1. Most US equity managers, prompted by personal inclination and the wishes of their employers and their institutional clients, adopt either a value (buying undervalued assets) or a growth(buying accelerating profit growth) investment style. In a typical business cycle, the first two years favor value stocks, the latter two growth issues. Over that cycle, a manager is likely to have two good years, one so-so year and one bad year. A skilled manager, however, will outperform over the cycle sc s whole, no matter what his style is.
This is another way of saying that the criterion of outperforming every year is unreasonable.
2. a truism: the pain of underperformance lasts long after the glow of outperformance has faded. A manager who builds a riskier portfolio expecting fame and fortune from significant outperformance risks exploding on liftoff and outperforming badly–thereby losing both his clients and his job. He also gives his firm a significant black eye. No one, however, gets fired for underperforming slightly and being in the middle of the pack of competitors.
As a result, many long-lived investment organizations are constructed on the idea of strong marketing and so-so performance. I’ve always regarded Merrill as the poster child of this approach in the mutual fund arena.
In other words, outperformance isn’t the most important attribute of a successful investment product.
3. Most investment organizations find that a running a research department of their own is difficult and expensive. Many, especially (in my view) the majority which are run by professional marketers, have long since eliminated proprietary research and have been depending heavily on brokerage houses to supply this service. Doing so has the additional advantage that in-house analysts are no longer a drain on management fees received (brokerage house research is paid for with clients’ commissions). That “solved” a problem and enhanced profits at the same time.
However, brokerage houses gutted their research departments during the market downturn in 2008-09. The sharp decline has also accelerated an ongoing trend away from traditional investment managers and toward a diy approach using index funds.
So there’s no longer a plethora of high-quality brokerage reports and no “extra” management fee money to reconstitute proprietary research departments. Where are the good new ideas going to come from? I think this new client preference for investment performance over salesmanship will create severe difficulties for traditional investment organizations.
Interesting insight Dan, thanks for posting this.