Later this week I meet a fresh cohort of post-graduate students for the first time for a course on ‘Asset Management and Financial Analysis’. What will I tell them? Obviously, there are requirements of the curriculum. But these requirements are simply a list of topics. I hope to engage a critical approach. After decades in and around the AM industry, a persistent unanswered question remained: what is the purpose of asset management and financial analysis? A full answer is hard to come by. So, talking to a class of graduate students is an opportunity to test ideas. This post is an abbreviated rehearsal, and I’d love to get your feedback – before young minds are irretrievably polluted. In the interests of brevity, I generally use the term Asset Management as a portmanteau description that includes financial analysis, unless otherwise stated.
It is easy to find a conventional answer to the question of ‘what is the purpose of Asset Management?’. When I asked the question of my wife, Louise, a shortened version of her reply was: ‘the purpose of Asset Management is to protect or increase material wealth in return for a fee’. Google Bard replies to the same question with a longer version of the Louise’ answer: “financial asset management is the process of managing investments like stocks, bonds, and real estate for individuals or institutions. The goal is usually to maximize the value of the portfolio over time while managing risk. This is done by professional asset managers who analyse markets, select investments, and make trading decisions.” ChatGPT replies to the same question with a list of required operational areas in asset management functions, Optimising Performance, Managing Risk and Costs, Compliance, Strategic Planning, Lifecycle Management and Decision Support. Obviously, ChatGPT was trained on management consultant brochures rather than my wife.
All these answers are correct, but insufficient. And their omissions lead to misunderstanding. All answers so far assume the question could be reframed as ‘what business processes are involved in Asset Management?’.
A list of current businesses processes only go so far. In particular, the answers fail to address the question: ‘what are the implicit rules of the game of Asset Management?’ Rules, explicit and implicit are an important long-term consideration of purpose in any activity. Yet in the case of Asset Management the rules are rarely explored.
A sound grasp of Financial Analysis is the sine qua non for understanding any society, not just capitalism, if what is meant by analysis is a painstaking mastery of how information and resources valued by that society are allocated and measured. And yes, I include tribal, feudal, and communist societies, in that description.
By extension, asset management is the activity which seeks to exploit, aggregate, and improve the gains of this analysis in an organised manner and express the results in value scheme broadly agreed by the society. But how?
My fundamental contention is that an asset management function in any society has always directed (and directs) more focus to the exploration and control of information than to the control of resources. Of course, resources are always needed to feed the population, provide transport, and keep the lights. But the provision of resources is always a particular application of information, invariably both hierarchically controlled yet equally a source of innovation which, over time, altered the transmission of information itself and thus resources. It is a game, with malleable rules.
There are endless examples of this use of information as a set of rules. Temples in Greece acted as repositories of wealth, including gold, used in trade. Mammon was literally codified and deified. In a latter parallel example, the success of the Medici family stemmed from their control of information on the transfer of tribute to the Catholic Church in Rome. They gamed the rules of the current hierarchy to create a new hierarchy.
Seventeenth century England saw growing supply of the original ‘black gold’ (coal) from Newcastle to London due to dwindling availability of wood in the capital. On the face of it, the new trade was apparently simply a matter of resources. Yet, the reality is the trade in coal was a recasting of existing information. Namely, that the new resource provided a more condensed and reliable energy source than wood.
It is noteworthy that the improvement of this trade in ‘information’ encouraged, before 1660, the construction of the world’s first railways (called waggonways), using wooden tracks. These waggonways transported coal from mines to Newcastle port at perhaps twice the efficiency as conventional wagons with much less damage to environment or vehicles. Control over the coal information largely accrued to mine and transport owners. Their own innovation in transport clearly led to improvement in the transmission of information (railways and shipping), albeit by degrees. The rules evolved. Later railways themselves supported the development of national newspapers. And so on…
Map showing pit villages (large dots) around Newcastle in 1635.
Crucially, the distribution of information is always asymmetric. So, the game of investment is never fully fair. It will always be so. This is a consequence both of inherent uncertainty in all information, and a protective reflex of existing interests.
Asymmetry requires mediation by a system of value, money; a system that will always reflect access to the information valued by society. The asymmetry is therefore a part of the game, required by the rules, either by prescribed hierarchy or operational access.
Not surprisingly, this system creates inherent tension and instability. There is thus no prospect of value stability – despite the proclamations of General Equilibrium economists. The degree of control by sectors of society may impede, but can never succeed in halting dissemination of information, and thus some modification to existing rules. The system of signs available to humans is far too extensive ever to halt meaningful communication. Information is always broader than declared and controllable knowledge, or the current accepted rules of the game.
Despite the constant leakage of information, the purpose of asset management (and financial analysis) is to protect their information asymmetry. One seeks to become an asset manager, and to remain one, in part, to control the benefits of asymmetric information not available to your customers. That asymmetry may be promoted as ‘market power’, or ‘history of outperformance’, or even novelty.
