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What About Beta? | Culture Eats Sharpe Ratios for Breakfast

By John Bowman, CFA, Senior Managing Director, CAIA Association

This article was originally posted on FundFire on March 24, 2021.

Alternative fund manager due diligence has an execution problem. The evidence is mounting that investors, managers, and consultants agree the typical fund vetting process overlooks increasingly important qualitative factors that can determine future performance success and sustainable results. But the due diligence practices across today’s alts investing landscape remain heavily tied to the quantitative measures of the past—and it’s time for industry players to change that balance.

The investment management industry is systemically beholden to self-feeding machinations that foster a game of hot potato with capital allocation. The entire value chain fans the flame of buying general partners (GPs) high and selling low through its captivity to the short-term overlords of quarterly peer rankings, market-weighted index relative performance, and Sharpe ratios. Channeling the wise Jedi sage Obi-Wan, these are “not the metrics you’re looking for.”

To test whether the industry is indeed underweighting the power of qualitative factors in its manager selection methodology, the Chartered Alternative Investment Analyst (CAIA) Association recently conducted an exclusive survey of both allocators and investment managers. The results were overwhelmingly convincing: qualitative factors are considered equal to or more important than quantitative factors by 97% of the respondents and disproportionately relevant in private capital such as private equity, venture capital, private debt, and real assets. Perhaps most strikingly, 75% of respondents claim that qualitative factors have moderate to high predictive power for future investment performance versus 51% for quantitative factors and just 43% for operational factors.

It’s not that quantitative or operational factors are unimportant. On the contrary, persistence of relative risk-adjusted performance is often table stakes to even get initial consideration from investors, and operational weaknesses in compliance, valuation process, or fees can often disqualify managers. Fiduciary responsibility has its primacy in delivering a return stream to meet future liabilities, and particularly in this muted capital market assumption environment, limited partners (LPs) must hire talented managers. But what defines talented managers must widen to incorporate the qualitative element as well, particularly elements such as culture.

Peter Drucker, the Austrian leadership maestro, is perhaps most famous for his provocative claim that “culture eats management for breakfast.” Culture is often defined as the norms and behaviors that define a work environment. Drucker recognized that culture is the fuel of sustainable business results and the two are co- dependent for healthy stakeholder outcomes. Emphasizing culture is not another case of competing “bottom lines,” alpha versus pleasant people, but rather a leading indicator. That’s where the CAIA survey’s overall message was clear: culture eats the Sharpe ratio for breakfast when it comes to identifying attractive long-term partners for capital management.

So why don’t we rely on these factors more deeply? Why is the industry apparatus still anchored to relics of the past? I believe it’s tied up in our DNA. We are wired to manage to what we can measure, to follow the herds towards the latest darling outperformer for fear of missing out, and to choose the path of least resistance in justifying a new manager to the investment committee.

To heal this collective muscle memory, we entreat the industry towards three qualities—integrity, alignment of interests, and transparent communication—that should balance and complement the traditional quantitative and operational processes. These three priorities were the highest-ranked ingredients to developing strong culture in the CAIA survey and their emphasis should be elevated in manager selection methodology.

First and foremost is integrity. Regardless of historical performance, does the manager have a value set and moral compass that matches your own? Because when the inevitable adversity and difficult stretches arrive, those challenges will reveal the true character of your partners.

Second is alignment of interests. What circumstances allow for the manager to participate in reward or penalty? The standard carried interest arrangement of GPs is a nearly free option with asymmetric payoff benefits. The industry should move to an expectation of higher capital commitments by GPs alongside investors and sharing of both upside and downside around a hurdle rate. Further, how inclusive is the carried interest participation at the firm? Is the manager breeding a celebrity system or one where all team members partake in the same outcomes as the client?

Finally, there is transparent communication. LPs must ascertain the answer to a simple question: is the manager delivering a product that does what it says on the tin? Our survey participants underscored that overreliance on a standard due diligence questionnaire (DDQ) for this critical fiduciary role is short-sighted. Is the investment process consistent with their behavior in all market environments? Is there evidence of discipline to stay the course in the face of counter-cyclical or unfavorable conditions? Questions posed across and down the firm that expose times where the strategy or “edge” broke down, and how the firm responded, can be highly effective.

We suggest allocators create a repeatable and comparable process such as a dashboard or discussion guide to evaluate these three qualities and their various sub-components within GP organizations. The “scoring” outcomes of this systematic process should ultimately weigh as heavily on hire decisions as traditional, quantitatively heavy questionnaires.

Investing is often called a combination of art and science. Ultimately, we must start with the premise that this is a profession, grounded in a sacred responsibility to serve the needs of a client that is entrusting stewardship of their assets to another. We as an industry must take delegation of fiduciary duty much more seriously and approach it more comprehensively. When hiring managers, they become a party to an intimate social contract with our clients, one that demands an unwavering faithfulness to their financial goals and fiscal care. This ethical duty should rightly expand due diligence beyond sheer numbers to the driving motivations and purposes of our partners.