The Missing Link to the Best Performance of Investment Managers

New research by the Center for Applied Research, the independent think-tank of State Street, and CFA Institute, argues that to succeed, the investment industry and its professionals need to move from a performance-driven culture to one that is purpose-driven to better ensure clients’ long-term goals are met.

The research, titled “Discovering Phi: Motivation as the Hidden Variable of Performance,” has identified “phi”, a factor that has a positive impact on organizational performance, client satisfaction, and employee engagement. Phi is the alignment of purpose, habit and incentives at the intersection of the goals and values of the individual, the organization, and the client. The research asked three questions based on motivation theory (self-determination theory) to diagnose phi: What motivates you to perform generally and in your current role? What is the reason that you are still working in the investment management industry? Would you describe your work as a job, a career, or a calling?

The research found that phi has a statistically significant and positive link to broad performance measures, including client satisfaction and employee engagement, that can sustain the industry and drive client satisfaction for decades to come. A one point increase in phi is associated with 28% greater odds of excellent organizational performance, 55% greater odds of excellent client satisfaction and 57% greater odds of excellent employee engagement.

Rebecca Fender, CFA, head of CFA Institute’s Future of Finance initiative, who is based in Charlottesville, Virginia, and is a co-contributor to the report, tells PLANSPONSOR, the analysis did not get into the specifics of how phi in an organization affects performance of investments offered to clients because of how complicated that would be. “But, long-term organizational performance [of investment managers] client satisfaction and employee engagement are important,” she says. “The latter item is important because of turnover of investment management employees who make important judgements. It is important to have consistency, and CFA interviews with investors found consistency in investment management organizations is important to them.”

The research report says the findings clearly point to the existence of phi as a previously uncovered variable that, in addition to motivation, might have an outsized impact on investment performance, as in quantum mechanics, where a “hidden variable” is an element missing from a model that leaves the system incomplete. The research argues that the same is true for the investment management industry: without the alignment of purpose and passion, the industry model is flawed.

So, how can plan sponsors and advisers determine if an investment manager organization has this culture of purpose and passion?

Fender notes that plan sponsors have a long-term time horizon for investing, but for many investment managers, professionals’ incentives are the opposite. She says the research found 39% of investment professionals would be in favor of extending their bonus cycle to two to five years instead off one year, which, Fender adds, would be helpful for the entire system.

In addition, those organizations with high phi are driven by working in the service, and similarly, they have a belief they can reach organizational and client end goals, and they focus on end goals. “Doing due diligence and having conversations can get a sense of an investment professional’s calling,” Fender adds.

Mirtha Kastrapeli, senior research analyst at the Center for Applied Research at State Street, who is based in Boston and is a co-author of the report, tells PLANSPONSOR State Street has a diagnostic test:

• Identify managers that have the ability to close the gap between what they say they have and what they do have - Do leaders spend time talking about values and belief, do they create and opportunity for investment professionals to see what matters in clients lives?
• Habits - How is that manager creating a habit of learning how to learn—providing effective feedback, quickly recognizing and addressing mistakes without fear and making sure they are aligning with clients’ goals?
• Incentive structure - A short-time contingency award is a red flag. Are incentive structures aligned with clients’ and the investment manager organization’s long-term goals?

“We are working on a diagnostic tool, a quantitative measure of something that is hard to measure,” Kastrapeli says. “We are designing a potential survey or questionnaire to assist plan sponsors and advisers with recognizing managers with phi. We are looking toward rolling that out next year.”

According to Kastrapeli, researchers also looked at phi for individual investors using a different methodology—looking at psychological personalities and sensitivities to the environment around them, among other things. On one hand, motivational investors are focused on goal setting and attaining, they trust investment managers, have knowledge of fees and use advisers. On the other hand are investors driven by fear and negative consequences; they fail to engage and they buy and sell at the wrong times.

Fender adds that investment managers with higher phi are more engaged with retirement planning. “The more we know about plan participant investors’ motivations, the more we can customize education and advice. Motivation is the engine that drives behavior,” she says.

In addition, Fender notes, phi is something investment managers can control during market volatility. It can create a better relationship with clients and alignment with client interests.

Fender says a worrying finding of the research is that 54% of individual investors said investment managers are looking out for the firm’s best interest rather than clients’ best interests. In addition, 62% of employees at investment manager firms said the same. “The paper is a call to action for investment manager leaders,” she says. “A lot of a firm’s culture goes back to leadership; 44% of investment professionals think their leaders are articulating a specific vision.”

Fender concludes: “There’s a big opportunity for the investment management industry. The research shows only 17% have high phi, and more than 50% have low or no phi. Better cultures lead to better long-term performance.”