Pinocchio’s nose grew longer and longer as he told more lies. I want to soften this analogy as you will see, but the abstraction is sadly not far off.
Hopefully, this promotes discussion
Active asset managers have been struggling for some years to maintain trust with their clients regarding performance, and the constant assault on charges by the media coupled with buy/hold outperformance has not helped their cause. The essential problem is the Promise delivery so often falls well short. I would like to highlight particular behaviours that aggravate this problem,
Reality check. Bloomberg News Markets – U.K. Active Asset Managers Get Pounded in Coronavirus Turmoil. By Lucca De Paoli April 6, 2020
- Investors yanked about $2.1 billion from active funds in March
- Passive funds had their best month on record during the rout
Active managers have been waiting for volatility to arrive after the longest bull run in history in the hope of winning back investors; it seems the opposite has happened.
Its time to take stock, and maybe travel a different route, one of self-reflection.
There is no doubt that today’s asset managers are the most educated and sophisticated than they have ever been; also, technology has improved at pace since PCs became faster, and high-quality data is now in abundance. The point is that the skills and the intelligence of the people in the industry are well spread, they don’t reside in just a few large institutions – all chasing the elusive alpha. With ever more sophisticated trading technology, making people feel they have more control over investments, something very much remains the same – poor returns. Why?
Well, I don’t pretend to have all the answers, but if we take it at the most simplistic level, we could just leave it as a result of increased smart competition, in much the same way Hedge Funds fell from grace in the retail market pretty much for this reason. But I think the story is much richer and worth exploring. Let’s take a look at human nature operating in financial services across the board.
Human behaviour is a fascinating subject, and indeed, Tversky and Kahneman in their book Thinking Fast and Slow (one of my favourite books) beautifully illuminates us in all our “magnificence.”
Looking at two particular pockets of human behaviour, the first being where the herd takes over operating and stampedes, causing misery, and the second where people emerge as leaders on frontiers making groundbreaking discoveries.
Three Questions for those active in asset management.
- Do you see Pinocchio at work in your business? Do see yourself wanting to object to decisions, but find yourself complicit in a Pinocchio story?
- Is his presence “visible” at every level, all the way up the technical food chain?
- Is “Groupthink” operating within your business on the big issues, do you see it in motion?
If you can say no to each of the above, you are likely between jobs or still a young whizz.
To examine these points, I have to leap back in time, some 41 years – scary when I write that down.
I started in this industry as an assistant “investment analyst” for a small broker. I write that in inverted commas because what I was really doing was framing statistics for the marketing department to help with sales. Pinocchio was our team leader in my view. I was very aware that almost everyone in the department was digesting the pictures we painted as real, even though internally within our team, we knew the data was being manipulated (we were doing it). Groupthink cloud cuckoo land had swallowed up the rest of the company; they had shiny illustrations of how wonderful we were doing. Seminars would have been a treat to watch for any budding psychologist. The framing worked, and people invested.
Other companies were producing funds like the proverbial sausage machine, every one a winner until they weren’t; they were then unceremoniously dumped never to be seen again. Fantastic for survivorship bias protecting the return histories of certain market segments.
I now have to wind forward several years to 1985 – 35 years ago because I followed a different work pathway for a time. 1985, I joined a subsidiary of an old merchant bank which presented itself professionally and was doing what I saw as a great job in wealth management where asset management fused with estate planning. In-house training was first class, and there was a definite emphasis on clients winning, as there is in most companies. Around one year in, one of the wise men in the asset management team gave us a general talk about investing in equities, in that talk, he said: “you will never find a 5 year period where equities have not shown a better return than deposits.”
In a flash, this became a mantra for very many sales meetings and seminars up and down the country – I knew it was not valid. I am sure many other people also knew this, but the draw of the message on sales soon brought everyone under the spell of its simplicity. Pinocchio had entered the room again as a saviour when facing a hurdle to a sale or dealing with awkward downturns.
When October 1987 arrived, I got my first taste of a client’s horror as she watched her portfolio value drop off a cliff. The pain was palpable, and I felt every last bit of it. I will never forget that moment, which is saying something because I forget most things these days. How was I to respond to her distress? Yes, you have it – I said: “don’t worry, ride the storm, you will be rewarded within five years.” In those days people had longer time horizons, unlike today. I don’t think my words helped her, because she was still bruised at the bottom of the cliff, but I had an answer, which helped me. Maybe the wise man was a prophet of things to come, or more likely, he had lived through many downturns for which he had no practical answer, so a bit of bluff helped. As it was, she was rewarded in much less time. A popular misconception when looking at the time back to the peak is to look at the market indices and not the particular funds – there can be a huge time difference.
