Recently, an asset owner told me that one of their public equity strategies had underperformed its benchmarks over one, three, five, seven, and ten years.
“Why would you continue to stay with this manager?” I asked. The reply: “The manager assured me they are rolling up their sleeves and committing substantial resources to improve performance.”
Given the persistent underperformance of its strategies, the manager certainly knew that its process was not working as expected. So why hadn’t the manager made this commitment much earlier? It seemed ludicrous to assume that the manager had simply done nothing over the previous few years to remedy the underperformance.
The situation reminded me of a conversation I had a few years ago with one of the most successful asset managers I know. We were walking on a beach in Florida, and I took the opportunity to ask him about his firm’s mission. He answered without hesitation: “To provide clients with investment excellence.” He added that every team member and board member embraced this mission, and every decision and action was taken to fulfill it.
He summarized in six words the universal mission of all asset managers, making it strikingly clear that a manager’s singular focus should be the fulfillment of that mission.
Because alpha is scarce, transitory, and capacity-constrained, this singular focus certainly requires a manager to continually (not just during a market crisis) reevaluate and, when necessary, enhance or redesign its investment process.
AQR succinctly lays out this reevaluation process on its website: “Our investment process, built over 20 years, is based on a continuous process of design, refine, test, repeat.”
An integral part of this process is the regular and prudent exploration of how new tools, techniques, and talent might help generate better investment returns — even if these tools, techniques, and talent challenge a manager’s long-held investment beliefs.
A manager — like the persistent underperformer above — might assess its investment process and find that that process cannot be improved enough within the bounds of its current methods, tools, and staff to beat its benchmark. After all, the manager’s edge might have been arbitraged away, or it might have applied only to a certain market environment.
I would argue that if this is the manager’s conclusion, then the manager is obligated to notify its clients that, despite its “best” efforts, its process can no longer provide the promised excess return and it must return the clients’ capital.
This is certainly a difficult decision to make, but if a manager is truly acting in the best interest of its clients, then it has no other choice.
Though you might think no manager would ever actually fall on their sword, I know of at least one individual with this kind of fortitude: Ted Aronson of AJO Partners. In 2020, AJO gave up the ghost and returned about $10 billion of client capital. In an interview with MarketWatch, Aronson pulled no punches in announcing the decision to shutter his 37-year-old firm: “Our return sucks over the past few years. . . . Our shit is so bad, it’s unbelievable compared to our peers.”
The decision demonstrated the commitment of Aronson and his firm to investment excellence and to putting client interests before their own.
But not every manager seems to make the pursuit of investment excellence its north star. As one service provider puts it: “The business of money management is inherently conservative, with the retention of capital just as important as asset gathering. New technology can be embraced, but adoption is likely to be cautious and incremental.” This explicit focus on asset retention and asset gathering is completely at odds with the pursuit of investment excellence.
Investment excellence is the touchstone that properly aligns the interests of manager and client. The client knows the manager is committed to doing everything it should to provide the expected returns, and the manager knows that if it successfully fulfills its mission of providing investment excellence, it will build a robust, sustainable business.
So when performing due diligence, the first question asset owners and consultants should ask a manager is “What is your firm’s mission?”
The manager might not be able to provide as pithy an answer as my friend did, but the response should attest to a commitment to investment excellence. An example of this is Verger Capital Management’s statement of its philosophy: Our mission is “to deliver strong, stable, risk-adjusted returns with consistent and reliable payouts in perpetuity.”
However, because there is often a chasm between words and deeds, asset owners and consultants also should ask managers to provide empirical evidence, going back in time, demonstrating that it has repeatedly dedicated resources to fulfilling this mission.
If a manager fails these two tests, there is no need to continue the due diligence process.
Angelo Calvello, Ph.D., is co-founder of Rosetta Analytics, an investment manager that uses deep reinforcement learning to build and manage investment strategies for institutional investors.