If you're an equity manager that uses a fundamental approach, you have probably sensed the sea change. Has your performance been good, but you can't raise money? Or even though performance has been relatively steady, have your AUM's dropped? If you nodded yes to either of these, there's a chance trouble is brewing and has been for some time. The reason being, the standard investment management operating manual is no longer cutting it. Consultants and investors demand more.
You might think the struggle to raise assets is systemic to all equity managers. After all the drain from stocks into ETF's, index funds and alternative assets is the trend these days. But if this is your only line of thinking, that the drain is simply a result of other products competing for assets, then you have some of the cause and effect mixed up. Equity managers are not struggling solely because of other products, many are struggling because of a mindset. Yes, there are more options out there these days and investors are voting with their feet. But there are fundamental equity managers raising money, and doing so at a healthy pace. These shops usually have something in common, something that the stagnant firms lack; and it's not just performance.
The bottom line is consultants and investors are no longer impressed by armies of CFA's, technology, high powered stock screens, claims of being fully diversified across all sectors or layer upon layer of any combination of these factors. These selling points might have worked ten years ago, but not today; because they are paper tigers if firms are missing a main ingredient.
Today's investor demands that fundamental equity shops pay more attention to their stocks, and do so by means of a deep and unique research approach. That's it? That's the big insight you might be asking? Well yes, and no. Yes, it's that simple. And no, because the current investment manager mindset is sometimes a road block making the simple not so easy.
It's a mindset that has some managers reading this reasoning, "We are a bottom-up shop that pays attention to the 400+ stocks we own across all products. We have a team of eight CFA's, powerful screening processes and strict portfolio management guidelines towards this end. How much more can we pay attention?" Unfortunately none of these translate into paying attention to the stocks in their portfolios or depth of research and unique approach for that matter. In fact, each reason cited above may just give a false sense of paying attention but doing just the opposite.
Firms citing screens, portfolio management techniques, and the like, as reasons they can legitimately cover 400+ names is analogous to parents rationalizing having 10 children works because of owning a large home, using cutting edge child monitoring equipment and having innate organization skills. While all of the stuff is nice, it's ancillary to what really counts. Ultimately the kids will lose out on some level as parental attention is spread thin, because there are so many of them to care for. All of the structural, monitoring and organizational devices that money can buy won't make up for the lack of parental attention, and in fact might get in the way of it. (The difference between children and stocks is that children benefit from being around one another, so having a large family can be good……although 10 is pushing it!).
Like the parents above, many investment managers mistakenly think the use of investment tools, or stuff, can fill in the gaps of what really counts, working at their core area of investment expertise; and working at their core expertise, whether it's a unique approach to analyzing businesses, a sector specialization, whatever it might be, is the best way to pay attention to their stocks. Once there is an over reliance on the stuff, a hodgepodge of investment tools and approaches develop that, for all of its accuracy, gets in the way of and dilutes the firm's core expertise.
How can a firm tell if it has a hodgepodge and isn't paying enough attention to their stocks? A check of symptoms usually starts with looking at the number of holdings per analyst on the research team. There is no hard and fast number that can serve as the limit, but holding 50 names for each analyst is too many. A much healthier number is closer to 20. There are other factors that come into play, for example turnover, but to keep it simple let's stick with the number of holdings. A firm holding 50+ names for each analyst almost guarantees the research is diluted, regardless of how much stuff they add into the mix. This is especially true for firms touting fundamental bottom-up approaches.
But addressing the hodgepodge is not simply a matter of lining-up portfolio metrics to get things "in-line", say by reducing the number of holdings to show they are paying more attention, and then moving on to the next product and getting that "in-line" too. This is often a manager's knee-jerk reaction, to line-up the metrics; but merely lining-up the metrics is treating the symptom, not the underlying ailment. The ailment is the hodgepodge.
A Blunt Question about Performance
If you are a fundamental manager still reasoning that your product with countless names is edging out the benchmark over the past 5 years and therefore the dilution argument is wrong, make sure there isn't survivorship bias in your performance assessment. Of all the products launched in your firms history how many have outperformed their benchmark since their inception (for live products) or until their close (for those products that were closed or merged into other products)? Most of the firms I look at can only answer "yes" for a minority of their products, and most of the time it's for their newer products with less history.
