What’s in your bug-out bag? As a denizen of the 21st century, you no doubt are aware that a well-stocked bug-out bag is key to any survival plan. But what about your investment bug-out bag? This issue of Excess Returns considers the implications of survivalist culture for investment management companies. Specifically, how can investment firms do a better job of communicating about risk?

With best wishes,

Liz Hecht
Founder, Principal and Director of Research

Print a PDF of this newsletter

In This Issue

Doomsday Prepping for Investors

Envisioning the Worst

The Big Short Revisited

Alpha Partners is an investment marketing firm specializing in research and presentation strategy. Our goal is to create alpha (excess returns) by helping investment firms win, keep and diversify assets under management.

Alpha Partners LLC
435.615.6862

www.alphainvestmentmarketing.com

Doomsday Prepping for Investors

“… the machines are going to fail, the political systems are going to fail, and a few men are going to take to the hills and start over.”

— Lewis in Deliverance, by James Dickey

The bad news is I’ve lost control of the clicker. The good news is, while being doomed (slight pun intended) to watching one of my husband’s favorite and my least favorite television shows, I have an idea for this issue of Excess Returns. National Geographic’s Doomsday Preppers profiles survivalist families getting ready for various forms of natural or man-made disasters ranging from global financial collapse to earthquakes to biological warfare (to name just a few).

Part of me gets this show. There is a certain appealing simplicity in the concept of survival: one is not overburdened with an abundance of choices; one’s focus is clear. But I prefer not to envision a future without raw food restaurants, HBO and perfectly chilled Chardonnay. I do not want to take to the hills and start over.

As I watch this week’s episode, however, it occurs to me that investment managers could learn from all these survivalist families stocking their bug-out bags and building their safe rooms. As evidenced by the number of wealthy investors with portfolios mainly in cash, bonds and gold, the investment industry can still do a much better job of communicating about the realities of risk.

Best Practices for Communicating About Risk

After 2008 many investment firms improved the way they define, monitor and manage risk, and many more companies today now emphasize their risk management systems and strategies. Where I have not seen significant improvements, however, is in the way investment firms communicate about risk. The following best practices, when applied systematically, can turn communications about risk into a competitive advantage.

Define terms first. Your Great Aunt Tabitha and the CIO of a sovereign wealth fund are likely to view risk very differently. Investment company professionals therefore should communicate about risk in the context of what risk means to a prospective client. Is it something that can be described with a Monte Carlo simulation or something that inspires visceral dread? (Describing risk in the context of client goals seems obvious, but if it’s so obvious why don’t investment firms do this more often?)

Demonstrate understanding of what could go wrong. Communicating about risk has little to do with tracking error or standard deviations or correlation coefficients. The real risk that investors understandably fear is that their investment manager’s worst-case scenario does not capture everything that might go wrong. “Understandably” because, as documented in Never Saw It Coming: Cultural Challenges to Envisioning the Worst, human beings do not excel at envisioning worst-case outcomes. Investors thus are likely to gravitate toward asset managers who acknowledge a complete spectrum of risk when describing individual investments and the portfolio as a whole.

Communicate consideration of risk at every stage of the investment process. The typical investment process map ends with the portfolio and then sometimes includes a separate page about risk management. The way one contains or capitalizes on risk should animate the entire process discussion — as opposed to being treated as an add-on or an afterthought.

Give the sell discipline its due. For many traditional investment strategies, a thoughtful sell discipline executed consistently is possibly the most important form of risk control. And yet one still finds detailed investment process descriptions — page after page of information on how the manager selects investments — without one drop of ink on when and why the manager sells. Similarly, a recent white paper on risk management by a large global financial services firm details 24 discrete forms of risk without any mention of faulty sell discipline implementation.

Think big picture. Portfolio managers routinely tell investors that they cannot predict the future. I always find these protestations to be somewhat wearisome, not the least because investment managers make them so often using exactly the same language (we don’t have a crystal ball, blah blah). Of course these managers can’t predict the future. But they can develop a well-informed global macroeconomic view, seeking to understand the full range of risks confronting their investors.

Equate risk with returns. Many investors still don’t understand (or need to be reminded) that returns are derived from risk. Investment opportunities also arise based on ingenious humans finding new ways to prevent worst-case scenarios. An asteroid wiping out all or part of our planet strikes me as being the ultimate risk (sorry preppers, your gas mask or water purifier won’t help you there). And yet a recent episode of NOVA, “Asteroid: Doomsday or Payday?” dramatizes how studying the risk of asteroids is already creating investment opportunities in space.

