The problem with Investment Committees
The decisions which have the most negative impact on investment results tend to be associated with capitulating on a good strategy after a stretch of bad performance. In fact, capitulation can evolve into a pattern of selling low and buying high as the investor seeks to recoup foregone returns.
The typical investment committee structure doesn’t help
Clearly, it’s not always a bad idea to capitulate; extending the holding period will not transform a bad strategy into a good one. That said, there is no doubt in my mind that exiting a sound strategy after a stretch of bad performance is one of the biggest weaknesses of many institutional investment programs.
My friend and Russell Investments colleague, Tim Noonan, recently commented, “If you are not loyal to a decision, you are more likely to capitulate.” Tim’s statement got me thinking about how the structure of a typical investment committee actually leads to an environment where remaining loyal to a particular investment idea becomes more difficult and capitulation more likely.
The reason is two-fold. The first relates to the turnover of decision makers. It is understandably very difficult to support a decision that you did not make which has underperformed. The second relates to having multiple decision makers where the degree of support across the group varies. Some individuals will be strong supporters, while others may have reservations. While this creates an important check and balance of the investment process, the naysayers in the minority do not go away once the decision is made. In fact, the volume of their voices increases in proportion with the underperformance.
A current example: CalPERS and tobacco
Pensions & Investments recently reported CalPERS was reconsidering their divestment of tobacco holdings following a period over which the decision cost the fund an estimated $3 billion.1 This sum is fodder for an attention grabbing headline but since capitulating on this decision now doesn’t remove the impact from their actual performance experience, the question of whether to maintain their divestment policy should only be made from a go-forward basis. Unfortunately, setting aside past experience is harder than it first appears.
First of all, it is unlikely all of those who originally approved the divestiture policy are still on the investment committee. Secondly, among the group in place today, there are likely some who support the decision to continue the policy and those who oppose it. Given recent performance, those with reservations (even if in the minority) are in a much stronger position.
To be clear, my objective with this blog post is not to express a view one way or the other as to the investment merits of divesting from tobacco. Instead, I am using this example to illustrate how remaining loyal to a particular investment idea, following a period of underperformance, is quite difficult and the risk of capitulation rises. This is the type of decision that has the potential to have a very material impact on investment results.
Steps to reduce the odds of capitulation
Investment committees play an invaluable role in the management of large pools of assets. That said, their decision making process does have some shortcomings. Three ways to help remain loyal to an investment decision when the inevitable rough patch occurs are:
- Document and regularly review the committee’s objectives and investment beliefs.2
- Clearly articulate how each investment is expected to contribute to the objectives and how it is consistent with the stated investment beliefs.
- Regularly remind the decision makers of the range of possible outcomes associated with each investment with an emphasis on the environment in which the strategy is expected to underperform and the potential magnitude of this underperformance.
Many of us are in the midst of evaluating investments which have disappointed (e.g. emerging market equity) or considering new strategies (e.g. whether to “decarbonize” the portfolio or not). While determining whether these constitute a good investment strategy or not will have to wait for another blog post, the steps noted above can certainly lessen the odds of capitulating when the inevitable stretch of bad performance occurs.
Please note: Content for the Fiduciary Matters blog is being provided by guest authors while Bob Collie is on sabbatical.