Aformercolleagueofoursepitomizesleader-shipdisengagementanddemonstratedhowanarchyevolves.Thiscolleagueespousedandsupportedwhateverideahadmostrecentlycomeacrosshisdesk.Hewasfirmlybehindtheproposalandplanuntilthenextdistractionwaltzedinfrontofhim.Asaresult,noneofhispeersorreportscoulddiscerndirection;hewasacompletepowervoid.The“product”ofaninvestment-drivenfirmissuperiorinvestmentper-formance.Theproductismadedifferentlyeverysingleday.Themanufac-turingenvironmentchangeseveryday.Aninvestmentfirmisnotafactory,andtheCIOneverknowswhichemployee,frommostseniortomostjunior,willofferagreatinvestmentideaorinsight.Inthisregard,allemployeesarepeers.Whereascontrolisviableforprecisemissionsandroles,andwithaclearhierarchy,andanarchyinvolvesthechaoticcollectionofindividuals’inde-pendentendeavors,collaborativefreedomisanimportantmiddleground.Butwhatdoescollaborativefreedommeantoaleader?Collaborativefreedomisaleadershipframeworkcomprisingmission,values,andobjectiveswithinwhichproductiveandcreativeactivityoccurs.Thefuture,Hamelcontends,willrelyonmorecollaborative,peer-basedleadershipstructures.13Intheassetmanagementindustry,thereal-timeneedfordiverseperspectivesandconstructivedisagreementsuggeststhatleadershipthroughcollaborativefreedomisofimmediateimportance. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms21Thisleadershipstyleleavestremendousauthoritytoindividuals.Indi-vidualsclearlyseethedesiresoftheleaderandusethisknowledgetoplanandmakedecisions.Theroleoftheleaderistoestablishevolvingendsandallowmanagementandstaffamultitudeofunspecifiedmeanswithwhichtoexecute.Itmayseemodd,butin1944,neartheendorWorldWarII,aBritisheconomistpublishedoneofthebestcommentariesonleadership.FriedrickA.Hayekfearedthattheidealsofsocialismandfascism,particu-larlyinNationalSocialistGermany,theSovietUnion,andItaly,weretooeasilyembracedbyintellectualsaroundtheworld.Heexploredthemannerinwhichtheseideasadverselyhijacktheleadersandmembersofeconomicsystems.Hayek’sTheRoadtoSerfdomisconsideredprimarilyacommen-taryonpoliticalsystems,buttheleadershipideasapplyubiquitously.14Hayekcouldseethepoweroffreedomandthegreatnessofleaderswhoaffordfreedom.Heobserved,“Wheneverthebarrierstothefreeexerciseofhumaningenuitywereremoved,manbecamerapidlyabletosatisfyeverwideningrangesofdesire.”15Peopleaskthedifferencebetweenaleaderandaboss.Theleaderworksintheopen,andthebossincovert.Theleaderleads,andthebossdrives.—TheodoreRooseveltIn1962,AlfredChandlerpublishedStrategyandStructureabouttheorganizationofcorporations,arguingthatstructurefollowsstrategy.WhiletheexamplesinChandler’sbookarguedthatthatstrategywouldleadtoanorganizationalstructurethatfacilitatedsuccessfulimplementationofthestrategy,itidentifiedariskthatsuchstructurewouldsubsequentlydictatefuturestrategies.Chandlerreasonedthatstructureneededtoberedesignedinordertosupportevolvingstrategy.16HamelalsoobservedthatManagementprocessesoftencontainsubtlebiasesthatfavorcon-tinuityoverchange.Planningprocessesreinforceout-of-dateviewsofcustomersandcompetitor,forinstance;...incentivesystemsprovidelargerrewardsforcaretakermanagersthanforinternalentrepreneurs;[and]measurementsystemsunderstatethevalueofcreatingnewstrategicoptions....Redistributepowertothosewhohavemostoftheiremotionalequityinvestedinthefutureandhavetheleasttolosefromchange.17WhileHamel’suseoftheword“power”issomewhatamorphous,histhesisclearlypointstothelimitsofcommand-and-controlleadershipand P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford22INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTthestrengthsofacollaborativefreedomleadershipsystemforfosteringthecontinualchangeofstructuretosupportevolvingstrategy.AsHayekobserveddecadesearlier,“Thefundamentalprinciplethatintheorderingofouraffairsweshouldmakeasmuchuseaspossibleofthespontaneousforcesofsociety,andresortaslittleaspossibletocoercion,iscapableofaninfinitevarietyofapplications.”18Bringingthistheorybacktorealitytoday,ourresearchisincrediblycon-sistent.Topassetmanagementfirmsembracethistypeoftransformationalleadership.Thecultureofthesefirmsemphasizesideasoverhierarchyandexecutionoverintention.Investmentleadershipdependsonthevoluntarycooperationofindivid-uals,exploitingandleveragingeachother’sdiverseskillsandknowledge.Afirm’sculture,mission,objectives,andvaluesdefinetheframeworkwithinwhichthisvoluntarycooperationachievesdesiredoutcomesforallemploy-eesandallclients.Theleaderidentifiestheendswhilecollaborativefreedomdeterminesthemeansandshapesstrategythatinturnshapesthefirm’sIDEASOVERHIERARCHYAnumberoffirmsinoursurveywereidentifiedasbestinclassinhiringandcultivatingtalent.Thesefirmsareperceivedtolivethevaluestheyespouseasitrelatestoencouragingapeer-drivenmangementstyle.Thefocusofthesefirmsisonideageneration,collaboration,empowerment,andencouragingemployeestoopenlydebateandchallengeoneanotherinaconstructiveway.Creatingthiskindofcultureisdifficult,buttherewardsforsuccessfulexecutionareevident.
“Conflictinthepursuitofexcellenceisaterrificthingandisstronglyencouraged,infactdemanded.Thereshouldbeno(oraslittleaspossible)hierarchy.”-RayDalio,BridgewaterInvest-ments
“Newhiresoftenenjoysurprisingamountsofresponsibility,andweencouragecollaboration,personalmentorshipswithseniorteammembers,andtheopenexplorationofideas.”-D.E.ShawGroup
“Ourprimarygoalistorecruittop-tiercandidates,challengetheirthinking,cultivatetheirtalent,andultimatelyhelpthemsucceed.”-TheBlackstoneGroup P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms23structure.Whiletherewillalwaysbeleadershiplevels,eachandeveryindi-vidualisapeerinthefutureoftheorganization.Chapters2and3elaborateontheimplicationoftheseconceptsfortheleadershipandmanagementofaninvestmentorganization.Letahundredflowersbloomandahundredschoolsofthoughtcontend.—ChineseProverbChandler’sthesisisthatexecutionisfosteredbyastructurethatderivesitsformfromthespecifiedstrategy.Culture,mission,values,andobjectivesleadtokeyperformanceindicators(KPIs)thatprovidecontinualguidancetoalldivisions,teams,andindividualstoexecuteandmakedecisionsconsis-tentwithstrategy.CharleyEllisstatesthat,“thelong-termdestiniesofmostinvestmentmanagementorganizationsaredisproportionatelydeterminedbycompromisingdecisionsmadeduringtheveryearlyyearsoftheorganiza-tionshistory.”19Ellisseemstobeobservingthefactthattheinitialstrategydictatesastructurethatlaterbecomescompromisingtotheorganizations.Infact,hefurtherobservesthat“successwithaspecificstrategyalltoooftenleadstothebuildupofacorporatestructurethatgetsmoreandmoreconsistentandefficient—andeventuallyrigid.Thisappearstoenhanceeffi-ciency,asreportedresultsgetbetterandbetterforawhile.Butovertime,“thewaywedothingsheregetscelebratedandcodified....Theorgani-zationalstructure,withitsfamiliarpracticesandcomfortablepractitioners,theyreinforcerisingrigidity.”20Theleadershipteamestablishestheendsand,ultimately,executionbecomesaformoforganizationalandindividualcommitmentandintegrity.INTEGRITY:ANUNQUESTIONABLECHARACTERISTICOFSUCCESSAmongitsdefinitions,“integrity”istypicallyunderstoodtomeanstrictadherencetoamoralcode.Tousthisisonlypartofit.Integrityhasamechanicalaswellasamoralmeaningthatisimportantforhigh-qualityassetmanagementfirms,regardlessoftheirfocus.Consideracomplexmachine,suchasavotingcardreader.Ifthevotingmachineistohaveintegrity,itmustmeetcertainminimumstandardswith-outerrororfailure.Similarly,agunthatfunctionstime-after-timewithouterrorisacomplexinstrumentthatissaidtohaveintegrity. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford24INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTTheshortestandsurestwaytolivewithhonorintheworldistobeinrealitywhatwewouldappeartobe.—SocratesAsaleaderoremployee,integrityisaboutdoingwhatyousayyouwilldo.Youractionsmatchyourwords,withouterrororfailure.Youractionsareconsistentandpredictable.2008–2009CASESTUDY:50BILLIONLESSONSLEARNEDFROMBERNIEMADOFFTherearehundredsoflessonsinrecenthistorythatdemonstratejusthowdifficultitcanbetoassessintegrity.Thereisonefromtherecentperiodthatdeservesspecialattention.BernardMadoff,awell-knownindustryprofessional,wasexposedasaconmanaftercommittingafraudofepicproportions.Whilethetallyingisnotyetcompleteasofthiswriting,itappearsthatheswindledprivateandinstitutionalinvestorsoutofsomewherebetween$30billionand$50billionbyconvincingthemthathehadastrategythatcouldmakemoneynomatterwhatandthathehadbeendoingsoformanyyears.Inreality,hewasfalsifyingdocumentsandperpetratingperhapsthegreatestin-vestmentscamofalltime.Thatisastaggeringamountofmoney,anditislargerthanthegrossnationalproductofmorethan100recognizedcountries.Doyouthinkthatthehundredsofindividualsandinstitutionsthat“invested”capitalwithBernardMadoffbelievedthathewasnotonlyanindividuallackingintegrity,butalsoasociopathcapableofdeceitfulwealthdestructionofthescalethatappearstobethecase?Ofcoursenot.Forwhateverreason,hehadtheircompletetrust.Sometimesthesmartest,mostcharismatic,andpersuasiveindividualsendupdemon-stratingaremarkablelackofintegrity.Andthisisalessonforusall.Integrityissomethingthatmustbedemonstratedbyactionsacrosstime.Investorscannotbeafraidtoaskfortransparencyandverifiableevidenceinsupportofclaims.Andmostimportant,investorscannotshortcuttheirownprocesses,asitappearsmanydid.DespitetheclearlackofintegrityinthecaseofBernardMadoff,aninvestorwithanykindofinvestmentprocessandintegrityofthatprocesswouldhavebeenhardpressedtoeverallocatemoneytohiminthefirstplace. P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestfordCharacteristicsofSuccessfulAssetManagementFirms25Realintegrityevidencesitselfintimesoforganizationalstress.Integrityisdoingtherightthinginthefaceofadversity,exactlywhenitwouldbeeasiestnotto.Itisholdingfasttoyourbeliefsandprincipleswiththeknowledgethatdoingsowillcertainlycausegreaterpainintheshort-run.Throughoutthisbook,wewillcomebacktotheissuesandimportanceofintegrity.CONCLUSIONAstrongandpositiveculture,limitedsize,stronggovernancefortheprotec-tionofclientinterests,collaborativeleadership,andintegrityareallcompo-nentsofanorganizationthatdoesrightbyitsclients.Forinvestment-drivenassetmanagementorganizations,“hoovering”assetsisnotintheclients’bestinterests.Limitinggrowthandsizerequiresanadditionaloverlayofintegrity,theintegritytosay“no”tocapabilityvariations,toassetsundermanagementgrowththatbecomesadragoninvestmentperformance,totakingmoreriskthanaclientiscomfortabletaking,toanythingthathasthepotentialtoimpedeinvestmentperformanceinanynon-negligiblemanner.Accordingtooursurveysandinterviews,someofthemostconsis-tentexamplesofinvestment-drivenfirmsincludeBrandesInvestmentPart-ners;BridgewaterAssociates;Grantham,Mayo,VanOtterloo(GMO);andMarsicoCapitalManagement.Inthelate1990s,GMOheldfirmtoitsvalue-basedfundamentaldis-ciplineandrefusedtobuythehigh-flyingTMTstocks.Manyofitsclientsterminatedtheirrelationship,perhapsinevitablebutafailureofcommuni-cationnonetheless,andGMO’sAuMwashalved.AftertheTMTbubbleburst,clientsunderstoodGMO’shighlevelofinvestmentintegrity,enablingadoublingoftheinitialassetbase.TheAmericanFundssubsidiaryoftheCapitalGroupisauniqueinvestment-drivenorganizationinthatithasanextremelylargeAuM,butithasastrongcultureandhaslimitedthenumberofcapabilitiesthatitman-ages.Thestrengthofcultureandlimitedcapabilities,despitehighAuM,haveenabledAmericanFundstosustainaninvestment-drivenexistencefordecades.Amongproduct-drivenfirmsandformerinvestment-drivenfirmsthathaveshiftedintotheproduct-drivencategoryareFidelityInvestments(MutualFunds),Nicholas-ApplegateCapitalManagement,NorthernTrust,NuveenInvestments,SchroederInvestmentManagementLimited,andTheVanguardGroup.Thepowerfulincentiveof2percentmanagementfeesand20percentperformancefeestogrowassetsandweakgovernancestructurescom-pelledmanyhedgefundfirmsthatwereotherwiseinvestmentfocusedand P1:a/bP2:c/dQC:e/fT1:gc01JWBT154-SingerAugust26,200910:53Printer:CourierWestford26INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTpossessedstrongculturestobecomeextremelyhighpriced,product-drivenfirms.Oursurveyidentifiedanumberoffirmsaboutwhichinvestorshavegrowingconcerns.Amongthesefallenangels,andavoidingthefraudulent,areBearStearnsAssetManagement,GoldmanSachsAssetManagement,HighbridgeCapitalManagement,andMANInvestments.Theiractions,fo-cus,andintegrityinthedaysaheadwillhaveagreatimpactontheirultimatesuccessorfailure.Transparencymakesethicsandintegrityeasier.Thebrightlightoftrans-parencypreventstheshadowypresenceofmisalignedincentivestodriveinvestment-drivenassetmanagementfirmsfromtheirinitialcorepurpose—investmentperformanceandclientoutcomes.Absenttransparency,thecul-turecanchange,sizecanbecomeapriority,governancecanfalter,andleadershipcanwane.JusticeLouisBrandeiscoinedaphrasethatshouldgarnerourattentionwhenhesaid,“Sunlightisthebestdisinfectant.”Hewasreferringtotransparencyandhonestyinpublicpolicy.Butwhethertalkingabouttherelationsofafirmwithitsemployeesorwithitsclients,wewouldalldowelltotakeheed.Inthischapterwehaveidentifiedanumberofcharacteristicsofhigh-qualityassetmanagementfirms.Wefocusedontheimportanceofastrongcultureandwhatthatmeansforsuccessfulassetmanagementfirms.Wealsodiscussedthehazardsposedbygrowthofassetsandproliferationofproducts.Lastlywereiteratedtheimportanceofeffectivegovernance,lead-ership,andintegrity.InChapters2and3wewilloutlineamoreprescriptiveframeworkforbuildingasuccessfulassetmanagementfirm.Thisstartswithanotherdetailedlookatmissionstatementsandvalues.However,wequicklymoveintoadiscussionofthepracticalconsiderationsforsettingupman-agementandgovernancestructuresandidentifybestpracticesforexecutionofthemission. P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestfordCHAPTER2BuildingaCathedralAFrameworkforTurningtheMissionintoCollectiveActionhisandthefollowingchapterwilloutlineouruniquemodelforeffectiveTleadershipandmanagement.Asleadersitiscriticallyimportanttoem-bracetheorganizationalvalues,mission,andgoalstoprovideaframeworktomakethenecessaryandsometimesdifficultdecisionsaboutyourstrategy,yourorganization,andyouremployees.Itisequallyimportanttoalignin-dividualandteamobjectivesettingandperformancemeasurementinwaysthathelptoachievethemission.Torevealtheimportantrolethatmissionstatementsplayinguidingemployeebehaviorandeventuallythelong-termsuccessofyourinvestmentfirm,wefirstneedtotellyouastory.Thisstoryfocusesnotonlyontheimportanceofwhat,asCIOs,ouremployeesaredoingbutalsohowtheyperceivewhattheyaredoingaspartofthelargerpurposeoftheorganization.Oneday,aladywalksdownthestreetandpassesamanworkingbythesideoftheroad.Theladyasks,“Whatareyoudoing?”Hesays,“I’mcuttingstone.”Shewalksalittlefurtherdowntheroadandseesanothermandoingexactlythesamethingandasksofhim,“Whatareyoudoing?”Thismanre-sponds,“Cuttingcornerstonesforabuilding.”Shecontinueswalkingdowntheroadandnottoofardownshepassesanotherman,againcuttingstone,andasks,“Whatareyoudoing?”Thismansays,“Buildingacathedral.”Thisanecdotedemonstratestheimportantpurposeofamissionstate-mentforallemployees,aswellastheimportanceforinvestmentprofession-alstohaveaninvestmentphilosophystatement.Employeesmustseethebigpictureandhowtheycontributetoit,andnotjustthenarrowfunctionthattheyarefulfillingonaday-to-daybasis.Ifyouremployeesrespondtothequestion,“Whatareyoudoing?”withsomethinganalogousto“Buildingacathedral,”thentheleadershipisdoingitsjob.27 P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestford28INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTAFRAMEWORKFOREFFECTIVELEADERSHIPANDMANAGEMENTTable2.1outlinesabasicframeworkforeffectingleadershipandman-agementthatcanbeadaptedtomostorganizations.Inthesectionsthatfollow,wewillnotaddresseveryaspectoftheprocessforexecutionofthisframework,butwetouchonthemostcriticalpartsaswellasthelessonsthatexperiencehastaught,inthehopesthatsomeofourmistakescanbesidestepped.Itisokaytomakemistakes,butitisbesttolearnfromthemistakesofotherswhenwecan.Goodjudgmentcomesfromexperience,andalotofthatcomesfrombadjudgment.—WillRogersWhilewearenotaimingtowriteamanagementself-helpbook,weacknowledgethataprescriptiveapproachmaybeinterpretedassuch.WearealsocognizantthataprescriptiveapproachsuchasthishaslimitationsTABLE2.1AFrameworkforEffectiveLeadershipandManagementComponentoftheFrameworkWhoIsResponsible?Determine&LiveOrganizationalValuesAllemployees(Enduring)CreateaMissionStatementand/orInvestmentCEO,CIO,BoardofPhilosophyStatement(Enduring)Directors,ManagementCommitteeSetStrategicGoalsfortheOrganization(1toManagementCommittee5YearView)EstablishTeamGoals&KPIs(1to5Year)TeamHeads&ManagementCommitteeEstablishIndividualGoals&KPIs(1YearIndividual&Managerand3Year)EvaluateIndividual,Team,andAll(withdifferingOrganizationalPerformancealongresponsibilitiesforvariouscriticalityandperformancedimensionsaspects)(Annual)CommunicatecriticalityandperformanceatAll(withdifferingalllevels(AtleastAnnual)responsibilitiesforvariousaspects)AlignRemunerationwithMeritZonesManagementCommittee(Annual) P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestfordBuildingaCathedral29andisdependentonthestructureandgovernanceofeachorganization.Forthisweapologizeinadvance.Onethingthatiscriticaltothisprocessatalllevelsisafocusonper-sonalaccountabilityandcollaborativeassessment.Itisincumbentontheindividualtotakeanactiveroleintheprocessofsettingandevaluatingtheirownobjectives.Fosteringacultureandorganizationalprocessesthatmakethishappenisthejoboftheleadershipteam.ESTABLISHINGANDLIVINGORGANIZATIONALVALUESWediscussedtheimportanceoforganizationalvaluesinChapter1.Valuesareindividualtoeachorganization,andwewillnottrytobeprescriptiveherewithanapproachforsettingthosevalues;howeverwewillshareanexperiencethatmayserveasaguideforothers.Valuesflowup,down,andacrossanorganization.Thatistosaythatindividualsinfluencetheorganiza-tion’svaluesandviceversa.Asaresultthevaluesneedtobealwayspresentinthemindsofthoseevaluatingcandidatesforpotentialroleswithintheorganization.Furthermore,inthehighestqualityorganizations,thevaluescanbefoundtoimpacttheclientexperienceorclientoutcome.Takentogether,anobjectiveanalysisofthesetwogroups(clientsandemployees)maybetheultimatetestofwhetherthestatedvaluesareinfactacrediblereflectionofthefirm.Ultimatelythisprocessstartswiththeleader,andforaninvestment-drivenorganization,thisstartswiththeCIO.Laterinthechapterwewilldiscussingreaterdetail,theprocessforevaluatingwhetherornottheorganizationislivingitsvalues.Inanyevent,thevaluesrepresentthegroundthatyourcathedralwillbebuilton,andassuchdeservesignificantattentionfromthemanagementteam.SettingOrganizationalValues:ACaseinPointWhenBrianSingerbecametheheadofaglobalinvestmentteamresponsibleformanagingnearly$200billionofmulti-assetportfolios,heneededtodevelopastrongandpositiveculture.TheteamwasarelativelyunmotivatedanddisparatecollectionofinvestmentprofessionalsfromBrinsonPartners(acquiredbySwissBankCorporation),Phillips&Drew(acquiredbyUnionBankofSwitzerland),acontingentofSwiss-basedcolleaguesfromthesebanks,andlateragroupfromMitchellHutchinsAssetManagement(the“in-house”assetmanagementgroupoftheformerPaineWebber).Eachcountryandcityoforiginbroughtauniqueculture.Complicatingthingsfurther,theculturesofthepredecessororganizationswerecompletely P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestford30INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTdifferent.Capturingtheculturaldivergence,themanagementteamreferredtothethreeoriginalcontingentsas“TheThreeTribes.”BrianturnedtoJimWare,thefounderofFocusConsultingGroup,toassisthisefforttocreateaunifiedteam.HedidnotknowJimatthetimeorhisfledglingconsultingoperation,butJimunderstoodtheproblemandwasexcitedtoworkwiththeteamtoidentifycommonvaluesandfosteraunifiedfocus.Theultimateoutcomewasmorethanoriginallyenvisionedpossible.Thecombinedteamanditsmanagementbeganamultiyearcathedralrenovationproject.Startingwithasetofdiverseculturesandattitudes,thegroupfirstembarkedonajourneytodiscerncommonvaluesandbehaviorsuponwhichtobuildafocusedteam.WeinvitedthemanagementteamtotheUnionLeagueClubinChicagoforameeting.Eachpersonindicatedwhattheyexpectedandanticipatedfromtheiremployment.Wediscussedourinvestmentandbusinessphiloso-phies.Themanagementteamsearchedforcommonthreadsthatwouldallowustoworktogether.Sometimesweagreed,andmanytimeswedisagreed.Luckily,“TheThreeTribes”werecomfortablewithafundamentalinvest-mentphilosophythatcouldenhanceperformancethroughthequalitativeuseofquantitativeportfolioconstructiontools.WeplasteredthewallswithPost-ItNotesofeachindividual’svaluesinordertodiscernsimilaritiesanddifferences.Aftertwodaysweidentifiedsharedvaluesandamutuallyagreedmission.Wefurtherrefinedourmis-sionbyspecifyingasetofstrategicobjectivesthatwewouldjointlypursuefromourdisparatelocationsandthroughthelensesofseparatenationalcultures.Mostoftheinitialstaffacceptedtheguidingprinciplesandmissionthatweidentified.Tothebenefitofallparties,theindividualswhodidnotaccepttheorganization’svaluesandmissiondidnotstay.Fewweretermi-nated.Formost,theobviouslackofalignmentwastransparent,enablingeachindividualtodecideforthemselvestoseekalternativeemployment.Employeecommitmentsorteditselfwithdignity.Inalmostallinstancesthemotivationwasclearandtheoutcomeadvantageous.Overthesubsequentyears,theteamthrived.Wedeliveredsuperiorinvestmentandbusinessper-formance.Wecreatednewinvestmentproductsthatspecificallytargetedclientneeds.Morethananything,wehadprideinourworkandenjoyedeachother’scompany(forthemostpartanyway).Wetookfromthisexperiencetheobservationthatvaluesandculturearegrassrootsinnature.Theyarenotexternallyimposed.Theyemanatefromindividualsontheteamandareespousedbythosebroughtintotheteam.Ifstartingfromscratch,thecultureandvaluescanbeprespecifiedandindividualscanbehiredwithfullknowledgeofthevalues.Ifstarting P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestfordBuildingaCathedral31withapreexistingteam,thevaluesmustbederivedfromandagreedbytheindividualsinplace.CREATINGMISSIONAND/ORINVESTMENTPHILOSOPHYSTATEMENTSSeeingthebigpictureprovidescontextforthedelegationofauthoritytosubordinates.Individualsbecomeinvolvedintheorganization,whichleadstointerestinandcommitmenttothecauseoftheorganization(itsmissionandinvestmentphilosophy).Italsoleadstoloyalty,aswellaspersonalinvestment,intheorganization.Thetaskoftheleaderistogethispeoplefromwheretheyaretowheretheyhavenotbeen.—HenryKissingerForinvestment-drivenfirms,asopposedtoproduct-drivenfirms,theinvestmentphilosophystatementandthemissionstatementcanpotentiallyberolledintoone.Thecombinedstatementshouldindicatebothwhatanorganizationseekstoaccomplishandhowitseekstodoit.Twoprimecasestudiesofhowinvestment-drivenfirmshavebeenabletofusetheirinvestmentphilosophiesandmissionstatementsareBrinsonPartnersintheearlyandmid-1990sandDodge&Coxtoday.MissionStatementCaseStudy1:BrinsonPartnersIntheyearstheauthorsspentwithBrinsonPartners,wewitnessedtheevolu-tionofitsinvestmentphilosophyandmissionstatements.Inthebeginning,GaryBrinsonwasthechiefexecutiveofficer(CEO)andchiefinvestmentofficer(CIO),andBrinsonPartnershadaveryclearmissionstatementthatwovetogetherthemissionandtheinvestmentphilosophyoftheorganization:Buildthepremierglobalinstitutionalassetmanagementfirmbyoperatinginassetclassesandgeographicareaswherewecanachieveexcellenceinthedeliveryofperformanceandclientservice.Garyusedthismissionandphilosophystatement,hisgravitas,andastrongteamtodrivetheindustrytowardgreaterglobalizationandmoreeffectiveuseofassetallocationforportfolioriskmanagementandreturnenhancementpurposes.Infact,hissermonsonassetallocationhelpedto P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestford32INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTcreateanewmainstreamsegmentintheassetmanagementindustry—onethatwasfocusedprincipallyontheallocationofassetsacrossassetclassesandgeographiesasameansofseekingreturnandreducingrisk.Thebestwaytopredictthefutureistoinventit.—AlanKay,originatoroftheWindowsoperatingsystemAsaresult,therewasnoconfusiononthepartofanyemployeethathisorherprioritywasportfolioperformanceandclientservice.Theattentiontodetailinallclientinteractionwasextraordinary.Garywouldleteverybodyknowifaphonewentunansweredorapresentationpagehadevenaminorerror.Everybodyatthefirmdreadedan“after-hours”callfromGarybeforehemetwithaclientandthelate-nightfiredrillscorrectingminorerrorsinhisefforttoupholdastandardthatfewcouldevenhopetoachieve.Periodsofweakinvestmentperformanceresultedinlatenightandweekendvigilstoquestionourresearch,testourvaluations,orposealternativehypotheses.Alackofattentiontodetailandtheslightestindicationofinvestmentindolencereflectedpoorlyonthefirmandwouldnotbeevenmarginallytolerated.Overtime,therewasashiftfromacombinedmissionandinvestmentphilosophystatementtoseparatestatementsthatsignaledashiftwithintheorganization.IntheBrinsonPartnersorganization,everyindividualembracedtheprimacyofinvestmentperformanceandclientservice.By2001,theroleofCEOandCIOhadbeenseparated,themissionstatementindicatedabroaderdirectionforassetmanagement,andtheinvestmentphilosophystatementtargetedonlytheinvestmentprofessionalsandsignaledashiftinfocusfromevenlybalancedtop-downandbottom-upinvestingtoamorediffusedbottom-up,alphaboutiqueorientation.Alphaboutiquesaretypicallysmall,independentorganizationsnarrowlyfocusedonthegenerationofsuperiorinvestmentperformanceinaparticularassetclassorwithaspecificinvestmentstyle.Perceptiveinvestorsdetectedthisfundamentalshiftintheorganization.MissionStatementCaseStudy2:Dodge&CoxTheDodge&Coxfundfamilyalsowovetogetherthefirm’smissionandinvestmentphilosophystatements.Itstillputsthisstatementfrontandcenterinitsmessaging,“Ourdisciplinedinvestmentapproachisguidedbyalong-terminvestmenthorizon,independentresearch,andportfoliodiversification.”1Moreover,thereisaveryfocusedstatementthat,“Re-searchisourcommonlanguage...Wehavefoundnoquantitativemodelorresearchservicethatcanreplacethebenefitsofholdinganonsitemeet-ingwithacompany’smanagement,conferringdirectlywithitscompetitors, P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestfordBuildingaCathedral33customers,andsuppliers,ortakingthetimetoanalyzeitsfinancialrecordfromtoptobottom.”2Thisservesclientsaswellasadisciplined,long-term,research-drivenapproach.Whilenotnecessarilydeliveringsuperiorinvestmentperformanceallthetime,Dodge&Coxhasadheredtoitsinvestmentphilosophytodeliversuperiorinvestmentperformanceovertime.STRATEGICGOALSANDKEYPERFORMANCEINDICATORSAprocessforsettingstrategicgoalsinanorganizationiscriticalforaligningtheactivitiesofemployeeswiththemissionstatement.Bystrategicgoals,werefertodesiredaccomplishmentsrequiredforthefirmtobemovingtangiblyinthedirectionofmissionfulfillment.Whileamissionstatementtendstoliveonwithoutexpiry,strategicgoalsaretimebound.Strategicgoalsmaybedesiredaccomplishmentsforthisyearorforthenextfiveyears,oracombinationofthetwo.Thegoal-settingprocesscaninvolveinputanddatacollectionfromallemployees,butultimatelyitistheresponsibilityofthemanagementcommittee.Forinvestmentfirms,thisgoalsettingtendstorevolvearoundtheachievementofrealisticperformanceobjectives,butcanandshouldincludegoalsrelatedtoclientresultsandclientsatisfaction.Thisgoal-settingprocessrequiresthatthemanagementcommitteeevaluatetheexternalenvironmentaswellasorganizationalresources.Goalscanbestretchgoalsbutmustbeperceivedbyemployeesaspotentiallyattainable.Oneofthemosteffectivemethodstheauthorshavefoundforgoalsettinginvolveshavingallmembersoftheseniormanagementteam,thefirm’sleaders,submitanimaginativefuturisticdescriptionofthefirm.Thisdescriptionisonethatthemanagementteammemberwritesasifheorsheisajournalistwritingafeaturearticleaboutthefirmatsomedesignatedpointintimeinthefuture.Thisnotonlyhelpsprovideadocumentthathighlightsdifferentviewsaboutstrategicpriorities,butitalsohelpstheteamexecutespecificinitiativesthatwillhelpdrivegoalachievement.Inourexperience,itcanalsoprovideacreativerelease.Someoftheartworkthathasbeensubmittedwithsucharticleshasleftlastingimpressionsinourmindstosaytheleast.Aleaderdoesnotnecessarilyneedtobethemostintelligentmemberofhisgroup...ratherheistheonewiththeclearestandmostfar-reachingvision.—SheikhMohammedbinRashidAlMaktoum P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestford34INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTTheestablishmentofthefirm’sstrategicgoalsprovidestheroadmapforplanning,budgeting,andresourceallocations,andalsoimportantlyforteamandindividualobjectivesetting.MeasuringtheattainmentoftheseobjectivesateachlevelistheroleoftheKeyPerformanceIndicator(KPI).Ifthemissionandinvestmentphilosophystatement,likeblueprints,com-municatethearchitect’svisionofthecathedral,theseKPIsprovidespecificstatementsofeachemployee’sobjectivesforbuildingourcathedral.WerecommendasetofKPIsforthefirmandconsistentsetsofKPIsforeachteam.Ifaninvestmentfirmistoremaininvestment-driven,thentheKPIsmustpredominantlyreflectinvestmentperformance,andeachemployee,tovaryingdegrees,mustbeheldaccountableforthatinvestmentperformance.WeightingInvestmentPerformanceversusSuccessfulClientOutcomesAnappropriatesetofKPIsforaninvestment-drivenfirmwoulddictatethatsomethingontheorderof60percentofoverallperformancebebasedoninvestmentperformance,withtheremaining40percentbeingbasedonbuildingaplatformforsuccessfullong-termclientoutcomes(seeFigure2.1).Theuseofthephrase“clientoutcomes”isaveryimportantaspectofKPIs.Whileitisdifficultatbesttogeneratesuperiorinvestmentperformance,itismuchmoredifficulttoprovidesuperiorinvestmentoutcomesforclients.TheinvestmentperformanceKPIsarefornaughtifclientsandultimatebeneficiariesdonotexperiencethecompetenceoftheinvestmentmanager.OftenthisderivesfrominappropriateconstraintsthatareagreedtoincreaseSuccessfulClientOutcomesInvestmentPerformance40%60%FIGURE2.1SuggestedKPIweightingsforanInvestment-FocusedFirm P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestfordBuildingaCathedral35theprobabilityofwinninganinvestmentmandateorinappropriateriskcalibrationthatresultsinearlymandatetermination.Giventhislitanyofcaveats,howcantheperformanceofinvestmentandbusinessprofessionalsbeeffectivelyevaluatedandincentivized?Ontheonehand,themanagementcommitteewantstocreateincentivesthatrewardinvestmentandbusinessprofessionalsforstrongperformanceduringtheircareerswiththefirm;competitorshaveawayoftemptingawayemployeeswhoareperceived(evenifrandom)tobesuperiorperformers.Ontheotherhand,themanagementcommitteemustincentivizelong-horizonthinkingandinvestmentperformancethatisconsistentwiththeprofessionals’fidu-ciaryresponsibilitiestothefirm’sclients.Whileinvestmentperformanceisthecriticalproductofaninvestmentorganization,itwouldbeinappropriatetoconsideritastheonlycriterionbywhichtoevaluateemployees.Investmentperformancereflectstheconfluenceofallfactorscurrentlyatplayintheorganization.However,itisonlyasingleoutcomefromaninfinitesequenceoffeasiblereturnoutcomes.Otherpiecesofinformationcanprovidevaluabledirectioninassessingskillandcompetence.Moreover,inbuildingaplatformfortomorrow’ssuccess,itisnecessarytoconsidernotonlyfactorsimportanttocurrentrealizedinvestmentperfor-mance,butalsotoincentivizeaplatformforfuturesuccess.Thecollectionofcompetenciesthatprovideaskillfuledgetodaymaynotprovideanedgeinthefuture.Theorganizationandeachindividualmustnotbeincentivizedtotradefuturesuccessforcurrentsuccessbecauseofcompensationstructure.Instead,anongoingprocessofresearch,development,experimentation,andinnovationmustbeestablishedandrewarded.Giventheclients’relativelylonginvestmenthorizon,achievingsuperiorclientoutcomesdirectstheman-agementcommitteetoplacesomethingontheorderofa40percentweightonKPIsassociatedwithsuperiorclientoutcomesovertimeviabuildingandmaintainingaplatformforfuturesuccess.Theassessmentofeachemployee’ssuccessinbuildingandmaintainingaplatformforfuturesuccessismorequalitativethantheprocessofassessinginvestmentperformance.Thefactorsthatareinvolvedinthisaspectofeachemployee’sjobarevariedandcaninclude:
Innovation
Independence
Teamwork
Research
Transparency
Clientoutcomes
Values P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestford36INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTORGANIZATIONALKEYPERFORMANCEINDICATORS:HYPOTHETICALEXAMPLEAsimpleexampleofafirmwithafive-yearinvestmenthorizonmightconstructKPIsthatlooksomethinglikethatshownintheboxbelow.Thefocusshouldalwaysbereturnperunitofrisk,withriskdefinedinawaythatisrelevantfortheparticularstrategyorapproach.60%Risk-AdjustedInvestmentPerformance1-Year3-Year5-Year1-Year3-Year5-YearInformationInformationInformationPeerPeerPeerRatio∗RatioRatioRankingRankingRankingWeighting>10%15%25%10%15%25%InvestmentGoal:Goal:Goal:Goal:Goal:Goal:StrategyGreaterGreaterGreaterTopTopTopABCthan.5than.5than.5thirdthirdthird∗Informationratiomeasuresexcessreturnoralphadividedbythetrackingerrororrelativeriskofaportfoliocomparedwithitsbenchmark.WewilldiscussthisfurtherinChapter3.40%SuccessfulClientOutcomes
10percentimprovementinclientservicequalityratingsfromclientfeedbacksurvey.
Successfuldevelopment,rollout,and50percentclientusageofnewonlinereportingtool.
Successfuldevelopmentandrolloutofnewriskreportingprogramandinclusionofstatisticsinclientreportingandclientpresenta-tions.
AssetsUnderManagement
Priority1:Assetretention.
