August 2013

The history and the future of asset management

Sakari Virkki, with contributions from Shirah Foy
The future is unknown that is for sure. But in some cases history is also unknown, or at least unexplained. This is very true when we take a look at the history of asset management. It is difficult to find even a single article about it. Yet, without knowing the history, it is even more difficult to predict the future. This article is an attempt to record a fragment of that history. The area is so vast that any attempt to comprehensively explain it in a single article would be doomed to fail. For this reason I have decided to make a radical reduction of the explanatory factors forming and driving asset management. I have selected the most descriptive concepts among these. The first concept I selected was distribution. While the use of distribution is most common in statistics, I selected it as a key concept because of isomorphisms in physics - especially related to the concept of work (W). Take a look at work within thermodynamics, mechanics, electricity, etc., and you start to capture the picture: potential energy can do work only when there is a distribution of height; thermal energy can do work only if there is a distribution of temperature; electricity can do work only if there is a distribution of power. In these examples the energy is unevenly distributed. If it were evenly distributed, no work could be done. So how does this concept of distribution work within asset management? To explain that, we need two additional concepts: competence and capital. While both are important, the space here allows us to concentrate on competence. Using the isomorphism from physics we can state that competence can do work if, and only if, it is not evenly distributed. I wrote it in bold because it has huge consequences. But how is it distributed in capital markets? I have studied this subject for 22 years, analyzing competences of market participants (later market actors or just actors). I discovered that the competences of those actors, measured by the profitability of their trades, are highly distributed. This is very true even if we look at the trades of a single actor among different instruments. The first requirement holds - there is a distribution that can work for us. When you realize this you start to see these kinds of distributions everywhere. For example: education, as it becomes more specialized, is one form of creating distributions in competence. A highly educated doctor can charge far more for his services than an ordinary doctor because of his higher competence. This is in fact an important part of the resource allocation system every society must have.

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But we will not go any deeper into this. We now have the tools to tackle the history of asset management.

The history of asset management We start from a situation where actors have some capital of their own and they invest it into various instruments i.e. everyone is taking care of their own assets. For sure there is no common result, but everyone performs differently. This is based on different amounts of capital, transaction costs, and most importantly the distribution of competences. Some of the actors perform well and become wealthy within time. As the competences of the best performers are acknowledged, it is evident to others that they would do better if they put their assets under more competent management. Here we have the first evolutionary step of asset management, leading to a changed distribution of capital benefiting those who take part in this action. In a sense, static capital becomes dynamic. A tentative asset allocation system is emerging. While the competent fellow does just fine, it is not the end of story. He still fails in some of his investments while there are investors who succeed with the same instrument. This underlines the fact that no one is best at everything. And this is a fundamental limitation of contemporary asset management: Without a proper resource allocation system to allocate competences more effectively (i.e. to allocate the top competences by each of the instruments), the system remains far less than perfect even mediocre. It shows: In 2012, 87% of hedge funds lost against the S&P500. This limitation is the motivation behind the second evolutionary step of asset management. Competences become dynamic Based on the statistics revealing the true nature of the evolution of asset management, I have designed a system that is able to assess the competences of each actor by each of the instruments. In this way it is able to put the uneven distribution to work by dynamically allocating the best competences to each of the instruments. One might call it information physics, because of its striking isomorphism to the science. In 2012 my system generated a 35.40% annual return (result audited by Ernst & Young), outperforming the S&P500 at 16.00%. If I were running the system for a US fund, this fund would have been third best in the US among non-leveraged funds (according to the data cited by Associated Press). However, the contribution of this innovation is not limited to superior performance in the markets. There is also a contribution to economics - this novel approach implies major adjustments to market theories including the Efficient Market Hypothesis. And those adjustments start the third evolutionary step of asset management, one which takes full advantage of the wisdom of the crowds and beyond.

August 2013

We will return to this topic as things start to take shape. Visit www.competencemapsolutions.com to read about other implications of this innovation.