The argument of active v. passive focuses on how the building blocks (asset classes) of the portfolio are constructed. However, we know from the Brinson study that the primary driver of the investor’s eventual performance is the relative weighting of the asset classes the investment manager selects, not whether those asset classes were actively or passively constructed.
The affirmative decision to allocate capital among the available asset classes ought to be the reserved exclusively for the investment manager, and it is this decision which drives the ultimate performance of the portfolio. The manager’s allocation to stocks v. bonds, large cap v. small cap, growth v. value, etc. are the primary determinants of portfolio performance, NOT whether those allocation decisions are implemented using an active v. passive approach. An investment manager could build a “bad” portfolio using only passive products in the same way a manager could build a “good” portfolio using actively managed products. (Good and bad in the prior sentence is defined by the risk and return characteristics of the portfolio over an extended holding period.)
Many investment managers spend too much time debating the relative merits or deficiencies of active vs. passive management and spend almost no time establishing key performance indicators to measure the strategic and tactical allocation decisions they are making irrespective of whether they abide by an active v. passive approach. If 90% of the results will flow from the investment manager’s strategic and tactical allocation decisions, shouldn’t the effort be placed on measuring the effect of these decisions rather than whether the investment manager uses active or passive building blocks in their implementation?
If the capital owner is a trustee for someone else’s money (individual trustee, ERISA trustee, endowment trustee, or business manager) this practice of establishing several key performance indicators for the investment manager’s strategic and tactical allocation decisions is central to their fiduciary duties.
Following is a link to a white paper that explains these benchmarking best practices.
Link to Benchmarking White Paper
Josh Yager | Portfolio PI
At Anodos, we help our clients answer the question, “Is my investment manager doing a good job?” Many of our clients are individual trustees, business managers, ERISA trustees and endowment board members who are obligated to independently monitor the activities of the agents to whom investment duties have been delegated. What makes us unique is this is all we do. We don’t manage money, sell insurance, or accept referral fees. We don’t have a horse in the race.
The Problem: You are a business manager(1), and it is either explicitly or implicitly the case that you are responsible for monitoring the activities of the investment managers that have been entrusted with your clients’ capital. (If you are not a business manager or disagree with this statement, stop reading. This paper does not apply to you.) The problem is that most business managers don’t have the internal systems, licensure, training, staff support, or time to conduct the independent monitoring functions that their clients expect and the law requires(2).
The Way It Is: In response to this problem, many business managers rely on the current money managers to evaluate their own investment acumen. These self evaluations produce predictable results. The incumbent managers typically report, “We did great! We are above average!” Looking for a more objective analysis, business managers frequently ask a competing money manager to review the portfolio designed by the current money manager. Again this “peer review” has predictable results; the competing money manager reports that the incumbent manager is a knucklehead and that the Business Manager should fire the incumbent manager and higher the candidate manager because they are “above average.”
The Way It Should Be: It should be easy to answer the question, “Is my client’s investment manager doing a good job?” And it is easy if the business manager takes the time to define what the job is that the investment manager is being hired to do. Good investment governance begins with the business manager helping their client document the outcomes that the investment manager is being hired to accomplish. Not only should the job description include the financial objectives being pursued, but also the parameters or investment principles that the client holds. This job description will include, at a minimum, the client’s targeted rate of return, the anticipated contribution & distribution rate from the portfolio, the agreed upon fee to be paid to the investment manager, the maximum allocation to illiquid investments, a policy regarding the minimum amount to be allocated to a capital reserve (a “bond bunker” made up of short-term, investment-grade bonds), and how frequently and by which party independent monitoring and review will be conducted.
Your Job v. Their Job: Once the “Job Description” has been approved by the client and delivered to the investment manager it is important that the business manager’s role be constrained to monitoring the actual results versus the documented objectives. Too many business managers are willing to accept responsibility for strategic and tactical portfolio decisions which are beyond their contractual responsibility, legal authority, or licensure. It is reasonable for the business manager to have an opinion that their client relies upon, but if the business manager does not have the legal authority to do so, their personal views should not dictate policy. The allocation, strategy, and tactics are the investment manager’s responsibility, though they must remain consistent with the “Job Description” that has been given to them. The business manager’s job is to be the arbiter of whether the investment manager’s recommendations stay within these defined bounds. If the business manager confuses their job (monitoring and reporting) with the investment manager’s job (investment allocation and tactics), the business manager opens the door for a charge by the investment manager that “the business manager told me to do it this way. It’s not my fault that things went badly.” The investment managers have and will continue to make this claim under oath because in most cases it is true.