One of the main reasons I don’t like Doomsday Preppers is that the preppers usually are blinkered in their focus on what could go wrong. Each prepper family, it seems, has zeroed in on just one disaster to prep for (this one over here is prepping for a cyber-attack while that one over there is wholly focused on the negative consequences of global warming). These preppers would have more credibility if they acknowledged the complete range of potential negative outcomes. That’s what I want my investment manager to do.

Envisioning the Worst Never Saw It Coming: Cultural Challenges to Envisioning the Worst explores what author Karen A. Cerulo describes as “positive asymmetry” or the human tendency to imagine positive outcomes in greater detail than negative outcomes. Positive asymmetry, argues Cerulo, a professor of sociology at Rutgers University, can at least partly explain 9/11 and the 1986 Challenger disaster, while negative asymmetry helps to explain the avoidance of catastrophe in the case of the Y2K millennium bug and the SARS outbreak of 2003. For investment professionals who want to improve the way they think about and describe risk, this book is a must-read cover to cover.

In Never Saw It Coming, Karen A. Cerulo documents “positive asymmetry,” a phenomenon that may explain why so few investment firms communicate effectively about risk.

The Big Short Revisited

Speaking of negative asymmetry, I recently had the pleasure of rereading The Big Short: Inside the Doomsday Machine, by Michael Lewis. The Big Short tells the story of the people who understood the risks inherent in the subprime market long before those risks became front-page news. This is a classic well worth revisiting, and it may soon be a movie, too (Brad Pitt’s production company, Plan B Entertainment, has optioned the film rights).

Questions? Comments? Dissent? Click here.

Click here for other issues of Excess Returns.

You are receiving this newsletter as a member of the investment community. If you no longer wish to receive it, please respond to this email with “No More Penguins” in the subject line. To subscribe to this newsletter, send an email with your request to info@alphainvestmentmarketing.com. Your privacy is important to us. We will never rent, sell or share any information that you provide.

The two most powerful words in any presentation are “for example.” Yet investment managers use specific examples infrequently or without skill. This issue of Excess Returns considers why investment company professionals so often get this wrong and what can be done about it.

With best wishes,

Liz Hecht
Founder, Principal and Director of Research

Print a PDF of this newsletter

In This Issue

The Power of Examples

But Is It Legal?

The Missing Component

Alpha Partners is an investment marketing firm specializing in research and presentation strategy. Our goal is to create alpha (excess returns) by helping investment firms win, keep and diversify assets under management.

Alpha Partners LLC
435.615.6862

www.alphainvestmentmarketing.com

The Power of Examples

When I began working on Wall Street in 1981, I spent a lot of time during interviews with portfolio managers and securities analysts thinking, “I wonder what they really mean?” The lexicon of the financial world was new to me and I thought that was the problem. Yet here it is 32 years later, after I have built a career in this business, and I still frequently wonder what investment professionals really mean.

Over the course of my career, I have listened to thousands of presentations by different investment companies and, with stellar exceptions, these presentations often are completely devoid of supporting examples and explanatory detail. During new business presentations, simulating a finals for a multimillion dollar mandate, I sometimes feel like the dog in the famous Far Side cartoon: all I hear is “Blah blah blah Liz blah blah blah Liz blah blah.”

Beyond Blah Blah Blah

The blah blah factor stems from the fact that most investment managers are selling exactly the same thing (enhanced returns with reduced risk) using exactly the same language (fundamental research blah blah secular trends blah blah tail risk blah). So they all sound alike. To cut through all this sameness, I have learned over the years to ask a simple question: Can you please give me an example?

When I ask this question, one of two things happens: (1) investment firm professionals answer the question enthusiastically and I start to understand what they mean or (2) they skirt or botch the question, and I realize that they don’t really know what they’re talking about or don’t really do what they say. Put another way, this question causes professionals in our world either to rise to the occasion or fall apart.

In the July 2011 issue of this newsletter, I wrote about what we at Alpha Partners call “elephant questions,” or questions that are so big and important that they should be answered before they are asked. In my view, requests for examples are elephant questions. Investment marketers should provide specific examples before they have to be asked. Yet there are many reasons why this still does not happen:

Living in a bubble world. Few investment professionals operate outside of their own rarefied environment. They actually think that most people understand terms such as “secular trends” and “tail risk.” Compounding the problem, those out there in the real world who do not know what these terms mean are unlikely to admit it. Like the dog in the Far Side cartoon, they listen attentively without understanding.

Portfolio manager inaccessibility. The portfolio manager or portfolio specialist does not routinely make fresh, relevant examples available to marketing and client service professionals. At many firms (still, in 2013!), much lip service is given to the importance of transparency but a true culture of transparency has yet to take hold.

