It’s important for us to understand where Seed Alpha fits into the overall job duties that our client base has. When we can see the broader context we will be better positioned to effectively solve their problems and empathise with their needs.
What do Asset Management Firms do?
By now it may be obvious but it’s worth reconsidering why asset managers exist in the first place and what their role in the economy is.
If you recall from my long post at the beginning of this year, finance is all about efficient capital allocation in the face of risk.
Investment Funds are an essential part of this process and refer to any collective investment scheme. Investment Funds are capitalised by clients such as pension funds, family offices and endowments and are usually created with a specific mandate to fulfil; e.g. a technology investment fund, a fund to invest in mid-cap Chinese stocks, a fund to invest in AAA rated bonds etc.
These Investment Funds are run by Asset Management companies which charge fees for this work. The total amount of investment funds under management (Assets Under Management or ‘AUM’) is a common benchmark for size.
Asset management firms can range from 1 man bands to global firms with thousands of employees but one thing unites them — they all exist to invest capital.
Asset managers sell their services to clients such as pension funds, funds-of-funds and high-net worth individuals. Typically they differentiate themselves based on; track-record performance of their funds, variety of investment funds under management and their internal ‘investment process’.
Typically asset managers like to prove to their clients that their investment process is unique, robust and repeatable — i.e. their performance is not just luck.
A large chunk of this investment process is the research process.
How do Asset Management Firms operate?
Typically asset managers can be split into professional and business roles. The professional side is focused on making and executing on investments while the business side is focused on sales, business operations and investor relations.
Asset managers rely on the business guys to keep the lights on and manage sales/clients. These people to not typically interact with research at all and are beyond our scope. The exception to this is when we are making enterprise sales to COOs and Compliance roles.
Our bread and butter is the professional side of the business, the guys who make the investment decisions and aim to generate ‘Alpha’.
There are a few roles here:
- Fund Managers/Portfolio Managers
- Analysts
- Traders
- Trade Support (Middle Office)
- Settlements/operations (Back Office)
The job scope for buy-side professionals are:
- Idea generation
- Research
- Portfolio Construction
- Portfolio Management
- Trading
- Settlements
Generally speaking the order of work goes like this:
For Seed Alpha we’re only really interested in Idea Generation and Research but for the broader context here is a simple explanation of how the roles interact.
Fund Managers/Portfolio Managers
These are the guys who are in charge of a fund. Remember, an asset management firm can have multiple funds under their management so they can have multiple fund managers working for them. Small asset management firms tend to only have one or two funds — in this case the fund manager is also the boss.
As each fund has a mandate the fund manager’s role will be to find assets within said mandate (e.g. technology stocks, American corporate bonds or Asian small-cap companies) to invest in that return alpha over their benchmark.
Fund managers tend to have a large amount of oversight on how they construct their portfolio. They can commission analysts, traders and trade-support to help them do their job.
Often a fund manager will rely on analysts to have done in-depth research into countries, sectors or individual stocks. Having seen their recommendations and read the work an analyst has done they will decide whether to increase/add the stock to the portfolio, reduce/remove the stock from the portfolio or do nothing. These decisions will be relayed to traders to execute on them.
Fund managers must also constantly monitor the performance of the overall portfolio. They look at risk-factors to the portfolio and use hedges to minimise these risks. For example if a portfolio may be overly exposed to a change in the price of the Euro, but the fund manager does not have the mandate/any view on how the Euro will trade then they may hedge the position out. This work is often assisted by trade support.
Fund managers are usually ex-analysts/traders and as such a good portion of their skillset and work overlaps.
Analysts
Typically has a very narrow focus of work. Analysts will often look just at a particular country, region or sector, e.g. Brazil, Europe or Technology stocks.
Analysts come up with their own investment ideas based on a deep understanding of their area of focus and pitch these ideas to fund managers.
They will often read sell-side research, news and industry/country trade journals to stay on top of their game. When they speak to sell-side analysts to get more information from them this is known as ‘Analyst Access’
Analysts also speak directly with the management of companies they follow. This is known as ‘Corporate Access’
They typically come up with financial models to value the companies they follow based on the research they have conducted. On this basis they usually come up with an investment recommendation which they then pass on to the fund manager to assess.