The Portfolio Audit: A truly objective portfolio audit is designed to compare the actual outcome produced by the investment manager’s decisions against a series of predefined objectives and key performance indicators. To preserve the independence and objectivity of the review process, the auditor must be disqualified from ever managing the portfolio that is being audited. The auditor should also have a depth of experience and training to conduct such an audit. Knowing how to manage money and knowing how to conduct a portfolio audit are close disciplines, but they are not the same. There are five central questions that any portfolio audit should answer:
- Is this portfolio likely to accomplish the desired objective?
- Is the return that was realized appropriate given the risk taken?
- Is the portfolio reasonably diversified?
- Is the advisory fee fair given the portfolio size and objectives being pursued?
- Are there any operational risks with the investment manager or their company?
The Admonition: That’s how to watch the hen house. Go and do likewise.
Anodos helps clients answer the question, “Is my investment manager doing a good job?” Many of our clients are individual trustees, business managers, ERISA trustees and endowment board members who are obligated to independently monitor the activities of the agents to whom investment duties have been delegated. What makes us unique is this is all we do. We don’t manage money, sell insurance or accept referral fees. We don’t have a horse in the race.
(1) Typically a hybrid accounting practice providing a variety of related service (accounting, audit, bookkeeping, investment oversight, royalty audit, financial project management, et cetera) for high net worth clients typically in the entertainment, sport, or other creative performing arts industries.
(2) CalProbate Codes 16052(a)(i,ii,iii) re prudent selection, delegation and monitoring of investment advisory functions.
Do “big investors” have better investment results than “small investors”? Many business managers expect that their wealthy clients with large portfolios ($25m+) should have better returns because the clients have access to the best and brightest members of the investment industrial complex. Many business managers believe that size does matter.
Based on our experience of doing investment manager audits since 2005 for portfolios as small as a few hundred thousand dollars to mega pension plans exceeding $20b, the size of the portfolio is not a contributing factor in the portfolio’s risk and return outcome. To be sure, larger investors do have access to esoteric, non-correlated, alternative investment products. But these more exotic investment options that are only available to “qualified” investors add complexity, cost, and opacity to the investment process which smaller investors are not burdened by. Given a similar asset allocation, we have not observed that the risk and return outcomes of large portfolios are better than the retail investment options available to investors of more modest size. In short, size does NOT appear to matter.
If you disbelieve our observation, simply test the performance of your largest client’s portfolio against the return produced by the Vanguard Lifestrategy Moderate Growth mutual fund (VSMGX) which has a globally diversified 60% equity and 40% bond allocation and requires a minimum investment of only $3,000. If the best and brightest minds in the investment industry can’t outperform this retail mutual fund that is designed for investors who are just starting out, it puts into question the assumption that size matters. (If your largest client’s portfolio is more conservative than a 60% equity and 40% bond allocation, you can instead use the Vanguard Lifestrategy Conservative Growth fund (VSCGX) which has a 40/60 allocation.)
I am not arguing that business managers rush off and recommend that their clients fire their investment managers and move all their money to Vanguard funds or a model portfolio from Betterment. I merely suggest that a prudent business manager will test the thesis that the investment industrial complex purports–that the big guys do better than the little guys. Trust, but verify.
The Problem: You are a business manager and it is either explicitly or implicitly the case that you are responsible for monitoring the activities of the investment managers that have been entrusted with your clients’ capital. (If you are not a business manager or disagree with this statement, stop reading. This paper does not apply to you.) The problem is that most business managers do not have the internal systems, licensure, training, staff support, or time to conduct the independent monitoring functions that their clients expect of them and the law requires.
The Bogert treatise states that a fiduciary “…cannot assume that if investments are legal and proper for retention at the beginning of the [relationship], or when purchased, they will remain so indefinitely. Rather, the [fiduciary] must systematically consider all the investments of the [portfolio] at regular intervals to ensure that they are appropriate” (A. Hess, G. Bogert, & G. Bogert, Law of Trusts and Trustees §684, pp.145–146 (3d ed. 2009)). If a business manager is a fiduciary acting on behalf of their client, part of that responsibility includes an ongoing investment review process that monitors the risk and return that was produced by the client’s investment manager. A prudent business manager will not “set it and forget it.”
The Target Return
The investment manager’s actual performance will initially be compared to a targeted rate of return that the manager was hired to produce. This begs the question whether the business manager and their client have taken steps to define a targeted rate of return for the portfolio. If they have not, they are encouraged to do so. The Target Return can be expressed as an an absolute number (e.g., 6.0%) or as a real, inflation-adjusted number (e.g., Inflation + 3.0%).
