Change on the Horizon: Diversity within Asset Management

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Paul Greenwood, CEO and CIO of Pacific Current Group, joins to discuss an article he published in Pension & Investments called “Commentary: Improving manager diversity demands that shortcuts stop.” On this episode, he breaks down the decades-old rules of thumb that need to change in order to diversify manager selection and increase overall performance. To read the transcript of this episode, head over to our website at www.gomercatus.com/podcasts/ and be sure to sign up for our Mercatus Digest newsletter to stay up to date on the latest insights and updates in the private markets. Click that follow button and leave us a review on iTunes, we’d love to hear from you.

Transcript:

Kali Jakobi:
Hi everyone, and welcome back to this episode of data disruption. I’m joined today by Paul Greenwood, the CEO and CIO of Pacific Current Group, to discuss an article he recently wrote about the structural changes needed in order to create greater diversity within asset management. Paul, I’m so excited to talk about your article with you, thanks for joining me.

Paul Greenwood:
Thank you. I appreciate it.

Kali Jakobi:
You wrote this article back in December, what prompted you at that time to write this?

Paul Greenwood:
Well, obviously issues of diversity inclusion are much in the news these days. And as I looked at the investment management industry, there’s a lot of noise within the investment management industry about improving diversity and inclusion, but I’m not a big fan of how some folks want to pursue that. And having been in this industry actually 30 years now, I’ve realized that there’s some structural flaws in how this industry works, that has the result of working against women and minority on firms. And so this article was prompted by, frankly, decades of frustration of how this industry approaches that and the adverse impact that has on women and minority-owned investment management firms.

Kali Jakobi:
Well, you definitely gained some traction. For those listening, if you haven’t checked out the article yet, head over to Paul’s LinkedIn and be sure to read the comment section because there’s a great discussion happening there which I loved reading and just seeing everyone really rally behind that there are changes that need to be made and it is decades behind. So for those who haven’t given it a read just yet, Paul, [inaudible 00:01:55] a quick rundown of the article of what are the issues that you saw and what are the changes that you’re proposing?

Paul Greenwood:
Sure. Well, the investment management industry is an interesting one because I can’t think of many industries that have as much intellectual horsepower devoted to them as investment management. There’s rooms of PhDs and all these smart people scouring the world for great investment opportunities. And then they take that and they create investment products, and those investment products are consumed by individuals or institutions. But one of the funny things is, despite all the sophistication that goes into the creation of these products, the way investment products are ultimately selected is unbelievably crude and unsophisticated.
And so by that, and this article talks about this, is typically you will have allocators of capital such as a pension fund decide which investment manager they want to hire based on things like the last three to five of performance. And that plays a dominant role in their decision-making, and yet in reality, that performance is not indicative at all, statistically, of future performance.
So they’re relying on a metric that works actually against them. But it’s simple and there’s some behavioral reasons why people get trapped into sort of focused on past performance. But the net result of that is, people will tend to invest with larger firms that have been around a long period of time and that have produced good historical performance yet all of the academic research and sort of the anecdotal evidence suggests that they would be much better off if they invested in smaller asset managers that manage less money.
And so because women and minority-owned firms tend to be newer and smaller, the net result of sort of this institutional practice is that it disadvantages these newer and smaller firms, which has a disproportionate impact on women and minority on firms. So that’s sort of the motivation, that’s one of the problems in this industry, is the current practice as to how investment managers are selected. And so then we get into how best to address that.
Kali Jakobi:
I like how you presented all of the academic research, is point to the fact that it’s a better outcome to go with these smaller firms. Why is that though? Why is it more of an advantage to go with a smaller firm?

Paul Greenwood:
Yeah. There’s a host of reasons. And in some investment strategies, actually in many investment strategy, size is your enemy. Imagine I’m a professional stock picker and I manage a billion dollars. Well, a billion dollars within sort of professional stock picking is not a lot actually. And so if I held 50 stocks in the portfolio that means my average position size is $20 million. 20 million is relatively small, and I can get in and out of that stock very efficiently.
If I had a hundred billion and I held 50 stocks, that means my average investment is $2 billion. And reality is, when you start buying two billion or selling $2 billion worth of stock, you can’t execute that as efficiently as you can smaller amounts. So that’s a sort of a liquidity argument.
Then the other argument, and it’s actually probably ultimately more powerful, but it’s a little more nuanced, is smaller firms tend to have better alignment of interests because the entrepreneurs tend to own more. They also tend to be less bureaucratic because they’re smaller. And the decision making tends to be crisper for reasons that anyone who’s ever worked in both a small and a large institution can appreciate.
So all of those factors contribute, I think, to the performance advantage that many investment firms have. I once wrote a paper called The Perils of Success that described the corrosive impact that size actually has on future performance. So it’s interesting and sort of ironically, the better you are, the more assets you grow, the more assets you sort of garner. And the more assets you have, the more difficult it becomes to perform well. And that is just a structural feature of the investment management industry. And it’s why trees don’t grow to the sky in this industry. Unlike Amazon or some industry where scale is always your friend, in investment management, that’s not the case.

