Sunday, September 9, 2012

Reputational Risks Await Big Money

Investment management literature usually covers portfolio manager career risks gently. This is the risk of a managed portfolio in a current time frame under-performing an index, or for the more advanced managements, underperforming peers either by accepted asset classes or better yet, by well-chosen funds. As a natural defense against career risk, too many active managers dwell on short-term variations to the index and often hide out with a somewhat closet index portfolio. From a career standpoint this strategy works when correlations between securities are close.

Reputational risks are not a composite of career risks

Many large institutional accounts have an investment committee or a board to which portfolio managers report. My British friends who I expect to visit in October call these groups a collection of the “worthies.” Generally these worthy gentlemen and gentle ladies are retired from the investment, financial, and marketing fields. Somewhat naturally these people think of long-term as a period up to their retirement from these boards/committees. This is the first risk to the underlying institution:  that the relative light hand of this governance is shorter and often very much shorter than the institution’s planned life. For endowments and other immortal bodies, their investment life is way beyond that of the current portfolio manager and their team.

The risk of comfort

Many of the members of these investment committees are no longer in the business of finding new and different major investments. Much of their focus is on the macro concerns facing the world. Numerous members have had instant favorable reaction to the latest announced moves by the ECB to permit central banks to buy bonds with maturities of three years or less. If they dig into the matter they will see that this is a way for the governments to recapitalize the banks so they can write off the government and commercial loans to the countries and companies on the periphery of “Euroland.” Similarly the committees believe they know which way the German Constitutional Court will decide, the size and shape of the soft landing in China, and the results of key elections around the world, as well as knowing the impacts of these events on short and longer-term stock prices. The broader the subject, the greater comfort they have in setting policy. I find this point of view to be frightening.

Many of the brightest minds in the hedge fund world manage “Macro Funds.” A study of these hedge funds (which have little in the way of constraints) shows how few of them have a consistent long-term record of success. In various investment committees, too much time is spent on macro judgments, which in my opinion have little chance of being meaningfully correct.

The historical trap

Investors in general and most investment committees present their views in the context of historical performance. A given number is larger or smaller than another number and that defines good or bad. As someone who for many years sold relative performance to fund groups and their directors around the world, I have often stated that performance analysis did not supply answers, but was a good place to start a dialog of questions. Many committees treat poor performance as the reason to fire a manager, without any understanding as to what caused the variation. Every good manager with a long-term record has had an uncomfortable number of periods with sub-par performance. I attempt to understand the nature of investment mistakes. Often such errors are result of making poor personality judgments on managements. Other times it is a premature or faulty choice on new product/services, sometimes it is getting out of step with a major macro change, and at times it is sloppy financial analysis. Good managers learn from their mistakes and don’t often repeat them. If one studies the cyclicality of performance, one of the best times to buy into a manager is after a period of poor results. Thus firing a manager with “poor performance” as the only explanation is probably an early sign of institutional reputational risk. 

The biggest risk is extrapolation

Most committees have become captured by immediate past history. They are like many general staffs for the military. The generals and admirals plan to fight the last war better this time. History suggests that the early success of an aggressor is based on not just tactical surprise but some believed technological or political advantage. (America does not seem to learn from this history in that once again we are shrinking our global and to some degree our technological capabilities which will likely invite a new attack for which we are not prepared. So believes this proud member of the US Marine Corps.)  In the investment world the equivalent to the generals refighting the past war is to believe that all of the conditions that are now present in the marketplace will be the same during the life of the institution. There is no awareness of a Christopher Columbus effect or the invention of the semiconductor, let alone the impact of the fall of the Berlin Wall.

Today most committees are looking to protect their image as “worthies” in preserving their assets. To me this is the biggest single reputational risk to the long-term health and respect for any institution dependent upon its investments. Currently we are in an extended period of a flat equity market and a rising fixed-income market. I don’t know when things will change; 2012, 2013, 2016, 2020 or some other initiation of a major equity market and a crumbling of fixed-income prices. I firmly believe that this will happen soon enough that an institution that is not prepared for this change will miss out on substantial amounts of easy money.

These beliefs have led me to exit a more conventional thinking investment committee after many years of service.

How to get ready?

First, reduce exposure to fixed-income, particularly high quality and do not expect high yield paper to do particularly well as spreads versus treasuries narrow as the market (with or without additional quantitative easing) will recognize the risks in the low yielding treasuries. Next recognize that each day technology marches on in almost every field of human endeavor, from new building techniques, retail shopping in person and on the Internet, the encashment needs around the world, the delivery of improved medical products and services and a need to eventually rebuild our global defense establishments. Equities should be viewed on a global basis. Dodge & Cox International fund noted that on the surface it had 40.7% invested in Europe (using the custodian’s balance sheet standards). However, management points out that 70% of its “European” investment is in companies that have 60% or more of their sales outside of Europe. Analytically this suggests that when we look at this portfolio some 17% of its sales are outside of Europe, so its exposure to the problems of a narrowly defined Europe is not what it seems. Further, one of the fund’s small positions, 1.3%, is invested in a bank that has half its market value covered by its minority investments in fast growing banks in Poland and Turkey. Whether they are counted as US or European, I believe many of our holdings in other funds have similar sound investment exposures. These views are ahead of market indexes and the ETF crowd. For the first six months this fund gained 3.3% after expenses vs. the MSCI EAFE gain of 3.0%. There are other funds being led by active managers who are also aware of these developments. As the game changes I want to be with some funds that slightly anticipate the changes rather than wait for the committee of the “worthies” to catch on to the change.

Holding cash

Should a nimble account raise cash? My studies suggest a major cash commitment, (e.g., 25% of the total value) will retard a sudden decline, but won’t produce a positive result. For many, the biggest problem with cash is that it is too comfortable and therefore difficult for many to get the courage to reinvest until the market is higher.

Our own investment committee

Even as individual investors we have an informal investment committee of people whose judgment we trust. You know who they are even if they have not been formally identified. In many ways your working investment committee is like that of an institution. You have the same problem of getting them up to speed with your own investment needs and that of your family and heirs.

Please share with me how you are refreshing your own personal and institutional investment committees.
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