Priority2:Developmentofnewrelationshipswithlong-terminvestors.Ofcourse,KPIswillbedifferentforeveryorganizationandmayfocusondifferentmetrics.Theimportantthingisthattheyarethoughtfullydevelopedandcommunicatedtoallwhosefunctioncontributestoaccomplishingthem.Theweightingsgiventodifferentperformanceperiodsforevaluationpur-poseswillalsovary.Inthenextchapter,however,wewillmakethecaseforsignificantlyhigherweightingsappliedtolongertermperformancenumbers. P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestfordBuildingaCathedral37TheintentofthissystemistotargetandsubstantiallymeettheKPIs,althoughtheorganizationshouldnotbeexpectedtomeetthetargetforeachKPIeveryyear.Ourexperiencesuggeststhatallemployeesshould,tovaryingdegrees,beheldaccountableforinvestmentandbusinessper-formanceKPIs.Ifallemployeesareaccountable,3theyhaveanincentivetounderstandhowtheirjobsinfluenceinvestmentperformance.UnderanincentivestructureofbroadaccountabilityforinvestmentKPIachievement,employeestakeaninterestininvestmentdecisionsandbegintomodifytheirbehaviorstoimproveinvestmentanalysis,decisionmaking,andimplemen-tation.Similarly,broademployeeaccountabilityforbusinessperformance,evenifnotdirectlywithintherealmofauthorityoftheindividual,leadstobehaviorsthatindirectlyinfluencebusinessoutcomes.Wedonotwanttosuggestthatpeoplebeheldaccountableforout-comesbeyondtheirauthorities.Rather,wewantpeopletorealizethattheirauthoritiesextendbeyondnarrowjobdescriptions.Realizationoftheseau-thoritiesincreasesthepotentialforavirtuouscircleofsuperiorinvestmentandbusinessperformance,higherrevenue,andhighercompensationforallemployeesinthefirm.CONCLUSIONDevelopingandlivingorganizationalvaluesisthefoundationofleadershipsuccess.Asharedmissionisasecondcriticalstepandisderivedfromandsupportedbytheorganizationalvalues.Theword“shared,”iscriticalhere,anditistrulynoeasytask.Itrequiresconstantcommunicationfromtheteamatthetop.ReviewingthemissionandtheorganizationalgoalsandKPIsasitrelatestothemissionis,well,missioncritical.Thisoverarchingmissionmustbetranslatedintoactionableandmeasurablegoals,whicharemeasuredbytheorganizationalKPIs.Wehaveputthisframeworkinplaceandtesteditoveranumberofyearsandwithdifferentorganizations.Inourview,itisrequisitetothesuccessofaninvestmentorganization—oranyorganizationforthatmatter.InChapter3,wewilldigdeeperintosomeofthepragmaticconsiderationsofthisapproachwithafocusonmeasuringindividualperformanceandappropriatelysettingindividualcompensation.Ultimately,trulysuccessfulorganizationshaveacultureandapproachthatensuresthefirmisatruemeritocracy. P1:a/bP2:c/dQC:e/fT1:gc02JWBT154-SingerAugust12,200913:38Printer:CourierWestford38 P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordCHAPTER3BuildingaMeritocracyUnderstanding,Evaluating,andRewardingEmployeeContributionschievementofindividualandteamKPIsisthebasisformeasuringAperformance.However,eveninawell-structuredmeritocracy,itisnotthesoledeterminantofanemployee’sabsoluteorrelativecompensationandpromotionpotential.Compensationandpromotionshouldbedrivenbytheobjectiveassessmentofemployeesacrosstwodimensions,namelyperformanceandcriticality.Criticalityisameasureofhowimportantandintegraltheindividualisindrivingattainmentoftheorganization’sgoals.PerformanceisameasureofthedegreetowhichKPIshavebeenmetoverthemeasurementperiod.Wewilldiscussourapproachmorespecificallylaterinthischapter.PERFORMANCE:ADEEPERDIVEItisimportanttooutlinethisbasiccompensationmethodologyupfronttohelpframethinkingaboutevaluationprocesses.Figure3.1providesimpor-tantcontextforthinkingaboutcriticalityandperformance.Utilizingthisevaluationframeworkandcommunicatingtoemployeesalongthesedimen-sionsservesmanypurposes.Chiefly,ithelpstosetemployeeexpectationsandfacilitatesfasterdecisionmakingwithrespecttoemployeehiring,firing,andcompensationdecisions.Wewillexpandonthisframeworkanddiscussmorepracticalimplementationideasandconsiderationlaterinthechapter.Butfirst,wefocusonthemoregeneralquestionsofdeterminingtheap-propriateweightingsofKPIsinassessingperformanceandthehorizonoverwhichperformanceshouldbeevaluated.39 P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford40INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTHighHigherScores=HigherCompensationLowerScores=LowerCompensationEmployeeCriticalityLowerScores=ReassessmentofEmployee“Fit”LowHighEmployeePerformanceFIGURE3.1TheTwoDimensionsofMeritocracy:Criticality&PerformanceHORIZON:THEFALLACYOFTHETHREE-YEARTRACKRECORDWehavealwaysfoundthethree-yearperiodtypicallyusedtoevaluatein-vestmentperformanceandtomakemanagerhiringandfiringdecisionstobelaughablyshort.Itcouldevenbecharacterizedasaviolationofthefiduciaryresponsibilitiesofmosttrusteesandagents.Thethree-yearinvestmenttrackrecordthatisatthefoundationofmostmanagerorfundhiringandfiringdecisionsmakesalmostnostatisticalsense.1Yet,itispreciselythisbrieftimeperiodthatmakesitsodifficultforclientstoexperienceinvestmentperfor-manceofsuccessfulmanagersandformanagerstocreateopportunitiesforlong-terminvestors.Thereisadangerofexpectingtheresultsofthefuturetobepredictedfromthepast.—JohnMaynardKeynesThereisabigproblemthatdogseveryoneinvolvedinperformanceanalysis—noonecanbecertainthatinvestmentskillexistsforamanager.Averysimpleexercisedemonstrateshowdifficultitistoascertaintheskilllevel P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy4110000After10years,thereareonly10managersoutoftheoriginal10,000whowecansayarestillperceivedtohaveskill.8000600040002000NumberofManagersPerceivedtoHaveSkill100012345678910YearsFIGURE3.2RandomnessandtheAppearanceofSkillofaninvestmentmanager.Assumethatthereare10,000investors.Imagine,forexamplethatthesearetheinvestmentmanagersbehindthemutualfundslistedintheperformancesectionoftheWallStreetJournal.Further,assumethatnomanagerhasskill,eitherpositiveornegative.Eachyear,wewouldexpecthalfofthemanagerstooutperformtheirbenchmarks.Afteroneyear,5,000managerswouldhaveoutperformedtheirbenchmarks.Aftertwoyears,thenumberwouldbe2,500,andsoitgoes.Figure3.2demonstratesthenumberofmanagerswhowouldhaveoutperformedtheirrespectivebenchmarksafterthenumberofyearsindicatedonthehorizontalaxis.Inthis“realworld”situation,despitetheabsenceofanyskillonthepartofanymanager,after10yearsabout10managerswouldhavebeenexpectedtobeattheirbenchmarksineachandeveryyear.CouldthismeanthattheBillMillersandPeterLyncheslaudedbytheinvestingpublicthatpresumesobservedperformancetobetheultimateindicatorofinvestmentcompetencearemerelyrandomoutcomes?Investors,historically,haveshownatendencytochaseafterthese10managers,whiledumpingmanagersinlowerdeciles.Iftherereallywereskillintheinvestmentcommunityandthisrandomnessweretheextentoffactorsthatconfoundperformanceanalysis,investorswouldhavetheopportunitytoachievesuperioroutcomesbyapplyingstatisticaltoolsto P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford42INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTlong-termperformancetrackrecordstoidentifyandselectsuperiorman-agers.However,investorsandagentsdonotconsider10-yearperformancetrackrecords;theytypicallyconsiderthree-yeartrackrecords.Afterthreeyears,morethan1,000ofourunskilledmanagerswouldbedeemedsupe-riortothecrowdand,ashistoricaldatashows,moneywouldflowfromtherandomlypoormanagerstothe1,000randomlysuccessfulmanagers.Let’sfaceit;ifyoucangetajobmakingafeeontransactionsthatmovemoneyfromonemanagertoanotherandyoulackintegrity,thenyourcareershouldmakeyouawealthyindividual.Ifyouhaveintegrity,thenyouwouldattempttomoveyourclientsoutofthisfeetreadmill.TheCFAInstitutereportsthattherewereabout54,000mutualfundsatyear-end2003.2Ofthese,only15percentwereU.S.based,orabout8,500funds.Nottoodissimilarfromthe10,000assumedintheexampleabove.Ifthereare54,000mutualfundsandperformancewaspurelyrandom(e.g.,nomanagerisskilled),thenroughly50ofthemwouldoutperformtheirbenchmarkseveryyearfor10years.Thereisnodoubtthatfundanalystsworldwidewouldpontificatethemyriadskills,insights,andprescienceofthese50fundmanagers.Worstofallisthattheywouldlikelyrecommendportfolioscombiningsubsetsofthese50fundstodemonstratetheir“backtested”prowessindesigningmultimanagerinvestments.(AnasidethatisdevelopedinChapter4,itisprudenttoaskthefundanalystswhattheywererecommending10(orthree)yearsago,notwhattheyarerecommendingnowbasedonpriorperformance.)PerformanceAnalysisWhenNoSkillExistsAssumethatamanagerhasskill,withtheabilitytoadd100bpsofaddedvalueperyearatastandarddeviationofexcessreturnsoverthebenchmarkof4percent.Themanager’sskillcanbemeasuredbytheratiooftheactualaddedvaluetothestandarddeviationofannualaddedvalues.Thisratioisreferredtoastheinformationratio(IR):addedvalueIR=standarddeviationofaddedvaluesItisimportanttostatethattheaddedvalueofannualreturnsisused.AnystatedIRhasanimplicittimehorizonbuiltintothecalculation.Forexample,assumethataninvestoradds50bpsperquarterinexcessofthebenchmarkanddoessowitha2percentnonannualizedstandarddeviationofquarterlyreturns.TheIRcanbeamultitudeofnumbers,butthetwoobviousoneswouldbethequarterlyIRandtheannualIR: P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy43ReturnStandardDeviationInformationRatio(IR)Quarterlya0.50%2.00%0.25Annuallyb1.93%4.00%0.48aThequarterlyaddedvalueandvolatilityarenotannualizedandtheIRissimplythereturndividedbythevolatility.bTheannualizedaddedvalueassumesquarterlyreturnsthatareindependentandidenticallydistributed(iid)andtypicallycanbeapproximatedas{1+quarterlyreturn–variance/2}4−1,or{1+0.50%−[(2.00%2)/2]}4−1.Theannualized√volatilityiscalculatedasquarterlyvolatility∗4.TheIRisthereturndividedbythevolatility.Sincethereturnincreasesaboutlinearlywithtime(linearlyifthevolatil-ityiszero)andthestandarddeviationincreaseswiththesquarerootoftime,theIRincreaseswiththelengtheningofthemeasurementhorizon.3Ifreturnsareunrelatedfromoneperiodtothenextandhavethesamereturncharacteristicsineachperiod,thenwecanmakesomestatementsabouttheprobabilitythatthemanager’sskillisobservable.Giventhatrealizedinvestmentperformanceisaproxyofthemanager’strueskill,whatistheprobabilitythatthisskilledmanagerappearsunskilled?TheIRisthetoolweusetoundertakethisanalysis.Figure3.3showstheprobability50%IR=0.25IR=0.5040%IR=0.75IR=1.0025%WhereitReallyExists10%ProbabilityofConcludingThereisNoSkill012550YearsFIGURE3.3CertaintyofInvestmentPerformanceoverTime P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford44INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTofconcludingthataskilledmanager,withskillmeasuredbytheIR,isunskilled.IfthemanagerhasanannualizedIRof0.25,thenafterthreeyearsthereisnearlya35percentchancethathistoricalperformance,beingonlyasampleofthetrueperformance,indicatesthatthemanagerhasnoskill.Itwouldtakenearly50yearstoreducetheprobabilityofinappropriatelyassessingthemanager’sskilltoabout5percent.Sincemostmanagers,regardlessofcompetence,declareanIRof0.50,theprobabilityofinaccuratelyconcludingthemanagerhasnoskillremainsabove20percent.Inmeasuringinvestmentperformance,thesesubtletiesdictatenotonlyanaccurateaccounting,butalsoaclearunderstandingofthataccounting.Wethinkthatitisbesttouseannualizedreturns,volatilities,andinforma-tionratios.Theoccurrenceofseriallycorrelatedreturnsandtheanalysisofilliquidassetsrequireadditionalanalysisforbetterunderstandingandperformanceanalysis.4Allmanagerswanttobeskilled,andallagentsandclientswanttohiremanagerswithskill.Regardless,integritycompelsustodistinguishbetweenwhatwewanttobetrueandwhatwecanobjectivelyconcludeistrue.Yes,wewanttoidentifyskillafterthreeyears.Despiteourdesires,wemustaccepttremendousinvestmentperformanceuncertainty,evenwhenweknowthatthemanagerweareevaluatinghasskill.Whenwedonotknow,thetaskofselectingandcompensatingisevenmoreofafool’serrandthanmostintheindustryarewillingtoadmit.CaseStudy:DefinedBenefitPlansConsidertheinvestmenthorizonofdefinedbenefit(DB)planbeneficiaries.Generallyspeaking,DBplansarepay-as-you-goschemesthatplacetheburdenonthesponsoringcompaniestopayspecifiedbenefitstoemploy-eesuponretirement.MostDBplansprovideincentivesforpensionerstowaituntilSocialSecurityretirementagetostartreceivingbenefits,whichis65yearsoldintheUnitedStates.Currently,thelifeexpectancyfora65-year-oldmaleisnearlyanother20years.Forsomeonewhowishestomaintainprincipaluntildeathandthenpasstheprincipaldowntohisorherheirs,20yearswouldbethetimehorizon.Twentyyearswouldbethemeanofthelifeexpectancydistribution,andthereisvariationaroundit,withapos-itiveskew.Somepensionerswouldnotseektomaintainprincipal,butdrawdowntheprincipalovertime.Thesepeoplehaveashortertimehorizon.Inessence,thelifeexpectancycouldbeequaltoorlessthanthe20-yearinvest-menthorizon.Regardless,theduration—theexpectedtimetoretireecashflowfromthedateofretirement—isabouteighttonineyears.DependingontheDBplan’sratioofactivetoretiredemployees,theinvestmenthorizonisinalllikelihoodatleastnineyears. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy45Personalsavingsmayreflectashorter-termdesireforfuturecashflowthanconventionalDBplans,but,sincecurrentstateandprivatesystemsareunlikelytomeetthecashflowdesires(asopposedtoneeds)ofmostindividuals,thepersonalsavinginvestmenthorizonislikelytobelongerthanthreeyears.Despitethetendencyformanyindividualstoinvestwithveryshorttimehorizons,investorappreciationofthewealththattheywillrequiretosupportacceptablefuturelivingstandards(asopposedtodesire)isprobablytoolow.Otherpoolsofwealth,suchassovereignwealthfunds,endowments,andfoundations,generallyareperceivedtohavelonginvestmenthorizons,muchlongerthanthreeyears.PERFORMANCEANALYSIS:PRACTICALLYSPEAKINGThemainpointhereisthatitisoftenverydifficulttodifferentiategood(orpoor)performancefromgood(orpoor)outcomes.Performancedataalonewillalmostneverprovideaclearpicture.Twothingsthatcanhelpare1.Objectiveperformanceattributionmethodologiesandprocessesthataredesignedtoreflecttheinvestmentprocess,and2.Settingexpectationsex-anteregardingenvironmentsinwhichthestrat-egyshouldoutperformorunderperform(andthenevaluatingrealizedperformanceagainstthoseexpectations).Liketheevaluationofinvestmentmanagers,employeeofinvestmentfirmsshouldbemeasuredonwhattheyhaveaccomplished.Employeesshouldalsobementoredforwhattheyarecapableofaccomplishing.Whiledifficult,measurementandanalysisofpastperformanceistheeasierofthetwo.Supportandguidancewhentheteamcomesunderfireforjustifiableandunavoidablepoorperformanceisordersofmagnitudemoredifficult.PerformanceAttribution:Ex-PostAnalysisWeareknownforourresearchontheseparationofassetandcurrencyinvestmentdecisionsandperformanceanalysis.5Ourintentwastodevelopanattributionmethodologythatparalleledourinvestmentprocess.Tangen-tially,wespecifiedageneralframeworkthatappliestoallassetandcurrencyanalysis.Otherseparationsofinvestmentdecisionscanandshouldbebuiltintothisframeworktomeasureperformancealongthesamedimensionsthatinvestmentprofessionalshaveauthoritiesandareheldaccountable. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford46INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTPerformancePerversion:Ex-AnteExpectationsAnyskillfulfundamentallybasedinvestmentprocesswilltendtogeneratesuperiorperformancewhenpricesmovetowardfundamentalvalues(asdefinedbytheinvestmentprocess).Theprocessshouldgenerallyperformpoorlywhenpricesmoveawayfromfundamentalvalues.However,aspricesmoveawayfromfundamentalvalues,theopportunityforfuturesuperiorperformanceincreases.WhenweworkedatUBSGlobalAssetManagement,ourteamdevelopedanopportunitysetmeasurethatroseaspricesmovedawayfromvaluesanddeclinedaspricesconvergedonvalues.Thekeyistodesignportfoliosthatlimitpoorperformanceastheopportunitysetgrowsandcapitalizeonashrinkingopportunityset.Figure3.4providesahypotheticalexampleofthisprocessovertime.From1997to2000(periodII)andfrom2005to2007(periodV),thearrowsindicatetheopportunitymeasureinthedottedlinerosedra-matically.Currencyperformancewas“poor,”indicatedbythedownward-slopingarrows(periodsIIandV).However,giventhemagnitudeofinvestmentopportunityincreasesaspricesmovedawayfromvalues,the“poor”performancewasactuallycommendable.Subsequenttoeachofthese“poor”performanceperiods,periodsIIIandVI,astheopportunitiesdrop,superiorperformanceiscapturedinevengreatermeasure.Basedontheseobservations,titular“poor”performanceshouldhavebeenrewarded.Conversely,ofcourse,positiveperformanceconcurrentwithawideningopportunitysetmaynotberewarded,andmayevenbeconsideredaredflagofinadvertentriskexposure.1102.01081.81061.61041.41021.21001.0980.8OpportunityPerformanceIndex960.6940.4920.2IIIIIIIVVVI900.01993199419951996199719981999200020012002200320042005200620072008PerformanceOpportunityFIGURE3.4OpportunityversusPerformance P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy47Thereisnodoubtthattheincentivestructureofsuperiorinvestmentfirmsmustexceedthetypicalthree-yearhorizonthatpermeatestheinvest-mentindustry.Sowhydoestheindustryseemtransfixedwiththethree-yearinvestmenthorizon?Wecredittwoprimaryfactors:1.Behavioralfactorsthatresultinsubrationalinvestmentdecisionsonthepartofinvestmentprincipals—beneficiariesandmoneymanagers.2.Thechainofagentsbetweentheinvestmentfirmsandbeneficiariesmustjustifytheirfeesand,insodoing,activelymakedecisionsevenwhenthebasisforthosedecisionsdoesnotexist.Chapters4and5delveintotheseissuesingreaterdetail,butconsiderthearrayofagentsthatinterjectthemselvesintothesavingandinvestmentprocesses:
Morningstar,Lipper,andotherfund-rankingandanalysisentities
Consultants
Investmentstaff
Humanresourcesstaff
Trustees
Boardsofdirectors
Financialadvisors
GovernmentagenciesTheseagentscanmakeapowerfulcontribution,andregulationoftenrequirestheirintercessionintothesavingandinvestmentprocesses.How-ever,theintentionoftheseagents,despiteanyhigherpurpose,fallsuncon-scionablyshortoftheirexecution.Likeinvestors,agentsoftenaredismalfailuresanddolittletoimprovethelotoftheprincipalsthattheypurporttobenefitandprotect.Takingtheseconsiderationsinconjunction,itappearsthatmanyfidu-ciariesmayinfactbedetrimentaltotheprocessofprovidingforfutureconsumption,whethertheyareinvestmentfirmsoragents.Theseplayersaresimplyrespondingtotheirincentives,andallthecarpingintheworldwon’tchangethesituation.Rather,theincentivesneedtochange,andthefirstplacetolookfortheincentivesisinthefees.Thesecondisinjobstabil-ity.Bothinvolveissuesofintegrity,ethics,andmoney.Theimportanceofunquestionableintegrityandethicspermeatesthisbook.TheimportanceofmoneyisaddressedspecificallyinChapter5.Mostofeconomicscanbesummarizedinfourwords:‘Peoplerespondtoincentives.’Therestiscommentary.—StevenE.Landsburg P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford48INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTFinally,intheprocessofevaluatingthree-yearperformancetrackrecords,manyprincipalsandagentsplaceaninordinateimportanceonthemostrecentyear’sperformance.Inconsideringamanager,anindividualorfirmwilltypicallylookatatableofone-,two-andthree-yearperformances,consideringeachofequalimportance.Ifso,theone-yearperformancewillinadvertentlyreceiveaweightofover60percent—thefull331/3percentweightontheone-yearperformanceplushalfofthe331/3percentweightonthetwo-yearnumberplusone-thirdofthe331/3percentweightonthethree-yearnumber.Thesecond-yearperformanceoutcomewillreceiveabouta30percentweightandthethird-yearoutcomewillreceiveabouta10percentweight.SeeTable3.1.Evenifonlythethree-andfive-yearperformancenumbersarecon-sideredequally,eachofthefirstthreeyearsreceiveabouta25percentweightandyearsfourandfiveonlyabouta10percentweight.Evenequalconsiderationofthefive-andten-yearperformancehistoriesresultsin75percentoftheweightonthefirstfiveyearsand25percentonthesecondfiveyears.Togetbeyondtheendemicshort-termismthatprevails,theCIOshouldestablishaperformanceweightingcriterionthatplacesweightsontheorderof50percentonthe10-yearreturn,30percentonthefive-yearreturn,15percentonthethree-yearreturn,and5percentontheone-yearreturnandhavetheintegritytosay“no”toclientswhowanttheskillsofthemanagerbutareuncomfortablewiththelonginvestmenthorizon.IntegrityrequirestheCIOtorecognizethelonginvestmenthorizons(basedonfutureconsumptionneeds)oftheclientsandtherealityofuncertaintyinmeasuringskill.Furthermore,theCIOissimilarlycompelledtorejectclientswhodonotliveuptothesamelevelofintegrityandfiduciaryaccountability.Evenwiththeweighting60/40schemeprofferedabove,thereisasignificantchancethataninvestmentmanageroremployeewithskillwillbedeemedtohavenoskill.However,anythingshorterislikelytocreateinstabilityintheemploymentofkeyinvestmentstaff.Forthisreason,anddespitetherigorousapproachdescribedinthischapter,performanceevaluationmustbeahumanprocess.Individualswhoadheretotheinvest-mentphilosophyandfollowtheinvestmentprocessshouldbeexpectedtounderperforminmanyperiods.TOP-DOWNANDBOTTOM-UPAPPROACHTODETERMININGPERFORMANCETheprocessofevaluatingeachemployee’sperformanceistop-down,be-ginningwithanevaluationofthefirm,proceedingtoevaluationsofeach P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford%%%%5%16%11%...impliesindividualasinthiscolumn.weightingtheannualreturn...5%21%15%30%16%11%50%returnshistoricalWeightingtheaccordingtothiscolumn%5%5%5%55%15%15%15%15%15%...impliesindividualasinthiscolumn.weightingtheannualreturn...returns100%100%100%100%historicalWeightingtheaccordingtothiscolumn%5%5%5%50%50%implies27%27%27%10%...individualasinthiscolumn.weightingtheannualreturn...returnshistoricalWeightingtheaccordingtothiscolumn%0%0%0%00%0%50%0%10%50%...impliesindividualasinthiscolumn.weightingtheannualreturn...AppropriatelyWeightingInvestmentPerformancePeriodsreturnshistoricalWeightingtheaccordingtothiscolumn123433%533%6033%708061%9026%11%50%TABLE3.1Year10Total100%100%100%100%49 P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford50INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTteam,andendingwiththeevaluationofeachindividual.TheCEO,CIO,andtheexecutivemanagementteamevaluatethefirm’sperformance,fo-cusingprimarilyoninvestmentperformanceandbuildingaplatformforfutureinvestmentsuccess.Secondaryconsiderationisgiventoassetsundermanagement(AuM)growth.Thisreflectsabitofa“builditandtheywillcome”mentality.However,forafirmholdingoutinvestmentperformanceasitsraisond’etre(asopposedtosociallyresponsibleorpassiveinvesting),acorecompetenceofsuperiorinvestmentperformanceistheonlyethicalwaytoraiseassets.Second,asnotedinChapter1,successfulassetmanagementfirmslimitthenumberofcapabilitiesmanaged,limittheassetsundermanagement,andingoodconscienceturnclientsandassetsaway.Justsayno.—NancyReaganThus,eachandeveryemployeeisresponsibleforinvestmentperfor-mance,andtheKPIsofthefirmsubsumetheKPIsoftheinvestmentteamandtheKPIsofeachemployee.Thisprovidesanincentiveforeveryem-ployeetoactinamannerthatdirectlyorindirectlyimprovesinvestmentanalysis,decision,implementation,andclientcommunication.Afterevaluatingtheperformanceoftheorganization,executiveman-agementevaluatesteamperformance.Theprimaryreasonthattheexecutivemanagementteamdiscussesperformancetogetheristhateachteam’sexe-cutiondependsontheotherteams’performance.Thus,itisinappropriatetofaultoneteamforitsfailuretoexecuteifthatfailureisafunctionoftheteam’sdependenceonanotherteam’sperformance.Ifthereisafailuretoexecute,therootcausemustbearthebruntofthepoorperformancescore.Executionsupersedesintention.—BrinsonPartners,Inc.“GuidingPrinciples”Eachteamisevaluatedrelativetothatteam’sKPIs,theaggregationofwhichisconsistentwiththefirm’soverallKPIs.OncetheteamhasreceivedaKPIperformancerating,theindividualsintheteamcanbeevaluatedaccordingtotheirKPIs.Again,thisisaccomplishedbythejointevaluationoftheexecutivemanagementteam.Theevaluationofeachindividualbytheentiremanagementteamhasacoupleofimportantandpositiveexternalities:Uniformity–somemanagersarehardergradersthanothers.Understanding–eachmanagerlearnsaboutthefunctionsofotherteamsandaccountabilities,strengths,andweaknessesofeachemployee. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy51Leverage–increasedabilitytoleveragethetalentsofeachemployeeacrosstheorganization.Consistency–preventsfavoritismanddiscrimination.Sincetheaggregationoftheindividuals’KPIsmustcombinetotheKPIperformancescoreoftheteam,andthatoftheteams’KPIstothefirm’sKPIs,eachemployeeisevaluatedinanobjectiveandconsistentmannerwithfullappreciationofthefirm’smissionandKPIs.Everybodyintheorganizationknowsaboutandworkstoimproveinvestmentcompetenceandperformance.DESIGNINGYOURRATINGSYSTEMTOHELPMAKETHEDIFFICULTDECISIONSInourexperience,wehaveseenthatitisbeneficialtoaskallperformancescorestorangebetween1and4,only1,2,3,and4areallowed.Ascoreof1isbadandascoreof4isgood.Theuseofanevennumberofperformancescoresforceseachmanagertoavoidthetendencytoselectthemidpoint.Eachemployeemustbescoredwithgoodorbadperformance.Ifthefirmperformsasexpected,thenadistributionofallemployees’performancescoreswouldfollowabellcurveshape.Ifthefirmdoespoorlyandgivesitselfanoverallperformancescoreof1.5,thenthedistributionforallemployeeswouldbenegativelyskewed.SeeFigure3.5.Ifthefirmdoeswell,withaperformancescoreof3.5,thenthedistribu-tionwouldbepositivelyskewed.Sinceperformancescoresrangefrom1to4,andonlyscoresof1,2,3,or4areallowed,managersarepreventedfromtakingtheeasyoutofselectingamiddlingperformancescore.Asacoinmustfalloneitherheadsortails,eachemployeemustbedeemedtohaveperformedpoorlyorwell.Intheend,aftermuchdiscussionamongthemanagementteam,employeescanbemovedonanexceptionalbasistoa2.5score.Employeeswhohaveworkedlessthanayearautomaticallyreceivea2.5scoreastheperformanceevaluationperiodistypicallytooshorttobemeaningful.Sincetheperformancescoreisordinal,itistherankthatmattersandnotthedistancefrom2to5orfrom1to3thatmatters.Thus,theorderingof1,2,2.5,3,and4canberecategorizedasscoresbetween1and5.Thesmallnumberof2.5scoresbecomes3andtheprevious3and4scoresareincreasedto4and5.Ifroughly10percentoftheemployeesareneworaredeterminedtohavesimplyandexactlymettheirexpectations,thenthedistributionswouldappearasshowninFigure3.6. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordMeetExpectationsAboveExpectationsBelowExpectations408080357070306060255050204040153030PercentageofEmployeesPercentageofEmployeesPercentageofEmployees10202051010000123412341234ScoreScoreScoreFIGURE3.5EmployeePerformanceDistributionsandSkewMeetExpectationsAboveExpectationsBelowExpectations40606035505030404025203030152020PercentageofEmployees10PercentageofEmployeesPercentageofEmployees10105000123451234512345ScoreScoreScoreFIGURE3.6DistributionofPerformanceRatings52 P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy53WHATDOESTHEPERFORMANCESCOREREALLYMEAN?Theperformancescoreisnotanabsolutemeasureofhowwellateamoranemployeeperforms.Rather,itisameasureofperformancerelativetoKPIs.Aninvestmentprofessionalmayhaveidentifiedgoodinvestmentopportunities,butifthatistheemployee’sjobandtheopportunitiesareinlinewithwhatwouldgenerallybeexpected,thenamiddlingperformancescoreiswarranted.Let’sfaceit,investmentprofessionalsaregenerallynotanunderpaidlot.Further,outsizedrewardisnotwarrantedifKPIsaremerelymet.Iftheanalysthasnotgeneratedmanyinvestmentopportunities,thenperformancewouldbebelowKPIexpectationsandtheperformancescorewouldbelow.Thus,aninvestmentteamthatfocusesongeneratingsuperiorinvestmentperformancemusthavemorethannormalinvestmentskillandoutcomestoachievehigherthannormal,ormedian,compensation.Ideally,anyadditionalincomethataccruestoordisappearsfromtheorganizationbecomesanequityorpartnershipinterest.Nowthatwehavecomeupwitharealmeasureforemployeeperfor-mancethatavoidsmanyofthepitfallsofatraditionalmethod,weneedtodefinethenextcriteriaofemployeeeffectiveness,andthatiscriticality.CRITICALITY:ADEEPERDIVEAsdiscussedearlier,itisnotsufficientsimplytoevaluatetheperformanceofeachemployeerelativetothatemployee’sKPIs.Ifajunioranalystwithlim-itedauthorityandresponsibilityandaseniorportfoliomanagerwithmuchLARGEVERSUSSMALLORGANIZATIONSANDTHEEFFECTIVENESSOFTHEMODELObviously,thisstructurebenefitssmall,stand-alonefirmsoverassetmanagementorganizationswithinlargeorpubliclyheldfinancialfirms.Largefinancialfirmshaveanincentivetorespondtoshorter-termpar-entorshareholderinterestsoverlonger-termbeneficiaryinterestsoftheassetmanagementdivision.Whilethistensionexistsforallinvestmentoperations,theseparationbetweentheownerandtheclientsofanassetmanagementdivisioninalargeorganizationissogreatthatfiduciaryinterestsarequestionablyupheld.Itisdifficulttobuilddurablegov-ernanceandcompensationstructuresthatsuccessfullyrewardownersconsistentwithclients.Itisanevenmoremonumentaltaskinlargefinancialfirms. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford54INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTmoreauthorityandresponsibilitybothdemonstratesuperiorperformancerelativetotheirKPIs,itwouldbeinappropriatetocompensatethemequally.Why?Notbecauseoneis“senior”orhasmoretenurewithintheorganiza-tion.Rather,theyshouldbepaidbasedontheircriticalityandimportancetotheorganization.Thus,whileeachemployeecanhaveaperformancescoreof1through4(or1through5onanadjustedbasis),eachemployeeshouldberankedintermsofcriticalityusingthesamescaleCriticalityishierarchical,withonepersonatthetopandanotherpersonatthebottom.Eachemployee,regardlessoffunction,canbesortedaccord-ingtohiscriticalitytotheorganization.Inaninvestmentorganization,theinvestmentprofessionalswilltendtobethemostcritical,butbynomeanstheonlyindividualsofhighcriticality.Itiscrucialtoappreciatethefactthatitisboththeindividualandtheroletheindividualfillsthatdeterminecriticality.Thisrealizationdemon-stratesthatcriticalityistheresponsibilityoftheemployeeandtheemployee’smanager.Superiorexecutionbyanemployeeinacertainfunctioncreatescriticalityinandofthatfunctionthatdidnotpreviouslyexist.CaseStudy:LettingYourEmployeesIncreaseTheirOwnCriticalityAyoungmanworkingformeinanadministrativecapacity,monitoringderivativepositionsinourportfolios,cognizantoftheinvestmentprofes-sionals’intent,discoveredameansofeliminatinganundesirablemismatchinsomeportfoliohedges.Afterfullyresearchinghisalternative,heproposedandtheinvestmentteamadoptedhisrecommendation.Overthecourseofthesubsequentinvestmentcycle,thischangeaddedsignificantlytoportfolioperformance.Lawscontrolthelesserman.Rightconductcontrolsthegreaterone.—ChineseProverbThisindividualmigratedfrommoremundaneperformancemonitoringactivitiestomorecriticalportfolioconstructionactivities.Thishighperfor-manceindividualgarneredgreaterauthorityandresponsibilityinhisexist-ingjobandpositionedhimselfforpotentialpromotiontoafunctionofevengreatercriticality.Responsibilityshiftedtothemanagertoidentifyfunc-tionsthatcouldfurtherleveragethisperson’sknowledgeandcompetence,affordinggreateropportunitiesforhimtoadvancehiscriticality.CaseStudy:CriticalityIncentivizesInnovationCriticalityisnotaone-waystreetthatseespeopleincreasingincriticality.Highperformingteamsandorganizationstendtocontinuouslyimproveandsometimesleavemembersbehind.Thewaythistendstomanifestitselfis P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy55inacriticalityrankingthatdoesnotmoveupor,infact,slipsbackward.TheinvestmentteamthatImostrecentlyworkedwithprovidedseveralexamplesofthis.Overaperiodofthreeyearsutilizingthisprocess,wesawthatwewerebuildingahigherandhigherqualityteam,raisingthebarforeveryone.Membersthathadbeenrankedattheaveragelevelofcriticalityeithermovedupormoveddown,oftenwithoutanysignificantchangetotheiroverallrolesintheorganization.Inotherwords,doingthesamejobyoudidlastyeartendedtopushpeople’scriticalitydown.Inthisway,afocusoncriticalityimprovestheorganizationbyincentivizingpeopletoinnovate.WhyIsCriticalitySo...Critical?Criticalityisameasureofauthorityandresponsibilityaccruedafteryearsofdemonstrablysuperiordecisionmakinginsituationsofuncertainty.Decision-makingresponsibilitiesspanaspectrumfromnorisktohighandsystemicrisk.Riskisdeterminedbythedegreeofdifficulty,timeavailable,andhabituation.Experienceisnotwhathappenstoyou,itiswhatyoudowithwhathappenstoyou.—AldousHuxleyTheHierarchyofChoiceinFigure3.7segmentscriticalityaccordingtotheriskinessofdecisionsandthetitleoftheindividuallikelytomakethedecisions.Attherightofthefigure,theangledtextprovidesdescriptivesupportforthetypesofdecisionstypicallymadeateachlevelofcriticality.Werealizethatnotallassetmanagementfirmsarestructuredwiththistitlehierarchy,buttheframeworkisgenerallyapplicabletoallorganizations.Manyorganizationssacrificetheopportunitytoincurhighercriticalityandrisk-takinginfavorofsaferandmorereliablemanagementprocedures.Whilethesearrangementsattempttoimproveefficiency,theytendtoimpedetheextraordinary.Itisnoaccidentthatdaringandinnovationwaneasorganizationsgrowlargeandsuccessful.Maintaininghighlevelsofefficiencyrequiresthatleadershipshunhindrancestoandexplicitlyrewardcriticality;otherwise,managementproceduresyieldnothingmorethanahigherlevelofmediocrity.Themanatthetopoftheintellectualpyramidcontributesthemosttoallthosebelowhim,butgetsnothingexcepthismaterialpayment,receivingnointellectualbonusfromothers...Themanatthebottomwho,lefttohimself,wouldstarve...contributesnothing(intellectually)tothoseabovehimbutreceivesthebonusofalltheirbrains.—AynRand P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford56INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTSystemicRiskStrategicdirectionCEO&CIODecisionsareunique,timingiscriticalHighRiskPortfolioManagerAnalysisisunique,timingiscriticalModerateRiskSeniorAnalystCriticalityHabitualanalysis,timingnotcriticalMinimalRiskJuniorAnalystHabitualactivityNoRiskOtherStaffFIGURE3.7ALookattheHierarchyofChoiceTherankingandrewardingofindividualsaccordingtocriticalityisanimportantleadershipfunction,andasimpleprocedureeachyearcanaccomplishthistask.Eachmanagerrankshisteaminorderofcriticalityandthenpicksthemostcriticalandimportantemployeeinhisstaff.Thesetopemployeesarethencomparedacrossteamsandranked.Theprocessmovesdownonelevelofemployeecriticalityandcomparisonsaremadebetweenemployeesbeingcurrentlyconsideredandthosealreadyranked.Theprocessconcludeswhentheleastcriticalemployeeisidentifiedandalistofrankedemployeesiscompleted.Forexample,aninvestmentteammaybeginwithconsiderationofsev-eralportfoliomanagersatthetopofthecriticalityranking.Eachportfoliomanagerisdiscussedandrankedrelativetotheothers.Movingdownthecriticalityspectrum,analystscanbeconsidered.6Someoftheseanalystsmayhaveextendedtheiractivitiesbeyondanalysis,becomingactivelyin-volvedindevelopingsuccessfulstrategiesforimplementingtheirresearchanddesigningportfolioriskexposures.Theseindividualsaremakingthem-selvesmorecriticaltotheorganizationandshouldberankedaboveothersenioranalysts.Thisprocessshouldproceeddowntolesscriticalposi-tions,fromanalystsandjunioranalyststoquantitativesupportfunctionsandsoon. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy57TheBenefitsofCommunicatingCriticalityAswiththeperformancediscussions,rankingdiscussionsleadtogreaterap-preciationofthecriticalityandimportanceofeachteamandeachindividual,despitetheverydifferentfunctiontheymayperform.Allmanagerslearnthattheoutcomeoftheorganizationdependsonmorethanjusthisteam;itde-pendsonhowhisteamreliesontheexecutionoftheotherteams.Second,eachmanagergainsabetterunderstandingofthefunctionandcontributionofeachemployeeintheorganization.Third,thereisadegreeofpersonalcon-nectionthatisbuiltbetweenmanagersandwhatwouldotherwisebename-lessemployees.Finally,andprobablymostimportant,thereistherolethisprocessplaysinadvancingthecareers,creatingopportunities,andenhanc-ingtheaspirationsofemployees.Whenthemanagementteamunderstandsandknowstherolesandperformanceofeachemployee,thenmanagersarebetterabletofillpositionsandpromotefromtheinternalpooloftalent.MERITZONES:PUTTINGITALLTOGETHERConsistentlyandobjectivelyrankingeachemployeeaccordingtocriticalityandscoringeachemployee’sperformanceenablescompensationandpromo-tiondecisionsthatleadtoappropriateincentivesforemployeeperformance.InFigure3.8,ascatterplotisusedtoseparateeachindividualintodistinctMeritZones.EachemployeeisrepresentedbyasquareiconontheMeritZonechart.Thescatterplotisdividedintosixmeritzonesbyfivedashediso-meritlines.Twoemployeesonasingledashedcurvewouldhavesamemerit.Performanceandcriticalityarenotconsideredequivalent.Inthisex-ample,criticalityisconsideredabout2.5timesasimportantasperformanceindeterminingmerit.Suchatrade-offisdeterminedbyanddifferentforeachfirm,butpersonalexperiencesuggeststhatthe2.5:1ratioisgenerallyanappropriatestartingpointTherearethreeemployeesinMeritZone1.Theseemployeesmaybeindifferentfunctionsandhavedifferentcriticalitygradesandperformancescores.Regardless,theyareconsideredtohavehighandverysimilarworthtotheorganization.Similarly,therearefourindividualsinMeritZone2.Thesefouremployeesareofsimilarworthtotheorganization,butlessthanthatoftheindividualsinMeritZone1.Figure3.9showsahypotheticaldistributionofallemployeesacrossthemeritzones.Therearerelativelyfewemployeesinthehighestorlowestmeritzones.Thoseinthehighestmeritzoneshouldbetheonesthatexecutivemanage-mentnurtures,retains,andcompensates.Thoseinthelowestmeritzoneshouldbeaddressedremediallyorterminated.TheindividualinMeritZone P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford58INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENT1MeritZone1MeritZone22MeritZone33MeritZone4Criticality/Importance4MeritZone5MeritZone6554321PerformanceScoreFIGURE3.8EmployeesFallIntoDifferentMeritZones6andaperformancescoreof3shouldbecoachedforbetterperformanceandpotentiallyformoreauthorityandresponsibilityofahighermeritzone.TheothertwoindividualsinMeritZone6,andperhapsthelow-performingindividualinMeritZone5,shouldbeconsideredfortermination(seeFigure3.9).Theironruleofnatureis:yougetwhatyourewardfor.Ifyouwantantstocome,youputsugaronthefloor.