By Mark Barnicutt on February 24, 2011
Most people agree that bad habits are hard to break. The unfortunate reality, though, is that the global investment management industry has developed a really bad habit over the past several decades:
Convincing investor clients that their goal should be to try to consistently outperform the various stock & bond market indices.
I believe that this is an incredibly bad habit for the following reason:
The relative performance of a client’s investment portfolio (ie: beating the indices) has absolutely nothing to do with the real investment performance benchmark which is meeting a client’s future consumption requirements.
LET ME EXPLAIN HOW I GOT HERE:
1. All Clients Have Real Goals: Every client with whom I’ve worked — family or institution — has some combination of future funding (also known as consumption) requirements that need to be funded. In the case of a family, those funding requirements may be for retirement/income generation, university educations for children & grandchildren and/or philanthropic purposes. For institutions such as foundations & endowments, it’s the future spending/payout requirements, and in the case of pension plans, it’s the future pension obligations to plan members.
2. Goals Need To Be Defined: Through a proper client discovery process, such future consumption requirements are always captured in terms of expected dollar amounts and time horizons (ie: short, medium or long-term).
3. The Role Of The Investment Counsellor: The real job of an investment professional is then to ensure that the client’s investment capital base is sufficiently secure in order to satisfy such future consumption requirements (subject to each client’s tolerance for risk to both capital and/or income).
4. What Constitutes Investment Success: For this reason, the success of any given investment plan should really be measured by the ability to meet each client’s future consumption requirements, tailored to their true tolerance for investment risk.
5. The ‘Old School’ Approach To Portfolio Construction: A few decades ago, most investment managers structured client portfolios by using such a “goals-based” or “asset-liability” approach to managing client wealth. The general performance of “the markets” had nothing to do with how they structured their clients’ portfolios.
6. Market Indices Proliferation: With the many technology advances over the past few decades — that enabled the development of so many global capital markets indices — the investment industry, and by extension investor clients, have become obsessed with “beating the indices” instead of simply meeting each client’s unique set of investment objectives.
7. Risky Behaviours: Such “relative investment return seeking behaviour” drives investors — and their advisors — to source securities and investment managers who assume heightened levels of investment risk in order to “beat the index”………or……in many cases we see, firing investment managers when they’ve had a few quarters of relative underperformance (despite the fact that their philosophies & processes remain intact) and replacing them with managers who have recently demonstrated outperformance numbers. This is many times, the equivalent of “buying high” and “selling low”…which is never a recipe for investment success!
8. Good vs Bad Investment Outcomes: The outcome of such “relative” investment thinking is that if investors meet/exceed a given benchmark (ie: TSX, S&P, etc.) then they should be happy while if their investment portfolio underperforms a given benchmark, then they should be unhappy. To challenge this thinking, I frequently present clients with the following two investment performance scenarios and ask them which scenario they’d prefer:
Scenario #1: You have a consumption requirement of $100,000 in three years from now, and your Investment Counsellor structures a portfolio that MEETS this requirement BUT the portfolio UNDERPERFORMS a given market index by 1%
Scenario #2: You have a consumption requirement of $100,000 in three years from now, and your Investment Counsellor structures a portfolio that DOES NOT MEET this requirement BUT the portfolio OUTPERFORMS a given market index by 1%.
As everyone’s financial reality is a “cash flow world” — ie: income & expenses — everyone that I’ve presented these scenarios to has indicated their preference for Scenario #1.
In the institutional segment – such as pensions as well as foundations & endowments – the relative investing approach is ‘alive & well’ with Peer Group comparisons. Specifically, investors end-up comparing their performance against other ‘peer groups’ who most times do not share the same funding goals, time horizons & risk tolerances. For instance, in the 2002 – 2007 time period, many institutional clients became obsessed with following peer group comparisons for allocations to hedge funds. As a result, many such institutional clients made large allocations to hedge strategies without necessarily understanding the risks involved. The classic peer group example were foundations & endowments who wanted to follow the Yale and Harvard Endowment investment models. The end result, was that everyone who had followed these Peer Group comparisons, realized during the 2008/2009 Global Financial Crisis that they’d adopted investment & portfolio strategies that were not well-suited to their organization. Asset Management, done properly, should be a tailored experience that balances goals, time horizons & risk tolerances — not a ‘group-like lemming’ experience in which everyone ‘goes off the pier” into the Abyss!
The unfortunate reality, though, is that so many clients nowadays have been lured into the “relative investment performance game” by the global investment industry and paid the price of not meeting their future consumption requirements. Actual examples of this today include:
– Pension plans who have seriously unfunded liabilities because their portfolios were designed to “perpetually chase relative returns” instead of focusing on matching their assets to future pension obligations.
– Foundations who have had to cut their spending policies because their asset bases — and subsequently income generating capabilities — were impaired due to their focus on finding investment managers who “consistently beat the indices”.
– Families across Canada who have had to defer retirement because they were “chasing relative returns” instead of focusing on the accumulation of a capital base that would fund a future quantified retirement income for them.
SO WHAT’S THE SOLUTION:
I believe that the global investment industry needs to break its “bad relative performance habit” and get “back to the basics” of being true fiduciaries and get focused on structuring portfolios for clients that actually help them meet their future consumption requirements (subject to each client’s tolerance for risk to income and/or capital) and stop “blowing smoke” at investor clients by trying to convince them that relative investment performance is of primary importance to them — because it’s not.
Now, this is not to say that investors should not pay attention to how their investment managers perform relative to their respective market index benchmarks over various market cycles — because they should. Nobody wants to pay for long-term, material underperformance, especially given the range of quality money management expertise, both active and passive, in the marketplace today…..it’s just not a responsible use of client assets. It’s just that I believe that investment manager relative performance is of secondary importance to whether or not an investor’s future consumption requirements are being satisfied in a manner that aligns with his/her true tolerance for investment risk.
As Charles Ellis, in his book, “Investment Policy: How To Win The Loser’s Game” states:
“The truly important but not very difficult task to which investment managers and their clients could and should devote themselves involves four steps:
1. Understanding the client’s needs,
2. Defining realistic investment objectives that can meet their needs,
3. Establishing the right asset mix for each particular portfolio, and
4. Developing well-reasoned, sensible investment policies designed to achieve the client’s realistic and specified long-term investment objectives.
In this work, success can be easily achieved.”
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