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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Winning at Active Management conducts an in-depth examination of crucial issues facing the investment management industry, and will be a valuable resource for asset managers, institutional consultants, managers of pension and endowment funds, and advisers to individual investors. Bill Priest, Steve Bleiberg and Mike Welhoelter all experienced investment professionals, consider the challenges of managing portfolios through complex markets, as well as managing the cultural and technological complexities of the investment business.
The book’s initial section highlights the importance of culture within an investment firm – the characteristics of strong cultures, the imperatives of communication and support, and suggestions for leading firms through times of both adversity and prosperity.
It continues with a thorough discussion of active portfolio management for equities. The ongoing debate over active versus passive management is reviewed in detail, drawing on both financial theory and real-world investing results. The book also contrasts traditional methods of portfolio management, based on accounting metrics and price-earnings ratios, with Epoch Investment Partners’ philosophy of investing on free cash flow and appropriate capital allocation.
Winning at Active Management closes with an inquiry into the crucial and growing role of technology in investing. The authors assert that the most effective portfolio strategies result from neither pure fundamental nor quantitative methods, but instead from thoughtful combinations of analyst and portfolio manager experience and skill with the speed and breadth of quantitative analysis. The authors illustrate the point with an example of an innovative Epoch equity strategy based on economic logic and judgment, but enabled by information technology.
Winning at Active Management also offers important insights into selecting active managers – the market cycle factors that have held back many managers’ performance in recent years, and the difficulty of identifying those firms that truly possess investment skill. Drawing on behavioral economic theory and empirical research, the book makes a convincing case that many active investment managers can and do generate returns superior to those of the broad market.
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Seitenzahl: 410
Veröffentlichungsjahr: 2016
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Further praise for Winning at Active Management
“The chances of success in fund management, as in professional sports coaching, are inversely proportional to time. The longer you are in the game, the greater your chance of having a poor run over a measurable window (say, three years), and involuntarily exiting the field. So the thoughts of a manager with 50 years' experience are worth reading. This book, unlike many written by active managers, does not claim to have found El Dorado and a path to untold riches; indeed, it acknowledges that passive investment may be appropriate for some applications.
The reason Bill has succeeded for so long comes across well in his and his co-authors' approach to culture, and in their dismissal of the Price-Earnings Ratio – a figure that whilst discredited, and never used in private markets, remains a mainstay of most active managers' processes. Economies and markets do not stand still, and yet many active and quant managers believe that what worked before will work again without the need to change and evolve their processes. It is in this area, more than any other, that 50 years of experience is invaluable.”
Robert Waugh Chief Investment Officer The Royal Bank of Scotland Group
“One of the most difficult aspects of consulting to institutional investors is finding active investment managers who will produce consistent results over a long period. While an investment process that is both sound and repeatable across different market environments is critical, it is insufficient unless implemented in a thoughtful way by an investment team that possesses the skills and values, and is offered the right incentives, to make optimal investment decisions. To my mind, a firm's leadership must inculcate and manage this sort of culture within the entire team in order to remain successful over a long period, and the first part of this book highlights that cultural challenge.
Technology has become a game changer in the investment industry, and the organizations that apply it most effectively will be the long term winners. Given the incredible amount of information that is now available, winnowing the critical insights to a manageable amount and sharing them among the investment team has become essential to an investor's success. In addition, using technology to better understand the factors behind market behavior can help an investment firm to evaluate its own performance. Again, the book speaks effectively of the need to make better use of technology within all parts of the investment industry.”
David Service Director, Investment Consulting Willis Towers Watson (Retired)
“Bill Priest, a leading practitioner of free cash flow-based investing, explains why that philosophy has been so successful. And much more: he and his co-authors tackle the most difficult issue in the investment management business – culture – and demonstrate how to maintain it in challenging periods. The book also addresses the industry's latest challenge, the proliferation of quantitative algorithms in every corner of the investment world, and describes how the value of judgment has increased as machines have come to exploit the short-term relationships that can be tested. Recommended reading for this generation of investors, and the next one.”
Michael Goldstein Managing Partner Empirical Research Partners
WINNING AT ACTIVE MANAGEMENT
The Essential Roles of Culture, Philosophy, and Technology
William W. Priest Steven D. Bleiberg Michael A. Welhoelter with John Keefe
Cover image: © Maxiphoto/Getty Images, Inc. Cover design: Wiley
Copyright © 2016 by William W. Priest. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions.
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Library of Congress Cataloging-in-Publication Data:
ISBN 9781119051824 (Hardcover)
ISBN 9781119051770 (ePDF)
ISBN 9781119051909 (ePub)
To Jack L. Treynor – the Albert Einstein of Finance, a man of great principle, a co-author, and a friend, from whom I learned more finance and economics than any other person.