—CharlesMungerItisworthreiteratingthateachemployeehasbeenconsideredinaconsistentandobjectivemannerandthattheopportunityforfavoritismordiscriminationhasbeensignificantlyreducedoreliminated.Moreover, P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy5910864EmployeeCount20132465MeritZoneFIGURE3.9DistributionofEmployeesAcrossMeritZonesknowledgeofeachemployeehaspermeatedtheexecutivemanagementteam.Inlargerorganizations—ourexperiencesuggestssomethingoverabout100people—theprocesscanfilterdowntolowerlevelsofmanagement.Themanagementteaminvolvedinthehighest-leveldiscussionscanextendtheprocesstotheirmanagementteams,ensuringconsistencyandlimitingseniormanagementdistraction.Decisionsregardingpromotion,training,andterminationcanbemadewithlessuncertaintyandmoreconfidence.COMMUNICATIONOFPERFORMANCEANDCRITICALITYWhilesomeinformationisconfidential,thevastmajorityofinformationiswithheldbecauseitcreatesuncomfortablesituationsforleadership.Itiseasiertowithholdinformationandnotaddressissueshead-onthanitistoallowthemtoslowlyfesterwithoutmuchnotice.However,transparencyandintegritycreatethebasisfortrustamongmanagementandstaff.PerhapsthegreatestbenefitoftheMeritZonediagramistheabilitytocommunicatewitheachemployeeinanhonestandtransparentmanner.Intraditionalsettings,eachemployeeistypicallyinformedofperformanceinisolation,withlimitedabilitytograspboththeabsoluteandrelativenatureofperformance.Moreover,managershaveatendencytopracticeavoidance P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford60INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTbehaviorwhencommunicatingperformance,resultingintheconveyanceofinaccurateand,evenworse,misleadingperformanceinformation.TheMeritZonediagramfacilitatesclearcommunicationandreducestheabilityofmanagerstopracticeavoidancebehavior.Theultimateresultofshieldingmenfromtheeffectsoffollyistofilltheworldwithfools.—HerbertSpencer,EnglishPhilosopher(1820–1903)EachemployeeisshowntheMeritZonechartandtoldwhichsquarerepresentshimorher.Forexample,anemployeemaybetoldthatheisthesquarewiththegreencircleinMeritZone3(seeFigure3.10).Thedialog1MeritZone1MeritZone22MeritZone33MeritZone4Criticality/Importance4MeritZone5MeritZone6554321PerformanceScoreFIGURE3.10ACloserLookatMeritZone3 P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy61canandshouldincludediscussionsofcriticality—whythereareroughly10employeesofgreaterand20oflessercriticality.Moreimportant,giventhestrongperformancescore,hecanandshouldbetoldoflikelypromotionandopportunitiesforcareeradvancementinthecomingyear.Theevaluationdiscussioneasilyseguesintotheaspirationsoftheemployeeandthedesiresandneedsoftheorganization.Theoutcomeisanagreementthatinthecom-ingyearapromotionwillinvolvemoreauthorityandaccountabilityandthepotentialforgreatercompensation.Commensurately,hisKPIswillreflectthehigherlevelofauthorityandaccountabilitythatcomeswiththepromotion.ThemoredifficultandnecessarydiscussionoccurswiththeindividualinMeritZone3andcircledinred.Thisindividualisascriticalastheemployeecircledingreen,buthasfailedtodeliverattheperformancelevelexpectedofanemployeewithKPIsofaMeritZone3employee.Theopportunityexistsforhismanagertodiscusstheperformanceshortfallandmeasuresthatshouldbetakentoimproveperformanceinthefuture.Thismayleadtoadiscussionoftrainingorashiftinfunctionalresponsibilities.Itmaybethecasethatthisindividualisvaluable,butthefunctionfailstoenablethevalue—merit—toberealized.Whenpeoplearemadetofeelsecureandimportantandappreciated,itwillnolongerbenecessaryforthemtowhittledownothersinordertoseembiggerbycomparison.—VirginiaArcastleWehavefoundthatindividualsonbothendsoftheperformancespec-trumandinhighorlowcriticalityappreciatetheclaritythattheMeritZonediagramprovides.Inmanyinstancestheseindividualswereunawarethattheywerenotperformingatthedesiredlevel,thinkingthattheirperformancewasbetterthanwasreallythecase.Similarly,theseindividualsperceivetheircriticalitytobeunrealisticallyhigh.Whentheseinstancesarise,discussionsofmeansforadvancingcriticalityorimprovingperformanceareopenlysoughtandactivelyactedupon.Itisclearthatcriticalityisafunctionoftheleaderandtheemployeeand,withintheKPIguidelines,performanceisafunctionoftheindividual.Therearenosurpriseswhenitcomestocompensationorpromotion.Eachindivid-ualisawareofwheretheystandintheorganizationandhowtheyexecuterelativetotheirKPIsandrelativetoothers’performanceandtheirKPIs.MeritZonesandCompensationThesplitbetweensalaryandincentivecompensationisdeterminedbytheorganization,function,andculture.Certaincountries,suchasSwitzerland P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford62INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTTHERISK/REWARDPROFILEOFSALARYVERSUSINCENTIVE-BASEDCOMPENSATIONInvestmentfunctionstendtoplacelessemphasisonsalaryandmoreonincentive-basedcompensation.Backofficefunctionstendtoleantowardsalary.Aproclivityforsalaryshouldnotresultinaone-to-onetrade-offwithincentivecompensation;rather,ashifttosalaryfromin-centiveshouldresultinlowertotalcompensation.Compensationthatprioritizesincentiveuncertaintyoversalarystabilityshouldbehigherthansalary-orientedcompensationstructures,impartingacompensa-tionriskpremiumonthosewhoincurcompensationrisk.andJapan,tendtoplacemoreimportanceonsalaryandcompensationstability.Othercountries,suchastheUnitedKingdomandtheUnitedStates,tendtopreferariskiercompensationstructurethatplacesmoreimportanceontheincentivecomponentoftotalcompensation.Regardless,theMeritZoneapproachenablesconsiderationoftotalcompensationandsimplifiedaccommodationoftheseculturaldifferences.Obviously,highermeritzonesshouldbepaidmorethanlowermeritzones.GivenboththecriticalityandthehighperformanceofMeritZone1individuals,theirtotalcompensationshouldbesignificantlyhigherthanothermeritzoneindividuals.Agoodbeginningruleofthumbprovidesforadoublingoftotalcompensationforeachincrementinmeritzone.Figure3.11demonstratesanappropriatepayscale.Whileeachorganizationandmanagementteammustdeterminetheexactshapeofthiscurve,thedoublingoftotalcompensationforeachmeritzoneisappropriateforhighlycompetitiveorganizationswithlargeincentivecomponentsoftotalcompensation.Organizationswithalowerincentivecomponentwouldfindalowercompensationdifferentialtobeappropriate.Experienceisahardteacher.Shegivesthetestfirstandthelessonsafterwards.—AnonymousDistributionofCompensationThefinalstageofcompensationistodistributethecompensationpoolacrossallemployeesinallmeritzones.ThisbringstogethertheMeritZone P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy63$2,500$2,000$1,500$1,000TotalCompensation(in000s)$500$0654321MeritZoneFIGURE3.11TotalCompensationperEmployee(byMeritZone)DistributionandtheTotalCompensationperEmployeediagrams.Eachin-dividualinameritzoneshouldbecompensatedsimilarlyandconsistentwiththeabovecurve.Thiscanbedeterminedbyasimplegoalseekfunctioninanyspreadsheet.Thegoalseekwouldestablishthecompensationofthetopmeritzone(eachlowermeritzonewoulddropbyonehalf)andmulti-plythenumberofindividualsineachmeritzonebythatmeritzone’stotalcompensationinordertosumtothetotalcompensationpool.Thetotalcompensationthatisindicatedforeachindividualisabso-lutelyconsistentwitheveryotheremployee.Eachemployeeisevaluatedobjectivelyandconsistently,andcompensationissimilarlyanchored.How-ever,itwouldbeinappropriatetopresumethatthisnumericprocesswouldresultinthecorrecttotalcompensationforeachemployee.Whilethecal-culatedtotalcompensationisobjectiveandconsistent,itdoesnotreflectamultitudeofotherfactorsthatshouldbetakenintoconsiderationinde-terminingthecompensationofeachemployee.Forthisreason,itiscriticalthateachmanageractasahumanintermediarybetweenthequantitativerecommendationandtheactualcompensationeachemployeereceives.Thequantitativeapproachprovidesarigorousfoundationforthefinaltotalcom-pensationnumberdeterminedbyeachmanagerwithspecificknowledgeofuniqueconsiderationsforeachemployee. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford64INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTCaseStudy:CommunicatingMeritZonesandImprovingEmployeePerformanceOnecolleague,whomIfoundtobenearlyashardheadedandrecalcitrantasme,provedtobeaparticularchallenge.Hewassetonhisteam’sdirection;however,hisdesireswereonlypartiallyconsistentwiththeKPIsofthegroup.Wehadmanydiscussionsovertheyear,buthedidn’tseemtoabsorbtheinconsistencyofdirection.Meritzonediscussionsattheendoftheyearrevealedanunexpecteddeclineinperformanceandthecriticalityofhisposition.Thechangeinmeritzoneandanopendiscussionofitsmotivationleadtoalignmentofdirection,consistentwithgroupKPIs.Overtime,weworkedtogetherverywellandbothcametorespecteachotherhighlyforourstrengths,diversity,andopenquestioningofeachother’sviews.WhileIdonotbelievethatIwasabletofullybringoutthepotentialofthisindividual,hebecameavaluableteammemberandtherewasneveranyconsiderationbymeofreplacinghim.CaseStudy:TheDangersofNotEffectivelyCommunicatingPerformanceThelastcaseillustrateshoweffectivecommunicationcanleaddirectlytoimprovedperformance.Ontheotherhand,wewouldliketoillustratethedangersofwhatcanhappenwhenthisisnotdonewithanotheranecdote.Whileresearchingandwritingthischapterwehadtheopportunitytomeetajunioremployeeofalocalfinancialservicescompany.Hetoldusthestoryofhowhehadcometoworkathiscurrentemployerandthathiscurrentpositionwasactuallythethirdpositionhehadheldforthethirdemployerinasmanyyears.Hetoldusthatheessentiallyheldthesameresponsibilitiesinallthreepositions.Whydidhemakethesemoves?Theanswertohimwassimple:Inallofhispreviouspositionshisformeremployerswerenotabletoclearlydemonstratetohiminhisannualevaluationshisperformanceandcriticality.Theywerenottransparent,andasaresult,heperceivedhiscompensationtobetheluckofthedrawasopposedtotheconclusionofamodel.VALUESANDCOMPENSATIONAfirm’svalueshaveyettobeconsideredaspartofemploymentdecisionsandongoingevaluationandcompensationprocesses.Duringthehiringprocess,candidatesshouldbeintroducedtothevaluesoftheorganization,andaportionofaninterviewshouldincludeavaluesdiscussion.Theemployer P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy65shouldclearlycommunicatetheimportanceofvaluesinpromotionandcompensationconsiderations,andthecandidateshouldunderstandthatthevaluesaremorethanwordsonapieceofpaper.Valuesshouldbeconsideredintwowaysduringtheevaluationprocess.First,managerintermediationinthecompensationprocessprovidestheabilitytoadjustcompensationand,assumingtheemployee’sactionsarealignedwiththevalues,communicatethedegreetowhicheachemployeelivesthevaluesofthefirm.Second,andmorefundamental,istheassessmentoffutureemploymentbasedontwodimensions:valuesandperformance.Thereisnosuchthingasasmallbreachofintegrity.—TomPetersAnorganizationthatmaintainsthehighestlevelofintegrityisobjec-tive,consistent,andtransparentwithemployees.Further,high-integrityorganizationsplacegreaterimportanceonemployeealignmentwithvaluesthanongoodperformance.ThisdoesnotimplythatpoorperformanceisVALUESANDTHEINTERVIEWPROCESS—NOBETTERTIMETOSTARTTHANFROMTHEBEGINNING!Despitewhatappearstobeanimportantpartoftheinterviewpro-cess,wehavefoundthatmanagerstendtoavoidvaluesdiscussions,perhapsbecausetheythreatentheswaggeringandaloofimageofanindependentinvestmentprofessional—the“DirtyHarry”offinance.Evenworse,wewitnessedinterviewprocessesthatweredistinctlyin-dicativeoflow-integritycultures.Acolleagueonceproudlyconveyedaninterviewtechniqueheusedtodeterminewhetherjobcandidateswerereallypreparedfortheglobaltraveldemandsoftheposition.Thetechnique,heproclaimed,wastoaskeachcandidateherpassportnumber.Ifthecandidategaveanumber,thenitsignaledcomfortwithinternationaltravel,ortheintelligencetofabricateanumberthattheinterviewercouldnotverify.Iftheintervieweedidnotgiveanumber,thenheorshewassimplynotsmartenoughfortheposition.Astonish-ing!Thisindividualcreatedaninterviewtechniquethatwascalibratedtoidentifyindividualslackingintegrity—theyarecleverenoughtolieand,worse,tobegintheprocesstorealizeultimatelythatitisvalued. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford66INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTPerformanceGoodBadReconsiderAlignedRetain&DiscussValuesSolicitTerminateNotAlignedDepartureFIGURE3.12AValues-BasedFrameworkforHiringandFiringDecisionsacceptable.Rather,itindicatesthatafailuretolivethevaluesoftheorga-nizationisunacceptable.AsimpledecisionmatrixisshowninFigure3.12.Anemployeewhoseactionsarealignedwiththevaluesoftheorga-nizationandwhoseperformanceisgoodshouldberetained.Thisistheeasiestemploymentdecisionasitrequiresnodecisionatall.Withoutques-tion,wecanseethatanemployeewhosevaluesarenotalignedandwhoseperformanceisarisktotheorganizationshouldbeterminated.Again,thisemploymentdecisioniseasy.Theterminationdecisionisdeterminedprimar-ilybythefailuretolivevaluesratherthanpoorperformance.Substandardperformancesimplymakesthedecisioneffortlessandunremarkable.Thetwootherpotentialoutcomesaresomewhatmoredifficult.Anemployeewhoseactionsarenotalignedwiththevaluesoftheorganizationandwhoseperformanceisgoodisultimatelyunacceptable.However,itisbesttosolicitthedepartureoftheemployeewithaclearindicationofthereasons.Whileperformanceisgood,theindividualislikelytobehappierandmoreproductiveatanotherorganization.Unlessafailuretolivethevaluesinvolvesunethicalbehavior,thedepartureshouldbesolicitedratherthanabruptlyperformed.Finally,anemployeewhoseactionsarealignedwiththefirm’svaluesbutwhoseperformanceisbadshouldbereconsideredwithopenandhonestperformancediscussions.Suchemployeesmaybeabletoperformatahigherlevelifthefunctionchangesoriftheirunderstandingwasmisplaced. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestfordBuildingaMeritocracy67Integrityconsiderationsarecriticaltothesuccessofaninvestmentorga-nization.Theultimateterminationofemployeeswhodonotlivethefirm’svaluesistheonlythingthatseparatesEnronsandWorldComsfromotherorganizations.Allfirmsespousesuperiorvalues.Onlythosewhoseculturerevolvesaroundthevaluesandthatrequiretheemployeestolivethevaluesthriveandsurvivetothebenefitofallstakeholders,includingclients.CONCLUSIONTheobjectivity,consistency,andtransparencyofourmodelarefrighteningatfirst.Wecanwarnyouthatyoushouldnotbesurprisedwhenmanagementandemployeespushbackintheearlystagesofimplementation.However,astimepasses,thebenefitsoverwhelmpreexistingfearsandallpartiesfindtheprocessandoutcomestobesuperiortopreviouslyexperiencedevaluationprocesses.TheMeritZoneprocesshasintegrityandhelpstofosterhigherlevelsofintegrityandtransparencyintheorganization.Arrogancethatisbredinisolationbygroupsthatperceivetheircontributionstobethelinchpinoftheorganizationgiveswaytohumilityandappreciationofthecontributionsofothers.Thisisastrongfoundationformanagementandemployeerelationsandforthecareerdevelopmentthatallpartiesdesire. P1:a/bP2:c/dQC:e/fT1:gc03JWBT154-SingerAugust26,200911:7Printer:CourierWestford68 P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestfordCHAPTER4InvestmentPhilosophyandProcessALoftyCathedralNeedsaDeepFoundationhefoundationuponwhichasuccessfulinvestmentmanagementorgani-Tzationisbuiltisitsinvestmentphilosophyandinvestmentprocess.Inthischapter,wediscusstherolebothplayinthepathtosuccessfulstewardshipforinvestmentfirms.Thephilosophyandprocessprovideabasisforlead-ershipandforteamaffairsand,assuch,arecriticalmarkersforviablefirmstructureandcompromisingfirmtransformation.ThischapterlaysthegroundworkforamoredetaileddiscussionofinvestmentprocessimplementationinChapter5.THEIMPORTANCEOFINVESTMENTPHILOSOPHYANDPROCESSININVESTMENTORGANIZATIONSAninvestmentphilosophyisasetofprinciplesthatguidestheinvestmentac-tivitiesoftheorganization.Philosophystatementsoftenincludewordslike“fundamental,”“quantitative,”“team-based,”“value,”“growth,”“mo-mentum,”or“contrarian.”Theinvestmentphilosophystatementcommu-nicateshowaninvestmentorganizationaccomplishessomething,notwhattheinvestmentorganizationseekstoaccomplish.Inthisbook,wefocusoureffortsonactiveinvestingasopposedtopassiveinvesting.Assuch,theinvestmentphilosophystatementsthatweconsiderarethoseofactiveinvestment-drivenorganizations.Thisisnottosaythatpassiveinvestingiswrong.Thereisalotofmeritintheconstructionofapassiveandwell-diversifiedinvestmentportfolio.Thetruthisthatmanyindividualsarenotsophisticatedinvestors,andevenamongthosewhoare,69 P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestford70INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTwewouldarguethatonlyaminorityactuallypossesstheskillsnecessarytoidentifyactivemanagersthatwillbeatthemarket.AsBillSharpediscusseditbackin1991,investingcanbethoughtofasazero-sumgame.1Allinvestorscanbeclassifiedaspassiveoractive.Thepassiveinvestors,bydefinition,getthemarketreturn,whileactiveinvestorscanbesplitintotwocategories:thosewhobeatthemarketandthosewhounderperformthemarket.Thecumulativeperformanceofalltheseinvestorsgenerates“market”performance.Thegainsofinvestorswhobeatthemarketareoffsetbythelossesofthosewhounderperformthemarket.Thus,activeinvestingisadversarial;tobeatthemarketandbeawinneryouhavetotakeadvantageofthosewhounderperform.Eventhoughactiveinvestingcanbethoughtofasazero-sumgame,itprovidesatremendousbenefitforsociety.Inparticular,theactiveinvest-mentprocessdeterminesthepriceofallassetsandresultsintheefficientallocationofresourcesacrosssociety.Itwouldbeinappropriatetoconcludethatbecauseactiveinvestingisazero-sumgame,everybodyshouldjustin-vestpassively.Ifthisweretooccur,thepricemechanismwouldfailandresourceswouldbeinefficientlyallocatedacrosssociety,whichisknownastheGrossman-Stiglitzparadox.2INVESTMENTPHILOSOPHY:COREBELIEFSFollowingtheapproachthatwerecommendcreatesavaluableinvestmentedge,beginningwiththespecificationofaninvestmentphilosophytoguideinvestmentbehaviors.Asnoted,theinvestmentphilosophycommunicateshowsomethingwillbedone,notwhatwillbedone.Thebasicpremise,whichisoftenoverlookedbymanyindividualsininvestmentorganiza-tions,isthatbehaviorsconsistentwiththeinvestmentphilosophystatementaremorecriticalthanthoseinconsistentwiththephilosophy.Guidedbytheinvestmentphilosophy,eachemployeeknowshowtoprioritizeissuesandwheretofocustheirtime.AnexcellentexampleofthiscanbefoundinthewayBrinsonPartnersconveyeditsphilosophytobothclientsandemployees.Ahiddenconnectionisstrongerthananobviousone.—HeraclitusofEphesusFigure4.1expressestobothclientsandemployeesalikeexaclywhatthefocusofthepartnershipwasandpreciselywhatwasconsideredimpor-tant.ThecontentofthispresentationpagewasnotuniquetoBrinsonPart-ners.Nearlyeveryorganizationspeakseitherdirectlyorvaguelytothese P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestfordInvestmentPhilosophyandProcess71GuidingPrinciples:TheEquationsEquation#1People+=Process+PhilosophyPerformanceEquation#1Performance=InvestmentResults+ClientServiceEquation#1MaximumPerformance=MaximumBusinessResultsFIGURE4.1BrinsonPartnersEquationsSource:BrinsonPartners1996AnnualMeeting.behaviorssomewhereintheirliterature.WithBrinsonPartners,however,thisconceptwasmorethanjustamarketingtool.Thefirmcommunicatedunrelentingly—tobothemployeesandclients—whatwasimportantandwhatbehaviorsshouldbeprioritized.Themissionstatementandinvest-mentphilosophywereessentiallyone,andeverypersonintheorganization,whetheraninvestmentprofessionalornot,knewthatthefocusoftheorga-nizationwasinvestmentperformanceandclientservice.Everyendeavorofeveryindividualwasprioritizedwiththatmissioninmind.BrinsonPartnersfurtherclarifiedhowsuperiorinvestmentperformancewouldbeachievedbyaugmentingtheinvestmentphilosophystatement,referringtoafunda-mentalandresearch-driveninvestmentculturethatfocusedondeterminingthefundamentalvalueofassetsandassetclasses.TheBrinsonPartners’examplehighlightsthecorrectimplementationofaninvestmentphilosphy.Conversely,wecanfindtheoppositeintheeventualevolutionofthisverysamefirm.In2001,afterBrinsonPartnershadbeenboughtbyUBSandrenamed“UBSAssetManagement,”themissionandtheinvestmentphilosophystate-mentswereseparated.Themissionstatementnolongerembracedtheinvest-mentphilosophyoftheorganization.Itbecameamoregenericassetman-agementorganization’smission:“Ourmissionistobethebestinvestmentinstitutionthatinvestsacrossthebreadthoftheglobalcapitalmarket.”Gonewerereferencestoinvestmentperformanceandclientservice.Theinvestmentphilosophywasreferredtoasa“fundamentalinvest-mentphilosophy,”andwastargetedatjusttheinvestmentprofessionals,ratherthantoallstaffattheorganization.The“fundamentalinvestmentphilosophy”wasasfollows:“Ultimatelythevalueofanysecurityisperma-nentlylinkedtothefundamentalswhichdeterminethepresentvalueofthe P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestford72INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTcashflowsthesecuritycangenerateforcurrentandsuccessorowners.Whatasecurityisworthmustbegovernedbythecashflowgenerationabilityoftheenterprise,theabilitytogrow,[and]theuncertaintyofthediscountrateappliedtotheflowsavailabletotheowners.”TheassetclassreferencesoftheBrinsonPartnersdaysweregoneandthefirm’sfocusseemedtoshiftfromanequalconsiderationoftop-downandbottom-uptowardpredominantlybottom-upprioritization.Ultimately,acleanbreakwasmadefromthepast,andtheinvestmentorganizationbecameacollectionof“alphaboutiques.”Inotherwords,thetop-downfocuswaseschewedforthebottom-upsecu-rityanalysisofalphaboutiques,andwiththis,theconsistentmissionthathadoncepermeatedthroughoutallareasofthefirmwaslost.Therewasnothingnecessarilywrongwiththismissionshift,itmerelyreflectedashiftinbusinessstrategythatwasperhapsnecessitatedbythefirm’ssize.Regardless,themissionshiftsignalledchangeswithintheorga-nizationthatwouldhavepleasedordispleasedvariousclients.WhileBrinsonPartnersprovidesgreatexamplesthattheauthorsareintimatelyfamiliarwith,therearealsootherinvesmentfirmsthathaveclearlyandsuccinctlyarticulatedinvestmentphilosophystatements.OneoftheseisTheCapitalGroup,whoseinvestmentphilosophystatement,whilelengthy,couldnotbemoreclear:ThecompaniesthatcompriseTheCapitalGroupshareaninvestmentphilosophythatisdistinguishedbyfourkeybeliefs:
Webelievethatsolidresearchisfundamentaltosoundinvestmentdeci-sions.Ourcompaniesemployteamsofexperiencedanalystswhoregu-larlygatherin-depth,first-handinformationonmarketsandcompaniesaroundtheglobe.
Webelievethataninvestmentdecisionshouldnotbemadelightly.Inadditiontoprovidingextensiveresearch,ourinvestmentprofessionalsgotogreatlengthstodeterminethedifferencebetweenthefundamentalvalueofacompanyanditspriceinthemarketplace.
Webelieveinalong-termapproach.It’spartofthebig-pictureviewourinvestmentprofessionalstakeofthecompaniesinwhichweinvest.Thisisreflectedbythetypicallylowturnoverofportfolioholdings.Inaddition,ourinvestmentprofessionalsusuallyremainwithusformanyyearsandarecompensatedaccordingtotheirinvestmentresultsovertime.
Webelieveinthevalueofmultipleperspectives.Theassetsofeachfundorportfolioaredividedamonganumberofportfoliomanagers.Thesemanagersmakeindependentinvestmentdecisionsandmanagetheirportionsasthoughtheywereseparatefunds.Overtime,thismethodhascontributedtoconsistencyofresultsandcontinuityofmanagement.3 P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestfordInvestmentPhilosophyandProcess73Whileclearinvestmentphilosophystatementsprovidedirectionforem-ployees,theimpactonclientsismoresubtleandalsomorevaluable.Theinvestmentphilosophystatementprovidesastructureforallcommunication,assistinginaccuracyandclarity.Moreimportantly,itenablesemployeesandclientstoreachbeyondsimplestatementsabouthistoricalperformanceandtoframeandcontextualizevariousinvestmentenvironmentsandissuesacrosstime.Forexample,clientscanleveragetheinvestmentphilosophystatementintheiranalysisofaninvestmentadvisor.Allinvestmentactivitiesandclientcommunicationscanbeevaluatedagainstthephilosophystatement,elimi-natingtheever-seductive“spin.”Anydeviationincommunicationorchangeinthemissionand/orinvestmentphilosophystatementshouldbeconsideredanimmediateredflag,regardlessofactualinvestmentperformance.Con-versely,theclient-facingprofessionalsoftheinvestmentadvisorcanusethephilosophystatementtoputshort-termperformanceinitscorrectcontext,andhelpclientsrefocustheirattentiontotheirlong-terminvestmentgoals.Theinvestmentorganization’smissionstatementanditsinvestmentphi-losophystatementareenduringtenantsspecifyingtheorganization’spur-poseand,asCollinsandPorrasstateinBuilttoLast,“aperpetualguidingstaronthehorizon;nottobeconfusedwiththespecificgoalsorbusinessstrategies.”BasedontheresearchofCollinsandPorras,fiddlingwiththemissionorinvestmentphilosophystatementshouldbeacauseforconcernforbothemployeesandclientsoftheorganization.4INVESTMENTPROCESS:CONTROLANDANARCHYInvestmentprocessstatementsprovidegreaterspecificitythantheinvestmentphilosophystatement,communicatingtherealmofactivitiesemployeescanundertakeonaday-to-daybasis.Itprovidesaframeworkforprioritiza-tionandforthesuccessfulintegrationofdisparateindividualswithintheorganization,divisionsoftheorganization,andtheentireorganizationasawhole.Thelanguageofaninvestmentprocessstatement,whileoftensimple,ismoreprecisethanthelanguageofaninvestmentphilosophystatement.Unfortunately,lessthanessentialattentionisoftenplacedontheinvest-mentprocess,perhapsbecauseitissosimpleandseeminglyredundant.Inthefollowingsectionswewillexaminehowwe,andothers,constructtheirinvestmentprocess.Tobegin,awell-constructedinvestmentphilosophyandprocess,withclearlydefinedboundaries,willcreateanenvironmentwheretheCIOdoesnotneedtomicromanage.Rather,behaviorsthatarewithintheboundariesshouldbeconsideredacceptableanddesirable,eveniftheyarenotbehaviors P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestford74INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTthattheCIOwouldundertake.Borrowinganoftenrepeatedmanagementdictum,theCIOcanhirethebestpeopleandsteppartiallyoutoftheway,allowingemployees’investmentcontributionstosucceedorfail.Inthisman-ner,successislikelytoprevailandtheCIOleveragestheuniqueknowledgeandskillsofeachandeveryindividualontheinvestmentteam.Itisourbeliefthattheabsenceofinvestmentprocessboundariesresultsinadhocmicro-managementbytheCIOandthecollapseoftheinvestmentteamintooneindividual:theCIO.UltimatelyinvestmentprofessionalsbecomebitplayersintheCIO’s“investmenttheater.”WewilldiscusstheroleoftheCIOandhowhecanbestleveragetheuniqueskillsoftheinvestmentteam,laterinthechapter.Fewthingshelpanindividualmorethantoplaceresponsibilityuponhimandtolethimknowthatyoutrusthim.—BookerT.WashingtonWiththisphilosophicalfoundationproperlydefined,theinvestmentpro-cesscanbeliberating,asopposedtoconstraining.Asanaside,itisimportantthatthislibertynotbeconfusedwithanarchy.Thereisacontinuumfromabsolutecontroltoanarchy.Control-orientedpeopleandanarchiststendtoseecontrolandanarchyasaneither-orsituation,withnothinginbetween.Control-orientedpeopleseeanythingshortofheavy-handedcontrolasanar-chy.Conversely,anarchiststendtoviewanymeasureofcontrolastheonlyalternativetoanarchy.However,withinthespectrumfromabsolutecontroltoanarchythereexiststhefreedomofself-governance.HerbKelleher,ex-ecutivechairmanandformerCEOofSouthwestAirlines,characterizestheintermediaterealmoffreedomfromtheperspectiveofasuccessfulleader:I’veneverhadcontrolandIneverwantedit.Ifyoucreateanenvi-ronmentwherethepeopletrulyparticipate,youdon’tneedcontrol.Theyknowwhatneedstobedoneandtheydoit.Andthemorethepeopledevotethemselvestoyourcauseonavoluntarybasis,awillingbasis,thefewerhierarchsandcontrolmechanismsyouneed....We’renotlookingforblindobedience.We’relookingforpeoplewhoontheirowninitiativewanttobedoingwhatthey’redoingbecausetheyconsiderittobeaworthyobjective....ThefactthatIcannotpossiblyknoweverythingthatgoesoninouroperation—anddon’tpretendto—isasourceofcompetitivead-vantage.Thefreedom,informality,andinterplaythatpeopleenjoyallows(sic)themtoactinthebestinterestsofthecompany.5Ingettingbacktotheinvestmentprocess,Figure4.2,takenfromtheCFAInstitutecurriculum,identifiesthreeelementsoftheprocess:planning, P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestfordFeedbackAttainmentofinvestorobjectivesPerformancemeasurementExecutionMonitoringinvestor-relatedinputfactorsPortfolioconstructionandrevisionAssetallocation,portfoliooptimization,securityselection,implementation,andexecutionMonitoringeconomicandmarketinputfactorsPortfoliopoliciesandstrategiesCapitalmarketexpectationsPlanningPortfolioPlanning,Execution,andFeedbackCFAInstitutecurriculum.Specificationandquantificationofinvestorobjectives,constraints,andpreferencesRelevanteconomic,social,political,andsectorconsiderationsFIGURE4.2Source:75 P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestford76INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTexecution,andfeedback(p.495).6Theleftmostboxesofthediagramex-pandontheplanningportionoftheprocess,themiddlethreeboxesdelin-eateaspectsoftheexecutionphase,andtherightmostboxfocusesonthefeedbackphase.Takentogether,thisoutlinesaninvestmentprocessforafundamental-orientedinvestmentorganization.Thiscanimplyfundamentalanalysisoftheeconomy,fundamentalanalysisoffactorsaffectingassets,andfundamentalanalysisoftheactualvalueofassets.Webuildourprocessaroundthefundamentalvaluationofassets,thoughthisisnotnecessarilythenorm.Typically,fundamentalinvestmentprocessesofmacroinvestmentfirmsaredesignedtobuildstrategiesbasedonforecastsofmacroeconomicorotherfundamentalvariablesthataredeemedtoinfluenceassetclasses,sec-tors,andindustries.Thereareanumberofverybright,highlyeducatedindividualswhodevelopstrategiesinthisway,butwetendtofindthisap-proachlessdesirable.Tous,itisreminiscentoftheoldjokethateconomistsarelikepickupsticks,whenaskedaquestiontheycomedownpointingineverydirection.If,forexample,weweretogatherrecommendationsfrommacrostrategistsaroundtheworldatanypointintime,surelywecouldfind10verywellthoughtoutandarticulatedargumentsastowhytheequitymarketsshouldgodown.Atthesametime,wecouldfind10equallywellthoughtout,articulatedargumentsastowhytheequitymarketsshouldgoup.Mindyou,thesewouldbeargumentscomingfromindividualswithPhDsfromthebestschools,andwouldbeaccompaniedbytremendousamountsofdata,fancyequations,andnovelchartstosupporttheirpositiveornegativeviews.Letusexaminearecentspecificexample.CaseStudy:PickupStickAnalysisInMarch2007,DresdnerKleinwortofferedabearishviewontheS&P500and,concurrently,UBSinvestmentresearchofferedabullishview.DresdnerKleinwort’sbearishviewwaspredicatedontheexpectationofvulnerableeconomicactivity.TheU.S.economy,Dresdnerargued,wassusceptibletoweaknessbecausethehouseholdsectorwasinfinancialdeficit.Thisfinancialdeficitmeantthatcompanieswouldhaveweaktop-line,orrevenue,growth.Inaddition,Dresdnerfeltthatprice-earnings(PE)multiplepressurewouldaccelerateduringtheperiodoftrend-earningsweakness.Theseviewswerewellbackedupintheresearchreport,leavingDresdnertoconcludethat“weremainequitybearswhiletherestofthesellsideissanguine.”7TheUBSInvestmentBankresearchreporthadadifferentoutlook.UBSfeltthattheeconomywasinfactsoft,butthathouseholdandcorporateincomeswerelikelytoremainstrong,and,therefore,earningsgrowthwould P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestfordInvestmentPhilosophyandProcess77remainreasonable.Moreover,UBSfeltthatsoftnessintheeconomywasalreadypricedintotheequitymarket.ContrarytoDresdner,UBSfeltthatPEmultipleswerelikelytoexpandbasedontheirviewthattheeconomywouldbesoft,butnotweak.Finally,UBSofferedthatmarketriskaversionwashighatthatpointintimeandlikelytocomedownsubsequenttoarecentvolatilityspike.Thisdeclineinmarketriskaversionwouldleadtolowerdiscountratesandthereforehigherequityprices.Intheirreport,UBSconcluded,“webelievethatongoingmarketturbulencehasmoretodowithpositioning,riskmanagementandprofit-takingthanwithanysignificantchangeintheunderlyingfundamentals.Thus,werecommend...toaddtopositionsinglobalequities.”8BoththeUBSInvestmentBankreportandtheDresdnerKleinwortre-portsseemreasonable.Ifinclinedtochooseoneviewortheother,mostprofessionalinvestorswouldlikelyfindbrilliantthereportsupportingtheirownview.Forecasting:TheFoolsGoldofInvestingIntheend,aninvestmentprocessbasedontheforecastsofinvestmentstrate-gistsisvulnerabletoacommunicationbias.BasedonsomeresearchthathadcomefromHarvard,JeffDiermeier,theheadofUSEquitiesatBrinsonPart-ners,opinedthatasuperiorinvestmentteamcouldbeconstructedbyhiringpeoplewithlimitedcommunicationskills.Suchindividuals,heobserved,relyonanalyticalstrengthratherthanonpersuasiveproficiencytosucceed.Moreover,thecommondiscussionandforecastingofeconomicvariablesconsidersthewrongvariables—economic,nottheassetvariables—andre-sultsinwhatcouldbeconsideredastrategist’sbeautycontest.Investmentdecisionswouldcomedownnottothebetteranalysis,butrathertothemostarticulateconveyorofthatanalysis.Macrostrategists,forthisreason,areoftenskilledatpublicrelationsandquitecapableofpersuadingmarketparticipantsoftheappropriatenessandsuperiorityoftheirviews.Theyarenotnecessarilygoodatstrategyformulation.Thosewhohaveknowledge,don’tpredict.Thosewhopredictdon’thaveknowledge.—LaoTsu6thcenturyBCThebestwaytoavoidbecomingprisonertothebestcommunicatoristoputinplaceaninvestmentprocessthatispredicatedondirectfunda-mentalassetvaluation,asopposedtoindirectforecastingofeconomicorfundamentalmarketvariables.Thisandthenextchapterwillfrequentlyreturntotheimportanceoffundamentalassetvaluationasacriticaltool P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestford78INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTtoavoidweak,thoughperhapsstimulating,analysisandinsteadbeatoolforobjectivityinhighlyemotionaltimes.Ideally,analystsshouldfocusondiscountingfuturecashflowsinordertodeterminethefundamentalvaluethattheywouldbewillingtopayforanassetorassetclass.Theinvestmentprocessbeginswithafocusondeterminingfundamentalvaluebygarneringcashflowanddiscountrateinformation.Forecastingisinevitable,butconsiderationofobjectivelydeterminedcashflowsratherthansubjectivelydrivenassetpricesisimperative.Oncedetermined,fundamentalvalueisacurrentobservationthatcircumventsthebehavioralwhimsofmarketparticipantsandpersuasiveabilitiesofinvest-mentstrategists.AVOIDINGTHEPITFALLSOFBEHAVIORALBIASESEvenwithaspecificfundamentalvaluationlaunchingpointfortheinvest-mentprocess,thereareseveralpotentialpitfallsthatfirstneedtobeil-luminated.Theliteratureofbehavioraleconomicsandfinancehighlightanumberofthesehumanbiasesthatcanleadtosuboptimaldecisionmaking.However,ourexperiencehasshownatendencyforfourmainculpritstothrowsandinthegearsofanotherwisesoundinvestmentapproach:1.Perceivedreality2.Toomuchinformation3.Theconfirmationbias4.BeliefperseverancebiasAfterdiscussingthesepotentialpitfuls,wewillreturntotheimplemen-tationoftheinvestmentprocess.PerceivingorConstructingRealityThefirstpitfallhastodowiththegatheringoffacts.Ananalyst’sfunctionoftenhasbeenreferredtoastheassimilationofaninformationmosaicthatallowstheanalystand/orportfoliomanagertoinferabigpictureandmakeinvestmentdecisions.Itisseductivetothinkoftheprocessassimplyobtain-ingmoreandmorefacts,liketilesfillingthemosaic;however,thetruthisthatitisimpossibletosimplygatheraplethoraoffacts.Thereasonisthatfactsdonotspeakforthemselves.Rather,theyareinterpretedfromtheper-spectiveoftheobserver.Theanalystprovidescontext,andthatcontextisafunctionofhisorherethnicity,education,experience,training,culture,andsoon.AccordingtoRichardJ.HeuerJr.’sbook,PsychologyofIntelligentAnalysis,“judgmentiswhatanalystsusetofillgapsintheirknowledge.It P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestfordInvestmentPhilosophyandProcess79entailsgoingbeyondtheavailableinformationandistheprincipalmeansofcopingwithuncertainty.Italwaysinvolvesananalyticalleap,fromtheknownintotheuncertain.”9Realityismerelyanillusion,althoughaverypersistentone.