Where They Come From and How To Cultivate Them
It has often been said in recent months that one benefit from the global financial crisis is that funds managers and investment banks will not be vacuuming up the best brains in the world in future; they will be left to pursue more worthwhile endeavours such as medical research, physics or engineering.
Is that too harsh? What have those best brains achieved during the 20-year financial services bubble?
STEPHEN SHORE and GREG BRIGHT look at how ideas are generated and whether the investment management industry is well equipped for innovation.
Should funds management firms spend time and resources on innovation? Times of crisis are often fertile environments for innovation.
During World War II, Robert Oppenheimer was in charge of bringing together a diverse group of some of the world’s most brilliant scientists to develop the first nuclear weapon.
He coordinated a group of independent and quirky people, not known for their social skills, to come with fresh ideas expediently and under enormous pressure.
Whether it was the existence of a clear, definite goal, or the threat of imminent death, they managed to not only strike upon great ideas, but to practically execute them in a way that achieved a real result and won the war. Such examples have inspired much debate in psychological circles as to whether the creative process can be institutionalised. If you throw a bunch of bright people together in a room, will they eventually stumble across a genius idea?
Or must you patiently wait for the next Einstein to come along? Since 2003, Nathan Myhrvold, founder of Microsoft’s research division, has been trying to achieve Einstein-like insights by holding “invention sessions” with some of the US’s most prominent physicists, engineers and neurosurgeons. Myhrvold’s group, Intellectual Ventures, is currently filing around 500 patents per year, with a backlog of some 3000 ideas.
Could a similar principle be applied to funds management? At BT Funds Management, back in the 1980s when the firm was a clear market leader, the firm certainly thought so. Under the stewardship of Mike Crivelli and Olev Rahn, BT hired bright young people, some of whom, for half a day once a week, were required to go away and think. Afterwards they would report back on any ideas that they had.
John Evans, associate professor of actuarial studies at University of NSW (UNSW) and a Guardian of NZ Super, says that at the time, BT was one of the best innovators in Australia. “I think it was out of that environment that the innovation that came out of BT actually grew,” he says. “And when things started to fall in a heap, I think it is what kept them alive and differentiated them.” Jack Gray, director of Brookvine and former co-head of asset allocation at GMO, recalls similar experiments were tried at GMO. “We had research Monday,” he says.
“We tried to institutionalise research and thinking, but I don’t think it really worked. Washington Mutual also used to have a day a month or every two weeks where their senior executives had to turn off their phones and PCs and think, but you can’t do it that way,” Gray says. “Half a day is not enough.
If you’re thinking about a problem, and it’s a difficult problem, you’ve got to be at that 24 hours a day, seven days a week to crack it. You really do. And you need to have a shitload of talent too. Einstein did that, all the great thinkers do. They’re obsessive, that is why they tend not to be very social or work with other human beings very well. They truly are obsessive individuals, and often they are a bit autistic too.”
Jules Henri Poincare, the French mathematician, physicist, philosopher and generally agreed genius, often described his insights as arriving abruptly. He referred to it as an “aha” moment; after days of wrestling with a problem, his thoughts would be occupied elsewhere, when suddenly the solution would come to him, as he boarded a bus, without any of his prior thoughts seeming to have paved the way for it.
But few commercial organisations can spare the resources for the obsessive type of contemplation that Gray believes is necessary for a breakthrough. So should they bother to try to tap genius between, say, lunch and 6pm on a Thursday afternoon? “It’s an important symbol, I think,” Gray says. “To send that symbol to the organisation, that we value innovation, is critical but in the end it is only a signal.” Asset consultant JANA is one organisation that believes sending the message that innovation is encouraged is critical, but chief executive Ian Patrick force creativity.
“We don’t do it formerly, in the sense of setting half a day aside, and personally I think that kind of construct, while useful to motivate the allocation of time, doesn’t necessarily feed innovation in isolation. But having that culture is absolutely critical,” he says. Patrick believes innovation is more likely to occur spontaneously because of the organisation’s flat management structure where openly challenging ideas is encouraged. He estimates that the consultants would spend 5 to 15 per cent of their time on free thinking, but because the client is always the number one priority, much of their time is occupied with client-specific problems.
