Evaluating the Evaluation of Investment Performance

Introduction

I wonder whether my old fencing team has found the best way to evaluate investment performance? (More below).

This possibility seems strange from someone who built a first career on the production of mutual fund data for management organizations and their independent directors. My second career has two sets of masters, the first being the accounts I manage as a fiduciary and the second as a chair or member of various investment or finance committees. What is clear to me is that not only is investing an art form but judging investing is also an art form. I have learned this on the basis of not only my experience but discussions with some of the best investors in the world.

The governance trap

Professional fiduciaries want, above all else, to protect themselves from being sued (or in the case of trusts and estates surcharged). The bait in the trap is the definition laid down by Judge Putnam in his 1830 Prudent Man Rule. The case of  Harvard vs. Amory defined prudence as doing what other men....would do with their own funds. Notice in the introduction that prudence is a function of being allied in actions with peers. Nothing was said as to investment success or avoidance of risks of permanent substantial losses. The trap was sprung by reliance on the difference between US legal thinking and those of the U.K.  Under US law one can do everything one desires as long as it is not specifically prohibited. In the British tradition of a non-written constitution they require actions to be “fit and proper” with the sitting Judge making that decision.  As an outgrowth of these differences, in the US our investment policy statements (IPS) spend most of the words on what is a prohibited transaction and very little on accomplishing the goals of making money without undue risk of permanently losing large amounts of money. This philosophy has led to hurdles to safely jump over in terms of peer performance and fees charged. This is like telling Rembrandt how much paint he can use to create a great masterpiece because that is the amount painters’ use. My experience with investment committees is that those that are dominated by lawyers or salespeople have the bulk of the focus on comparative numbers. Usually the majority of the discussions are about periodic past results.

A number of organizations have recognized that the make-up of the committee will materially impact the long-term result.  Caltech, Atlantic Health Services and at least one major successful US state pension fund requires that only those trustees with significant investment experience sit on investment committees. The greater part of the conversations at these investment-driven groups is about meeting the long-term needs of the account while accepting reasonable risks. This second group is much more focused on the quality of thinking being expressed in the portfolio.  

Mutual funds are appointing accomplished analysts and former portfolio managers to their boards. Just this week, I was happy to learn that a woman who served on the board of the New York Society of Security Analysts has been invited onto the board of a major mutual fund board.

I believe that performance measures are not the way to select funds or managers, but that is the way many investment committees function. I believe that performances over various periods are a good place to begin the series of questions to see whether there is a proper fit. One way to begin the discussion is to look at the individual relative performance over the last forty quarters compared to perceived peers. For funds that are used to intelligently participate in a market segment, I want to see the bulk of the quarters within the middle three relative performance quintiles. When they pop out of the fat part of the bell shaped curve, which is what funds in the mid quintiles inhabit, I want to understand why. When looking for an aggressive manager to fully capture a leadership position, I look at the ratio of leading quintile performance to lagging. Normally, I like to see a ratio of three to one in favor of the leading quintiles. I am very interested in the pattern of the reversals from among the best to among the worst; I want to understand what if anything did the portfolio manager do to correct the fall from grace.  In other words, I try to get into the mind of the manager and determine what behavior modification went on. This is similar to what is happening to my old fencing team.

The stretch or the lunge?

In Saturday’s New York Times there was a rather extensive article entitled “No.1 Columbia Fencers Are Aided by a “Jedi Master.” 

Back in the cave dwelling days when I went to Columbia University, I was a substitute épée fencer on the Varsity Team. In subsequent years as with many Columbia sports teams, performance deteriorated. Luckily a few years ago a former computer software salesman became the head coach for the team. He used his computer orientation to trap all sorts of quantitative information about the members of his teams, opposing teams, possible recruits etc., somewhat like the baseball coach in the book and movie, “Moneyball.”

But to me one of the keys to the success of the Columbia Fencing Team (now Number 1 in the US) is how they go beyond the numbers into the mental framework of the fencers. The head coach was able to retain an 82 year old assistant coach to instruct these athletic fencers to lie down and meditate as part of his instructions in mental discipline. The message that I take from this article for us in dealing with investment committees is that statistics can only capture the past, aiding in mental behavior modification can change the past patterns that would be missed by merely looking at the past record.

In the search for the best

In searching for the best long-term investments I am mindful of expenses, (not their size, but where the money is being spent). If it is being spent wisely on talent, that can lead to good results. This is the sort of judgment that an investment committee full of professional investors can determine. An investment committee not so constituted runs the risk of commodity type pricing, believing that rare talent is easily interchangeable, and in the end getting below-optimum results.

Next week

We will discuss whether we have experienced a peak to be followed by a major decline. Let me know your thoughts.

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