The Prudent Fiduciary Digest
August 15, 2016
In November, I'll be hosting my first public due diligence and manager selection workshop. The website for it isn't live yet, so I'll include a link to it in the next digest. For now, there's a "soft open" for those who get my due diligence newsletter; if you want more information, just respond to this email and I'll send it to you.
Investment decision makers face a training gap. That's true for asset owners as well as asset managers and other kinds of organizations. The workshop is my attempt to address one of the key areas where better training is needed.
On to the readings.
State Street Global Advisors released "Building Bridges," a survey of "senior executives with asset allocation responsibilities at 400 large institutional investors." The results were, well, amazing.
It's not too surprising that capital growth was the predominant "primary objective" of those surveyed (on page 9), but it is striking that downside protection was only mentioned in that regard by a few percent. With most markets at rich valuations in comparison to history and memories of two notable corrections in risk assets since 2000, a more balanced view would seem likely.
But then (on page 10), you see that the expectations for individual asset classes and their overall portfolios seem wildly at odds with the low-return environment that most market observers see. Are they smoking something or just smarter than the rest of us?
From the information at the bottom of page 16, I'd say it's definitely the former. The results from the question, "How long is underperformance tolerated before seeking a replacement?" are stunning. Such shortsightedness is a prescription for failure.
And, the top obstacle to implementing smart beta (page 18) is a "lack of widespread adoption by peers." Really? Oh, then there's the fact (on page 19) that 54% think that other organizations will need substantial change, but that only 22% think that their own will.
All in all, there is a lot of evidence of unrealistic expectations among this sample of "large institutional investors."
Defined contribution plans
Michael Drew and Adam Walk of Griffith University (and Drew, Walk & Co.) in Australia recently published "Governance: The Sine Qua Non of Retirement Security in the Journal of Retirement. (Normally behind a paywall, the article is available for free through the end of the month.)
The shift that we've seen to defined contribution plans around the world means that "the risks that were once pooled within DB plans are now distributed among DC plan participants, for each to manage (or not)." The authors use a simple anecdote to show how dramatically outcomes can differ even when participants behave in similar ways.
They think that more attention has to be paid to the governance of the plans, asserting that there are real gains for participants that come from good governance. That means that the fiduciary body must be "capable and qualified," with the time and resources necessary to meet the needs of the plan. The organization must be aligned and "directed to acting in the interests of plan participants," using a "comprehensive, documented investment policy."
The investment beliefs that are desired: "retirement income is the true measure, investors are heterogeneous, time frames are finite, market returns (or beta) matter most, [and] dynamism is important." Each stands in contrast to the way that most plans are structured today.
And the motivations, actions, and needs of plan participants are critical. Importantly, there must be education and guidance, all against a backdrop of the findings of behavioral finance.
In the United States, there has been a rash of litigation related to defined contribution plans, including at the very asset management firms that oversee many of them (some of whom have paid settlements). Recently, a number of high profile universities also have been accused of mismanagement of their plans. The allegations include excessive fees, poor investment choices, undue complexity, and other issues.
One gets the sense that the defined contribution plans have been defined (if you will) primarily by the interests of the plan sponsor and the investment providers rather than the needs of the participants. It's time for a major rethink.
The Center for Economic and Policy Research (CEPR) has released a paper, "Are Lower Private Equity Returns the New Normal?" For investors in private equity, it raises a number of important questions.
First up for consideration is "internal rate of return" (IRR), which is still the standard for performance reporting in the industry, even though it has been "widely discredited." Why does that discrepancy persist? Chiefly because IRR makes performance look better than it really is. The paper goes into a fair amount of detail about alternate metrics.
It also examines the decline in the relative and absolute performance of private equity over time – and an erosion in the historical persistence of performance that remains widely expected by investors today – and poses questions about what kind of performance should be expected from private equity (versus public equity) given its risks.
The authors not only think that private equity has not been the portfolio blessing that most think it has been, but that the conditions today argue for headwinds rather than tailwinds going forward. Since CEPR is described as a "progressive" think tank, you might take the paper as an attack on greedy capitalists, but, as it indicates, the statements of private equity executives and the dismal performance of their stocks show that caution is warranted, even as investors pour money into the private equity coffers.
(For more on private equity, you can check out the working paper "Public Fund Governance and Private Fund Fees," by Paul Rose. Among public pension plans, are "high and hidden private fund fees . . . a deception by private funds on unsuspecting pension funds," or "a result of poor governance by state legislators and pension funds themselves"?)
I've previously referenced the innovative approach of Girard Miller, the chief investment officer of the Orange County Employees Retirement System (OCERS). He's at it again, having issued a "preliminary and exploratory" request for proposal for a "strategic and risk advisor." (Here's the article about it from Chief Investment Officer.)
OCERS already has four different consultants and other asset owners have multiple ones, but this seems a bit different. As the RFP said, "the OCERS investment committee developed an interest in exploring the feasibility of a secondary or conferring investment advisor to provide a 'second opinion' and 'system oversight' function."
Since much of my consulting work falls into the "second opinion" category, you might assume that I think this is a good idea (and you'd be right). Organizations have a difficult time seeing what they aren't built to see. The assignment of internal devil's advocates and other tactics are helpful, but they are rarely as productive as an outside pair of eyes. The challenge for OCERS, if it decides to implement the idea, will be to do it in a way that the independent view stays distinct from the internal view over time.
Here are some questions you might ask at your next meeting:
~ How would we answer the questions in the State Street survey? What are our expectations?
~ Is our defined contribution plan designed in the best interests of the plan participants?
~ Are we evaluating private equity in the right way? What are its prospects for the next ten years?
~ Could we use a second opinion?
Other links of interest
~ "The Big Disconnect in the Pension Industry," Norman Mogil, Sober Look.
~ New talent tenions in an era of lower investment returns," McKinsey & Company.
~ "Top Six Tips for an Effective Investment Committee," Scott Middleton, Innovest.
~ "Exploring ESG: A Practitioner's Perspective," BlackRock.
~ "Political Cognitive Biases Effects on Fund Managers' Performance," Marian Moszoro and Michael Bykhovsky, SSRN.
~ "Program Related Investments Highs + Lows," top1000funds.
And, from me:
~ What is a high conviction manager anyway? (Also, a piece from S&P Dow Jones Indices on the same topic.)
~ Why asset classification schemes are more important than you think for asset owners and managers.
~ Some thoughts about karma and dogma in the investing world.
Many happy total returns,
Tom Brakke, CFA