A popular misconception when looking at the time back to the peak is to look at the market indices and not the particular funds – there can be a huge time difference.
The wise man gave us something that is blatantly untrue to those with more knowledge but can have great utility when building the business during difficult times. But in the long run “fixes” just accumulate damage. Some clichés:
- Equities always outperform deposits over five years
- For those able to invest MORE the pound (Dollar) Cost Averaging is a delight to increase sales – it’s mostly nonsense, but please don’t draw me into this. I hear it still being used today.
- Missing the 10 or 15 best days of the stock market upswing leaves you severely out of pocket. Again, this is a truism but is missing the point all too often for many investors. Framing is the name of the game.
There are many more examples.
Turning to more dangerous themes. The following example is pertinent because it makes an important point, even though not related to financial services. Some years ago, I was asked to watch a math’s professor on YouTube to give an opinion, it is probably still there, and no I couldn’t give an opinion because I knew nothing about oil reserves. He was explaining the impact of the exponential function on oil reserves, with the message that we were doomed very soon. It was a compelling argument, we were running out of oil imminently, and everything he said about the exponential function was right, as you would expect. Still, concerning oil reserves, he was wrong – his initial assumptions were way out.
This is significant because it explains the mass blindness that can occur when a bit of maths and logic is misapplied. The same applies to the markets because so often the big picture gets lost in the minutia of the complexity of the equations and graphs. It makes some people feel very smart, and those less knowledgeable on the detail fall into a false sense of security. Yes, I am now heading towards the USA Housing Bubble, the subprime mortgage crisis.
Once again a misuse of mathematics was inventively applied to build a fantastic sales story, this time to institutions who should have known better – but Pinocchio, groupthink and stampede got in the way, just like my smaller experiences earlier in my life. Whatever the truth (probably the detail and logic is blinding the error), its obvious utility, if true, could build enormous sales volume, and it did, and some. The little gem that helped this happen is known as the Gaussian Copula, which isn’t hard to decipher but became an error of epic proportion by failing to see the likely real Correlation in the bundles – there were voices of sense, but they were drowned out in the furore.
In the spirit of building profits, institutions (big ones – Lehman, for example) started to create ever riskier bundles, profits blinded nearly everyone. Probably most participants selling these bundles were entirely ignorant of the potential for failure all they saw was an easy sale – as they say, hindsight is a great teacher, until the next time. We all know this story, but do we reflect on our behaviour to mitigate future disasters?
I am painting here ignorance and groupthink on a colossal scale. Pinocchio’s nose would have reached the moon. In this case, Pinocchio operated at every technical level in the asset management business.
Proof. Some of the biggest write-downs due to the subprime crisis
- Citigroup $39.1 billion
- UBS $37.7 billion
- Merrill Lynch $29.1 billion
And on and on…
Now for the perfect example of a “symbiosis” between retail investors natural risk aversion and institutional ingenuity – the result of which is much poor value for investors. Structured Products.
When interest rates were in the “normal range”, it was possible to buy a block of zero-coupon bonds and invest the rest in, or their derivatives, and secure the clients capital. The Protected Note (structured products) had arrived and with it the promise of a “decent” return and often a Guarantee of Capital. Here I am talking about Retail products, not institutional. Wonderful, everyone is a winner – the institutions, the salesmen and finally, the client. Then came low-interest rates, and with it came ever more complex products.
The idea that retail investors can understand the implication of interest rate corridor risks or Monte Carlo Analysis results is absurd. Likewise, some institutions do not understand the Monte Carlo analysis themselves; they just applied it like a sausage machine.
I advised one bank not to use the analysis and product design they had done when buying a product I was selling, despite this, they bought huge quantities, presumably blinded by the opportunity for profit, certainly groupthink was at work, I saw it. I sat in the two due diligence meetings and on both occasions I said to both sides of the bargain; this is a mistake. The deals went ahead, and I got paid, the bank that bought the assets suffered badly, my boss made a fortune because he sold out to a private equity firm shortly after the purchase, and yes I am guessing the bank’s end clients suffered.
