His new book is out today, and it is called: Organizational Alpha: How to Add Value in Institutional Asset Management.
When we discuss Alpha, most of the time we are referring to the performance of a specific investment portfolio relative to its benchmark.
However, there is a much broader context to Alpha — think of it in the way an organization could optimize its operation to improve its chances for success. We do this by maximizing the strengths but just as (if not more) important minimizing the opportunities for error. Described differently, what are the common mistakes, misperceptions, actions, and other such errors that negatively affect total portfolio returns.
My world view looks out on a universe of things that can go awry; this is why I spend so much time discussing cognitive errors, investor psychology, behavioral economics, high cost managers, etc. Institutions such as Pensions, Charities, Foundations, Endowments, etc. all need to learn how to generate Organizational Alpha.
Any organization responsible for managing assets is also responsible for:
-Creating an investment philosophy;
-Expressing that philosophy through specific strategies;
-Aligning the investment portfolio with the long-term mission of the organization;
-Having a Board of Trustees and Investment committee both of which employ a thoughtful decision-making process;
-Communicating the firms actions to its stakeholders, board members and fund donors as well as externally to the public;
-Managing both internal investment staff, and external consultants and money managers;
That is before the organization even gets to “managing the different egos, goals, people and competing interests that come with investing multiple millions or even billions of dollars in a quest to do good for their beneficiaries,” as Ben describes it.
Too much of the time, institutions are so busy worrying about performance that they overlook several deceptively simple steps that will create value for their stakeholders. Anyone who is associated with any organization that manages assets on behalf of clients should READ THIS BOOK.
There has never been anything written that covers this subject so clearly and succinctly. You will find an excerpt of the book after the jump. Go read it now.
Excerpt after the jump
There’s an old cartoon that shows a large group of cave men standing around. One says to another, “We have one hunter and one gatherer. Everyone else is a consultant.” This same idea could be used to describe many institutional investment programs.
In the U.S., over $13 trillion of institutional capital relies on consultants for investment advice. Pensions, endowments, foundations and other large pools of capital utilize consultants for a wide range of services, most notably due diligence and outside money manager recommendations. Unfortunately, the research shows that investment consultants as a group add no value through their selection of outside investment managers. They chase past performance and make far too many unnecessary changes. Data also shows that the managers consultants fire have gone on to perform better than the ones they hire.
These large pools of capital make the same exact mistakes as mom and pop retail investors, it’s just that the reasons tend to be different. Here are a few studies to consider:
- Researchers looked at the investment choices from consulting firms that control roughly 90 percent of the U.S. consulting market. They found, “no evidence that consultants’ recommendations add value to plan sponsors.” In fact, the average returns were much worse in the funds they recommended than non-recommended funds.
- Researchers also looked at the performance of the nation’s largest pension plans from 1987 to 1999. Out of the 243 plans in the study, each investing hundreds of millions or even billions of dollars, 90 percent of them failed to beat a simple 60/40 stock/bond portfolio benchmark.
One of the problems is that all of these funds end up using the same consultants and investment models. In the U.K., the six largest consultants control 70 percent of the market. In the U.S. the top ten consultants have an 81 percent share. Worldwide, the top ten consulting firms control 82 percent of the market.
If these consultants control so much institutional capital and are considered experts in the field of choosing money managers, why are the results typically so poor?
Consultants constantly feel the need to give as much advice as possible. They have to try to prove that they’re worth the fees they charge, so they advise change even when doing nothing is the right move. You can’t blame consultants for all of these results and mistakes. Trustees for the funds in question also have to accept a lot of the blame for their decisions and how their investment process affects performance. The short-term performance demands placed on outsourced advisors can create an environment where they feel the need to churn the portfolio or make unnecessary changes. Many consultants are simply giving their clients what they ask for.
