Developing Resilient Investment Portfolios - What You Need to Know
- Claude Macorin, CFA
The world is going through a difficult period with COVID-19, and people are beginning to realize that our collective well-being is inextricably linked. What someone does on one side of the planet has an impact on everyone. This pandemic is a wake-up call, and humanity is being put on notice that the environment is fragile. There are challenges on the horizon, but I believe that we will emerge from this episode with greater empathy, and a heightened awareness of social and environmental considerations.
We frequently hear the word “unprecedented” to describe the current environment. We know, however, that throughout history, there have been numerous “unprecedented” threats to humanity and the global economy, and each time humankind has found a way to bounce back. The fact is that we are incredibly resourceful when we pool our resources to fight a common enemy. Today, that common enemy is COVID-19. We will deal with COVID-19 and in due course, it will come to pass.
Notwithstanding our resiliency, we are saddened that this deadly virus has resulted in a significant number of fatalities and lasting social repercussions. There will be many more deaths before the virus runs its course. We offer our sincere condolences to those among you who have lost family and friends.
COVID-19 has sent the economy into a tailspin, and governments and central banks are responding with extraordinary stimulus designed to soften the blow and avert a prolonged recession. Debt levels are at an all-time high, and growing trade tension has increased the geopolitical risk, with the global superpowers battling to extend their influence on the world stage.
The capital markets have recovered from their lows in March. This surprising turnaround is occurring at a time when the economy and the capital markets are decoupling, each moving in opposite directions – sending mixed signals about the future. There is significant risk in the market, and it is during these times that good governance and a thoughtful approach is most valuable (more on governance later).
Over the years, we have had the privilege of managing through a variety of major market corrections, including the market crash of 1987, the dotcom crash 2000-2002, the global financial crisis of 2008, and now the 2020 COVID crisis. The chart below demonstrates that no matter how bleak the circumstances, the markets always recover.
S&P 500 – 90 Year Historical Chart
What differs from one period to another is the amount of time that it takes to recover. And the level to which the portfolio must climb to restore what was lost. The chart below highlights the recovery of the S&P 500 following significant market corrections. We see that the correction and recovery in 2020 are the most rapid in history and likely an indication of increased volatility.
A History of Market Corrections – S&P 500
An area that is frequently misunderstood is that an investment portfolio needs to rise to a much higher level to recover what was lost. For example, the 20.9% decline recorded by the S&P/TSX in the first quarter of 2020, will require an increase 26.4% just to break-even. The math of percentages shows that as losses grow, the return necessary to recover to break-even increases at a much faster rate. This asymmetric relationship between losses and gains is why downside protection is critical.
There is no doubt that market corrections are discomforting, but they often provide an excellent opportunity to purchase securities at attractive prices. It is also a perfect time to make improvements and position the portfolio for the next market cycle.
There are benefits to understanding how the markets operate to avoid common pitfalls and enhance decision-making. Before we deal with the pitfalls, it is essential to understand the investment landscape, which requires that we reflect on the following points:
Investment management is becoming increasingly complicated
Most investment managers under-perform their benchmarks, particularly after fees, and only a minority of managers have a favorable long-term track record
The belief that an investment manager can consistently outperform a benchmark is not supported by empirical evidence.
Long-term out-performance and short-term under-performance are inseparable. You cannot have the former without the latter
Managing risk and earning a satisfactory return on investment is a significant challenge for most Foundations and Pension Plans – and therefore, the services of an experienced consultant/advisor can significantly increase the likelihood of success
An investment manager is not a consultant/advisor, albeit some attempt to serve in this dual capacity. A lack of separation in these two functions represents a conflict of interest, and an area of concern.
Investment management is a business where the price that appears on the invoice fails to reflect the service’s actual cost – there is plenty of room for slippage, and unreported costs get buried in performance.
How to Avoid the Most Common Pitfalls with Investing
Pitfall #1 – Not Understanding the Actual Cost of the Service
Let us start with this last point. When you hire an investment manager, you likely have a good idea of how they performed in the past, but you have no idea how they will do in the future. Most investment managers have a disclaimer indicating that past performance is not indicative of future results. We believe that under-performing a benchmark is a cost that should be accounted for.
For example: If we hire an investment manager for a $50 million mandate who charges an investment management fee of 0.40% per year, the annual fee will be $200,000 ($50,000,000 x 0.004), assuming there is no change in the value of the portfolio. If that manager then proceeds to under-perform their benchmark by 1% per year over the next four years, is that manager still costing $200,000 per year? We believe not. They are, in fact, much more expensive than their invoice would suggest.
The math is easy. Once again, for the sake of simplicity, let us assume that the value of the portfolio stays at $50 million over four years. The 1% of under-performance is equal to an opportunity cost of $500,000 per year ($50,000,000 x 0.01 = $500,000) or $2 million in losses over the four years ($500,000 x 4 = $2 million). The calculation demonstrates that this manager would have cost the client $800,000 in billable management fees over four years ($200,000 x 4) plus $2 million in losses due to under-performance, for a total of $2.8 million. Our view is reflecting the fact that the Foundation could have opted to invest passively and achieve index like results at a fraction of the cost, instead of hiring an active manager.
Under-performance is one of the more common costs associated with investment management, but others are not as apparent. For example, many pooled funds charge operating fees that can vary from 0.01% to 0.15%. These fees are charged directly to the pooled fund and never appear on an invoice. Do you know how much your pooled fund is charging?
