Understanding Business Risk

There are certain risks that exist within any business that nobody pays much attention to them until things go wrong. I never really considered business risk before witnessing it firsthand during the financial crisis. Here are a few things I saw or heard from peers in the industry:

  • Funds closed completely because they had one large investor who decided to pull their capital from the fund.
  • Some portfolio managers decided to close their funds to “spend more time with family.” (aka I’m sick and tired of dealing with clients complaining about my performance and I’m already rich). This is called key man risk which comes from a concentration of power within an organization in the hands of a single portfolio manager.
  • Funds with poor performance saw investors pull money after large losses, which only made things worse as selling begets selling, putting pressure on fee revenue from both sides.
  • Funds took on too much leverage and became forced sellers when margin calls hit, causing many to lock-up investor capital from redemptions.
  • Funds with really good performance were actually penalized because they were used as ATMs by investors who themselves were over-leveraged or ran into liquidity issues and needed cash anywhere they could find it.
  • Certain fund managers are great investors but terrible at running a business. The big red flag here is when the fund makes a big announcement about the hiring of a new COO to run the day-to-day operations so the PM can focus on running the fund. I’m sure there are examples of this working out, but it’s usually a sign that all is not right within the firm from an operational standpoint.
  • There were funds and firms who practiced radio silence and stopped communicating altogether during the crisis. I think many were scared they were going to say or do something wrong and were tired of being blamed for poor performance

Business risk is different than career risk, which can come from sticking to your knitting and strategy when it’s not working at the risk of losing client dollars because they don’t have enough patience to stick around. It’s easy for people to forget that financial firms are businesses too and not just investors. When the markets fluctuate widely, so too do the revenues and profits of these firms.

Many times there’s nothing you can do about business risk as an investor because you never truly know how an organization will react during a panic in the markets until you experience it firsthand. I’m sure some people have already forgotten many of the transgressions witnessed during the crisis, but those are the times when you realize whether or not you’re working with the right people and firms.

In his latest Masters in Business podcast, Barry Ritholtz had a great conversation with Vanguard CEO Bill McNabb that touched on a number of different issues related to business risk. One that I thought was worth mentioning came during an exchange about how the firm handled the financial crisis:

Most of our competitors stopped talking to the press and stopped going out and meeting with clients. At least that’s what we heard. We were very vocal and visible. And we were very clear that we didn’t know how this was all gonna unfold. But we had to step back and get back to basic investment principles. And what we saw is that it had a real calming influence on our investors. I did a webcast, probably in October of ’08 and I think it was downloaded 100,000 times in 24 hours. […]

There was certainly a lot of commentary out there that the world was ending as we knew it. We didn’t see it that way but we knew it was going to be rough. And then the third thing we did, which again seemed tactical, but we thought it was really important is we told our people, “Don’t worry about your jobs. You all have jobs. Nobody’s going to lose their job over this. We want you to focus on being there for your client.” And boy that set a tone inside. And I think that really helped them with the client interaction because they had confidence when talking with the clients.

I thought this was a great example of the right way to treat both your customers and employees. One of the most impressive stats McNabb shared was that Vanguard actually had lower than average investor activity in 2008 than they normally do. From 2007-2009, three-quarters of Vangurd’s 401(k) investors made no changes to their portfolios while only 3% completely sold out of stocks.

People assume that all of Vanguard’s success over time stems from the rise of indexing and their low fee structure. That has certainly played a large role in their growth, but I think the culture of the firm and how they treat both their employees and investors is an under-appreciated reason for their success and trillions of dollars under management.

If fund firms would like to build a long-term investor base (and they all do), one of the best ways to do it is to treat your stakeholders the right way.

MiB: Bill McNabb, CEO of Vanguard (Big Picture)

Learning From Vanguard Investors
Enduring Lessons From the Financial Crisis
Wall Street is Not Going Down Without a Fight

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