And to my family – wife Katherine, Jeff, Karen, Amanda, Jack, Jacob, Hayley, Spencer, Joan, and Steve, who provide support, questions, and the occasional “what in the world were you thinking!” – William W. Priest
To Terri, Ben, Katie, and Ellie, and to my father, Lawrence Bleiberg, in whose footsteps I have followed – Steven D. Bleiberg
To my wife, Leslie, and my children, Christopher, Megan, and Lindsay – Michael A. Welhoelter
CONTENTS
Preface: Active Management is Not Dead Yet
Notes
PART I: Culture
Chapter 1: Culture at the Core
The Original Organizational Culture: Command-and-Control
An Alternative Culture for Knowledge Businesses
The Partnership Culture Model
Justice and Fairness
Notes
Chapter 2: Culture in Investment Management
Values
Integrity
Trust
Culture and Clients
Firm Culture under Stress
Culture in Recruiting
Acquisitions
Evolution of Culture
Notes
PART II: Philosophy and Methodology
Note
Chapter 3: The Nature of Equity Returns
Linkages: The Real Economy and the Financial Economy
Components of Stock Returns
Price-Earnings Ratios
The Historical Makeup of Stock Returns
Notes
Chapter 4: The Great Investment Debate: Active or Passive Management?
The Debate Is Timeless
An Elegant Theory: The Capital Asset Pricing Model
Further Elegance: The Efficient Market Hypothesis
Reality Intrudes
The Problem with MPT
Notes
Chapter 5: A More Human Description of Investors and Markets: Behavioral Finance
Loss Aversion
Mental Accounting
Minimizing Regret
Overconfidence
Extrapolation and Reversal
Investor Behavior in Action
MPT Still Lives
Notes
Chapter 6: Active versus Passive Management: The Empirical Case
Market Regimes
Correlation and Dispersion
Company Quality
The Weight of Cash
Luck versus Skill
Investors Voting with Their Dollars
Notes
Chapter 7: The Case for Active Management
April 2015: Investment Giants Square Off in New York City
An Active-Passive Equilibrium
The Case for Active Management
Notes
Chapter 8: Debates on Active Managers’ Styles and Methods
Manager Style
Free Cash Flow Is the Measure of Value
Depreciation
Accruals
Research and Development Costs
The CFO Perspective
Notes
Chapter 9: The Jump from Company Earnings to Stock Prices
Flaws in Traditional Valuation Measures
Accounting versus Finance: A Case Study
Notes
Chapter 10: Epoch’s Investment Philosophy
The Starting Point: Generating Free Cash Flow
Choosing to Reinvest
Capital Investment: Returns and Capital Costs
Once More: Cash Flow-Based Measures Are Superior
Trends in Capital Allocation
Dividends
Share Repurchases
Debt Buydowns
Capital Allocation: What’s the Right Mix?
Notes
PART III: Technology
Notes
Chapter 11: High-Speed Technology
Information Technology: Three Relentless Forces
Notes
Chapter 12: Technology in Investing
Information at Work
Order from Chaos: Applying Scientific Frameworks
Computers to the Rescue
A Virtuous Circle
Expansion of Index Funds
Betting Against the CAPM
Concurrent Developments
The Spread of Quant
Computing and Data, Neck and Neck
Big Data—Beyond Bloomberg
Artificial Intelligence
Notes
Chapter 13: The Epoch Core Model
Factors in the Epoch Core Model
Results of the Epoch Core Model
Notes
Chapter 14: Racing with the Machine
Investing Is Too Important for Robots Alone
Racing with the Machine
Seeking High Return on Capital
A More Practical Study
Is Persistence Contradictory?
