The Prudent Fiduciary Digest
June 8, 2015
There has been a longer-than-normal interlude since the last edition of this newsletter. Hopefully it will have been worth the wait. You'll find a good crop of readings that address various aspects of the investment responsibilities that you face.
In addition, you might want to look at a newly-issued Request for Information (RFI) for a foundation that I advise. It seeks responses regarding ten topical issues that the organization wants to consider before proceeding to the design phase of the process to restructure its investment function.
The RFI is open to all, not just investment providers. In particular, the perspectives of other institutional investors would be very valuable to receive, so please respond if you have an interest. Or, you might find the RFI to be a source of ideas if you are starting your own review.
It seems like every week there are new studies and initiatives concerning gender and investing. Just since the first of the month the CFA Institute held its first conference on "Women in Investment Management" and State Street's Center for Applied Research issued a white paper, "Addressing Gender Folklore: Diversity in Investing or Investing in Diversity?"
There are many interlocking issues involved, including the big one, as stated in the paper, "Could it be that gender-specific differences in investing are contributing to the industry's failure to achieve true success?"
The statistics are unavoidable – women are vastly underrepresented in the industry – and are backed up by anecdotal evidence. For example, it is still very common to find firms responsible for billions of dollars of assets without any women in important investment roles.
There is a great risk in misinterpreting the results of any study or drawing specific conclusions. But the body of evidence is such that asset owners should question firms that persist in creating a male-dominated decision process. And, you might want to mull over the mystery of an industry supposedly structured to "wring out the very last basis point from every single investment position," but that avoids acting on evidence that would support some innovation in how it deploys its human capital.
One of the challenges in assessing investment managers is to understand actual process versus stated process and the link between philosophy and performance. Identifying the constructive and destructive behaviors of managers is a key part of seeing what really happens behind the numbers.
While behavioral finance has gotten lots of attention over the last two decades, most investment firms do not analyze the behavioral underpinnings of the choices made by analysts and portfolio managers. Asset owners that have position and transaction transparency could do similar analyses too, but it's still quite uncommon.
There are tools and services that can help you to gauge the tendencies of managers. For example, Novus highlights the capabilities of its platform (which I haven't seen) in a recent piece, "Five Manager Mistakes That Diminish Returns."
The first of those mistakes relates to small positions in a portfolio. Novus thinks that they are a performance drag in aggregate. The ones that do end up being winners tend to have their best performance before the portfolio holding is increased in size (in other words, after the manager gets "comfortable" with the idea).
Behavioral attribution is the next frontier in portfolio analysis.
The purpose of consultants
In May I wrote a posting on the role that investment consultants play. It was in response to a piece of academic research about manager selection by consultants and articles in reaction to it that appeared in Pensions & Investments and Chief Investment Officer. My bottom line was that there needs to be much better definition about the roles of consultants and that they should be evaluated "in a much more expansive way."
Now Gordon Clark and Ashby Monk have published a paper, "The Contested Role of Investment Consultants: Ambiguity, Contract, and Innovation in Financial Institutions," that provides more insight on the questions at hand. Their assumption is that "the relationship between asset owners and investment consultants is under-determined," that "contracts are open-ended, ambiguous as to the nature and scope of services to be provided, and virtually silent on issues such as performance." Of particular interest in the paper is the examination of how the relationship between consultants and clients changes depending on the size of the fund.
Action at state plans
Speaking of size, state pension plans are among the biggest around, and actions taken by them tend to influence other asset owners over time. Those plans set the agenda to a certain extent and are front and center as representatives for "institutional investors" with regulators, the media, and investment providers.
There's a lot going on with the state plans right now, including the always-present political battles and some dramatic shortfalls in funding. In addition, Rhode Island is requiring investment funds to be transparent about "their performance, fees, expenses and liquidity." As is happening elsewhere, there is a battle in New Jersey about whether hiring expensive managers of "alternative" portfolios has added value. ("Well, let's just say that seems up for debate.") And, CalPERS just announced its plans to trim it manager roster to "gain the best deal on costs and fees that we can."
The plans seem destined to stay in the news for quite some time. (There's a great new website that provides lots of information on public plans should you have an interest.)
Here are some questions that you might ask at your next meeting:
~ Do we consider the gender makeup of our own organization or those that we hire to invest on our behalf? Based on the evidence, should we?
~ How deeply do we analyze the (investing) behaviors of asset managers when we do due diligence?
~ Are we clear about our expectations of our investment consultant(s)?
~ Which of the issues being addressed by the state plans affect what we do?
Additional readings of interest:
~ "Asset allocation should be the outcome (not the driver of) investment decisions," John Kay.
~ "Investment Decisions: How to Avoid Groupthink ," Usman Hayat, Enterprising Investor (CFA Institute).
~ "Fees Eat Diversification's Lunch," William Jennings and Brian Payne, SSRN.
~ "Loyalty Rewards: A Better Fee Structure for All," Ted Seides, Enterprising Investor (CFA Institute), and "Why Mutual Funds Should Pay Investors for Loyalty," Jason Zweig, Wall Street Journal.
~ Other postings by me, all with implications for due diligence: 1) reflecting on Ray Dalio's machine, 2) trying to find a way in to understand an investment organization, 3) looking in the fridge (metaphorically) when you are there, and 4) finding the gaps between expectations and reality.
Many happy total returns,
Tom Brakke, CFA