—AlbertEinsteinHeuerobservesthattheperceptioncomponentofanalysisisreallyanac-tive,ratherthanapassive,process.Thismeansthattheanalyst“constructs,ratherthanrecords‘reality’.”10WhileHeuerreferstothisinanegativemanner,implyingthatpriorexperienceswilltainteachanalyst’sperceptionprocessinanadversemanner,wehavetheoppositeview.Wemaintainthatthealternativeperceptionsofeachindividualbeconsideredpositive.WenotedinChapter1thattheculturalenvironmentsatmanyofthehighestqualityfirmsareconstructedexactlywiththisnotioninmind.Differentin-terpretationsthatarisefromdiversityofexperience,education,culture,andsoonallowthefactstobeperceivedinwaysthataffordtheconstructionofdifferentrealities—adifferentperspectivefromeachanalyst.Thisdiversityofperceptiondependslessonunderstandingandenablestheconstructionofnotjustaprimarymentalmodelofasituation,butalsoanumberofalternativementalmodels,orhypotheses.Eachmodeldependsoncollectiveunderstandingsthatderivefromdiverseindividualperceptions.Asmallbutsufficientlydiversepoolofskilledanalystscanovercomemisstepsintherealityconstructionprocess.Tothedegreethataskilledinvestmentteam’sdiversityisbetterthanthemarket’sandthecompetition’s,realityconstruc-tionbecomesapositiveinvestmentedge.But,thiscanonlyhappenwhenanorganizationalculturesupportsthistypeofbehavior.Whatpreventsanunendingstreamofirreconcilablementalmodelschar-acterizingeverysinglesituation?Howcantheconstructionofallofthesedifferentmentalmodelsbedoneinacontrolledmanner?Theinvestmentphilosophystatementisnecessaryinthisregard,butitisnotsufficient.Anexplicitinvestmentprocess—onethatprovidesaframeworkintowhicheachanalystplugshisorheralternativementalmodel—needstobeputinplace.Thecombinationofapreciseinvestmentphilosophystatementandawell-definedinvestmentprocessiscriticalfortheanalystsandportfoliomanagerstofunction.TooMuchInformation,orAnalysisParalysisThesecondpotentialpitfallisthedesiretogathermorefactstoclarifytheinvestmentlandscape.Itisfairlystandardintheinvestmentindustryforstrategistsandpunditstocommentthatmoreinformationisneededbe-foredecisionscanbemade.Unfortunately,capitalmarketsaresufficiently P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestford80INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTanticipatoryandefficientthatbythetimethesepunditsgettheinformationtheydesireitwillbetoolatetoact.Investmentmanagersneedtoactbeforealloftheinformationisinplace.Itisinappropriatetoexpectthatmoreandbetterinformationwillprovidesufficientclarityfortheanalystorportfoliomanagertomakedecisions.Infact,alaypersonwouldmakegreatdecisionsifalltherelevantinformationweregathered.Theraisond’etreoftheinvest-mentmanageristhecapabilitytomakedecisionswithmoderate,orevenscant,information.Thekeyisnottheacquiringoflargerquantitiesofinformation,butratherthatrelevantinformationisefficientlyused.Marketsaresufficientlycomplexthatthenumberofvariableshavinganimpactonassetpricesisvirtuallyinfinite.Ifinvestmentanalystsmanagetoidentifytherequisiteandaccessiblefactsandconstructalternativerealitiestovet,thenperceivedfundamentalvaluewillbeclosetoanomniscientbeing’sunderstandingoftruevalue.Hence,themostcriticalaspectofthedecision-makingprocessistheabilitytouseavailableinformationtothegreatestdegreepossible.Therewilloftenbeananalystwho,likeaneoclassicalpainter,wantstocaptureeverydetailoftheinvestmentscenewithabsoluteprecision.Unfortunately,decisionswillrarelybeforthcoming,exceptunsurprisinglywhenthepaint-ingofthepreconceivedpicturehasbeencompleted.Inthesesituations,theindividualshouldbeproddedtotakemoreofanimpressionistapproach,capturingtheprimaryperceptionofthesceneryandmentallyfillinginthedetailofthefulllandscape.Thispointcannotbereiteratedenough:Itisnotaboutmoreinformation;itisaboutusingtherightinformationeffec-tively.Thespecificsoftheinvestmentprocessthatwedevelopinthisandthesubsequentchapterfocuscriticallyonenhancinginformationvalueandleveragingfundamentalassetvaluationtoavoidinvestmentpitfalls.ConfirmationandBeliefPerseveranceBiasesNassimTalebsuggestsfurtherpitfallstoinformationgathering:thecon-firmationbiasandthebeliefperseverancebias.Theconfirmationbiasisthetendencyforindividualstoseekinformationthatconfirmsanexistingopiniontheypossess.Thebeliefperseverancebiasisanindividual’snaturalresistancetochangingpreviouslyheldopinions.11Tohelpcombatthesepitfalls,weprefertothinkofinformationaseither“flow”informationor“stock”information.Flowinformationaddressesthechangeofavariable;forexample,inflationasthechangeofprices,incomeastheincreaseordecreaseofwealth,oranyoftheplethoraofeconomicstatisticsthatarereportedtochangeonamonth-by-monthbasis.Stockinformationaddressestheconceptofameasurablelevel.Forexample,onecanthinkofnetworthasthestockvariablethatgivesrisetoincome,theflow P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestfordInvestmentPhilosophyandProcess81variable.Recently,investorshavebeenobsessedwiththehundredsofbillionsofdollarsofsubprimeandAlt-Amortgagedefaults,withoutrealizingthatthisisarelativelysmallportionofover$80trillionofhouseholdassetsandover$50trillionofhouseholdnetworth.12Theperspectiveofthestockinformationseemstobelostinthedownpourofflowinformationthatinundatesinvestorseverysingleday.Unfortunately,theconfirmationandbeliefperseverancebiasesaresupportedbyalmostalloftheflowinformationthatistransmittedregularlyregardingeconomiesandcapitalmarkets.Whatisreadinresearchreportsandregularlyheardinthemediaisin-formationoftheflowvariety.Thereasonsaresimple:Flowdataisveryeasytoobtainrelativetostockdataandismuchmoreinterestingtoreport.Forexample,itismoreenticingtorefertoa$500billionincreaseinhouseholdassetsinanygivenyearthanitistoreportthathouseholdassetsincreasedby0.67percentfrom$83.5trillionto$84trillion.Withoutknowingthatthebaseisontheorderof$84trillion,the$500billionchangeseemsmuchmoresignificant.Tohighlightthispointevenfurther,letusconsideranexamplefromthefieldofscience.In2003,scientistsdiscoveredthattheMilkyWay(thehomegalaxyofplanetEarth)incurredamassivecollisionwiththeCanisMajordwarfgalaxy.TheMilkyWayrippedtheCanisMajordwarfgalaxyapartandabsorbedanestimatedonebillionstars.Thissoundsprettymassive—onebillionstars.YettheMilkyWayhasanestimatednearly200billionstarsandthecollisionwithanothergalaxyisactuallyaprocessthatoccurscon-tinuously,feedingthegrowthoflargergalaxies.The“flow”ofonebillionstarsslammingintoourgalaxysoundsprettyimpressive,untiloneconsidersthe“stock”of200billion(somesayasmanyas400billion)starsintheMilkyWay.ItjustisnotasexcitingtosaythattheMilkyWayisexpectedtogrowfrom200billionto201billionstarsoverthecomingmillennia.Andsuchisthenatureofthefrequentlychurnedoutresearchreportsandcommentaryonthefinancialindustry.Toproduceamonthlyresearchreport,ortobeadailytalkingheadonthenewsmedia,thefocushastobeonflowinformation.Thesereportsandinformationarealwaystoutedasbeingrelevantorevencritical,butinrealitytheinformationdoesmoretoincrease,andoccasionallydecrease,confidencethanitdoestoincreaseknowledge.Thisinformationflowsupportsboththeconfirmationandbeliefperseverancebiases.Figure4.3isfromRichardHeuer’spreviouslyreferencedbookPsychol-ogyofIntelligentAnalysis(page68,13referencingfootnote5314).Whatthischartshowsisthatanincreaseininformationgathered,whileincreasingconfidence,doesnotnecessarilyincreaseaccuracy.Inthevaluationofanasset,theendlessstreamofflowinformationservesprimarilytoincreaseconfidence,butseldomdoesitincreaseaccuracybeyondthatattainedby P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestford82INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENT4040AccuracyConfidence3030Confidence(%)2020Accuracy(%)1010CorrectFirstPlaceSelections005102040ItemsofInformationFIGURE4.3MoreInformationBreedsConfidence,ButNotAccuracySource:RichardHeuer,ed.PsychologyofIntelligenceAnalysis.NewYork:NovaNovinka,2005.thefirstfewitemsofinformation.Themosaiccanlooklikeanimpressionistpaintingorthecompletelydetailedrenderingsoftherealistgenre,butthepictureisavailablefromthelessrichimpressionistdepiction.Moredetaildoesnotchangethepicture.Inhisbook,TheWisdomofCrowds,15JamesSurowieckireferstoastudyconductedbyPaulAndreasenatMITinthelate1980s.Thestudydividedstudentsintotwogroups.Eachgroupwasgivenaportfolioofstocksthattheywereallowedtotradeintheopenmarket.Eachgroupwasalsoprovidedwithfundamentalinformationabouteverystockintheirportfoliothatwouldgivesomeindicationofafairprice.Onegroupwasabletoseethechangesinthepricesoftheirstocks.Theothergroupwasabletoseethechangesinthepricesoftheirstocksandwasgivenastreamoffinancialnewsthatpurportedtoexplainthechangesinstockprices.Thestudyfoundthatthestudentswhodidnothaveaccesstonewsperformedfarbetterthanthegroupthathadthenewsfeed.Andreasenfoundthatthegroupwithaccesstonewsoverreactedtothatnews,overplayingtheimportanceoftheinformation,whilefailingtoquestiontheusefulnessoftheinformation.Thisevidencehasimportantimplicationsforhowgoodanalystsspendtheirtime.Theconfirmationandbeliefperseverancebehavioralpitfalls,andtheuncertaintyofanyassetvalueestimate,suggesttheneedforamore P1:a/bP2:c/dQC:e/fT1:gc04JWBT154-SingerAugust12,200914:30Printer:CourierWestfordInvestmentPhilosophyandProcess83robustinvestmentprocess,notmoreinformation.Theholygrailisaprocessthatextendsbeyondjustvaluation,openingdoorstofactorsthatnotonlydetermineanasset’sfundamentalvalue,butalsothemarketbehaviorsthatdetermineitsprice.CONCLUSIONTheinvestmentphilosophyandprocessprovideguidanceforleadershipdecisionsandemployeebehaviors.Basedonourinvestmentproclivities,weofferedafundamentalphilosophyasanexamplethatcanbeusedtosteerleadersandinvestmentstaffclearofmanybehavioralbiasesthatdogtheoverwhelmingmajorityofinvestors.Ultimately,investmentprofessionalsmakedecisionsbasedonlimitedinformationand,absentthefoundationofastrongphilosphyandprocess,cansuccumbtothesepitfalls.Clearly,adoptingaphilosophyandprocessdoesnotprecludethemanymistakesthatinvestorsmake,butitprovidesafirstandfoundationalstepintherightdirection.Theabsenceofaphilosophyandprocess,ontheotherhand,opensthedoortoamultitudeofinappropriateandinvestmentperformancehinderingbehaviors.Theinvestmentphilosophyiscastinstone,immutable.Theinvestmentenvironmentevolves,however,andtheprocessneedstoevolveaswell.Toretainaninvestmentedge,theinvestmentprocessmustremainatleastonestepaheadofcapitalmarketdevelopments.Thefollowingchapterfocusesontheinvestmentprocessinresponsetoevolvingmarketconditions. 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P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordCHAPTER5InvestmentProcessinanEvolvingWorlddoptinganinvestmentphilosophyandprocessisnoinvestmentpanacea.ATheyprovideessentialboundariesforleadersandinvestmentprofes-sionals,butlittleelse.Inthischapterwediscusstheinvestmentprocess,payingparticularattentiontoleadership,staff,andmarketbehaviors,espe-ciallyduringextremeperiodssuchasthedeleveraging-drivenmarketcrashof2008/early2009.Weexaminethehurdlesthatmarketbehaviorcreatesfordisciplined,fundamentalinvestorsandwaystocombatandbenefitfromthesechallenges.ThischapterprovidessomepracticalimplicationsfortheCIO,examiningtherolehemustplayinboththeconstructionandman-agementofaninvestmentteam.Finally,weconcludebyprovidingsomeconceptsonoptimalportfoliodesign.IntheIntroductiontoInvestmentManagement,AswathDamodaranobservestheinordinatefocusofenergyputintoinvestmentphilosophiesandstrategies,andlackoffocusontheinvestmentprocess.1Giventhatcreatinganinvestmentprocessissosimple,andthatitissuchacriticalcomponentofasuccessfulinvestmentorganization,thelackofattentionseemsodd.ThereexistsabeliefthatdecisionsmadebytheWarrenBuffetsandBillMillersoftheindustryarebasedonagutfeelingorasixthsense.Thisisdecidedlynotthecase.Thetruthofthematteristhattheonlygutfeelorsixthsenseinsuccessfulinvestingisdisciplineandhardwork.Thereisnomagicbullet.Opportunityismissedbymostpeoplebecauseitisdressedinoverallsandlookslikework.—ThomasEdisonDisciplineandhardworkcannotsimplyfocusongatheringmorein-formation.Readingmoreanalystreportswillnotbehelpful,andreading85 P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford86INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTmorenewspapersreallydoesnotaddanythingofvaluetothesituation.Rather,drawinguponthediversityoftheinvestmentteamtodissectmarketbehaviorandturneachmentalmodelsidewaysorupsidedowniswhatisrequiredforsuccessfulinvesting.Somebodywhoonlyreadsnewspapersandatbestbooksofcontemporaryauthorslookstomelikeanextremelynearsightedpersonwhoscornseyeglasses.Heiscompletelydependentontheprejudicesandfashionsofhistimes,sincehenevergetstoseeorhearanythingelse.—AlbertEinsteinIMPLEMENTATIONOVERVIEW:THE“HOW”OFTHEINVESTMENTPROCESSTheinvestmentprocesscombineswithafirm’smission,values,andphilos-ophytodefineandprioritizeabroadsetofacceptablebehaviors.Pensionplans,endowments,foundations,individuals,andsovereignwealthfundsdevelopinvestmentguidelinesthatspecifytheirinvestmentobjectivesandconstraints.Fromaninvestmentmanager’sperspective,thisclientpolicy-settingprocessisoutsidetherealmofthemanager’sinvestmentprocess.Indevelopingtheinvestmentprocessthatweuseinthischapter,theexecutionphasespecifiedintheCFAInstitutecurriculum(asintroducedinChapter4,Figure4.2)ispertinenttotheinvestmentmanager.Sincewenarrowlyfocusonexecution,asimplestructurefortheinvestmentprocessissufficient.Thischapteradoptsaprocessofthethreecomponents,showninFigure5.1thatwebelieveisavaluabletoolforinvestmentleadershiptodeliversuperiorinvestmentperformance.Beyondputtinganinvestmentprocessinplace,leadershipmustfosteritsongoingimplementation.TheCIOandotherinvestmentleadershipmustusetheinvestmentprocesstospecifyauthoritiesandprovideboundarieswithinwhichthereisunfetteredfreedom.Theinvestmentprocessprovidesthemostbasicsetofboundariesdefiningacceptableactivitiesforinvestmentprofessionals.MarketandTeamFundamentalValuationPortfolioDesignBehaviorAnalysisFIGURE5.1ThreeComponentsoftheInvestmentProcess P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld87Aleaderwhosepowerismanifestviacontrolwillfindthisstructureuncomfortable.Alesscontrol-orientedleader,however,willleveragethephilosophyandprocesstoleadtheinvestmentteamwithoutmicromanag-ing,providingeachinvestmentprofessionalwithmorefreedomthanwouldotherwisebethecase.Throughexperienceworkinginbothcontrol-orientedandcollaborativefreedom-orientedinvestmentenvironments,wefindthatthecontrol-orientedenvironmentcansurvive,butonlyintheshortrun.Thecollaborativefreedom-orientedenvironmentlaysthefoundationforlong-runsuccess—affordingexperience,opportunitiestogroomsuccessors,andgarneringlong-termloyaltyandcommitmentofallemployees.Allowinginvestmentprofessionalstoroamfreelywithintheconfinesoftheinvestmentphilosophy,processandvaluesenablestheiranalysisandresearchtobelimitedonlybytheirimaginations.ThisisconfirmedbyDovSeidmaninhisbookHow.2Seidmanobservesthattrulyinnovativeandsuccessfulinvestmentteamsworkontheedgeofchaosatalltimes.Chaosshouldnot,anddoesnot,implyalackofdisciplineorstructure.AsshowninFigure5.2,awell-establishedinvestmentphilosophythatisunderstoodbyallfirmemployees,coupledwithanestablishedinvestmentprocess,providesthefoundationandframeworkforinnovativefreedom—freedomtoconstructdifferentrealitiesandmolddivergentperspectives—byeverybodyassociatedwiththeorganization.Abroadbutboundedareaofcollaborativefreedomisprescribedwithinwhichallbehaviorsareacceptableanddesired,evenifnotagreedbyall—especiallytheorganization’sleadership.CollaborativeFreedomMission(EdgeofChaos)&PhilosophyValuesProcessFIGURE5.2TrueCollaborativeFreedomistheIntersectionofOrganizationalValues,Mission,Philosophy,andProcessAdaptedfromHowbyDovSeidman. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford88INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTFUNDAMENTALVALUATIONReferringtoourproposedinvestmentprocessdiagram,thefirststageisthefundamentalvaluationofallassetsandassetclasses.Eachassethasafundamentalvalue.Eventhoughthisisasimplestatement,and“asset”isasimpleconcept,thefinancialcommunityhasconfoundedtheconceptimmeasurably.Sinceweassertthat“asset”isasimpleconcept,let’sbeginbyreviewingitsbasicdefinition:Assetsareclaimsonfutureincomethatarisefromsaving.Therearetwowaystosave:31.Lendorgiveupcurrentincomeinexchangeforfutureincome,and2.Buyandoperatedurable(capital)goodsforfuturecashflow.Therearetwofundamentalinstrumentsassociatedwiththesetwoformsofsaving:41.Bondsforlending,and2.Equitiesforowningdurable(capital)goods.Bondsareatransferofcurrentincomefromonepersontoanotherand,therefore,atransferofcurrentincomeforfutureincomebythebondacquirer.Buyingthebondmeansthatyouforfeitfundstoday(currentcon-sumption)inordertoreceiveanincomestreaminthefuture(futurecon-sumption).Equityistheresidualownershipclaimondurable(capital)goods.Buyinganequitymeansthatyouforfeitfundstodayforapiece(share)ofacapitalgoodspoolthatcanbesoldinthefuture.Thetotalassetpoolisnothingmorethantheaggregationofallequitiesandbonds.Therearesubsetsofthesebasicassets,suchasventurecapital,andderivativesoftheseassets(likefuturesorswaps),butthebasicelementsareequitiesandbonds.Additionally,someassets,suchasconvertiblebonds,mixthecharacteristicsofequitiesandbonds,butagain,thefundamentalbuildingblocksremainequitiesandbonds.Manythingscanbetraded,butthatdoesnotmakethemassets.Com-moditiesandartaregoodexamples.Commoditiescanbetraded,andtheactivetradingofcommoditiesmayaddtoone’swealth,butcommoditiesarenotassets.Buyingcommoditiesisneitheraformoflendingnorthecreationofaclaimonadurable(capital)good.Ifsomethingisnotanasset,thenitdoesnothaveafundamentalvalue.Itdoeshaveapricedeterminedbydemandandsupply,andfuturepricesmaybepredictedbyknowledgeable P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld89traders,butthatdoesnotmakecommoditiesanassetanymorethanitwouldmakeaneggplantanasset.Thefundamentalvalueofanassetismerelythediscountedvalueofitsfuturecashflows.Thereexistaplethoraoftextsonfundamentalvaluation.Foramorein-depthanalysisofthistopic,wereferinterestedreaderstotheCFAProgramanditscurriculum,5BenjaminGraham’sorDavidDodd’sSecurityAnalysis,andAswathDamodaranInvestmentValuation.6Whileitisusefultodefertothesetextsforthemechanicsoffundamentalvaluation,thereareseveralcriticalaspectsthatweaddress.First,ifeveryassetisvaluedbasedonthepresentvalueoffuturecashflows,theninvestmentstrategiescanbesetonanapples-to-applesbasis.Allassetclasses,whetherequitiesorbonds,canbeidenticallyevaluated.ItiscommoninthefinancialindustryforequityinvestorstolookatPEratios,PEGratios,andotherfundamentalvariables,whilebondinvestorsevaluateyieldspreads.Theproblemisthatfundamentalequityvariablesarenotthesameasfundamentalbondvariables,preventingequitymarketsandbondmarketsfrombeingcomparedonanequalfooting.Thus,inordertosetmacrostrategiesacrossassetclasses,allassetclassesarepreferablyvaluedinexactlythesamemanner—discountingfuturecashflows.Thisenables,forexample,JapanesebondstobecomparedequivalentlywithGermanequitiesasinvestmentalternatives.Second,valuationis,tothegreatestdegreefeasible,asnapshotofthecurrentsituationfromtheperspectiveoftheinvestor.By“snapshotofthecurrentsituation,”wemeantheconcurrentcalculationofthefundamentalvaluesofallassetclasses.Withinthevaluationprocessthereisanembeddedforecastofcashflowsandanestimateoffutureuncertaintyunderpinningdiscountrates,butfundamentalvalueisameasureataspecificinstant.Thesefundamentalvaluescanbecomparedtomarketpricesatexactlythesamemomentintime.Thus,alldiscrepanciesbetweenmarketpricesandfundamentalvaluescanbecomparedacrossallassetclassesonaconsistentbasis.Moreover,theycanbecomparedwithpriceandvaluediscrepanciesatanyotherpointintimeonaconsistentbasis.Third,thekeyrolefortheCIOemployingthisapproachismaintain-ingadisciplinedadherencetothefundamentalvaluationprocess,ensuringtheintegrityoffundamentalvaluationmodels,andfosteringevolutioninre-sponsetonewanalyticaltools.Maintainingdisciplineisbynomeansaneasytask.Thegreatertheneedfordiscipline,thestrongerthetestoftheCIO’sandeachinvestmentprofessional’swill.LetusconsiderBenjaminGraham,thefatheroffundamentalanalysis.JasonZweigwrotein“TheIntelligentInvestor”columnofTheWallStreetJournalduringthe2008financialcrisis,“Eventhegreatestinvestorshavefeltthesamekindoffearandpainyouareprobablyfeeling.Forproof,looknofurtherthanSecurityAnalysis.... P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford90INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTGrahamwasoneofthebestmoneymanagersofthe20thcentury,abrilliantanalystandmarkethistorian,andWarrenBuffett’smostinfluentialteacherandmentor....Grahamhimselfstucklargelywithstocksinhisinvest-mentfund.Butattheconclusionofhisbook,headvisedtheinstitutionalinvestorsamonghisreaderstoshunthestockmarketentirelyandinvestinbonds.Grahamdoubtedtheycouldstomach‘theheavyresponsibilitiesandrecurringuncertainties’stirredupbystocks.”7Withinthesimplethree-stageprocessadoptedinthisbook,fundamentalinvestorsbeginbyvaluingassets.Historically,knowingfundamentalvaluesforassetsprovidedasignificantedge,butseveraldevelopmentshavealteredthatenvironment.Forseveraldecades,theCFAInstituteandnumerousuniversitygraduateprogramshavechurnedouthundredsofthousandsofindividualswhoarewellschooledintheartandscienceofvaluation.Know-inghowtodeterminethefundamentalvaluesofassetsmakesananalystoneofalarge,similarlytrainedcommunity.Therearestillvaluationadvantagesthatcanbegarneredthroughhardworkandanalyticalinnovation,buttheopportunitiesaremorelimitedthanwaspreviouslythecase.MARKETBEHAVIORANDHOWITCHALLENGESTHEFUNDAMENTALINVESTORToday,thefundamentalinvestmentprocessmustextendbeyondassetvalu-ation.Infact,futureopportunitiesfortheinvestmentcommunityarelikelytoresidemoreinsuperiorunderstandingofmarketbehaviorandportfo-lioconstructioncompetencethaninfundamentalanalysis.Behavioralandportfoliodesignadvantagesderivenotonlyfromthefactthatpricescandeviatefromfundamentalvaluesforlongperiodsoftimeandbydestructivemagnitudes,butalsobecauseportfoliosolvencycanbethreatenedbydevia-tionsbetweenmarketpricesandfundamentalvaluesforassets.Fundamentalvaluationisnecessary,butitisnolongersufficient.Themarketcanstayirrationallongerthanyoucanremainsolvent.—JohnMaynardKeynesMarketBehaviorandLargeEvents:TheFirstChallengetoFundamentalValueInvestingThesecondcomponentofthethree-stepinvestmentprocessismarketandteambehavioranalysis.Thisisatopicthathasgainedincreasingpopularityinthepastcoupleofdecades.Overthisperiod,theindustryhasbeenpep-peredwithanendlessstreamofanecdotesandstoriesabouthowindividual P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld91investorsmakemistakeswhenpresentedwithvariousgames.Whilethisisanoftentalkedaboutsubject,mostinvestmentprofessionalsneverseemtogetpasttheanecdotestotheorydevelopment.Moreover,therewasalotwrit-tenaboutindividualbehavior,butmuchlesswrittenaboutgroupbehavior.Withoutquestion,therehavebeensomeseminalbooksoncrowdbehaviorandmanias,beginningwithCharlesMackay’sbookoriginallytitledMem-oirsofExtraordinaryPopularDelusions,publishedin1841.8Somewhatmorerecently,in1978,CharlesKindlebergerpennedManias,PanicsandCrashes,addressingtheoriginsofsuchevents.Finally,EdwardChancellorpublishedDevilTaketheHindmost:AHistoryofFinancialSpeculationin1999.Thesebookshavelaidthefoundationformodernthinkingoncrowdbehavior,andweconsiderthemessentialreadingforanymacroinvestor.Butitwasnotuntilthreebookswerepublishedinthefirstdecadeofthismillenniumthatwefeltsignificantprogresscouldbemadetoin-corporatecrowdbehaviorintotheinvestmentdecision-makingprocesses.ThefirstbooktobepublishedwasUbiquity:WhyCatastrophesHappen,byMarkBuchananin2000.9Thisbookispopularsciencewritingthatbarelyaddressescapitalmarkets.JamesSurowieckipublishedTheWisdomofCrowdsin2004.10Surowiecki’swell-writtenbookcoversabroadnum-beroftopics,includingfinancialmarketsandtheimpactofcrowdbehavior.Finally,PhilipBallpublishedCriticalMass:HowOneThingLeadstoAn-otherin2004.11Ball,likeBuchanan,isapopularsciencewriter,andCriticalMassrangesfarandwide.Itmovesthroughallmannerofphysicstopics,ad-dressingmarketsandtheinteractionofeconomicagents(theplayersintheeconomy)midwaythroughthebook.However,thebookneveraddressesdirectlytheissueofmarketbehaviorasitimpactsinvestors.Allthreebooksgobeyondchroniclingcrowdeventsandprobetheorigins,orperhapsmoreappropriately,thecontextofinteractiveagents12andcrowdbehavior.Wewillleaveittothereadertoreadoneormoreofthemanystan-dardbehavioralfinancetextbooks.Thestandardtextbooksaddressmentalaccounting,confidencebiases,prospecttheory,andotherstandardtheoriesofindividualinvestorbehavior.13Wefocusonsomenewfrontiersofphysics,physiology,andpsychologytoarguethatfundamentalvaluationprovidesnecessary,butincomplete,informationwhenassetreturnsarenotnormallydistributed.Aspartofthisdiscussion,wearguethattheinteractivityofreasoningindividualscreatescrowdbehavior,whichinturnresultsinthenon-normaldistributionsthatrenderfundamentalvaluationinsufficient.Beforedelvingintomarketbehavior,itisusefultodrawacompari-sonbetweentheanalysisofmarketbehaviorandfundamentalvalue—thefirsttwocomponentsoftheinvestmentprocessthatwehaveputinplace.Asnoted,fundamentalvalueisasnapshotatanypointintimefromthe P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford92INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTperspectiveoftheinvestor.Marketbehavioranalysisshouldbeundertakenonthesamebasis,avoidingforecastsoffuturemarketpricesandotherfundamentalvariables.Assuch,marketbehavioranalysisencompassestheunderstandingofmarketprices,asopposedtofundamentalvalues,fromtheperspectiveofallothermarketparticipantsataspecificpointintime.Inshort,marketbehavioranalysisisanattempttounderstandwhypricesdeviatefromfundamentalvalues.Analystsandacademicshaveobservedforalongtimethatfat-taileddistributionsaremoredescriptiveofassetreturnsthanthemorecommonlyusedsymmetricnormaldistribution.14Beyondthefat-tailconstruct,NassimTalebextendedtheworkofBenoitMandelbrottopopularizethephrase“blackswans”inhis2007booktitledTheBlackSwan:TheImpactoftheHighlyImprobable.15,16Inparticular,ablackswanisalow-probability,high-impacteventthatcouldbeconsideredinconceivable.Itishardtomakeanystatementaboutthedistributionofreturnswhenoneconsidersthepotentialforablackswan.OurindustryowesadebtofgratitudetoNassimTaleb.Theenjoyableinsistenceofhiswritingstyle,repletewithTaleb’sexperiencesandobserva-tions,makesMandelbrotaccessible.WeonlywishthatmoreinvestorshadlearnedthelessonsthatTalebhassoeloquentlytaught.Forsomeonewhoissuchapromoteroftheterrorsofunknownun-knowns,Talebholdstremendouscertitudeabouttheperfectionofhisownideas.Herecommendsthatinsteadofputtingyourmoneyinmediumriskinvestments,youshouldput85percentto90percentinextremelysafein-strumentslikeTreasurybills.Hequalifiesthesafeinstruments,sayingtheyshouldbe“assafeaclassofinstrumentsasyoucanmanagetofindonthisplanet.”Theremaining10percentto15percentshouldbeplacedinex-tremelyspeculativebets,“asleveragedaspossible(likeoptions),preferablyventurecapital-styleportfolios.”Thisisaportfoliodesignednottoblowupfromablackswan(thelossof15percentissufferable),whileatthesametimeproducingasmallreturnday-inandday-outfromthelow-riskinvestment.Thisrecommendation,however,isthinpabulumforinvestorsandshouldbeconsideredanill-informedandill-formedportfolio.Thisport-folioistheequivalentofasurvivalisthidingoutinthemountainsinfearofalow-probabilitycatastrophethatheis,intheend,ill-equippedtocounter.Thisisnotanexistencethatwewouldnecessarilytoutforotherstopursue.Ifthesurvivalist’sportfolioisinappropriate,howcananinvestorincorpo-rateTaleb’sanalysisandinvestforhigherfutureconsumption?Theanswerbeginswiththedeterminationoffundamentalvalue—drawinguponthedistinctionthatwasmadeearlieraboutstockandflowinformation.Theexistenceoffundamentalvalueisastocknumberthatrendersthenewsflow P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld93nonrandom.Whilethenewsmayappearrandomandpushmarketpricesbothawayfromandtowardfundamentalvalues,fundamentalvalueactssomewhatlikegravityinthatitisacontinuouspullonmarketpricesinanonrandomdirection.Blackswans,asTalebpresentsthem,resultfromtherandomflowofnews,ignoringtheimportantstockconceptoffundamentalvaluethatinfluencesnewsanditsinterpretation.Thefirststepinavoidingblackswansistoinvestonlyinthingsthathavefundamentalvalues.Thesecondrequiresanevolutionaryperspectiveoncapitalmarkets,andanappreciationforthefactthat,overtime,there-turnsincurredbyexposurestotheoccasionalblackswanmaybebetterforinvestorsandsociety,evenifincrediblydestructiveblackswansoccur.Eachindividualmustfunctioninthecurrentenvironmentandrealizethatwatch-ingthehorizoninanticipationofablackswaneventisawasteofenergyandresources.Inshort,youdon’tneedtopredictablackswan;youjustneedtoappreciatetheevolvingvulnerability.Talebappropriatelyadvisesagainsttryingtopredictblackswans,suggestingthatitonlymakesyoumorevul-nerabletotheonesthatyoudidnotpredict.Moreover,Talebsuggeststhatblackswans“canbecausedandexacerbatedbytheirbeingunexpected.”Finally,leveragecanbeuseful,butitexposestheinvestortolossesinexcessofinvestedcapitalandcanexacerbateliquiditydifficultiesduringextremeevents.Leverageislikecandy,goodwhenusedinmoderation.Taleb’sviewofmodernportfoliotheorymaybeborneofangeratanalystswhobasetheirquantitativemodelsonassumptionsofnormallydistributedassetpricereturns.Thisangerissomewhatwarranted,butwemustrememberthatmodelsbasedonnormaldistributionsaresimplytools.Let’sagainturntoscienceforaparallelanalogy.Inphysicsclasses,welearnaboutJohannesKepler’sLawsofPlanetaryMotionexplanationfortheorbitsofplanets,eventhoughitiswrong.ThereasonforthisisthatanunderstandingofKeplerprovidesafoundationforunderstandingEin-stein.Itwouldbeinappropriatenottoteachthefoundationsbeforemovingtomuchmorecomplexconcepts.Kepler’smodelsaretoolsthatopenthedoortomanyobservationsandmuchknowledgethatdoesnotrequirethecomplexityofEinstein.Backintherealmoffinance,theassumptionofnormallydistributedreturnsopensstudentstoaworldofhigher-levelfi-nance.Witheachincrementofknowledge,thesestudentscangraspmuchmoreknowledge.And,weallmusthumblyobservethatwearealwaysstudents.Thetheoryespousedinthischapterisbasedonnewadvancesinphysics,psychology,andneuroeconomics,anditprovidesavaluableadvancebeyondTaleb’ssurvivalistdeadend.Talebcharacterizedhistoryasopaque:Weob-serveasingleseriesofpricechangesperhapsleadingtoacatastrophicblackswanevent.Similarly,tumblinggrainsofsandmayleadtoanavalanche,but P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford94INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTwecannotobservetheinfinitenumberofseriesoffallinggrainsofsandandsandpilesthatdidnotoccur.Thetheorysupportedhereviewshistoryastranslucentratherthanopaque.Theevolutionofasequenceofpricechangesrewardscertaincharacteristicsinthemarketplace,justasevolutionrewardscertaincharacteristicsoflivingcreatures.Thesequenceleadsinexorablytoasystemicvulnerabilitythatcanbeanticipated,evenifthespecificeventcannotbepredicted.Normallydistributedreturnsindependentof,andidenticallydistributedto,priorreturnsmakefundamentalvaluationofassetsorassetclassessuf-ficientforlonghorizonfundamentalinvestors.Evenifweassumefat-tailedreturndistributions,thelonghorizoninvestorwouldprobablystillbeinprettygoodshapeusingonlyfundamentalvaluation.Itisoncewebegintoconsiderthepotentialforblackswans,andcomprehendtheevolvinghistory,asopposedtoopaquehistory,ofsomeblackswans,thatthepowerofourrecommended“vulnerabilitymodel”ofmarketbehaviorcomesintoplay.Historybecomestranslucenttothetrainedandexperiencedinvestmentteam.Theproposedtheorytakesastepbeyondthepriorassumptionsofnor-malreturns,fat-taileddistributions,andinconceivableblackswans.Thetheoryembracesthefactthatgroupbehaviorissignificantlyimpactedbytheinteractionofreasoninggroupmembers.Figure5.3providesaroadmapforthediscussion.Non-InteractiveAgentsInteractiveAgentsHistoryIsOpaqueHistoryIsTranslucentThinkingPowerLawFat-TailedInteractiveNormalReturnFramework&Return“BlackSwans”Agents&DistributionsEvolutionaryDistributionVulnerabilityModelsModelFIGURE5.3RoadmapforBuildingtheBehavioralResearchFramework P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld95MarketBehaviorandUnknownValue:IsThereEquilibrium?Thissectiondevelopsatheoryforaccommodatingcrowdbehaviorinthemacroinvestmentdecision-makingprocess.Thetheorybeginsfirstwithconceptsdevelopedinphysicsoverthelast10to15years.Theseconceptsdescribeevolution,avalanches,earthquakes,andotherblackswanevents.Thetheoryisextendedbeyondsimpleinteractiveagents,suchasgrainsofsandleadingtoanavalanche,toreasoninginteractiveagents,suchaspeople,leadingtomanias,bubbles,crashes,andothersignificantmarketevents.Eachassethasanintrinsicfundamentalvaluereflectingitsfuturecashflowpotential.Unfortunately,uncertaintyaboutfuturecashflowsrenderstruefundamentalvalueunknowabletomarketparticipants.OnecouldaskwhowouldhaveeveranticipatedtherapiddemiseofLehmanBrothers?Clearly,theoutcomewaspossible.Infact,itoccurred.Analystsmayormaynothaveanticipatedthatoutcome,butthatfailuremaysimplyreflectaninabilitytoimaginethedemisescenarioorcomprehendtheevolvingrisk.Whileahigherbeingmayknowfundamentalvalue,analystsendeavoreverydaytodevelopingfuturecashflowprojectionsthatarediscountedtodeterminetheirestimatesoffundamentalvalue.Figure5.4demonstratesanasset’struefundamentalvalue,andpricesandperceivedfundamentalvaluesovertime.Themarketsimultaneouslyaggregatesevolvingunderstandingofpriornewsandinstantaneouscom-prehensionofnewinformation.Theprogressiveunderstandingofpriorinformationprovidesacontinual,gentleforcethatpullspricetowardfunda-mentalvalue.Thisprocessisslowandmodestrelativetoinstantaneousreac-tionstonewinformationand,therefore,hasalargelyundetectableinfluenceonprice.Regardless,thecontinualpulldrivespricestowardfundamentalvalues.Sophisticatedanalystsdevelopknowledgeableestimatesofthetruefun-damentalvalueofanasset.Inaggregate,wemightsaythatthemarkethasaperceptionoffundamentalvaluebasedontheanalysis,communication,andpersuasionofthesesophisticatedanalysts.Theperceivedfundamentalvaluevariesaroundthetruefundamentalvaluethatisultimatelyunknowable.Sincetheseanalystsarenotindependentofeachother,theyoftenadoptsimilarviews.Inaggregate,acrossthesophisticatedinvestor,thelackofin-dependencefrequentlyresultsinconsistentbiasesandsystematicdeviationoftheirfundamentalvalueestimatesfromtruevalue.Moreover,themarketatlarge,comprisingbothsophisticatedandunsophisticatedinvestors,ef-fectuatespricesthatdeviatefromtruefundamentalvalueevenfurtherthanperceivedvaluesgeneratedbysophisticatedanalysts. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford96INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTPricePerceivedTrue,butunknowablePricefundamentalvaluefundamentalvalueTimeFIGURE5.4FundamentalValueandPriceHavethecourageofyourknowledgeandexperience.Ifyouhaveformedaconclusionfromthefactsandifyouknowyourjudgmentissound,actonit—eventhoughothersmayhesitateordiffer.(Youareneitherrightnorwrongbecausethecrowddisagreeswithyou.Youarerightbecauseyourdataandreasoningareright.)—BenjaminGrahamSincetruefundamentalvalueisunknowable,andpricenoiseiscom-poundedbyunsophisticatedinvestors,canfundamentalvaluereallybeanattractiveforceonmarketprice?Alternatively,onecouldarguethatevery-thingisdeterministic,andstatistics,suchasfundamentalvalueexpectations,aremerelyhumans’meansofparameterizingtheirignorance.Ifvaluesandbehaviorsaredeterministic,whichwedonotbelieveisthecase,despitetheargument’sviability,thenanalystsaresimplyignorantofthefactandusestatisticalanalysistoimproveunderstandingoftheunknown.Obviously,thisdiscussioncanbecomequitephilosophical,butaslongastruefundamentalvaluesexist,knownornot,exchangesofassetsinamarketplaceexist,andendeavorsofmarketparticipantstounderstandfundamentalvaluesoccurs,thereexistsaconvergentforce.Thisforcemaybesmallandfrequentlydominatedbyshort-termnoise,butitdoesexistanddoespullpricestowardvalues. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld97Atanypointintime,analysts’estimatesoffundamentalvaluesarebasedonexistingknowledge.Marketparticipantsshouldexpectpricestogravitatetowardtheanalysts’perceptionsoffundamentalvalues.Thereisadvantagetobuyingassetswhentheirpricesarebelowtheanalysts’perceivedfundamentalvalues,andthereisadvantagetosellingassetswhentheconverseistrue.Suchbuyingandsellingwouldreflectabehavioraledge,butnotaknowledgeedge.Aknowledgeedgewouldarisefromdetermininganassetvalueestimatethatissuperiortothatofsophisticatedanalysts.Mandelbrot’sinterestinpricebehavior,andTaleb’ssubsequentinterestinblackswans,treatsallpricehistoriesidentically.Cottonprices,theorig-inalinterestofMandelbrot,reflecttheeconomicequilibriumofsupplyanddemand.Assetprices,however,reflecttheeconomicequilibriumofsupplyanddemand,buttheyalsoaregroundedbytheweakforceoffundamentalvalues.Onecanpredictcottonandassetprices,butknowledgeofanasset’sfundamentalvalueisdistinctfromtheforecastofitsfutureprice.IwouldsayifCharlieMungerandIhaveanyadvantageit’snotbecausewe’resosmart,itisbecausewe’rerationalandweveryseldomletextraneousfactorsinterferewithourthoughts.Wedon’tletotherpeople’sopinioninterferewithit....Wetrytogetfearfulwhenothersaregreedy.Wetrytogetgreedywhenothersarefearful.Wetrytoavoidanykindofimitationofotherpeople’sbehavior.Andthosearethefactorsthatcausesmartpeopletogetbadresults.