Novus Soapbox Episode 1: Desperately Seeking Investment Skill Set
The purpose of this series is to identify the top problems in the alternative investment industry. Today, we tackle the quantification of investment skill.
This is the first 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.
This episode is about investment skill set measurement (and improvement), and how it’s a necessary condition for sustaining and improving returns in a world where the alpha pie seems to be shrinking, and how little attention is being paid to the problem. (Pardon me, I meant opportunity.) These observations were distilled from thousands of interactions with managers and allocators; both their portfolio decisions (which we see every day), as well as the conversations we’ve shared.
Trying to Relive the Heyday
Hedge fund investors have followed an eerily similar path as professional golfing legend Tiger Woods. They came to prominence in the late 1990s (Woods winning The Masters in 1998). They both dominated the attention of their field, racking up many big wins. They also took in spectacular media attention, leading to world-class renumeration. Perhaps a bit of a stretch, but they are both undergoing a media-speckled fall from grace. With the occasional bout of former glory, they simply haven’t demonstrated the same level of dominance as their glory days.
This is somewhat to be expected, as Woods’ mastery of his sport heralded heightened competition. Golfers were coming to the sport fitter than ever, with an eye towards training, technology, and strategy. Courses gradually became harder, coping with a rising level of talent. Similarly, fund managers saw their outsized early performance (and renumeration) invite competition. This added brainpower led to an explosion in growth of the industry and a commensurate increase in efficiency in markets. Where the parallels diverge is that unlike golf, investing is a zero-sum game. That is to say, the pursuit of over-performance vs. the market (the average performance of all participants) must come at the expense of those who underperform.
The zero-sum pursuit of alpha lives by the universal law of outperformance: an investor needs edge to consistently outperform. (Nobody proved this better than R. Grinold and R. N. Kahn in their seminal book Active Portfolio Management.) The available sources of edge in those early days—light competition, asymmetric access to information, some may dare say private information—have all but disappeared. And so, managers must rethink how to improve in a world with less structural barriers to entry and less walled gardens of information. They need to get back to self-improvement and self-disruption. In short, they need to review the tape and watch their golf swing.
In some ways this is Business 101. Heightened competition spurs self-disruption and innovation, which in turn drives greater productivity. For too long, fund managers have enjoyed abnormally high margins and relatively scarce margin pressure. There was no need to self-disrupt. In today’s business world, the first fundamental “must-do” is embracing self-improvement and self-disruption. This means improving on core competencies while shedding weakness.
Unlike golf, fund managers get to choose what areas to specialize in. If they are great at certain pockets of the market, they can specialize, unlike a golfer who needs to drive, chip, and put. But comparative advantage can only truly be understood through honest self-reflection. Investors understand this viscerally because they are often “teaching” the companies they invest with these very same principles, “Shed these nonperforming assets! Focus on your business lines that are world class! Improve margin!” Some do it through constructivism/activism, others through closed-door dialogue. The same can’t always be said about their own business practices. Practice what you preach may we say.
Measurement & Feedback Loops
It all begins with measurement. Golfers watch tapes of their swing, and investment managers must review the behaviors of their portfolios through rigorous analytical output. There is no difference. If a portfolio manager claims skill at what she / he does, then it must be possible for said skill to be measured. If it can't be measured, then I would argue it doesn't exist, and investment managers must be sober to this fact.
If this proves true, all portfolio managers should be constantly measuring skill set. This is a necessary condition to create virtuous feedback loops. Once you know what your core competencies are, you focus on the areas you do well, you do less of the things that you don't do well, and you generate the positive feedback needed to enhance performance. Enhanced performance unlocks resources which allow you to further solidify your comparative advantage.
As an aside, feedback loops are a not-so-novel, yet fascinating discipline, spanning mathematics and engineering (it’s feedback loops that keep your room warm at a constant temperature). However, their application to enhance and sustain investment management performance is more recent. George Soros mentions them in his Alchemy of Finance, and M. Syed refers to them while dissecting the key ingredients to outperformance in Bounce and Black Box Thinking.
Introspection can be a painful process. It may undermine existing organizational myths, pecking orders, and our most ingrained bad habits. But this is the world we live in. Through that painful process, those who decide to self-disrupt can change their habits. This will ultimately lead to better swings and better outcomes. It didn’t take Tiger Woods to figure that out for the rest of the business, but it seems to linger on the minds of many of the world’s best investors.
The title of this episode is a nod to the 80s wanna-be-cult film “Desperately Seeking Susan.” Not recommending you watch it, as it featured horrible acting and an even less-impressive plot. But it did gift the world Madonna’s “Into the Groove,” a formative piece of 80s pop culture.