An ROIC Strategy
The Value of Judgment
Notes
Epilogue
Notes
Appendix A: Selected Articles and White Papers of Epoch Investment Partners
The Canary in the Coal Mine: Subprime Mortgages, Mortgage-Backed Securities, and the US Housing Bust
The Financial Crisis: A “Whodunit” Perspective
The Power of Zero + The Power of the Word
Appendix B: Financial Asset Valuation
Bonds—A Basic Case
Stock Valuation through Cash Flows
Notes
Appendix C: Feathered Feast: A Case
Feathered Feast: A Case
Acknowledgements
About the Authors
Index
EULA
List of Tables
Chapter 5
Table 5.1
Chapter 6
Table 6.1
Chapter 10
Table 10.1
Chapter 14
Table 14.1
Table 14.2
Appendix A
Table 1.1
Appendix B
Table B.1
Table B.2
Table B.3
Appendix C
Table 1
Table 2
Table 3
List of Illustrations
Chapter 1
Figure 1.1 Tenets of Professional Partnership
Chapter 3
Figure 3.1 Links from the Real Economy to the Financial Economy
Figure 3.2 U.S. Gross Domestic Product (Left Scale) and Corporate Profits after Tax (Right Scale), 1947–2015
Figure 3.3 S&P 500 Operating Earning per Share and Cash Dividends Share, Latest 12 Months, December 1988–December 2015
Figure 3.4 S&P 500 Price Level and Earnings per Share, versus U.S. Nominal GDP, 1954–2015
Figure 3.5 S&P 500 P/E Ratio versus 10-Year U.S. Treasury Yield, 1988–2015
Figure 3.6 P/E versus 10-Year, 1988–2002 (Left Panel) and P/E versus 10-Year, 1988–2015 (Right Panel)
Figure 3.7 Components of S&P 500 Total Return, by Decade, 1927–2015
Figure 3.8 Components of S&P 500 Total Return, Rolling 10-Year Periods, 1927–2015
Chapter 6
Figure 6.1 Average Pairwise Correlations for Russell 1000 Index Stocks, Rolling 63 Days
Figure 6.2 Proportion of U.S. Institutions’ Large-Cap Core Equity Assets in Active Strategies, 2005–2015
Chapter 10
Figure 10.1 Applications of Free Cash Flow
Figure 10.2 Capital Investment and Distributions of U.S. Corporations in the S&P 1500, 1994–2013
Figure 10.3 Dividends and Share Repurchases of U.S. Corporations in the S&P 1500, 1994–2013
Chapter 13
Figure 13.1 Cumulative Relative Return of the Epoch Core Model, January 2002–November 2015
Chapter 14
Figure 14.1 Factors Determining Operating Profits
Appendix A
Exhibit 1
Exhibit 2
Exhibit 3
Exhibit 4
Exhibit 5
Figure 1 U.S. Real Home Prices: OFHEO Index Deflated by CPI
Figure 2 House-Price-to-Income Ratio in “Bubble Zone”
Figure 3 National Homeownership Rates
Figure 4
Figure 5 Alt-A Loans Share Subprime’s Risky Features
Figure 6 Mortgage Schematic,* House Prices, Mortgage Defaults, and CDO Loss Transmission Mechanism
Figure 7
Figure 8
Figure 9 U.S. Banks’ Willingness to Make Mortgage Loans
Figure 10 Nontraditional Loan Origins Fall Sharply in 3Q as New Rules Took Effect. Year-over-Year Change in Origination Volume
Figure 1 Earnings Are Correlated with GDP
Figure 2 Equity Prices Were Helped by a Collapse in Interest Rates
Figure 3 Recent Returns Predominantly the Result of Expanding P/E Multiples
Figure 4 Components of Compound Annual Equity Returns for Trailing 10-Year Periods
Figure 5 G7 Gross Government Debt % of GDP
Guide
Cover
Table of Contents
Preface
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Preface Active Management is Not Dead Yet
During a writing project like this one, once the key ideas are established, a question nags at the authors: What should we call it? Early on we came up with a working title “Not Dead Yet.”1 It was meant as a tongue-in-cheek response to the stream of reports over the past few years on the decline of active management of equity portfolios flowing from financial journalists and market observers—as well as the marketers of index funds, exchange-traded funds and other products that compete with actively managed strategies. To an extent, they make a valid point: the performance of active managers as a group has been less than desired. But there are several reasons to explain managers’ underperformance: some are cyclical, as markets of recent years have been affected by new sorts of macro influences, while others are secular, and related to how managers carry out their investment processes (Chapter 6).
However, the markets have not changed inalterably, at least not in our view. The essence of active management is a well-designed investment process that measures the relative value of individual stocks, and takes advantage of the many mispricings that result from less-than-optimal actions of investors, both individuals and professionals (Chapter 5). Granted, the stock market may have become harder for many managers to beat for several years. But inefficiencies in the pricing of stocks are timeless, and we believe that active equity management still works, and that the best managers can deliver excellent performance over the long term (Chapter 7). Active management is not dead.
This book is a second installment to a volume that I authored in late 2006 with Lindsay McLelland, Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor, published by John Wiley & Sons in early 2007. A few years after the founding of Epoch Investment Partners in 2004, I wanted to share views on what we saw as crucial investment issues of the day, and relate insights from the perspective of the firm’s investment process. The factors that would lead to the global financial crisis had just started to surface, and while we weren’t prescient on every topic in the book, we got many of them right as evidenced in white papers Epoch published at the time. (For example, see “The Canary in the Coal Mine: Subprime Mortgages, Mortgage-Backed Securities and the U.S. Housing Bust” from April 2007, reprinted in Appendix A.) More important, Epoch’s strategies fared well in the markets that followed, so the firm and its clients came through the global financial crisis in good stead.
A couple of years ago, I decided to write a second book. People that I talked with assumed it would take the form of a memoir about my 50 years in the investment industry. That idea had some appeal, as the markets of those years were varied and dynamic, and I have been “in the room” at critical junctures of market volatility with important and colorful people, and have plenty of stories and lessons to share.