—WarrenBuffettToobtainaknowledgeedge,theanalystmustpushtheboundariesofknowledgebeyondwhatiscurrentlyknowntocapturewhatisunknownbutknowable.Thisistheendeavorofhumankind.Therewillalwaysbeunknownunknownsthataffordtheopportunityforblackswans.However,ithasbecomeconvenienttodeclareeverysignificantmarketpricechangeablackswanwhentheunknownwas,infact,knowable.Themorethatmarketparticipantsknow,thelesstheyneedtoparameterize,orcharacterize,theirunknownswithstatistics.However,intheirquestforknowledge,analystsshouldneverforgetthattherelikelyareunknownsthatarenotknowableinanyrelevanttimeframe.Thisawarenessallowstheanalysttoavoidrejectingfactsthatdofitintheanalysiswhentheystarttoappear.SeeFigure5.5.Evolutionofpricehistoriescreatesaknowablevulnerabilityinthemar-ketplace.Thefactthatavulnerabilitybecomesknown,however,doesnotmeanthatanoutcomebecomespredictable,butitdoesmeanthatwecanunderstandheightenedriskforlargemagnitudeevents.Forexample,weknowCaliforniaisvulnerabletoearthquakes,yetwecannotpredict P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford98INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTKnownKnown–UnknownUnknown–UnknownValueoftheDowFlipofCoinYesterdayDate:JustbeforeDate:Todaytossingthecoin9/11TerroristAttacksDate:9/10/2001ReturnoftheDowinTenYearsDate:TodayTheNextReturnoftheDowPresidentTomorrowoftheUnitedStatesDate:TodayDate:October25thFIGURE5.5BodyofKnowledgeexactlywhentheywilloccur.Untilwefullyunderstandthisvulnerabil-ity,scientistsmustdrawuponothermeanstofurthertheirunderstandingandmanagerisk.Similarly,marketsarevulnerabletohugeevents,butourabilitytoidentifytruevaluesislimited.Ourabilitytounderstandevolvingmarketvulnerabilitybyanalyzingthebehavioralresponsesofmarketpartici-pantstoassetpricedeviationsfromfundamentalvaluesimprovesourinvest-mentedge.MarketBehaviorandEvolution:AStepBeyondBlackSwansAnenormouscraterishiddenunderthewateroftheGulfofMexicoandthegroundoftheYucatanPeninsulainMexico.Thiscrater,createdbyacometthatcollidedwiththeEarth65millionyearsago,isalmost200kmindiameter,butcannotbeseenduetomanymillenniaofdustanddebrisaccumulation.Analysisofsoilsamplesaroundtheworldindicatethattheinfluenceofthiscollisionspannedtheentireearth,extinguishing95percentofallspeciesatthattime.Thisextraordinaryeventeliminatedallmannerofdinosaurs,anditallowedmanysmalleranimals,suchasmammalsandreptiles,tosurviveandbegintothrive.17Thisscenarioseemstomakesense.Atremendousimpactfromthecometaffectedtheatmosphereoftheentireworldanddrovemostspeciestoextinction.However,thisisnottheonlydocumentedevidenceofEarth P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld99sufferingsuchatremendousimpact.Thereisevidenceofa100kmcraterinSiberiaandanotherslightlysmallercrateratthemouthoftheChesapeakeBayintheUnitedStates.Theseweremadeabout35millionyearsago,apparentlybycometssmashingintoEarth.Theconundrumisthatfossilrecordsshowabsolutelynothingunusualintermsofspeciesextinctionatthattime.Evenmoreconfusing,thereisevidenceofmassextinctions210,250,365,and440millionyearsago.Yetthereisnoevidenceofanysignificanteventthatwasthecatalystfortheseextinctions.Wemayeventuallyfindsomecausalevent,butatthispointintimeweareunawareofanythingsimilartothecometthatcrashedintoEarth65millionyearsago.Whydidtheextinctionsoccur65millionyearsago,butnot35millionyearsago?Whatcausedthem210or440millionyearsago?Tounderstand,wewillneedtolookattheprocessofevolutionandthevulnerabilityitcreatesasitrewardscertaincharacteristicsthatallowspeciestothriveandpunishesothersthatcausespeciestodisappear.Tohelpunderstandthisevolutionaryprocess,wecreatedahypotheticalexampleofanimalevolution.Weaccompaniedthishypotheticalscenariowithdiagramstoaidinvisualizingtheimportanceofevolutionincreatingenvironmentalvulnerability.Inthisexampleweassumethattheenviron-mentgoesfromanormalclimatetoacolderclimateandsustainsthatcolderclimateforalongtime.Figure5.6showstheinitialnormalclimate5432AbilitytoThrive105041322Hair314Fat5FIGURE5.6Evolution:NormalClimateEnvironment P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford100INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTenvironment.Animalshavehair,somethickandsomethin,aswellasfat,againsomethickandsomethin.Thedistributionofeachanimal’sexposuretothesecharactericsisbothrandomandnormal.Generallyspeaking,astheenvironmentgetscolderoveranextendedperiodoftime,animalswithmorehairandmorefatsurviveandthrive.Conversely,animalswithverylittlehairandnotmuchfatbegintodisappear.Figure5.7portraysthelatephaseofthecoldenvironment.Aswecansee,animalswithmorehairandfatflourish,andthepopulationevolvestoevidenceafitnesspeakforanimalswiththesecharacteristics.Whilethisevolutiontowardmorehairandmorefatoccurs,let’sassumethatglobalwarmingacceleratesandtemperaturesriserapidly,perhapsoveracoupleofdecades.Additionally,assumethatthiswarmingcreatesalandbridgeconnectingthecoldenvironmentwithalandmasswherethereexistsapredatorthathasbeenrewardedbyevolutionforitsspeed,ratherthanforjustthickhairandmorefat.Itisnotthestrongestofthespeciesthatsurvives,northemostintelligent,buttheonemostresponsivetochange.—CharlesDarwinThesefleet-footedpredatorsfindthemselvesinheaven,foraroundthemtheyseenothingbutfat,lumberingcaloricpackagesuponwhichtheycangorge.Theenvironmentnowrewardslesshair,lessfat,andspeed.Sothe5432AbilitytoThrive105041322Hair314Fat5FIGURE5.7Evolution:LatePhaseofColdEnvironment P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld1015432AbilitytoThrive105041322Hair314Fat5FIGURE5.8Evolution:FastPredatororHotClimateEnvironmentslowestofthecreatures,perhapsthosewiththemosthairandfat,nowfindthemselveseliminated,asshowninFigure5.8.Ifglobalwarminghadoccurredatanearliertime,beforeevolutionhadrewardedthickhairandmorefat,thentheintroductionofanewpredatorwouldnothavebeencatastrophic.Butovertime,theanimalsironicallybecomeincreasinglyvul-nerableforadoptingtheexactcharacteristicsthatenabledthemtothriveinthecoldenvironment.Thisisnottoofar-fetched.DodobirdsontheislandofMauritiuswereeliminatedbypredatorsintroducedtothatenvironmentbyhumans.Thedodobirdevolvedtobeflightlessandfearlessonanislandthatwasiso-latedfromitspredators.Whenhumansarrived,thebirdswerehuntedtoextinctionbyhumansandthepredatorstheybrought.Torealizetheprecariousnessofthesituationdoesnotrequirepredictingtheintroductionofafleet-footedpredatororglobalwarming.Allthatisneededistorealizethatanimalswell-suitedtooneenvironmentmaybevulnerableinadifferentenvironment.Theadaptionprocessoccursslowlyandevolvescharacteristicsthatenhancesystemicvulnerability.ApplyingTheseEvolutionaryConceptsThatwasalong,andhopefullysomewhatinteresting,discussionofelemen-taryevolutionaryprinciples.Butwhatdoesthishypotheticalscenariohave P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford102INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTtodowithmarketbehavior?Theanswerisanawfullot.Infact,weneedonlylookbacktotheperiodoftimebetween2002and2009tofindanexampleofsuchevolutioninthefinancialarena.Subsequentto2002,capitalmarketswerecharacterizedbybothlowvolatilityandhighliquidity.“Liquidity”canbeadifficulttermtodefine,butweuseabroadinterpretationthatincludesaccommodativemonetaryconditionsandcreditavailability.Overtheperiodfrom2002toearly2007,investorsinitiatedstrategiesthatwererewardedinthisenvironment.Thesepositionsincludedyieldcurveexpo-sure,creditspreadexposure,equityexposure(especiallyhigh-riskequitiessuchasemergingmarketandsmall-capequities),orcurrencycarrytrades.In2007and2008,liquiditydriedupasfinancialinstitutionsbecameconcernedaboutprovidingcredittootherfinancialinstitutionsthatmayhavebeenexposedtotheprecarioussubprimemortgagemarket.Bythesummerof2007,creditspreadsbegantowiden.Thecharacteristicsthathadbeenrewardednolongerwere.Infact,thenewenvironmentoflowliquidityandhighvolatilityfurtherpunishedinvestorsastheytriedtoshedtheirpositions.Insteadofanenvironmentofmutuallyreinforcingbehavior,theenvironmentshiftedtooneofmutuallydestructivebehavior.Theyearsleadingupto2007rewardedinvestorswhoincurredex-posuresthatbenefitedfromtheuniquelow-volatility,high-liquidityenvi-ronment.Theseinvestorswereincreasinglyexposedtoanemerging,andultimatelyafullydeveloped,vulnerability.Investorswhounderstoodthevulnerabilityhadtheopportunitytotakeoppositepositionsandbenefitfromthecollapseofanunsustainableenvironment.Therewere,however,twoproblemswithbeingontheoppositesideofthecharacteristicsthatwererewardedbefore2007.First,contrarianpositionswerenot,andwouldnot,berewardeduntiltheenvironmentchanged.Predictingthetimingofthechangewasdifficultatbest.Second,thesteadyflowofnewparticipantsinthestrategiesthatwererewarded,andtheexitofparticipantsinstrate-giesthatwerenotrewarded,ledtoareflexiveresponseofmarketpricesthatfurtherperpetuatedtheunsustainableenvironmentandpenalizedanycontrarianbehavior.Buchanan’sUbiquityandBall’sCriticalMassprovideinsightintotheevolutionarybehaviorofmarketpriceandassistourbehavioralanalysis.Buchananpointsoutthat,“Evolutionaccomplishesitsendsthroughthetripleactionofvariation,selection,andreplication.Inanypopulationofrabbits,forexample,somewillseebetter,runfaster,orthinkquickerthanothers.Thisisvariationbroughtaboutbytheprocessofmutation.These‘fitter’rabbits(i.e.,thosewiththeadvantageousmutations)tendtolivelongerandproducemoreoffspringthandoweakerrabbits.Thisisselection.Andbecauseparentspasscopiesoftheirgenesdowntotheiroffspring,thenextgenerationalmostcertainlycontainsagreaterproportionoffitter P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld103rabbitsthandidthelast—aconsequenceofreplication.Theoverallfitnessofthepopulationslowlyincreases.”18Itappearsthatthepopulationofmarketparticipantsfollowsasimi-lartriple-actionprocess.19Ratherthanselectionandreplicationworkingthroughoffspring,theinvestmentpopulationrespawnseachperformanceperiod.Interestingly,andquiteunexpectedly,MarkBuchananpublishedanarticleabouttheevolvingenvironmentduringthedraftingofthistext.OnOctober1,2008,asglobalequitymarketsperchedattheedgeofanabyssintowhichtheywouldfallacoupleofdayslater,Markwrote“ThisEconomyDoesNotCompute”forTheNewYorkTimes.Buchananob-servedthateconomistswerecartingouttraditionalequilibriumtheoriestounderstandmarketdevelopments,assumingmarketshave“norealinternaldynamicsoftheirown.”Reflectingontheinteractiveagentsinfinancialmarkets,Buchananreferstomarketsas“self-propellingsystemsdriveninlargepartbywhatinvestorsbelieveotherinvestorsbelieve.”ReferringtoanagentmodeloftheeconomybytheYaleeconomistJohnGeanakoplos,alongwithtwophysicists,DoyneFarmerandStephanThurner,Buchananstates:Inthemodel,marketparticipants,especiallyhedgefunds,dowhattheydoinreallife—seekingprofitsbyaimingforeverhigherlever-age,borrowingmoneytoamplifythepotentialgainsfromtheirinvestments.Moreleveragetendstotiemarketactorsintotightchainsoffinancialinterdependence,andthesimulationsshowhowthiseffectcanpushthemarkettowardinstabilitybymakingitmorelikelythattroubleinoneplace—thefailureofoneinvestortocoveraposition—willspreadmoreeasilyelsewhere.That’snotreallysurprising,ofcourse.Butthemodelalsoshowssomethingthatisnotatallobvious.Theinstabilitydoesn’tgrowinthemarketgradually,butarrivessuddenly.Beyondacertainthresholdthevirtualmarketabruptlylosesitsstabilityina“phasetransition”akintothewayiceabruptlymeltsintoliquidwater.Beyondthispoint,collectivefinancialmeltdownbecomeseffectivelycertain.Thisisthekindofpossibilitythatequilibriumthinkingcannotevenentertain.20Marketparticipantsactedrationally,respondingtotheirincentivesandbringingthefinancialsystemtoadisequilibriumcriticalstatethatsurvivedforyears.Likeanavalanche,thesystemcamecrashingdowninasuddenphasetransitiontoinstability.Thefinancialsystembecamemorevulnerableasagentsadoptedcharacteristicsthatwererewardedinthemarketplaceinacompetitiontothriveandsurvive.Alltheregulationintheworldwillnot P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford104INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTprecludefuturefinancialcrisesanymorethantheycanpreventagentsfromrespondingtotheirincentives.Asforestfiresresultindeadwoodstrewnacrosstheforestfloorandaforestthatisincreasingvulnerabletouncon-tainablefires,regulationstendtocreatedeadwoodmarketparticipantswhodothesamefortheworldfinancialsystem.Occasionalcrisesareahealthmeansforfinancialsystemstoweedtheweakandfraudulentplayers.ThephasetransitiontoinstabilityofafinancialsystemwasdocumentedandresearchedbyHymanMinsky,aneconomistatWashingtonUniversityinSt.Louisuntilhisdeathin1996.Minsky’s“financialinstabilityhypoth-esis”statesthatsuchinstabilityisinherentinthefinancialsystem.Stability,heobserved,isinherentlydestabilizinginexactlythewaythatBuchanan,Geanakoplos,Farmer,andThurnerhypothesize.ForMinsky,stabilitycre-atesvulnerabilityasdebtbegetsmoredebtandmoreunstabledebtstruc-tures.Thefinancialsystemreachesacriticalstatethatisvulnerabletocol-lapse,the“MinskyMoment.”Whiletimeisnotthecriticalfactor,thelongerthefinancialsystemisstable,themoremarketparticipantsadoptrewardedcharacteristicsandthegreaterthevulnerabilitytoaMinskyMoment.StopDancingbeforetheMusicStopsThisevolutionaryanalogyplaysitselfoutrepeatedlyintheinvestmentworld.Howdoyouavoiddisappearingifyouhavelittlefurandinsufficientfatincoldtimes?ChuckPrince,theformerCEOofCitigroup,waspressuredtoresignin2007shortlyafterthebank’ssubprimelosseswereexposed.IfPrincehadnot“dancedwhenthemusicplayed,”wouldhehavebeenfiredbymyopicshareholderslongbeforethesubprimedebaclehadrunitscourse?BrinsonPartners’experienceinthelate1990sdemonstratestheconverseexample.Ratherthantakepartinthetech-buyingfrenzyanditsrallyingmomentum,thefirmeschewedthehigh-flyingsector.Asaresultitlostroughly40percentofitsassetstoclientwithdrawalsin1998and1999asitlaggedtheperformanceofadot-comdominatedS&P500index.Whatcanbedone?Unfortunately,afoolproofsolutiondoesnotexist.Rather,abroadarrayofresponsesmustbeused.First,inmanaging“otherpeoples’money,”continual,transparent,andtrustworthylinesofcommu-nicationmustbemaintainedwithinvestors.Puttingresultsinthebestlight,forexample,shouldbeavoided.Spinisashort-termpalliativethatoftenresultsinlong-termdistressforallparties.Second,theworst-casescenarioshouldalwaysbeportrayed,regardlessofassetclass,ascompleteloss.Theonlythingthatchangesistheprobabilityoflosingeverything.Higher-riskassetshaveahigherprobabilityofcompletelossthanlower-riskassets.Evencashunderthemattressisariskyposition. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld105TheGermanswitnessedthehighestdenominationoftheircurrencygofroma50,000Marknotein1922toa100,000,000,000,000Marknotein1923.Thatold50,000Markbillretrievedfromunderthemattressin1923wouldnothavebeenveryuseful.Marksweremorevaluableasfiretenderthantheywereforconsumption.Theinflationratewas3,250,000percentpermonthin1923.Nottobeoutdone,theGreeksaccomplishedaninflationrateof8,500,000,000percentpermonthin1944.Inflation-protectedsecuritiescanexperiencedefault,eveniftheprincipalvaluecannotbeinflatedaway.Investorsmustunderstandthatthereisthepotentialforextremeloss,andtheymustnotholdanymisguidedperceptionthataninvestmentisriskfree.Wewilldiscusshowtoproperlyeducateclientsonthisrealityinthenextchapter.Third,portfoliosmustbemanagedwithinacceptableriskparameters.Pricesmaybefurtherawayfromfundamentalvaluesthantheyhaveeverbeen,butthatdoesnotmeanthatthediscrepancycannotbecomelarger.Diversificationmustbeacrossnotonlyassets,butacrossbehavioralas-sumptions,riskmodels,investmentphilosophies,andsoon.Finally,fatandfurrycreaturesmayneedtolearnhowtoshaveandtodiet,veryquickly.Lumbering,slowinvestors,likethelargeandcomplexfirmsmentionedinChapter1,arealwaysvulnerabletorapidshiftsincapitalmarkets.Nimbleinvestorsandinvestorswiththefreedomtoreactandpreactwithoutbu-reaucraticapprovalprocessesmaynotcatchthechangeinadvancebuttheyatleasthavetheabilitytorespond.Toshortenresponsetimes,wemaintainwhatwecallthe“canaryportfolio.”Likeacanaryinacoalminethatsuc-cumbstonaturalgasbeforetheminersdo,atthefirstinstanceoftroublethestrategycanbeinstantaneouslyexecuted.Thecanaryportfoliorequiresasimpledecisiontoexecuteandnottheadditionalcomplexityofstrategyformulation.LessonsfromtheFinancialCrisisNowlet’sreturntoourexampleoflowvolatilityandhighliquidityfromtheyearspriorto2007.Asuncertaintygrewregardingfinancialinstitutionsandmarketparticipantsincreasedex-posurestosecuritiesthatbenefitedinthatparticularenvironment,marketsbecamemorevulnerableandinvestorsmoreskittish.Suddenly,inresponsetoaneventthatwouldhavepassedwithlittlenoticeayearortwoearlier,alltheinvestorswhohadtakenoncreditspreadexposure,enteredcur-rencycarrytrades,andbuilthigh-riskequityexposurebegantoexperiencelosses.Itisdifficulttopreciselyidentifythecatalyzingevent.ManycitetheFebruary2007announcementbyHSBCofhigherloan-lossprovisionsonbadmortgages.OtherspointtotheJanuary2007Chapter11filingbyOwnitMortgageSolutions.The3.3percentnationwidemedianhouseprice P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford106INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTdeclineinthefirstquarterof2006mayhavebeenthestrawthatbrokethebacksofOwnit,Ameriquest,MortgageLendersNetworkUSA,NewCenturyFinancial,andCountrywideFinancial.Ofcourse,wecouldiden-tifytheaccommodativemonetarypolicyofAlanGreenspan,whobroughttheFedFundsratedowntoonepercent,thelowestin45years.Yet,theCommunityReinvestmentActresultedinFannieMae’s2000announcementthattheDepartmentofHousingandUrbanDevelopmentwillrequireittodedicate50%ofitsmortgagesecuritizationbusinesstolowandmoderateincomefamilies.Beingextreme,wecouldgoallthewaybacktothe1938creationoftheFederalNationalMortgageAssociation,FannieMae,aspartofFranklinDelanoRoosevelt’sNewDeal.Eachofthesedevelopmentswasanothergrainofsandthatledtotheavalanchethatisnowreferredtoasthe“SubprimeCrisis”or“CreditCrisis.”Whyonegrainofsandcausedtheavalancheandnottheothersisamystery.Clearly,thefinancialsituationhadreachedacriticalstate.Whilenotknowingwhatthecatalyzingeventwouldbe,itwasnottoodifficulttodeterminethattherewerelargegroupsofinvestorsvulnerabletoachangeinthecapitalmarketenvironment.Someinvestorsthathadrealizedthecriticalstateoffinancialmarketspredictedtheimplosionofthesubprimemarket.SomeinvestorsshortedsubprimeandAlt-Acredit,variouscreditspreads,andcurrencycarrytrades.Theseinvestorswhohadshiedawayfromthestrategiesthatworkedinthelow-volatility,high-liquidityenvironmentbecametheultimatewinners—thesurvivors.Inlate2007and2008,financialmarketswerewitnesstothecatastrophicextinctionofmarketparticipantswhofocusedonshort-termreturnsandgarneredcomfortfromhidinginthecrowd.SuchvenerableinstitutionsasBearStearns,LehmanBrothers,MerrillLynch,andothersdisappeared.Thisperiodalsowitnessedthedemiseofanumberofhedgefunds,includingFocusCapital,PelotonPartners,SowoodCapitalManagement,andOspraieFund.InTheWallStreetJournalonTuesday,September16,2008,JeremySiegelwasspotoninhisunderstandingandcharacterizationofthisevo-lutionaryprocess.“Fewwerewillingtoadmitthatsubprimerealestateloanscouldbeasriskyasequities.Itwasjusttooprofitabletoissuethesemortgages.Soeyeswereclosedandthemoneykeptpouringin.Groupthinkprevailed.ToparaphraseJohnMaynardKeynes,itismucheasierforamantofailconventionallythantostandagainstthecrowdandspeakthetruth.”21Beingpartoftheherdandparticipatingingroupthinkmightfeelgoodintheshortrun,butabsentahealthydoseofluck(whichafterthefactwouldbedeemedskill),itismorethanlikelydestinedforfailure.Standingagainstthecrowdbyadheringtothetruthoffundamentalvaluecanbeverypainfulandcanevenmaketheprudentinvestorappeartobestupid,butitisafoundationelementofsuccessfullong-terminvesting. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld107Thedifficultyliesnotinnewideas,butinescapingtheoldones,whichramify,orthosebroughtupasmostofushavebeen,intoeverycornerofourminds.—JohnMaynardKeynesMarketBehavior:NoiseandTimeHorizonsIntheshortruninvestorsareoftenmotivatedbythenoise.Investorshaveatremendousincentivetocaptureshort-rungains,eveniftheyincuranincreasinglylargeexposuretoanemergingmarketvulnerability.Whenev-erythingblowsup,thecommonrefrainsare“therewasnohistoricalprece-dent,”“theeventwasasix-sigmaeventthatcouldnothavebeenexpectedbyanybody,”oreven“thiswasanactofGod.”Foratruefundamentalinvestor,theserefrainsringhollow.Donotwishforquickresults,norlookforsmalladvantages.Ifyouseekquickresults,youwillnotreachtheultimategoal.Ifyouareledastraybysmalladvantages,youwillneveraccomplishgreatthings.—ConfuciusARomanstatesmanwritingunderthepseudonym“Cato”observedthat,“theremustcertainlybeavastfundofstupidityinhumannature,elsemanwouldnotbecaughtastheyare,athousandtimesover,bythesamesnare,andwhiletheyyetremembertheirpastmisfortunes,goontocourtandencouragethecausestowhichtheyareowing,andwhichwillagainproducethem.”Itneverceasestoamazeusthatmarketparticipantsseemtofallintothesametrapsoverandoveragain.Weshouldnotconsidertheseparticipantstobestupidorirrational;rather,weshouldthinkoftheirbehaviorsasnaturalresponsestoincentivesand,therefore,manageablebyaleaderduringtheinvestmentprocess.Nothingismoreterriblethanignoranceinaction.—JohannWolfgangvonGoetheFewclientsseemenragedoremboldenedenoughtochangethesein-centivessothattheshort-termhorizonofmanagersisnotpursuedattheexpenseofclients.Itisdifficulttofaultmarketparticipantsforsimplyre-spondingtoincentivesthatcomefromtheirclients.Marketsrewardcertainbehaviorsintheshortrun,andclientssupportmanagersintheirpursuitofshort-runprofits.Weshouldexpectmanagerstoalignonthecharacteris-ticsthatarerewardedinthemarketandbecomeincreasinglyexposedto P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford108INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTasystemicvulnerability.Whentheevolutionaryenvironmentchangesandthesecharacteristicsarenolongerrewarded,orareseverelypunished,thesystemicvulnerabilitywillrevealitselfintheresultsofclients,therewardsoflong-terminvestmentmanagersandtheravagesofshort-termmanagers.Togetasenseofhowinvestmenthorizonshavechanged,considertheaverageholdingperiodforstocksmeasuredinyears.BothBain&Co.andSocieteGeneraleprovidecorroboratingevidenceofdeclininginvestmenthorizonsoverthepastfiveorsixdecades22asshowninFigure5.9.Itisouropinionthatthegreatestopportunitiesforinvestmentmanagerstodayoriginateinalonginvestmenthorizon.Somanyinvestmentmanagersfocusonshort-termgainsthatmanyopportunities,requiringthecommit-mentofcapitalforextendedperiodsoftime,remainunder-exploited.Itisnotnecessaryforthelong-horizonmanagertoidentifytheexactcatalystthatwillbringavulnerabilitytoanend.Itisnecessaryonlyforthelong-horizonmanagertostudytheencroachingsystemicvulnerability,identifythedevelopmentofacriticalstate,andtopositiontheportfoliotobenefitfromanultimatetransitiontoanewcapitalmarketenvironment.Inherentinanylong-horizoninvestmentstrategyistherealityofshort-termriskandoccasionallyextremeunderperformance.Theabilitytoweatherthatunder-performance,andincreaseexposuretotheriskfactorthatiscausingtheunderperformance,iswhatconfersopportunitytolong-terminvestors.1098876654inYears(Bain&Co)332AverageHoldingPeriodforStocks211019601970198019902000FIGURE5.9AverageStockHoldingPeriodsDramaticallyDecreasingSource:Bain&Co. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld109MarketBehaviorandCriticalStates:EmpiricalEvidenceShort-termpricechangesinfinancialmarketsthatareinacriticalstatearestrikinglysimilartoanumberofphenomenainphysics.Theyhaveadistinctfeaturewherebythemagnitude,orsize,oftheoutcomeisinverselyrelatedtotheprobabilityofitsoccurrence.Specifically,itissimilartoapower-lawprobabilitydistribution.AccordingtoPhilipBallinCriticalMass,“thebestwaytoshowthepower-lawistoplotthelogarithmofavalanchesizeagainstthelogarithmofitsprobability:thegraphthenbecomesastraightline.”Theslopeofthelineisequaltotheexponentofthepower-law.WeviewthisconceptinFigure5.10.Thissandpileexampleportraystherelationshipofprobabilityandmagnitudeofadisequilibriumsituation.AsBallobserves,despitebeingnonequilibrium,thecriticalstateisastationarystatefromwhichthesystempredictablystrays.23Thisdisequilibriumbutstationarystategoesbythename,“criticalstate.”Buchananobserves,“thelessonisthis:whenitcomestounderstandingsomethinginacriticalstate,mostofitsdetailssimplydonotmatter.Physicistsrefertothisconsiderablemiracleas‘criticalstateuniversality,’andtheprincipalhasnowbeensupportedbythousandsofexperimentsandcomputersimulations.”24BuchananreferstocriticalstateLogarithmofProbability0.1-10.01-20.001-30.0001-4ProbabilityofAvalanche0.00001-51101001000SizeofAvalancheLogarithmofSize0123FIGURE5.10AnatomyofanAvalancheSource:PhilipBall,CriticalMass:HowOneThingLeadstoAnother. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford110INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTuniversalityasoneofthemostprofounddiscoveriesintheoreticalphysicsinthelastcentury.Buchananstates,“Tounderstandanyrealphysicalsysteminacriticalstate,youmayaswellforgetallthereal,messydetailsaboutthatsystem.”Recallourpreviousadmonitiontoavoidthesiren’sappealofmoreinfor-mationandfocusonusinginformationmoreeffectively.Despiteignoringthemessydetailsoftherealsystem,westillknowthatthesysteminacrit-icalstate—anon-equilibriumbutnonethelessstationarystate—willdisplaypredictablecriticalbehavior.Animportantaspectofthecriticalstateisthatanysystemnearitscriticalstateisextremelyresponsivetodisturbances.Tohelpsimplifythisconcept,imaginedroppingonegrainofsand,followedbyanothergrainofsand,andsoonuntilapileofsandarises.Eachtimeanewgrainofsandlandsonthepile,theexistingpileshiftsalittlebitandsmallgroupsofsandshiftdownthesideofthepile.Occasionally,anavalancheofsandbringsdownamajorportionofthepile.Thissandpileisinastationarybutprecariouslycriticalstate.Theobservedseriesoffallinggrainsofsandisoneofaninfinitenumberofseriesthathistorycouldhaveprovided.Itisimpossibletopredictwhichgrainofsandwillresultinanavalanche.Moreimportant,itisimpossibletolookatthehistoricalsequenceofgrainsofsandtodeterminewhichonewouldinfactcausetheavalanche.Weobserveoneoutcome—theseriesofgrainsdroppedonthepile—leadingtoanavalanchefromaninfinitenumberofotheroutcomesthatmayormaynothaveresultedinavalanches.Thesandpilesystemreachesacriticalstate.Inthecriticalstate,eachgrainofsandmayresultinarangeofdisturbancesfromamerejostlingofanadjacentgrainofsandtoafull-fledgedavalanche.Thepower-lawfunctiontellsusthatthelogofthemagnitudeoftheseeventsisinverselyproportionaltothelogoftheprobabilityoftheevent.Thecasesofcriticalstateuniversalityhaveanimportantfeature:Eachoftheindividualagents—grainsofsandinasandpile,oraswewilldiscussinamoment,investorsinfinancialmarkets—areinteractiveagents.Theyhavebothattractiveandrepulsiveforces.Grainsofsandhavegravityat-tractingthemtowardeachotherandchargepushingthemawayfromeachother.Similarly,individualagentsinfinancialmarketsinfluenceothersinthemarketplace.Wecanthinkofindividualsinfinancialmarketsasanalogoustograinsofsandfallingonasandpileandthemarketsystemasbeinginacriticalstate.Contrarytoequilibriumfinancialtheory,thestatewouldbenon-equilibriumbutstationary.Eachinvestor’sresponsetoanewpieceofinformation,likeagrainofsandfallingonasandpile,couldleadtoaverysmalljostlingofpricesoracatastrophicavalancheofprices.RecallingTaleb,“historyisopaque.”Witheachnewpieceofinformationwehavenoideawhetherthemarketresponsewillbesmallorlarge.However,fromcriticalstate P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld111universality,wedoknowthatthemagnitudeofmarketresponsewillbeinverselyrelatedtoitsfrequency.WefindthattheU.S.stockmarketpricesdemonstratethepower-lawfeaturesofstationarycriticalstatesintheshortrun,usinghighfrequencydata,butnotoverlonginvestmenthorizons.Overlonghorizons,thesystemgravitatestoanormaldistributionofreturnsthatwouldbecharacteristicofanequilibriumstate.Afeatureofsystemsthatself-organizeintocriticalstatesisthattheyarescalefree.Themagnitudesofscale-freevariationsareindependentofthedurationofthetimeintervals.Thus,ifyougraphDowJonesIndustrialAverage(DJIA)logofdailypricechangessince1885againstthelogoftheprobabilityofthosepricechanges,thechartwouldbeastraightlineandwouldlookthesameifitdepictedmonthly,quarterly,yearly,orotherperiodicdata.Figure5.11showsDJIAdailypricechangemagnitudes(absolutevalues)inagraphdesignedtorevealwhethertheindexlevelfollowsapower-lawdistribution.Theverticalaxisistheprobabilityofadailyreturneventoccurringdepictedonalogscale.Thehorizontalaxisisthedailyreturns,orpricechanges,alsodepictedonalogscale.Thusa1percentreturnoccurredaboutevery10days,about10percentofthetime.Thecirculardotsreflect100%DowJonesIndustrialAverage/daily10%Randomreturns/daily1%0.1%0.01%0.01%0.1%1%10%100%FIGURE5.11StockReturnsDoNotAppearNormallyDistributedSource:SamuelH.Williamson,“DailyClosingValuesoftheDJAintheUnitedStates,1885toPresent,”MeasuringWorth,2008.URL:http://www.measuringworth.org/DJA/. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford112INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTtheactualdataofthestockindexsince1885,andtriangulardotsshowsimulatedresultsforanormaldistributionwithnon-annualizedmeanandstandarddeviationcharacteristicsidenticaltothatoftheactualdailystockmarketreturndata.BallevaluatedS&Pdataoverone-minutetimeintervalsanddiscoveredthatthedatamorecloselyresemblesapower-lawdistributionthananormaldistribution.25Shiftingtodailydata,wefindthatreturnsappearslightlymorenormalthantheperminutedata,but,exceptingfattails,roughlyadheretoapower-lawfunction.Higherfrequency(daily),smallermagnitudereturnsthatwestudiedalsofollowatrajectorythatlooselyresemblesthatofanormaldistribution.Thedotsonthebottom-rightofthechartarelow-frequency(y-axis)andhigh-magnitude(x-axis)dailyreturns.Thedottedovalidentifiestherangeoverwhichthedatafollowatrajectorymorelikepower-lawfunctionthananormaldistribution.ThisfindingisconsistentwiththatofBallinCriticalMass.Thereturnsfromabout1percentto10percentfollowapower-lawfunction,deviatingquitesignificantlyfromthesimulatednormaldistribu-tion.Inthisrange,themarketperchesprecariouslyinanon-equilibrium,butstationary,criticalstate.Inthisstate,eachpieceofinformationcancauseasmallmarketresponseorlargemarketresponsewithoutourabilitytoforecasttheoutcome,andwithoutourabilitytopointtohistorytounder-standthatoutcome.Humilitydoesnotcomeeasilytoindustryprofessionalsorassociatedmedia.Asaresult,theopacityofhistoryisunderappreciatedandeverymarketwiggle,largeorsmall,isdeemedtohavebeencausedbysomeeventorcatalyst.Weshunthecatalystidentificationgame.Itmaybegoodformarketing,butitisbasicallyauselesswasteofinvestmenttime.Catalystsearchinggoesbeyondanalysisformoreinformation,likelytoim-proveconfidencemorethanaccuracy,toanalysisofinformationthatdoesnotexist.Overlongerperiods,unliketheinteractiveagentsofphysics,peopleincapitalmarketsarethinkinginteractiveagents.Thesethinkinginteractiveagentshavetheabilitytolearnreflexivelyfromtheir,andothers,experiences.Overtime,thethinkingprocesscausesthesystemtogravitateawayfromaratherprecariousstationarycriticalstatetowardonethatismoreconsistentwithanequilibriumstateoftheModernPortfolioTheory(MPT).Inthisstate,pricechangesarenormallydistributed.WecanobservethesystemgravitatingtowardanormallydistributedstructurebylookingatannualpricechangedatainFigure5.12.Again,circulardotsrepresentactualpricechanges,andtriangulardotsrepresentthesimulatedoutcomesfromanormaldistributionwiththesamemeanandstandarddeviationastheactualdata.Ratherthanbeingscalefree,thespectacularcharacteristicofthepower-lawwherebyallsub-segmentsarecopiesofthewhole,theannualpricechangedataismorecloselyalignedwith P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld113100%DowJonesIndustrialAverage/annualRandomReturns/annual10%1%0.1%1%10%100%FIGURE5.12AnnualReturnsSource:SamuelH.Williamson,“DailyClosingValuesoftheDJAintheUnitedStates,1885toPresent,”MeasuringWorth,2008.URL:http://www.measuringworth.org/DJA/.whatwouldbeexpectedfromanequilibriumsystem.Inotherwords,theresponseofthesystem(i.e.,pricechanges)isslightlymorepredictablefromtheinformationthatisintroducedtothesystem.Thehistoryisbecominglessopaque.Whilethesophisticatedeyeballtestsuggestsmorebutnotperfectnor-mality,returnscanbestatisticallytestedtodeterminewhethertheyadheretoanormaldistribution.Jarque-Berastatisticstestifthehypothesisofanormaldistributioncanberejectedforagivenempiricaldistribution.Thep-valueofthetestistheprobabilityofobtainingaresultatleastasextremeastheobserveddistribution,assumingthereturnsareactuallynormallydis-tributed.Thus,alowp-valuemeansthatthedistributionisunlikelytobenormal,andahighp-valueindicatesahighprobabilitythatthedistributionisnormal.Table5.1summarizestheJarque-Berap-valuesforvariouspricechangefrequencies.Forfrequenciesof3,5,and10years,itisnotpossibletostatisticallyrejectthehypothesisthatthedistributionofstockmarketreturnsisnormallydistributed.However,thepowerofthetestisgreatlydiminishedbythedeclineindatapointsasthefrequencydecreases.Theprogressionfromshort-termstationarycriticalitytolong-termequilibriumcanbeobservedinquintile-to-quintileplotsofreturnmagnitudes. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford114INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTTABLE5.1Long-termvs.Short-term“Normality”FrequencyJarque-Berap-valueDaily<0.1%Weekly<0.1%Monthly<0.1%Annual3.1%3-Year17.4%5-Year14.8%10-Year>50.0%Thequintile-to-quintile(QQ)plotsinFigure5.13showactualquintilesofreturnsonthex-axisandsimulatedreturnsfromanormaldistributiononthey-axis.Ifthepricechangesfollowedanormaldistribution,thedotswouldfallveryclosetothediagonalline.Aswecansee,asweincreasetheperiodicityfromdailytoweeklytomonthlytoannualtothreeyears,thereisaconvergencetoanormaldistribution;andthustheassumptionsofMPTandfundamentalvaluationtechniques.ReturningtoTaleb,therecordedU.S.equitymarkethistoryisbutonehistoryofaninfinitenumberofhistoriesthatcouldhaveoccurred.Perhapsthehistoriesofallequitymarketsincountriesaroundtheworldwouldbemorereflectiveofhistoricalreality.GiventhattheU.S.equitymarketisbutonehistorythatwasuniquelyuninterrupted,itislikelythattheappropriate0.25Daily0.20.150.1SimulatedReturnQuintiles0.05000.050.10.150.20.25ActualReturnQuintiles(a)FIGURE5.13ReturnPeriodicityandNormalcy P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford0.5Weekly0.450.40.350.30.250.20.15SimulatedReturnQuintiles0.10.5000.050.10.150.20.250.30.350.40.450.5ActualReturnQuintiles(b)0.25Monthly0.20.150.1SimulatedReturnQuintiles0.05000.050.10.150.20.25ActualReturnQuintiles(c)FIGURE5.13(Continued)115 P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford1Annual0.90.80.70.60.50.40.3SimulatedReturnQuintiles0.20.1000.10.20.30.40.50.60.70.80.91ActualReturnQuintiles(d)23-Year1.81.61.41.210.80.6SimulatedReturnQuintiles0.40.2000.20.40.60.811.21.41.61.82ActualReturnQuintiles(e)FIGURE5.13(Continued)116 P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld117futureinvestmenttimehorizonforfundamentalinvestorsismoreontheorderof5,10,oreven15years.Longhorizonfundamentalinvestingislikelytobesuccessfulforacouplereasons.First,thepower-lawdistributionofreturnsfromacriticalstatesys-tembreaksdownashumansbegintothinkmoreobjectivelyandreflexivelyabouteventsandinteractions,compellingthesystemtowardfundamentaltruthandreturnstowardamorenormaldistribution.Drawingfromevolution,themagnitudeofmarketresponsewillbedependentuponthecurrentvulnerabilitythathasevolvedfromthenever-endinghistoricalprocessofinterpretingfacts,constructingreality,andtrans-actingthatresultsinrewardedinvestorbehaviorspersistinginthemarket-place.Aswehavediscussed,thisfostersincreasingvulnerabilityinthesystemasinvestorsgravitatetowardsstrategiesthatarerewardedintheshortrun,increasinglyexposingthemselvestosomemajorevent.Unfortunately,thisdoesnothappenovernight;rather,ithappensslowlyoveraperiodofseveralyears.Asthisprocessevolves,thelonger-termreturnsreflectthecharacteris-ticsofthenormaldistributionthatisatthefoundationofequilibrium-basedfinancialtheories,thebasisforfundamentalvaluation.Second,unlikepriceresponsestorandominformationflowthatisTaleb’sfocus,priceresponsetoinformationinfinancialmarketsisunrelent-inglyinfluencedbythecontinuouspulloffundamentalvalue.Thiscontinualpullisnotsostrongthatpricesreflectfundamentalvaluesinshortperiodsoftime,butthelongerthehorizonthemorewefindthefundamentalvaluesig-naloverwhelmstheshort-termpricechangenoise.Long-termpricechangesarenormallydistributed(moreaccuratelythelogdeviationsarenormallydistributed)aroundfundamentalvalues.Consequently,activelonghorizon,fundamentalportfoliomanagersexperienceidiosyncraticnoiseintheirper-formance,butovertimeskillemergesasthedominantinfluenceonportfolioperformance.Duetothelong-termnatureofthefundamentalvaluation,thefirststepofourinvestmentprocess,itmustbeaugmentedbythesecondstepoftheprocess,marketbehavioranalysis.Marketbehavioranalysistriestowadethroughthelackofobjectivityofmarketparticipantstodiscernwhypricesdeviatefromfundamentalvaluesatanypointintimeandevolvingvulnerabilities.Marketbehavioranalysishasthepotentialtoimprovethetimingandmagnitudeofportfoliostrategies.Itisnotapanacea;however,understandingprice/valuediscrepanciesandmarketvulnerabilitiesprovidesanedgeintheinvestmentprocess.Duringthelow-volatilityandhigh-liquidityenvironmentthatendedin2007,investorsfocusedonshort-runfundamentals,implementedcarryandcreditspreadtrades,andinvestedincomplexsecuritiesthatwereviableonlyinthatenvironment.Inlate2007and2008,thatenvironmentdisappeared P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford118INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTandinvestorsbegantorealizethatthepricesoftheseassetswereincon-sistentwiththeirfundamentalvalues.Theprocessoftransitioningfromalow-volatilityandhigh-liquidityenvironmenttoanewenvironmentwasbynostretchoftheimaginationnormal.Thetransitionwasinfactveryab-normal,resultinginseveredislocationsintheglobalfinancialsystem.Thevulnerabilityevolvedovertime,andthetransitionmagnitudewaslarge.Wereallycouldnotexpecttoanticipatehowthetransitionwouldoccurorwhatthefullmagnitudeofthetransitionwouldbe.Thespecificscenariowasbe-yondcomprehensionand,perhaps,imagination.However,thedislocationassociatedwiththeincreasingvulnerabilitywasplainlyvisibleincapitalmarkets.Thesuccessoflong-termhorizonfundamentalinvestingshouldbeasurprisetonobody.ItisamusingthatWarrenBuffettoftenemergestorevealreasonashestepsintothemaelstromwhenpricesdeviatefromfundamentalvaluesandfearandgreedoverwhelmobjectivity.Buffethastheluxuryofalong-terminvestmenthorizon.Heinvestsinastructurethat,whilenotnecessarilytaxefficient,enableshimtohavealong-termperspective.Mostinvestorsdonothavethisluxury.Perversely,clientshaveatendencytomovemoneyeveryfewyearsinafruitlessattempttoinvestalongsidethe“nextWarrenBuffett.”Interestingly,endowmentsarenowviewedasthemodelstructureatthebeginningofthismillennium.Itisalmostfunnytolistentomarketparticipantsspeakofadoptingthe“endowmentmodel”withoutrealizingthatitsgreatestbenefitisalong-terminvestmenthorizon.Additionally,eachendowmenthasoneclient.Itdoesnotworryaboutflowsinandoutoftheendowmentbasedonpastperformance.Itsbeneficiariesarefarinthefuture,anditinvestsaccordingly.Thereismuchthatwecanalllearnfromthesebasicobservations.TEAMBEHAVIOR:LESSONSFORTHECIOFROMJELLYBEANSANDFREUDFortheCIO,notonlyisfundamentalinvestingcomplicatedbythenuancesofmarketbehaviorthatcreatetheopportunitiesforactiveinvestors,butitisalsoconfoundedbybehavioralissuesoftheinvestmentteam.TherearetwoprimarybehavioralissuesthatanyCIOmustatleastbeawareof,andatbesttrytomanage.First,theCIOmustleveragethediverseskillsoftheinvestmentteam.Thiswouldbeaseeminglysimpleleadershipchallenge,butindividualsoninvestmentteamssufferfromallthesamebehavioralissuesthatcomplicatethemarket.Inparticular,theCIOneedstobeconcernedwithgroupthink,thedominanceofstrongpersonaltiesandcommunicators, P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld119andthelimitedwillingnessofreservedorcontraryinvestmentprofessionalstovoicetheirthoughtsandopinions.TheCIOcanleverageideasproposedinJamesSurowiecki’sTheWis-domofCrowdstomakethemostoftheinformationthattheinvestmentteampossessesatanypointintime.Specifically,theCIOcantakeadvantageofinformationaggregationtoolsthat,whenappliedacrossallindividualsintheinvestmentteam,extractinformationsuperiortothatfromindividualspecialistsorabroadconsensus.Second,FreudianpsychoanalysissuggeststhattheCIOcanplayanim-portantroleincombatingtheadoptionof“phantasticobjects”thatcloudthejudgmentofinvestmentteammembersandskewtheirconstructionofreality.Thephrase“phantasticobjects”comesfromstandardpsychoana-lyticthinking.