“Information is the resolution of uncertainty.” Information Theorist and MIT Professor, Claude Shannon
In a world filled with texts, tweets, emails, blogs, voicemails, podcasts, not to mention actual in-person meetings, how can investment committees ensure they are effectively utilizing these sources of information to improve their long-term investment outcomes? Throughout this paper, we will explore ways in which committees can leverage and streamline the plethora of information they receive, focus their discussions and decisions, and hopefully, improve their returns to support the long-term missions of their institutions.
While serving on a panel at the Philadelphia CFA Society Endowment and Foundation Conference, I heard a telling comment from the trustee of a major participating institution. The trustee noted that it was difficult for him to know when, and if, the institution was on track to meet or exceed its long-term investment goals. The number of asset classes, managers and vehicle types in the portfolio had become so complex that it made him long for the days of a simple stock and bond portfolio. He had the utmost confidence in the diversified portfolio that he and his fellow trustees had created, but the manner in which he reviewed the data, and even the data itself, made it hard for the committee to focus their attention and decision making.
While the investment industry has spent decades improving reporting and communications practices, the improvements have led to a litany of statistical data points being made available to investors without always focusing on the real value of these additional pieces of information. Reporting packages have literally taken on a life of their own with hundreds of pages now available to slice and dice the data from the portfolio. The unfortunate consequence is that most committees are now inundated with performance and portfolio allocation information that could be submitted as a doctoral thesis rather than a foundation or endowment’s investment review.
To compound the problem, the average investment committee has a finite number of opportunities to gather each year to review the portfolio and make decisions. These groups could certainly meet more than the average four times per annum, but the reality is that most committee members are busy community leaders with limited additional capacity for further engagement on any one board. Thus, it is even more critical to spend their valuable time measuring areas of importance.
Michael Mauboussin, in a 2009 report for Legg Mason, characterized this process as focusing on the Important Unknowables. In other words, spend the most time on your process and considering the implications of items such as greater volatility in the portfolio and long term asset class trends rather than the “little time” on the Unimportant Knowables such as whether GDP data for the fourth quarter of 2012 was revised downward by 0.1% in the most recent release. This concept seems straightforward, but you would be surprised by the time allocated to such topics in investment committee meetings. If this scenario is now unfolding on your committee or board, how can you develop a better process that still allows the group to glean investment insights, but does not create information overload?
Don't Set It and Forget It
As the proud father of three little girls under the age of 8, my wife and I are often up in the middle of the night for a random cough, the need for water or the occasional thunderstorm. At some point during these early morning adventures, I found myself watching an infomercial by the esteemed Ron Popeil, the king of all infomercials and the genius behind such products as the pocket fisherman and the Chop-O-Matic. In the infomercial, Popeil showcased the Showtime Rotisserie, whose tag-line is “set it and forget it”. While this concept may work for roasting a chicken, it does not meet best practices of fiduciary behavior for an investment committee.
To change the set it and forget it mindset, the committee should set aside greater time to think about prospective returns rather than historical returns. This is not to say that committees should ignore the recent portfolio returns and allocations. Instead, they should allocate a greater percentage of their time to improving the long-term investment strategy of the organization through the development and review of the appropriate targets and ranges for the strategic allocations in the investment policy statement.
These targets and ranges will guide the group over time and allow the committee to focus more broadly on where the portfolio should be going rather than where it has been. The review process coupled with the use of expected return and volatility simulations for the portfolio will generate even greater understanding by the committee. In addition, the process gives the committee’s investment advisor or consultant the requisite flexibility and accountability to make decisions on the committee’s behalf within the specified guidelines.
Accountability is a fundamental aspect of improving outcomes. By clearly defining who is accountable for all decisions made in the portfolio, the committee can then consider attribution analysis pertaining to the three elements of return generation: strategic asset allocation, tactical asset allocation, and implementation.
The attribution analysis should include specific information to answer questions such as those outlined below:
- Strategic Asset Allocation – When strategic target allocations and ranges to emerging market bonds and hedge funds were added to the portfolio, what was the impact?
- Tactical Asset Allocation - When the advisor lowered exposure to MSCI EAFE two years ago, was it a positive or negative impact?
- Implementation - When the advisor hired XYZ Manager to manage fixed income mandates to replace another fixed income manager, was it beneficial?
This attribution information will reinforce the value proposition of the advisor or the consultant, and allow the committee to stay focused on the broader implications for spending and investment policy.
Primary and Secondary Benchmarks
The final ingredient in improving investment outcomes is the establishment and monitoring of relevant benchmarks. These are typically referred to as primary or policy benchmarks and/or secondary or relative benchmarks. These benchmarks are critical to understanding the trend of performance and how the portfolio is tracking to long-term targets rather than overly emphasizing the most recent monthly or quarterly data, i.e. too great a focus on the small cap value manager that makes up less than 2% of the total portfolio. For example, a straight-forward 70% S&P 500 and 30% Barclays Aggregate portfolio has underperformed an absolute return policy benchmark of CPI + 5%1 in the past decade, but the same portfolio well outperformed the absolute return benchmark from 1982-2001 (see chart below). Bottom line, an absolute return policy benchmark is valid, but may require a long market cycle to achieve.
Investment committees continue to struggle with the right process to ensure the long-term success of their investment programs in a market environment that has no easy solutions. Nevertheless, committees must continue to find ways to improve their processes, and ultimately, their outcomes and to focus on the long-term. As the protagonist, Jesse Livermore, states in Edwin Lefèvre’s classic investment novel, Reminiscences of a Stock Operator, “Throughout all my years of investing, I’ve found that the big money was never made in the buying or the selling. The big money was always made in the waiting.”