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The Bridge Competition

March 16, 2012

The Bridge Competition

london-bridge1_16MAR2012

On March 6th, 2012, former Texas tycoon R. Allen Stanford was convicted of pilfering $7 billion of investors’ money through a Ponzi scheme. In my beloved city of Montreal, victims of another Ponzi scheme run by Earl Jones reached a $17 million settlement agreement with the Royal Bank of Canada. The victims contended that the bank’s negligence was a contributing factor in allowing Jones’ scheme continue and had launched a class action lawsuit against the bank.  These are extreme cases of financial mismanagement, but there are many other firms out there who legally mismanage investors’ savings and continue to operate and thrive. The reason for investors continually investing with such firms/managers is that they focus solely on the “window display” of performance. These “displays” only scratch the surface of what is really going on in the firm. In this blog, I will recount the story of a bridge competition I once participated in at one of my past employers that exemplifies the importance for the need of a deep understanding of performance in the evaluation process of firms and managers. Whether it is the investor or the firm itself, the benefits are there for all stakeholders of the industry.

At an annual company meeting, where departmental presentations were made in the morning and team building exercises were done in the afternoon, this year’s team building exercise would be a bridge competition. The employees of the firm were divided into approximately 5 to 7 teams. The objective and rules of the competition were to build a bridge that would span a fixed distance between two chairs. The materials provided were a limited amount of sheets of newspaper and transparent adhesive tape. Moreover, we were provided a fixed budget to purchase additional tape or paper and as well, accorded a limited number of questions to use in determining additional factors that could assist us in the design and build of the bridge. The backgrounds’ of the participants was typical of an investment management firm with mostly finance and accounting backgrounds. There were also two engineers, one mechanical, yours truly, and the other computer, that were separated in order to avoid giving an overwhelming advantage to any one team. Some of these participants were also handymen who liked to talk shop. The winner of the competition would be the team that could build the bridge that could support the most weight. In this case, juice boxes were used as weights.

Different approaches were taken by the teams in the design and construction of their respective bridges. Some favoured a heavy use of tape as the main supporting material, others designed complex arrays of trusses, and a couple of teams decided early on that they would focus more on the fun aspect of the competition. The key to success in this competition lied in the factors involved: how much paper to use, how much tape to use, what design would work best, and as equally as important, the information we needed to obtain by asking the judge the right questions. Since time was limited, teams rushed to decide the most important factors, the design, the additional information required and finally to construct it. After a hectic and stressful preparation period, the teams emerged from their respective rooms to set up their bridges for the testing phase of the competition.

The testing of the bridges was composed of two parts: the first was the mandatory stress testing of every bridge using 5 juice boxes. All teams had to have their bridges withstand the weight of five juice boxes in order to pass on to the second and final phase. As the bridges were now exposed to these stresses, some began to bend and ultimately fail under the weight of the juice boxes. Others bent but did not break and a few exhibited no signs of weakness. The final was now set and the bridge that could hold the most weight would be crowned the winner. This sounds straight forward except that every team had to estimate the number of juice boxes their bridges could hold. In other words, even if your bridge could hold the most weight, if you were to overestimate the number of juice boxes and your bridge collapsed under that weight, then you would lose. On the other hand, being conservative in your estimate ran you the risk of underestimating and allowing other teams with higher estimates a better chance of winning. Before testing began, every team handed in their estimate with all but one being conservative. Our team, on the advice of an excited portfolio manager, decided to “go big or go home.” At 15 boxes, our team’s estimate was the highest by at least 50%. As the final testing began, the elaborate bridges built by the handymen that had a look of stability and strength, the increased stresses started to show their effect: these bridges bent considerably and most failed. My team’s bridge was last to go and an expectation of failure hung over us from most other teams due to our estimate and the lack of an elaborate design. Fortunately for us, our bridge held and exhibited an enormous amount of stability and strength.

What does a bridge competition at a team building event have to do with the investment industry? Everything! In the investment world, performance is the main driver of firms’, funds’ and managers’ marketing. For the average investor, and for many of the non-performance specialists in the industry, the performance material presented before them may appear as an accurate reflection of the strength of a strategy. Similarly, the elaborately designed bridges with multiple trusses seemed the strongest and most stable for the non-engineers (including the computer engineer). As a mechanical engineer, I knew that the type and amount of material available to us was not sufficient to construct a bridge whose only transfer of weight lied on the two chairs that the bridges spanned. What was needed was as much direct support under the bridge that spanned its whole length; in other words, columns. These columns were made up of multiple sheets, rolled up, taped together and placed vertically, thus maximizing the strength of the paper. This knowledge was the key to building the strongest and most stable bridge. In performance, understanding the underlying reasons for the what, the how, and the why of returns is key to evaluating and identifying the strongest performers.

While most marketed performance reports may seem to exhibit the firm’s strength, under the right amount of stresses (economic and financial), these returns may collapse as quickly as those elaborately designed bridges. To maximize the evaluation of any investment firm, fund or manager, maximizing the use of performance analysis is critical. Relying on a simplistic understanding of performance, like the handymen’s knowledge of physics in the bridge competition, can result in a misallocation of assets with sub par firms, funds, and managers. Worst of all, investors may end up placing their financial wealth with the Allen Stanfords of the world. People relied on the image of his “fund” and did not perform the proper performance evaluation and due diligence. With performance material readily available and the presence of performance specialists in the industry, there is no reason for investors, firms included, not to be able to avoid these types of schemes. From the extreme cases of Ponzi schemes to the everyday overselling of performance, people should never rely on the initial look of a fund, firm or manager. Look behind the numbers and obtain the understanding that will allow you to make the right decisions. The bridge story is a reminder of how deceptive appearances can be, but you don’t have to take my word for it, just remember the moral of Aesop’s fable “The Wolf in Sheep’s Clothing”, appearances are deceiving.

 

 

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