“Phantastic”referstoanimaginaryscenethatthecreatorhasanunconsciouswishtofulfill.Thecreatoristheinvestor.Theword“object”referstoamentalrepresentation.26Inparticular,whileindividualsharbor-inghopesanddreamsmaybuyintophantasticobjectsovershorthorizons,marketparticipantstendtobecomemoreobjectiveoverlonghorizons,caus-inglong-termreturnstofollowmorecloselytheequilibriumassumptionsofModernPortfolioTheory.TheCIOmustdecidewhenamentalmodelheldbytheinvestmentteamisrealandwhenitishope.Psychoanalysiswouldsuggestthathopeismuchmoreprevalent,andmoreunderstandable,thanmostinvestmentleadersappreciate.Mostpeopleareotherpeople.Theirthoughtsaresomeoneelse’sopinions,theirlivesamimicry,theirpassionsaquotation.—OscarWildeWehavealllikelyplayedagamethatprovidesaprizetotheindividualwhocanguessthenumberofjellybeansinajar.Whatweperhapsdidnotrealizewasthatthebestwaytowinthegameisnottoguessatall.Rather,bywaitinguntilthegamehasnearlyconcludedandsubmittinganestimatethatistheaverageofallthepreviousguesses,wearemuchmorelikelytowintheprize.Theaverageislikelytobeanestimatethatissuperiortoover90percentofallguesses.How?Whatdoesthistellusaboutmarkets?Remarkably,thelessonsimbeddedinthissimplegameareprofound.Asmentioned,aprimarydistinctionoftheCIOandotherleadershipfunctionsistheneedtobesimultaneouslyleaderandpeer.Asleader,theCIOhastheultimateresponsibilityforallinvestmentperformance.Thatdoesnotmean,however,thattheCIOshouldmakealloftheinvestmentdecisions.WehaveworkedinanorganizationwheretheCIOseemedtothinkthatultimateresponsibilitynecessitatedultimatedecisionauthority.WealsohaveexperiencedenvironmentswheretheCIOrealizedhisultimate P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford120INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTresponsibility,butdelegatedauthoritytopositionsandindividualsontheinvestmentteaminordertoleveragetheirdiversityandskills.Itisunques-tionablethatthelatterexperiencewassuperiorinallregards,particularlyinvestmentperformance.Wefindthatnearlyalllargeorganizationspayhomagetodiversity.Un-fortunately,ourexperiencesuggeststhatthemotivationisprimarilypoliticalandlegal.Thatisunfortunate,becausediversityisperhapsoneofthemostpowerfultoolsavailabletotheCIO.Inparticular,diversebackgroundspro-videindividualsontheinvestmentteamwiththeabilitytoconstructdifferentrealitiesfromtheirobservations.WorkingwithahighlydiverseinvestmentteamatUBSGlobalAssetManagementwashighlyilluminatingandverybeneficialtoourinvestmentperformance.Diversityenableseachindividualtodevelopamentalmodelofmarketsandmarketbehaviorthatislikelytobedifferentfromtheseofotherindi-vidualsontheinvestmentteam.Avaluablefunctionofanyinvestmentteamistotakethesemodelsofmarketbehaviorandcomparethem,challengethem,andpotentiallychangethem.Intheend,theteamhastheopportunitytoleveragethediversebackgroundsoftheseindividualsforbetterunder-standingofmarketbehaviorthatisdifferentfrom,andbetterthan,thatofanyindividualontheteam,inparticular,thatoftheCIO.ThetoolsoutlinedinChapters1,2,and3providetheCIOwithavalu-ableedgeinextractingandrewardingthediverseskillsofeachinvestmentprofessional.Additionally,recentresearchhasdiscussedanothertoolthathasbeenknowntoeconomistsforcenturies.Thattoolisthemarket.JamesSurowiecki,inTheWisdomofCrowds,usestheterm“market”inaverybroadmanner.Themarketisaplacewherethesellersofsomethinginteractwithbuyersforapotentialexchange.Bothpartiesmusthavesomethingtheycanofferinexchangefortheretobeapotentialtransaction.Exchangescaninvolvemoneyandgoods,ortheycaninvolvemoneyandinformation.Theycaneveninvolveinformationandinformation.Exchangescanoccurinaphysicallocation,buttheycanbeanonymous.Forexample,theCommod-ityClearingCorporationistheoppositepartyofalltransactionsonfuturesexchanges.Thebuyersandsellersareunawareandunconcernedabouttheother’sidentity.Surowieckidelineatesthecharacteristicsthatmakethemarketsosuccessful.27First,marketsworkbestwhenthereisadiversityofopin-ionstobeaggregated.Truediversityoftheinvestmentteam,likeatUBS,isatremendousassettobeexploitedbytheCIO.TheCIOshouldseekdi-versityamongtheinvestmentprofessionals.Itshouldbeasignificantdriverofhiringandfiringdecisions,howevertheCIOonlybenefitstothedegreethatheorshecanleveragethatdiversity;andthatiswhatthemarketissosuccessfulataccomplishing. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld121Second,theindividuals’viewsandideasmustbeindependent.Interest-ingly,anonymousexchangesprovideforincreasedindependenceasbuyersandsellersarelessabletoinfluenceeachother.Withininvestmentteams,itcannotbethecasethatasingleideaorseveralideassimplytravelthroughtheinvestmentteamlikeachainlettertoberepeatedbyallmembersduringinvestmentstrategysessions.Allindividualsonaninvestmentteamshouldcommunicatecontinually,exchangingideasandmodifyingviews.TheCIOmustmakesurethatinvestmentdiscussionsdrawuponindependentviewsanddonotsimplyratifyacollectiveviewthathastraveledthroughtheteam.Independenceiscritical,andtheCIOmustleveragethatindependence.Theanonymityofblindvotingonideasprovidesa“market”forinformationthatenablesthosewhoexchangeinformationorideastobenefitwithlim-itedmutualinfluence.ThemarketisatremendoustoolattheCIO’sdisposal.Third,decentralizationincreasesthevalueofamarket.Asmentioned,atUBStherewasahighlydiverseteam,drawingfrommanydifferentna-tionalities,educationalbackgrounds,andethnicities.Investmentdiscussionsincludedtheinsightfrommanydifferentcountries.Theinvestmentprofes-sionalswereabletodrawuponuniqueperspectivestheyhadofdevelop-mentsintheirregionsanddevelopmentsinotherregions.ThejobofCIOwastodrawuponthisdecentralizedspecialization.Finally,themarketmechanismprovidesfortheaggregationofdiverse,independent,anddecentralizedviewsofindividualsintheinvestmentteam.ThewayweimplementedthismarketmechanismatUBSwastoconductsurveysofeachindividual.Wewouldtypicallyasksomequestion,forexam-pleviewsonearningsorrecommendedinputstoourvaluationmodel.Theobjectivewastogarnerfeedbackfromthoseindividualsusingthesurveyasanaggregationtoolbeforediscussionofthetopicathand.Byconductingthesurveywewereabletoobtaindiverse,independent,anddecentralizedviewsbeforeourdiscussionstaintedtheseperspectives.Somecompaniesusethistypeofmarketfunctiontomakebetterde-cisions,givingtheiremployeesmoneytotakepositionsonsuchthingsasreleasedatesofsoftwareorthesuccessofmarketingprograms.Thismarketsurveyorvotingprocesscanbeconductedovertime,providingongoinginformationtoandfromindividualsintheorganizationseeingthetopicfromamultitudeofperspectives.Astimepasses,managementhasause-fulsetofinformationtoimprovetheirdecisions.28Itisthisapplicationofthemarkettoolthatweintroducetoimprovetheinvestmentanalysisanddecision-makingprocesses.Thereain’tnorulesaroundhere.We’retryingtoaccomplishsomething.—ThomasEdison P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford122INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTAccordingtoSurowiecki,“Ifyoucanassembleadiversegroupofpeoplewhopossessvaryingdegreesofknowledgeandinsight,you’rebetteroffentrustingitwithmajordecisionsratherthanleavingtheminthehandsofoneortwopeople,nomatterhowsmartthosepeopleare.”29Suggestingthattheorganizationwiththesmartestpeoplemaynotbethebestorganizationisheretical,particularlyinthebusinessworldcaughtupinaceaseless“warfortalent”andgovernedbytheassumptionthatafewsuperstarscanmakethedifference.ItisasifSurowieckihadinvestmentprofessionalsinmindwhenhedraftedthosecomments.OurMarketversusTheMarketSohowcananinvestmentorganizationbestructuredtouseamarkettobeatthemarket?Presumably,themarket,drawinguponthediverseviewsofglobalmarketparticipants,wouldbeunbeatable.However,whenmarketbehaviorgoesastray,thebeneficialcharacteristicsofthemarketdisappear.Themarketbecomesvulnerable,acollectiveviewthatdoesnotreflectadiverse,independent,anddecentralizedsetofviews.TheroleoftheCIOistomakesurethattheinvestmentteamremainsindependentanddoesnotbecomecohesivelyattachedtotheevolvingvulnerabilityofacollectivemarketview.Surowieckinotesthatteamhomogeneityfostersconformity.Itiseas-ierforeachindividualtochangehisorheropinionthantochallengethegroup.30TheCIOmustsupportdissensionandfightconsensus,forcon-sensusdoesnotreflectaninvestmentteam’sdiversity.Consensusoutcomesoftenfeelgoodbecausetheyarethepathofleastresistanceandavoidconfrontation;however,itisourbeliefthatconsensushasnoplaceintheinvestmentprocess.TheCIOmustrewardindependenceanddissent,andtheobjectiveMeritZoneevaluationprocessdelineatedinChapter3isatremendoustool.TheMeritZoneprocessenablesincentivestopenalizeconsensusbehaviorsandrewardconstructivedissent.Asimplerecommendationthatweemploytohelpincreaseindependenceanddiversityistohiresmart,young,andtrainableindividuals.InastructureofcollaborativefreedomfosteredbytheCIO,theseindividualshavetheopportunitytoprovethemselvesandbepromoted.Wedonotrecommendhiringseniorinvestmentprofessionalsintoaninvestmentteam,unlesstheinvestmentteamisdysfunctionalandneedstobecompletelyrebuilt.Asuccessfulinvestmentteamislikelytohavemutuallyacceptablevaluesanddefinedinvestmentphilosophyandprocess.Aseniorinvestmentprofessionalisunlikelytoseamlesslyfitintothatstructure.Thisisnotmeanttosuggesthiringpeoplesimilartothosealreadyintheorganization,afterall,withthat P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld123youwouldlosetheaforementionedbenefitsofdiversity.Whileyouwantdiversityfromthestandpointofculture,ethnicity,education,andsoon,theCIOwantstoavoiddiversityofvaluesandinvestmentphilosophiesandprocesses.Hiringjuniorpeoplehasotherpositiveexternalities.Theycanbetrainedtounderstandtheinvestmentphilosophyandinvestmentprocesses,withoutthehindranceoflegacybiases.Theyareyoungandfulloffreshideas.Theseyoungindividualsdonothaveaplethoraofresponsibilitiesthatresultinguardedbehavior.Rather,theycantakerisk,canbethevoiceofdissent,andcancountertheongoingpropensityforcohesionofthoughtamongtheinvestmentteam.WewouldrecommendbringingyoungindividualsintotheinvestmentteamandusingtheMeritZoneprocesstocoaxandcoachthemintohigherperformanceandgreatercriticality.Successinthisprocesswillcreateapoolofsuccessorsforyourseniorteamasyourorganizationgrowsanditsskillsexpand.InadditiontotheobjectivityoftheMeritZoneprocess,theCIOshouldlookforadditionalwaystoleveragetheskillsoftheinvestmentteam.Inthisregard,wecanlearnfromThomasEdison,whoprovidesagoodexampleofhowaleadercansucceedinthistask.Edisonwasanincrediblyhardworker,buthealsohadabrilliantmanagementstyleinoverseeinggroupsof“muckers,”orinventors.Edisonhimselfwasthe“ChiefMucker,”andoftenhehiredinventorsstraightoutofcollegeandinspiredthemtoworkincrediblylonghoursforworkmen’swages.Theircreativityandproductivitywereastounding.Hewasabletoextractahighlevelofproductivityfromhisworkersinpartbycreatinganenjoyableenvironment.Forexample,EdisonputapipeorganintheMenloParklabforentertainmentduringbreaksthroughoutthedayandwhenmuckersworkedlateintothenight.TheatmospherecreatedbyEdisongeneratedaconstantspiritofinventionandfun.Geniusisonepercentinspirationandninety-ninepercentperspiration.—ThomasEdisonInlearningfromEdison,theCIOcanalsofostercreativityandinspirehardworkbycreatinganenjoyableenvironment.TheconfinesofphilosophyandprocessaffordtheopportunityfortheCIOtoencouragefunandliberatecreativity.Micromanagingwithintheconfinesofthephilosophyandprocessreducesthebreadthofinformationandideas,effectivelyreducingthesizeoftheinvestmentteam.TheCIOshouldinspire,coax,admonish,andsupport,butheshouldnotburdentheteamwithrulesbeyondormicromanagementwithinthephilosophyandprocess. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford124INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTTheCIOversusPhantasticObjectsEarlierinthischapter,weintroducedtheconceptofphantasticobjects.In2008,DavidTuckettandRichardTafflerpublishedanarticleintheInternationalJournalofPsychoanalysisdiscussingphantasticobjectsasameansofunderstandingstockmarketinstability.31TuckettandTafflerbasetheiranalysisonclinicalexperienceappliedtoinstabilityinfinancialmarkets.Theyfindthat,“whenthereisnewsthatrealprospectshavechanged,economicagentsbuyorselluntilpriceschangeinlinewiththeirchangedexpectationsof‘reality.’Insofarasnewinforma-tionisunambiguousandthereareenoughinvestorstocalculateaccuratelyandactpromptly,settingasidetheirpreviousattitudesandviews,anewequilibriumwillbeestablishedinaconsistentandefficientway.”32Fromafundamentalinvestor’sperspective,thisequilibriumisnothingmorethanfundamentalvalue.CWSmithinterviewedseniorWallStreetinvestmentprofessionalsandfoundthattheyoftenwereuncertainoftheirviews,yetseldomadmittedthoseuncertaintiestothepublic.33Eventhoughtheseprofessionalsclaimedtofullyunderstandtheirposition,whenpushedbySmith,theyadmittedthattheydidnothavefullcomprehension.ConsistentwithHeuer’sobservationthatmoreinformationislessvaluablethanusingtheinformationalreadypossessedmoreeffectively,Smitharguedthattheirlackofunderstandingwasnotduetoalackofinformation,butratheralackofexplanations.“Alotofthesecompaniesshouldneverhavegonepublic,”saysThomasMcDonald,anassociateofbillionaireSamZell....“Ithinktheoverzealousbankersconvincedfounderstheirdreamswouldcometrue,andatvaluationstheyneverimagined.”—AntonioRegalado,“Brazil’sIPORushHitsRoughPatch,”TheWallStreetJournal,June20,2008Emotionsandstatesofminddeterminethewayinformationaboutre-alityisprocessed.Excitementoveraconstructedrealityleadstoeuphoriaasinvestorsprojectamentalfantasyofafutureinwhichtheyattainarewardthatisdesiredintheirunconsciousmind,butnotattainableinthemarket.Inthemindsofmarketparticipants,realitymovestoaeuphoricmentalstateofdesireandhope.Thepsychoanalyticmodelarguesthatinthecontextofuncertainty,investmentprofessionals,thinkofbrokeragefirminvestmentstrategistsandTVpundits,donotadmittoaclearlackofcomprehension.Intheseinstances,thereisapreviouslydevelopedmentalstateregardingobjectivefactsandconstructedrealities.However,inthefaceoftheuncer-taintyandambiguityobservedbySmith,thisrealityshiftstoanunrealistic P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld125“reality”thatreflectsthelatentdesiresoftheindividual.Thetechbubbleprovidesanexcellentand,asFigure5.14demonstrates,aremarkablytypi-calexample.Internetsharesultimatelyacquiredthequalitiesofphantasticobjectsandinvestorswere“unconsciouslyunderstandingthemratherasconcreteopportunitiestoachieveomnipotentandomniscientphantasies,whichareusuallyrestrainedfrombecomingconsciousrealityortreatedasdelusions.Theseexcitingphantasieshadthepowertooverridemorerealisticcalculationandthejudgmentofthefacts.”34Atthispoint,thevulnerabilitymodelandthepsychoanalyticmodelfeduponthemselves.Investorswhoboughtintothetechhypewererewardedbytheirclients.Investorshadatremendousincentivetoalignthemselvesonthecharacteristicsthatwererewardedinthemarket,namelyInternetstocksinthetechbubble.Thisevolutionledtothedevelopmentofphantasticobjectsinthemindsofmarketparticipants.Notonlydidmarketparticipantsre-spondtoincentives,theyskewedtheconsciousandunconsciousperceptionoftheseincentivestofurtherloadonrewardedcharacteristics.Marketpar-ticipantsloadedonthesecharacteristicsbybuyingmoretechstocks,andinaperpetuatingcyclefoundmorereasonstosupporttheirfantasy.By1999,theevolutionarymodelhadfullyreinforcedthepsychoanalyticmodel,whichinValuation“NewParadigm”!!!DenialSmartMoneyInstitutionalPublicReturntoInvestors“Normal”DelusionGreedBullTrapFearEnthusiasmCapitulationMediaAttentionReturntoFirstSellOffTheMeanTakeOffBearTrapDespairStealthPhaseAwarenessPhaseManiaPhaseBlowOffPhaseTimeFIGURE5.14MainStagesofaBubbleSource:Dr.Jean-PaulRodrigue,Dept.ofEconomics,HofstraUniversity. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford126INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTaviciouscyclefedbackontotheevolutionarymodel.Themaniawasinfullforceatthisjuncture.Therewereinvestorswhorefusedtobuyintothesephantasticob-jects;luminarieslikeJulianRobertsonofTigerManagement,GaryBrinsonofBrinsonPartners,andJeremyGranthamofGMOstayedoutoftechstocksinthelaterportionofthe1990sandexperienceda“short”periodofdevastatingperformance.Unfortunately,JulianRobertsonclosedupshop.BrinsonPartnersandGMOheldtotheconvictionprovidedbyfundamentalvalueanalysisandwitnessedatransitiontorealitythatprovedtobethemostpowerfulproofoftheirinvestmentphilosophiesandprocesses.Manyconcludedthatthemacroinvestmentskillsoffundamentalin-vestorssuchJulianRobertson,GaryBrinson,andJeremyGranthamweresimplyuntenableinthemarketplace.Perhapsaninadequatecomprehensionofthereinforcingnatureofthevulnerabilityandpsychoanalyticmodelsledtotheextinctionofthosewhonarrowlyanduniquelyheldtofundamentalvaluemetrics.Consultantssteppedintothevoidtoprovidethisservicetoinvestors,butfailuretoprotectclientsduringthetremendousdownsidein2000,2001,and2002,andsubsequentfailuretocapturemuchofthere-boundingupsideprettymuchendedtheirtenuresasmacroinvestors.Today,afewconsultantshavestayedtruetotheirdisciplineandprovidefiduciarycontributionstotheirclients.Othersabandonedtheconsultingbusinessandbuiltfunds-of-fundsinvestmentstructures,usingthefailedstyleboxmodelsandasset-classsilostructuresofthe1990s.TheroleoftheCIOinthisenvironmentistomakesurethatfundamentalvalueremainsabeaconintheuncertainstormofchaoticnewsflow,andthattheinvestmentteamunderstandsmarketbehaviorinfluenceswhilenotrespondingtounavoidableshort-termincentivesorafantasy,whatTuckettandTafflerrefertoas“themanifestcoverstory.”35TheCIOneedstomakesurethathedoesnotprovidecoverfortheadoptionofphantasticobjectsbyindividualsontheinvestmentteam.Shillersuggestedinhis2005bookIrrationalExuberancethatauthoritativepronouncementscanpreventthedevelopmentofpricebubbles.36Tomaketheseauthoritativeproclamationsatmomentsofextreme(mandate-altering)greedorfear,theCIOmustbeconfidentandhighlyrespected.Onlyahighlyrespectedindividualwouldhavetheauthoritytomaintaintheconfidenceofinvestmentprofessionalsandclients.TheCIOandotherleadersintheorganizationhaveimportantroles,notonlyintheunwaveringpursuitofsuperiorreturnsconsistentwiththeinvestmentphilosophyandinvestmentprocess,butalsointheconsistent,continual,andclearcommunicationofthistoeveryindividualintheor-ganizationandtoeveryclient.Thisismucheasiersaidthandone.TheCIOmustpushbackagainstclientsanddistributioncolleagues.Oftenthis P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld127pressurecanbecomeinsurmountablewithoutthetypesofgovernancestruc-turesdiscussedinChapter1.ClearlyaCIOmusthavesuperiorinvestmentcapabilities.Butthereismoretothejobthanbeingagoodinvestor.AtrulysuperiorCIOmustleveragethediversityoftheinvestmentteam.Hemustlooktohireinvest-mentprofessionalswhocanchallengeconsensusandprovidefreshideas.Heshouldlooktocreateanenvironmentthatfostersfun,creativity,andhardwork.Finally,thesuperiorCIOmustusehisgravitastoavoidpres-surestochasephantasticobjectsandtopreventinvestmentprofessionalsfromrespondingtoshort-termincentivesthatinevitablyexposeaportfoliototremendousvulnerability.PORTFOLIODESIGNInadditiontoalong-terminvestmenthorizon,portfoliodesignisprobablythemostimportantaspectintheinvestmentprocessforgeneratingsuperiorreturns.Thethirdandfinalstageintheinvestmentprocess,portfoliodesign,isbestbuiltupontherigoroustheoreticalfoundationsoffinance,exploitingquantitativemethods.Wedonot,however,advocatequantitativeportfolioconstruction.Rather,wehavefoundthatqualitativeportfoliodesign,builtonastrong,theoreticallyrigorous,andquantitativefoundation,issuperior.Inthe1980s,aftertheextremevolatilityofthelate1960sand1970s,assetallocationandglobaldiversificationbecamethefoundationofriskmanagement.IndividualslikeSirJohnTempletonandGaryBrinsonpio-neereddiversificationaffordedbyallocatingassetsacrossnumerousassetclasses,bothdomesticandinternational.Unfortunately,intheperiodfromtheearly1980stotheendofthetechbubblein2000,equityandbondmarketsgenerallymovedalmostunwaveringlyhigher.Themarketdeclineof1987wasoneofepicproportions,butitwashesoutinthequarterlyandannualreturndata,speakingvolumestothefocusthatfundamentalin-vestorsshouldhaveonlonghorizons.Unlikethevolatilityofthe1960sand1970s,thesubsequenttwodecadesexperienceddecliningandlowvolatility,decliningandlowinflation,andincreasingproductivitytovaryingdegreesworldwide.Diversificationwasn’tnecessarilyrewarded.Asthe1980sand1990sprogressed,passiveinvestingbecamevogue.TheU.S.equitymarket,asmeasuredbytheS&P500,cametobeincreasinglydominatedbyasmallnumberofoverpricedstocks,intheextremedrivenbythetechbubbleinthefinalportionofthe1990s.Multiassetclassinvestingseemedtohavebeendiscreditedinashortperiodoftime.Subsequently,theburstingofthetechbubbledetractedfromtheallureofpassiveinvestmentportfolios.Whatemergedwastheseparationofalphaandbeta,alphabeing P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford128INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTachievedbyinvestinginalternativeinvestmentsandbetabeingachievedbyinvestinginindexfunds.Theindexfundspreservedfeesforthemoreimportantandexpensivepursuitofalpha.RiskCapitalAllocationAlpha–betaseparationreflectsanadvanceinportfoliodesign,butwebelievethewayitisnormallyimplementedisadeadend.Ratherthanachievingbetaexposurethroughindexfundsandalphathroughalternativeinvestments,investorswouldbebetterservedbyrealizingthatbetaisnothingmorethanariskthatiscompensatedovertime,butnotcompensatedallofthetime.Inportfoliodesign,alphaandbetashouldbothbeconsideredonanequalfootingbyinvestorsseekingcompensatedrisks.Sincetheseparationofalphaandbetainappropriatelyseparatedriskexposuresthatmustbeconsideredsimultaneously,aspracticed,alpha–betaseparationwasanunsatisfactorymethodofportfoliodesign.Sayingthatalphaandbetarisksshouldbeconsideredonanequalfootingisperhapsabitgeneroustoalphaandstingytobeta.Whyisthis?Well,thepursuitofalphaisonaveragenotcompensated,andalphaisverydifficultandexpensivetofind.Beta,however,iscompensatedovertime,ifnotallthetime,andisveryeasytofindviaexposuretoanyassetclass.Thus,itisinappropriatetoviewbetaexposureasanafterthoughtandfocusallenergyonthepursuitofalpha.Thefutureofmacroinvestinginvolvesidentifyingsystematicriskexpo-sures(multipleactivebetas)andevaluatingpotentialcompensation.Activebetasarenotisolatedtoanyindividualassetclass.Theassetclassconceptisalegacyconstraintthatoffersopportunitiesforthosewillingtobreakdownasset-classbarriers.Thepursuitofcompensatedsystematicriskexpo-suresacrossallassetclasses—activebetamanagement—isasuperiorwaytodesignportfolios.Forexample,onecouldinvestininfrastructureasanassetclass.Alternatively,onecouldinvestinprivateequitythathasexpo-suretoinfrastructureprojects,equitiesoffirmsinvolvedinbasicindustriesthatmaysupportinfrastructure,andfixedincomeassetsofthosesamecom-panies.Theexposureiscompensated,butnotthroughdirectinvestmentininfrastructure.Itmaybethatdirectexposure,duetorelentlessbuyingdrivenbysomephantasticobject,isbetterachievedoutsidetheassetclassthroughindirectexposureacrossmanydifferentassetclasses.Inthisnewframework,macroinvestingis“riskcapitalallocation.”Theallocationofcapitaltobothsystematic(multipleactivebetas)andidiosyn-cratic(multiplealphas)risksissuperior.Sometimesbetarisksarecompen-satedandtheyshouldbeincurred.Sometimesalpharisksarecompensatedandshouldbeincurred.Regardless,oneshouldnotblindlyincurindexexposurestoobtainbetaandthenfocusallenergiesonalphaexposure. P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestfordInvestmentProcessinanEvolvingWorld129Toundertakemacroinvestingasariskcapitalallocationmethodology,theinvestmentorganizationmustfirstandforemosthaveaviable,forward-lookingriskmeasurement,analysis,andmanagementtool.Itisimportanttonotetheuseofthephrase“forward-looking.”Mostriskmodelsarebuiltonshort-termhistoricaldata.Thepurposeofthistext,however,isnottodelveintotheconstructionofconsistentforward-lookingriskmodels.Rather,wereferyoutotheindividualandcollaborativeresearchofDiermeier,Singer,Staub,andTerhaarformoreonthissubject.37Withthisrisksysteminplace,thephysicalcapitalcanbeusedtoobtainalphafromanumberofsources,butsourcesthatarenotspecificallytiedtoanyassetclass.Thereisnoreasonforthebottom-upinvestmentprocesstobeconstrainedbyartificialassetclassesorstyleboxbarriers.Theriskanalysissystemenablestheisolationofsystematicexposuresembeddedinthealpha-orientedcomponents.Oftentheseexposuresarecomingfrommultiplesourcesandmaycompoundoroffsetoneanother.Sometimesthesesystematicexposuresarecompensatedandthereforedesirable,butsomeofthemmaybeuncompensatedornegativelycompensated,inwhichcasetheyaretobeavoided.Derivativescanbeprudentlyusedtoshiftriskcapitaltowarddesiredcompensatedriskandawayfromundesireduncompensatedrisk.Thephysicalcapitalisusedtoobtainalphaexposures,andtheriskcapitalismanagedviaderivativestoisolatethedesiredlongandshortbetaexposures.Asitrelatestoportfolioconstruction,weareofthebeliefthatthereisnoreasonforaportfoliotobelongonly.Buildingaportfolioofdesiredriskexposuresbyinvestingonlyonthelongsideisakintoenteringaboxingmatchwithonehandtiedbehindyourback.Whilesomepeopleareunderthefalsebeliefthatshortingisaskillthatonlyhedgefundspossess,webelievethatshortingisariskmanagementtoolthatmakesanyinvestmentprocesseasier.Itislikelytruethatshortingofindividualstocksasameansofgeneratingpositivereturns,requiresuniqueskill,dedication,experience,andanuancedunderstandingofmarketdynamics.However,shortingasameansofhedgingriskandisolatingexposuresisnotonlytherealmofhedgefunds,itistherealmofallprudentinvestors.Byutilizingtheabilitytogobothlongandshortbetaintheportfoliodesignprocess,aninvestmentfirmwillbeabletomoreefficientlyseekitsreturnobjectiveswhilesimultaneouslyavoidingwhatitdeemstobeuncompensatedrisk.CONCLUSIONAtthecoreofanysuccessfulinvestmentmanagementfirmareitsinvest-mentphilosophyandprocess.Inordertocreateavaluableinvestmentedge,theseparametersdefineleadershipandbehavioralboundariesthatmustbe P1:a/bP2:c/dQC:e/fT1:gc05JWBT154-SingerAugust28,200921:27Printer:CourierWestford130INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTcommunicatedthroughouttheorganization.Withintheseboundaries,teammembersfunctionattheedgeofchaos,bringingawealthofdiversityandcreativitytotheinvestmentprocess.Webelieveourthree-partinvestmentprocessoffundamentalvalua-tion,marketandteambehavior,andportfoliodesignprovestobeaveryvaluableconstructforinvestmentleadershiptodeliversuperiorinvestmentperformance.Thechallengestoinvestmentperformancepresentedbymar-ketandteambehaviorscanbeovercomebyadherencetothisprocessandvialeadershipthattakesadvantageofinvestmentteamdiversityanddoesnotallowinvestmentprofessionalstogetcaughtupintheshort-termemo-tionsthatmaybedrivingthemarket.Astrictadherencetothisframeworkisonlythefirstpartofachievinginvestmentsuccess.Thepathtosuccessfulstewardshiprequiresinvestmentprofessionalsoftheorganizationtoworkcloselywiththedistributionprofessionalstoassurethatsuperiorinvestmentperformanceleadstosuccessfulclientoutcomes.Superiorclientoutcomesarisefromthesymbiosisofequalinvestmentanddistributioncooperation.Inthenextchapter,wediscusshowaninvestmentorganizationcanusecommunicationtodeliverpositiveclientexperiences. P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestfordCHAPTER6CommunicationforSuperiorClientOutcomesegardlessofhowwellanassetmanagermaydoinproducingtop-tierRinvestmentperformance,acriticalandoftenoverlookedcomponentofcreatingasuccessfulorganizationisassuringthatitsclientsactuallyattaintheinvestmentresultsthefirmisachieving.Whatsoundslikearelativelysimpletask(afterall,whywouldn’taclientachievethesamereturnsastheportfolioinwhichtheyareinvested?)isarguablythebiggestobstacletocreatingsuccessfulclientoutcomes.Theunfortunaterealityofthesituationisthatthelong-termreturnsthataninvestorachievesarequiteoftennowherenearasgoodasthelong-termresultsofthemarkets,oreventheveryportfoliosinwhichtheyareinvested.Thischapterfocusesonthecriticalrolethatthebusinessfunctionshouldplayinaninvestmentfirm.Theendresultalltoooftenisanegativeclientexperience,despitewhatmaybesuperiorinvestmentperformanceproducedbytheinvestmentfirm.Sothequestionthischapteraimstoansweris,“Whatcanthefirmdotoactuallydeliverapositiveclientoutcome?”Deliveringapositiveclientexperienceisfarmoredifficultthaniscom-monlybelieved.Thereareamultitudeoffactorsthatcombinetoconspireagainstclientoutcomes.Simplyput,mostinvestorsdon’tstickwiththemanagerstheyhirelongenoughtobenefitfromtheskillsforwhichtheyarepaying.Whyisthis?Itisbecauseweoperateinanindustryconsumedwiththird-partyratings,pastperformance(oftenshort-term)andmanagerselec-tion.Wehaveinvestmentfirmswithseverepressurestogrowquickly,whopushhardestonthatwhichiseasiesttosell,andoftenneglecttosupportthosecapabilitiesthatmaysimplybeoutoffavoranddueforaperiodofstrongperformance.Wealsohavebothinstitutionalandprivateclientintermediarieswhooftenfocustheireffortsandbasetheirprimaryvaluepropositionontheselectionofinvestmentmanagers.Perhapsthisisbecauseitisataskthat131 P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestford132INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTappearstobeverydifficultandrequiregreatexpertise,hencejustifyingthefeesfortheservicesperformed.However,therealgoalofintermediariesandassetmanagersalikeshouldbeonclientbehaviormodification.Thatistosay,thatthereisgreatvalueinassistingtheprocessbywhichinvestorsdonotsuccumbtotheirnaturalbehavioralbiases.Unfortunatelythistaskmayappeartobesosimplethatpeopleareunwillingtopayforthison-goingservice,despiteitbeingperhapsthegreatestsourceofvaluecreation(ortheavoidanceofvaluedestruction).Theseadvisorsandintermediariesareunderconstantfearthattheythemselveswillgetfiredwhentheman-agerstheyselectexperienceperiodicunderperformance.Asaresult,theyoftenseethemselvesas“performancevigilantes”whoarepaidtohireandfiremanagers–asitturnsout,oftentothedetrimentoftheirclients.Mostofusintheindustryknowalltoowellthatpastperformanceisreallynoguaranteeoffutureresults.Itisnotjustarequireddisclosure,butalsoanabsolutetruth.Mostofusunderstandthatinvestorwantsareoftentheoppositeoftheirneeds,andthattheeasysaleisoftenthewrongsale.Mostofusrealizethateventheverybestmanagersgothroughmulti-yearperiodsofpoorperformancewherethemarketsarenotrewardingtheirviewsorapproachtoinvesting,anditisduringtheseperiodsthatitisoftenthebesttimetobestayingthecoursewith,orevenhiring,thesemanagers.Unfortunately,thepressurestosell,togrow,andtojustifyfeesoftenleadtovalue-destructiveactions.Thegoalofaninvestmentfirmhastobethreefold:1.Attractiverisk-adjustedresultsovertime.2.Explainableperformanceallofthetime.3.Anabsolutetop-downcommitmenttoexceptionalclientservice.Withrespecttoclientservice,webelievethreethings:1.Mostclients/intermediariesneedongoingeducation,coaching,andsupporttoextendtheirtimehorizonsandholdingperiodswiththemanagerstheyselect.Thisisjobnumberone.Issuesofmanagerselection,pastperformance,andfeestakeabackseattoextendingthetimehorizonsandholdingperiodsofinvestors.2.Realisticexpectationsaboutperiodicunderperformanceofmanagers,theimpactofperformancechasingonrealclientoutcomes,andthehistoricfrequency,duration,magnitude,andimpactofbullandbearmarketsarevitaltodeliveringasuccessfulclientoutcome.3.Aninvestmentfirmhastocreateaculturearoundclientoutcomes—notjustinvestmentexcellence.Asdiscussedinpreviouschapters,thisisabout,asJackBogle,founderofVanguard,advocates,“placingstew-ardshipaheadofsalesmanship.” P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestfordCommunicationforSuperiorClientOutcomes133Aninvestmentfirm’sbestpathtosustainablelong-termprofitabilityistodorightbyitsclients.Doingrightismulti-faceted.First,itmeansofferinganinvestmentsolutionthatisbothsoundandrepeatable.Second,itmeansofferingthisinvestmentsolutionwithinacceptableboundariesofriskandvolatility.Third,itmeansatotalcommitmenttokeepclientsinvestedlongenoughsothattheycanactuallybenefitfromtheinvestmentskillsforwhichtheyarepaying.Afailuretoexecuteagainstanyoneoftheseobjectiveswillprobablyperpetuatethehideousgapbetweenmanagerperformanceandinvestorresults.Ofcoursewearenotsayingthatinvestorsoradvisorsareneverjustifiedintheterminationofamanager,onlythatahardlookshouldbetakenthatplacespastperformanceatanappropriate(andlower)priorityinthedecision-makingprocess.Inthischapterwewilldiscusssomeofthekeyobstaclesformostinvestorstoachievingtheirlong-terminvestmentobjectives.Further,wewilltalkaboutsomepracticalwaysforinvestmentfirmstohelpclientsstayinvestedthroughthecourseofmarketcyclesandavoiddestructiveperformance-chasingbehavior.Finally,wewilldiscusstheidealsandculturethatafirmshouldlooktocreatetoassurethatapositiveclientexperienceistheprimarygoalatalllevelsoftheorganization.ItisnoaccidentthatyouwillseeanumberofquotationsfromWarrenBuffettsprinkledthroughoutthischapter.MuchofthesuccessofBerkshireHathawayistheresultofacuteattentionpaidtoavoidingthesecommonmistakes.THEPROBLEM:HUMANNATURENumerousstudiesshowthatbothindividualandinstitutionalinvestorstendtounderperformthemanagerswithwhomtheyinvest.Whyisthereagapbetweeninvestmentandinvestorperformance?Managerselection?Probablynot.Expenses?Probablynot.Thegapexistsbecausehumannatureisofteninconflictwiththetenetsofsuccessfulinvesting.Excessivegreedinlate-stagebullmarketsandexcessivefearinlate-stagebearmarketscausesinvestorstobuyhighandselllow.Chasingperformanceonthewayup,andpanickingoutofaninvestmentonthewaydown,istoooftentheorderoftheday.Weroutinelywitnessinvestorsandintermediariesseekingoutthehottestmanagersafterthey’vedonewell,thenfiringandterminatingmanagersafterthey’vedonepoorly.Holdingperiodsareoftentooshortandexpectationsareoftenunrealistic.Asyouwillseeshortly,theaverageholdingperiodforanequitymu-tualfundoverthepast20yearshasbeenabout37monthsaccordingtoDALBAR,Inc.Investingwithamanagerforthreeyearsmaylooklikeaninvestmentbecauseyou’replacingmoneywithaprofessionalmoneyman-ager,butinrealityitisnothingmorethanaspeculativetrade.Whether P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestford134INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTthatparticularmanagerhappenstoprovideattractivereturnsduringanygiventhree-yearperiodismorearandomeventthanastatementofskill.Thelengtheningofinvestorholdingperiodsisessentialtoachievingbetterresults.Equally,whileitisrealistictoexpectsuperiorrisk-adjustedperformanceovertime,itisunrealistictoexpectsuperiorperformanceallofthetime.Mosttop-qualitymanagersgothroughmulti-yearperiodswhenthemarketsarenotrewardingtheirparticularstyle.Infact,arecentstudyconductedbyRobertW.Baird&Co.findssomeastonishingresultsasitrelatestothefrequency,magnitude,anddurationofunderperformance.1Accordingtothestudy(whichidentifieda“high-performingmanager”asadomesticorinternationalequitymutualfundwithatleasta10-yeartrackrecordthathasoutperformeditsrespectivebenchmarkbyaminimumof1percentannualized,netoffees):
Onehundredpercentofhigh-performingmanagershavehada12-monthperiodoftimewheretheyhaveunderperformedtheirbench-markbyatleast3percentagepoints,withfouroutoffiveofthemhavingexperienceda12-monthperiodwheretheunderperformancewasinexcessof10percentagepoints.
