There are few people more aware of the importance of trust in financial services than Herman Brodie. Formerly an algorithmic trader for an investment bank, he became fascinated by the predictable aspects of human behaviour and how that affects investing and the markets.
Herman and Klaus Harnack’s book, The Trust Mandate, is aimed at industry professionals and investigates what it is that makes someone choose one asset manager over another. Their findings, however, can lead to a broader consideration of what makes a consumer trust a financial professional, and a new clarity on what trust is actually is.
In the first part of a two-part interview, Herman talks about how they came to write The Trust Mandate, and why understanding trust is important for investors.
Herman, first tell us about your background and how you first became interested in finance and investing.
Well, after university I went into the financial services. I started in the commodity trading industry, and then ultimately moved into investment banking where I worked in the city of London, and subsequently in Paris as well as in Frankfurt. I graduated, interestingly enough, in 1987 and I went to work in the capital markets. About a month after I started the global financial markets crashed. So, you can imagine, there was panic everywhere and everybody was running around, mostly taking care of their own personal portfolios rather than those of the clients!
And for me it was all very new, honestly, I thought it was like that all the time. I had no idea we were experiencing something that was really exceptional, but very quickly I recognised that financial markets would not work in exactly the same way as I studied at university. This was a completely different thing. And this drove me in the direction of a quantitative approach to financial markets, and at the investment bank where I worked, we developed algorithmic models for trading in all of the capital markets, equities and bonds and short interest futures, as well. And that was, for me, a way of distancing myself from the market.
I recognised that, myself, as well as my colleagues, were limited in our abilities to be purely objective and to take into consideration all of the information, and to act in a consistent fashion. In order to prevent some of the problems that can occur when someone behaves in that way, I wanted to have a certain separation between myself and markets, and financial models and algorithmic trading allowed that.
I became more and more interested in behavioural finance, which occurred, really, just through an intern who showed me some of the literature. It became clear to me that the kind of behaviour that I was subject to, and that I saw amongst my colleagues in the investment bank, was actually a lot more widespread than I thought. In fact it was taking place in every financial institution pretty much everywhere in the world. Everybody was doing exactly the same thing at the same time! I thought this must mean that there was a systematic element to human behaviour, and if it’s systematic, it’s something that one can predict and, therefore, one can exploit. And this changed, completely, the way we approached algorithmic trading. Then, over time I decided that I wanted to leave the bank to concentrate on behavioural finance full-time.
Tell us about your book, The Trust Mandate, which you wrote with Klaus Harnack. What is it about, and why did you write it?
The Trust Mandate was a deep dive into very specific areas of behavioural finance and behavioural sciences. It was a response to a question by one of our clients, a fund manager, who basically wanted to know why a client chooses one fund manager over another, when, on paper, the performance of the both of them is pretty much the same. Why is it, for example, that some asset managers lose their mandates during those difficult phases, whereas others don’t, and sometimes the performance of the one who loses their mandate is actually better than the one who keeps it?
I was embarrassed not to know the answer to that question, because for fund managers, it’s the ultimate question. Why does a client choose you? And if a client doesn’t choose you, of course, you don’t even have a business. Nothing else really matters. So, what we did is to do a dive into research going back over about a thirty-year period, looking for evidence as to what was driving those choices.
The conclusion to all of that research, put together, was that hard factors, things like the performance of the fund, the size of the fund, the fees, the age of the fund, and the CV of the fund manager, explains only about a third of those choices. The other two-thirds is put down to what we called soft factors. This has to do with the ‘credibility’ of the fund manager, the consistency of the investment philosophy, the clarity in decision making, things like the usefulness of the reports and meetings or, quite simply, ‘the kind of guys they are’.
So then we wanted to know, why are these soft factors so important to people, especially as they don’t have any predictive capability for performance? We tried to unpick those soft factors to get to the bottom of what it is that clients are actually looking for. They are trying to find out what the relationship with the asset manager is going to be like. Specifically, they’re trying to get a gauge of the asset manager’s intentions towards them. Is that asset manager really going to have their best interests at heart or is there a chance they may have their own selfish interests at heart? They’re asking, how is that person going to behave when I’m not looking? Essentially that’s what those soft factors are.
So, there are two judgements that they’re making when they’re choosing an asset manager. The first one concerns their intentions: are the asset manager’s intentions benevolent? And the second one is to do with their abilities: is this person capable, resourceful, smart, what is their competence? And when there is a backdrop of risk, those two judgements combine into what, ordinarily, people would describe as trust. So trust is a high score on two very specific domains: intentions, and competence. and that’s important when there is a this backdrop of risk or vulnerability.
In financial services then, is it more important to be benevolent or competent?
Well, of those two judgements, the first one that is always made when there is risk is the one on intentions. In fact, you might be surprised to learn, that being being smart is, actually, not that important. Having somebody smart around you is only good if they’re on your side. If they’re working against you, it’s actually not a good idea to have a smart person. Rather, have a dumb person if they’re working in the opposite direction to you!
So clearly, intentions is the more important judgement when there is risk involved. If you’re putting your fate into somebody’s hands, you will only ever do that if you genuinely believe that they have your best interests at heart. If that’s not the case, there is absolutely no way a transaction is going to take place.
Why is understanding trust important for investors?
Well, I have to tell you that The Trust Mandate, and in fact the whole of the research was done for the benefit of the financial service provider. So the book is really for asset managers, bankers, brokers and financial advisors, to help them better understand what’s driving their clients’ and potential clients’ decisions.
However, there are big advantages for both the investor as well as the provider when it comes to understanding trust. It’s one of those genuine win-win situations. The advantage for the investor is that trust reduces the perception of risk. If I trust my advisor or my asset manager, the perceived riskiness of the whole enterprise we’re doing together is actually diminished, so my level of anxiety is reduced.
A lot of bad things can result when we are overanxious about the engagements we’re involved in, and financial markets are fraught with all of the kinds of things that we as human beings find the most disagreeable. This often leads us to doing precisely the wrong thing at the wrong time. Now, if we perceive the whole riskiness of the engagement to be reduced because we trust the person to whom we’ve entrusted our assets, then of course this brings an enormous reduction of stress.
It also means that clients can actually absorb higher level of market risk without increasing their anxiety. Now, if I hold consistently higher level of market risk then over the long run it’s likely that my returns are going to be much higher. I’m going to be able to go into equities, for example, instead of remaining in low-yielding assets, and as a result my long run returns are likely to be higher and that’s all thanks to the trust that I have in my service provider.
It also means that I’m more likely to stay with the same provider over the long run. Jumping from one advisor to another does not bring any great advantages. It just brings costs, with no great upside for the investor. So that trusting relationship allows me to stay with the same person over the long run. It also allows me to speak honestly with that person, and to be completely transparent about what I really want to achieve. Very often, clients don’t tell the whole truth about their assets or about their objectives. That, of course, makes it very difficult for the advisor to be able to propose the right strategies. But if I trust that individual then it’s more likely that I’m going to share the kind of things that will enable them to provide the best service to me.
Next time: In Part 2 of this interview, Herman Brodie talks about the behaviours which make us bad investors, and how we can make better decisions.