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June 27, 2017 at 07:48 AM
Throughout the Active Equity Renaissance series, we have pointed out the obvious need to overturn modern portfolio theory (MPT) and replace it with something better.
How have we done this? By describing the broken 1970s model of portfolio management, enumerating what we call the Cult of Emotion, and declaring the fall of MPT.
But what should replace MPT? We first proposed new frontiers of risk assessment, then new behavioral portfolio management concepts, and last what we call Renaissance Portfolio Management.
Active management is in our DNA and our history, so we recognize that what we are calling for is a radical rethink of the industry. It will not happen overnight, but with some smarts, willpower and time, we believe the Active Equity Renaissance can be launched.
Renaissance investment management firms, built on our concept of Renaissance Portfolio Management, will be critical to inspiring and propelling this new era of active equity.
Structure Investment Management Firms
Several years ago, we attended a conference presentation by a top-ranked fund manager. The subject? The secrets of his success. What were those secrets? Financial statement analysis, valuation, discussions with management, independent verification of company data (i.e., “channel checks”), on-site visits with company management, and so on.
Chances are that not one of these “secrets” strike you as secret, right? Every fundamental manager ought to be doing them. But when asked about how he managed his relationship to his wholesalers to ensure that they sold his fund to end clients correctly and how he managed his relationship with his board of directors to ensure the same end, he said, “Well, that’s everything, isn’t it?”
While we don’t think it is “everything,” how an investment management firm structures itself is a critical issue. After all, what good are superior fundamental analysis, security selection and portfolio management if wholesaler compensation is misaligned with the strategy? What good is superior analysis if the board does not understand the strategy and obstructs delivering outperformance? Even IT departments need to support, not hinder, ace portfolio management.
Yet all too often the creation and continued growth of a firm are done ad hoc and haphazardly once the original strategy delivers outstanding results and starts to attract sizable assets under management (AUM).
Investment management firms must ensure that their firm structure supports the firm’s investment strategies.
Aligning Tools and Strategy with Minds
How a firm hires research analysts tends to be arbitrary. New hires are often brought in based on their credentials: Ivy League educations, bulge-bracket employment and well-regarded asset management pedigrees. Lovely. Underwriting standards is important, but so is hiring quality minds.
This raises the question: What is a quality mind? One that sees the world as it is, and not what it wants it to be. It is a mind that can sense its own thinking and control its own function. These attributes exist outside of the normal underwriting criteria.
How do you interview for such a person? The interviewer needs a quality mind, too. Investment management firms should involve the portfolio management staff in the hiring process early on. What sort of people should they look for? Those who are tirelessly in “learning” mode and have voracious curiosity, people who have self-correcting mechanisms that ensure they are evaluating the performance of their minds relative to reality and independent of the calculation of rates of return. Analysts and portfolio managers make many more decisions each day than appear in the portfolio as buys/shorts. These quality minds are also naturally inclined to center themselves on delivering their clients’ desired outcomes.
