The Prudent Fiduciary Digest #42

The Prudent Fiduciary Digest

November 4, 2016

In the last issue, I mentioned that I'd be holding my first public due diligence and manager selection workshop in November. Unfortunately, it had to be postponed until spring. If you'd like to get an early notice of its announcement (spots will be limited), please sign up to get my due diligence newsletter.

On to the readings.

Active versus passive

The active versus passive debate has boiled over in the last few months, no doubt spurred on by the continuing large outflows from active strategies in favor of passive.

On one side, there are the active asset managers themselves, who as a class have been underperforming for quite a period of time. They have a lot on the line, given the high profit margins that have been the norm for the industry.

Many of them are producing studies that show why their particular brand of asset management is attractive. As examples, see items from Capital Group and Fidelity. Alliance Bernstein's research unit even penned a report entitled "The Silent Road to Serfdom: Why Passive Investing is Worse the Marxism." The title was deceptive, however, in that the piece was about the societal effects of too much passive investment (essentially resulting in subpar capital allocation) rather than the wisdom of any particular investor choosing a passive approach over an active one.

But the outspoken views of active managers can barely be heard above the drumbeat of opinions proclaiming their imminent decline. For instance, the Wall Street Journal came out with a large grouping of articles, "The Passivists: A series exploring the rise of passive investing." While active investing still dominates the landscape, it is definitely losing the PR battle – and the hearts and minds of many investors.

A couple of things to consider:

~ Can the apparent failings of active management be addressed to improve its practice as we know it? Consider, for example, the ideas put forth in an interview with Tom Howard in Enterprising Investor. He thinks that the structure of asset manager relationships is flawed, leading managers to build bloated strategies with portfolio drag and asset owners to make repeated choices that destroy value over time.

~ There is a cyclicality to the performance of passive versus active strategies. The Leuthold Group published a study in July that looked at the indicators of relative performance between the two. The six strongest indicators all were in favor of passive at the time the study was done. But you can be assured that that will change.

The challenge for fiduciaries is charting a course for the long term amidst all of the shouting about what is "best" based upon a look in the rear-view mirror.

Pension plans

Vanguard has issued a paper on "Best practices for plan fiduciaries." It covers a lot of ground but is quite readable, dealing with a variety of issues of importance to defined benefit and defined contribution plan sponsors. Areas covered include fiduciary duties and best practices, the organization of committees, investment selection, etc. While written for a pension plan audience, much of the paper applies to other kinds of organizations as well.

Given the number of legal challenges to defined contribution plans and the onset of the Labor Department's fiduciary rule, you can expect to see a big increase in fund reviews. Costs will be a big factor in such reviews (see information from Vanguard and NEPC that might be of help to you in that regard), but you also need to think about the overall process that you and your consultants/advisors employ when selecting managers and strategies. (Send me a note if you have some questions along those lines.)

Capacity management

The Centre for Internal Finance and Regulation (CIFR) has issued two papers on the important but chronically-overlooked topic of capacity management. Yes, managers get asked what their capacity (for assets under management) is and an answer is provided, but what does it really mean (and is it just marketing)?

The first of the two, "Evaluating Fund Capacity: Issues and Methods," looks at "the size that a fund might attain before it becomes unable to create additional value for investors." Sections discuss the definition of capacity (is the definition being used one that's favorable to you as an asset owner, or one that's not in your best interest?), ten drivers of capacity, and how to analyze it. The paper provides a much more rigorous approach to the evaluation of capacity than is typical in the industry.

The second, "Capacity Management for Institutional Asset Owners," applies the findings to the management of institutional portfolios. The issues vary by the size of the funds being invested, and "where and how a fund invests should evolve as it grows." In fact, the authors believe that "investment performance is more a function of skill in identifying and executing the right strategy for the fund's size, than a function of size per se."

Topics include the issues of capacity across different asset classes, the attributes of scalable strategies, managing capacity in a multi-asset context, and dealing with the capacity of external managers. In the latter section are very good evaluations of the different motivations of the parties to an investment management relationship, some questions to ask your managers, and the games that get played.

Remember, "Most investment management companies have an incentive to overstate potential capacity." Knowledge of the issues and "a healthy dose of skepticism" are your best defenses.

Endowment envy

It's that time of year. We're in the midst of the annual comparison of endowment returns, in which the management of funds in perpetuity is judged to be good or bad based upon one-year returns. Silliness.

I saw one OCIO pronounced as bad and another proclaimed as good because of their results for the fiscal year ended in June. They may very well change places after the next lap around the track, but so what?

The comparisons are counterproductive and don't take into account the specific circumstances of each endowment (which should affect asset allocation, liquidity, and other choices) or the fact that generating good long-term performance often means foregoing what's working today.

Yale has become the benchmark to which all others are compared. It had another good year relative to its "competitors," although absolute returns were hard to come by for everyone. Markov Processes looked at the performance of the Ivy League endowments and at the degree to which others have adopted the Yale Model. (One cautionary note: The precision of measurements from regressions of style indices like Markov uses should be taken with a grain of salt.)

On the flip side, Harvard has become the punching bag, as years of management turnover (another new head of the investment office was recently named) and so-so performance has led to a surfeit of negative articles. One highlighted a McKinsey report conducted on the endowment, which called its approach "lazy, fat and stupid." Wow.

The excessive comparisons (also found in other areas of institutional investment) of returns often mask important realities. Under the tutelage of David Swensen, Yale has produced admirable returns over time. Trying to copy that road to success is likely not an effective strategy despite its allure.

Questions

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

~ How have we arrived at our beliefs about active versus passive management? (What are our beliefs?)

~ What "best practices" are we in sync with? Where do we fall short?

~ Do we have a good understanding of our managers' capacity and where we are likely to reap less competitive returns going forward?

~ Are we able to look at our own situation and make independent decisions, or are we swayed by the choices of leading investors?