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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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Can Credit Ratings Be Sexy?

The Mae West quote that “too much of a good thing is wonderful” reflected her playful method of sexual innuendo and is the way many investors view credit ratings. Upon her other revelations, I do not believe that the burlesque queen, movie star and stripper was conversant on how bond credit ratings affect relative stock price performance. But that is the dilemma that I have been working on this week. I come to view this issue from two divergent vantage points .

My challenge

I manage a number of balanced (bonds and stocks) accounts for institutions as well as wealthy individuals. As part of our responsibility for one client with multiple accounts we have the task of managing an all fixed-income portfolio in separately managed fixed-income securities and fixed-income mutual funds. In connection with this client I am reviewing and updating the account’s investment policies. At the time of the inception of the account in 2007 certain quality and diversification standards (or what now appear to be constraints) were mandated. As mere thoughtful mortals drew up these policies they did not consider the current tiny short-term interest rates and their manipulation by the major central bankers of the so-called developed world.

High quality, poor relative performance

My associates and I have been reviewing various stock investments of certain equity funds to understand their past two years of relative under performance compared to their perceived peers. In these cases the absolute performance of individual stocks and funds has produced positive results. However their relative investment performance was disappointing. The one common characteristic of the portfolio managers of these funds is that they are oriented toward owning high quality investments, a bias that I share. On average many of these relatively underperforming stocks are higher quality than those found in their relatively better performing peers.

These formerly successful funds are believers in investing in quality companies many of which would have sounder balance sheets and higher margins than found in their relatively better performing peers.  The market recovery phase started in 2009, accelerated in 2012 and continued thus far in 2013. During this period of extremely low interest rates the less credit worthy companies were able to borrow money at historically low rates. With new capital they expanded their capacity and were also able to lower their selling prices which put their higher quality companies at a disadvantage, at least in the eyes of the stock market.

The fiduciary’s selection dilemma

On the one hand we need to set the filters so that managed accounts can meet their funding requirements under practically all absolute conditions. And on the other hand we seek to earn relatively good intermediate and long-term investment performance.

One of the characteristics of all professions is to use codes to abbreviate concepts. In the investment world one very important code set is bond credit ratings. These are thoughtfully issued by three major credit ratings groups Moody’s^*, Standard & Poor’s^*, and Fitch in various stylized alpha numeric abbreviations starting with the most secure, AAA and declining in terms of potential defaults down to D. On average and over time these ratings have done a more than reasonable job of alerting investors as to forthcoming defaults. However, as with all work done by humans, they are not perfect. As a practical matter investors worldwide recognize as far as taxable issuers are concerned that the first four full ratings are so-called “investment grade.” The term investment grade came out of a case in the 1930s that decided that the first four grades  (AAA, AA, A, BBB or their equivalents) were appropriate as high quality investments for fiduciaries. Since then the lower credit ratings were referred to in polite society as non-investment grade or high yield but the in argot of  “the street” as junk. Notice this whole exercise deals with the probability of timely payment of principal and interest, not whether they are good investments particularly in considering current prices.

Funding vs. performance

There is another decision tree axis which is not quite as well known, but in many respects more important. The filter for this matrix is the earliest expected involuntary pay back or maturity date. Once one is assured that the debt will in all likelihood be paid back, the twin questions facing the investor are how long will this stream of income be delivered and (in many ways much more significantly) the interest earned on the reinvestment of the interest received. For long-term bonds, under “normal” conditions, the size of repayments of principal, total interest received and the income earned on reinvestment are listed in reverse order of aggregate size. For instance even a low 3% coupon payment reinvested for 30 years in available, high-quality paper will be significantly greater than just adding up the interest payments paid on the bond, or the return of the original issue price. While this concept of interest on interest is mathematically correct, for many individual and institutional investors it doesn’t work that way. The reason they own fixed-income securities is so that they can consume the interest payments to meet their various funding needs, for example to make grants, pay for maintenance of people and facilities, etc.

Investment Policy Statements

One of the advantages of blogging is that occasionally one can see the discontinuity in one's thinking. Investment Policy Statements (IPS) are legal documents typically imbedded within contracts or board minutes. Often they are drawn up by lawyers or at least blessed by them. As with the U.S. Constitution, essentially they are limiting the powers; in this case the investment manager or investment committee. IPSs do not focus on how to make money for the account, but detail what not to do. This blinding realization came to me as I started to write about credit ratings, recognizing credit ratings can be sexy.

AAA vs. AA

We prize high credit ratings in an IPS, the closer to AAA, the better. In terms of attempting to make money for the account, as an analyst/portfolio manager and investor there are times that I question the cost to the investor of an AAA rating. Let me give an example of two holdings in my private financial services fund. Both Automatic Data Processing^* and Berkshire Hathaway^* are major beneficiaries of the floats of their clients' money. At one time both companies had AAA ratings. Now ADP has the highest rating, Berkshire does not. (Berkshire was downgraded to AA some time ago.) ADP is one of a handful of large US companies that has an AAA. The reasons given for the downgrade of Berkshire was the increasing risks inherent in its reinsurance activities. Both of these companies have had a practice of acquiring other companies. ADP has slowed down in these activities while Berkshire has not, as it has been buying large and mid-sized companies. While both companies' stocks and bonds have risen in price, the AA has clearly outperformed the AAA. Many analysts believe if ADP could find suitable acquisitions that do not threaten the perceived quality of its large short-term float, the prices of its securities would have done better.

Betting against dropping ratings

Recently Moody's^* announced that will be lowering the ratings on four of the leading financial services companies; JP Morgan^*, Goldman Sachs^*, Morgan Stanley^* and Wells Fargo^*. For the moment Moody’s is leaving the ratings on Bank of America^* and Citigroup^* unchanged. Interesting the two unchanged companies have very recently done better shedding their endangered zombie species. The bulls on these two stocks will acknowledge that they are work in progress with the hope that they can approximate the returns of the four leaders.

^* Owned in a wide range of sizes by my private financial services fund or by me personally.

The official reason for the downgrade is the belief that if any of the four leaders ran into financial problems the levels of bailout will be less. Quite possibly true, but I wonder how germane? As an investor and entrepreneur addicted to the long-term, I would much rather own the businesses and more importantly the people of the four leaders than the two turnaround candidates. If protecting their credit ratings and other fortress-like characteristics has prevented them from intelligently expanding their activities or handling their leverage better, the lower ratings could help us shareholders.

I could use your help

I am still struggling with what to put into an institutional IPS in terms of its fixed-income investment accounts to meet some specific needs as well as general strategic balancing needs. Please contact me with your views.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.