Some consultants have argued that a move away from hourly charges and retainer-based remuneration, and towards asset-based fees, would enable more free thought and innovation. There is sufficient academic research to support both the “aha” moments and planned think-tank sessions theories of ideas generation. And you don’t have to be in the office to be thinking about work.
In fact, there is also considerable evidence to suggest that early mornings are the best time to think – lying in bed or in the shower. Taking a break from thinking is also helpful. Try this test: name every word you can think of which starts with the letter ‘q’. Chances are you will peter out at a dozen or so words.
Go away, not consciously thinking about the task, and then return to start again. You will probably have another burst of several ‘q’ words come to mind. Andrew Boal, chief executive at Watson Wyatt, says that the firm regularly takes consultants away from the office for brainstorming and think-tank sessions, but it is also a matter of reading widely, and talking to a broad range of experts.
“You never know when, or from where that spark of inspiration is going to come,” he says. “It is often from unlikely sources, so you need to keep your mind open.” It is important when these thinktanks are conducted that people such as Myhrvold make sure there are sufficient support staff and the proper environment to take advantage of the good ideas. In his new guise he applies for patents. For a funds manager, harnessing the ideas and monetising them may be more difficult.
But perhaps this is not enough. A survey conducted recently by Morgan Stanley found that one-third of the chief investment officers of large US public funds complained that their consultants did not generate enough original ideas. Comments such as: “Consultants could be smarter; they need to know more than we know,” and “they could think… a lot of consultants really don’t do much original work.
They basically just respond to what people have asked them to do,” were common in the Morgan Stanley survey. Patrick admits that with the amount of paperwork and research that passes across the average consultant’s desk, there is not a whole lot of time left for pure thinking. “We would all want more time to spend on pure, non client-related, non research-focused innovation,” he says.
“I think innovation is critical, but that doesn’t mean you have to be an innovator to succeed. People who stick to one fundamental discipline and do it well will succeed equally, if they are smart in their narrow area.” A common response to the criticism that asset consultants do not provide enough new ideas is that investors do not pay them enough to allocate resources to original thinking. It is no secret that asset consultants are paid poorly in comparison with funds managers, and are swamped by the duty of compiling monthly reports that in the end are unlikely to be widely read.
Evans believes the industry is just not set up to innovate. “It’s called business risk,” he says. “If a consultant suggests something innovative and gets it wrong, the client is going to remember it. If they put up something innovative and get it right, the client will say; ‘Oh, right, that’s your job’. The downside risk is too high. “I think the whole industry is set up for mediocrity. I have seen a couple of fund managers blow themselves skyhigh by taking some logical well-researched positions which turned out to be wrong.
The safest path is to just do the same as everybody else and tweak along the edges,” Evans continues. Patrick says there is a reticence in many places to go beyond the status quo. “If you have an existing product set that is delivering a healthy margin, why run the risk that you either: expend resources and cannibalise that margin with unsuccessful innovative pursuits, or run the risk of putting your clients offside with product proliferation without any perceived benefits?”
Gray asks: “How do you go to your board and say we are spending $2 million a year on the possibility of some bright idea? It has got to be in the culture. But this is a real challenge even in universities and research institutes. Because doing research is so uncertain and can be so unsatisfying. In investment management it is even more so. “Imagine you are an investment manager doing research on improving a certain process, and this process has worked pretty well for the last 20 years.
The hurdle of getting your ideas into the portfolio is going to be enormously high, and it should be high. Otherwise you are flipping around and changing all the time. And that can be incredibly frustrating to people. You never get any recognition for it. I think the number of people who have the ability and the temperament to do research is pretty small.” The other difficulty is that innovation, in theory, is much harder to turn into practice in finance, Evans says.