Kali Jakobi:
So when we’re looking at these things to put in place to help the minority and women-owned firms, is it even possible to put something industry-wide in place to flip the script?

Paul Greenwood:
Yeah. That’s a good question. I wish there was, but I think in reality, what needs to change is there needs to be changes in incentive structures and, frankly, there needs to be more education. Of course, there are structural impediments to this. One of the structural impediments you have in the investment management industry is many of these allocators, so pensions, endowments, foundations, use consulting firms to advise them on which investment managers just select.
And many of those consulting firms like to play it safe by giving them reliable names that everyone’s heard of, BlackRock, or Vanguard or… Household names, because they feel like they’re not going to get fired if they’re recommending those. And so, because so many, but certainly not all, consulting firms have this bias to playing it safe, I think do their clients a disservice by depriving them of some of the best talent which can be found in some of these up and coming firms, but they don’t have an incentive to provide that to their clients.
So I think the changes that need to happen is you need to have people at the allocator level have their compensation more directly linked to performance so that they stop thinking about just playing it safe and protecting their own career, but rather they know they have to deliver. I think that would help a lot.
And then I think having the industry be better educated as to the risks of investing with small firms. My view is that a lot of the risks are overstated with investing in a smaller firm, and as a result, they’re biased away from allocating to these smaller firms, when if they, I think, properly understood the risks, they’d be much more comfortable.
I’ll give you an example. You will often hear people say, “Well, I’ll allocate to these people, but I don’t want to be too much of their total asset base.” Well, that might make someone feel better, but it doesn’t provide any economic protection to them. Imagine you are this investment manager that manages a billion dollars, and I give you half a billion more, so I’m a big client. And you’re investing in public stocks. And you go out of business. You’ll lose all your other clients. And now you’re not even going to be able to manage my money anymore.
Well, what happens to my investments? The answer is absolutely nothing. Your business risk doesn’t impact my performance at all. And I think people intrinsically feel that there’s some sort of risk that translates over and impacts them economically. And it’s really not the case. It just feels riskier. And so because of how it feels, they’re biased against that when, in reality, those managers, statistically, produce better performance. If I’m an early investor with an investment manager, I can usually negotiate better fees for myself. And so there’s all these economic advantages that accrue to the folks that understand the real risk of investing over these earlier-stage firms.

Kali Jakobi:
Well, it kind of sounds to me that playing it safe is actually the most dangerous game to play. I like when you were talking about education on the risks. So what are the measures that you take personally to provide the education for yourself? Or how should people go about that education process?

Paul Greenwood:
I wish I knew the answer. As I said earlier, my frustrations about how the industry approaches this are long-standing. And hopefully, that article is a very small contribution toward facilitating a discussion around some of the things that need to happen. And basically, my view is the industry is guilty of using all these proxies for risk as opposed to actually evaluating risks.
For example, when they invest with a new firm, they say, “Well, how much money do they have under management?” What they’re really getting at is, the investment manager stable from a business perspective. Well, instead of addressing that question directly, they do it by saying, “Well, I only invest with companies with X dollars under management.” Well, to me, that’s laziness. It’s a shortcut. And why don’t you just go and actually find out what the firm’s financial condition is and evaluate the risk directly instead of using these proxies.
I saw one example once where someone was concerned about the business risk of the company even though the founder had invested more than a hundred million dollars of his own money into the investment products. And so I’m not sure what you’re really worried about. Do you think this firm’s going to go out of business when he has a hundred million dollars in his own investment strategy? And people don’t think about that sort of thing.
So ultimately, we need people to understand that consultants and allocators need to do real… If they really want to enhance diversity and inclusion, they need to do real work, which means evaluate, not be afraid of shorter track records, for example. Because, guess what? Statistically, they don’t tell you anything anyways. People love long track records even though statistically they’re of no value. And so, my view is if it’s of no value, statistically, then go ask the questions about track records, or that you think a track record would provide. Go ask those directly. And a lot of those questions are actually answerable if you ask the right questions.

