The Prudent Fiduciary Digest
December 8, 2015
As we wind down the year, I'd like to thank you for subscribing to this newsletter and for your comments and suggestions. Have a great holiday season and look for more readings of interest to come your way in 2016.
In August, I had the opportunity to participate in a one-day gathering of asset owners, asset managers, consultants, and vendors. It was organized by Cathleen Rittereiser of Uncorrelated, under the banner of DoDiligenceTM – Reinventing the Due Diligence Process. A white paper about the event reviews some of the ideas that were put forth, and provides information about those in attendance.
There are many different angles to the due diligence process. The conference was organized in a way that focused on three: qualitative thinking, technology, and data and analytics. (I was one of the speakers, discussing my ideas on the qualitative aspects of due diligence.)
The report identifies three themes of the conference: fiduciary responsibility, flexibility, and forethought. A due diligence endeavor ought to be reflective of a particular organization's governance situation, should emphasize "flexibility over rigidity," and should involve "strategically planning and thoughtfully executing" an approach that is specifically designed for the task at hand.
While standardization has its benefits, many due diligence efforts have become exercises in documentation rather than discovery. To have differential results, your approach needs to deviate from the norm.
(Be sure to look at "Making Cybersecurity Part of Due Diligence," on page 13. Simple ideas for your own organization and those that you analyze.)
The last edition of this digest opened with a link to a great paper on the agency problems that are rife in the investment world. The system as we know it has pools of money being "run" according to industry conventions, disconnected in many ways from the ultimate purpose of the funds.
That's probably why Jason Klein's remarks at DoDiligence rang such a loud bell for me. As the chief investment officer of Memorial Sloan Kettering, Klein said that his mission and that of his team is curing cancer. Everything is in service of that.
We need to remind ourselves that getting better at due diligence or improving any other part of the investment function is all about meeting the needs of the beneficiaries of the assets over time. Not only do our tactics tend to fall into the ruts of established trails, but the trails often lead to destinations that may not serve the ultimate purpose of the institutions that we represent.
Breaking from the pack
Jason Hsu of Research Affiliates has written a great white paper, "If Factor Returns Are Predictable, Why Is There an Investor Return Gap?" His thesis: Investors should be able to take advantage of dislocations in the market by looking at the ebb and flow of high and low valuations of various assets. But they don't. Why? The decision process that has been institutionalized throughout the investment world leads to failure.
Trend-chasing allocation decisions seem like the right thing to do, but are actually destructive (unless they come early in the game). The "poor performance of the adopters of modern investment selection practice" stems, ironically, from "the pursuit of positive alpha, which leads to the regular switching of investment strategies and managers," and which "is the very reason why mutual fund investors and pensions have earned negative alpha."
To Hsu, "the delegation of investment decisions has failed miserably along a dimension that has received scant attention." This is a business of herding, as I wrote some time ago. Consider these questions from Hsu:
"Would a consultant or financial advisor recommend a shortlist of managers with poor recent performance? Would the pension CIO and his staff choose a manager with a negative trailing three-year alpha to present to their layman board? Given a keen understanding of investors’ buying behavior, would salespeople and marketers educate client prospects on products that have recently underperformed?"
In terms of the way things work now, the obvious answers are "no" to each question. But, the evidence shows that alpha might actually be found by doing so.
Impact investing is hot.
I use that term as an umbrella for the various activities that incorporate analysis that goes beyond the standard textbook approach to investment. One part of it carries the moniker of ESG (environmental, social, and governance).
A paper from NEPC is a good overview of where the industry is at regarding ESG. Contrary to the popular perception that using ESG filters detracts from returns, most research studies of late show that it is a positive for long-term performance. NEPC provides an overview of how the industry has evolved and how specific managers use ESG in their work.
Also of interest is a piece from UBS, "A revolution in equity investing: A deeper dive into nonfinancial data." It focuses on the sources of value and risk in an investment. Many of them are not financial in nature. An amazing fact: Forty years ago, 83% of the market value of S&P 500 companies was represented by tangible assets. Now, a similar percentage is intangible. Value and risk are vastly more subject to factors not found in financial statements (and certainly not discussed on quarterly conference calls by the myopic investment industry).
Here are some questions that you might ask at your next meeting:
~ Does our due diligence process (or that of those we expect to do due diligence on our behalf) lead to a discovery of value-added information?
~ Does our investment approach fit the goals of our organization as a whole?
~ Are we willing to stand apart from the crowd in order to have better performance, or do we want to be a part of it, knowing that we'll likely get poor results in return?
~ Have our managers instituted a substantive approach to ESG analysis? Should they?
Additional items of interest:
~ "I Know It Was You, Fredo," Ben Hunt, Epsilon Theory. Often, we "act in what we think is our own self-interest when actually we are acting in the interests of others." A fascinating look at expectations, modeling, markets, and portfolio construction.
~ "Investment Jargon: Just What Does That Mean?" Rogerscasey.
~ "Peering Into a Portfolio Manager's Glass House," Russell Campbell, LinkedIn.
~ From me: an essay on the benefits of open networks, and two short pieces related to due diligence. One concerns the different standards that are applied to asset managers (how do you look at Group A versus Group B?) and another considers the importance of digging beneath the language and the narrative of those being analyzed.
Many happy total returns,
Tom Brakke, CFA