Fear of being pinned down. Portfolio managers live in a changing world where what makes sense one day might very well seem foolish the next. Some managers react to the vicissitudes of the investment markets by refusing to be pinned down on the specifics regarding anything at all. They are much more comfortable being vague and so a nebulous quality begins to infect all aspects of their communications. (I find it incredible, for example, that some portfolio managers still say that they plan to meet their performance objectives over a full market cycle. Whatever, the average layperson must wonder, might that mean?)

Fear of oversimplification. Sometimes investment professionals are concerned that specific examples will oversimplify their investment process. This is true in particular of firms with quantitative investment strategies. This concern may be well-founded. An even more legitimate concern, however, is that a simplified example may be the only way to make a quantitative strategy understandable and prospective clients are unlikely to buy something that they do not understand.

A low bar for salespeople. Often, when I suggest to clients that specific examples would help build understanding of the investment strategy, they say, in effect, “Liz, we are concerned that our salespeople might give the wrong examples or might give examples that create misperceptions about our investment process.” This is a legitimate concern at some companies where the salespeople, for any number of reasons, really don’t fully understand what they are selling. Such reasons range from portfolio manager inaccessibility (noted earlier in this article), firm cultures that have not yet embraced transparency and the mistaken belief that salespeople are intellectual lightweights unable to discuss the investment strategy in any depth.

The risk of faulty execution. There are indeed many pitfalls in presenting examples effectively. The wrong examples (a holding notoriously unfriendly to unions presented to a Taft-Hartley plan) can be worse than no examples at all. An example or examples presented with excessive detail can kill a presentation. Examples that contradict the investment process also are a common problem. (Such examples may prompt the question “That’s a nice story you just told me. But what does it have to do with the investment process you described earlier?”)

When Long-Term Capital Management (LTCM) began marketing to investors, writes Roger Lowenstein in his fascinating book When Genius Failed, “Long-Term even refused to give examples of trades, so potential investors had little idea of what the partners were proposing.” By not providing effective examples, investment firms rob prospective clients of that critical moment of understanding where they can say, “Aha! I see! Now I know what you mean!” After the fall of LTCM and Bernard Madoff, investors may be more likely to demand specific examples before writing a check.

But Is It Legal?

Whenever Alpha Partners recommends the use of examples, the first objection we typically hear is, “But our compliance department has told us that using specific examples is illegal.” Compliance experts Marvin Barge of Barge Consulting and Otto Medrano of Forensico Partners explain, however, that it is legal to use specific examples in investment marketing literature as long as certain conditions are met.

According to a No-Action Letter (Franklin Management, Inc., December 10, 1998), written examples can be used in investment marketing literature only to describe how the investment process is implemented — not the results of process implementation with respect to a specific security. A more recent No-Action Letter (The TCW Group, November 7, 2008), Mr. Barge explains, specifies that investment managers can present examples showing results, “but only if they show an equal number of holdings that contributed most positively and most negatively to the performance of a representative account.” Based on recent No-Action Letters, says Mr. Medrano, “compliance professionals have better guidance and thus can probably find a way to include examples in their presentations that are consistent with the law.”

At Alpha Partners, we recommend that our clients use examples in written marketing materials only to show how the investment process works; we believe that portfolio performance over time — as opposed to any one example or even a balanced suite of examples — is the best indicator of results. When presenting specific examples, however, investment management professionals should be aware of the results so as to be able to answer any questions that arise.

It is important to note, too, that the No-Action Letters referenced above pertain to Rule 206(4)-1(a)(2) of the Investment Advisers Act of 1940. These No-Action Letters apply within the United States and to companies outside of the US seeking to attract US investors. Firms not domiciled in the US, not registered under the Advisers Act of 1940 and not seeking US investors should follow the rules of their governing body.

The Missing Component

An important assignment recently sent me to the private equity section at Amazon where I found The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything. As I write this I am halfway through the book and enjoying it immensely. As the infographic on Amazon points out, this book dramatizes how pervasive private equity has become, playing an investment role in many of the products that populate our daily lives. It is this precise component that I find to be missing from many investment marketing efforts: an understanding of the underlying investments in the form of real companies, products and personalities. Investors, it seems to me, want to know that they are investing in something more tangible than a list of top 10 holdings or a pie chart showing sector allocations. They want to know what the companies in the portfolio make or do and how they fill a void or realize a dream.		Jason Kelly’s 2012 book dramatizes the role of private equity in the products that populate our daily lives.

Questions? Comments? Dissent? Click here.

Click here for other issues of Excess Returns.

You are receiving this newsletter as a member of the investment community. If you no longer wish to receive it, please respond to this email with “No More Penguins” in the subject line. To subscribe to this newsletter, send an email with your request to info@alphainvestmentmarketing.com. Your privacy is important to us. We will never rent, sell or share any information that you provide.