No single benchmark can precisely measure the acumen or shortcomings of the investment manager. The most prudent approach is to compare the risk and return of the actual portfolio against several key performance indicators to judge whether the client’s investment objectives are being accomplished. It is rare that a benchmarking study would ever conclusively prove that the manager was either exceptional or incompetent. More often, such a study would conclude that the manager’s performance was or was not within a reasonable range of return and risk outcomes. Common benchmarks that are used in a benchmarking study are: 1) the benchmark suggested by the investment manager; 2) a Strategic benchmark which only includes the major asset classes; 3) a Tactical benchmark that is designed to exactly match the sub-asset class allocation of the actual portfolio; and 4) a Peer Group benchmark.
The Quantitative Risks
In addition to measuring the manager’s performance against several benchmarks, there must be an evaluation of the risk that has been accepted by each manager. Some forms of risk can be discovered through statistical analysis. Often used statistical risk measures include Standard Deviation, Value-at-Risk, Beta, Sharpe Ratio, M-Squared, et cetera. This type of analysis for a marketable portfolio can be easily done by the software the current investment manager has access to. (If they cannot do this analysis it should put doubt in their ability to balance risk and return since they are not able to monitor the risk of the portfolio.)
The Qualitative Risks
Other types of risk that cannot be deduced from statistical inquiry and require a more subjective analysis.
- Lack of Liquidity: The % of the portfolio that cannot be liquidated within 5 business days.
- Concentration: The % of the portfolio held in the single largest security.
- Leverage: The % of leverage used within the portfolio as reflected in a debt-to-equity ratio.
- Lack of Valuation: The % of the portfolio assets that do not have daily valuation.
Get help. Most investment managers, if provided with this overview, can help the business manager create a record that these factors have been considered and documented. If the investment manager is unable to help develop such a record, a prudent business manager will take steps to independently evaluate these factors or find an investment manager that is willing and able to do so.
For several decades, the investment industry has promoted the virtues of hedge funds and private equity funds for large instructional investors and ultra high net worth individuals. But over the last few years these products have come under increased scrutiny because the hoped-for benefits have, for the most part, not materialized. A report in April of 2017 by the PEW Charitable Trust reported that the shift toward more complex investment vehicles over the last two decades increased management fees by nearly 30% but did not result in a higher success rate for the portfolio that included these alternative investments. According the PEW report, only 2 of the 73 funds included in the study accomplished the targeted return for their portfolio. There is evidence to suggest that any gross of fee benefit being capture by these esoteric investments is eroded by the high fees being charged to access these products.
Large, sophisticated investors are abandoning their allocation to hedge funds in record numbers. The CEO of CalPERS, the single largest pool of investment assets in the U.S., noted in her 2015 year-end report, “As part of our ongoing efforts to reduce complexity and cost in our investment program, we eliminated the hedge fund program from our portfolio…” The New York Times reported on October 20, 2016, “[T]he Kentucky Retirement Systems voted to exit hedge funds over the next three years. The New Jersey State Investment Council also announced plans this month to pull nearly $2 billion from 11 hedge funds. MetLife, the New York City employee pension and the American International Group have recently started asking hedge funds for their money back, too.”
Not only have hedge funds come under fire, but increased scrutiny is being focused on the private equity asset class as well. The Wall Street Journal reported on April 16, 2017, “CalPERS is sick of paying too much for private equity. The fund’s private-equity returns were 12.3% over the last 20 years, but they would have been 19.3% without fees and costs.” An article published in the Financial Analysts Journal in the summer of 2016 studied the performance of private equity funds compared to small cap publicly traded stocks. The study found that the return from the private equity asset class between 1986 and 2014 did not significantly exceed an equivalently-levered investment in small cap stocks (FAJ Vol. 72, Issue 4, July/Aug 2016, pp 36-48.) An earlier study published in the FAJ in 2012 concluded that private equity funds do have a relatively low market beta, but the authors could find no evidence for their out-performance against small cap stock The authors noted, “We find that self-reported net asset values significantly overstate fund values for mature and inactive funds” (FAJ Volume 47, Issue 3 June 2012, pp. 511-535).
Governance for Alternative Investments
Anodos advocates neither for nor against the use of alternative investments in one’s portfolio. Rather, we encourage that when these high cost, illiquid and non-transparent products are included in the portfolio, a defined governance process should be established. It is critical to define what the maximum allocation to these alternative assets will be, how the claims of their promoters will be tested and how the risk and return performance of these products will be measured.