This should be uncontentious, though it is rarely openly trumpeted by the AM industry. Asymmetric information is a necessary part of profitability. Asset managers refer to this asymmetry as ‘edge’.
The arrangement does not mean the customers do not benefit. Customers could choose to avoid the arrangement by disavowing savings altogether. Some people follow this path, even some with relatively high incomes. However, some rudimentary form of asset management is needed just to ensure basic sustenance and shelter. As customers become more informed and prosperous, their sophistication in asset management tends to increase, through graduations of state protected condescension.
Most never progress above this level, but it is possible. If customers can prove they are sufficiently safe from ruin or sufficiently familiar with the precariousness of investment information, they are allowed to declare themselves ‘accredited investors’ in the US, or ‘well-informed investors’ in Europe.
The graded categorisation of investors in ascending sophistication is eerily like Jean Piaget’s Four Stages of Cognitive Development in children. The four stages describe the growing understanding of rules of life until conventions are accepted based on utility for the child and their peers – which also, of course, implies the possibility of rejecting certain rules. Piaget’s framework also describes how children learn to play increasingly sophisticated games.
The first ‘sensorimotor’ stage of Piaget’s progression sees very young children display interaction with the world through bodily response. Language is used solely for demands. This is equivalent to the least sophisticated investor. Essentially, the stage allows the formation of habit, such as saving for the future, or understanding diverse valuation in concrete terms. Managing a bank account or opening a first brokerage account may count as evidence of a similar stage in investor development.
The second stage sees the child (or investor) receive examples of codified rules through trial and error. Play is mostly egocentric, with little reference to other players. My own experience of initial investment experience showed a similar naive acquaintance with how the rules of investment worked; put some money in an investment and see what happens. Learning is often through imitation, and often prone to error. For instance, early in my investing career I learned to treat recommendations of new friends with suspicion – an example of asymmetric information which was costly, and consequently never forgotten.
Third stage shows ‘incipient co-operation’ where children begin to concern themselves with mutual understanding and agency. A corresponding stage in investing may be the acceptance of mutual fund investment or ETFs. This stage still lacks consistent explanations of life’s rules, which may be expressed in contradictory terms even from the same child, or investor. Investors going through this stage may display an interest in technical analysis, or believe others have access to material inside information or show interest in superficially attractive, though spurious, correlations between economic factors and securities prices.
The final stage of childhood for Piaget, which he declared occurred around ages eleven or twelve, shows a full codification and high consensus around the rules. The game of life becomes conventional. Similarly, this seems analogous to a higher stage of amateur investor sophistication where a working model of the investment universe, including its uncertainties develops. Appeals to authority for adjudication of rules are frequent, and it is also possible to see occasional collective attempts to adjust the rules. Something similar often appears in investors displaying this level of sophistication. For instance, class action suits against a particularly egregious asset management practice. The dismantling of the endowment mortgage product in 2000s in the United Kingdom is an example.
Of course, full agency is not developed in children until after the final stage of childhood. Amateur investors frequently end their development in the still relatively unsophisticated fourth stage, which precludes full agency and responsibility.
Jean Piaget with children at play.
Informationally naive is how asset managers probably prefer their customers. However, they face a permanent battle to keep ahead of the inevitable natural dissemination of information through society, no matter how rigorous the censorship. The desire for added information and agency never leaves investors, so asset managers are required to justify their profit by advancing the asymmetric frontier.
This explains, in large part, why the asset management industry has devoted such effort to developing the ETFs, which simultaneously aggregate moderately sophisticated investors to lower costs, yet simultaneously transfer economic power of investment into a few hands. It also may account for the rise of private equity (and debt) investment funds, which explicitly remove agency from investors in return for uncertain higher benefits at some future date. The machinery of valuation remains hidden in private equity space allowing for temporary, and possibly permanent, asymmetric information. Hedge funds deliver a similar transfer of agency, accompanied by high costs in return for expectation of non-correlated, or higher returns.
This manipulated image is not intended to infer any impropriety on the part of the original advertiser, or their associates. It is simply an example of the use of information by Asset Management companies.
A more conventional, and less confrontational, description of the purpose of asset managers is that managers perpetually need to persuade their investors that the Edge and Odds of their product adequately compensate investors for the costs. That the pain of playing the game is worth the rewards. That this is often transparently not the case, even for so-called successful asset managers, could reflect the effective barriers to information flow that have been erected. But it does not stop people playing. Nor should it.
In a future post I want to look at how Modern Portfolio Theory, including Efficient Market Hypothesis fits into this schema. I also have my own approach to overcoming the transference of agency from investor to manager which may make an appearance. Of course, it is not for everyone and you will have to pay to hear it. That is the rules of the game.