The Prudent Fiduciary Digest
December 10, 2014
As we near the end of the year, I'd like to thank you for reading and for passing this newsletter along to others.
While it is written for the investment committees, governing boards, and staff members of institutional asset owners, the topics tend to be of interest to a wide range of readers, including asset managers, consultants, and investment advisors.
If you have any feedback (or an idea for inclusion in an upcoming issue), please send me an email.
I appreciate your support. On to the readings.
Are we too short-term in our approach to investing? That's the subject of a new paper by Michael Mauboussin and Dan Callahan of Credit Suisse, "A Long Look at Short-Termism: Questioning the Premise." Mauboussin (one of five writers I cited in Letters to a Young Analyst as being "consistently good in terms of the quality of the material, the quality of the writing, and the importance of the issues addressed") and Callahan tie together theory and practice, with great historical context and tons of citations for further exploration.
As indicated by the title, the authors question the premise that we are much more short-term in orientation than we used to be, observing three interdependent constituencies (asset owners, investment managers, and companies). Given the scope, there is no one "bottom line," although I'd say that the evidence presented reinforces the need for asset owners to reconsider the issue of time horizon, especially as it relates to manager selection and evaluation.
Certainly there are principal-agent problems that can harm asset owners, but "poor behavior can run in two directions. Investment managers may do things that are not best for their investors, but investors also do things that hamper the investment manager's ability to take a long-term view." Chief among them is having an evaluation period that feels right but in practice is counterproductive.
The authors offer some recommendations for each of the three constituencies For example, asset owners should "understand reversion toward the mean" and "recognize the value of inactivity," remembering always that "your behaviors influence your return."
If you want to delve still deeper into the topic, check out "Long-Term Investing: What Determines the Investment Horizon?" It's the first of three papers by Geoff Warren of the Centre for International Finance and Regulation (available on SSRN), which lists twelve "influences on the investment horizon" and examines various definitions of what it means to be "long-term." Warren's preferred one: "Iong-term investors are perhaps best characterized as those who set their sights on the generation of value and returns over the passage of time, backed by considerable discretion over when they trade."
As a complement to the section of the Credit Suisse paper regarding manager evaluation and selection, you should read the excellent short report by John West of Research Affiliates, "Hiring Good Managers is Hard? Ha! Try Keeping Them!" It covers some of the same ground, but it is pitch perfect in describing the behavioral impulses of those who evaluate managers.
Even the best managers go through periods of underperformance. However, with unrealistic expectations and evaluations which are dominated by performance (even though we say they aren't), "chances are we won't stick with them" over time.
A watch list seems like a good idea, but it can trigger bad behavior. The "virtually continuous loop of performance measurement" leads to pressure to do something. After all, "a hard number . . . has enormously persuasive power." That leads to a cycle that is all too familiar: "measure, watch, terminate, hire another likely candidate, repeat."
Evaluating the story
To get beyond the numbers, asset owners need to be able to assess the stories that they are told by asset managers. In the reading from Mauboussin and Callahan, managers are urged to "make sure your behavior is congruent with your process." Why? "In communicating their process to clients, investment managers generally dwell on what they aspire to do rather than what actually happens."
If that's the case, then asset owners should focus on changing the debate. Part of that is understanding the nature of the messages that are coming your way, how managers are positioning themselves. In that regard, you should read a posting from DeSantis Breindel, "Do All Investment Managers Tell the Same Story? How Brand Differentiation Drives Growth."
If you've been in a room while, one after another, a number of asset managers vie for a spot to manage a part of an institutional portfolio, you know how hard it can be for them to differentiate themselves. It's important for them to create a narrative. As I wrote recently, an asset owner is responsible for cracking the narrative open to see what's really there.
Improving the organization
Dealing with any of these issues requires thoughtful organizational design. If you're not set up in a way that leads to effective decision making, you probably won't make much progress, even if your heart and head are in the right place.
Therefore, I periodically include links in these newsletters to materials that can aid you in assessing your organization and processes. Here are some for your consideration:
~ "Making Dumb Groups Smarter," Cass Sunstein and Reid Hastie, Harvard Business Review. This is one of the best articles that I've read about group decision making in quite a while. (I wrote a posting about it if you want more perspective.)
~ "Strive for the Best: Building and Maintaining an Excellent Board," Commonfund. (Also from that organization, a paper on assessing a board's risk tolerance.)
~ "Fiduciary Responsibilities of Investment Committees," Fund Evaluation Group.
~ "Improving Governance Under an OCIO Structure," NEPC.
Here are some questions you might ask at your next meeting:
~ Do we take a long-term view? What impediments do we have to doing so?
~ Do we give managers the time that they need to add value, or are we in a unnatural rush to "perform"?
~ How well do we evaluate the stories that we are told about how investment managers are operating on our behalf?
~ Is it time to rethink our organizational design? What's working and what's not?
Here are a few additional items that you might have an interest in:
~ "The Folklore of Finance," State Street Center for Applied Research.
~ "17 Signs You Were a CIO in 2014," Chief Investment Officer.
~ "Manual High Teacher Sues Kentucky Teachers' Retirement System Over Underfunding," WFPL News. See also this update to the story.
~ "Big Ideas from Small Hedge Fund Managers," Institutional Investor. As if you needed any more evidence, look at another crazy way managers are evaluated.
~ "Five Issues Fundsters and Fund Boards Will Worry About In 2015," MutualFundWire. All of them are relevant to institutional asset owners.
~ "A Skeptic's View of Today's Religion," Angelo Calvello, Chief Investment Officer. (My rebuttal, on Freezing Assets, the editorial blog of CFA Society Minnesota.)
Many happy total returns,
Tom Brakke, CFA