But I am not a historian—I am an investor, and as such I am much more oriented to the future than the past. Of course, history is often the best guide to the future, but the “present” that today’s investors are facing—which includes the recent unusual period of the global financial crisis, and how governments, corporations, and markets have contended with the world since—make the further past of my career seem less and less relevant going forward.
Still, my experience has been pretty interesting, so I will share a bit. I joined the industry cavalcade in July 1965 at a mutual fund management firm, working as a research analyst initially and eventually a portfolio manager. I joined BEA Associates in New York, as a portfolio manager and partner of the firm, in July 1972. That November the Dow Jones Industrial Average closed above 1,000 for the first time. (The 1,000 mark on the Dow presented a challenging summit for equity investors: the average broke through 1,000 in intraday trading three times in early 1966, but did not end the day there.2) The firm’s staff numbered 11, and BEA managed less than $300 million in client assets—pretty small even in 44-year-old dollars. Not only was BEA a minor force in the market; the firm also had a weak balance sheet and at the beginning operated hand-to-mouth.
Shortly after I joined the firm, there was a significant collapse in stock prices—from its peak in December 1972 through December 1974, the Dow dropped 44 percent.3 My timing in leaving a large firm for the entrepreneurial excitement of a startup could not have been worse: the resulting decrease in assets and management fees led to a few BEA staff (of whom I was one) having to forego cash compensation for several weeks. However, BEA was fortunate to have a strong culture—one based on personal integrity, the motivation for the work that lay ahead of us, and the drive to provide superior performance for our clients.
There’s a saying in the stock market, which applies to life in general: Timing Is Everything. For BEA Associates, it was everything, and more. In 1974 Congress passed the Employee Retirement Income Security Act—ERISA—for the protection of employee pension funds, requiring employers to adequately fund them, and segregate the assets in formal pension plans. (The expanded requirements for recordkeeping, regulatory compliance and investment mandated by ERISA were so sweeping that those in the business jokingly called it the “Accountants, Lawyers and Money Managers Relief Act.”) The resulting flow of contributions from corporations to the pension funds they sponsored launched a new era for institutional asset management. The passage of ERISA was prompted by “the most glorious failure in the [automobile] business.” In 1963, after stumbling financially for many years—a strong postwar market for U.S. car sales notwithstanding—the Studebaker-Packard Company closed its plant in South Bend, Indiana. Workers aged 60 and over received their expected pensions, but younger workers received a fraction of what was promised or nothing at all. The shutdown helped advance a growing debate on pension reform into the national legislative arena, leading to the passage of ERISA in 1974.4
The new regulations forced the financial analysis underlying pension funding to a higher level, and to meet some of that need, I was fortunate to co-author, with financial scholar Jack L. Treynor and fellow BEA partner Patrick J. Regan, The Financial Reality of Pension Funding Under ERISA, published by Dow Jones-Irwin in 1976. Our conclusions grabbed the attention of legislators, and I testified before a congressional committee that influenced later regulations on the viability of insuring pension plans via the Pension Benefit Guaranty Corporation (PBGC). My co-authors and I were concerned that under certain circumstances, the PBGC could go broke, and Congress did indeed repeal and amend the section known as CELI—Contingent Employment Liability Insurance.
BEA expanded rapidly in the new era: by 1980 our managed assets had climbed to $2 billion, and the firm was recognized as a leader in U.S. institutional money management. In 1989, I became the CEO of BEA Associates, but continued to manage institutional portfolios. A year later the firm entered into a formal partnership with global bank Credit Suisse, although BEA Associates maintained its name until early 1999, when it became Credit Suisse Asset Management-Americas and I continued as the CEO. We then acquired Warburg Pincus Asset Management in spring 1999, at which point the fully built-out CSAM-Americas managed assets of nearly $60 billion. In 2000, Credit Suisse purchased the brokerage firm Donaldson, Lufkin & Jenrette, and its asset management arm also joined CSAM-Americas, bringing total assets to about $100 billion.
Over the course of those 30 years, as BEA Associates grew from a startup to the cornerstone of a large global institutional firm with offices in New York, Tokyo, London, Zurich, and Sydney, I witnessed the full life cycle of an asset manager—from the diseases of infancy that infect and threaten all new companies, to the limitless potential of vibrant middle age, to the comfortable but sclerotic bureaucracy that constrains complex global firms that grow too large.
Then in 2001, Credit Suisse’s corporate policies caused me to “retire”: the bank had a policy of “60 and out” for executives at my level. I was always aware that such a policy existed—I just didn’t think it would apply to me! Having no desire to retire, in March 2001 I joined Michael Steinberg, an excellent investor I had known for some time, and we formed Steinberg Priest Capital Management. The firm’s managed assets grew from $800 million to over $2 billion in three years, but the partners had differing ambitions and we disbanded the structure in 2004.
