Asset Management and Preservation for Charities and Institutions
In New Zealand, trustees oversee a large amount of public money for institutions and charities that frequently have good and noble causes.
Trustees are often passionate about the use of the assets they oversee, as well as the beneficiaries they serve. At Bradley Nuttall, we help channel trustees’ energy into one specific activity that is 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 overexposed to risks they didn’t properly understand. Many trustees weren’t aware how much risk their portfolios were exposed to. They were relying on the advice of an expert on the committee, and felt unqualified to challenge this expert’s opinions.
It is 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 trustees
- Uniform, standardised, and convenient reporting and benchmarking
Strong evidence that Institutions, Foundations and Endowments often invest badly
Institutions, not for profit organisations, and endowments represent some of the most sophisticated investors in the New Zealand marketplace. These organisations often have both significant resources at their disposal and access to a range of investments not normally available to the investing public.
This is why it’s all the more surprising that, despite these advantages, evidence suggests that 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’ll look at the evidence, then we’ll 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. Entitled “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors,” this study investigates the reallocation of assets by institutional plan sponsors (trustees). The fundamental question posed was this: Did their allocation decisions add or detract from value relative to the status quo of doing nothing?
In the study, the authors examine 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 this 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 those investments that subsequently outperform and/or out of the investments that subsequently under-perform.
The study shows that over one, three, and five year pay-off periods, the investment decisions taken by institutional trustees result in negative net returns. In fact, they found $170.2 billion in losses due to those poor decisions. To summarise, 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 resulted in aggregate losses of over 1% of funds under management, relative to doing nothing.
How could trustees have gotten it so wrong?
This 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 toward a new manager, who has outperformed over 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 have found that around half of your supposedly skilled managers have subsequently under-performed, and again the process repeats.
So why doesn’t this work? Simply because those co-called skilled managers were really just lucky. Unfortunately, luck doesn’t endure 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 should 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 have set their risk exposure, they should select asset classes and weights that provide the best opportunity for long-term returns based on that level of risk exposure.
Next, trustees should select funds that diversify as widely as possible into the asset classes defined in their Investment Policy Statement. Diversification lowers volatility, while often increasing returns.
Lastly, trustees should try to allocate their funds at a low overall fee (including both explicit costs such as expense ratios, and implicit costs such as execution). The more they pay in fees, the worse their assets will perform.
While the above sounds straightforward, it can either be implemented carefully or carelessly. The difference can have large 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. These are to achieve:
- Greater diversification
- Lower costs
- Purer risk exposure
- Better execution
Evidence indicates that the above four conditions increase long-term returns and/or reduce long-term volatility. Simply put, if there are investments available which allow you to achieve the above, then a prudent process would advocate a change.
Note that changing underlying fund managers based on short-term investment returns is intentionally missing from the above list. Short-term investment returns should have little or no bearing on the decision, simply because study after study has shown that such returns have no predictive power, and add no value to allocation decisions.
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 such as “Absence of Value.” Strong governance and prudent processes 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 assets. Bradley Nuttall helps institutions 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 by making prudent decisions going forward.
1There is some evidence that poor managers in New Zealand do have persistent poor performance, where other managers are more subject to chance. Thus, removing poor managers as a practice has some merit. However, the question would remain, 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.