State Street’s Suzanne Duncan Reveals Investors’ Biggest Mistakes

In an exhaustive study, the head of research at the State Street Center for Applied Research found that money managers overemphasize alpha.


The investment management industry’s success has been built on stories. In the 1980s, Fidelity Investments grew into an industry leader after Peter Lynch famously delivered double-digit returns for years to investors in his Magellan Fund. Bill Gross might have infamously left Pacific Investment Management Co. last year, but the bond king still almost singlehandedly built the Newport Beach, California–based firm into one of the world’s largest asset managers, with $1.7 trillion in assets.

But the industry’s models for success are broken, contends Suzanne Duncan, global head of research with the State Street Center for Applied Research, which does primary research on the future of asset management. Duncan, who spent ten years at International Business Machines Corp.’s Institute for Business Value before joining State Street in 2011, says profitability masks problems lurking below the surface, largely because alpha — risk-adjusted returns above a benchmark — is still the gold standard of success. But not only has alpha become more difficult to deliver as professional investors bring out ever-more-expensive machinery to gain an edge over rivals; clients’ goals are not being met even when money managers produce stellar returns. Individual investors can’t retire on excess returns, and professionals can’t rely on alpha to help pension funds make good on their promises to beneficiaries.

A student of behavioral finance, 40-year-old Duncan believes investors make mistakes that impede their goals. Her latest research at the State Street center, The Folklore of Finance: How Beliefs and Behaviors Sabotage Success in the Investment Management Industry, released last December, looks at the conscious and unconscious decisions that weaken investment results. Duncan and her fellow researchers surveyed almost 3,800 institutional and retail investors, money managers, intermediaries and regulators around the globe and conducted face-to-face interviews with more than 200 executives. Their goal: to identify errors, along with activities that can create better outcomes for investors and a more sustainable industry.

Duncan got her start in finance at Bank of America Corp., where she interned while studying political science and philosophy at College of the Holy Cross in Worcester, Massachusetts, first as a teller and then in branch operations. After graduating, Duncan joined State Street Corp. in custody and moved into sales for State Street Global Advisors, the Boston-based firm’s asset management arm. She left to get her MBA in finance at Boston College before joining IBM’s sales department. Duncan says she found her true career when she transferred to the Institute for Business Value, which researches emerging trends and innovations.

What did you discover in your research that most surprised you?

How difficult it was for many executives throughout the industry to define success. That is a fundamental question, and what that difficulty tells me is that there is a reckoning going on. Most organizations are going through some significant questioning of the business model, the value proposition and their reason for existence. We would be sitting in a room, and when I would drop the question “How do you define success?” there was silence.


You could see that as being somewhat disturbing, but I think it’s healthy. The industry is asking whether it has it right, and considering that it might not have it right and might need to consider changes. I think it’s triggered by the financial crisis after which so much has changed, whether it’s shifting correlations or the needs of clients or low interest rates. It’s a hard question to answer because the value proposition used to be very simple: the production of alpha, period. Now it’s much more complicated: We need to help investors achieve their long-term goals.

You found that only 53 percent of individual investors and 42 percent of professional investors believe alpha is attributable to skill. What does that mean to you?

Not even half of professional investors think skill is the primary driver of outperformance, yet 60 percent of the industry’s capital is spent on the singular pursuit of alpha. Houston, we have a problem. Why are we spending so much to get so little is the point. People are skeptical for good reason. It’s very difficult to separate skill from luck. But investors want proof because of the fees they are paying: Why am I paying you this money and I can’t see the value that is being delivered to me?

What did people say during face-to-face interviews that tells the story behind these numbers?

A gentleman working for a large asset manager in Europe had once been a portfolio manager of a top-performing strategy and moved to a risk management role. He said in hindsight there was no way he could distinguish between his skill and his luck. But now that he has a risk hat on, he sees how risk factors, not individual security positions, are driving alpha. The point is profound: We in the industry are overconfident. When he was a portfolio manager, he thought security selection was driving his performance, but in fact, it was risk, which means it was luck.