Hodgepodges often emerge as firms gradually twist and contort themselves away from their core area of expertise, usually in the quest for growth. With computers allowing an abundance of low cost information to flow from all corners of the investment spectrum, and the ease at which firms can incorporate it into their process (at least on paper), technology is the primary, but not the only, culprit enabling firms to go down the hodgepodge path.
With growth on their minds firms convince themselves they can use technology to leverage their core expertise or even try on a new expertise hat. The reasoning goes something like this…. "Why wouldn't we, a bottom-up shop, add some top-down forecasting to our process if it will help us expand our product offerings? We can accomplish this with relative ease by adding a macroeconomic screening overlay to our research process. This will provide a bigger tent under which we can gather more assets." Makes sense right? On paper maybe, but venturing into new areas or leveraging their core expertise is never as turn-key as they think; often demanding a skill set they don't possess and straining their core expertise.
Again, technology isn't the only route to a hodgepodge. For example, the firm above may hire an economist to add top-down forecasting, instead of buying the technology, but is still trying on a new investment hat. Or a firm might add extra, marginally followed, stocks to their portfolios in the name of being "fully diversified". A marketing employee might suggest rolling out a new product to catch the latest industry trend. The list goes on, with each successive step diluting their core area of expertise and moving them farther down the hodgepodge path.
There are an unlimited number of hodgepodge combinations, but they usually involve making one or more of the following mistakes:
#1 Diluting a core area of investment expertise by venturing into areas beyond their core and/or wearing too many investment hats.
#2 Holding too many stocks, thereby diluting the effectiveness of their analysts.
#3 Having the mindset that the addition of investment tools (portfolio management, screening, etc.) allow mistake #1 and/or #2 to go without consequence.
#4 Overusing/relying upon investment tools to the point of crowding out the craft of analyzing stocks.
It's worth noting that the items on this list don't exist in a vacuum and usually feed off each other. It's also worth noting that any of these items can occur at the firm and/or analyst level. It's not always the case that a firm will, let's say, engage in an area beyond its expertise (#1), and therefore its analysts are limited to that single mistake. Analysts will often engage in their own strand of mistakes as well, further complicating the hodgepodge.
Analysts Assembly Line Workers
As we've discussed, with technology in abundance firms built foundations upon the idea that they can leverage it to "process" (although they might not call it that) more stocks and gather assets. The result is they became stock processing assembly lines. So where does this leave the analysts that work at the firms?
Analysts resort to employing assembly line processing methods to keep up with the demands of the machine. The pace at which they must feed stocks into it and the various boxes they must check-off to comply with the multiple layers of the hodgepodge are overwhelming. It makes gravitating towards just the computer generated metrics/numbers the only game in town, since it flows fast, is at their fingertips, and is measurable; all of the things that assembly line workers need.
The result is analysts have abandoned the other crucial half of the equation, the deeper and more artful craft of analyzing the underlying businesses behind the stocks. It has created an industry wide epidemic of analysts commoditizing the businesses behind stocks as if there is no qualitative differentiation.
Mindset Change or Bust
Firms have to change their mindset in order to unwind the hodgepodge and pay more attention to their stocks. They need to figure out which of the four offenses above apply to them and tease-out how they are intertwined.
Unwinding the hodgepodge comes down to a firm asking two questions:
A) "In how many areas do we as a firm profess to be experts?" If the answer is more than two, they need to narrow their focus because wearing too many hats usually spells h-o-d-g-e-p-o-d-g-e.
B) "Are we serious about maintaining a high level of expertise in these areas?" If they answer "Yes", but say hold 50+ names per analyst, they better ask the question again because they are diluting their expertise (in this case at the analyst level).
Anything short of a change in mindset and a firm's competition will do the unwinding for them by draining their assets. Investors seeking equity products will continue to gravitate to three major alternatives unless firms make the change. They are:
#1 Equity managers that pay more attention to their stocks.
#2 Specialty firms/products that pick-off various aspects of a firm's hodgepodge of specializations. For example ETFs will pick away at the hodgepodge selling point of being fully diversified.
#3 Index funds as investors simply give-up on active managers in general.
There won't always be a direct traceable link where firms can say, "Client A withdrew from a product because of #1, #2 or #3." But over time, in the marketplace of products, equity assets will be lost to one, or some combination, of the above.