There are over 120,000 chartered financial analysts with the CFA institute and in the US alone the BLS estimates there are over 270,000 financial analysts.
Traders
When a fund manager makes their decisions about what they are going to buy and sell they then pass these orders on to traders.
The traders have their own benchmarks for execution and specialise in generating alpha by beating these benchmarks.
They typically speak with sell-side brokers and other buy-side traders to ensure they find the best prices to trade at.
At smaller firms this role tends to overlap with other functions but at large firms it is often highly decoupled from the research side of the business.
In such firms the orders are centralised across all fund managers and then handed to the trading desk to manage how they see fit. Often a lot of orders are ‘crossed off’ internally as one fund could be selling stock that another fund wants — this saves commission and other related execution costs such as ‘slippage’ and ‘implementation shortfall’.
Some traders are avid consumers of research too as it is their job to understand what is driving the market across any relevant time frame. On balance however news and market commentary tends to be more important than long-form research. Traders, like analysts may specialise their focus too.
Trade Support
Trade support or middle-office probably has the biggest variance in job scope across firms.
At some firms trade support is simply a function to help traders manage their positions and calculate intra-day risk.
At others they also support the portfolio management aspect by calculating Value-at-Risk measures for portfolio managers.
They tend to use quantitative methods to analyse companies and portfolios which is then used by Fund Managers, Analysts and Traders to do their jobs.
At smaller firms this job tends to be subsumed between Traders/Analysts and Settlements teams and may not exist.
Trade Support may also be tasked with monitoring and calculating the effects of corporate actions such as rights issues, dividends and stock splits on the portfolios.
Operations
When trades are made they are usually executed across a very large number of counterparties such as exchanges, brokers and other funds. Even a single trade will rarely be executed with only one counterparty.
To reconcile all these executions is the job of settlements. Counterparties’ settlements teams will send ‘Trade Confirmations’ to each other to ensure timely and correct settlement.
Exchanges usually have settlement dates delayed by 1–3 days (denoted by T+1, T+2, etc.) to give firms time to match up their trades. If a trade is not matching due to a firm’s own error then a couple of things can happen:
1) The settlements team may ask the traders to buy/sell the stock deficit/surplus through exchanges, brokers or other funds
2) If they can not match up the trade in time for settlement the exchange will buy/sell the requisite amount of stock to complete the trade and charge a large penalty to the offending party
They will also handle settlement of corporate actions such as rights issues, dividend payments and stock splits.
So what is research?
While some regulators have very specific technical definitions of what may constitute research, as is often the case this does not hold true in practice.
The broader spectrum of research comprises the following:
- Analyst access: speaking to other analysts about their research
- Corporate access: speaking to the management teams of companies about their business
- Sell-side reports: the reports we have been working with up to now
- News
- Trade journals
- Primary research: research conducted by the buy-side themselves — this may be as simple as reading financial reports or as complex as sending analysts to count footfall in shopping mall car-parks or casino floors.
Taking from the job spectrum above the research process itself typically follows these steps:
Understanding how these parts overlap is critical to building an effective solution.
Idea Generation
This is probably the most undefined of processes across research. Ideas can be generated just by talking with people, reading the news or actively running quantitative screens to look for companies out of a ‘norm’.
Although easy to overlook it is potentially the most important part of the research process. If a firm can consistently come up with original investment ideas then this is a strong advantage, especially when competition is high and many firms are chasing the same investments.
If we improve on existing methods by even 10% then we are providing tremendous value. If we can improve by 10x then we will be killing it.
Existing tools tend to focus on a specific method of idea generation. For example there are stock screening tools where you can input certain parameters like (5 year earnings growth >5%)+(daily trading volume >$100MM)+(price-book ratio <1).
These tools only exist in the better defined portions of idea generation. However the real ‘meat’ of idea generation is in what we passively consume through our eyes and ears. Every conversation we have, every video clip we watch and every article we read influences how we make connections in our mind. When these connections come together in a cohesive manner we have an idea.
If we can help our users find insights across all the information they have available then we are well on our way to solving this problem. We become a new idea generation tool.
If we can individualise the insights we generate then we become a killer idea generation tool.
Research
There are a variety of information inputs that asset management firms use to make their decisions including, but not limited to:
- Third-party research reports (like broker research)
- Analyst access
- Corporate access
- News
- Market data
- Company filings
- The internet (for lack of a better term..!)