Many organizations like having consultants around because it gives them someone else to blame when things go wrong. Institutions can blame the consultants. The consultants can blame the money managers. And the money managers can blame the Fed or some other factor that’s out of their control. Everyone is happy except for the end investor, the beneficiaries.
The institutional consulting business model is predicated on scale, which is why the market is so concentrated. But this means that there has to be a herd mentality as all the clients are investing in similar managers and strategies. It also means there is little room for personalized advice when some of these firms are overseeing trillions of dollars in assets. This can lead to something of a cookie-cutter approach to their investment models. It’s costly to perform due diligence and spend time putting clients into smaller money managers, but it’s typically these small funds who have a better chance of outperforming since they have a wider opportunity set. Once their outperformance becomes known by the investing community, they are showered with money. Size is the enemy of outperformance in terms of assets under management, but many institutions load up with top performers from the past because they are the funds that have the capacity.
It can be very difficult for these firms to offer objective advice. Consultants typically have a list of approved money managers that they use. It’s not very easy for managers to make it onto these lists, but it is very lucrative once they do because that means they will likely be recommended across many different client accounts. The consultant-money manager partnership can be tricky for trustees to understand from a conflict of interest perspective.
Many consultants assume their number one job is to beat the market, provide sources of alpha and help their clients pick the best fund managers. Manager due diligence tends to overshadow tasks such as asset allocation, portfolio construction, performance monitoring, risk management, setting return expectations, educating board members and constantly reminding them how the markets and human nature generally work. The search for alpha often blinds investors from paying attention to the policy basics, which are far more important in the end.
There is so much time wasted debating the relative merits of the different money managers and short-term investment opportunities that it becomes easy to lose sight of your overall goals and organizational mission. Selecting the best investment opportunities won’t matter if you can’t control your behavior or implement an overarching plan. An investment opportunity should not be confused with an investment process, the latter of which is far more important for those that wish to be successful over the long haul.
Consulting firms can be helpful to institutional investors. They just have to focus on the right areas. The paradox here is that nonprofit institutions need outside advice in most cases. In fact, the Prudent Investor Rule, which is what the fiduciary duty is directly based on, encourages trustees to seek outside help with the management of their portfolio. The problem is they’re often paying for the wrong kind of advice.
Like clockwork, every year at nonprofit board meetings across the country consultants pitch a few new fund ideas to replace the current cellar dwellers in the portfolio. No one wants to admit there’s a problem with this model of doing business so status quo reigns. It’s hard enough to pick one money manager that can outperform, but when you try to pick multiple outperformers and do that multiple times every year your odds just continue to get smaller and smaller. The degree of difficulty is through the roof on this approach.
There are many ways in which consultants can add value if they choose to focus their efforts beyond the standard money manager musical chairs:
- Client education and improved communication efforts.
- Behavioral management and modification.
- Performance and risk reporting that doesn’t include 100 page reports with useless information no one reads.
- Setting realistic expectations, which can help with both organizational planning needs and keeping investor emotions in check.
- Ensuring the portfolio’s asset allocation matches the risk profile and time horizon of the organization.
- Documenting the investment process to ensure continuity in the program over time.
- Saying ‘no’ over and over again to investments or funds that don’t fit within an institution’s mandate, tolerance for risk or stated objectives.
- Honesty, transparency and the ability to say “we don’t know.”
- Reminding these organizations of their time horizons and long-term goals.
- Doing nothing most of the time in terms of making changes to the portfolio.
You have to set the correct expectations up front for what you hope to get out of the relationship and then follow-up along the way to make sure the advisor or consultant is doing what they said they were going to do at the outset. All services should be clearly defined up front before coming to an agreement. Some firms only offer money manager due diligence services. Others offer more comprehensive planning and monitoring. Some firms are strictly consultants who act at an arm’s length while others take a more hands-on approach and take over much of the day-to-day money management duties. You have to make sure you know what kind of firm you’re dealing with upfront, as these things can be confusing to those outside the world of finance.