Jason Hazell, Head of Investment Communications, NAB Asset Management
Sir Isaac Newton famously noted his challenges with complex systems when he lost his life savings in the South Sea Bubble of 1720, commenting that: “I can calculate the motion of heavenly bodies, but not the madness of people”.
The faster and more interconnected the world becomes, the more complex economies and financial markets become. The new generation of interconnected companies, such as Google, Uber and Airbnb, are fundamentally different business models, which are not only disrupting the industries they started in but significantly changing a much broader range of industries within the market. So what does this mean for the evolution of traditional approaches to investment management?
Frederick Taylor is often credited with being the father of reductionist management techniques. His 1911 book, The Principles of Scientific Management, provided a summary of his techniques to improve industrial efficiency in the late 1800s. He applied engineering principles to basic manufacturing processes of the time, reducing them down to their constituent tasks. In doing so, he was able to significantly decrease manufacturing times and increase output rates. Reductionist management techniques have dominated companies ever since.
The study of financial markets is clearly not a manufacturing process that can easily be broken down into parts. Each factor, balance sheet item, company or economic measure has numerous correlations with other factors and the economy. This interdependence between factors is what characterises complex systems. A manufacturing process is not complex, as it can be broken down into its constituent parts and understood; there are no relationships between the parts. It might be complicated, but it is not a complex system, like financial markets or human behaviour.
This line of thought has, of course, driven a debate within investment management for decades as to whether investing is more an art or a science.
Passive, quantitative, smart beta managers are on one hand, firmly in the science camp and often employing a reductionist management approach to analysing companies and building portfolios. Fundamental managers, on the other hand, meet with company management often to assess strategy and execution. While there is clearly a heavy analytical component to identifying value mispricing, most fundamental fund managers ascribe a lot of their value-add towards the art of stock selection and portfolio construction.
Peeyush Gupta, Co-Founder of IPAC Securities, Non-Executive Director of National Australia Bank and Chairman of MLC Limited, agrees with the fundamental managers: “we must remember that the study of economics is not a science, it is an arts/humanities discipline, and as such is impacted by social, geopolitical and behavioural considerations”.
Peeyush also provides a timely reminder that, while it is tempting to believe that what we are experiencing right now is somehow different, “there is always uncertainty, always change. I’m not sure it is different”. He goes on to caution that, “however, there are elevated tail risks at the moment, including reaching the limits of monetary policy effectiveness and the elevated levels of leverage globally, that we need to be aware of in our investment processes”.
Errol Woodbury, Founder and CEO of Woodbury Financial Services, a boutique financial advisory firm in Sydney took a different perspective on complexity, focusing on non-linear or exponential growth patterns in many of the leading companies and industries of today, noting that “it is the exponential growth profile of these new business models, such as Uber and Airbnb, that is possibly changing the market. This is potentially what is driving the increasing complexity that we are seeing”.
Errol has recently spent time at Stanford and Singularity University in Silicon Valley, where these ideas are currently being examined, and he references Salim Ismail from Singularity University and his 2014 book “Exponential Organizations: Why new organizations are ten times better, faster, and cheaper than yours (and what to do about it)”. This book examines the new style of company that has been developing over the past five to ten years, that is increasingly connected and showing growth rates significantly higher than existing businesses.
The speed of disruption is coming from this new breed of companies. The old style of business model was to secure an asset or workforce and put a legal boundary around it; then to sell access to that scarcity. The new style of company that we are seeing has a different business model. They keep a small footprint, and tap into an abundance of information from outside the company using technology. Airbnb is predicted to be the biggest hotelier in the world, but it doesn’t own any hotels. Uber is the world’s largest taxi company, but doesn’t own any taxis or employ any drivers.
“Will the successful investment processes that we see at the moment be nimble enough to continue to drive returns for investors in a market that is non-linear, like we are seeing at the moment?” asks Woodbury. This is an important question for both the investment management industry as well as the advice industry.
Drawing on his time in the industry, Errol notes that the evolution today away from the traditional balanced fund, with a fixed debt/equity mix and towards outcome-oriented funds is a welcome development for his clients. This evolution means that financial advisory firms such as his, have greater confidence in being able to deliver on the investment strategy and risk profile parts of his advice discovery loop. Peeyush agrees that this is a welcome development for the market and notes that the current reality is that the majority of new Superannnuation Guarantee Contribution (SGC) flows go into MySuper default options, which are typically balanced funds and not outcome-oriented funds.
This presents a challenge for the industry at a time when the rate of change of financial markets is accelerating rapidly due to technology and access to information. In a world that has been dominated by reductionist management for over 100 years, these new generation companies, that are highly interconnected and growing exponentially, are well placed to challenge traditional business models. Fund managers should remain nimble to ensure they continue to evolve quickly enough to maintain a competitive advantage and generate the investment returns that investors demand.
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The Principles of Scientific Management. Frederick W Taylor, 1911.
Exponential Organizations : Why new organizations are ten times better, faster, and cheaper than yours (and what to do about it). Salim Ismail, 2014. www.exponentialorgs.com
Team of teams: New rules of engagement for a complex world. Stanley McChrystal, 2015. www.mcchrystalgroup.com/teamofteams
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