“It is not the same as building a steam train, where you build one in miniature and say: ‘That works, now I’ll build a bigger one’.” “What works as a small innovation could blow itself up if it gets too big. We have now had this fairly big disaster with this alpha/beta separation. Theoretically, it was a very clever idea; it made a lot of sense. But it is now quite clear from a practical implementation point of view, it isn’t going to work. There was an assumption that alpha existed, and it doesn’t in most situations. In private equity we’re not even sure what is alpha and what is beta. There is a real danger that a great idea will fall apart in the implementation.”
Where can you innovate?
“Up until mid-2007, it was generally agreed that the geniuses, the bright young things, were all in hedge funds because that’s where there was an opportunity to exercise real creative thinking,” Gray says.
“It was only the dull plodders that got left behind in long-only management. And there was some evidence that brighter people were being taken into the hedge fund industry. The interesting thing with long-only funds management is that it may be that the most effective, the most consistent, are the ones that largely are dull plodders. They do what they do very, very well, and they do it over and over again.”
There is a lot of evidence in academic literature that suggests the best thing you can do when you want a surgeon to remove you’re gall bladder is to find someone who only does gall bladder removals and has perfected that to such an extent that he can do it with his eyes closed. “That is probably true in our business too,” Gray says.
“But the surgeon also needs to be able to handle the odd occasion when things go wrong. I mean, really, that is what you are paying them for. So, a pure dull plodder with no imagination isn’t going to work. You also want somebody who can think beyond what is going on in the day-to-day. I think the point of that is you need both.
Really smart people tend to be poor at the mid-office, regular, persistent [things], watching everything over and over again. They tend to be pretty poor at that, their temperaments aren’t good. If you only have those people I don’t think you will be able to do good investment management. You have to have, therefore, a blend of them.” That leads back to the cultural issue: how do you blend those two groups of people, and how do you recognise that both are important?
Need new ideas
It may be hyperbole, but many investment managers now feel they are working under a similar kind of pressure to that of Oppenheimer and his group.
For many firms it literally is a matter of life or death. The general consensus in the industry is that opportunities abound, but which mangers are positioning themselves, or indeed are able to position themselves, to take advantage? As we head into recession, organisations in nearly every industry are cutting staff. And people in “expendable” departments such as research and development tend to be among the first to go. But in a time of crisis, are ideas the place to take shortcuts? In the 1980s recession, the American steel industry as a group cancelled its research and development. “They just brutally got rid of any thinker, any scientist, any engineer, and just focussed on the here and now,” Gray says. Japan and, interestingly, the Soviet Union, took a different view, and focussed on the problem of the continuous casting of steel. Gray, a mathematician, was working on the problem with BHP at the time.
He says: “Up until then you could only cast steel, as BHP did, in small batches. You then had to merge them together through welding and other things. That meant it was not only costly, but there were weaknesses in the steel. There were all sorts of technical barriers to doing it; you could continuously cast aluminium, but steel you couldn’t do. But both the Soviets and the Japanese at that time found a way of doing it. BHP had to pay leasing agreements to the Japanese for the continuous casting process, and the American steel industry has never recovered. That is a pretty typical story.
“How many funds are doing that right now? They are saying; ‘We’re in survival mode’. Some are, and maybe they don’t have that luxury. But I think that is what they should be doing and the really smart ones will be doing.” There are examples of executives who have been brave enough to continue to try innovation even in the direst of times.
While running the troubled Chrysler automotive company in the 1980s, Lee Iacocca was faced with a major cash crisis, apart from structural and all sorts of other problems. He was urged to get rid of the research-related departments and buy in only those functions which were essential, from contractors.
Rather, Iacocca decided to sell the most profitable division, the military vehicles division, to give himself more time to make long-term changes. He is quoted as saying “research is our future”. Sadly, mavericks like Iacocca often fall foul of small-minded boards and invariably have to overcome the resistance of people who Paul Keating still likes to describe as “dead ordinary”.
Evans says a big inhibitor to innovation in the asset management area is that you have zero chance of getting a new idea funded until you can prove it exists over three to five years, and that is particularly a problem. “Most of the asset consultants are just too terrified to recommend something new, and the trustees are not set up to engage in it,” he says.
