The Prudent Fiduciary Digest #35

The Prudent Fiduciary Digest

October 23, 2015

An interesting mix of readings for you – enjoy!

Attacking the agency problem

When I started reviewing the paper, "Long-Term Investing as an Agency Problem," by David Neal and Geoff Warren, I realized I was underlining almost every sentence. You should read it.

I have linked to many articles about principal-agent problems and the tendency toward short-term thinking/actions. This one expresses the issues as well as I've ever seen. It's straightforward and not too long.

The authors briefly mention the "public benefits" of correcting the agency problems that plague our financial system, but the focus is on the "private benefits" to an organization that can buck industry conventions. It starts with the recognition that evaluating and compensating agents on short-term performance is a flawed system if the goal is to deliver absolute returns over time. The "long chain of delegations" has failed its intended purpose.

The paper identifies four key problems that we face and offers some specific solutions. It is required reading for those who are frustrated with the way the game is played and who want to design better ways of helping asset owners meet their real fiduciary obligations.

Economic regimes

The popular notion is that the performance of financial markets is a good reflection of the economic environment. However, those of us involved with investments know that "connecting economic fundamentals with asset returns proves to be a difficult task."

Despite that, Meketa Investment Group has trademarked the term "Economic Regime Management" and has issued the first of three papers under that title, with the stated goal of providing insights for long-term investors who are trying to close the analytical gap between economic conditions and market behavior.

For starters, Meketa notes that "real-time data is often not the same as the historical data," because of lags in reporting and frequent revisions of data. It then focuses on expectations and surprises: the market response to a change in economic fundamentals depends on whether it had been expected, so "high" and "low" in a historic context probably means less than you think, while whether something was "in the market" or not matters a great deal. The degree of uncertainty (judged by the range of expectations for a certain variable) is also a critical factor.

Using those concepts, Meketa evaluates changes in four measures: growth, inflation, interest rates, and systemic risk. The report includes a number of interesting graphics (in particular, see the one on page nine that shows the sensitivities of various asset classes to changes economic events). It's a good first step in explaining complex issues, including why we tend to be surprised by non-normal and seemingly off-kilter returns that don't match with our sense of the economic world.

Quarterly reports

Another quarter has come and gone (an exciting one at that), so now we are in a period of information transfer – and, let's be honest, narrative extension. However, communicating effectively is a challenge for many in the investment world.

Part of it is the routine. If you are responsible for producing investment materials, it's hard to both cover the information that's expected of you and to make it interesting on a consistent basis. (Check out some of the recommendations in this piece; it's aimed at asset managers and advisors, but applies to others as well.)

If you're on an investment committee with a portfolio of much size and complexity, you receive reports with scores or even hundreds of pages of information from consultants, asset managers, custodians, and/or internal investment staff. It's easy to get lost in it, especially at meetings when time is precious and there are a few strategic things that are of most importance.

I was struck by a 2013 posting from Sellwood Consulting that said, "We create shorter books not because we can’t produce the longer ones, but because they are more valuable to our clients." I don't know whether that firm is good at meeting that goal, but I do believe it is the right goal to have.

Most reports have too much information and aren't clearly organized. If you are responsible for producing them, it's worth the effort to make them better; if you receive them, help your providers and yourself by giving them feedback about what works and what doesn't.

Constructing equity portfolios

Cambridge recently issued a report, "Constructing Superior Equity Portfolios." It looks at the performance of a "donut" structure of high conviction asset managers versus a "core-satellite" structure that employs active and passive vehicles. As you can probably tell from the title, the firm likes what it sees in the former.

Any study like this comes with caveats, including the survivorship bias referenced by Cambridge. Its goal was to use a long time horizon, diversify the managers by style and capitalization, and select those with high active share. It believes that the distribution of returns (see the chart on page 18) is attractive, without causing higher volatility.

And here is an important perspective if you are wondering what to do with individual managers that have underperformed for a time: "the single best portfolio of the ten thousand we ran spent more than half of the 17-year period with one or more managers below the benchmark by at least 200 bps – and this is a portfolio that nearly doubled the index return over time."

Questions

Here are some questions that you might ask at your next meeting:

~ Can we change what we do to align our organizations (and those of our agents) in ways that help us to meet our stated goals?

~ Do we talk about the relationship between the economy and the markets without sufficient data to back up our assumptions? Should we be changing how we assess the connections?

~ Do the reports that we use help us to deal with the major issues that we face or distract us from doing so?

~ What is the intent of the overall equity strategy that we employ?