What a difference a year makes. Our society was in a knife fight with a virus that, at the beginning of last year for most people, was a little-noticed headline in a distant country. Our economy has lost millions of jobs in the last year, many permanently, and families everywhere are wondering when they will recover their income and when their children will be able to return to school full-time, which for many is its own economic issue. Conversely, our markets are higher than they were a year ago (at all-time highs in fact), bolstered by an understandable loose monetary policy by the Federal Reserve; the perception (however tone-deaf) that inaction by a divided government is beneficial; and a growing disconnect between Main Street and Wall Street, in part due to a decades-long bipartisan marginalization of large swaths of our country.1
Usually in these pages, we work hard to help investors identify market risks based on economic and corporate risks, but increasingly, that causal relationship between fundamentals and market prices seems more theoretical than ever. This is surprising to us given the many events we just went through as a nation in 2020, any one of which would be enough to place the year that just passed in the history books as a case study in unexpected risks. But this disconnect has also helped to reveal what may be the biggest risks of all hidden in plain sight: apathy and complacency.
For just over 14 years, I have tried to instill some basic rules of life in my children. One of those principles is understanding the difference between what one is technically allowed to do and what one actually should do. This principle can be interpreted as part of a personal code of ethics, or it can be interpreted as risk management – reducing potentially negative consequences of behaving in a way that may be viewed by others as inappropriate even if not forbidden.
There is a framework from the field of psychology for these two interpretations: The former is intrinsic motivation; the latter is extrinsic motivation.2 Put simply, intrinsic motivation occurs when one’s own values and goals drive a particular behavior. Extrinsic motivation occurs when earning rewards or avoiding punishments drives the behavior. It is not uncommon for behaviors to start off with extrinsic motivators, but it takes more to turn those behaviors into habits. The trick is to train oneself so that the motivation becomes intrinsic. This isn’t easy, but it is necessary if one values consistency and longevity.
Yet everywhere we turn, we seem to be faced with behavior which models a different message: If you can get away with it, you should do it. This amoral acorn doesn’t fall far from the Machiavellian oak tree, which extolls that the ends justify the means. In today’s world, the ends are almost always some form of personal gain, whether money, power or some other modern-day metric of success.3 Moreover, we don’t just see this behavior modeled; it seems to be deliberate much of the time. And investors have not been immune.
While there are investors who send this “win at all costs” message to their managers intentionally, we believe the conventional wisdoms and traditional methods of asset allocation may be inadvertently and erroneously making this a rule of the markets. A focus on performance in and of itself, without an analysis of how and why it happened, sends this message. Overemphasizing relative results between materially different strategies sends this message. Short-term comparisons to broad-market indices and passive portfolios send this message. And the asset management community has heard this message loud and clear: A majority of allocators want managers to prioritize returns regardless of what risks they must take to get them. In turn, a majority of managers appear to have complied because that is the path to the most robust asset growth. In practice, this means tactical asset class exposures have eclipsed security selection as the primary risk drivers of many fund portfolios as this is the only way to reliably deliver on the demand for short-term relative outperformance over passive indices. As it turns out, the hardest thing for a manager to do in today’s investing environment is to stay disciplined.
As a result, just within our subset of the investing universe, fixed income managers who are hired for security selection have shifted into buying broad market ETFs, SPACs and equities in pursuit of performance. This has been going on for years; most managers have the flexibility to deviate from their mandate to some extent, and while some hide such deviations, others go to great lengths to argue that such deviations are within their mandates. And to be fair, for those managers to whom their investors have clearly sent the message to prioritize performance regardless of risk, returns (the ends) do indeed justify the style drift (the means). In our experience, however, most investors care very much about the risk they are taking on a forward-looking basis. And those investors should care that this undisciplined behavior was particularly prevalent in the depths of the 2020 market decline precisely because it was so easy to miss.
The problem lies in the tendency of investors to hold managers accountable only after the fact for the risk they take and only if the performance was disappointing. This has given many managers a free pass in 2020 that leaves unsuspecting investors at risk. After all, who can argue with the recovery many portfolios showed from the market lows in late March? Does anyone really want to know how that recovery was achieved? Is anyone really interested in comparing recoveries across managers and discovering who stayed true to their mandate and who did whatever they could get away with? Who really cares if a manager took a Machiavellian approach or a principled one?
The rest of this discussion is for that subset of investors who care about risk and reward. Not everyone will fit into that category, and that is ok. As we have said for many years, investing in managers is an exercise in finding the best fit for the goals of a portfolio. Some portfolios value consistency of risk profiles, while others prefer returns regardless of the risk required to achieve them. Many investors accept that they will only learn about risks in the portfolio after they have had a negative impact.
What we and other similarly disciplined managers have in common is intrinsic motivation in both our business and our portfolios. Investors recognize, over years not months, who holds transparency and consistency to be foundational values, not just client-relations tactics. That is what keeps us pointed at true north even when buffeted by a pandemic-induced storm.
We encourage every investor to ask their managers questions and to take the time not just to look at performance in 2020 but to understand how and why it happened and where it came from. We believe it is in every investor’s best interest to find out if a manager did what you thought they were doing. Not all managers took the Machiavellian path in 2020, but many managers strayed from the principled one. Investors would be wise to ferret out if there is some unexpected exposure that they may have inadvertently benefited from in hindsight but that they don’t want going forward (or never wanted in the first place).
Edmund Burke was onto something. It would be dramatic to refer to Machiavellian investors as evil. Machiavelli himself is viewed by many as a seminal and positive contributor to the history of political science. But a bad actor isn’t necessary for bad things to happen when good people do nothing. The challenge of our day isn’t good vs. evil. The challenge of our day is awareness and intentionality, whether that applies to what allocators ask of their managers, diversity or investment risks. Even with the best of intentions, it takes extra work to be aware, and it’s work we believe is worth doing.
By Venk Reddy
Originally published in Q4 2020 letter
1 This is not entirely without reason. The poorest 50% of our country holds a mere 5.6% of total assets as of Q3 2020 according to Federal Reserve data. It makes sense, then, that this group might get ignored, as their impact on the overall economy in aggregate is small. But this is also why Fed Chairman Jay Powell has repeated continuously since March that a sustained recovery requires a fiscal solution (i.e. requires legislation from Congress); monetary policy cannot help people who don’t have access to capital in the first place, and investors acting in their financial interest are not incentivized to favor more inclusive policies. Only those in our leadership charged with the well-being of all citizens and who (should) have no profit motive are in the position necessary to address this growing chasm.
2 If you are interested in the research, we suggest you start with the following paper and run head first down the rabbit hole that it opens: Cerasoli, C. P., Nicklin, J. M., & Ford, M. T. (2014, February 3). Intrinsic Motivation and Extrinsic Incentives Jointly Predict Performance: A 40-Year Meta-Analysis. Psychological Bulletin. Advance online publication. http://dx.doi.org/10.1037/a0035661
3 Enough said.
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Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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