When Retail investors come across these structured products, often the person presenting them has little understanding of the complexity of the product, so neither of them is in a position to assess the risks involved. No problem, they say, the capital is guaranteed, and this is almost all a retail investor hears and comprehends – I get my money back. Credit risk aside, the opportunity-cost when these go wrong can be considerable, in fact, even when they go right. Another gem is when two or more indices or stocks must reach a hurdle, the appreciation of the word AND in this context is seldom appreciated. Most likely, they draw the opposite conclusion. The Promise of the guarantee overrides all common sense.
We all know investor fear is real, which is why such products are invented; we cannot convey years of knowledge to a retail investor overnight and expect it to be digested. The customers form an impression of the salespeople and decide whether or not to trust them. When they hear the word guarantee, that often seals the deal, they don’t have to trust their instincts. Only years later will they find out the reality. Once again, accumulated mistrust.
Here is Trust 🙂
Groupthink and the Pinocchio effect is ever-present in asset management (and all other industries – remember NASA and the Challenger explosion); we are all human after all.
One last example that cannot be ignored. I visited a fund of hedge funds manager in London who proudly showed me the technical complexity of how they assessed CTAs and their due diligence processes. It looked and sounded impressive, yet I walked away with the word “bluster” more in my mind than any sense of admiration. I also frequently met with a prolific salesman at a similar company in Switzerland, a very nice genuine man, he invested his shirt in his company.
In both cases, many institutions bought their funds. Supposedly, they were people who know what they are doing and were trusted by institutions, but only after being subjected to heavy “due diligence.”
Then came Madoff, both companies died, it turned out almost all the funds they invested were channelled through circuitous routes into the Madoff fund – all roads led to Madoff. So much for technical knowledge and multiple levels of due diligence. Madoff was the perfect disguised Pinocchio.
The pain was felt far and wide. The Promise of expert care had failed yet again.
We all live with the homegrown heuristics we have built to manage complexity, these basic “truisms” of the past cobbled together we expect to lead us forward with some level of safety. Sadly this is a myth.
In the hands of academics, the random walk theory has been a ruthless weapon to push investors down a one-way street to buy and hold of passive funds, all at the expense of active managers. Unfortunately, most managers haven’t helped themselves by suggesting they have something others do not, and deliverables mostly do not materialize with any degree of consistency.
As long as the industry and the media support the silly notion that there are those among us who are Gurus’ and we should trust in their infallibility, the centre of gravity of the active management industry is built on sand, with the tide coming in. I won’t name names because there are so many examples.
The academics were wrong; their insights are limited. James H. Simons proved that there is more information in the markets, hidden from human sight.
Wisely, he didn’t share the information outside his own fund. The most successful investor ever, a code breaker mathematician, he saw what no one else could see, signals not picked up by standard methods. He built models to take advantage, and no one has come close to his success. He saw this and created his fund in 1982 more than thirty-five years ago – I would say he proved his point, this is not luck – although everyone needs some.
Artificial Intelligence Supported Asset Management Is Nothing More Than A Tool.
It is not a replacement of smart people doing their job, although many fear so.
A list of tasks the A.I cannot do, but the asset management teams can:
- Manage client assets universes according to investment preferences and goals and risk parameters as the clients move through their life cycle.
- Meet with clients to assess financial status, needs, risks, goals and progress. Amends profile accordingly.
- Prepare financial statements, business activity reports and forecasts.
- Develop, organize, and maintain client portfolios. In the A.I. world, managers have time to look at the big picture of individual needs.
- Fosters and maintains positive client relationships.
- Study market trends to maximize profits and identify investment opportunities. They give A.I. its directions.
- Manages Fixed Interest and cash
- Coordinates with property and alternative asset manager, brokers and other third parties.
- Assesses financials for legal compliance.
- Review financial reports to find ways to reduce costs.
- Compile and presents asset management reports to clients, supervisors and senior executives.
- Contribute to team efforts by accomplishing related tasks as needed.
Something has to change in the active management industry. In the world of passive investment, investors don’t expect anything other than market participation, so when markets fall, no one is to blame. The pain they suffer is hidden from view, the media have no target, so pay no attention. Shameful.
Talk with us, or talk to someone else. Nothing ventured, nothing gained.