Over80percentofthehigh-performingmanagersanalyzedhadathree-yearperiodwheretheirportfoliostrailedtheirrespectivebenchmark.
Sixty-sixpercentofthehigh-performingmanagersspentaminimumofthreeyearsinthebottomquartileoftheirMorningstarpeergroup.Whilethereisnodoubtthatsomeperiodsofunderperformancemayin-deedbeacauseforconcern(e.g.breakdowninprocessorPMturnover),toomanyinvestorsfailtoseethattheseperiodsofunderperformanceareoftenastatementofdisciplineandlessacauseforconcernoraneedtotakeaction.Gettingclientstounderstandtheinevitabilityofperiodicunderperformanceisacriticalcomponenttoachievingbetterresults.ACLASSICTALEAsdiscussed,investorsareconstantlyshufflingtheirportfoliosaroundatanalarminglyrapidpace—chasingafund,assetclass,orsectorthathasexperiencedasuccessfulrun,usuallyjustintimeforittofalloutoffavorandreverttothemean.Sowhiletheseindividualsmayviewtheiractionsasinvesting,inrealitywhattheyaredoingislittlemorethanmerelygambling.Whilethisisastorythathasbeentoldtimeandtimeagain,fromtulipbulbsin1637Hollandtooilinthesummerof2008,perhapsnoperiodoftimeencapsulatesthisdetrimentalbehaviormorethanthetechnology,media,andtelecom(TMT)bubbleofthelate1990s,asdemonstratedinFigure6.1. P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestford12-MonthReturns(%)200%150%100%50%0%-50%-100%Jul-08Jan-08BurstJul-07Jan-07Jul-06sectorprovidedtotheFRCbyMorningstar.Jan-06offutureresults.Technologymutualfundsales,Jul-05Jan-05Jul-04undermanagementarebasedonmonthlydatacalculatedJan-04Jul-03Jan-03Jul-021-YearreturnatpurchaseJan-02Jul-01Jan-01Jul-00Jan-00Jul-99Jan-99Jul-98Jan-98TechnologyFundsSawLargestInflows,JustbeforetheBubbleJul-97Technologyfundsnetflows1-yearreturn12monthsafterpurchaseJan-97FinancialResearchCorporation(FRC);usedwithpermission.Jul-96$14$12$10$8$6$4$2$0-$2-$4Jan-96NetFlows(Billions)FIGURE6.1Forillustrativepurposesonly.Pastperformanceisnoguaranteeredemptions,exchanges,reinvesteddividends,andassetsbyFRC.PerformanceinformationbasedonSpecialtyTechnologyUBS104.2526C.Source:135 P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestford136INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTThesolidlineshowstheaveragerollingone-yearreturnsoftechnology-focusedmutualfundsoverthepast12years.Asyoucansee,beginninginthesecondhalfof1998,theperformanceofthesefundsexperiencedameteoricrise,peakingatareturnofover175percentinthe12monthsendingFebru-aryof2000.Unfortunately,theaverageinvestordidnotbenefitfromthesephenomenalreturns.Thebarsshowfundflowsintothesetechnologyfunds,whichcapturedtheirbiggestinflowsnotin1998or1999(whentheywereexperiencingtheirexcellentreturns),butratherin2000,justintimeforthecrashoftheTMTbubble.Infact,thedottedlineshowstheactualreturnsexperiencedbyinvestors12monthsafterinvestinginthesefunds.Sowhilethemajorityofindividualsinvestedtheirmoneyatatimewhentheseportfo-lioshad“rear-viewmirror”one-yearreturnsinthetripledigits,thereturnstheyexperiencedwereinexcessof-50percentinthefirstyearalone!Asyoucansee,theseportfolioshaveessentiallybeeninnetoutflowseversince.Thereisonestrategythatisguaranteedtoworkininvesting:Buylowandsellhigh.Ifonlyitwerethatsimple.Interestingly,humannature,behav-ioralbiases,agencyissues,liquiditypressures,andavarietyofotherfactorsconspiretomakethisaverydifficultproposition.Timeandtimeagainin-dividualsdotheexactopposite,namelybuyhighandselllow,anddestroytheirwealthintheprocess.It’sfarbettertobuyawonderfulcompanyatafairpricethanafaircompanyatawonderfulprice.—WarrenBuffettThebehaviorpatternofchasingpastperformanceisexhibitednotjustbyindividualinvestors;weseesimilaractionswiththemanyprofessionalsinvolvedinthehiringandfiringofinvestmentmanagers.Manyofthesepro-fessionalsarejudgedforcompensationandpromotionpurposesonshortertimeframesthanthehorizonoftheinvestmentphilosophiestheyinvestin.Asaconsequence,manyprofessionalsdonothavethetimeorinclinationtodeterminewhetheraperiodofpoorinvestmentperformanceisastatementofdisciplineorarealcauseforconcern.Theyviewanyperiodofpoorper-formanceasanopportunitytodemonstratevaluebytakingaction—evenwhenthebestactiontobetakenisnoactionatall.Toomanyprofessionalsareinthebusinessofwhatcanbestbedescribedascombiningfive-starmanagerstocreateatwo-starclientexperience.Theyareessentiallydrivingforwardlookingintherearviewmirror,andtheyaremoreinterestedinsellingsomethingthaninachievinglong-termandsustainableclientresults.BillMiller,chairmanandchiefinvestmentofficerofLeggMasonCapitalManagement,lamentedinhisSecondQuarter2008Commentary,“Thebesttimetoopenanaccountwithushasalwaysbeenwhenwe’vehad P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestfordCommunicationforSuperiorClientOutcomes137dismalperformance,andtheworsttimehasalwaysbeenafteralongrunofexcessreturns.Yetwe(andeveryoneelse)getthemostinflowsandthemostinterestAFTERwe’vedonewell,andthemostclientterminationsAFTERwe’vedonepoorly.Itwillalwaysbeso,becausethatisthewaypeoplebehave.”Theevidencehereismorethananecdotal.Anumberofacademicstudiesandempiricalevidencehasbeencollectedtodemonstratethefutilityanddestructivepowerofperformancechasingtobothindividualandinstitutionalinvestors.Acoupleofthesekeypiecesofresearcharesummarizedbelow.CASE1:INDIVIDUALINVESTORS,THEIMPACTOFPERFORMANCECHASINGOneofthemostwell-knownstudiesthatattemptstoquantifytheimpactofinvestorbehavioroninvestmentreturnsispublishedannuallybyDALBAR,Inc.ShowninFigure6.2,Dalbarlooksatthe20-yearannualizedreturnoftheaverageU.Slarge-capequitymutualfundandcomparesittotheaveragereturnrealizedbytheaveragedollarinvestedinthesefunds.Forthe20yearsthrough2007,theresultsareclear:Sonotonlyisitthecasethatinvestorswilldrasticallyunderperformthemarket,buttheywillalsodrasticallyunderperformtheveryportfoliosinwhichtheyareinvested!Towhatcanthishorrendousgapbetweenthereturnsthemarkethasprovidedandthereturnstheaverageinvestorhasreceivedbeattributed?Theanswerischieflythis:humanemotion.Investorsareconstantlyshufflingtheirportfoliosaroundatanalarminglyrapidpace(Dalbaralsoconfirmsinitsanalysisthattheaverageholdingperiodisonlythreeyears),chasingafund,assetclass,orsectorthathasexperiencedasuccessfulrun,usuallyjustintimeforittofalloutoffavorandreverttothemean.Sowhiletheseindividualsmayviewtheiractionsasinvesting,inrealitywhattheyaredoingisnothingmorethanmisguidedspeculation.Inthebusinessworld,therearviewmirrorisalwaysclearerthanthewindshield.—WarrenBuffettCASE2:AREINSTITUTIONALINVESTORSTHE“SMARTMONEY?”Ourownexperience,aswellasanumberofacademicstudies,hasshownthatperformance-chasingbehaviorisnotconfinedtotheindividualinvestor. P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestford138INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENT1611.8%1284.5%43.0%AverageAnnualTotalReturns:1988–20070S&P500IndexDalbarAverageEquityInflationFundInvestorFIGURE6.2TheAverageInvestorUnderperformstheAverageFundbyaWideMarginForillustrativepurposesonly.Pastperformancedoesnotguaranteefutureresults.Performancecalculatedassumingreinvestmentofalldividendsandcapitalgains.TheS&P500Indexisanunmanaged,weightedindexcomprising500widelyheldcommonstocksvaryingincompositionandisunavailablefordirectinvestment.TheDalbarAverageEquityFundInvestoristherateofreturninvestorsearned,basedonthelengthoftimeshareholdersactuallyremaininvestedinequitymutualfunds.Overthetimeperiod1988–2007,theequitymutualfundshareholdersheldtheirmutualfundsforanaverageof3.1years.Mutualfundsales,redemptions,exchanges,reinvesteddividends,andassetsundermanagementarebasedonmonthlydataprovidedbytheInvestmentCompanyInstitute.TheaverageannualreturnoftheDalbarAverageEquityInvestorisbasedonallequityfunds,representedbytheDalbarEquityIndexwhichwascomprisedoftheS&P500IndexandtheIbbotsonSmallCompanystockindex.Source:Lipper,Inc.andDalbar,usedwithpermission.Itseemsthatthethree-year“reviewmirror”performanceevaluationcriteriausedbymanyinstitutionalinvestorsisquitedetrimentaltoinvestorout-comes.AnempiricalstudybyGoyalandWahalexaminedtheselectionandterminationdecisionsof3,400institutionaldefinedbenefitpensionplansponsorsandprovidesstrongevidenceofthissameperformance-chasingphenomenon.Intheirstudy,GoyalandWahalconcludedthatinstitutionalplansponsorshiredinvestmentmanagersafterthesemanagersearnedlargepositiveexcessreturnsduringthethreeyearspriortotheirhiring.Despite P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestfordCommunicationforSuperiorClientOutcomes139attractivethree-yearpastinvestmentperformance,thehiringoftheseman-agersdoesnotdeliverpositiveexcessreturnsthereafter.Afterhiringthesemanagers,excessreturnswereinfactindistinguishablefromzero.Similarly,plansponsorsterminatedinvestmentmanagersafterobservedperiodsofunderperformance.Again,theempiricalevidencesuggeststhattheexcessreturnsofthesemanagersafterbeingfiredwerefrequentlypositive.Finally,andperhapsmostinteresting,thestudyfoundthatifplanspon-sorshadstayedwiththeoriginalinvestmentmanagersthattheyfiredforunderperformance,theirexcessreturnswouldbelargerthanthoseactuallydeliveredbythereplacementmanagers.Whatcanbedonetohelpindividualandinstitutionalinvestorsalikebecomebetteratavoidingthepitfallsofperformance-chasingbehavior?Communicate,communicate,communicate.Framing,contextualizingandsettingappropriateexpectationsarethekey.Makingsurethatclientsarefullyawareoftheperilsofperformancechasingiscritical,buttherearesomeotherkeyconceptsthatwelooktoinanefforttohelpclientsachievelong-terminvestmentsuccess.Twoofthemoreprominentonesaredis-cussedbelow.Clientsmustunderstandtherealityofinvestinginequitiesandbeschooledonthemathematicsofrecovery.Anddon’tworry;wecangetthroughthiswithoutadegreeintheevolutionaryeconometricsofavalanches,Gaussiandistributions,thermodynamics,andblackswans.THEREALITYOFINVESTINGINEQUITIESStockinvestingbecamewildlypopularinthebullmarketofthe1980sand1990s,andtheposterchildofthefinancialindustryforgettingclientstoinvestinequitieswasthereturnstreamshowninFigure6.3.Theprimarypointofthechartisfairlyself-explanatory:Overtimestockshavesignificantlyoutperformedbonds,cash,andinflation.Whilefactuallycorrect,thatcommonexplanationisincomplete,misleading,andarguablyoneofthecausesfortheunrealisticexpectationsmanyinvestorshave.Forstarters,theIbbotsonChartassumesthatclientshavean80-plusyeartimehorizon.AsDalbarandotherstudieshavetaughtus,theaverageinvestor’sholdingperiodismuchcloserto80weeksthanitis80years.Secondly,thechartmakesitseemasifequitiesgoupinasomewhatsmooth,linearfashionandgrosslyminimizestheimpactofdownturnsandbearmarkets(the2000–2002bearmarketisaproverbialbliponaradarscreenandthemarketcrashof1987isbarelyperceivable).Eventhecurrentequitybearmarket(2008–throughQ12009)doesnotappeartobealong-termcauseforconcern.Thevolatilityassociatedwithequityinvestinggetssolostinthischartthatitiseasytounderstandwhymanyindividual P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestford140INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENT$100,000,000S&P500IndexU.S.LTGov’t.90-dayU.S.TBillU.S.Inflation$10,000,000$1,000,000$100,000$10,000$1,000192519301940195019601970198019902000FIGURE6.3CompellingReturnsonStockInvestmentsDrewinClientsStocksrepresentedbyStandard&Poor’s(S&P)500Index,long-termgovernmentbondsby20-yearU.S.Treasurybonds,90-dayU.S.TreasurybillsandinflationbytheConsumerPriceIndex(CIPthroughNovember,2008).TheS&P500Indexisanunmanaged,weightedindexcomprising500widelyheldcommonstocksvaryingincomposition.Returnsconsistofincome,capitalappreciation(ordepreciation),andcurrencygains(orlosses).Certainmarketshaveexperiencedsignificantyear-to-yearfluctuationsandnegativereturnsfromtimetotime.Stocksaremorevolatileandsubjecttogreaterrisksthanotherassetclasses.Indexesarenotavailablefordirectinvestment.Pastperformanceisnotaguaranteeoffutureresults.Source:NedDavisResearch,usedwithpermission.investorsfallvictimtothemythofthe10percentreturn.Themythofthe10percentreturnspeakstotheincorrectassumptionsunderwhichalltoomanyindividualinvestorsoperate.WhileitistruethattheannualizedreturnsontheS&P500goingbacktothemid-1920sisapproximately10percentperannum,toanticipateanywherenearthisamountinanygivenyearisquiteanunrealisticexpectation.Infact,asFigure6.4shows,inthepast83years,therehaveonlybeenfivetimesthattheS&P500hasevenreturnedbetween8percentand12percentinanygivencalendaryear,withavastmajorityofcalendaryearreturnsnowherenearthe10percentaverage.Itisnotonlythecasethatindividualyear-by-yearreturnscanbefarawayfromthehistoricalaverageofthestockmarket,butevenlonger-term P1:a/bP2:c/dQC:e/fT1:gc06JWBT154-SingerAugust28,200921:31Printer:CourierWestfordCommunicationforSuperiorClientOutcomes1413530TheS&PIndexhasgrownataboutitsaverage8%cumulative5yearalphaBeforeaddressingthedeterminationofbeta,itisinstructivetocom-parethefeesassociatedwitha1percentbasefeeand20percentper-formancefee(overtheT-Billreturn)structureandtheproposedfeestructure.Forthiscomparison,itissimplynecessarytoassumeanarbi-traryinvestmenthorizonandcommensuratefeedeterminationperiod.InTable7.1,assumeineachofthefourcasesprovidedthattheT-Bill P1:a/bP2:c/dQC:e/fT1:gc07JWBT154-SingerAugust20,200912:18Printer:CourierWestfordWherearetheClients’Yachts?181TABLE7.1FeeCaseStudies–PerformanceInputsCase1Case2Case3Case4BetaPositiveBetaPositiveBetaNegativeBetaNegative&Alpha&Alpha&Alpha&AlphaPositiveNegativePositiveNegativeBeta(static0.75(7.63%)0.75(7.63%)−0.25(4.13%)−0.25(4.13%)marketreturn)AlphaReturn6.00%−2.00%6.00%−2.00%TotalPortfolio13.63%5.63%10.13%2.13%ReturnPortfolioReturn8.63%0.63%5.13%−2.87%overT-Billreturnis5percentandthatthemarketreturnis10percentperannum.The1/20feestructureandtheproposedfeestructureresultinthefeesshowninTable7.2.Thefollowingcasesincludefiguresthatdisplaythecomponentsofthefeestructuresina“waterfallchart”demonstratingtheaccumulationoffees.Case1:BetaPositive&AlphaPositiveInCase1,themarketincreasesandthemanagerhasapositiveexposure,benefitingfromthemarketrally.Moreover,thealphacontribution,beyondthegainfrommarketexposure,ispositive.Thetypical1/20feestructure,showninFigure7.5,earnsthe1percentbasefee(blue)andearnsthe20per-centperformanceparticipationonthestaticmarketreturn(red)andthealphareturn(green).Theyellowbarmeasuresthetotalfeeof2.73percent.TABLE7.2FeeCaseStudies–RealizedFeesCase1Case2Case3Case4BetaPositiveBetaPositiveBetaNegativeBetaNegative&Alpha&Alpha&Alpha&AlphaPositiveNegativePositiveNegative1%/20%2.73%1.13%2.03%1.00%Proposed1.91%0.86%1.90%0.85% P1:a/bP2:c/dQC:e/fT1:gc07JWBT154-SingerAugust20,200912:18Printer:CourierWestford182INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENT3.02.52.01.5FeeComposition1.00.50.01%/20%ProposedBaseFeeImpliedBetaFeeImpliedAlphaFeeTotalFeeFIGURE7.5FeeComparison(BetaPositiveandAlphaPositive)Theinappropriatenatureofthisfeestructureistheaccrualofperfor-mancefeesformarketexposurethatisobtainablewithoutanyskillwhat-soever.Theproposedfeestructureincludesthesame1percentbasefeeforeaseofcomparison.Thestaticmarketreturn,acquirablewithoutskill,garnersa50basispointfeethatissimilartowhatitwouldcosttoreplicateapassiveglobalequityportfolio.The1%/20%structureearns53basispointsofstaticmarket-basedperformancefees,andtheproposedfeestructureearnsonly1basispoint.Alpha,theportionoftheportfolio’sreturnthatisattributabletoskill,garnersaperformancefeeof15percentratherthan20percent.Thepro-posedfeestructureearnsanalphafeeof90basispoints,belowthe120basispointfeethatisexcisedbythe20percentparticipation.Intotaltheproposedfeestructureis30percentbelowthe1%/20%feestructure,andtheperformanceportionoftheproposedfeestructureisnearly50percentlower.Case2:BetaPositive&AlphaNegativeAmoreinterestingsituationariseswhenmarketparticipationresultsinagainthatmorethanoffsetsalossduetoskill.InCase2,showninFigure7.6, P1:a/bP2:c/dQC:e/fT1:gc07JWBT154-SingerAugust20,200912:18Printer:CourierWestfordWherearetheClients’Yachts?1831.61.41.21.00.80.6FeeComposition0.40.20.01%/20%ProposedBaseFeeImpliedBetaFeeImpliedAlphaFeeTotalFeeFIGURE7.6FeeComparison(BetaPositiveandAlphaNegative)themarketralliesandthemanager’sbetaispositive,resultinginaperfor-mancefeeof53bps.Thealphareturnisnegative,resultinginanoffsettingfeelossof40bps.Sincethecombinedstaticmarketandalphafeeispositive,thefull20percentperformanceparticipationischarged.Despitealossaris-ingfromactiveportfoliomanagement,themanageraccruesaperformancefeeof13bpsontopofthe100bpsbasefeeforatotalfeeof1.13percent.Theproposedfeestructureaccruesaminorgainof1bpduetostaticmarketexposure.Thealphareturncontributionisnegative,sotheperfor-manceparticipationis7.5ofthealphaloss,ornegative15bps.Thetotalfeethataccruestothe1%/20%feestructureis1.13percent.Theproposedstructureearns86bps,afeethatisalmost25percentlower.The1%/20%structureearnsapositiveperformancefeeandtheproposedstructureincursanegativeperformancefee.Case3:BetaNegative&AlphaPositiveAreductioninportfolioperformancethatarisesfromanegativeportfoliobetainarisingmarketorapositivebetainadecliningmarketpresentsaninterestingandperhapsunintuitiveoutcome.Thereductioninportfolioperformanceduetoadversestaticmarketexposurepartiallyoffsetsthepos-itivealphareturn.Asaresult,showninFigure7.7,theperformancefeeischargedonasmallerportionofthetotalreturn.Inthe1/20feestructure P1:a/bP2:c/dQC:e/fT1:gc07JWBT154-SingerAugust20,200912:18Printer:CourierWestford184INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENT2.502.252.001.751.501.251.000.75FeeComposition0.500.250.001%/20%ProposedBaseFeeImpliedBetaFeeImpliedAlphaFeeTotalFeeFIGURE7.7FeeComparison(BetaNegativeandAlphaPositive)accruesanegativemarketperformancefeeof18bps,partiallyoffsettingthepositivealphafeeof120bps.Thetotalfeeis2.03percent.Theproposedfeestructurehasastaticmarketfeecontributionthatisnegative,butroundstozero.Ifthebetaexposurecontributiontotheport-folio’sperformanceisnegative,thenthe1/20structure,notdistinguishingbetweenbetaandalphareturns,experiencesaperformancefeereduction.Ofcourse,anegativebetaisanuncommonhedgefundposition,exceptforshort-sellers.Thus,theclient’sfeebenefittendstooccurwhenthemarketdeclines,anenvironmentwhenhedgefundclientstendtobedispleasedbyfundperformancetoamuchgreaterdegreethantheyarepleasedbytheperformancefeereduction.Theproposedfeestructureresultsina90bpsskill-basedalphacontri-bution.Thetotalfeefortheproposedstructure,at1.90percent,isabout5percentbelowthatofthe1%/20%structure.Theperformancecontributionfromtheproposedstructureis90bps,about10percentbelowthe102bpsofthe1%/20%structure.Case4:BetaNegative&AlphaNegativeThefinalcase,showninFigure7.8,isoneinwhichboththestaticmarketandalphareturncontributionsarenegative.The1/20issimple,neitherthe P1:a/bP2:c/dQC:e/fT1:gc07JWBT154-SingerAugust20,200912:18Printer:CourierWestfordWherearetheClients’Yachts?1851.21.00.80.6FeeComposition0.40.20.01%/20%ProposedBaseFeeImpliedBetaFeeImpliedAlphaFeeTotalFeeFIGURE7.8FeeComparison(BetaNegativeandAlphaNegative)betanoralphaactivitiesgenerateaperformancefee.Theproposedstructuredoesn’tearnabetafee,butitearnsanegative15bpsfromtheskill-basedalphaactivity.Intotal,the1/20structureearnsthebasefeeandtheproposedstructureearns0.85percent,slightlybelowthebasefee.Theglaringproblemwiththisfeestructureistheuncertaintyofbeta.Thereneedstobeasufficientlylongreturnseriestocalculateabetathatisrepresentativeofrealityorstatisticallysignificant.Sincefundamentalinvest-mentprocessesshouldbelongterminnatureforfullperformancebenefitstobecaptured,theperformanceandthebetadeterminationperiodsshouldbeconsistentwiththerelativelylonginvestmenthorizon.Anescrowaccountforthepurposeofpayingperformancefeescanbeestablishedtoaccommodatethelongerinvestmenthorizonthatisneededtoreducebetauncertaintyand,therefore,thestaticmarketandalphareturns.Eachclient’sinvestmentisseparatedintoanon-escrow(regular)portionequalto95percentofthefundsinvestedandanescrowportionequaltotheremaining5percent.Regularandescrowfundsareinvestedthesame.Attheendoftheperformanceevaluationperiod,sayfiveyears,thebetaisdeterminedsothatthestaticmarketandalphafeescanbedetermined.Priortotheconclusionofthefirstfive-yearperiod,thebetaisassumedtobeconsistentwiththeanticipatedmarketexposure,say0.50,oracombinationof0.50andtherealizedbetauptothetimethattherelationshipconcludes. P1:a/bP2:c/dQC:e/fT1:gc07JWBT154-SingerAugust20,200912:18Printer:CourierWestford186INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTSomeclientsmaybeuncomfortablewiththecomplexityoftheproposedfeestructure.Whilesuchdiscomfortwouldbeunfortunategiventhatitisdesignedforthegreatestalignmentofinterests,twoalternativefeestructurescanbeemployedwiththesameexpectedtotalfees.First,asimple1percentbasefeeand10percentperformancefeeoverT-Billshasroughlythesameexpectedfee.Second,a1.40percentfeeisequivalenttotheperformancefeestructuresovertime.Eachofthealternativefeestructureshasareducedalignmentofincentives,withtheflatfeereflectingtheleastalignment.CONCLUSIONInvestingsuccessfullyisdifficultinthebestoftimes,andeventhenittakesseveralyearstoidentifyskillthatisworthyofcompensation.Ourobjectiveinthischapterhasbeentoproposeideasforinvestmentmanagerfeestructuresthatbetteraligntheinterestsofclientsandmanagers.Indoingso,weproposeaframeworkthat:
Compensatesskill.
Rewardspositiveperformanceandpenalizespoorperformance.
Chargeslowfeesforstaticmarket-basedreturnsthatcanbesimplyobtained.
Dissuadesinappropriaterisktaking.Skillshouldberewarded,butfeestructuresshouldnotbedesignedtorelyonintegrityaloneforappropriatebehaviors.Ourrecommendationvastlyreducesmanyoftheinappropriateincentivesoffeestructuresthataroseinthe1990s.Wedonotexpectthistobetheultimatefeestructure.Theremaybemoresimplewaysofachievingthesameendswithrollingperiodfeestructures,andwewillendeavortoconstructsuchframeworks.However,wefeelourcurrentrecommendationisnotonlyasignificantadvancebutalsofeasibleundercurrentregulations.Itrequiresacloserelationshipandtransparentcommunicationsbeyondinvestmentindustrynorms,butintegritysupportsourproposalandtransparency.Afterthefinancialcrisis,theinvestmentindustryisreadyforchange,andwefeelthatitisripeforrecommendationssuchasours. P1:a/bP2:c/dQC:e/fT1:gc08JWBT154-SingerJuly30,200919:44Printer:CourierWestfordCHAPTER8FinalThoughtshewritingofthisbookisaprojectthattookmorethanayear,drawingTuponhundredsofconversationswithinvestorsonfivecontinents.Whiletheprojectitselftookayear,itisbasedontheauthors’collectiveexperienceofmorethan65yearsintheassetmanagementbusiness.Together,wehaveworkedinprivatefirmsandpublicfirms,institutionalfirmsandretailfirms,largefirmsandsmallfirms,investment-drivenfirmsandproduct-drivenfirms,well-runfirmsandpoorlyrunfirms,successfulfirmsanddyingfirms.Wehavebeenfirmacquireesandacquirors.Betweenus,wehaveworkedinvirtuallyeveryfacetofthebusiness,includingtrading,operations,legal,clientservice,marketing,emergingmarketsequity,assetallocation,currencymanagement,riskmanagement,productdevelopment,researchandstrategicplanning.Wehavelaunchedfirms,builtfirms,soldfirms,andleftfirms.Overthesemanyyears,wehavetalkedtothousandsofinvestorsinamultitudeofcountriesfromtheinvestmentnovicetothemostsophisticatedinstitutionalandprivateinvestors.Wehavecontinuallylearned,andwehopethatprocessneverstops.Thesediverseexperienceshavetaughtusanumberofvaluablelessonsandprinciples,manyofwhichwehopewehavebeenabletoeffectivelypassoninthisbook.WhilewehavesometimestakenadirectroutefrompointAtopointB,therehavebeentimeswheretheroutehasbeenmorecircuitous.Further,withnumerousauthorsmakingcontributionstothistext,thereaderiscertaintonoticeafewidiosyncrasiesaswellasinstancesinwhichafewdeadhorsesweresystematicallybludgeonedforgoodmeasure.Accordingly,wedecidednottoleaveanyobservationinsufficientlybludgeonedandnowtakethisopportunitytorecapsomeofthemainideasofthisbookalongwithsomefinalthoughts.187 P1:a/bP2:c/dQC:e/fT1:gc08JWBT154-SingerJuly30,200919:44Printer:CourierWestford188INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTCHARACTERISTICSOFGREATASSETMANAGEMENTFIRMSItisoftennotedthattheassetmanagementindustryislackinginleadershipandmanagementtalent.Whilewearenotsureifthatisatruestatement,wedofirmlybelievethatthenumberonecharacteristicthatdifferentiatesthepremierleagueofassetmanagementfirmsfromthenexttierofcompetitorsisleadership,especiallyintheformativeyears.Wehaveallwitnessedanumberofverygoodinvestorspromotedtopositionsofmanagementandleadership.Wehavealsoseenindividualswithgreatrelationshipmanagementskillspromotedintopositionsofmanagementandleadership.Inallcaseswenoteinvestingskillandrelationshipmanagementskillhaveverylittlecorrelationwithleadershipskill.Whileitmayormaynotbeanindustrywithavoidofstrongleaders,onethingisclear:Organizationswithstrongandstableleadershipareabletoexcelwhereothersdonot.Firmsthatarerecognizedasbestinclassshareanumberofqualitiesandvirtuallyallofthemstemfromthevisionandexecutionofstrongleaders.RecallinChapter1,weassertthatthemostsuccessfulfirmssharefiveconsistentcharacteristics.1.Strongculture2.Limitedsizeandcomplexity3.Cleargovernanceofthebusinessandinvestmentfunctions4.First-rate(butnon-hierarchical)investmentleadership5.IntegrityEachandeveryoneoftheseisonlypossiblewithstrongleadership.Lead-ersnourishandupholdthecultureofanorganization.Theymakechoicesthatinevitablylimitthesizeandscopeofactivitiesthattheorganizationundertakes.Agoodleaderwillonlyworkinafirmwherethereisclearandeffectivegovernancetoprotecttheculture,philosophyandinvestmentdisciplineofthefirm.Themosteffectiveleaderscreateanon-hierarchicalenvironmentinwhichideasharingisencouraged,anddiligentexecutionisrewarded.Theyalsoestablishasolidfoundation,adurableframework,andprocessesforsuccessfullymanaginganorganizationthatcanmaintainthesequalities.Andlast,agreatinvestmentleaderhasazerotolerancepolicyforbreachesofintegrity.Byintegrity,wemeannotonlyhonestyandfulfillmentoffiduciaryobligation,butprocessintegrity.ITSTARTSWITHASHAREDMISSIONANDVALUESRecalltheanecdoteabout“cuttingstones”versus“buildingacathe-dral.”Thebestorganizationsshareasenseofpurpose.Theyarenotjust P1:a/bP2:c/dQC:e/fT1:gc08JWBT154-SingerJuly30,200919:44Printer:CourierWestfordFinalThoughts189cuttingstonesormakingwidgets.Theyareaspiringtodomoreandbebetter.Afirm’ssharedaspirationsbeginwithitsmissionstatement,acleararticulationofthelong-termgoalsoftheteam.Itissomethingthatev-eryemployeeknowsandisconstantlyremindedof.Thebestfirmsandtheirleadershipteamstakecaretoreinforcethemissionwithallemployeesandtocontinuouslyview,frame,connect,andrecognizethefirm’sactivi-tiesandactionsinthecontextofthemission.Theconnectionisenhancedbyintertwinedemployeevaluesandfirmmission.Amissionstatementisnotthebe-allandend-allofaninvestmentfirm.Itissimplyastartingpoint.Thevaluesthatarelivedbyemployeeshelpsustainthemissiononanongoingbasis.Themissionstatementwillonlyholdwaterifthemanagementprocesseswithintheorganizationaredesignedtosupportit.Settingorganizationalgoals,teamgoals,andindividualgoalsthattangiblyhelptodrivetheorganizationinthedirectionofthemissionareparamount.Asimportantasacoherentsetofgoalsandobjectivesistheestablishmentofatruemeritocraticprocessforevaluatingandremuneratingemployees.Inatruemeritocracy,employeeswillseekexcellenceknowingthatappropriaterewardswillfollow.TRUEMERITOCRACYEstablishingameritocracy,however,isnoeasytask.Inatruemeritocracy,employeesarepaidtoreflecttheircontributiontotheattainmentofthefirm’sgoalsanditsmission.Thatmeansemployeesmustbepaidbasedonbothperformance(howwelltheyperformtheirroleontheteam)andcriticality(howimportant/criticaltheyaretotheachievementoftheorganizationalmission).Thiscanonlybedonewithatransparentandcommunicativemanagementteamthatisdriventoputthefirm’scollectiveobjectiveaheadofthoseofeachindividual.Further,inatruemeritocracy,eachmemberoftheteamknowsandunderstandsherposition,andwhatittakestoimprovetheirownperformanceandtheirowncriticality.Strong,transparent,andfrequentdialogueisrequiredtoachievethis.Webelievethataccomplishedleadershipmeasuresemployeesonwhattheyhaveaccomplishedandmen-torsthemonwhattheycanaccomplish.Observingthatinvestmentindustryleadershipoftenoriginatesinthepromotionofindividualswithstronginvestmentorclientrelationshipskillsandlittledesiretoexploreleadershiptheory,inChapter3wefur-nishedasystemformeritocraticleadershipimplementation.Thesystemprovidesforobjectiveanalysisofcriticalityandperformanceandprescribestransparentcommunicationthatisoftenavoidedbyleaders.Importantly,thesystemprovidesameansofanalysisandcommunicationthatisless P1:a/bP2:c/dQC:e/fT1:gc08JWBT154-SingerJuly30,200919:44Printer:CourierWestford190INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTthreateningandmoreconstructivethantheadhocprocessesthatpermeatemostinvestmentfirms.AVOIDINGTHEPITFALLSWhenitcomestogeneratingsustainable,attractiverisk-adjustedperfor-manceovertime,“theroadtohellispavedwithgoodintentions.”Bythiswemeanthatallinvestmentfirmsstartoutwiththegoalofdeliveringcon-sistentvalue-addedinvestmentperformancefortheirclients.Theyalsostartwithaframeworkforachievingthisgeneralgoal.Thatsaid,thereareliterallyhundredsofpitfallsandroadblocksthatstandbetweentheorganizationandthegenerationofattractivelong-termresultsforclients.Themostnotablepotentialpitfallsforaninvestment-drivenfirminclude:1.Philosophicaldrift2.Processdrift3.Behavioralbiases4.WrongclientsPhilosophicalDriftAninvestmentphilosophyisasetofcoreinvestmentbeliefsthatdriveafirm’svalue-addedinvestmentactivities.Theinvestmentphilosophyistheheartofaninvestment-drivenorganization.Withadamagedheart,theorganizationcanneverfunctionquitethesameagain.Whilesomeinvestmentleadersareskilledheartsurgeons,itisaninfrequentoccurrencewhenaninvestmentorganizationisabletomodifyitsinvestmentphilosophyandmaintainitscompetitiveedge.Greatcareshouldbetakenbyanyorganizationinalteringitsinvestmentphilosophy.ProcessImprovementandSlippageAgoodinvestmentprocessbalancesthenaturaltensionbetweenconsistencyandinnovation.Itsetsreasonableboundaries,butempowersindividualsactingwithintheprocess.Whileinvestmentprocessescanevolve,theyshoulddosoindeliberateandmethodicalfashion.Processshortcutsvirtuallyalwaysendinpainforclientsandforthefirm.Ifitquacks,itisprobablyaduck,orGilbertGottfried.Investmentprocessesshouldbedesignedaroundaframeworkthatunderstandsthepotentialsourcesofvaluecreationandseekstosystem-aticallymeasureandanalyzethem.Aneffectivelong-termprocesshelpstheorganizationsseekcompensatedriskwhileavoidinguncompensated P1:a/bP2:c/dQC:e/fT1:gc08JWBT154-SingerJuly30,200919:44Printer:CourierWestfordFinalThoughts191risk.Withthisideainmind,theinvestmentprocessisessentiallyariskbudgetingprocessdesignedtoallocatetheriskcapitalinthemostefficientandcompensatedmanner.Oneclearsignofabreakdownintheinvestmentprocessisinefficientlyormisallocatedrisk.Whenriskisundetectedoroutsizedrelativetotheopportunitysetpresentinanareaoftheriskbudget,itshouldbeawarningsigntothemanagerandtoclients.Toooften,themanagerlookstheotherwayinthefaceofevidencethatsuggeststheinvestmentprocessisslippingaway.Keepyoureyesandearsopen.Useriskmeasurementandanalysistoyourbenefit,butensurethatimplementationisnotmechanical.Weareabsoluteinourbeliefthattheremustbeahumaninterfacebetweenrisksystemandportfoliostrategy.Ifyouthinkyouhearaduck,youprobablydo.Takeaction.BehavioralBiasesBiasesaffectusallandcanhaveparticularlyilleffectsonourinvestmentdecisionmaking.Astrongprocessprovidessomeguardagainstthem.How-ever,theinputstotheinvestmentprocessareoftentheplacethatbiasescanplaythemostdetrimentalroles.Beingcognizantofandremindedfrequentlyofthosebiaseswillprovidesomeguardagainstthem.Further,diversityofskills,cultures,andideasisanotherimportantdeterrentofbias.Themostimportantthingforustoacknowledgeisthatashumanbeingswetendtoconstructandconfirmourownrealities.Asaresult,addinginformationtoouranalysesdoeslittletoimproveourdecisionmaking.Newinformationinsupportofourpre-existingideasisusuallywelcomedwhilenonsupportiveinformationisexcused.Adoptingtools,techniques,orspecificprocessestoavoidthesebiaseswillhelptoimprovetheconsistencyandqualityofourinvestmentresults.MarketBehaviorandFundamentalApproachesBecauseweconstructourownrealities,andbecausethemarketisacollec-tionofindividuals,ittooconstructsitsownreality.Andthisistherealitythatendsupmeaningthemost.Neverunder-appreciatethepowerofthemarket.Themarkethastheultimatesayinwhowinsandwholoses–intheend,itisneverwrong.Themarketequilibratescurrentsupplyanddemand,butitdoesnotdistinguishwhenthatsupplyordemandisfundamentallydrivenornot.Marketbehaviorplaystheroleofbothfriendandenemytothefunda-mentalinvestor.Marketbehavioriswhatdrivespricesawayfromfunda-mentals,andprovidesopportunitiestobuyundervaluedassetsandtosell P1:a/bP2:c/dQC:e/fT1:gc08JWBT154-SingerJuly30,200919:44Printer:CourierWestford192INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTovervaluedassets.However,marketbehaviorisalsothethingthatkeepspricesdivergentfromfundamentalvalues,oftenforlongerthantheinvest-mentstrategyanditsclientscantolerate.WrongClientsAninvestmentfirmisnothingwithoutitsclients.Neverforgetthat.How-ever,alsodon’tforgetthatfewthingscanbeascatastrophictoaninvestmentfirmashavingthewrongclients.By“wrongclients”wemeanclientswhosetimeframe,objectives,orexpectationsarenotalignedwiththestrategyandapproachoftheinvestmentmanager.Anumberofoncegoodbutnowde-functinvestmentfirmslearnedthislessonthehardwayduringthecreditandfinancialcrisesof2008.Casesinpointarethosehedgefundsthatcateredtostructuredproductprovidersandretailinvestorsasasourceofcapital.Manyhedgefundfirmsofferliquiditytermsthatarebetterthanthedefactoliquidityoftheirun-derlyinginvestments.Theydothisbecauseofthepowerofpoolingoftheircapitalbaseandclients.Aslongasasignificantnumberofclientsdonotactinconcertandsimultaneouslypulltheircapital,thefirmcancontinuetomeetredemptionswhileeffectivelymanagingitsportfolio.Unfortunately,themassdeleveragingof2008exposedtheflawedexecutionofmanyman-agersinthisregard.Toohigharelianceoncertainsourcesofcapital(thatasitturnsoutcanactinconcertundercertainconditions)leftanumberoffirmsunabletomeettheirclientcommitments.Perhapsthesemanagersdidnotknowtheyhadthewrongclients,butitistheclient’sresponsibilitytoassurealignmentmorethanitistheresponsibilityofthemanager.Amanagerwithintegritywillactingoodfaith,buttheonusisontheclienttoascertaingoodfaith.FORSUCCESSFULCLIENTOUTCOMES:COMMUNICATE,COMMUNICATE,COMMUNICATEAswehavesaidsuperiorclientoutcomesareequalpartsinvestingandcommunication.Generatingsuperiorinvestmentperformanceisextremelydifficultbutisachievableforthehighestqualityfirms.However,actuallydeliveringsuperiorinvestoroutcomesraisesadditionalchallengesthatmostoftheinvestmentindustryneitheracknowledgesnorachieves.Virtuallyallinvestorshaveatendencytochasepastperformanceasahopefulindicatoroffutureperformance.Unfortunately,itisacertaintythatpastperformanceisnotanindicatoroffutureresults.Infact,pastperformanceoveranarrowtimeframetendstobeacontraryindicatorof P1:a/bP2:c/dQC:e/fT1:gc08JWBT154-SingerJuly30,200919:44Printer:CourierWestfordFinalThoughts193futureresults.Despiteanumberoftheoreticalandempiricalstudiesthatdemonstratethehazardsofperformancechasing,thisisthemostdramaticandnegativebehavioralbiasthatinvestorsneedassistanceinovercoming.Sound,consistent,andtransparentcommunicationwithclientsthehigh-estsuccessstrategyforachievingsuperioroutcomesandhelpingthemavoidthepitfallsofperformancechasingandothervalue-destroyingbehaviors.Firmsthatcommunicateconsistently,frequently,andrealisticallyarebestpositionedtoretainclientsanddeliversuperioroutcomesovertime.IT’SALLABOUTINCENTIVESIncentivesarenotonlyfinancialinnature.Theyarealsoemotionalandego-driven.However,financialincentivesareverypowerful,andmisalignmentofincentivescanandhasinfactproventoworktothedetrimentofinvestors.Wehavechallengedsomeofthepervasiveandundifferentiatedmodelsintheindustrytoday,especiallythoseofthetypical2&20hedgefundfeestructure.Properalignmentofincentivesrequiresaminimumsetofgoalconsiderationsincluding:
