When it comes to investment philosophies, many emphasize (increasingly scarce) informational advantages, but research into institutional investors shows culture is the true competitive advantage, as it is more difficult to replicate. The most important part of culture is dealing with behavioral issues and coping with mistakes. The reality of being a portfolio manager is, even if you are successful, you are probably making wrong decisions 40% of the time. How can you create investment processes that manage that chronic failure and maintain investment performance? How can you identify and minimize mistakes that stem from cognitive bias and ensure that you "fail better" than others?
There are five key elements to structuring a successful multiasset team:
1. Accountability. It is human nature to want to focus on one's successes and explain away one's failures. This natural human tendency is corrosive to investment performance and compounded even greater depending on the number of people involved in a decision, as groupthink may occur. Sometimes it is easier to go with the crowd, as the peer comparison risk is lower. The impact of one's decisions needs to be measured and an individual needs to be held accountable for decisions linked to financial incentives. This ensures earlier recognition of mistakes.
2. Skin in the game. Traditionally, multiasset investment committees consisted of various representatives of the asset classes comprising the portfolio. To help make asset allocation decisions, these representatives were asked to provide the case for their particular asset class. Therefore, espousing the relative merits of different asset classes were not necessarily their day job or what they were rewarded for. As a result, they had no 'skin in the game' for making such calls in the sense that they would not be measured and rewarded for these kinds of decisions. They are rewarded for generating good performance within their respective asset classes and as a result, attracting more assets. Thus, there might be an upward bias in terms of their forecasts of assessment of prospects for their asset class.
3. Size of the decision-making team. If a committee is too large, it becomes unwieldy, lacks coordination and accommodates passengers. In fact, the phenomenon known as the Ringelmann effect describes the tendency for individual members of a group to become increasingly less effective as the size of the group increases. Too small a team becomes undemocratic and overconcentrated. Some social scientists have suggested that five or six may be the optimal size of a team. There is a definite 'Goldilocks' effect when considering the appropriate size of an investment team.
4. Creating healthy rivalry. Increasing bench strength of an overall team is important, and competition for places is vital to keep team members on their toes and avoid complacency. It is important to give emerging talent a chance to show what they can do and participate and be measured in the same way as full members of the investment committee. Incumbent members should be aware that they can be replaced. A flat structure with little hierarchy encourages open debate and challenging of investment positions.
5. Diversity of thought. This concept is imperative to ensure investments and risk are analyzed from every angle. Although the concept of diversity of thought is now quite fashionable, some researchers suggest that too much diversity is undesirable as similar individuals are more likely to share values and thus work more effectively toward a common goal. Bringing individuals together with opposing perspectives should be looked at as a "controlled explosion," in which team members confront each other about ideas but aggressive or patronizing behaviors are not tolerated. Team leaders must ensure individuals feel heard throughout the process. In short, badly managed diversity can have very negative outcomes, while well-managed diversity allows us to continue to grow and develop.