Predicting Thunderstorms

An excerpt from essay appeared under the title “Gaining Inflows From Your Rivals’ Missteps” in Ignites on June 28, 2012. 

Think like a farmer. Opportunities to grow assets under management are often a matter of planting seeds and waiting for a thunderstorm. When the storm arrives, successful managers (that is, farmers) capture the rain, tend their carefully planted gardens and avoid the risks of lightning strikes. When your competition loses focus, becomes complacent and gets hit by the odd bolt, be prepared to take advantage.

With few exceptions, new business being won by asset managers is taken away from other managers, not new allocations from cash. If not driven by asset allocation decisions (from one asset class to another), shifts in money most often come when the incumbent manager stumbles.

Managers must focus on gaining from their competitors’ missteps. To anticipate weaknesses and eventual downfalls, I advise asset managers to take the perspective of sophisticated investors (research/due diligence analysts) when analyzing competitors’ and their own businesses. Look for potential holes. Think about what can go wrong. Anticipate the lightning. For those asset managers who take the advice, benefits are twofold: (1) they protect their own business and (2) they take advantage of those who don’t.

Summer Storms

It has been hot on the East Coast of the U.S. Under clear blue skies, temperatures have reached 38c/100f. All the heat and high levels of humidity make the mid-Atlantic region particularly prone to summer thunderstorms. These storms often come on with great intensity and little warning.

Meteorologists, like most professional prognosticators in their respective fields, have difficulty in predicting the intensity of these violent storms.

The other night, the hour by hour weather report on my iPhone certainly gave no hint about the intense storm that was brewing. Next to each hour on the weather app was an image of  bright sunshine. From inside my air-conditioned house all seemed well outside. But to see what was truly going on, I just had to open the door and observe; there were clear signs of the turmoil on the horizon.

Many of these signals for a pending storm follow a standard structure. It goes like this. An hour or so before the first thunderclap sounds and rain drops fall, telltale signs begin. Birds are some of the earliest indicators. Their flying patterns shift. Their songs become more pronounced and seemingly urgent. I don’t speak ‘Birdish‘ but I am sure I can hear them saying, “feels like a storm’s coming guys, better take shelter”.

Soon, from a dead stillness, an unexpectedly cool breeze begins to blow. After a few minutes, the wind patterns shifts – first from the west, then from the east- seemingly directionless. The undersides of leaves on the trees are exposed as the wind gusts. Then, entire branches of even the largest trees sway under the strength of the wind. Dark clouds form on the periphery, beginning slowly, then more quickly, gathering overhead. The temperature drops; suddenly becomes cool. Then, ka-boom, crack!  The thunder roars, then streaks of lightning and sheets of rain.

How one reacts to such a storm has a lot to do with perspective and preparation. The farmer (think, diligent asset manager), who has been toiling outside for days in the heat is overjoyed – this is the time that the hard work of planting seed pays off.  The golfer (think, ‘late stage’ successful asset manager) on the other hand, deep into the back nine, is cursing. He has been playing so well and then ka-boom!- lightening strikes.

You don’t want to be standing on a green, putter in hand, umbrella overhead with lightning flashing.

In few other industries do the winners and losers change positions so rapidly. There are many examples of investment products going from $1 to $20 billion in assets only to turn around at the top and come crashing back down over very short time periods. That woeful slide from $20 to $1 leaves a $19 billion opportunity for somebody (assuming that the market has not taken the bulk of it).

In our story, one hopes that the competition has been hanging out on the golf course and not minding the shop. He gets hit by lightning (only figuratively of course), leaving an open opportunity. In turn, you have been a good farmer out cultivating relationships, developing an exceptional investment capability and client servicing model. When the thunderstorm comes, the seeds you have planted in a well-tended garden get plenty of rainwater.

The trick is to know which seeds to plant and how to predict the storm and its impact on your competitor. Of course, protecting yourself from the odd lightning strike is paramount.

Intermediaries – consolidating and reorganizing

As the pool of investable money has compressed, intermediaries, from global banks, to investment consultants, wealth advisers and U.S. broker-dealers are in a period of consolidation and reorganization.

An important outcome of these constraints and consolidation is that the number of products included on recommended lists and in discretionary mandates is being whittled down. A consistent question being posed by large intermediaries is: “Do we really need 15 different U.S. large-cap growth funds on the list?” The short answer is no.

All the while, risk reduction is the central focus. For manager research groups, a familiar type of risk is found in concentrated exposure to a limited group of asset management products. Outsized flows into narrow groups of strongly performing products keep research directors up at night. These products often become trouble spots and sources of opportunity for the well prepared.

From my own experience researching managers, I have consistently witnessed that quickly achieved successes of asset managers often leads to downfalls. Many of the signs are foreseeable way before the peer rankings slip.

I am consistently surprised by the number of asset management firms that do not spend time doing competitive analysis and understanding the landscape of relationships between asset managers and distributors. Particularly in this environment, when considering the take away nature of assets under management growth, it is imperative.

Preparing for lightning

Below are a few indications of potential competitor slippages that may prove useful. Think of them as the change in the birds’ song, the changing winds, the thunder over the horizon. Some play out over months, while others may take a couple of years. Focusing on performance results is not enough; by the time the problems show up in the numbers, the opportunity has slipped by for the ill-prepared. There are many qualitative factors that have important influence over success and failure (as experienced manager analysts know).

Examine big-picture trends. Look to the products with the largest inflows and best performance over the past couple of years. Think not only about the absolute rates of increase in the assets under management but how they have grown relative to where they were a couple of years ago. See all those new flows chasing past performance and not understanding what the future might bring? That’s how these stories always start.

Is the firm focusing on short-term growth over the integrity of the investment process or culture? Has the marketing and sales teams’ expenditure and effort grown faster than the investment staff? Or, on the other hand, has the company hired so many new analysts and managers in recent years without having the ability to train and inculcate them in the culture that maintaining the integrity of the culture and processes is all but impossible? Also, does there seem to be an imbalance of market skepticism between investment and sales professionals? Are the sales guys far more eager to raise money than the investment guys?

Is a fund’s investment thesis compromised? Has the projected capacity constraint in the strategy been moved up… and up… and up as “liquidity has grown”? Has the market capitalization of the portfolio and number of holdings increased to a point that the original thesis has “evolved”? Is the manager making lots of guest appearances on talking-head financial television programs? Lots of conference appearances? The last two could be a sign of a manager more focused on hype and publicity than on process.

Look for disconnects. Does the firm know who these investors are that keep sending them so much money? Do these investors know who the manager is, or are they just chasing the latest trendy strategy?

Enjoy the summer. May your garden thrive and your golf game improve. Be on the lookout for lightning!