Vanity, sanity, reality

“Our greatest assets are our people”

This is one of the most trite, overused phrases in modern business – but that doesn’t stop it being used constantly by many investment management firms.

Of course, like all modern business jargon it’s a blindingly obvious truism, and so arguably, therefore, not too offensive. However, what irritates me is not the gratuitous and frequent overuse of the phrase but the fact that those who use it seem to have spent little – if any – time actually thinking about what it means in practice.

The investment management sector has some particular characteristics, but it is not unique; those of us in the developed economies live in a society where a decreasing number of us earn a living making, building or growing stuff. Many of us today live in a society where knowledge and skill are our tools of the trade; where arguably, amongst the classic factors of production, labour is the most highly compensated and highly prized.

Despite this, many businesses in the service sector – including investment management – are wedded to outdated notions of what success looks like and how businesses should develop and expand.

In the aftermath of the industrial revolution, scale, quantity, and size were the goals of every business. Making things has a high fixed cost, plant is expensive, transporting raw materials is expensive and time-consuming, and labour had a simple price-driven dynamic; thinking bigger, producing more, selling more was the key to success. Greater scale leads to a lower unit cost which leads to a cost advantage which should mean higher revenues and higher returns for shareholders.

However, this formula doesn’t really work for most people businesses and is especially inappropriate for investment management businesses. Unfortunately, too many investment management firms have been infected by the fallacy that growing in size and complexity somehow makes the business better.

What do we mean by this?
Let’s consider those who actively manage portfolios. Doing it well is hard; if it wasn’t everyone would do it. It’s complex, it’s intellectually challenging and – done properly – it uses every working hour of those rare individuals who do it well. Managing a truly actively managed portfolio requires a significant commitment of time and effort and requires those involved at the research level to delve into multiple industries and geographies and understand the pricing, supply chain, competition and strategy for each of those businesses and then model various outcomes to try and find the true value of target investment. I would argue that for anyone who loves business or economics it’s one of the most stimulating jobs there is.

Even then stimulation is only part of it. Fund management is also one of those unusual businesses where success and failure are readily measurable and easily visible. For those who aren’t focused on short term results, there’s the excitement of uncovering an angle the market has missed, testing the thesis, then taking a position on a firm or industry or geography which is against the consensus or the herd view. This position may for many weeks or months seem to be a losing bet. Then if you get it right there’s the slow warm feeling of being vindicated by the market and – more importantly – seeing the visible results in terms of tangible out-performance and higher returns for clients. In short, working in an investment team is stimulating and rewarding – in every sense. The sense of satisfaction that those involved get from managing a portfolio is not, however, related to the size of the portfolio they manage. Managing $5bn in large-cap equities is probably just as satisfying as managing $10bn or probably even $25bn. What’s in the portfolio is what matters; the assets under management beyond a certain critical mass is largely irrelevant.

It flows from this point that investment management firms do not need to grow beyond a certain critical mass to keep the fund managers happy – or to be profitable. In fact, the perfect investment management firm would comprise an investment team, some operations, IT and support staff and just enough marketing and client service staff to ensure that clients were looked after. The investment team would be the largest group of people within the firm and any other functions would be just large enough to allow the investment team to do their job and to give the clients excellent service – but no larger.

Sadly, in the real world, this is rarely the case. The investment management sector is full of flabby, mediocre businesses with too many strategies, too many products and too many conflicts of interest and competing priorities. Unfortunately, in our experience, we find that in too many firms the investment team is no longer the largest group of employees in the firm and this is where the issue lies. No matter how talented and well-motivated the non-investment staff are within the firm – and in many cases they can be every bit as smart as the investment team – they simply have different motivations.

Salespeople want to sell more product, marketing people want to expand across client segments and geographies; product development teams want to launch more product. Each of these desires indirectly feeds more expansion. More product leads to more complexity and more systems support; geographical expansion leads to greater compliance, IT and premises support and more sales channels require more finance, data analysis and support.

Finally, all of this leads to greater organisational complexity and – because these are people businesses – a far bigger HR and reward team. The business loses focus and its ‘edge’ because now there are increasing numbers of people in the organisation whose ‘success’ is judged by criteria which are not directly related to investment performance or client satisfaction. These employees are only challenged if the business is consistently growing, expanding, and complicating itself and if it ceases to do so they quickly become expensive, demotivated employees. At that point even if it becomes desirable for the firm to restrict its capacity, close for new business, or cut its complexity or scope of operations many of those responsible for running the show find it impossible to bite the bullet and take these hard decisions.

The tragedy is that we find that these bloated, complex businesses are normally far less profitable per employee and per dollar of revenue than smaller much more focused firms and they find it harder to retain clients and retain talented investment staff. Remember, an excellent portfolio manager is stimulated, motivated and driven by the challenge of managing money. Participating in endless marketing roadshows, product prioritisation sessions, budget meetings, cost allocation forums and managing staff is unlikely to be high on their list of favourite tasks.

To put this starkly, every investment management firm should ask itself:
Would we be a better business if we just focused on managing money in one key asset class, where we have a real competitive advantage and ditched everything else?

In our experience the answer is yes.

Sadly, for many it’s too late, the genie is out of the bottle, especially those with public shareholders who’ve been sold a dream of growth, scale, and market domination.