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I apologize for the intervening gap between my last Alpha Wounds post about the active quality of passive investment management and this one. Given the length of the wait, let me dive straight into the discussion.
This month I want to highlight the advancement of short-termism into the investment management business and its deleterious effects on alpha.
Why Short-Termism Is Detrimental
Higher Trading Costs
Short-termism results in untoward trading costs (i.e., higher expense ratios). Hopefully this does not warrant a statistical analysis. More trading equals more trading costs equals more expenses equals more alpha drag. Yes? This is no secret. Here the data indicate that turnover in portfolios is accelerating, and this trend was well underway even before the rise of high-frequency trading (HFT).
Similarly, the greater the pace and volume of trading, the less time there is to understand a business and its securities. Instead, the intricacies must be ignored in favor of gross generalities. This disables, in part, some of what the human mind does exceptionally well, namely seeing the interconnections among disparate data as well as understanding the complexities of systems.
The Inability to Evaluate Management Well
One of the value-add propositions of active management is assessing the quality of a business’s management team. After all, managers are on the front lines, waging the competitive battle for marginal revenue and marginal profit growth. They are the ones appraising projects for the highest capital returns and responding to crises.
If you evaluate management effectively, and the quality of the management team is high and the company is well priced, then you probably have identified a worthwhile investment. But the only way to benefit from this assessment is to have a wide enough window of time for management’s decisions to differentiate the business from its competition.
Strategies Need Time to Be Fulfilled
Given the gyration of economic and market cycles — expansion versus contraction, creativity versus destruction, bull versus bear, growth versus value, small capitalization versus large capitalization — it can take time for your expertise to be valued by markets. If your skill set is in identifying securities that are undervalued, then by definition it takes time for such insights to reap rewards, just as it does for markets to revalue securities. Too short-term a focus, and alpha is left on the table.
Increased Behavioral Biases
Short-termism also means that there is less time for reflection and contemplation — less time to learn from your mistakes. It tends to evoke System 1 thinking as defined by Daniel Kahneman, godfather of behavioral economics. System 1 thinking is of the fight or flight variety: fast, instinctual, and likely to activate the whole panoply of behavioral biases long proven to kill alpha. System 2 thinking is slow, analytical, and deliberate: It helps you to steer clear of behavioral biases. Parenthetically, there is growing evidence that meditation — the hallmark of contemplative practices — allows practitioners to overcome their behavioral biases.
What Is Short-Termism?
So what exactly is short-termism? After all, one portfolio manager’s extremely short-term investment — say purchasing and holding an asset for one minute — would be an eternity to a high frequency algorithmic trader who holds securities for milliseconds. Short-termism is like an investor who rides a bicycle by keeping her eyes fixed on the front wheel. It isn’t that this is an illegitimate observation scale. After all, there are certainly times when you need to be concerned with the immediate circumstances. A perfect example is in the moment of the Lehman Brothers bankruptcy in 2008. At such a point, a focus on the short-term is entirely legitimate.
What is disturbing is when the bicycle rider feels that staring at the front wheel is her only option. To really ride safely, you must constantly adjust the time horizon evaluated: from short-term to long-term relative to the environment. In general though, each of us recognizes that staring at the front wheel is bound to result in unforeseen accidents and a lot of bike riding volatility. Put another way, isn’t it nice to have a full suite of options as a money manager? The real emphasis should be on executing an investment strategy that is a match for the skill set of the portfolio management team, of which the time horizon is only a small component.
So if there is, in fact, short-termism present, how did this state of affairs come about?
I recently engaged in a debate with an economics professor who believes that markets are efficient and, consequently, that if there was a movement to short-termism, it must be the efficient outcome desired by markets. That is, my professor acquaintance wasn’t buying the idea that short-termism is damaging to portfolio management returns. So, is there any research to define short-termism? Is there any research that demonstrates the alpha wounds inflicted by short-termism or that makes a causal link between the state of the investment profession and short-termism? Enter the work of Joachim Klement, CFA.
In a 2014 paper entitled “Career Risk,” Klement identified the pressures coming from investment management clients due to myopic loss aversion as the primary source of short-termism. Clients are increasingly impatient for returns. This contention is supported by the CFA Institute Research Foundation’s monograph Fund Management: An Emotional Finance Perspective by David Tuckett and Richard J. Taffler, in which our investment management peers lay bare their souls and say such things as:
“When we talk to clients, we always tell them the investment horizon is about three to five years. However, if you underperform substantially over a 12-month period, you can already be in trouble.”
“Frustratingly, [the tolerance for underperformance has] gone down as years have gone by, and even your institutional clients are irritatingly short term. And the reality is that if you underperform for two consecutive years, new business will dry up very quickly, and by the end of the second year, you’ll start getting some of your shorter-term clients throwing the towel in . . . There’s increasing intolerance for any period of underperformance.”
“Most people seem to think you can outperform not just every year but every quarter or every month, but they’re living in cloud cuckoo land, these people. And most managements in our industry don’t have a clue either, frankly. . . . The survival rate is actually quite low. . . . Why on earth do you want to go into an industry where you’re almost doomed to failure even if you’re good?”
Klement creates an interesting and robust definition of short-termism that relates the size of excess information ratios to the grace or evaluation period granted by clients. The higher the information ratio, the longer the grace period allowed by clients. While the lower the information ratio, the less patience among investors. Consequently, investment managers risk losing assets, at least, and their jobs, at worst. This is a helpful description that hopefully satisfies the professor I obliquely mentioned above.
So what does Klement find? He considers the case of an investment manager with a tracking error of 5% and an information ratio of 0.5 (or an annual “true” alpha of 2.5%). If the manager is evaluated annually, this excellent manager has a 31% probability of underperformance relative to a passive benchmark. The inverse of 31% indicates that roughly every three years there will be a risk of underperformance. If, instead, the portfolio is evaluated quarterly, then the risk of underperformance grows to 40%. If monthly, 44%; and if weekly, the chance of underperformance is 47%. Even a rock-star portfolio manager who delivers an information ratio of 0.7 faces career risk if she is evaluated on a quarterly basis. Ouch!
So what can be done to mitigate the alpha wounds inflicted by short-termism? Here are some suggestions:
- Client Education: Exhaustively school your clients about your investment strategy. Your only hope of reducing the short-termism pressure that they exert is to continually manage their expectations.
- Just Say “No”: If your exhaustively educated clients are still unwilling to grant you the grace period to execute your strategy, then divest them. I realize that this is especially tough to do. But look at the ultimate cost to your business of clients who pressure you to manage money poorly.
- Diversify Your Client Portfolio: If too many of your assets under management (AUM) come from too few patrons, then you are more vulnerable to the panicked or gargantuan client. Instead, strive for a good mixture of clients with slightly different portfolio mandates.
- Run a Lean Operation: The more streamlined your business, the higher your margins and the easier it is to let panicky AUM leave your care.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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