The Prudent Fiduciary Digest
January 18, 2017
Happy New Year. 2017 promises to be full of surprises. I hope that it proves to be fruitful for you.
On to the readings.
Science or baloney
Laurence Siegel has produced a thought-provoking article, "Is It Science or Baloney?" When faced with the recommendations of investment managers and strategists, isn't that what we really want to know?
Siegel charts a number of ideas on the spectrum between what he calls "real science" and "almost entirely hype," while acknowledging that "more often, they're in between – good investment ideas that, sooner or later, take on the shape of fads and become crowded trades that lose their effectiveness."
While I might disagree on the attainability of "real science" in the complex adaptive system that is the investment markets (especially after only a few decades of close observation), Siegel's opinions are interesting and insightful. He touches on all the high points: capitalization-weighted indices, fundamental indexing, low volatility strategies, risk parity, factor ("smart beta") investing, alternative strategies, and "the endowment model."
In the end, "By distinguishing science from baloney, one can deal better with the vast asymmetry between the interests of the manager, who needs to get it right once to become very rich, and those of the investor, who needs sustained and repeatable successes to build wealth over time." That's for sure.
There is a great deal of interest in sustainable investing these days. Assets under management are growing quickly. Donors are looking for organizations that have investment approaches that fit with their beliefs. Many nonprofits are aggressively pursuing sustainable investment choices that fit with their mission, while public pension plans debate whether or not to alter their investment policies. All the while, there's increasing evidence that sustainable investing actually adds to the bottom line, a big change from the widespread belief of the past that it hurt returns.
To get up to speed (if you aren't already), there are a couple of papers that you might want to read.
The first (and much longer) one comes from the World Resources Institute. It outlines the drivers of the interest in sustainable investing, the barriers to it, and the various strategies that are employed. Each approach is briefly examined by summarizing who is pursuing the strategy, how they are doing it, and what challenges exist. The appendices are great, providing information on investor networks and associations, some notable investing frameworks and guidance, a glossary of terms, and extensive references.
The other paper was issued by bfinance, "ESG Under Scrutiny: Lessons from Manager Selection." It provides insight into the allocation process by reviewing five manager searches.
Because of its popularity, sustainable investing has drawn lots of attention from asset managers and no small amount of "sophisticated window-dressing." In fact, "it has become increasingly challenging to distinguish between box-ticking and substance." Given that, plus the customized nature of many of the searches, manager selection can be a real challenge.
Two of the searches (one for private debt and the other for public equity) are outlined in some detail, with a description of the mandates, the selection approach, and the range of fees. The paper ends with a review of some of the trends in ESG searches.
You've heard of alpha and beta and perhaps gamma, but now there's "phi." Or Φ, if you will. CFA Institute and the State Street Center for Applied Research have joined together to produce a paper, "Discovering Phi: Motivation as the Hidden Variable of Performance."
"Phi" is actually an acronym, standing for "the motivational forces of purpose, habits and incentives that govern our behaviors and actions." The paper's thesis is that the investment management function – at asset management firms and asset owner organizations – needs to change in fundamental ways if it is to deliver real value over time.
The corrosive effect of career risk can prevent professionals from operating in the best interests of clients and stakeholders. The herding instinct is strong; to build an organization that can stand apart from the herd is not easy. The authors stipulate that the benefits of doing so are great and offer some suggestions of how to get there.
(Don't let the apparent length of the paper give you pause. Much of it – too much of it – is made up of pictures, quotes, etc. It's actually a very quick read.)
A new fiduciary layer
The headline in Pensions & Investments proclaimed "MiFID II research rules to add fiduciary layer for asset owners." MiFID II stands for Markets in Financial Instruments Directive II, a new regulation that affects European asset managers and, by extension, the owners of those assets.
Essentially, "New EC rules will require money managers with European operations, clients or investment strategies to disclose, in advance, a detailed budget of research charges that have historically been bundled with execution costs under what's known as soft dollars. Pension fund executives can either accept or reject those charges from their money managers."
If you have managers that are subject to the law, what will you do when presented with a research budget for approval? How will you judge whether it's reasonable?
The new regulation hasn't gotten a lot of attention in the asset owner community. But the long-term repercussions are significant. If there is ultimately an unbundling of research costs around the world, it could be disruptive for existing relationships, but there are potential benefits of "more transparency, lower research costs and real savings."
Here are some questions you might ask at your next meeting:
~ Do we agree with Siegel's characterization of the strategies that we use in our portfolio? Where's the baloney?
~ Are we all on the same page regarding sustainable investing and how it fits (or doesn't fit) in our investment plan?
~ Do we understand the hidden motivations within our organization and within those of the managers we employ?
~ What if anything are we doing to prepare for MiFID II?
Other links of interest
~ "The Art and Science of Investment Decision-Making," 2016 Global Institutional Investor Survey, Fidelity.
~ "How much of hedge fund profits are taken by management?" The Mathematical Investor.
~ "The Courage of Discomfort," Christopher Schelling, Institutional Investor.
~ "Seven easy ways to make your nonprofit board meetings more productive," Lawrence Hunt, NPdirection.
~ "2016 Was Not a Particularly Volatile Year," Clifford Asness, AQR.
~ "What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing," Timothy Martin, Wall Street Journal.
~ "Political Representation and Governance: Evidence from the Investment Decisions of Public Pension Funds," SSRN.
~ The CFA Institute has some model RFPs available on its website.
And, from me:
~ My latest due diligence and manager selection email concerned the Platinum Partners debacle and implications for manager evaluation processes. Let me know if you'd like a copy. To receive upcoming newsletters, please register here.
~ I've been working on an evaluation of the investment ecosystem. Also, I wrote some short postings on the zero-sum game, humility and curiosity, and the big board in an iconic Vonnegut novel.
Many happy total returns,
Tom Brakke, CFA