Relativelylowbasefees(managementfees)
Hurdleratesforincentivefees(e.g.,performancefeesaretakenonproceedsinexcessofanagreedhurdle)
Noorrelativelylowfeesformarket(beta-based)return
Relativelyhighfeesforalpha(trueskill)
Hinderinappropriaterisktaking
PenalizeunderperformanceWhilethereisnofeasibleandpracticalperfectfeestructure,wearecertainthatabetterapproachexiststhanthatbeingemployedbymanyin-vestmentfirmstoday.Performancefeehurdlesandtheabilitytoclawbacksomeportionofoutsizedincentivefeesintheeventoffutureunderperfor-mancewouldgoalongwaytocorrectingsomeofthemisalignmentsofincentivesexistentintypicalstructurestoday.INTEGRITYEthicsisknowingthedifferencebetweenwhatyouhavearighttodo,andwhatistherightthingtodo.—PotterStewart,U.S.SupremeCourtJustice P1:a/bP2:c/dQC:e/fT1:gc08JWBT154-SingerJuly30,200919:44Printer:CourierWestford194INVESTMENTLEADERSHIP&PORTFOLIOMANAGEMENTAssessingandencouragingintegritystartswiththeinterviewprocess,employeeindoctrinationandtraining,andofcourseissupportedwithap-propriateinternalcontrols,procesesandprocedures.However,integrityisnotsomethingthatcanbesimplystatedorverballycommunicated.Itissomethingthatisbestdemonstratedanddonesowiththepurestconsistencyfromthetopoftheorganizationdown.Oneofthetruesttestsofintegrityisitsbluntrefusaltobecompromised.—ChinuaAchebeManagingandleadingadiversegroupofintelligentandsometimesegocentrichumanbeingsisneveraneasytask.Andofcourse,thereisnoone-size-fits-allmeansforleadingsuchagrouponameaningfulandsuccessfuljourney.However,thereareafewbestpracticesandgoldenrulesthatcanmakethetaskmoremanageable.Wehopethatsomeofthoseideashavebeenarticulatelystatedandmeaningfullyconveyedinthistext.Themostimportantoftheseideasbyfarisintegrity.Withouttheintegrityofitspeople,aninvestmentfirmisultimatelydoomedtofailure. P1:a/bP2:c/dQC:e/fT1:gnotesJWBT154-SingerAugust12,200915:16Printer:CourierWestfordNotesCHAPTER1CharacteristicsofSuccessfulAssetManagementFirms1.CharlesD.Ellis,Capital:TheStoryofLong-TermInvestmentExcellence(Hoboken,NJ:JohnWiley&Sons,2004),63.2.DovSeidman,How:WhyHowWeDoAnythingMeansEverything...inBusi-ness(andinLife)(Hoboken,NJ:JohnWiley&Sons,2007),243.3.J.C.CollinsandJ.I.Porras,BuilttoLast(NewYork:HarperCollins,1997),73–74.4.J.C.CollinsandJ.I.Porras,BuilttoLast(NewYork:HarperCollins,1997),75.5.CapitalGroupwebsite-www.capgroup.com6.J.WareandJ.Dethmer,HighPerformingInvestmentTeams(Hoboken,NJ:JohnWiley&Sons,2006),17.7.CapitalGroup,www.capgroup.com/careers/itsdifferenthere/what.html.(No-ticethateventheURLspeakstotheculture).8.www.capgroup.com.9.Ellis,page36.10.T.M.Hodgson,etal.,“TheConceptofInvestmentEfficiencyanditsApplica-tionstoInvestmentManagementStructures,”BritishActuarialJournal,6,III(2000),485.11.T.M.Hodgson,etal.,“TheConceptofInvestmentEfficiencyanditsApplica-tionstoInvestmentManagementStructures,”BritishActuarialJournal,6,III(2000),456.12.GaryHamel,“MoonShotsforManagement,”HarvardBusinessReview,HBRatLarge(February2009):3.13.Ibid.14.FriedrichA.Hayek,TheRoadtoSerfdom:FiftiethAnniversaryEdition(Chicago:UniversityofChicagoPress,1994).15.FriedrichA.Hayek,TheRoadtoSerfdom:FiftiethAnniversaryEdition(Chicago:UniversityofChicagoPress,1994),20.16.AlfredD.Chandler,StrategyandStructure–ChaptersintheHistoryoftheIndustrialEnterprise(Cambridge:MITPress,1962).17.GaryHamel,MoonShotsforManagement,HarvardBusinessReview,HBRatLarge(February2009):6.18.FriedrichA.Hayek,TheRoadtoSerfdom:FiftiethAnniversaryEdition(Chicago:UniversityofChicagoPress,1994),21.195 P1:a/bP2:c/dQC:e/fT1:gnotesJWBT154-SingerAugust12,200915:16Printer:CourierWestford196NOTES19.CharlesD.Ellis,Capital:TheStoryofLong-TermInvestmentExcellence(Hoboken,NJ:JohnWiley&Sons,2004),25.20.CharlesD.Ellis,Capital:TheStoryofLong-TermInvestmentExcellence(Hoboken,NJ:JohnWiley&Sons,2004),92.CHAPTER2BuildingaCathedral1.https://www.dodgeandcox.com/about.asp.2.https://www.dodgeandcox.com/about.asp.3.Theterms“accountable,”“authority,”and“responsibility”arepreciselyusedinthistext.“Accountable”and“responsible”areusedsynonymouslyandinterchangeablytoindicatebehaviorsandactionsanindividualoragroupofindividualsareheldtoexplain,justify,andbearremunerativeburden.“Authority”referstothepowersanindividualoragroupofindividu-alshastoinfluencebehaviorsandactions.Individualsorgroupsshouldbeheldaccountableonlyforthosebehaviorsandactionsoverwhichtheyhaveauthority.CHAPTER3BuildingaMeritocracy1.Extraordinaryperformancelastingforaboutthreeyearspresagesmanagerhir-ingandfiringdecisions.”TheSelectionandTerminationofInvestmentMan-agementFirmsbyPlanSponsors,”GoyalandWahal,TheJournalofFinanceVol.LXIII,No.4August2008.2.CFAInstitute,“DerivativesandPortfolioManagement,”CFAProgramCur-riculum,Volume6,LevelII(2008),Reading72,“ThePortfolioManagementProcessandtheInvestmentPolicyStatement,”byJohnL.Maginn,DonaldL.Tuttle,DennisW.McLeavey,andJeraldE.Pinto,p.493.ThisisareprintofManagingInvestmentPortfolios:ADynamicProcess,3rdEdition,JohnL.Maginn,DonaldL.Tuttle,DennisW.McLeavey,andJeraldE.Pinto,editors2005,CFAInstitute.3.Ifreturnswereseriallycorrelated,thisstatementwouldbeonlyapproximatelytrue;however,sincethereturnsareassumedtobeIID,independentandidenti-callydistributed,thestatementisaccurate.Seriallycorrelatedreturnsofilliquidassets,suchasprivateequityandhedgefunds,resultinoverstatedinformationratios.4.MarkKritzman’sThePortableFinancialAnalystisaverygoodbookonanumberoftopicsandprovidesanicesummaryofhypothesistesting,suchasperformanceanalysisonpages134–136.5.DenisS.KarnoskyandBrianD.Singer,“AGeneralFrameworkforGlobalCurrencyManagement,”SecuritiesAnalystsJournal,March1991.6.Insomeorganizations,analystscanevidencethesameorhigherlevelofcriticalityasportfoliomanagers.Iusethishierarchymerelyforillustrativepurposes. P1:a/bP2:c/dQC:e/fT1:gnotesJWBT154-SingerAugust12,200915:16Printer:CourierWestfordNotes197CHAPTER4InvestmentPhilosophyandProcess1.WilliamF.Sharpe,“TheArithmeticofActiveManagement,”TheFinancialAnalystsJournal47(January/February1991):7–9.2.SanfordGrossmanandJosephStiglitz,“InformationandCompetitivePriceSystems,”AmericanEconomicReview66(1976):246–253.3.http://www.capgroup.com/aboutus/investmentphilosophy.html.4.JamesC.CollinsandJerryI.Porras.BuilttoLast:SuccessfulHabitsofVisionaryCompanies(NewYork:HarperCollins,1994),73.5.HerbKelleher,“ACultureofCommitment”,LeadertoLeader,No.4,Spring1997.6.DennisMcLeavey,etal.ManagingInvestmentPortfolios,JohnWiley&Sons,(March2007)Chapter1.7.AlbertEdwardsandJamesMontier,GlobalStrategyWeekly,MacroResearch,AssetAllocation,Global,DresdnerKleinwortSecuritiesLimited,7March2007,1.8.LarryHathaway,etal.,UBSWeeklyWeightWatcher,UBSInvestmentRe-search,GlobalStrategyResearch,UBSLimited,anaffiliateofUBSAG,2March2007,1.9.RichardHeuerJr,ed.,PsychologyofIntelligenceAnalysis(NewYork:NovaNovinka,2005),47.10.RichardHeuerJr,ed.,PsychologyofIntelligenceAnalysis(NewYork:NovaNovinka,2005),21.11.NassimNicholasTaleb,TheBlackSwan:TheImpactoftheHighlyImprobable(NewYork:RandomHouse,2007),144.12.Asthecreditcrisishasprogressed,deleveraginghasreducedboththeassetandliabilitysideofthehouseholdbalancesheet.Themagnitudesandtheimpactonhouseholdnetworthareunknownatthistime.13.RichardHeuerJr,ed.,PsychologyofIntelligenceAnalysis(NewYork:NovaNovinka,2005),68.14.PaulSlovic,BehavioralProblemsofAdheringtoaDecisionPolicy,unpublishedmanuscript,1973.15.JamesSurowiecki,TheWisdomofCrowds(NewYork:Anchor,2005),254.CHAPTER5InvestmentProcessinanEvolvingWorld1.PeterL.BernsteinandAswathDamodaran,eds.,IntroductiontoInvestmentManagement(NewYork:Wiley,1998).2.ThisideaisadaptedfromDovSeidman’s,How:WhyHowWeDoAnythingMeansEverything...inBusiness(andinLife)(NewYork:Wiley,2007).3.ArmenA.AlchianandWilliamR.Allen,UniversityEconomics:ElementsofInquiry(3rded.)(WadsworthPub.Co,1972),456.4.ArmenA.AlchianandWilliamR.Allen,UniversityEconomics:ElementsofInquiry(3rded.)(WadsworthPub.Co,1972),674. P1:a/bP2:c/dQC:e/fT1:gnotesJWBT154-SingerAugust12,200915:16Printer:CourierWestford198NOTES5.TheCFAInstituteprogramisequivalenttoamastersprogramininvestmentfinance.Theprograminvolvesthreeexaminationstakenoveraboutathree-yearperiod.Whencompletelysuccessfully,theCFAdesignationprovidesamarkofexcellenceineducationandethicsforitsrecipient.6.BenjaminGrahamandDavidL.Dodd,SecurityAnalysis:PrinciplesandTech-nique(6thed.)(NewYork:McGrawHill,2009).AswathDamadoran,Invest-mentValuation:ToolsandTechniquesforDeterminingValueofAnyAsset(WileyFrontiersinFinance,UniversityEdition,1996).7.JasonZweig,“ForInvestors,DealingwithaLossofControl,”WallStreetJournal,October2,2008.8.CharlesMacKay,ExtraordinaryPopularDelusionsandtheMadnessofCrowds,forewordbyAndrewTobias(NewYork:HarmonyBooks,1980).OrCharlesMackay,MemoirsofExtraordinaryPopularDelusionsandtheMadnessofCrowdsVol.I:TheEssentialLibraryEdition(NewYork:XlibrisCorporation,2000).9.MarkBuchanan,Ubiquity:WhyCatastrophesHappen(NewYork:ThreeRiversP,2002).10.JamesSurowiecki,TheWisdomofCrowds(NewYork:Anchor,2005).11.PhilipBall,CriticalMass:HowOneThingLeadstoAnother(NewYork:Farrar,Straus&Giroux,2006).12.Thephrase“interactiveagents”isusedthroughouttomeanthingsthatactandinteractwitheachother.Inmarketstheinteractiveagentsareinvestors,advisors,clients,andsoon.13.JamesMontier,BehaviouralInvesting:APractitionersGuidetoApplyingBe-haviouralFinance(Wiley,2007);HershShefrin,BeyondGreedandFear:Un-derstandingBehavioralFinanceandthePsychologyofInvesting(USA:OxfordUniversityPress,2007);AndreiShleifer,InefficientMarkets:AnIntroductiontoBehavioralFinance(USA:OxfordUniversityPress,2000);RichardH.Thaler,AdvancesinBehavioralFinance(RussellSageFoundationPublications,1993);RichardH.Thaler,AdvancesinBehavioralFinance,VolumeII(PrincetonUni-versityPress,2005).14.Technically,anormaldistributioncanhavefattailsthatresultfromskewnessorkurtosis.Weareusingtheterm“normal”looselyaswearetryingnottobetechnicalandprefertomoveontootherreturndistributioncharacteristics.15.NassimNicholasTaleb,TheBlackSwan:TheImpactoftheHighlyImprobable(NewYork:RandomHouse,2007).16.KarlPopper,BenoitMendelbrot,GeorgeSoros,andNassimTalebhaveallcontributedinvariouswaystothisdebate.17.TheseevolutionaryobservationsaredrawnfromUbiquitybyMarkBuchanan.MarkBuchanan,Ubiquity:WhyCatastrophesHappen(NewYork:ThreeRiversP,2002),90–91.18.MarkBuchanan,Ubiquity:WhyCatastrophesHappen(NewYork:ThreeRiversP,2002),105–106.19.Thiscanbeconsideredanaspectofwhatisoftenreferredtoas“SocialDar-winism.”SocialDarwinismhasavariedhistoryofacceptanceandridicule,howevertheuseinthistextisrelativelynarrow,andthereisnodesiretomakeanystatementbeyondwhatisexplicit. P1:a/bP2:c/dQC:e/fT1:gnotesJWBT154-SingerAugust12,200915:16Printer:CourierWestfordNotes19920.“ThisEconomyDoesNotCompute,”TheNewYorkTimes,October1,2008,Op-Edsection,NewYorkedition.21.JeremySiegel,“TheResilienceofAmericanFinance,”WallStreetJournal,September16,2008.22.JamesMontier,“MindMatters:TheQuestfortheHolyGrail,or,It’sOnlyaFleshWound”,SocieteGenerale:CrossAssetResearch(December13,2007).23.PhilipBall,CriticalMass:HowOneThingLeadstoAnother(NewYork:Farrar,Straus&Giroux,2006),238.24.MarkBuchanan,Ubiquity:WhyCatastrophesHappen(NewYork:ThreeRiversP,2002),126.25.PhilipBall,CriticalMass:HowOneThingLeadstoAnother(NewYork:Farrar,Straus&Giroux,2006),195.26.DavidTuckettandRichardTaffler,“Phantasticobjectsandthefinancialmar-ket’ssenseofreality:Apsychoanalyticcontributiontotheunderstandingofstockmarketinstability.”TheInternationalJournalofPsychoanalysis89(2008):389–412.27.JamesSurowiecki,TheWisdomofCrowds(NewYork:Anchor,2005),10.28.Ifthereaderismoreinterestedinthisidea,werecommendgoingtowww.intrade.comtoseefunctioningmarketsonanumberoftopicsaroundtheworldtoday.Wehavefoundthesemarketstobesuperiortopollsandpunditswhoclaimtohavebetterinsightthantherestofusmeremortals.29.JamesSurowiecki,TheWisdomofCrowds(NewYork:Anchor,2005),31.30.JamesSurowiecki,TheWisdomofCrowds(NewYork:Anchor,2005),38.31.DavidTuckettandRichardTaffler,“Phantasticobjectsandthefinancialmar-ket’ssenseofreality:Apsychoanalyticcontributiontotheunderstandingofstockmarketinstability,”TheInternationalJournalofPsychoanalysis89(2008):389–412.32.DavidTuckettandRichardTaffler,“Phantasticobjectsandthefinancialmar-ket’ssenseofreality:Apsychoanalyticcontributiontotheunderstandingofstockmarketinstability,”TheInternationalJournalofPsychoanalysis89(2008):392.33.Ibid.34.DavidTuckettandRichardTaffler,“Phantasticobjectsandthefinancialmar-ket’ssenseofreality:Apsychoanalyticcontributiontotheunderstandingofstockmarketinstability,”TheInternationalJournalofPsychoanalysis89(2008):396.35.DavidTuckettandRichardTaffler,“Phantasticobjectsandthefinancialmar-ket’ssenseofreality:Apsychoanalyticcontributiontotheunderstandingofstockmarketinstability,”TheInternationalJournalofPsychoanalysis89(2008):398.36.RJShiller,IrrationalExuberance,secondedition(Princeton,NewJersey:Prince-tonUP,2005),207.37.RenatoStaub,“MultilayerModelofMarketCovarianceMatrix,”JournalofPortfolioManagement(Spring2006):33–44.RenatoStaub,“GlobalInvestmentSolutions:CapitalMarketAssump-tions,”UBSGlobalAssetManagementWhitePaperSeries(February2005). P1:a/bP2:c/dQC:e/fT1:gnotesJWBT154-SingerAugust12,200915:16Printer:CourierWestford200NOTESBrianSinger,RenatoStaub,andKevinTerhaar,“AnAppropriateAllo-cationforAlternativeInvestments,”JournalofPortfolioManagement(Spring2003).RenatoStaubandJeffreyDiermeier,“Segmentation,IlliquidityandRe-turns,”JournalofInvestmentManagement(FirstQuarter2003).BrianSingerandKevinTerhaar,“EconomicFoundationsofCapitalMar-ketReturns”(TheResearchFoundationofAIMRandBlackwellSeriesinFi-nance,September1997).CHAPTER6CommunicationforSuperiorClientOutcomes1.TimothyByrneandAaronReynolds,“Investors’Paradox—AllHighPer-formingManagersUnderperform,”Baird’sAdvisoryServicesResearchGroup,August,2008.CHAPTER7WherearetheClients’Yachts?1.BurtonG.MalkielandAtanuSaha,“HedgeFunds:RiskandReturn,”FinancialAnalystJournal,61,6(2005).2.AndrewClavell,“PoorAcademicGrouseatWealthyHedgeFundMan-agers(again),”FinancialCookery,April4,2008.Availableathttp://crookery.blogspot.com/2008/04/poor-academics-grouse-at-wealthy-hedge.html.3.MartinWolf,“Whytoday’shedgefundindustrymaynotsurvive,”FinancialTimes,March18,2008.4.This$4.5millioncouldhavebeenusedtosellevenmorecalloptionsatthebeginningoftheyear.Thehedgefundcouldhavesoldjustenoughcalloptionstocompletelyextinguishtheirclients’$100millioninvestment.5.MartinWolf,“Whytoday’shedgefundindustrymaynotsurvive,”FinancialTimes,March18,2008.6.GeorgeA.Akerlof,“TheMarketfor‘Lemons’:QualityUncertaintyandtheMarketMechanism,”TheQuarterlyJournalofEconomics,Vol.84,No.3,(August1970):488–500.Thisreferencespage1ofthearticle,ormoreappro-priatelypage488.7.Thereisdeliciousironyinthefactthat“portfolioinsurance,”aputoptionstrategysimilartotheoneIusedcaptureablackswanevent,wasexactlythestrategythatinvestorspiledintoin1987,leadingtotheBlackMondaycrashinOctober1987.Intryingtoreducerisk,theincreasingpopularityofportfolioinsurancewasasignificantcontributortotheblackswancrash.8.MartinWolf,“Whytoday’shedgefundindustrymaynotsurvive,”FinancialTimes,March18,2008.9.Asimplealternativewouldvestandcrystallizefractionallyoverapre-specifiednumberofyears. 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P1:a/bP2:c/dQC:e/fT1:gAtAJWBT154-SingerAugust28,200921:26Printer:CourierWestfordAbouttheAuthorsBrianD.Singer,CFABrianSingeristhefounderandCIOofSingerPartners.Brianhas27yearsofinvestmentexperience,muchofthatdedicatedtothemanagementofuncon-strainedglobalassetallocationportfolios.Hehasservedontheinvestmentcommitteesofanumberofcollegeanduniversityendowments.Heisamem-beroftheCFABoardofGovernorsandanadvisoryboardmemberoftheJournalofPerformanceMeasurement.Overthepast20years,hehaswrittenandcontributedtoanumberofacademicjournalsandfinancialpublications.HeisarecipientoftheGrahamandDoddScrollandtheDietzaward.HispublishedworksincludeKarnosky,Dr.DenisS.,andBrianD.Singer.“AGeneralFrameworkforGlobalCurrencyManagement,”SecuritiesAnalystsJournal(March1991),andSinger,BrianD.,andKevinTerhaar.“EconomicFoundationsofCapitalMarketReturns,”TheResearchFoundationoftheInstituteofCharteredFinancialAnalysts(September1997).Hereceivedhisbachelor’sdegreefromNorthwesternUniversityin1982andhisMBAfromtheUniversityofChicagoin1986.Brian’spastimesincludefamily,fishing(mostlyforlargemouthbass),andpontificatingonthetopicsofeconomics,integrity,andlibertytoanyonewhowilllisten.GregT.Fedorinchik,CFAGregFedorinchikhas16yearsofinvestmentindustryexperience.GregisheadofInvestorSolutionsatMesirowAdvancedStrategies,Inc.,afirmspecializingininstitutionalmultimanagerhedgefundportfolios.GregspentmostofhisinvestmentcareerwithBrinsonPartners,Inc.inChicago,whichlaterbecameUBSGlobalAssetManagement.Hehasworkedinavarietyofinvestment,clientservice,andmarketingrolesandhashelpeddesignandmanageanumberofinnovativeglobalinvestmentofferingsforpublicandcorporatedefinedbenefitplans,definedcontributionplans,andotherinstitutionalinvestors.Gregreceivedabachelor’sdegreefromtheUniversityofMichigan(economicsandEnglish)in1993andamaster’sdegreeinmanagementfromtheKelloggGraduateSchoolofBusinessatNorthwesternUniversity(financeanddecisionsciences)in2001.GreggrewupinTraverseCity,Michiganandreturnsfrequentlytothatstateinpursuitofitstroutandwalleye.205 P1:a/bP2:c/dQC:e/fT1:gAtAJWBT154-SingerAugust28,200921:26Printer:CourierWestford206ABOUTTHEAUTHORSBarryMandinachBarryMandinachhas27yearsofinvestmentindustryexperience.HeworkedforDrexelBurnhamLambertinNewYorkfrom1981to1989.BarrycofoundedZweigMutualFundsin1989andworkedthereuntilthefirm’ssalein1999toPheonixInvestmentPartners.Heisalsothechiefmarket-ingofficerofUBSGlobalAssetManagement,Americas.Barryreceivedhisbachelor’sdegreefromEmoryUniversityin1978andhisjurisdoctordegreefromtheUniversityofMiamiSchoolofLawin1981.BarryspendshisfreetimewithhisfamilyandwheneverpossiblewatchingtheNewYorkMets,Knicks,andJets.ABOUTTHECONTRIBUTORJosephE.MacconeJoeMacconehasnineyearsofinvestmentindustryexperience.HeworkedatJ.&W.Seligman&Co.inNewYorkfrom2000to2002.In2002,hejoinedUBSGlobalAssetManagement,whereheiscurrentlytheNationalSalesDeskManager.Joereceivedhisbachelor’sdegreefromVillanovaUniversityin2000(financeandphilosophy)andhisMBAfromtheNewYorkUniversitySternSchoolofBusinessin2006(financialinstrumentsandmarketsandmanagement).Joeenjoysspendinghisfreetimewithhisfamily,andisanavidsportsandmusicfan. P1:a/bP2:c/dQC:e/fT1:gindJWBT154-SingerJuly30,200912:46Printer:CourierWestfordIndexAchebe,Chinua,194TheBlackSwan:TheImpactoftheHighlyAkerlof,George,167Improbable(Taleb),92Alpha,128–129,166–167,177,178.SeeBlack,Fischer,161alsoFeestructures,highintegrityBlackswans,92–94AmericanFunds,7,8,25.SeealsoCapitalBogle,Jack,2,3,132GroupBonds,88AmericanInsuranceGroup(AIG),168,169,TheBonfireoftheVanities(Wolfe),xii170Brinson,Gary,11,12,31–32,126.SeealsoAndreasen,Paul,82BrinsonPartnersArcastle,Virginia,61BrinsonPartners,11–12,29,31–32,50,Asset,88–90.SeealsoAssetmanagement70–72,77,126,169firmsBuchanan,Mark,91,102,103,109–110Assetmanagementfirms:Buffett,Warren,90,97,118,136,137,142clientoutcomes(seeClientoutcomes)BuilttoLast(Collins,Porras),73collaboration,19–23ABusinessandItsBeliefs(Watson),4culture,3–7feestructures(seeFeestructures)Canaryportfolio,105governance(seeGovernanceofassetCapitalGroup,2,72managementfirms)CapitalGuardian.SeeCapitalGroupintegrity,23–25,193–194CapitalInternational.SeeCapitalGroupinvestmentphilosophy(seeInvestmentCapital:TheStoryofLongTermInvestmentphilosophyandprocess)Excellence(Ellis),2leadershipandmanagement(seeCato,107Leadershipofassetmanagementfirms)Chancellor,Edward,91meritocracy(seeMeritocracyofassetChandler,Alfred,21,23managementfirms)ChiefExecutiveOfficer(CEO).Seepitfalls,190–192Governanceofassetmanagementfirmssize,7–12ChiefInvestmentOfficer(CIO)17–18,successfulcharacteristics,1–3,18873–74,119–120,122–123,124–127values,6,188–189(seealsoLeadershipofChiefMarketingOfficer(CMO),148assetmanagementfirms)ChiefOperatingOfficer(COO),18Assetsundermanagement(AuM),8–12,25Citigroup,104Clientoutcomes:Baird&Co.,134communication,192–193Ball,Philip,91,102,109,112culture,145–146(seealsoAssetBarclaysGlobalInvestors,7managementfirms)Beliefperseverancebias,80–82distributionshop,143–145Beta,128–129,175–177,178.SeealsoFeeequityinvestment,139–142structures,highintegrityinextrememarkets,149–157binRashidAlMaktoum,Mohammed,33humannature,133–134207 P1:a/bP2:c/dQC:e/fT1:gindJWBT154-SingerJuly30,200912:46Printer:CourierWestford208INDEXClientoutcomes(Continued)FocusConsultingGroup,30overview,131–133Foster,DeanP.,166performancechasing,134–137casestudies,137–139Gammatrade.SeeFeestructuresrecovery,142–143Geanakoplos,John,103salesandmarketing,146–149Governanceofassetmanagementfirms:Confirmationbias,80–82boardcomposition,15Confucius,107casestudy,16–17ContiCommodity,161–164CEOsandCIOs,17–18CriticalMass:HowOneThingLeadstoincentives,18,193Another(Ball),91,102,109,112missionstatement,13–15SeealsoLeadershipofassetmanagementDamodaran,Aswath,85,89firmsDarwin,Charles,100Graham,Benjamin,89,90,96DevilTaketheHindmost:AHistoryofGrantham,Jeremy,126FinancialSpeculation(Chancellor),91Grantham,Mayo,VanOtterloo(GMO),25,Diermeier,Jeff,76–77126Dittmer,Tom,163–164Grossman,Blake,7Dodd,David,89Grossman-Stiglitzparadox,70Dodge&Cox,8,32–33DresdnerKleinwort,76Hamel,Gary,19,20,21Hayek,FriedrickA.,21,22Edge(Taleb),167Heuer,RichardJ.Jr,78,81,124Edison,Thomas,85,121,123HewlettPackard,5Einstein,Albert,78,86Hewlett,Bill,5ElectronicDataSystems(EDS),19–20HierarchyofChoice,55–56.SeealsoEllis,Charles,2,9,23Meritocracyofassetmanagementfirms,EnronCorporation,4–5criticalityEquity,88.SeealsoClientoutcomes,equityHighPerformingInvestmentTeams(Ware),investment6–7How(Seidman),87Farmer,Doyne,103Huxley,Aldous,55Feestructures:foralpha,177,178InvestmentManagement(Damodaran),85anatomyofablowup,167–168Investmentphilosophyandprocess:forbeta,175–177,178behavioralbiases,77–82,191catch22,168–170controlandanarchy,73–76compensationsymmetry,172–173forecasting,76–77gammatrade,161–166corebeliefsof,70–73fakealpha,166–167fundamentalvaluation,88–90highintegrity,178importanceof,69–70casestudies,181–186marketbehavior,90–94,191–192specifics,179–181andclientdesires,170–172,192high-watermarks,173–174andcriticalstates,109–118inappropriaterisk,174–175andevolution,98–107marketbehaviorandclientdesires,andnoise,107–108170–172andtimehorizons,107–108overview,159–161andunknownvalue,95–98FirstChicago,169overview,85–87“Flow”information,80–82portfoliodesign,127–128 P1:a/bP2:c/dQC:e/fT1:gindJWBT154-SingerJuly30,200912:46Printer:CourierWestfordIndex209riskcapitalallocation,128–129overview,189–190teambehavior,118–122performance,39–40ourmarketvs.themarket,122–123performanceanalysis,40–42Investmentphilosophystatement.Seecasestudy,44–45Investmentphilosophyandprocess;ex-anteexpectations,46–48Leadershipofassetmanagementfirmsex-postanalysis,45Investmentprocessstatements.Seeinformationratio,42–45Investmentphilosophyandprocessperformancescore,52–53InvestmentValuation(Damodaran),89ratingsystem,51–52IrrationalExuberance(Shiller),126top-down/bottom-upapproach,48–51SeealsoKeyPerformanceIndicatorKarnosky,Denis,177Miller,Bill,136–137Kay,Alan,32Minsky,Hyman,104Kepler,Johannes,93MitchellHutchinsAssetManagement,29KeyPerformanceIndicator(KPI),34–37,ModernPortfolioTheory(MPT),11250–51,145–146Munger,Charles,58Keynes,JohnMaynard,40,90,107Kindleberger,Charles,91Netassetvalue(NAV),173–174King,MartinLutherJr,4Kissinger,Henry,31Packard,David,5PaineWebber,29Landsburg,StevenE.,47Passiveinvesting,69–70Leadershipofassetmanagementfirms:Perot,Ross,19,20framework,28–29Peters,Tom,65missionstatements,31–33“Phantasticobjects,”119,124–127,160philosophystatements,31–33(seealsoPhillips&Drew,11–12,29Investmentphilosophyandprocess)Prince,Chuck,104strategicgoals,33–37PsychologyofIntelligentAnalysis(Heuer),values,29–3178,81andcompensation,64–67SeealsoGovernanceofassetmanagementRand,Ayn,55firms;KeyPerformanceIndicatorReagan,Nancy,50LeggMasonCapitalManagement,136–137REFCO,163–164Liquidity,102,105–107Regalado,Antonio,124Litterman,Bob,164Riskcapitalallocation,128–129TheRoadofSerfdom(Hayek),21Mackay,Charles,91Robertson,Julian,126Madoff,Bernard,24Rogers,Will,28Mandelbrot,Benoit,92,97Roosevelt,Theodore,21Manias,PanicsandCrashes(Kindleberger),91S&P500,171,176–177MemoirsofExtraordinaryPopularSchole,Myron,161Delusions(Mackay),91SecurityAnalysis,89–90Meritzones.SeeMeritocracyofassetSeidman,Dov,87managementfirmsSharpe,Bill,70Meritocracyofassetmanagementfirms:Singer,Brian,29–31,175–176,177criticality,53–57Smith,Adam,xiimeritzones,57–59,122–123Smith,C.W.,124andcommunication,59–61,64Spencer,Herbert,60andcompensation,61–63Spin,104 P1:a/bP2:c/dQC:e/fT1:gindJWBT154-SingerJuly30,200912:46Printer:CourierWestford210INDEXStewart,Potter,193UnionBankofSwitzerland(UBS),11–12,“Stock”information,80–8229,71,76,121StrategyandStructure(Chandler),21Surowiecki,James,82,91,119,120,122Vanguard,2,3,8,132SwissBankCorporation(SBC),11–12,29Ware,Jim,6–7,30Taffler,Richard,124,126Watson,ThomasJ.Jr,4Taleb,Nassim,92,97,111,114,117,167Wilde,Oscar,119Thurner,Stephan,103TheWisdomofCrowds(Surowiecki),82,TigerManagement,12691,119,120Totalportfolioreturn.SeeFeestructures,Wolf,Martin,166,167,170highintegrityWolfe,Tom,xiiTsu,Lao,77WolfgangvonGoethe,Johann,107Tuckett,David,124,126Wuffli,Peter,11–12Ubiquity:WhyCatastrophesHappen(Buchanan),91,102Young,H.Peyton,166UBSGlobalAssetManagement,71,76,121,147,175Zweig,Jason,89 (continuedfromfrontflap)PraiseforFEDORINCHIKThereisnoone-size-fits-allapproachtoleadingSINGERadiversegroupofintelligentindividualsandtheInvestmentLeadershipfirmstheyrepresent.However,thereareafewbestpracticesandrulesthatcanmakethetaskaandPortfolioManagementmoremanageableone.WiththeideasarticulatedinInvestmentLeadershipandPortfolioManage-“Thisshortbookpacksalotofwisdomaboutportfoliomanagement.ItdemonstratesInvestmentLeadershipandPortfolioManagementment,you’llgainabetterunderstandingofhowtotheimportanceoffirmcultureandlongertimehorizonstosuccessfulinvesting,effectivelyoperatewithintoday’scompetitivein-whileputtingforwardatrulycreativeapproachtoperformancefees.”vestmentindustryandachieveasignificantlevel—BobPozen,Chairman,MFSInvestmentManagementofsuccess.“SingerandFedorinchikhaveaddedanimportantbooktothelibraryofinvestmentBRIANSINGERisChiefInvestmentOfficerleaders.Theydrilldeepintothequestionofproduct-drivenvs.investment-drivenofSingerPartnersandChairmanoftheCFAfirms,coveringimportantfoundationaltopicslikevision,mission,culture,compen-InstituteBoardofGovernors.Previously,hewasINVESTMENTsation,andfeestructures.WhenseriouspractitionerslikethesetwotakethetimetoheadofglobalinvestmentsolutionsatUBSGlobalwriteaboutbestpractices,theresultisabookthatringstrue.FullofpracticalideasAssetManagement(formerlyBrinsonPartners,thataresupportedbyadeepunderstandingoftheunderlyingfinancialtheoriesandInc.),responsibleforassetallocationandcurrencylotsofreal-world,front-lineexperience.Amust-readforallinvestmentprofessionalsstrategies.SingerisalsoEmeritusBoardMemberwhoarecommittedto‘gettingitright’inthispost-crisisenvironment.”oftheResearchFoundationofCFAInstituteandLEADERSHIP—JamesWare,CFA,authorofHighPerformingInvestmentTeams,anadvisoryboardmemberoftheJournalofPerfor-founderofFocusConsultingGroupmanceMeasurement.Heisarecipientofthe1991GrahamandDoddAwardanda2001recipientof“Inanexceptionalanddecidedlyuniquestyle,InvestmentLeadershipandPortfoliotheDietzAward.SingerholdsanMBAfromtheManagementdeservesspecialattentionfromanyinvestor.Theauthorsweaveawon-andUniversityofChicago.derfulmosaicoftheinvestmentmanagementlandscapethatisbothdifferentfromPORTFOLIOGREGFEDORINCHIKisheadofinvestorso-otherinvestmentbooksandcompellinginitsfocusonthetrulyrelevantissues.ThelutionsatMesirowAdvancedStrategies,Inc.,ancasestudiesandreferencestoactualexperiencesmakethisbookanenjoyablereadinstitutionalfundofhedgefundsfirmbasedinand,equallyimportant,providelong-soughtattentiontothefactorsthatreallymat-Chicago.PriortojoiningMesirow,hewasase-terinthequestforinvestmentperformance.”niorstrategistwiththeglobalinvestmentsolutions—GaryP.Brinson,President,GPBrinsonInvestmentsteamatUBSGlobalAssetManagement(formerlyMANAGEMENTBrinsonPartners,Inc.)andamemberoftheas-“SingerandFedorinchikhavelaidoutaclearvisionofthemodern,post-crisisassetsetallocationandcurrencycommittee.Fedorin-managementfirminwhichtheinterestsoftheinvestmentprofessionals,thefirm,andThePathtoSuccessfulStewardshipchikholdsanMBAfromtheKelloggSchooloftheendclientarefullyaligned.ThisbookcombinesdecadesofpracticalexperienceManagement,NorthwesternUniversity.withoriginalinsightsfromportfolioandbehaviortheory,inequalmeasuresofwitforInvestmentFirmsandwisdom.”—DonaldM.Raymond,PhD,CFA,SeniorVicePresident,PublicMarketInvestments,CanadaPensionPlanInvestmentBoardBRIANSINGERGREGFEDORINCHIK