Winning at Active Management. Welhoelter Michael A.

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

      PART I

      Culture

      Chapter 1

      Culture 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 environments6 and reduces uncertainty7 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.8.. Culture is to a group what a personality or character is to an individual.”9

      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.”10

      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

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.

6

Edgar H. Schein, Organizational Culture and Leadership, 4th ed. (San Francisco: Jossey-Bass, 2010), 16.

7

Roger Urwin, “The Impact of Culture on Institutional Investors,” Towers Watson/Thinking Ahead Institute, 2015.

8

Schein, Organizational Culture and Leadership, 18.

9

Ibid., 14.

10

Ibid., 3.