Turn and Face the Strange

• Think about sources of edge in the investment process: Identifying edge is crucial both because it provides a basis for active management, and the sources of edge can change over time. Similar to sports teams, sources of edge explain why a process is likely to work in the long term.
• Organizational alignment. This has a couple of elements. The first is to align the activities within the organization to the perceived source of edge. The goal is to make all activities within the firm congruent with the espoused method to succeed. Part of this initiative is to put into place methods to allow the investment team to remain focused on the process. The second is the client base. There is a lot of short-term noise in investment results, which means that even skillful managers have realized extended periods of underperformance relative to a benchmark. Having clients who understand the process and are willing to ride out the inevitable drawdowns is crucial to executing on a strategy. Research suggests that hiring managers based solely on recent past performance can be a challenge.
• Take a long-term view. The reason is that the ratio of signal to noise is very low in the short run and reveals itself only over the long run. Even a differentiated and effective strategy requires patience. There is research that supports this point. For example, active share, a measure of how different a portfolio is relative to its benchmark, has been increasing since the financial crisis (see exhibit 10). Funds that combine high active share and low turnover deliver excess returns on average. Further, the holdings of funds that trade frequently tend to generate excess returns in the short run, but the holdings of funds with low turnover add value only over longer time horizons.
• Spend a lot of time on people. Professional sports and investment management are similar in that both include a group of people coming together to perform at a high level in a very competitive domain. Sports teams attempt to construct a roster with the requisite skills for success in the face of constraints. Investment management organizations do much the same. Success generally requires congruence between process and people. Therefore, an understanding of the skills necessary to compete effectively is crucial. Developing a thoughtful inventory of skills allows for effective hiring and performance evaluation.
• Strive to learn constantly. In sports, the boundaries and rules are generally stable. The objective is to maximize performance given the constraints of the system. In investing, the landscape continuously changes. This includes the evolution of businesses, the nature of investment management, and the profile of investors. As a result, successful investors have little choice but to learn. This means being willing to ask naïve questions and to be mindful of the pitfalls of status quo bias. In investment management, reading is probably the best way to acquire knowledge. As Charlie Munger, vice chairman of Berkshire Hathaway, has said, “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.
  Michael Mauboussin and Dan Callahan have been producing some brilliant research pieces off late for Morgan Stanley’s Counterpoint Global Insights. This one is about what investment firms can learn from the world of sport about adapting to change. Basketball fans will particularly enjoy this as it has plenty of data-based analysis on the rather slow adoption of three pointers and the current reluctance to offensive rebounds as examples of the inherent resistance within teams (organisations) to change. The authors highlight reasons for such a resistance including loss aversion, status-quo bias and outcome bias and then recommend strategies for sports teams and investment firms to overcome these barriers to change. Here are excerpts on the section on “What Investment Management Organizations Can Do to Learn Faster”:
• Think about sources of edge in the investment process: Identifying edge is crucial both because it provides a basis for active management, and the sources of edge can change over time. Similar to sports teams, sources of edge explain why a process is likely to work in the long term.
• Organizational alignment. This has a couple of elements. The first is to align the activities within the organization to the perceived source of edge. The goal is to make all activities within the firm congruent with the espoused method to succeed. Part of this initiative is to put into place methods to allow the investment team to remain focused on the process. The second is the client base. There is a lot of short-term noise in investment results, which means that even skillful managers have realized extended periods of underperformance relative to a benchmark. Having clients who understand the process and are willing to ride out the inevitable drawdowns is crucial to executing on a strategy. Research suggests that hiring managers based solely on recent past performance can be a challenge.
• Take a long-term view. The reason is that the ratio of signal to noise is very low in the short run and reveals itself only over the long run. Even a differentiated and effective strategy requires patience. There is research that supports this point. For example, active share, a measure of how different a portfolio is relative to its benchmark, has been increasing since the financial crisis (see exhibit 10). Funds that combine high active share and low turnover deliver excess returns on average. Further, the holdings of funds that trade frequently tend to generate excess returns in the short run, but the holdings of funds with low turnover add value only over longer time horizons.
• Spend a lot of time on people. Professional sports and investment management are similar in that both include a group of people coming together to perform at a high level in a very competitive domain. Sports teams attempt to construct a roster with the requisite skills for success in the face of constraints. Investment management organizations do much the same. Success generally requires congruence between process and people. Therefore, an understanding of the skills necessary to compete effectively is crucial. Developing a thoughtful inventory of skills allows for effective hiring and performance evaluation.
• Strive to learn constantly. In sports, the boundaries and rules are generally stable. The objective is to maximize performance given the constraints of the system. In investing, the landscape continuously changes. This includes the evolution of businesses, the nature of investment management, and the profile of investors. As a result, successful investors have little choice but to learn. This means being willing to ask naïve questions and to be mindful of the pitfalls of status quo bias. In investment management, reading is probably the best way to acquire knowledge. As Charlie Munger, vice chairman of Berkshire Hathaway, has said, “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.

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