The Prudent Fiduciary Digest
February 17, 2016
This is only the second edition of this newsletter in four months. I haven't forgotten about you and good material to read is still being produced, but I've been out of commission for a time.
2016 has started off with a dose of volatility, so there is no shortage of market commentary around (much of it not really explaining why the previous market commentary didn't envision what's happening). None of that here, just some readings on the basics: long-term investing principles, governance, investment costs, and those RFPs we love to hate.
Previous editions of this newsletter have featured items on the importance of (and difficulty of) maintaining a long-term perspective amid the noise of the markets and the focus on short-term metrics. But I missed a good source of information that was released about a year ago.
Issued under the banner of "Focusing Capital on the Long Term," and developed by the Canada Pension Plan Investment Board and McKinsey, the white paper is called "Long-Term Portfolio Guide." The introduction (page 4) sets out "five core action areas for institutional investors": investment beliefs, risk appetite statements, benchmarking processes, evaluations and incentives, and investment mandates. The guiding principles (page 6) provide a tidy overview of the authors' views of what long-term investing is all about.
Each of the action areas is explored in depth, serving as a useful guide for a fiduciary analyzing an organization's approach. For example, the investment mandates section provides a nice overview of considerations for relationships with outside managers.
Reading through the paper, the differences between the proposals and accepted practice jump out at you. For example, it recommends that "asset managers consider how to deliver sufficient long-term absolute returns, not simply benchmark-relative management approaches. In doing so, asset managers will need the flexibility to increase cash holdings to a significant percentage of the portfolio when market pricing is unduly high and return expectations are depressed." That is a very long way from how things are done today.
Governance and best practices
NEPC's has released a summary titled "Governance: The Cornerstone of Successful Investment Programs." It provides a brief look at some of the basics of governance, as well as context from its survey of practices at foundations and endowments. Check out the self-assessment questions in Exhibit 6; simple but important.
"Fiduciary Primer: Best practices for managing an investment pool," from Pavilion Advisory Group, is a longer paper, broken down into topical sections of a few pages each. They are straightforward and helpful. See also the appendix; it is a glossary of investment terms worth knowing.
(Speaking of primers, I always recommend that new trustees read the monograph from the CFA Institute Research Foundation.)
The cost of investment management
Good information on the cost of investment management – the true, all-in cost – is woefully hard to come by. Commonfund Institute has taken a step in the direction of shining more light on this area with its paper, "Understanding the Cost of Investment Management: A Guide for Fiduciaries."
As stated in the piece, "The fiduciary duty to understand and manage costs is embodied not only in common law principles but also in statutory law." Yet the main takeaways for me when reading were how much fiduciaries underestimate the total cost load and how incomplete (and low) survey results about total expenses are in comparison to reality.
Commonfund provides a nice overview of the different kinds of costs, but the nagging sense is that there is a lot of "fee alpha" to be captured by those who are more aggressive about gaining transparency throughout the chain of costs.
In an earlier edition of this newsletter, I wrote about the guidance for investment providers that had been circulated by Girard Miller, CIO of Orange County Employees Retirement System (OCERS). I ended my comments with, "The answer: Tell them what you want. (You're the client.)"
Miller made news again recently with the issuance of a request for proposal (RFP) for a general investment consultant for OCERS. In an article, Chief Investment Officer called it "the RFP from hell." CIO said it's "bold, experimental, strikingly candid, and throws peer risk to the wind."
You might want to download the RFP from OCERS before it disappears from the website, so that you have it for future reference. It might help you think about how you approach the RFP process.
RFPs have been on my mind anyway, since in November I created one in which I tried to do what Miller does, get the basic information but also ask some unorthodox questions that force providers off of their routine game. Specifically, I like to pose ones for which it's not immediately obvious what a "good" answer might be. I find those open up productive areas for future due diligence.
Has OCERS gone too far? Not at all. Most RFPs have gotten stale and predictable, serving as vehicles for documentation rather than portals for discovery. Miller is leading the pack again.
Here are some questions that you might ask at your next meeting:
~ Does our approach foster long-term investing? Where should we start if we want to make changes?
~ Are there weaknesses in our governance structure? Which of the major building blocks of our investment approach needs the most work?
~ How well do we understand the total costs of our investment management program, both internal and external?
~ Do our RFPs give us the kind of information that we need or are the answers routine and not really that helpful? Are we approaching the process in the right way?
Other links of interest
~ "Even God Would Get Fired as an Active Investor," Wesley Gray, Alpha Architect.
~ "Organizational Alpha," Ben Carlson, A Wealth of Common Sense.
~ "Agecroft Partners’ Top 10 Hedge Fund Industry Trends for 2016," Donald Steinbrugge, Hedge Think.
~ "Risks and Opportunities From the Changing Climate: Playbook for the Truly Long-Term Investor," Cambridge Associates.
~ "The Gordon Gekko Effect: The Role of Culture in the Financial Industry," Andrew Lo, via MIT.
~ "Future Alignment Trumps Past Performance," Ashby Monk, Institutional Investor.
Many happy total returns,
Tom Brakke, CFA