Originally published: September 27, 2011, Phocion Investments Inc.
Looking back, it is hard to remember a world without the presence of the 24 hour business media. The likes of CNBC, Bloomberg TV and Fox Business News are constantly inundating us with information that is presented as informative, necessary and most importantly, actionable. Further analysis into what is being said would reveal that most of the daily chatter is nothing more than noise masquerading itself as informative news. Noise is not informative, necessary, nor actionable. In this environment of more is better, investment firms have been caught up with placing an importance in daily performance. Perhaps daily performance would provide significant feedback to a strategy, but that strategy would have to have a time horizon that is measured in days and not years. This article will look into some of the effects of daily performance, the reasons behind its “need”, and solutions to refocus firms on their original objectives.
What Does Noise Look Like?
The week of August the 8th was one of the most volatile weeks in recent memory. From a mathematical point of view, noise can be expressed through volatility and in the table below is a comparison of the S&P 500 Total Return daily volatility for the week of August the 8th to the Year to Date volatility prior to August the 8th.
The difference is significant and a manager focusing on extracting any relevant information from that kind of volatility will get lost in the noise and off-track from their long term strategy. How do these numbers translate into words? Taking a week’s long reports from Reuter’s articles published we can view noise in another way. Here is an excerpt of quotes from these articles in chronological order:
It is tempting to get caught up in all this noise and become distracted from one’s original objective. Perhaps it is human nature that leads us to believe that the more information we digest the more informed we are. Family offices, pension funds, foundations and any other long term focused investment firm would not further their performance by moving to a daily performance focus. The higher volatility in the numbers will eat away at their returns by increasing trading and inadvertently implementing a short term focus on their strategies. Ultimately, firms will end up unable to see the forest from the trees.
Why Would This Happen?
With so many uber-educated investment firm personnel, why would a firm easily fall into the trap of daily performance? Some possible reasons may be :
A firm becomes seduced by “more-is-better.” It is difficult to comprehend that sometimes simplicity is the best solution. More often than not, the lure that a large swath of data and analysis will provide a clearer understanding of the market becomes overwhelming. We seem to correlate complexity with increased intelligence. With respect to daily performance, the more focus you place on it, the less informed you are.
We all have a desire to be proven right by the positions we take in our lives. It is no different with portfolio managers. Whether it is a bottom –up or top-down approach, portfolio managers are attached to their positions in their portfolios for the sole reason that they want to be proven right in their decisions. This desire to be proven right leads managers to focus on the daily movements of their portfolios and place a greater importance on the volatility of the daily returns.
Remuneration in the investment field is considerable next to most other industries and as such, many investment professionals will overweight the importance of their bonuses and lose sight of the raison d’être of the fund. A manager will focus on his/her daily performance to keep track of the level of his/her bonus while losing sight of the purpose of the fund to begin with.
The lack of a qualified dedicated performance specialist whose independence can mitigate many of the reasons behind firms adopting a short term focus on daily performance. The performance specialist has no attachment to the holdings in the portfolio nor is his/her remuneration overwhelming tied to their performance. His/her quality of work depends on providing an informative analysis of what the firm originally set out to do, what it actually did, and how effective were the managers implementing those strategies.
Ensuring Your Firm Remains Focused
Educate, educate, educate. Investment firms need to understand the pitfalls of a daily performance focus and the importance of the firm’s managers to spend more time on evaluating investment opportunities and the surrounding economic environment. There is very little predictive value in the daily fluctuations of the firm’s returns and a manager who takes a longer term approach to his/her performance will position him/herself to take better thought out decisions.
Employing a qualified performance specialist will bring that emotional detachment from performance that a firm needs to properly evaluate the effectiveness of their managers’ theses and present more meaningful data that will assist the firm in making better decisions. Taking away performance duties from managers will provide the time and focus they require to manage their strategies.
At the end of the day, the buck stops at the top and the firm’s leadership needs to employ the investment professionals who can produce but who also put the objectives of the firm ahead of their own. In any team sport, if a player is looking out for their stats, the team will suffer and fail to reach the level of performance it could have otherwise. The same goes for an investment firm. If the leadership of the firm cannot create an environment where all the employees are working towards the objective of the firm, whether it is to meet the pension obligations or the spending requirements of a foundation, then the firm will be in a constant state of sub-optimal performance.
A daily performance focus distracts investors from the original objective and can inadvertently deviate a firm from any well thought out strategies they may have established. It also helps feed the fear/greed behavioral biases of the investment industry. Although it is important to re-evaluate a strategy when there is any significant market movement, daily re-evaluation will end up rendering the firm to one with no strategy at all. The optimal performing firm is one that has brought on board talented and dedicated individuals, one that has established a truly independent evaluation process with the help of a performance specialist, and one with the discipline to maintain a long term focus on performance. Noise is always present but to truly attain the highest levels, like all great athletes, we must tune out the noise and maintain a strong focus on the task at hand.