We’re pleased to provide you with insights like these from Boston Private. Boston Private is now an SVB company. Together we’re well positioned to offer you the service, understanding, guidance and solutions to help you discover opportunities and build wealth – now and in the future.
Finding things to do and watch during this winter phase of the pandemic has become a challenge. So I’ve turned to rewatching some personal favorites. One of those was the 2011 movie Moneyball. If you haven’t seen it or read the book, it’s about how the Oakland A’s used a new approach to build a winning team at a fraction of the cost of other organizations.
In the movie, there are a handful of scenes that depict Billy Beane and Paul Depodesta’s struggle to change the entrenched ways of thinking about team building and player selection. This was made most obvious in scenes where the scouts were meeting to discuss which players they liked for potential addition to the team.
During these meetings, they’d say things like:
- “He’s got a baseball body. Beautiful swing. Ball explodes off the bat. You can hear it all over the ballpark.”
- “I don’t know if we want to target that guy, he’s a little thick around the waist.”
- “The guy’s an athlete. Big, fast, talented, clean-cut, good face.”
But did these subjective assessments have any predictive value? Were the scouts even looking for the right things? With the benefit of hindsight, the answers are “very little” to “no”.
What did have predictive value in assembling a winning baseball team? On Base Percentage (OBP), and no one else was looking at that.
Over the course of the past 13 years, I’ve grown to believe there are many similarities between those old baseball scouts and the way manager due diligence analysts operate across wealth management, Outsourced Chief Investment Officer (OCIO), and pension consulting today. Managers are hired because they have:
- “a repeatable investment process”
- “a track record of success”
These are direct quotes from reports obtained from major consulting firms that have built large businesses based on selecting investment managers.
The problem with that is nearly every manager worth evaluating is experienced, has some degree of repeatability to their process, and has a track record of success (they wouldn’t be showing it to you if performance wasn’t good).
My point is not to discount those things, but to say that those are pre-requisites to even being considered for an allocation. And if most investment managers have these characteristics, how does this explain future performance?
In today’s markets, everyone is well resourced and talented. The number of MBAs and CFAs continues to rise. Data is abundant and easy to access. The playing field is very level, especially in the traditional asset classes of stocks and bonds.
Having “a track record of success” sounds like a valid reason to invest in an actively managed fund, until you look at the persistency data on mutual fund performance published twice a year by S&P Dow Jones in their SPIVA reports. Spoiler: there’s little to no persistence in peer group rankings.
So what actually makes one manager better than another?
How SVB Private evaluates managers
Our process is designed to provide better answers to “why are we recommending this?” We aren’t checking boxes or getting lost in the narrative of whatever position the manager likes most. We are not relying on the old cliché “repeatable investment process” or “track record of success” rationale for recommending an actively managed strategy.
Instead we look at what over a decade of research has led me to believe are the 3 most important variables of sustained success for an investment manager:
- Opportunity Set – how good of an opportunity is there for a given manager to generate attractive returns?
- Competitive Edge – what do they do better than their peers when employing the same strategy in the same asset class?
- Improvement/Adaptation – what are they doing to get better at their craft?
For the purposes of this article we’ll focus on #2, Competitive Edge, and save the other two legs of the stool for future discussion.
What is “competitive edge” in investing?
When it comes to evaluating an active manager’s edge our process is designed to focus on decision making and all the characteristics that help to make that process best in class. The focus on decision making is deliberate. All investment managers do, over and over again, is make decisions. At the portfolio level, they make decisions about what to buy, when to buy it, and how much to buy. At the firm level they decide who to hire, how to incentivize their team, and what culture to establish.
Each of these decisions, among many others, can help move the manager’s strategy ahead of the benchmark or farther behind. Moreover, each of these decisions can be made in a best in class way or simply perpetuate the status quo. We are in search of best in class decision makers and we’ve engineered our process around finding them.
Here are some examples of ways a manager can gain a competitive edge:
- An energy commodities hedge fund that has amassed a collection of both proprietary and 3rd party data sets not seen in their peers giving them an informational edge. In short, they have better information with which to make decisions.
- An equity manager that has structured his process so that each position in the portfolio has a quantified, falsifiable thesis in writing so that he mitigates the risk of “thesis creep” and the disposition effect simultaneously. The same manager mandates each stock in their portfolio and watch list have a dedicated devil’s advocate to mitigate the detrimental effects of overconfidence and confirmation bias. This firm mitigates cognitive bias (common decision making errors) better than the vast majority of their peers.
- A venture capital firm who has deliberately assembled their investment team with a collection of people from diverse backgrounds in terms of education, experience, culture, gender, race, and problem-solving styles. Not only because it’s the right thing to do, but also because it increases cognitive diversity and cognitive diversity leads to better decision making.
As a team, we view ourselves as scouts and the personnel department for your portfolio. Similar to the general manager and scouting department of your favorite sports team. Each asset class is a position that needs to be filled and our goal is to find the best “player” for those positions. Experience, research, and hard work have all indicated that focusing on how decisions get made and why they are made that way is the best way to find those players.
When it comes to recommending an actively managed strategy for your portfolio, a “repeatable investment process” simply isn’t adequate. Besides, what good is a repeatable process if it doesn’t facilitate good investment decisions?