Whenever Charles Ellis writes, I take notice. His classic book “Investment Policy: How to Win the Loser’s Game“ was for me the definitive eye opener. Starting out in the investment industry, managing mandates while working through several investment courses, the central ideas hinged on portfolio optimization, efficient frontiers and new innovative instruments. The implicit paradigm: let investment managers do their work, it’s after all a very technical business and client satisfaction eventually follows. Charles Ellis was – and still is – one of the authors who redresses the roles. He writes from the viewpoint of the client, who owns the responsibility for formulating and assuring implementation of investment policy. Truly understanding his own objectives, the characteristics of the financial markets, and work out this knowledge in investment objectives that should be pursued in a disciplined manner. Sounds elementary, but failing to do so haunted pension funds considerably over the past years.
Ellis recently published an article in the Journal of Portfolio Management[i], outlining his ideas on best practice investment committees. He argues that investment committees have an important governance responsibility in managing the endowments’ investments. The article discusses how the committee should be structured, the need for a clear committee mission, translated into investment objectives. Furthermore, investment committees should commit themselves to self-evaluations. He stresses the need to have a thought out process in hiring and firing managers. Charles Ellis points out that a committee should think about
- How many managers will be used and why
- What will be the minimum and maximum size of a mandate – and why
- What selection criteria and due diligence will be followed
- What criteria will be used for manager termination – and why?
Determining beforehand on when and/or how to terminate the mandate is one of the most difficult things to do. It is an issue that I regularly stress when teaching courses for pension fund trustees, which makes perfect sense to me. Three arguments why.
Disciplining. For starters, it helps disciplining decision-making. Determining ex-ante when to terminate is transparent and accountable. It provides objective triggers for the investment committee to discuss the mandate, and if no mitigating circumstances can be determined, the mandate is terminated. High marks for accountability and transparency all around.
Cognitive Dissonance. The second argument that I then put forward is known as cognitive dissonance. Suppose you have just bought a car, paying close attention to its safety. After cruising happily for a couple of weeks, the local automobile association published a damning report about the safety of your car. Most people want to hold the belief that they make good choices. When a product or item we purchase turns out badly, it conflicts with our previously existing belief about our decision-making abilities[ii]. This dissonance between belief and behavior is called “cognitive dissonance”. There are three ways to reduce cognitive dissonance:
- Focus on more supportive beliefs that outweigh the dissonant belief or behavior – “another report on safety is far more important and gives good grades to my car”.
- Reduce the importance of the conflicting belief – “on second thought; safety wasn’t really a decisive factor when buying the car”.
- Change the conflicting belief so that it is consistent with other beliefs or behaviors – “come to think of it, it wasn’t so much safety that appealed to me, but the easiness of driving”.
Not much fantasy is needed to replace car with investment mandate and safety with active management. If committee member have invested a lot of time in the selection process, they are bound to experience a lot of cognitive dissonance when results disappoint. Defining clear criteria to terminate a manager will mitigate this phenomenon to some extent.
Stop Loss Alpha. If the trustees are up to it, I tend to I throw in a third, rather technical argument in support of clear termination criteria. I readily admit I have not investigated it, but please bear with me.
Assumption #1: the manager selection process focuses on an active management strategy.
Assumption #2: alpha is a zero sum game over a longer period. Over a period of, say, 10 years, an asset manager who manages to deliver break even results after costs does quite nicely based on these assumptions.
Assumption #2: also suggest that periods of over performance tend to be followed by periods of underperformance. Investment staff and consultants will work diligently in selecting the right manager.
Assumption #3:. A promising manager generally turns up in the manager selection database if he – among other things – has been able to show above average results. By the time the manager is selected by the pension fund, a considerable part of the potential alpha has already been consumed by other clients. Defining termination criteria is therefore an absolute necessity from a stop-loss perspective.
However, trustees are hesitant to adopt such an approach. Why is that? Trustees find the concept appealing in a rational way, but they fear that it formalizes the relationship with the manager. After all, the intention is to create long-term relationships, and writing up a termination clause is not the way to do it. Perhaps such a down-to-earth approach also takes away some of the fun in investing, and that is what is holding trustees back. Finally, staff and investment consultants might be weary to adopt such an approach. They might interpret it as a failure of giving good advice when selecting a manager, and ignore the termination issue. A form of cognitive dissonance as well?
[i] Charles Ellis. Best Practice Investment Committees, Journal of Portfolio Management, Winter 2011, p. 139-146