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Novus Soap Box Episode 2: Condemnation of In-house Data and Analytics

The purpose of this series is to identify the top problems in the alternative investment industry. Today, we tackle in-house data and analytics.

Andrea Gentilini
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This is the second episode of a series on what’s wrong with the investment industry today. Yep, you read that correctly, we’re focusing on what’s wrong. Why? Well, as engineers, we tend to see the world and think in terms of problems. But fear not—an unsolved problem is an opportunity for those who are brave enough to act.  

Last time, we discussed investment skill-set measurement. In this episode we focus on the glorious path towards reaping the benefits associated with data and analytics (as opposed to the condemned path). In this case, the glorious path is called buy, and the condemned path is called build.  

Obvious disclaimer—shocker—we are biased in our opinion, as Novus represents the buy element in the equation. But hear me out, as the following is not intended to be a sales pitch; but rather, a set of observed facts emerging from a privileged point of view, interacting with several thousand institutional investors every year.  

Condemning Disregard for Budget Discipline

The second decade of the twenty-first century has come to an end with a tsunami of passive. This tidal wave hit active investment management particularly hard because the field largely failed to keep up with productivity gains that other industry verticals force upon entrants, if they want to survive. This is especially the case in commoditized industry verticals where competition is sharp, and survival depends on adaptation.  

Even in 2020, the asset management industry remains one of the richest industries in terms of margins. Paradoxically, these margins seem to invite waste, a trait that brilliant investors can keenly surface when analyzing a corporate balance sheet of a company they are looking to invest in, but are hesitant to uncover upon self-reflection. Figure 1, borrowed from a BCG report published in 2019, demonstrates how increased costs have eaten up any growth experienced by asset managers recently. How much of this is due to disregard for budget discipline?  

Figure 1: Costs are eating up profits (source).

Where we see waste most clearly and repetitively in our industry is the stubborn "build versus buy" bias for business areas that have nothing to do with core competencies.

A commodity business understands they must vigorously focus all of their investments on their core competency or perish, while trying to be efficient about everything else that’s not core (which means outsourcing). On the other hand, alternatives managers have not had to face that reality—not until recently, at least. The onslaught of fee compression caused by the abundance of zero-fee passive investing has led to margin compression with higher entry points (in terms of AUM) and larger critical mass (in terms of unit economics). This is exacerbated by traditionally high cost of rent, compliance, and human capital. Luckily, with the increasing adoption of software-as-a-service business models, businesses are adapting at a faster pace to keep up with the need for efficiency around their periphery: getting more for less in the operations and analysis of their businesses.

Case in point: when Novus was launched in the late 2000s, it was unthinkable for our hedge fund clients to accept having their most sensitive portfolio data in the cloud. While that sounds passé today, this led our business to maintain our own private servers with their own data protections. We had staff shuttle over to Seacacus, NJ from Manhattan to maintain hardware in data centers that were often reserved for high-frequency trading firms. This meant cost-redundancy to ensure business operation. Fast-forward a decade, and the meteoric ascent of Amazon Web Services, Microsoft Azure, and Google Cloud demonstrate the efficiency and economies-of-scale that can be had through “elastic computing,” not to mention best-in-class security and analytic integration. Novus adapted and outsourced an area of our business that had little to do with our core competency. We’re in the portfolio intelligence business, not in the server farms business.  

Unfortunately, the rest of the world seems to have taken their cue before most asset managers.

Condemning Unproductive Spend  

Many asset managers continue to in-source one of the most promising new business lines that grew from cloud computing: data & analytics. The proliferation of petabytes of data created new challenges in terms of leveraging efficiency, and a new class of businesses arose to meet that business need. Firms that want to get smart about managing their increasing data and harnessing analytics to drive outcomes are increasingly outsourcing vast parts of internal analytics to best-in-breed specialized SaaS platforms. Let us be precise: they outsource the infrastructure to make that happen. How to use it, the insights to derive, and the decisions to act on those remain theirs. With the asset management industry lagging, this is often a missed opportunity for investors.

The result? 40% of the aggregate time that investment teams at active asset management firms with a fundamental, bottom-up approach spend on tedious data tasks can be easily automated via portfolio intelligence solutions like Novus. Note, I'm emphasizing investment teams, not the operational back office. These are some of the most handsomely compensated employees in the world with impeccable professional and educational attainment, unable to engender the type of efficiency gains that are increasingly commonplace across the business landscape.

Let’s get real: anybody on the investment team finding themselves coding R, Python, or Matlab scripts to extract portfolio data in and out of SQL databases, match it against market cap figures, compounding returns over time and creating little nice reports is a spectacular squander of intellectual capital, let alone (ultimately) investor fees.  

Ladies and gentlemen, as an engineer, I get it. The thrill of bending computers to do exactly what you want and how you want it is intoxicating. But is this your job? Is this what investors are paying you for? Or is it your job to make optimal investment decisions using the best tools that are available to you?

For a while, it didn’t matter. If your AUM and performance were at a certain level, resource constraint was more theoretical than practical. You could hire more bodies and throw manpower at a problem and still enjoy a fantastically profitable business. We would see fundamental managers hire analytics teams and have them report to the CFO who is more CPA than data scientist. And you, as a principal in the business, you thought you were going to get amazing insights, didn’t you? I bet you were devastatingly frustrated when, two years into the game (and several million dollars later), you were told that “our data isn’t clean yet,” or that “we need a business intelligence tool to visualize data” (for more on that specific scenario, check this out), or that “we need to get a security master to run those analyses.” All you got were a few static PDFs to your inbox (or your desk on Monday morning), which you trash anyway, because looking at Bloomberg is way more fun. What have these guys been doing for two years?  Welcome to the inconvenient truth about big data, machine learning, and artificial intelligence.  

Praising Smart Investors

But along with this tidal wave of passive, investors are demanding better business practices, and alternative managers are forced to finally adapt. This is actually a good thing and will spearhead a revitalization for the industry. Successful fund managers will no longer simply be great investors but also great business leaders. Or they will partner with management teams that can leverage operational efficiency. We see it in some sense with talented managers agglomerating in firms that have operational efficiency (aka multi-manager platforms like Citadel, Millennium, Balyasny, Atom and many others). New fund launches that have worked in these firms will take their cues and spread operational efficiency when they branch out on their own.

The BCG report referenced earlier documents (Fig. 2) the value achieved by firms who deploy data and analytics across the entire organization.

Figure 2: The values of firm-wide deployment of data and analytics (source)

Members of the esteemed fundamentally inspired active management industry, wake up: don’t build what’s out there already. You’ll squander resources and waste precious time. Get the tools, and re-route those same resources (human capital primarily) to develop and test hypotheses, as well as recommend courses of action. That’s where the alpha is.  

TITLE INSPIRATION

The title of this episode was inspired by Depeche Mode’s Condemnation, released in 1990 within the album ‘Songs of Faith and Devotion.’ The album marked a turn towards a more electronic sound with less keyboards, which had dominated the 80s. If you asked your friends about their favorite Depeche Mode song, Condemnation probably isn’t the most common pick, certainly behind more famous hits like Never Let Me Down Again, or Personal Jesus. And yet, it’s Dave Gahan’s (the lead singer) favorite Depeche Mode song.  

If you took this blog post a bit personally, note the following excerpt as you listen...

If you see purity
As immaturity
Well it's no surprise
If for kindness
You substitute blindness
Please open your eyes

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