Kali Jakobi:
You mentioned this in the article about people not just doing this to check a box, and you’ve just said how it’s going to take real work to go and do this and uncover the real track records here. What advice would you give to someone who’s maybe struggling with the mindset from moving from checking a box to actually healthily growing their portfolios, their management teams, their business? What advice would you give?

Paul Greenwood:
That’s a good question. Well, it depends. Are you referring to allocators or investment managers?

Kali Jakobi:
Investment managers?

Paul Greenwood:
Well, from the investment manager’s perspective, this issue is incredibly common and frustrating one. So even a lot of the comments that I received in the article were for people that said, “Yeah, I’ve been bumping into this issue for years.” All I can say is, I wish there were some easier answers here for investment managers. I think they almost have to try to do the job of the consultant and the allocator for them.
And so that means when an allocator is talking about the length of track record or the business viability, or they’re asking questions that are related to that, I think the investment managers should be sort of on their front foot and be prepared to answer, here’s why we don’t really have any significant business risk. Here’s why the fact that we only have a two-year track record instead of a 10-year record shouldn’t be a major impediment.
And frankly, a lot of investment managers don’t do a good job with that. They tend to be very reactionary and as a result they don’t put their best foot forward and, and help people actually understand the true risks of their business.

Kali Jakobi:
It’s kind of sounds like we need to meet in the middle on both sides of, there’s significant change to be made for decades of things that have been put in place to hinder this, but on the flip side, the hurdle you know that’s in front of you, let’s work together to communicate why the people should pick you.

Paul Greenwood:
I think you’re right. And we’re starting to see some… The nice thing is we’re starting to… At least the subject matter is getting more attention. Which is great, because then you can start to engage people on what are the real issues around this. And so I’m cautiously optimistic that we’ll make some progress.

Kali Jakobi:
That’s amazing. Now, on the data side of things, a lot of times when we’re talking about ESG, it immediately is thinking about environmental, but when we focus on the G aspect, the governance of things, if any data is really tracked on who is running these firms, the demographics of that, how much does that play in effect?
Paul Greenwood:

That’s a great question. There’s limited… Some of the data providers provide some data, but it’s all self-reported. And we went in and looked at some of the data sources and found that it was a small portion, probably 20%, roughly, a small minority that had populated this data in a way that was useful. So I think that that’s an issue. I know there’s some small firms that are trying to improve some of the data on women and minority-owned firms, but that’s a major issue. And I suspect given the increased attention this general topic is receiving, that will lead to maybe some better data on this. But right now there’s, I’d call the data pretty limited.

Kali Jakobi:
It seems like this is the beginning of a much larger force happening in this industry, which I personally am very excited to be a part of. So Paul, to wrap us up, where do you hope this conversation continues to go?

Paul Greenwood:
Sure. Well, my passion is to see that great investment managers get discovered and our whole business is focused on trying to find these great firms wherever they exist. And so I would hope that, as we progress here, people will begin to look at better understand the true risks of hiring younger, smaller firms. And if they understand those risks, they will end up improving the diversity inclusion, the portfolios, and improving performance because of the advantages that some of these firms have.
This is not a situation where enhancing diversity comes at some economic costs. It’s exactly the opposite. And so why wouldn’t we want to pursue something that benefits all constituents? And like I said, hopefully we’re beginning to make progress there. It’s been slow here to four, but I suspect things will improve from this point.

Kali Jakobi:
That’s awesome. Well, Paul, thank you so much for joining me today. I’ve really enjoyed our conversation. And if anyone hasn’t seen the article just yet, it is on pension&investments.com, and it is called Commentary: Improving manager diversity demands that shortcuts stop. Paul, if anyone is looking to get in touch with you directly, where can they find you?

Paul Greenwood:
They can email me at pgreenwood@paccurrent.com. That’s a P-A-C-C-U-R-R-E-N-T. And that’s probably the best way to reach out.

Kali Jakobi:
Awesome. Thanks again, Paul.

Paul Greenwood:
All right. Thank you.
Speaker 3:

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More Podcasts from Mercatus

Change on the Horizon: Diversity within Asset Management

Paul Greenwood, CEO and CIO of Pacific Current Group, joins to discuss an article he published in Pension & Investments called “Commentary: Improving manager diversity demands that shortcuts stop.” On this episode, he breaks down the decades-old rules of thumb that need to change in order to diversify manager selection and increase overall performance.

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