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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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Betting For or Against Nobel Prize Winners

Introduction

This past week we learned that Gene Fama, Lars Peter Hansen and Bob Shiller  received Nobel Prizes for Economic Sciences. These are relatively new awards starting in 1969 in honor of the founder of the Nobel awards, Alfred Nobel.

Nobel Prizes, except the questionable Peace Prize given by a different committee in Norway, are based on the discoveries and insights developed many years before the award. A relatively small number of the awards given for economics have had their focus on securities selection. There is no substantive record of whether they work in producing winning portfolio performance. A number of past winners became highly paid consultants to investment groups after the award. These have produced nice lunches and wonderful dinners, but little in the way of commercially exploitable performance.

What are the implications of these three awards?

Each recipient was trying to find a systematic way to invest profitably. They should have gone to the racetrack and listened to those in the Grandstand or perhaps better, in the higher priced Clubhouse. After each race people talk about why in the next race their particular choice will win. If someone has a number of winners in succession or at least a preponderance of winners, he or she has a “system.” Having been exposed to these various systems whether they have been mathematically based or dependent upon anecdotal information about the horse, its breeding, its trainer, its jockey, the jockey’s agent, the condition of the track or the colors of either the horse or what the jockey is wearing, I can attest to the fact that none of them work a majority of the time. The key to making intelligent bets at the track and in the market is to be sensitive to changes from the past. Otherwise one can be like some generals/admirals in the Pentagon fighting the last war brilliantly; for after the war they have determined what may have caused the victory or defeat.

Is there is a message in the Nobel Prizes?

By awarding three learned economists this year’s prize where each had a different point of view, methodology, or to use the racetrack term a system, the committee may be saying that there is no uniform selection process that works all the time. This is not to say that their work is worthless. Gene Fama was one of the founders of Dimensional Fund Advisors (DFA) which manages a number of mutual funds, some of which we use for clients. The practitioners have focused their money using other selection and perhaps more importantly, trading techniques. The result is a relatively low cost (not as low as pure index funds) portfolio of a large number of securities which allows them to nibble at bargains when offered. Sometimes they will have above average results and some times not.  As the inventor of segmented performance by quintiles, I can’t remember seeing their performance in the top or bottom one fifth of an array.

The Shiller approach, looking at the last ten years earnings relative to current prices, is a useful beginning to analysis. The analyst in me rejects sole reliance on reported results. I believe that one must first adjust the results for changes in tax rates, mix of business and tactical opportunities, accounting changes, changes in shares outstanding and significant changes of management. While I urge client expectations to focus on performance of at least the last ten years, I do adjust my thinking to recognize cyclical developments.

All of these approaches are useful until they become too popular.  They are not the complete answers to successful investing. In part because the favored investment styles of the economists  (small, value, momentum, and quality) will be redefined by market forces and in all likelihood smart-eyed observers may find other winning groups based on management techniques, technological supply chains, beneficiaries of social media, etc.

Changing conditions

One of the problems when intensely looking at present conditions is that something that appears to portend broader changes may not be very important in the future, and other incidental observations could be the recognition of bigger things to come. Two items caught my eye this weekend. I offer them up for our subscribers to consider or reject in terms of implications and importance.

The first item is that hedge funds reportedly have their biggest short position in gold since January. This may be a sideshow and only important to “gold bugs” or it could be a clue of how some hedge funds are looking to play catch-up from being behind the larger market advances. Undoubtedly at some point various markets will decline, perhaps meaningfully. The risk that all short sellers take is if the items that they are short move up dramatically, they may be forced to buy back the shorted securities at a rapidly advancing price. In other words they could be caught in a short squeeze, particularly those who shorted gold. With announced trading volume quite light, a squeeze could be applied.

The second item is that yields on German Bunds are closing in on the yields on US Treasury Bonds. For some time, global investors have felt more secure with the credit value of the German government paper than that of the US. Thus they were more expensive in price with lower yields. The closing of the yield spread could indicate that global investors are less worried about the credit value of US government paper which could be good for the US stock market from a foreigner’s point of view. At the very same time foreign currencies are appreciating against the dollar. Part of this may well be caused by an increase of US investments into Europe and possibly Japan.

Would you please let me know what you think?

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