Top 400: The essential C-word in investment management
Over the past few years, a number of previously successful asset management firms have blown up spectacularly, unexpectedly tripped up, or surprised us all with how fast they have unravelled. Over the same period, however, relatively unknown players have risen to prominence, and some managers have continued to succeed despite serious knocks.
For years, I have been trying to answer this question: how to identify those investment managers most likely to fail in advance of their demise?
Many clients review their managers following a sustained period of bad performance or excess volatility beyond expected ranges, or after a key person leaves. However, these triggers are too simplistic, reactive and, unfortunately, identification usually only happens after the fact.
While we, as pension fund decision makers and consultants, spend a sizeable amount of time focusing on managers’ risk management and downside focus, our sell discipline as an industry is not particularly effective. In fact, it feels under-developed. Moreover, while the jury may be out on whether anyone can consistently identify the best manager in each category or strategy, it remains crucial that consultants help clients avoid the worst ones.
We need to identify the early symptoms – or the underlying causes – of disease. At Redington, we speak to fund managers, CIOs, CEOs, academics, researchers, clients and colleagues continuously in an effort to determine the key drivers of asset management failure.
The most oft-mentioned success factor is culture, although people rarely use that word. Indeed, culture is something of a dirty word in asset management; it is not one that asset management teams talk about, and it is used less by clients and advisers. However, its impact is underestimated until too late. Executive committees at investment management companies spend hours and days discussing incentive schemes, team structures, titles, reporting lines, risk management and regulation. However, if someone mentions culture, a deafening silence ensues.
It is understandable that this factor is ignored and sidelined, given the analytical and inherently cynical nature of most fund managers. Frankly, there is little consensus on what (corporate) culture is, let alone how to influence it and how it affects behaviour. Having said that, culture is not as intangible as many people believe. In my experience, there are plenty of clear, measurable and critical elements of culture that are quite tangible indeed.
Culture is embedded in the unwritten rules colleagues tell new joiners – ‘this is how things are done around here’ or ‘we have always done it this way’. Culture is a set of repeated habits, rituals, narratives and expectations that govern how people do things in organisations, and are based around the inherent values of decisionmakers. Culture is a control system that carries the behavioural norms that must be upheld, and determines the social consequences for those that do not stay within the boundaries.
It is not surprising that the UK’s new regulator, the Financial Conduct Authority (FCA), has shown a keen interest in the culture of financial services firms. “Culture is the DNA of the firm,” Clive Adamson of the FCA has said, noting that it shapes “how decisions are made at all levels of the organisation”. He is of the view that “in many cases where things have gone wrong, a cultural issue has been at the heart of the problem”.
Cultures can evolve naturally, be driven by role models or by a management team. Culture is usually carried by leaders, long-serving employees, historical narratives, habits and routines. It is influenced by incentives and sustained through recruitment and management of staff, the induction of new people, and through appraisals and discretionary rewards. Large organisations can have multiple sub-cultures that should not be ignored – the legacy of cultures within acquired units can persist for a surprisingly long period of time.
In my experience, there are 10 dimensions of culture that are critical to determining success, or failure in fund management. These are listed below, each expressed as a spectrum:
• People focus: Is the business long-term people oriented or short-term results oriented?
• Star culture: How are successful managers treated? How are support people treated?
• Self-orientation: Are portfolio managers loyal to themselves, their teams or the company?
• Conflict tolerance: Are people expected to agree or is conflict and challenge encouraged?
• Risk culture: Do employees tend to ask permission for everything or do they feel empowered to take risks? Are people trusted or is someone always watching?
• Approach to failure: How does the company deal with errors, mistakes and failure?
• Job security: Do people feel secure in their jobs, are they motivated to excel or avoid attention and ‘stay out of trouble’ motivated by career risk?
• Success definition: Is investment performance, client retention, net sales or share price appreciation the ultimate measure of success?
• Competition: Are individuals/teams incentivised to collaborate or allowed to compete?
• Abdication risk: To what extent are problems and issues escalated upwards, or do employees feel responsibility for dealing with issues?
This list is not a ‘yes’ or ‘no’ checklist. The key question is not absolute value or exact position of the firm on any of these cultural questions, but how aware and in control of the culture a management team is. What is particularly interesting when assessing asset manager riskiness is how their position on each of these issues fits together, how the culture has changed or is changing, what new employees are sold, what clients expect and whether there is a disconnect between the leadership and the people on the ground.
A year ago, my new client (now employer) Robert Gardner, founder and co-CEO of Redington, asked me to help develop a system to identify and communicate early warning signals that should be monitored by clients, in order to assist decision making around the engagement with, and timely removal of, managers.
After research and deliberation, 10 early warning signals presented themselves. These have now been developed into a system through which we aim to understand what might go wrong with a manager before any assets have even been allocated to them. We monitor and report on these critical issues on an on-going basis to help clients avoid being caught by surprise. These 10 key risk factors are:
• Business focus on asset gathering and short-term priorities
• Increased dependence on a single client or channel (asset persistence)
• Weak leadership
• Misaligned incentive structures (prioritising asset growth over investment performance)
• Increasing key person dependence
• Product proliferation and business complexity
• Process drift or moving away from core skills
• Poor capacity management
• Undisciplined growth implications for operational infrastructure
• Lack of challenge and accountability.
These are not a series of boxes that need to be ticked or crossed. Instead, they are considerations that help us to understand how a fund management company measures and rewards success, whether a portfolio manager’s interests are aligned with the clients.
It’s early days, but the FCA seems to understand that organisational culture is hard to change and it takes persistence. The responsibility lies with every employee, led by the senior management, and cannot just be delegated to the compliance, or HR department. To change deeply embedded behaviours, senior management have to support the right behaviour through rewards, performance evaluation, employee development and their own actions.
I am aware of how difficult it can be for clients to fire a manager as I have observed this from both sides of the fence. Often, relationships have been established over many years, and managers will make a case for having another chance – a new person, a new system, or lower fees. And, behaviourally, we are all programmed to prefer the course of no action.
As a result, I was keen to not just develop a checklist but an integrated monitoring framework to help clients focus on what matters most and to help them act logically and quickly when an issue is identified. This is not about creating excessive turnover amongst a client’s managers, but it is about helping them engage and be proactive if problems are expected to derail a team or the business in the future.
In conclusion, investment management is a complex business, and it is vital that consultants help clients to understand the various moving parts and key drivers of success or failure. The truth is that every institution, no matter how large, is vulnerable to failure; fund management companies can look strong on the outside despite being sick within.
While it may not be not possible to determine the fate of every firm, we assert that early symptoms, and even underlying causes, can be detected and can be avoided. The challenge is talk more openly about the C-word, understand corporate culture better and embed on-going assessments of whether an investment manager’s culture is aligned with its clients, and whether it risks creating a negative loop that could drag it downwards.
Mitesh Sheth is director of strategy at Redington