Asset management and preservation for Charities and Institutions

In New Zealand trustees oversee a great amount of public money for institutions and charities that often have good and noble causes. Trustees are often passionate about the use of the assets they oversee and the beneficiaries they serve. At Bradley Nuttall, we help channel trustees’ energy into one activity almost certain to help them add real value; a prudent and rigorous process for managing the assets under their control. The fallout from the finance company collapse revealed that many institutions were over exposed to risks they didn’t properly understand. Many trustees weren’t aware how much risk their portfolios were exposed to. Many relied on the advice of an expert on the committee and felt unqualified to challenge their opinions. It’s possible to learn from the past and for trustees to bring real tangible benefit to their beneficiaries and themselves by using a rigorous prudent process to manage their assets. Potential benefits include: Lower investment and custody costs Better performing investments Resolution of committee conflicts Clarity on investment objectives Match of risk capacity with risk exposure Increased diversification Protection for trustee’s Uniform, standardized and convenient reporting and benchmarking

Strong evidence Institutions, Foundations and Endowments invest badly

This is why it's all the more surprising that, despite these advantages, evidence shows institutional trustees have made very poor investment management decisions. Several studies document that the decisions of trustees have often detracted value from the assets they manage. In other words, institutions, in aggregate, would have greater assets if trustees had done nothing relative to the decisions they made.

First, we look at the evidence and then we discuss the implications for trustees of institutions in New Zealand.

Review of an important academic study on institutional investment

Perhaps the most comprehensive study was published in the Financial Analysts Journal, Nov/Dec 2009, by Stewart, Neumann, Knittel and Heisler. In their study entitled "Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors," the authors study the reallocation of assets by institutional plan sponsors (trustees). The fundamental question posed? Did their allocation decisions add or detract from value relative to the status quo of doing nothing.

The study examines an impressive amount of data. They use information from the PSN Investment Manager database (the largest independent investment management fund database in the United States). The database provides historic information on thousands of institutional investment products and includes funds representing over $10 trillion in institutional assets. The study reviews over 80,000 annual returns.

The method of the study was to look at which products received large inflows or outflows of assets. In theory, if institutional trustees were adding value, money would flow into investments that subsequently outperform and/or out of investments that subsequently underperform.

The study shows that over one, three and five year pay-off periods the investment decisions taken by institutional trustees result in net negative returns. In fact, they found $170.2 billion in losses due to those poor decisions. In other words the institutions would have had more assets if the trustees had done nothing.

The graph below shows the value gained or lost by institutions in the five years following a decision. In only two years, out of eighteen, did the trustees' investment allocation decisions add value. In eight years, again out of eighteen, their decisions result in aggregate losses of over 1% of funds under management relative to doing nothing.

How could trustees have gotten it so wrong?

The study offers a few suggestions about what institutional trustees were doing wrong.

Perhaps the number one error was relying on past performance of fund managers to predict future performance. We quote below from the study:

The results prompt several questions. The largest asks why plan sponsors [trustees] appear to fail in their goal of increasing the value of plan assets. Heisler et al. (2007) demonstrate that institutional investors are sophisticated in their use of historical track records to help determine where to allocate their money. Perhaps investment officers, either because they or their supervisors believe it themselves, find comfort in extrapolating past performance when in fact excess performance is random or cyclical. – Pg 23

We understand the temptation. You're sitting on a fund that has underperformed its benchmark. Your sophisticated consultant points you towards a new manager that has outperformed during the last several years. You reach a conclusion, the underperforming manager is unskilled and the outperforming manager is skilled. The conclusion is obvious – move your assets towards the better/skilled manager.

With frustration you find about half of your supposedly skilled managers have subsequently underperformed, and the process repeats.

Why doesn't this work? Simply because those co-called skilled managers were really just lucky. Unfortunately, luck doesn't persist and can't be forecast.

What are the Implications for New Zealand Trustees

So what are the implications for trustees managing institutional assets in New Zealand? Does this mean that you never change managers? The answer is, clearly, no. Trustees have a responsibility to prudently select, monitor and replace assets where necessary.¹

Institutional trustees should start by understanding that the source of investment returns is taking investment risk. The first question they need to ask is, "How much investment risk is prudent for the long-term objectives of the fund?" This often depends on their projected inflows and outflows.

Once institutional trustees set their risk exposure, they should select asset classes and weights that provide the best opportunity for long-term returns for that risk exposure.

Next, trustees should select funds that diversify as widely as possible into asset classes defined in their Investment Policy Statement. Diversification lowers volatility while often increasing returns.

Last, trustees should try to allocate their funds at a low overall fee (including both explicit costs like expense ratios, and implicit costs like execution). The more they pay in fees, the worse their assets will perform.

While the above sounds straight-forward it can either be implemented carefully or carelessly. The difference can have big implications for the growth of assets. Importantly, the process should not be driven by the fund managers as they have an obvious conflict of interest.

If you start from the premise of a diversified, low cost, portfolio at the appropriate risk tolerance, there are four basic reasons to consider moving managers, to achieve:

• Greater diversification,
• Lower costs,
• Purer risk exposure, and
• Better execution

Evidence shows that the above four conditions increase long-term returns and/or reduce long-term volatility. Simply said, if investments are available that allow you to achieve the above then a prudent process would advocate a change.

Perhaps more importantly, trustees should develop and follow an Investment Policy Statement (IPS). An IPS introduces a culture of prudent governance and can cite studies like "Absence of Value." Strong governance and prudent process protect trustees from making decisions that detract from returns. Such governance is of immense value to trustees and ultimately to the beneficiaries of the assets they oversee.

Bradley Nuttall acts as investment adviser for institutions and consults on the drafting of an appropriate IPS for their asset. Bradley Nuttall helps institution, develop a strong culture of investment governance and prudent processes for selecting, monitoring and replacing fund managers.

Contact us to find more information on how we can assist your fund in making prudent decisions going forward.

¹There is some evidence that poor managers in New Zealand do have persistent poor performance where all other managers are subject more to chance. Thus removing poor managers as a practice has some merit. The question would remain however, why were they selected in the first place? See Bauer, Rob, Otten, Rogér and Tourani Rad, Alireza, "New Zealand Mutual Funds: Measuring Performance and Persistence in Performance." Accounting and Finance, Vol. 46, No. 3, pp. 347-363, September 2006.