Influencing Investment Manager Risk Thinking (2/2)

Influencing Investment Manager Risk

Influencing Investment Manager Risk Thinking (2/2)

Even the best asset allocations fall short if not executed effectively. How do investors ensure that their investment strategy delivers the return to meet their goals, especially when they share execution responsibility with external investment managers?

As the end-investor, the biggest goal when outsourcing investment management is to minimize the gap between what YOU THINK the manager is doing and what the manager is ACTUALLY doing.

If investment managers underperform vs. expectations, it creates a real risk that the investors’ portfolios don’t meet their investment objective. A scenario that keeps most CIO’s up at night (unless they are reading this article before bed, after all we are discussing risk management!).

Trust, but Verify… Easier said than done!

In an attempt to maintain control and avoid surprises, investors have shifted towards greater transparency, disclosure and access to information from managers. This shift should have been a welcome change; however, greater transparency comes at a cost:

  • At the manager level: Back-office, product management and investor relations costs have risen dramatically in providing this additional transparency and disclosure, especially since requests are often fragmented and ad-hoc
  • At the investor level: Investors face significant additional costs in managing the increased flow of information

Today, investors request and receive, all or a combination of the following data points to evaluate risk related to a manager:

The system is flooded with data and information, without all of it being relevant to decision-making. Is keeping track of this information a sustainable approach? What an investor is left with is a day job of sifting through heterogeneous information to target relevant data, spending money and time to do so, while at the same time losing sleep over manager underperformance. How about an alternate approach that (a) transitions oversight to be exception based, and (b) increases focus on responsible management teams.

(a) Generating Assessment (er… Exception) Edge

While popular portfolio management and monitoring techniques involve analyzing portfolio holdings, this analysis alone fails to be an all-encompassing solution, even when paired with overemphasized track record analysis.

Processing fragmented sets of information in a cohesive fashion delays response time and leaves investors to be more reactive to situations.

These analyses may get an investor to the six yard line, but how do you get to the end zone? Why not incorporate an exception based framework, that makes a distinction between information within the expected band, and what could be an outlier?

Investors can manage the width of the expected band, identity outliers, assess which of these outliers are positive vs. negative for their portfolio, and where a deeper dive is then warranted. This is also an avenue to provide feedback to the managers, especially when they are a negative outlier, a long run goal of shifting the expected band to the left.

(b) Sound Decision Making as a Differentiator

Most big blowups are attributable to poor decision-making and control, conflicts, or lack of alignment of interest. In rare cases only is it attributable to modeling or measurement error. Corporate America has benefited from good governance, and the results are apparent in well run companies and their improving stock prices. Why not extend the thought process and investor activism when evaluating investment managers?

Currently most investors focus on historical returns, with a secondary evaluation of the management quality. If a manager meets the best practices hurdles, checks off the regulatory box, the management team passes the smell test. Investors should demand a stronger governance framework, to evaluate impact of the various management missteps, and the opportunity costs involved with dealing with a future crisis.

Investors who bring good governance to the forefront rather than having it as a secondary evaluation factor have historically avoided large blowups.

These investors send a strong signal to the asset manager and provide incentives to invest in the areas of:

  • Significantly greater and independent oversight from the board of directors acting as fiduciaries on behalf of the investors
  • Improve alignment between the independent stakeholders at the firm rather than maintaining a check the box approach

As more investors adopt this approach, we’ll see a shift to an empowered and responsible management teams, serving as a strong foundation for sustained performance, in addition to being a starting point for responsible investing focused investors.

From Trust, but Verify to Influencing Outcomes

Overall, having a targeted approach optimizes the need for information vs. cost of managing such information. This approach should leverage exception analysis, and emphasize governance, reducing the need to constantly pepper managers with questions and freeing up bandwidth. Investors, with expanded bandwidth and resources, can arrive in the end zone more frequently and record many more investment successes.

Let’s put this topic to bed (and you, assuming you’re not asleep already) and look forward to influencing risk thinking at the managers and positive portfolio outcomes.

Part 1/2

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