But I still had a desire to build a firm of substance, and in 2004 three partners—Tim Taussig, David Pearl, and Phil Clark—and I started once again, creating Epoch Investment Partners with 11 employees and initial managed assets of $640 million. As of the end of 2015, less than 12 years after its founding, Epoch oversaw nearly $50 billion in long-only equity strategies, and employed over 100 people.
So much for the memoir. In this book I have assembled a discussion that I hope will prove interesting and valuable to people in investment management—what’s happening today, and what the industry might look like in 5 or 10 years, both in the “investing business” (that is, the selection of securities and the managing of portfolios), as well as “the business of the investing business” (managing the many non-investment functions—product management and client services, and a firm’s information technology, operations, and compliance functions).
To be successful, an investment firm must clear three hurdles—its clients must reap superior investment performance; its employees must find desirable long-term employment; and its owners must earn fair financial returns. In this book, I have tried to share what I believe to be the required and essential elements to achieve these goals. Two of these are timeless, while the third reflects the growing dominance of information technology in every aspect of today’s personal and business life.
The first is firm culture, which is the bedrock of success for any firm, regardless of its industry. (Management theory pioneer Peter Drucker is supposed to have said, “Culture eats strategy for breakfast.”) In investment management—a people business based on shared efforts and rewards—culture is the sine qua non. The first section of this book is devoted to culture and includes a number of rough-and-ready observations on its importance in investment management.
As of early 2016, investment managers as a group are faring well but face challenges—like any other incumbent industry in a world moving at a rapid pace. After several slow years following the financial crisis, growth in new business has resumed in the industry, such that the total pool of assets available to managers in the United States is well above its 2007 precrisis highs. Since then, however, the center of gravity of the industry has shifted: whereas traditional defined benefit pension plans were once the largest source of new business, today’s inflows of assets are dominated by defined contribution retirement plans, as well as insurance companies, sovereign wealth funds, and high-net-worth investors resident in emerging markets. In the market for individual investors in the United States, market share is slipping away from large old-line wirehouse brokerage firms, in favor of independent investment advisers. (And lately, a wave of low-cost “robo-advisory” firms has been challenging them both.) These changes in the landscape are forcing traditional investment managers to reorient their marketing efforts, and contend with a new layer of costs.5
The focus of this book, however, is more the business of investing—managing client assets. While the business of the investing business has experienced an evolution, traditional active portfolio management has been under full-out assault. Many investors have favored passive investment products, such as conventional index funds and exchange-traded funds (ETFs) tracking market indexes, over active strategies trying to outperform the general market. A more recent marketing idea known as “smart beta” represents another group of semi-active products; like index funds and ETFs, they are able to deliver concise portfolios at fee rates below those of active managers.
This displacement, amounting to many billions of investment dollars owned by both institutional and individual investors, has occurred in part as the result of a shortfall by active managers in delivering market-beating performance. As the book discusses, it’s partly a cyclical phenomenon, but a great proportion of active managers have underperformed common benchmarks, and many of today’s investors seem willing to trade off the potential upside that active managers may provide in exchange for market performance and the certainty of lower fees.
Therefore, the second section of this book offers background on the debate over the merits of active management versus passive alternatives and points out that active investment managers have been challenged by an array of difficult market conditions. Among active managers, however, the industry also has become increasingly competitive: people are highly trained and talented, and armed with more relevant and timely data than I might have dreamed of in the 1980s, or even 10 years ago. (The competition is only growing, and becoming smarter: the CFA Institute, which confers professional certification on people in the investment business, counted about 135,000 members in 2015; during that year, an additional 80,000 new candidates sat for the qualifying exams.)
The second section also discusses Epoch’s view of the investment world, and what the firm sees as the most effective investment process for outperforming the general equity market. In brief, Epoch believes that the source of value in a company is its free cash flow, and that superior returns to stocks come from identifying those companies that generate substantial cash flow, and then allocate it wisely—reinvesting in the business when it is sufficiently profitable, and distributing the remainder to the owners. The philosophy can be expressed simply, but executing it effectively requires intensive fundamental research and insightful forecasting from analysts that know their companies well.
The human effort required for the analytical process is increasingly being supplemented by information technology, which is the focus of this book’s third section. For years, investors have applied scientific rigor to investing, whether from using mathematical frameworks for valuation, to borrowing models from the physical sciences for insights into the functioning of markets. As a result of their increasing power and decreasing cost, computers have taken over much of the burden of raw data analysis, and the widespread digitization of information of all kinds—economic reports, corporate financials, market prices, and the growing analysis of real-time consumer and business data, as well as the traffic on social media—has broadened and deepened the research process. At the same time portfolio management has become a global undertaking, and it demands from practitioners a grasp of many more markets, companies, and economic forces.
