The Prudent Fiduciary Digest

April 1, 2015

This is a day for hoaxes and other foolishness, although there is nothing found within this edition of the newsletter that is intended to deceive.

But don't let down your guard.  Here, there, and everywhere, digging up "the truth" is difficult for those charged with making long-term investment decisions.  A certain skepticism is required.  In fact, it may be the attribute that is most important for investors to possess.

Everyone talks their book to some degree (including me).  It comes with the territory, although the talking ranges from mild promotion to out-and-out manipulation.

Asset owners need to listen to the stories and try to poke holes in them (what I call cracking the narrative).  We can't see the future, but we can be easily fooled into thinking it will look a lot like the past.

On to the readings.

Value added

A white paper from CEM Benchmarking, "Value Added by Large Institutional Investors Between 1992-2013," concludes "that beating the market is rooted in active asset
management paired with cost savings gained through scale and managing assets in‐house."

It is based upon surveys of 200 to 400 defined benefit pension plans.  So, there's a question of how representative those investors are in general, but the cost conclusions seem pretty straightforward.  As to the statement that "beating the market is rooted in active asset management":  the definition of "the market" that is used is the individual policy portfolios of the respective plans, not quite "the market" as commonly described – and, since passive investment by definition does not involve attempting to outperform, the implicit comparison is a little stretched.  Still, the bottom line is different than that generally observed, so it deserves additional investigation.

I found myself most captivated by one section header in the report:  "What characteristics of pension plans predict value added?"  Rephrasing that by inserting a blank ("What characteristics of ___________ predict value added?") results in a question that could be asked over and over by fiduciaries.  Try putting "asset managers" or "consultants" or "research firms" in the blank.  Beyond cost, what characteristics matter?  It is an obvious question, one that gets at beliefs and the evidence that they are based upon, but it doesn't get asked frequently enough or broadly enough.  There are many important characteristics that are never even studied.

The flip side

In contrast to the CEM review, two pieces of academic research question the ability of institutional investors to add value.

The first, "Institutional Investor Expectations, Manager Performance, and Fund Flows," by Howard Jones and Jose Vicente Martinez, looks at the reasons that investors choose managers.  Basically, decisions are made based upon past performance and recommendations from consultants.  The authors argue that those factors mitigate career risk and trump a more in-depth examination of the characteristics that have a chance to lead to future value added.

The second, "The Market for Lemmings: Is the Investment Behavior of Pension Funds Stabilizing or Destabilizing?" by David Blake, Lucio Sarno, and Gabriele Zinna, is based upon an analysis of pension funds in the United Kingdom.  Its title speaks mainly to the macroeconomic conclusions of the paper, the foundation for which is the behavior of the investors in question:  "We find strong evidence that pension funds herd and, in particular, they herd in subgroups defined by size and sector type, consistent with reputational herding."

Neither of these papers offer conclusions that are surprising to seasoned observers, but they beg the question, "What does it take to break free from business as usual?"

Passive and active

Given the run of underperformance by active managers, the passive versus active debate is in full force, posing important questions for asset owners.

In a recent posting, Josh Brown wove together three strands of the debate:

~ The Incredible Shrinking Alpha, a new book by Larry Swedroe, posits that active management "will only get harder, not easier, going forward."

~ A paper from Neil Constable and Matt Kadnar of GMO asks, "Is Skill Dead?"  They see the confluence of headwinds of the last few years as "the ebb and flow of style," which is likely to revert, although not necessarily to the same degree.

~ Research from Savita Subramanian of Bank of America Merrill Lynch looks at the reinforcing feature of money coming out of active management, which puts pressure on active management.

Proponents of active management are definitely getting "active" on the PR front, stepping into the debate (as GMO did) with white papers, blog posts, advertisements, etc., extolling the virtues of active and the risks of passive (as in this article from Institutional Investor, by Yves Choueifaty, who questions the "suitability" of passive approaches).

The active versus passive arguments have eclipsed a very important question:  What about active management (and the selection of asset managers) works and what doesn't?  Perhaps it is that we are approaching it in the wrong fashion, by not focusing on the characteristics that work but on the comfortable, standard approach (which doesn't).  As Michael Ervolini wrote, we don't know much about the nature of skill in investing, because we have been looking at the wrong things.


The hand-wringing about lower levels of liquidity in the market (especially regarding the trading of fixed income securities) has been around for several years.  Howard Marks intensified and extended the concerns by publishing a memo on the topic.

(It's interesting to reflect upon the lessons of 2008, when I used a construct from the Beatles to write about liquidity's "nasty habit of disappearing overnight.")

As Marks indicates, today's markets feature the assumption of liquidity in lots of strategies where it is unlikely to be found when the stuff hits the fan.  In particular he calls out the current infatuation with "liquid alternatives":  "No investment vehicle should promise greater liquidity than is afforded by its underlying assets."


Here are some questions that you might ask at your next meeting:

~ What characteristics do we look for when selecting strategies and/or managers?

~ Are we susceptible to herding, to following our peers?  Does past performance unduly drive our consultant's recommendations and our selections?

~ Why have we made the choices regarding active and passive management that form the foundation of our approach?

~ Do we really have the liquidity that we expect?  Will it disappear when we most need it?

Other links

Additional readings of interest:

~ "Are Investment Committees Obsolete?" Ralph Wanger, CFA Institute Magazine.

~ "What's Wrong with Finance," Morgan Housel, and "What's Right with Finance," Ben Carlson, A Wealth of Common Sense.

~ "The macroeconomic drivers of hedge fund strategy returns," Aon Hewitt.

~ "Crude Oil's Low Price – Q&A on the Causes, Consequences and Implications for Investors," Segal Rogerscasey.

~ In-depth research on historical and projected returns can be found in "Global Investment Returns Yearbook 2015," from Credit Suisse, and "Long-term capital market return assumptions," from J.P. Morgan Asset Management.

~ A couple by me:  1) regarding the sins of memory that affect our decision making abilities and 2) on defining due diligence.  Speaking of which, if you want to be notified of upcoming due diligence workshops I'll be giving, please sign up.  (See, I told you people are always talking their book.)

Many happy total returns,

Tom Brakke, CFA
tjb research

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