Another area where slippage can occur is with trading. The investment manager regularly executes trades on behalf of their clients, and this trading takes place behind the scenes. Poorly executed trades can and do occur. Take the time to discuss and understand your investment manager’s trading policy, including how they ensure best execution and fair trading.
Some Foundations have started to invest in alternative assets such as private debt, real estate, and infrastructure in recent years. These investments offer an illiquidity premium but come with a trade-off that can make it difficult to exit or rebalance a portfolio. Moreover, they are often structured with embedded expenses that need to be discussed and understood. Furthermore, the range of outcomes is much more varied than with marketable securities.
Finally, there are occasionally additional costs with foreign currency translation. Currencies often need to be converted to and from Canadian dollars, and service providers execute foreign currency contracts on behalf of their clients - poor execution results in additional costs for the client. In recent years, there have been legal proceedings initiated by large institutional investors claiming over-charging on foreign currency trades, sometimes in the millions of dollars.
So, the next time that you look at your invoice, ask yourself the following question: is this the actual cost of the service?
Pitfall #2 – Not Understanding the Intricacies of Performance
There is overwhelming evidence to confirm that most investment managers under-perform their benchmarks. For this reason, investment manager oversight is a critical component of the evaluation process. Irrespective of the vital role that a manager plays, one should never lose sight of the fact that asset allocation and portfolio construction are the most important considerations in determining an investment program’s success. Therefore, these two areas are where you should spend most of your time and energy.
We routinely analyze to understand what is driving performance and the level of risk the manager is taking. The knowledge that a manager is 1% above or below their benchmark is of little value unless it is accompanied by further analysis that reveals the underlying reasons. An investor should understand what is driving performance, the level of risk, and whether the manager is adhering to the guidelines outlined in their mandate.
An area that attracts a lot of attention is a peer group review. Peer groups may arouse a lot of interest, but they have inherent shortcomings. For example, the peer group members have different investment policies, asset mix, and risk profiles that limit their usefulness as a tool for comparison. They also suffer from survivorship bias whereby poor performing members are frequently removed from the group, leaving primarily the better performing members. Notwithstanding these shortcomings, peer group analysis does provide useful information when it is applied and interpreted thoughtfully.
It is often said that investment management is as much art as it is a science. There are numerous metrics used to measure how well a manager is performing. We find qualitative factors like culture and values influence the investment process and distinguish the leading firms. Successful investment managers have a knack for assembling the right mix of talent and attributes (essential skills) required to create a culture that drives success.
We encourage our clients to look at their investment managers as long-term partners and keep turnover to a minimum. Frequent changes with investment managers and chasing above median performance will, for the most part, lead to disappointing results due to the implied cost and a lack of consistency in performance.
It is often argued that there is too much manager turnover, citing that part of the problem is the existence of ratings/rankings or the “buy list.” This process of ranking managers simplifies a detailed selection process and creates a questionable split between managers with no verifiable benefits. At Macor, we assess managers by applying quantitative and qualitative screens and avoid being unduly influenced by the noise that appears over shorter time frames.
The next time that you are about to terminate your investment manager, ask yourself the following question: what is the likelihood that this change will lead to a better outcome? Plan for every eventuality and leave nothing to chance.
Pitfall #3 – Not Understanding the Role of Good Governance
Managing an investment program is detailed, multi-dimensional work that involves much more than writing an investment policy and hiring an investment manager.
Governance does not elicit the same glamour as other facets of managing investments but understanding the importance of governance will significantly improve the odds of meeting policy objectives and avoiding conflicts of interest. Many organizations talk about governance, but it takes leadership and a proactive commitment to make it work. We find that there is a strong correlation between successful investment programs and good governance.
What is governance?
Governance is the process of making and implementing decisions. Ultimately, it is about accountability, transparency, and allocating the appropriate resources to meet policy objectives.
A strong governance structure will greatly improve the odds of meeting policy objectives
Good governance starts with a well-defined investment policy that reflects the objectives and risk profile of the organization. The investment policy is the foundation for developing an investment program and the tool by which trustees exercise their fiduciary duties. The content of an investment policy will vary among organizations and will typically cover the following topics:
Scope & Purpose
Definition of Duties, Roles & Responsibilities
Investment, Performance and Risk Guidelines
Asset Allocation
Risk Management
A problem that we occasionally encounter is that organizations mistakenly allow short-term issues to frame their long-term strategy. When there is market turmoil, trustees want to be proactive and feel obligated to make a change, irrespective of whether such change is necessary. This change often comes in the form of an investment manager termination, sometimes at the worst possible time. While there are issues that demand change, there are times when doing nothing is the best option. We find that occasionally, doing nothing is the most difficult decision to make.
Buyer Beware
The investment business is complex, and active investment managers face competitive pressure from passive and alternative investments, amid increased regulatory requirements. These pressures are prompting a never-ending array of new strategies to generate revenue and remain competitive.
With interest rates near zero and increased volatility, fiduciaries need assistance to cut through the noise and clutter to make thoughtful decisions. The challenge is that the lines between investment managers and consultants are blurred, and it is difficult for investors to obtain good independent advice.
A growing number of organizations turn to independent consulting firms to help them navigate through the myriad of strategies and assess risk accurately. When choosing an investment consultant, make sure the firm you hire has no economic interest or affiliation with the investment managers and products proposed. Good governance requires that you “never have the fox guard the henhouse”.
“The greater danger for most of us lies not in setting our aim too high and falling short, but in setting our aim too low, and achieving our mark” - Michelangelo