The Prudent Fiduciary Digest
April 19, 2016
If you're a new subscriber, welcome. You'll get one of these updates every month or so.
My goal is to provide a range of readings for those who serve as fiduciaries for long-term investment plans – and for other stakeholders and providers who work with them.
Some are long, some are short, and they cover a wide variety of topics that might be of interest to you. Hopefully there is something for everyone in each issue. To comment on any of the ideas or provide suggestions, simply respond to this email message. Thanks for your support.
On to the readings.
The International Monetary Fund recently issued a working paper, "Institutionalizing Countercyclical Investment: A Framework for Long-Term Asset Owners," authored by Bradley Jones. Its thesis is that long-horizon, countercyclical investing is "a valuable activity for both society and [your] own fund."
Unfortunately, that's not how asset owners tend to invest. The first part of the paper provides evidence (that dovetails with other analyses and practitioner observations) that the decisions of asset owners are on balance procyclical. That is, asset classes that have done well (and have lower prospective yields) are favored; those that have done poorly are de-emphasized even when they offer favorable yields. In some cases, that stems from "passive drift" (not rebalancing despite uneven returns causing changes in the asset mix), in others from "active return chasing."
The second part of the paper provides recommendations on strengthening governance, avoiding the problems of benchmarking, and dealing with risk management issues, including the risk of shortfall. For example, it was refreshing to read this: "For long-term investors, valuation risk, rather than volatility risk, should be the principle concern." These days, almost all attention regarding risk management by consultants and managers is based on volatility risk and almost none on valuation risk. The cost of having your eye on the wrong ball could be very great.
One of the sections in the previous paper is titled, "Realigning the Principal-Agent Relationship." No one has done more to focus on such a realignment than Ashby Monk.
He recently issued a draft of a new paper, co-authored with Rajiv Sharma, called "Organic Finance: The Ingredients and Incentives in Our Investment Products." As you might judge from the title, they draw analogies to the food industry, which has seen much change of late as consumers have fought back against many aspects of mass-produced foods, including a proliferation of questionable ingredients.
The "obfuscation of fees" has created a "distortion in the underlying incentives" creating "an increasingly short-term and disconnected financial world." The mass production of financial products "facilitated asset ownership at a distance," which turned out to be not all that it was cracked up to be. Information asymmetry and the nature of compensation structures have led to the benefits of active management accruing to the managers of the assets rather than the owners. The first step is to rip away at the opacity of the chain of principle-agent connections, to shine a light on the real economic costs and misaligned incentives.
The conclusion states: "1) Capitalism needs greater professionalism and sophistication among asset owners. 2) The only way to develop this is to demonstrate the true cost of external professionals and the distortions these costs are creating for capitalism."
John Minahan has written a number of good pieces over the years regarding investment philosophy, and he has teamed up with Thusith Mahanama of Assette to create another one, "Rethinking Investment Philosophy."
They define investment philosophy as "a set of beliefs that guides an investor's approach to investment management," and contrast it with such easy-to-confuse concepts as investment strategy, investment process, investment style, and investment objectives/goals.
The authors identify five myths about investment philosophy and "the essential attributes of a robust investment philosophy." Importantly, "It should be open to new knowledge." Often people assert that investment philosophy (and investment process, for that matter) should be consistent above all else. That is a prescription for trouble over time.
The previous edition of this newsletter had a section on RFPs. Normally I wouldn't include a topic again so quickly, but shortly thereafter the Greenwich Roundtable issued another in its series on best practices. Titled "Best Governance Practices in Delegation and Consultant Selection for Long-Term Funds," it provides an overview of some of the issues involved in selecting a consultant or OCIO provider, plus a thorough set of questions you might include in an RFP for one or another.
The paper reinforces the notion that there are a lot of different combinations of advisors available to investment trustees. You need to start by "knowing thyself" (and thy organization) and being honest about the resources and expertise that are available to you. The Roundtable uses "discretionary consultant" as I would use "OCIO," encompassing not just those OCIO organizations that had their roots in consulting, but others as well. That's a reminder that the terminology in this area hasn't gotten standardized yet, so it's easy to get confused.
If your organization is thinking about issuing an RFP, this is a good resource. But it also is a helpful tool for general review; which of the topical areas have been overlooked in the ongoing assessment of your current providers? A quick look through this guide will give you some ideas about questions to ask at your next meeting.
Speaking of questions, here are some other ones for you to pose:
~ Are we countercyclical in our approach to investing or procyclical? Do our actions match our beliefs?
~ Do we have adequate transparency into the chain of agents that we use to execute our investment strategy? Do we understand the all-in costs that we incur?
~ How do we assess the investment philosophy of our asset managers?
~ What questions haven't we been asking of our providers, either during our RFP/selection process or on an ongoing basis?
Other links of interest
~ "The Role of Assets," Pension Consulting Alliance. (A basic look at the characteristics of the major asset classes.)
~ "Strategy Primer: Investing in Real Estate," Oaktree.
~ "The World's Best Institutional Investors? It's Not That Simple," Charles Skorina.
~ "Alpha or Assets," Patrick O'Shaughnessy, The Investor's Field Guide.
~ "CFA Institute Survey: Investors Want Transparency, Ethics, Performance," CFA Institute.
~ "Simple vs. Complex," Joshua Brown, The Reformed Broker.
~ "Are 3-Year Track Records Meaningful?" Corey Hoffstein, Newfound Research.
~ And a few from me: On the shared delusions of asset owners and asset managers, what makes for an effective investment team, and why most manager selection processes start in exactly the wrong place.
Many happy total returns,
Tom Brakke, CFA