Sunday, August 5, 2012

Career Risk Can Hurt Long Term Performance - Especially Now

One of the traditional ways to address the potential conflicts between agents and owners of capital is to measure the performance of the agent or in the case of investments, the investment advisor.  As both a registered investment advisor and the chair or member of various non-profit institutions’ investment committees, I am very conscious of the potential for the termination of a relationship due to this focus on the measurement of performance. My experience is that current poor performance is often only the excuse for a termination, as opposed to deeper, more serious concerns over the relationship with the managers. I hope that other managers join me in assuring our accounts that from time to time we will under-perform. Obviously this warning is meant to defer the career risk of losing the account relationship.

Part of the lexicon in dealing with investments is to communicate the relative performance to other trustees, members of the family and even ourselves. This routine usually includes statements such as, “We beat the other universities, foundations, market indexes, (and my favorite) fund indexes.” This sequence continues, moving on to other topics. The brief bullet comments usually found do not address whether the account is going to fund the critical long-term needs of the account owner or beneficiaries. In one of its wisest edicts, the US Securities and Exchange Commission requires any performance statement to carry the caution that past performance is no indication of future performance. On the basis of my fifty-plus years of experience, I can state that absolute and relative performance is cyclical. 

Two personal examples of overreacting to career risk

First, when discussing the long-term outlook with an adviser to a significant museum endowment ten years ago, I cautioned him not to go to the extreme of owning only non-US stocks and high grade US fixed income. While I could see the relative attractiveness of selective foreign stocks, to me going out of US stocks was so extreme that there was significant career risk to the trustees and managers that took this approach. However in a ten year review, the relative performance of high-grade US fixed-income out-performed the popular stock market averages. As a result the endowment became larger and used its money when other museum endowments were cutting back. 

A second example illustrating my concern for other people’s career risk is when I met with a beneficiary of what I presumed a large family trust. I thought that the individual was not schooled in investments. He wanted some backing to urge the trustee and its professional investment manager to materially increase exposure to bonds. His view at the time was that bonds were a safer investment, regardless of how it would impact his income from the trust. I explained the long history of stocks out-performing bonds, particularly on an after-inflation basis. I suggested that if the trustee followed his desire, he was taking on career risk. This “uninformed” beneficiary has thus far proved to be wiser than the standard professional view.

Performance is cyclical, and occasionally extreme views need to be investigated, including both historical factors and future developments.

What should investment committees do?

Bragging rights are important and probably cannot be neglected in the face of strong development (fund-raising) efforts by the institution. I have two suggestions. The first is to focus as soon as possible on a twenty quarter rolling results analysis wherein not only the raw performance numbers are compared but also the number of better than average quarters achieved by each of the key components. Further, I would tie the spending rate to the same twenty quarter roll. The second suggestion I offer is to carve off at least one side of the portfolio that can take extreme choices, which would be measured over very long periods. This may well be an excellent time to explore extreme positions.

Why now?

I am not a market timer or a short-term trader, but rather a humble student of investing that has read and seen a lot. The biggest career risk we all face is that conditions change. In the early phases of most periods of change we tend to believe that past trends are continuing and that the current move is just another cyclical wiggle on a chart. We are not prepared for fundamental secular change. Our very unpreparedness is what raises the odds that we will be first surprised and then doubtful of a meaningful change.

The evidence for an advance

The US stock market and some other major markets have been essentially flat for twelve years. The market analysts refer to this chart pattern as either accumulation or distribution. We will know which when the market moves to a new high or breaks down past old lows. The theoretical math suggests that a move to a new high will eventually be extended at least by the same percentage move from the old low to the new high. From here this would translate to more than a 25% move from the old high when achieved. While there is little enthusiasm currently in the US stock market, it is set for an explosive advance.

The impetus

The impetus for this take-off in stocks is much more difficult to guess. Perhaps the sequence will be somewhat like the run-up to the First World War where the various countries were jockeying for global political advantage. No one expected that the assassination of the Austrian archduke would very quickly lead to armed conflict both in Europe and Africa.

What could give the spark to an explosion in equities would be news events such as the last night’s scheduled Mars landing (managed by Caltech’s Jet Propulsion Laboratory), the unveiling of the new iPhone and iPad or political developments in Europe and/or America.

Why do we need a strong equity market?

Jeremy Grantham and others have written about the coming food and water shortages that can destabilize large portions of the world population. To solve these issues we will need large infrastructure investments which are typically better done by the private sector. The one long-term need I am particularly watching is the need to productively put to work the huge number of people who will be freed from higher education classrooms and their dependent unions, as we shift from ineffective education to practical and reality-based learning.  In only a few years these students are going to make an enormous difference to our world and the investment processes have to be in place.

The question of the week

How are you going to spot the next secular change? Please share your approaches.
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