Two inconvenient truths are fundamental to the relationship between fund investors and asset/fund managers in real estate investing. They are straightforward and well-understood, but they are problematic.
When real estate investments are performing strongly, it is possible to let their significance and implications slip to the back of our minds.
But now that the long boom in real estate performance is over, we are relearning the importance of these two inconvenient truths.
- Past performance is not a good indicator of future performance
This must be one of the most written sentences in investment documents, but its meaning fails to penetrate our thinking.
We have an innate tendency to believe current trends will continue. Joe Wiggins describes extrapolation as “a convenient mental shortcut” and “psychologically comfortable”.
People do it in walks of life. In sports, for example, people often emphasise the importance of momentum.
In soccer, commentators and fans commonly describe teams that have recently won their games as “on a roll”. They assess their chances of winning their next match as higher. In contrast, they describe teams on a losing streak as “in a rut” and view them as more likely to continue losing.
However, a study of over 80,000 English league games found no evidence that sequences of consecutive wins generated a positive momentum effect. If anything, the effect was negative.
In sports, the apparent value of momentum is often a trick of the mind.
We imbue momentum with significance to impose cause and effect on a world where randomness plays a significant role. Humans are natural storytellers; developing narratives is easier for most of us than statistical reasoning.
But luck plays a significant role in determining the outcome of sports events and the same is true in investing.
What to do? Michael Mauboussin has the answer: assess the process, not the outcome. “Where luck is rampant,” he writes, “we must think of skill in terms of a process, because the results don’t provide clear feedback.”
During a sustained period of strong performance, it can be psychologically uncomfortable for fund investors to look past the recent track record, even if they should.
But when the market turns and the happy confluence of events that led to good performance has passed, it is time to refocus on assessing whether they can trust the process.
They do so by looking for evidence of investment discipline and robust underwriting. They should also look for a fund manager to clearly understand their source of edge, genuine expertise in their niche and a determination to stay within their circle of competence.
Fund managers need to get into a position to answer these questions and ensure their process stands up to scrutiny. They must articulate why they are good at what they do and evidence it by identifying their unique and lasting advantages.
They may have attracted capital during the long boom by pointing to recent historical performance. But now we are relearning that the proof is not in the pudding.
- The presence of risk asymmetry
In 1955, Fred Schwed wrote a book highlighting the follies and inequities of the investment business and called it Where Are the Customers’ Yachts?. The premise behind the title was that while bankers and brokers had yachts, the followers of their investment advice did not.
“A deeply embedded feature of fund management is that managers are rewarded no matter their performance”
Nearly 70 years later and the question remains pertinent. A deeply embedded feature of fund management is that managers are rewarded no matter their performance, so they are incentivised to maximise their assets under management (AUM) on which they earn fees rather than long-term investment performance.
Fund managers do face some downside risks. Unhappy clients are bad for business. In extreme cases, they get sacked. Nonetheless, the most considerable downside risks are born by underlying investors.
Fund investors can turn a blind eye to the presence of asymmetric risk when performance is good, but they can soon feel resentful when performance weakens.
It would be nice if managers always acted in the best for underlying investors. But Charlie Munger’s quote, “Show me the incentive and I’ll show you the outcome”, never stops being relevant.
When tailwinds drive performance and investors are keen to get their capital deployed as quickly as possible, the misalignment of interests is less apparent.
But when bad times come, fund investors might ask whether their managers were not more focused on the short-term goal of increasing the AUM on which they charge fees rather than long-term investment performance.
But some fund managers are better placed than others to demonstrate that they consistently keep investors’ interests front of mind.
Openness about the presence and power of incentives helps. Fund managers can significantly mitigate investors’ concerns if they have skin in the game with personal exposure to downside as well as upside risk. But investors’ concerns will be heightened where the remuneration of investment professionals is closely tied to the level of AUM or levels of investment activity.
Fund managers with a history of turning away capital because of a scarcity of attractive investment opportunities will be attractive to investors. In contrast, investors should treat boasts about how much capital has been invested as a warning sign.
The presence of an independent and influential research team that can guide when, where and how to invest helps. Researchers’ compensation and career goals are less closely tied to fund size or levels of AUM than, say, a portfolio manager.
When managers use research teams to determine an investment strategy that is being adhered to with discipline, it demonstrates to investors that they are being highly discerning and appropriately selective with the capital they are managing.
The two inconvenient truths will be front of mind of investors during the current downturn. The fund managers who realise this and adapt quickly are the ones who will fare best.