The changes in the investment business over 50 years have been monumental: the increased speed and complexity of the markets; how managers react to them; and managers’ understanding of the factors behind investment returns. The industry has more sophisticated tools for analysis and forecasting, but these have been matched by the volume and variety of information to be dealt with. The book concludes with our thoughts on how an optimal investment management process should be dominated neither by human judgment nor computer algorithms, but by an informed combination of the two—racing with the machine. Indeed, the last section previews an investment strategy that Epoch has developed over several years—one that likely would not have been possible without today’s rich resources for gathering and processing information.
Thank you for this opportunity to share my views.
William Priest
Notes
1.
With a nod to the movie
Monty Python and the Holy Grail
(Michael White Productions: 1975).
2.
Jason Zweig, “The 11-Year Itch: Still Stuck at Dow 10000,”
The Wall Street Journal
, June 12, 2010.
3.
S&P Dow Jones Indices. McGraw-Hill Financial. Accessed at:
www.djaverages.com/?go=industrial-index-data
.
4.
Wooten, James A., “The Most Glorious Story of Failure in the Business”: The Studebaker-Packard Corporation and the Origins of ERISA.
Buffalo Law Review,
Vol. 49, p. 683, 2001. Available at SSRN:
http://ssrn.com/abstract=290812
or
http://dx.doi.org/10.2139/ssrn.290812
.
5.
These observations have been measured and documented by consultants McKinsey & Company in their 2015 industry review, “Navigating the Shifting Terrain of North American Asset Management.” Accessed at:
http://www.mckinsey.com/client_service/financial_services/latest_thinking/wealth_and_asset_management
.
PART ICulture
Chapter 1Culture at the Core
Every organization—whether a business, a not-for-profit entity, or government—reflects and operates from a unique culture. It’s an inherent and essential element that brings order to the internal and external environments1 and reduces uncertainty2 among members of the group. The quality and strength of cultures explain many of the differences in organizational performance. But culture often operates below the surface of an organization, so that studying the abstraction of culture is elusive.
Organizational culture is especially important to the workings of a knowledge transfer business, such as investment management, because much of the work produced is intangible, and the environment changes so rapidly. Accordingly, culture is a critical component of any professional service firm, and we have made culture the introductory topic for this book.
Culture is a subject that has occupied management consultants and academics since the 1950s. One definition that we have found useful was put forward by Edgar Schein, an early scholar on culture and leadership, and today professor emeritus of MIT’s Sloan School of Management. He writes:
“The culture of a group can . . . be defined as a pattern of shared basic assumptions learned by a group as it solved its problems of external adaptation and internal integration, which has worked well enough to be considered valid and, therefore, be taught to new members as the correct way to perceive, think and feel.3 . . . Culture is to a group what a personality or character is to an individual.”4
Schein adds that culture often is those principles and beliefs a founder or leadership set has imposed on a group—and which have worked out well: “[The] dynamic processes of culture creation and management are the essence of leadership, and make you realize that leadership and culture are two sides of the same coin.”5
The owners or managers of an organization might consciously work at developing a culture, or a culture may evolve on its own as the result of years of decision making, but a culture is present in any setting where people are working toward common goals. In a new organization, culture can be very strong, as it is one of its few assets, and crucial to its early efforts.
Employees have a hand in corporate culture as well. “Not all of corporate culture is created from the top down,” wrote Andrew Lo, a professor of finance at Massachusetts Institute of Technology, in a paper on corporate culture in finance. “A culture is also composed of the behavior of the people within it, from the bottom up. Corporate culture is subject to compositional effects, based on the values and the behaviors of the people it hires, even as corporate authority attempts to inculcate its preferred values and behaviors into its employees.”6 Indeed, an organization benefits from a diversity of opinions to prevent “groupthink.”
“Most companies’ culture just happens; no one plans it. That can work, but it means leaving a critical component of your success to chance,” wrote Eric Schmidt and Jonathan Rosenberg, executive chairman and adviser to the CEO, respectively, at global technology giant Google Inc.7 They observe that the right time to plan a culture is early on, because after it takes shape—consciously or not—the founding principles are likely to reinforce themselves, as like-minded people will be attracted by them to join an organization, and those with other viewpoints may not.
The values and principles of a culture permeate every aspect of a business: operating strategy; products, services, and relationships with customers; firm structure and business model; “people processes”; and governance. Culture determines relationships among authority and peers, an organization’s common language, granting rewards and status, and the measures of success.8
Thus, culture is a shared view of how to carry out day-to-day tasks, as well as dealing with unusual conditions—how the firm’s long-term principles inform short-run actions. Culture also determines how a firm treats its customers and employees, and how the employees treat each other. Accordingly, organizations fortunate enough to arrive at the right culture gain a competitive advantage that carries the firm toward its long-term goals. In this section, we will consider the different approaches firms take to building and expressing culture and, in particular, its importance to success in the investment management industry.
