Au revoir [Are You Gonna Miss Me]

Now, let's discuss that: Is customer loyalty a myth?

You're right. We feel strongly about loyalty.

Now comes the hard part. Is customer loyalty myth in the business world?

Let me start with a question: Will your job exist five years from now?

For many of my client-facing peers in the investment management industry, the answer is becoming increasingly uncertain. Asset managers are making significant changes and investments to enhance their client coverage and service models, driven in part by the promises of digital transformation. While finding better ways to deliver client-centric experiences is crucial, it requires balancing functional efficiency with the all-important elements of human connection and trust.

In this age of digital transformation, achieving the desired outcomes for both investors and asset managers means the “human” aspects of client experience cannot be overlooked.

There’s a great saying by Ralph Waldo Emerson: “We boil at different degrees.” I love this idea because cultivating a culture of client-centricity requires agility and creativity, both rooted in human values and relationships.

In an ideal world (investment management industry), strong salespeople acquire new clients, talented portfolio managers (along with their proactive client relationship colleagues) retain those clients, and satisfied clients become the best advocates through word-of-mouth growth.

In the real world of institutional investment management, the decision to hire an external manager depends on three factors: (i) the asset manager’s past performance, (ii) personal connections between the institution’s personnel and the client-facing team of the asset manager, and (iii) recommendations from investment consultants and peers.

Indeed, many studies show a positive correlation between past investment performance and investor cash flows. Selecting managers based on past returns or alpha seems reasonable. However, improving outcomes requires a deep understanding of the market and its impact on each investment portfolio, among other factors. For example, decision-makers must evaluate the expected continuity of systematic exposure to “momentum factors,” the future soundness of the “investment thesis,” and the ongoing persistence of individual and/or collective “manager talent.”

Is “Investor Loyalty” a Myth?

So, how would you define a “long-term investor”?

• Less than 3 years
• Between 3 to 5 years
• More than 5 years
• More than 10 years

Definitions of what “long-term” actually means often differ between end-investors and their external managers. It’s no wonder there’s much debate about the meaning and relevance of a “market cycle.” From an institutional asset manager’s perspective, it’s tempting to think of asset owners as "hiring slow and firing fast" when it comes to external managers. We’ve all heard the argument that institutional investors are “impatient.”

Yet, a recent academic paper, "Forbearance in Institutional Investment Management" (Goyal et al., 2023), provides evidence that asset owners may be more patient than conventional wisdom suggests. The study surveyed over 200 institutional investors from 22 countries, representing over $4.1 trillion in AUM. Amit Goyal, Ramon Tol, and Sunil Wahal drew the following conclusions:

• Approximately 70% of respondents evaluate their managers at least quarterly.
• More than 68% report holding periods for active investment managers longer than 5 years.
• In equities, over 66% of respondents are willing to tolerate underperformance for more than 3 years. This tolerance declines to 56% for fixed income and 50% for hedge funds.
• Variations in holding periods suggest that performance orientation varies across cultures and geographies.

Many asset managers work hard to “do the right thing” for their clients, believing it’s a key step in earning long-term “investor loyalty.” But Goyal et al. are not suggesting that asset managers have “long tenure” due to delivering excellent client experiences. Instead, they write:

"If one believes in the wisdom of crowds, the fact that institutions appear to have longer-than-expected holding periods suggests decision-makers are cognisant of the costs associated with impatience."

I certainly hope Goyal et al. are wrong. Beyond investment performance, I believe that high-quality client service and transparency can be significant differentiators for asset managers. I’ve observed asset owners holding onto underperforming managers longer when both parties have invested considerable time together. Simply put, “the devil you know” notion. This highlights the importance of continuous exchanges of insights between asset managers and clients, as well as the value of quality client service once a mandate has been won.

The reality is that manager selection is (i) largely an asset allocation activity followed by (ii) a quest to find complementary, differentiating styles and approaches—essentially optimizing blends. For good insights on external manager selection, I recommend reading the report from the Norwegian Sovereign Wealth Fund (NBIM) on their experience over the last 20 years. Their decisions are based on: (i) how many active mandates should be awarded within a specific market, (ii) which “talented managers” are likely to perform in the foreseeable market environment, and (iii) when to adjust their aggregate exposure by changing allocations to different mandates. In my experience, institutional decisions about the future expected “turnaround of underperformance” are often influenced by past experiences and perceptions—whether related to a specific asset class, investment style, or organisation.

What Is the Optimal Holding Period?

While Goyal et al. (2023) reveal that termination decisions are primarily based on underperformance, they don’t provide additional insights into the efficacy of the decision-making process by institutions. However, the study indicates that externally managed equity mandates with a high tolerance for tracking error are positively correlated with a longer tolerance for underperformance by asset owners.

But what is the optimal holding period for your investment manager (or mutual fund)? I believe this question is something of a straw man. An aggregate number of years based on a survey of institutional investors would likely be meaningless. Simple numbers and rules don’t work consistently across changing economic and market conditions.

Instead of seeking “loyalty” over a specific number of years, the focus should be on “usefulness” within the context of overall asset allocation. It’s a win-win situation if asset managers and their clients commit to developing a trusting relationship based on insightful human conversations and interactions, facilitated by better data and technology. In an inefficient market driven by noise and investor psychology, a genuine understanding of expected risks and returns across different time horizons and economic scenarios is essential.

How to Win Hearts, Minds, and Money?

Eagle-eyed readers may have noticed that I’ve avoided discussing the importance of “personal connections between personnel at the institution and the asset manager.” It’s clear, as a management consultant might say, that “the opportunities to transform client experience are numerous.”

My advice, shaped by over 30 years in the industry, boils down to three key points:

1. Consistently strong investment performance across many market cycles is critical for client retention. However, achieving this is extremely challenging and rare. Therefore, it’s always worth (i) admitting mistakes early, (ii) ensuring transparency regarding portfolio, organisational, and operational changes, and (iii) remaining humble.
2. In an environment full of anxiety, uncertainty, and market noise, the expected outcomes of investment strategies are rarely as clear-cut as advertised. Your ability to collaborate internally and apply well-informed insights for the benefit of your clients is crucial for delivering excellent client experiences.
3. An uncertain future is not necessarily a negative one. Client experience is about staying useful. Long-standing relationships require the ability to quantify and communicate value to both existing and potential clients. Investment managers need to adapt to rapidly changing markets, and consider suggesting adjustments to investment mandates, fees, and reporting requirements. Above all, maintaining a genuine connection with your clients requires taking the time to demonstrate flexibility in both thinking and execution.

The importance and pleasures of meaningful discourse are many. I hope this article encourages you to reconnect with past, present, and future clients.

Until next time,

Chris Elsmark

May 30th, 2023

Thanks for reading. I'm always pleased to hear your thoughts and feedback. Catch up on past editions of the newsletter?on www.assetcircle.com

Recommended articles

Goyal, Amit et al. (2023) Forbearance in Institutional Investment Management: Evidence from Survey Data

Goyal, Amit et al. (2009) The Selection and Termination of Investment Management Firms by Plan Sponsors

NBIM (2020) Investing in External Managers

Important Information | This publication contains general information only. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. And it does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. Before making any decision or taking any action that may affect your business or investments, you should consult a qualified professional advisor.

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