Hopefully, that may be beginning to change. Funds such as HostPlus now run a “manager incubators” program, in which a new manager without a track record is given a small mandate to manage on a trial basis for 12 months before they are taken into the portfolio. Whether that is long enough is a management decision. HostPlus chief investment officer, Sam Sicilia, says that 12 months is not how long the manager has to outperform; rather it is the time needed to see if the performance is in line with the stated objectives of the manager’s strategy.
In other words, whether it is doing what they said it would do. How long do you wait for an underperforming manager to outperform? There can’t be quick answers, and performance is not uniform. People go through patches. Einstein went through long periods of time when he did nothing. But then his productivity afterwards showed that the period of doing nothing was actually a period of intense thinking. There just wasn’t any output yet.
Gray relates the story of a physicist in the US who had three rich gentlemen as patrons, funding his research. He believed he could develop an anti-gravity machine. The patrons were willing to fund him for a while, but after three years they began to wonder whether or not this fellow was a total nut. They asked Gray to have a chat with him and find out. “He was certainly a very smart physicist, but smart physicists can be total nuts too,” Gray says.
“The patrons, however, had a very intelligent view. The probability they knew, and I reinforced this, of him coming up with anything was close to zero, but not zero. The pay off if he did it, on the other hand, was spectacular. So if the money didn’t mean much to them, they should just continue doing it. What the hell? There is not really a point at which you can draw the line.”
You need naysayers
Even if a company can achieve a flat structure which is open to criticism, as Patrick says exists at JANA, it can still be difficult to question one’s superiors.
“This is an industry where things don’t get challenged. Again, it is a cultural issue,” says Gray. “There are firms that do – GMO did – but even there, it is very hard, and it is true in all organisations, to challenge somebody like, say, a Jeremy Grantham (GMO’s founder).
Not only is he very smart, he is also an incredibly impressive debater, and if you’re taking him on, you’re taking him on at that level, and it’s very hard to do it. I would hope [you wouldn’t], and I didn’t see any evidence at GMO that you would in any way get punished for challenging him, it is just damn hard to do it, that’s all. And that doesn’t mean he is always right. But it is also the case that in many organisations people don’t want to be challenged and are threatened by that.”
Evans says: “I liked the BT model, where everyone was involved. I don’t like the idea of a research area. You need to have roundtable discussions. If you’re an academic you get used to it; you’ll have people tell you ‘this is a pile of shit’, you’ll get to defend it, and then you’ll go off and have a beer together.
When I went on the New Zealand Super Fund board I had a problem for a while because I’d say ‘That’s crap!’ and then a while later I might say, ‘Oh, that’s OK, I understand what you’re saying now’ and I got criticised by one of the other board advisers for jumping in too quickly, but I think you’ve got to have a structure where everyone has input, from the admin people to the IT people. “One of the worst things you can do is hire people who follow in your footsteps.
You need people to give you a bloody hard time, and maybe get up your nose a bit,” Evans says. “Obviously you need a bit of constraint so that it doesn’t become dysfunctional, but hiring an analyst that will just follow in your footsteps… you’re going to follow them until you go over the edge, aren’t you?”
Perhaps the investment management industry is just not particularly creative, and there may not be room for a huge amount of creativity. “Having worked for 20 years in pure mathematics, theoretical physics, and philosophy, the questions and the issues there are truly deep compared to investment management,” Gray says. “Investment management, as they always say, is not rocket science; it just doesn’t lend itself to that.
The massive uncertainties in it just deny that. Most of it is just getting most of the things you do right and doing it very, very well, and implementing it effectively. “If you look back over the past 50 years, there was Modern Portfolio Theory, with Markowitz, that was a huge breakthrough. And things like the capital asset pricing model that came with it. And then there was Black- Scholes, and since then, really, bupkis.
In the academic world Black-Scholes has led to a whole industry of more and more fancy options, but what we do in investment management, say in asset allocation and normal long-only investing, there haven’t been the great breakthroughs. You’re looking at an industry where there aren’t breakthroughs, there are marginal, incremental improvements, and I think that is the way the business goes. “But, then again, that is the way most industries, including physics, work; marginal incremental improvements. The Einsteins of the world, after all, are the exceptions.”