The Original Organizational Culture: Command-and-Control
Cultures vary according to the sizes and activities of individual groups, and are intertwined with an organization’s structure. One combination of structure and culture, however, has prevailed during most of the evolution of corporate America, and probably for most of human history: “command-and-control.” (It’s often illustrated in management textbooks by a pyramid, but anyone reading this book has seen that image a thousand times, so we don’t repeat it here.)
The command-and-control structure assumes that one person, or a few people, at the top of an organization can determine the best direction, and that subordinates should carry out leaders’ decisions without inserting any ideas of their own—a principle called the great person theory.9 It’s the operative, and necessary, culture in any sort of military operation, or police and firefighting unit, where lots of people have to be trained to do the same thing, in exactly the same way quickly and without doubt or question, often in dangerous settings.
“In corporate cultures that lack the capacity to incorporate an outside opinion, the primary check on behavior is the authority,” wrote Andrew Lo: “From within a corporate culture, an authority may see his or her role as similar to the conductor of an orchestra, managing a group of highly trained professionals in pursuit of a lofty goal.” Others looking from the outside in might see a particular organization’s authority as blatantly forceful.10
Command-and-control became the favored form of culture in American business starting in the late nineteenth century, when standardized processes and behaviors were essential to the rapid growth of the manufacturing economy. The idea was advanced by Frederick W. Taylor, who was very successful as an engineer but also invented the profession of management consulting. For a growing manufacturing sector that had lots of workers, who possessed varying levels of skill and were accustomed to carrying out their work by hand in their own different ways, he developed a structure that imposed defined tasks—rewarding successful workers with high pay and terminating those who failed.11
Command-and-control cultures still prevail in most industries12 because, in many settings, a rigid hierarchy is useful and desirable. For instance, manufacturing organizations often need central control over the use of resources and quality control over processes, and to be able to respond swiftly to emerging problems. It also can work well in single-line businesses operating in stable markets, where little flexibility is called for. The short leash of command-and-control also is essential in situations where the organization’s goal is cutting costs.
It’s also suitable where creative thinking and initiative can create risks.13 For instance, a pharmaceutical maker has to follow strict controls over the manufacture of its products, and how they are sold: a drug firm’s Western region sales head could hardly decide to come up with his own custom version of the company’s big cholesterol drug. Organizations such as electric and gas utilities or hospitals must adhere to well-defined practices to ensure reliable service and the safety of their customers and employees. Similarly, bank credit officers have to follow standardized processes for lending, with decisions and approvals at several levels, to allow for systematic credit rating and proper allocation of the firm’s capital. Accordingly, command-and-control structures and cultures are often present in highly regulated industries.
Drawbacks of Command-and-Control
Although command-and-control allowed the industry of a young America to flourish, in the past couple of decades the structure has been discredited. Command-and-control is not an agile form, and in industries that are rapidly changing, a few senior managers don’t have enough time to micromanage an entire company. Moreover, the structure is not equipped to allow individuals further down in an organization to contribute their ideas upstream: a one-way information flow from the top of the pyramid to the bottom can result in significant missteps or missed opportunities. In many cases, people in the field may have better information about product and competitor dynamics, while those at the top may possess the least relevant information and therefore lack the insights needed for optimal decisions.14 The gap between the leadership team and the customer or client—that is, an organization’s layers of management—is often too wide in command-and-control cultures. Some firms have layers of reporting structure numbering into the teens. Many management consultants recommend a maximum of six to eight.
In human terms, employees in command-and-control structures have well-defined boundaries, duties, and career paths. Such a work environment may be desirable for many people, but current thinking in management science and practice recognizes that employees want to contribute ideas to their organizations, and argues in favor of fostering collaboration and creativity. For instance, IBM Corporation published a study in 2012 that surveyed corporate CEOs around the globe, who said they were aiming to change the nature of work “by adding a powerful dose of openness, transparency and employee empowerment to the command-and-control ethos that has characterized the modern corporation for more than a century.”15 As a practical matter, corporations, large and small, may have little choice: through the Internet and various social media, employees are probably sharing and collaborating whether management wants it or not.
An Alternative Culture for Knowledge Businesses
In contrast to the rigidity of the command-and-control model, professional service businesses such as legal and management consulting firms—as well as investment managers—often develop structures and cultures that better suit the nature of their work and the economics of their businesses.
Unlike manufacturers, which can carefully specify their standardized products, professional firms offer no tangible goods to sample or road test, and there are no set manufacturing processes: each lawsuit, audit, or financial market environment is unique, and a firm’s reputation and brand is built from past successes in contending with the varying circumstances. Accordingly, predicting product and service outcomes is much less certain for most investment managers, as well as other services businesses such as law firms, management consultants and medical practices. Prospective customers can look to firms’ prior work to understand their areas of expertise and skill, and even the reliability of their services in the past, but a firm’s success depends greatly on the context—for a law firm, the facts of a court case, or for a consultant, the state of a client’s affairs before a business is redesigned. Compared to a physical, manufactured product, the design of which can be reworked over many years, the environments in which professional service businesses work are often too complex, varied and rapidly changing to provide reasonably objective evaluations ahead of time.
