The Prudent Fiduciary Digest
July 6, 2016
The financial world has been captivated by Brexit and its implications. (By the looks of the bouncy markets, uncertainty is winning out so far.) Here are three topics that can take you past the headlines and on to key issues for the future of your organization.
McKinsey recently released a survey of some of the largest asset owners, which it titled, "From big to great: The world's leading institutional investors forge ahead." You may be one of those investors who participated. Or, you may sit on the committee of a small organization whose issues seem far removed from those giants.
But look at the history of investment theories and ideas. They usually start with the biggest players and filter down to the rest of us eventually. Being an early adopter can be fruitful – no matter what size asset base you're working with – so being aware of new trends in the industry is very important.
Not surprisingly, "portfolio is the priority," which means that new perspectives on asset allocation are coming to the fore, and investors are thinking about it more actively than in the past (especially relative to the huge amount of time spent on chasing managers).
But, liabilities matter and are getting increasing attention. That's very evident in the pension world, but how is it translating into other parts of the institutional landscape? Will foundations, for example, be more apt to de-risk and re-risk in response to their "funding ratios" of future liabilities, or will they hew to a fairly constant strategic asset allocation year in and year out?
New sources of return are in big demand. The reality is that "when every investor uses the same definitions, they find the same deals." Yes, yes, yes. The framework gets dated and the favored categories get crowded.
In some cases, the frontier is strictly the province of the big guys. Only the largest organizations can become operating entities unto themselves or have a big impact on the governance of their investments. But anyone can strive to "manage across silos" and "consider the spaces between asset classes and the issues that arise there."
The last half of the McKinsey piece identifies seven priorities, each presented in a simple yet cogent fashion, explaining "the big idea," offering reasons "why it's important," and suggestions "how to do it." They're all interesting and good.
The HP way
Speaking of those changes in asset allocation policy, check out "HP Lays the Foundation for a New Investment Model," an article from Institutional Investor. It's written by the firm's former chief investment officer, Gretchen Tai, so it comes across as sort of a victory lap, but it's worthwhile reading. In addition to the specifics of what happened at HP, I liked Tai's exposition of her previous experiences and how they shaped her beliefs.
"Witnessing these extreme market experiences was like going back to school and reevaluating what I had been taught. Are markets efficient? Yes, mostly, but sometimes no. Are investors rational, and will they choose the asset with the higher expected return given the same risk profile? Yes, mostly, but sometimes no. Do investors invest along the efficient frontier in alignment with their stated risk profiles and preferences? Almost never. My career had been a lesson about the gap between investment theory and reality."
The article identifies the problems that Tai and her team found with the two main belief systems driving institutional investing today: mean-variance optimization and the endowment model. They instituted a third approach, marked by a more risk-aware and dynamic allocation that uses derivatives for flexibility, the identification of new sources of return to reduce equity risk, a focus on maintaining better liquidity in the portfolio, and the willingness to protect and lock in gains in funded status.
It will be interesting to see whether this "HP model" gains traction going forward. I'll leave you with one other quote from Tai: "Any investor who wishes to outperform the average must possess at least one of the following: an information advantage, an analytical advantage or a behavioral advantage." Which ones do you think you have?
There has been a big change in the level of interest in sustainable investing, and a fair amount of confusion about the different terminology that is used to describe the various aspects of it.
A good place to start for an overview is a paper from J.P. Morgan Private Bank, "Decoding the Elements of Sustainable Investing." It walks through what it calls "a spectrum of approaches," from exclusionary screening to ESG (environmental, social, and governance) integration to positive screening to thematic investing to impact investing.
Each of those is given a short overview, including a definition, a description of how it's applied, some considerations, and a case study. Most of the attention in this area has been in the realm of equity assets, but there also is mention of some of the developments in fixed income and equities as well. And, it touches briefly on some of the changing conclusions regarding performance of these strategies versus standard benchmarks.
Another basic piece is "7 Myths and Facts About Sustainable Investing," from Morningstar. It is part of the promotion for the firm's "sustainability ratings," so some of the myths are in regard to those ratings; others are about that type of investing in general.
A more in-depth review of ESG is available from CFA Institute, "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals."
With interest growing and assets flowing to ESG strategies, many CEOs and asset managers are trying to position themselves accordingly. So, the question is, who is genuine in their interest and who is "greenwashing" to gain assets and attention?
A few things to read in that regard:
~ "Has ESG morphed to become just a box-ticking exercise?" Investment Week.
~ "CEOs Urged to Talk ESG, Though Wall Street Wants EPS," 3BL Media.
~ "Only Half of UNPRI Managers Follow Principles, Says Consultant," Chief Investment Officer.
The other thing to keep in mind: Interest in these strategies was strong in advance of the financial crisis, but then waned when markets got tough. Will it be more sustainable (so to speak) during the next bout of real weakness?
Here are some questions you might ask at your next meeting:
~ Which items moving onto the front burner at leading institutional asset owners are of importance to us given our circumstances today?
~ Should our asset allocation approach remain basically the same across market environments or should it be more dynamic?
~ What aspects of sustainable investing should be incorporated into our decision making and what would that mean for our manager selection process?
Other links of interest
~ "Adding Value with a Gender Investment Lens," Glenmede.
~ "The Problem with Investment Committees," Michael Thomas, Russell Investments.
~ "3 Ways to Make Money in the Markets," Ben Carlson, A Wealth of Common Sense.
~ "Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States, 1998-2014," CEM Benchmarking.
~ "The Optimal Size of Hedge Funds, Chengdong Yin, Harvard Law School Forum on Corporate Governance and Financial Regulation.
~ "Fifty Things I've Learned," Kip McDaniel, Chief Investment Officer.
~ "Pension Funds Pile on Risk Just to Get a Reasonable Return," Timothy Martin, Wall Street Journal.
~ From me: My talk on due diligence and manager selection was transcribed and featured in the CFA Institute Conference Proceedings Quarterly. A blog posting that looks at a key question these days, "What investment decisions should be made by people and what ones by machines?" And a rebuttal to a defender of Wall Street who thinks that the status quo is as good as it gets.
Many happy total returns,
Tom Brakke, CFA