Why Fund managers fail and the PNI (top 10 holding) Model

 Why do Fund managers fail?

There is a guy who constantly presents at ASA meetings on active managers' performance records and points out that with all their knowledge, hard work and experience, in aggregate, returns do not make a pretty picture. That may be true but the interesting question, imo, is why.

Many retail investors perceive that professional managers do what they do, look at balance sheets, listen to company calls, learn about competitive advantages, valuations etc. That is all true but fund management in the professional arena is more than anything, a business. The business part can easily outweigh the investment side in time and effort and decisions on things such as sales and marketing, product strategy, adequate resourcing, capital allocation and incentive structures can easily decide a firm's fate ahead of investment performance (in my experience).

During my 35 years in professional money management, I worked at 7 firms. All no longer exist, at least in any recognisable form, despite some having been nominated and won awards for performance. Also, some of the people who worked at those firms went on to build large and successful investment businesses elsewhere, why the change of fortune? Let's dig in (as the millennials say)

Before I go on, one wag, after hearing about the failed businesses said the reason for failure must be me (being the common thread). Well, yes very funny, however, I left these firms on average 3-4 years before they fell over or were forced to merge etc. Having said that the signs of critical weakness were there before I left, those weaknesses were quite apparent to me. The following is a list of the issues I observed at those firms and many other firms I have studied as competitors in the industry.

 

1.      No investment philosophy. Investment philosophy is a belief in how markets work and how to develop a systematic way to deliver alpha from them. Almost every successful LT investor has one.

2.      No investment process exists. An investment process is the systematic implantation of the philosophy to derive alpha.

3.      There is a stated philosophy but it is out of style—this is perhaps the most defensible failure, IMO. Remember that managers often sell themselves on a style. Saying you are the best value manager in the market, and then switching to growth because “value” isn’t working, stretches credibility, and may bring a swift end.

4.      There is a process but not enough of the team believe in it or follow it, or wander “off-reservation” leading to style drift, a sackable offence.

5.      The team does not operate as a unit, the “herding cats” syndrome. There are poor dynamics, with members split between being too bullish or bearish, some team members always proffering ideas and others never doing so. To be clear, this is not to say the members are not hard-working, intelligent or poor investors but that the team as a whole is too lopsided to coexist and create an environment that generates good returns over the long term. Perhaps the best team in investment history that we can observe in detail, Buffet and Munger, were a two-man team (small), but imagine the quality and efficiency of their conversations. Quite a rare combination in my experiences. A poor people mix, regardless of individual skill can lead to failure.

6.      Poor leadership—not understanding the business, or investment strategy, too short-term focussed, chasing yesterday's product stories, too willing to abandon ship at the wrong time in the cycle and not defend positions. Especially where the leader is not an investment person or not a PM.

7.      The Under-resourced firm can't buy or keep talent, and can't invest in research or product. Similar to other industries, FM depends to some extent on scale, if you don’t achieve scale, the company is forever under-resourced and doomed in the long term, IMO, regardless of investment performance.

8.      Poor strategy, too many products with no competitive advantage. Firms run by general management or sales make short-term decisions. Trying to satisfy what the market wants in a product at any one time, without having any exceptional skills in that product. What can happen is by the time, usually two years, you have a product and some track record to bring to market, the market has moved on and you appear to be a follower with no conviction on your investment philosophy. Losing credibility.

9.      Poor governance and behaviour, such as trading insider knowledge, and accepting kickbacks. These are rare but obviously can bring a company down. The fall comes if or when the behaviour is discovered or some of the team disagree with the behaviour or are not getting their share of the spoils, starting a civil war! Once it becomes general knowledge the fate of the firm is usually sealed.

10.   Inability to keep the confidence of investors/consultants when things go against them. All firms have poor patches, if the team is not united, including sales, it could lead to finger-pointing, and any cracks may prove disastrous.

11.   Poor incentive structures, bonuses to those not generating the alpha, continually moving the goalposts on incentives, changing agreements, reneging on deals or a range of similar activities. If the Candyman doesn’t recognise the real talent and reward it, trouble is in store.  

12.   Poor treatment of investment or other people, humiliation, bullying, sexual assault, a culture with no fairness or respect. More than most businesses fund managers are people businesses, you need to attract and keep the talent.

13.   Investment is not the main game. Management becomes attracted to other activities and wants to diversify, such as IT services, investor relations, and corporate services. Banks or insurance companies trying to run fund management operations can be quite tricky and have a poor record.

14.   Hubris-or the I know more than the market. Stubbornness vs. Conviction, it is a challenge to keep perspective.

15.   Laziness, investing is hard, once you have enough wealth, the beach beckons. Cant carry passengers, and it sends a poor message to others.

A few common threads are running through the above outcomes, one is that being a good investor does not mean you can manage a business well. I would argue that Fund managers are poor business managers, either completely hands-off, micromanaging, or brutal enforcement. These are people businesses first and foremost. Secondly, there is a theme of constant poor decisions around things such as taking the easy short-term solution that brings longer-term problems not understanding and backing any competitive advantage and constantly chasing fads and apparently easy returns.

Some managers are good at marketing and distribution but it is massively time-consuming, it is hard to be good at both investing and marketing and also having time to do both well.

The above will usually manifest itself into poor performance at some stage. The game is difficult enough without having to deal with the above. No one starts to fail, it is the culmination of a series of poor short-term decisions, which may make sense in the immediate, over time undermine the credibility and ability of the firm to function as a well-balanced optimised decision-making unit.

The above can serve as a due diligence checklist, before joining a firm for those interested, it's no fun to restart your career every few years as the horse you're on gets shot from under you.

PINNACLE INVESTMENT (PNI)

As I see it PNI invests in fund managers being fully aware of the above. Not every manager is conducive to being a success and it depends on PNI identifying candidates who exhibit (amongst other things) fairness and reasonable, have a long-term view, and have a talented team. By investing at fair value, PNI only makes excess returns as the FUM grows, usually, this takes time. PNI acts as a deterrent to short-term poor decisions, backs managers but also acts as an independent and aligned business partner. The alignment comes from the investment into the equity of the firm and is protected by the shareholder's agreement. The overarching strategy is to identify talent who have the character to operate in this structure and then to defend the investment talent and distribute the product to build a much bigger and more profitable organisation by avoiding the above paths to failure.

PNI is a market elastic investment so getting in at market ATH may be problematic. Perhaps my experiences are biasing me, after experiencing the downside in FM so many times maybe I'm too willing to believe in a cure. That could be the case. Lol.

 

Held top 10 position—still thinking about the SPP