What were some findings that you think the industry needs to act on?

Organizations need to go after pockets of opacity. It’s much easier to invest in something you understand and are close to. You see it with individual investors in their 401(k) plans all the time. If there is no default option, they invest in company stock. Behaviorally, it gives you a sense of false comfort, when it’s actually very risky, as your [job] is tied up with those investments as well.

It’s very similar on the professional side. You see so many professional investors in asset classes that are quite transparent — say, large-cap — and what you would like to see is the reverse. Managers should go after pockets of opacity, where there is less efficiency and information. That’s where they’ll get a successful outcome and be able to produce alpha. Yet there is such a crowding of the market in these fully transparent sectors where everybody is competing for the same finite alpha. This is behavioral: We understand IBM, and we’re not going to get penalized by making a bad decision on it. If you go into less crowded areas and you’re wrong, then you’re alone. That leads to career risk.

Tell us about career risk.

Let’s take a step back and remove ourselves from talking about asset classes for a second. There’s the folklore of knowledge, which can be summed up as the tendency to think we know, but we don’t know. It’s a human coping mechanism. After interviewing 130 portfolio managers all over the world at asset managers and asset owners, [I found that] they credit success to themselves but blame others when they fail. They think they know, but they don’t. This is unconscious behavior; they’re not even aware they’re doing it. “I was successful because of my experience, my analytical abilities, or I was unsuccessful because of the markets, et cetera.”

We’re not learning from our mistakes, and that’s a big problem. If we’re not learning from mistakes, then how can we improve? Well, we’re not. We’re all disillusioned about success and failure, so we do this to deal with fear, and the greatest fear in our business is career risk. It’s the largest driver of investment decisions. Career risk can be two things: to make sure that we’re maximizing the upside and then, of course, to not lose your job.

We asked, “How many periods of underperformance would it take for you to be fired?” and people said 18 months. We probably don’t fire people after 18 months, but the pressure these executives experience is real. That makes them overuse folklore like the folklore of knowledge. We found this to be true in equities, bonds, alternatives, in the U.S. and Europe and in fundamental and quantitative strategies. We need to address this.

How can firms root out the behaviors that hurt performance?

In the paper we recommend 17 tactics. But we spend the most time talking about how to revise incentive structures. If you are paid on an annual time frame, you’re going to be operating on a short-term basis, and everyone is paid on an annual time frame. We need to figure out how to pay based on a longer-term time horizon through the bonus, not the salary.

We also need to pay based on behavioral awareness: Does the portfolio manager understand his or her own behavioral biases? Does the sales and relationship manager understand the behavioral biases of clients? If organizations pay based on behavior in a meaningful way and not just on performance, then you can relieve the pressure cooker, the deep fear of career risk.

In other industries, breakthroughs such as new medicines or increased manufacturing efficiency using robots benefit the end user. Discoveries and new technologies in finance don’t always end up helping investors. Why?

I’ll support the pro-technology trickle-down, and then I’ll go against it.

There is some evidence of innovations in advice — robo advice — really taking off on the retail side. And these just cropped up since the financial crisis. It’s one area where I see technology as democratizing the world of investing. You probably saw in the paper that investors trust technology more than they do humans. Two thirds of individual investors believe technology will do a better job of serving their needs. And they’re not just saying it’s cheaper; they believe it will be higher quality than what they can get through a human.

It’s been a long time coming, but we see evidence that the industry is experimenting in how to leverage technology to provide a better value proposition to the client.

But more broadly, it’s less a question of whether the benefits of technology trickle down to investors and more about economies of scale. You would assume that, based on the scale of the industry and how large it has become as defined by assets under management, fees would have come down much lower than they have. It’s a scale business, and you would expect that the savings would be passed on to clients. But we don’t necessarily see that. There have been single-digit declines, but you would expect to see much higher fee compression.