The Three Most Common Types of Asset Managers
To “beat the market” or “find alpha” an asset manager has to believe he has the ability to form better—or more accurate—expectations for the future performance of securities than the market. More accurate expectations are what Russell Fuller, founder and president of Fuller and Thaler Asset Management, calls “the mother of all alphas.”
In his paper titled “Behavioral Finance and the Sources of Alpha,” Fuller goes on to describe three sources of alpha and the three types of asset managers who maximize each source, all with the intention of beating the market.
First, there are asset managers who believe they can access superior information in comparison to the market by doing deeper research on individual companies or industries. These asset managers are referred to as traditional or fundamental managers.
Second, there are asset managers who believe they can process information better than the market by developing better frameworks and processes for combining and utilizing the information. These asset managers are referred to as quantitative managers.
Lastly, there are asset managers who believe they can identify behavioral biases—ways that other investors behave irrationally and cause inaccurate expectations. We refer to these asset managers as behavioral managers.
But suppose there is a fourth type of asset manager that Fuller does not mention in his paper—i.e., a manager who orients the various sources of alpha around what we believe to be the true purpose of business: value creation.
A Fourth Type of Asset Manager
Let’s call this fourth type of manager the purpose-driven manager. This type of manager understands that investors and the businesses they invest in have a purpose to create value. The purpose-driven manager asks the question, “How likely is it that this company will create value in the future?” as a way to qualify and interpret the other sources of alpha.
So, while fundamental managers might use their access to superior information to understand the intangible qualities of a company—the competency of the management team, the attractiveness of the industry, and the scalability of its product—that are likely to make it more profitable, the purpose-driven manager asks if these qualities make it more likely that the company will be profitable by creating value.
As for quantitative managers, they seek to process information better by creating models that combine more relevant information in novel ways to generate more informed forecasts. But instead of simply interpreting the forecasts in terms of red and black, a purpose-driven manager seeks to understand if a positive forecast is the result of creating value.
Lastly, behavioral managers seek to understand the biases that people have that predicate the decisions they make. The purpose-driven manager, by contrast, seeks to understand the people’s positive behavioral biases that draw them to make good decisions that result in creating value for themselves and others.
Why We Believe It Works
The purpose of business and investing is commonly assumed to be profit generation, making profit the sufficient purpose of a business rather than a necessary outcome.
The true essence of a business, though, is its production of a good or service, which means that a business’s core purpose is to create something of value for society. The result of this purpose, then, is the generation of a profit.
Hence, the true measure of success for a business lies in its ability to generate a profit by creating value.
Of course, a business can also generate a profit by extracting value or giving the perception of creating value when it’s not. But profits generated by extracting value often have a limited lifespan. Profits generated by creating value, on the other hand, have the propensity to rejuvenate and sustain themselves, making value creation a potential source of alpha.
Let’s look at some ways that a business can become more successful as a result of creating value rather than extracting it.
Through its goods or services a business creates value by meeting an important human need. Society has very real physical and emotional needs that are addressed by the goods and services of companies spanning all sectors of the market. Businesses that build models and assemble teams that are most competent in delivering these goods and services stand to benefit from the inherent demand driven by people’s needs.
In contrast, a business can extract value by offering something that harms people by preying on their addictions or negative impulses, creating the illusion that they are offering something of value. The damage caused by these products or services that extract value, however, will eventually place the well-being of society at odds with the success of the company.
Through its operations a business creates value by creating mutually beneficial relationships with each of its stakeholders—customers, employees, suppliers, host community, the environment, and broader society. As a business prioritizes the health of each of its stakeholders, they in turn become healthier partners that help the business become more resilient and sustainable in the long-term.
In contrast, a business can extract value through its operations by exploiting its stakeholders to temporarily increase its bottom line. But this exploitation of its stakeholders often comes at a price. The health of the stakeholders is sometimes depleted to the point that they are no longer helpful partners to the business, making it more difficult for the business to grow.
Better Expectations
If the “mother of all alphas” is having better expectations, perhaps asset managers should first consider asking, “What do I expect from the businesses I’m investing in?”
Businesses have a purpose. And that purpose is to create value through the production of a good or service.
Understanding the purpose of business and investing gives new light to an investment strategy.
Value creation can be an underappreciated source of alpha.