The identity of professional service firms is closely tied to the people in possession of skills—individual lawyers, consultants or asset manager teams. (An investment industry bromide says that a firm’s most valuable assets leave by the elevator every night.) Accordingly, successful employees in these firms are highly compensated and often hold equity stakes, in order to tie their day-to-day efforts and resulting personal wealth to their firms’ long-term success.
Of course, professional partnerships have senior management teams: a completely flat organization, where everyone is enabled to decide and act on anything, would be chaotic. Senior management’s role, however, is more about leadership—guiding firm strategy, high-level business development and problem solving—as their detailed involvement in every client situation would be impractical and unnecessary. Professional partnerships operate by a set of rules, but don’t have a single absolute ruler, as do command-and-control organizations.
Senior management also typically sets compensation and controls the addition of new partners. Importantly, in less tangible matters, senior managers provide practical examples of the firm’s culture and what constitutes good behavior. Meanwhile, in handling client engagements, client teams apply their own experience and judgment to handling challenges as they arise rather than follow specific directives made at the top.
The differing characteristics of command-and-control versus professional partnerships will attract different sorts of people to each type of culture. Professional partnership careers tend to require more extensive training just to enter, and typically call for greater commitments of time to the job. Taking intelligent risks and raising individual initiative also are central to professional work. People with risk-seeking natures are more likely than not to be attracted to the more complex and challenging careers of professional partnerships, while risk-averse people may prefer a different environment.
The Partnership Culture Model
With less involvement of senior management in day-to-day decisions, the economic success of a professional firm is dependent on “multiple leadership,” that is, key decisions being made at many points in the firm. Figure 1.1 illustrates the relationships among the financial and working elements of a partnership: interdependence in carrying out their work, and support that individuals offer and rely on from one another. Both are built on a foundation of economic interests shared among the partners.16
Figure 1.1 Tenets of Professional Partnership
Source: Epoch Investment Partners
Interdependence
In serving the complexities of a given assignment, client-serving teams at professional partnerships often are likely to draw on the expertise in several areas of the firm. Attorneys, consultants, and investment analysts should be eager to share their knowledge, both within and among teams, in the interest of providing the best service to clients and moving the firm forward. Implicit in those goals, of course, is that the hard work and judgment has to be reciprocated among all members of the group when called for.
An illustration: in an investment management setting, it’s typical for analysts and portfolio managers in a firm’s equity group to share insights on the prospects for individual companies or industries with those running fixed-income portfolios. Each approaches the analysis a bit differently, providing complementary (and sometimes opposing) views.
Narrow views and overspecialization often get in the way of idea sharing, typically to organizations’ detriment. Gillian Tett, the U.S. managing editor of the Financial Times, has written on corporate culture and idea sharing from the perspective of an anthropologist, noting: “We need specialist, expert teams to function in a complex world. But we also need to have a joined-up flexible vision of life.”17 She cites companies hobbled by the “silos” within their structures, for example, Sony Corporation beginning in the 1980s, and the turnaround potential of removing them, such as at IBM Corporation in the mid-1990s.
Ms. Tett lauds Facebook, Inc. for its resistance to building silos, instead promoting an open organization where employees rotate through various teams, and come to know people in all parts of the company. It’s not the most efficient structure, she concedes, but citing a senior executive, “[It’s] a small price to pay to meet the goal of keeping the organization fluid and connected; it was crucial to have a bit of slack, or inefficiency, to breed creativity and give people time to stay connected.”18
Rotating people through the firm’s various departments isn’t feasible for us at Epoch (or for many asset managers). The knowledge needed to work on the investment teams, for instance, is quite specialized, and assigning people without in-depth training to our portfolio teams would fall short of our fiduciary obligations to clients.
In the case of Epoch Investment Partners, we manage several complementary strategies—all in equities, but investing in various markets and company sizes, and we encourage analysts and portfolio managers to share whatever they know about their companies with anyone else who might be able to use it. We don’t obligate people to rely on others’ decisions, but what counts is that the information—in the forms of both data and opinions—is freely available for everyone’s use. (Epoch maintains a research database that is open to all analysts and portfolio managers.) It is not uncommon in some firms to find people who feel protective of their hard work and want to keep it for their sole benefit, but in our case not sharing insights with another analyst or portfolio manager will lead to a collective loss—or at least a forgone opportunity to enhance the returns of another strategy. And since we reward employees on the firm’s overall results, the effect on returns from not sharing affects everyone’s rewards.
