Is Fencing the Key to Evaluating Investment Performance?
In Saturday’s New York Times there was a rather extensive article titled “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 #1 in the United States) 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 but mental behavior modification can change the patterns that would be missed by merely looking at the past record. It is clear to me 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 also discussions with some of the best investors in the world.
Governance Structures Need to Make Room for Art
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 College v. Amory defined prudence as doing what other men would do with their own funds. Notice 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 American and British legal thinking. 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 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 created hurdles that firms need 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 other painters use. My experience with investment committees is that those that are dominated by lawyers or salespeople have the bulk of their focus on comparative numbers. In these cases, usually the majority of the discussions are about periodic past results.
The Right Way to Manage
A number of organizations have recognized that the makeup of the committee will materially impact the long-term result. Caltech, Atlantic Health Services, and at least one major successful US state pension fund each require 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. 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 funds in the middle 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, the portfolio manager did 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.
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 the money 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’ve experienced a peak in the markets that precedes a decline. Let me know your thoughts.
Are you an investment trustee? The Research Foundation of CFA Institute has published a primer aimed at bringing you up to speed. Written for a new trustee at a university, it is a comprehensive discussion of investment issues relevant not only to investment trustees but also to investment professionals who work with trustees.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.