- Trade journals
Asset managers will use these information sources to come up with their own thoughts on how well a company or economy may do in the future. This research is what informs the assumptions in the financial models asset managers use to value assets.
Typically the work done in research can split into two parts: gathering the right information and analysing the information.
Most research tools to date have focused on aggregating information into one portal. Getting access to, cleaning and standardising datasets was the challenge they were solving and it is why companies like Bloomberg have been so successful — they have been doing this since the late 70’s. New platforms such as Quandl promise to make this more decentralised but we’re still not quite there yet. The less time asset manager spend finding information, the more time they can spend analysing it.
The real unchartered territory is in helping asset managers analyse this information. In particular as more information is becoming easily accessible via the web the value in aggregation is plummeting. Again, this part of the process is very atomised and while some firms will have guidelines on what forms of analysis are necessary it will vary dramatically. The only part of this process that is somewhat quantitative is financial modeling.
Again, if we can help users analyse their information more efficiently then we will breaking very new ground. There are certain similarities between research and idea generation when finding insights across all information sources. The major conceptual difference is that idea generation is passive and information is ‘pushed’ to users while research is active and information is ‘pulled’ by users. Understanding this difference could allow us to effectively provide a solution using a virtually identical featureset.
The problem we face is that in order to provide a valuable tool to help users analyse their research we need to expand our target sources to match the full universe of information that asset managers use to conduct their research.
Portfolio Construction & Management
Portfolio management is predicated on the theory that portfolios should be constructed not just on the merits of individual securities but also bearing in mind how the securities have characteristics that interact with each other.
Key to portfolio management is diversification. Typically this means monitoring for risk factors that affect multiple securities within the portfolio and either changing the portfolio or hedging out such risk.
This activity allows asset managers to generate the most alpha while taking the lowest amount of risk, known rather logically as risk-adjusted returns.
Portfolio management is dominated by Modern Portfolio Theory and is focused on building the most efficient portfolio to maximise risk-adjusted returns.
Companies like Advent (who also own Tamale) were build on their PMS ‘Geneva’. At asset management firms PMS’ are generally considered a higher priority than something like an RMS — typically because ‘research’ is not very well defined and is more qualitative while portfolio management has more quantitative elements to it. In another words effective tools do not exist, therefore it is not considered.
While we don’t do portfolio management tools there is a reason this is considered part of the research process. For asset managers to make decisions on how to rebalance their portfolios and whether to add/remove stock requires ongoing research into the portfolio constituents.
In addition this is the phase typically where macro-economic research is considered as a ‘top-down’ overlay to ‘bottom-up’ research.
A possible angle for Seed Alpha would be to allow asset managers to monitor their investments and potentially alert them when price or fundamental factors change. For example if the stock moves more than 5% in a day or the company files their quarterly returns we could bring them relevant research.
To give a practical example one fund manager we speak to keeps notes on every company he follows. He starts new notes for each company on an annual basis but will update the note on a quarterly when the company files and on an ad-hoc basis when he comes across new information. In the latter case this is usually triggered by a price movement which he monitors via Bloomberg.
Tying it together
We’ve seen that generating alpha is the ultimate goal, and raison detre for asset managers to exist. Therefore anything we can do to help asset managers to generate alpha is worth them paying for.
Asset managers sell the belief that a robust investment process is the key to them generating alpha. Since the research process is a large chunk of the investment process it follows that tools that assist the research process directly affect an asset managers alpha-generating capabilities.
While there are a broad number of roles within asset management firms we know that analysts and fund managers are the most involved in the research process and therefore solving problems for these roles is most important.
Across the four stages of the research process; idea generation, research and portfolio construction & management we know there is significant scope for improvement. In particular in:
- idea generation the challenge is to find meaningful insights in a natural manner
- research the challenges are organising the entire corpus of information available to make it easily accessible and digestible and then helping users analyse this information
- portfolio construction/management the challenge is to make research and insights contextually relevant any time there is a trigger to review the portfolio.
While the conclusions may seem familiar it’s important to understand why we draw these conclusions and the context within which they exist.
Hopefully this explains research, the broader industry and how it relates to what we do.
