Improving investment asset allocation decisions
Markus Schuller, Panthera Solutions
Professional managers of other people’s money, like regional banks, private banks, wealth managers, investment companies, (multi-) family offices, etc. are confronted for the first time in decades with a situation that forces them to do one of the following:
- Grow aggressively in size to play a shaping role in the industry’s concentration process.
- Take on the competition with investment management fintechs in offering low-cost, fully automated wealth management solutions.
- Position themselves as leaders in an investment management niche via innovation-driven competitive edge.
- Accept to be squeezed out of the market.
The first two options are out of reach for many investment service providers as they are too small, too conservative and/or too loaded with overhead costs. Assuming they want to survive, they will have to target a niche where they can exploit an innovation-driven competitive edge. This means becoming a learning organization with a continuous improvement cycle. We regularly ask the investment management deciders and investment committees how they learn. Silence is the most frequent response.
Another insight we gained in our consulting work concerns resistance to change. In our 2015 article “Man at the centre of the investment decision” we concluded that the underperformance of professional investors versus the market portfolio is dominated by two structural factors. The first is a straightforward cost penalty incurred due to transaction costs, management fees, distribution fees, etc. The second is the “Behaviour Gap Penalty”, defined as the contribution of the human factor to a biased perception of reality caused by cognitive dissonances. Indicators of the penalty along the investment process include certain market timing techniques, the application of flawed portfolio optimization techniques, minimizing career-risk as primary objective and other expressions of cognitive biases.
The less personal the aspect to be optimized in an investment process, the lower the organizational resistance, so minimizing fees, optimizing tax structures, or implementing regulatory changes meets relatively little resistance. Increased organizational resistance becomes visible when we’re dealing with asset-allocation related topics. There, one can distinguish between subject-specific input on methodologies, in which the professional investor got academically or professionally socialized (you do what you know) and subject-specific input on methodologies beyond the academic or professional socialisation of the professional investor.
For example, a CIO trained in modern portfolio theory can apply the mean-variance optimization in his job, and will show little resistance to a change towards minimum-variance optimisation. But if you ask that same person to switch from correlation-based risk management to causality-based risk management, expect a significantly increased level of resistance, as it goes beyond his or her background. The highest resistance level can be found when investment process topics relate to the individual decider, like optimizing the daily work routine, configuring the team role profile, or reducing the person’s knowing-doing gap.
So how do you create what we at Panthera call a High Performance Investment Team (HPIT©) able and willing to oscillate between the operational and meta-levels in its qualitative and quantitative optimisation of the investment process? Only working on low resistance levels will not lead to a sufficiently significant competitive edge. You have to go where it hurts, and this inevitably becomes personal. But if an industry has exceptionally high relevance for society and is rewarded over-proportionally well for it, equally high expectations have to be met. (A logic that is considered surprisingly new in the finance industry.)
We’ve identified four levels of change management interventions to boost performance: individual, team, process, culture. The quantitative and qualitative optimisation methods applied at individual and team level are similar, for example establishing certain skills and rituals that are needed to get the job done well. Where there is low resistance, change can probably be effected without any external guidance. But given the potential personal and organisational tensions involved in the medium higher resistance actions, it’s better to seek external guidance in tackling these issues.
Culture and Process define the game arrangement of an investment process. The meaning of this can be described as follows: we all know that the more often one plays at a casino, the more likely it is that the house wins, even if a player can temporarily enjoy a lucky streak. A certain asymmetry in favour of the house is structurally embedded in the game. The very same is true for the game arrangement in an investment process. If a certain overachieving behaviour of the individual decider, say high work ethics, is expected, while the same standard is not set as part of the team or organisational culture, it only is a matter of time until the individual aligns his behaviour to the established organisational culture or leaves the organisation.
To take a couple of examples. If an employee is expected to openly experiment with new asset allocation methodologies, following an evidence-driven trial and error process, but the organisation remains driven by a culture based on fear and therefore responds destructively to errors, it only is a matter of time before the employee either returns to the rituals that come with a fear-based culture or leaves the organisation. Or if an investment management employee is expected to act as intra-preneur, but the organisational decision-making process and compensation schemes are aligned to those of public authorities for civil servants, it is only a matter of time until the employee either returns to the rituals that come with a bureaucratic culture or leaves the organisation.
If professional managers of other people´s money want to position themselves as leaders in an investment management niche via innovation-driven competitive edge, the optimization goals shown in the illustration below have to be targeted to establish and manage high performance investment teams.
Source: Panthera Solutions