Have you ever played the game Mousetrap? It was the first 3-D board game debuting in 1963 and is still available today. It was a Rube Goldberg-type of game attempting the simple task of catching a mouse in a complicated way. As a child, it was fun to play but was often disappointing as the machine rarely worked to completion- failure due to complexity.
In 1987, Milton Bradley's Mousetrap commercial said it was "the craziest game you've ever seen." In my 25+ years in the institutional investment world, I have seen the "investment game" become so crazy and complicated that the comparison to Mousetrap now makes perfect sense.
Here are 5 questions plan sponsors should answer to determine if they are now investing like the game Mousetrap.
1. Are we paying higher and higher fees?
Complexity costs more, but sells better. Fees paid are a great indicator for how complicated your plan may have become. More managers, more asset classes, more transaction costs, more studies and more meetings create a higher cost hurdle affecting your bottom line.
Ask your investment consultant or auditor to chart your fee history as a percentage of AUM. Evaluate the fee change in light of your plan's investments and processes.
2. Do we have more than 10 active investment managers?
Without fail, every institutional investor for which I have performed due diligence of their investment consultant saw more and more managers employed. Worse yet, in every due diligence the active managers collectively failed to create alpha, net of fees.
There are many reasons too many active managers likely leads to collective failure. Not only is it difficult for managers to beat their benchmarks net of fees, but plan sponsors tend to chase returns by hiring managers after a hot streak and then firing after they stumble. But there is another reason I recently learned that I would like to share.
Northern Trust Asset Management recently published The Risk Report. It details six key discoveries that lead to under-performance for institutional investors. What caught my eye was the research into the Cancellation Effect- active managers cancelling each other with offsetting positions. On Page 8 they conclude; "Our analysis uncovered a shocking amount of this cancellation effect. Nearly 50% of the active manager risk was lost. Capturing just 50% of targeted active risk, while paying 100% of the manager fees, effectively translates into paying 2x more for each realized basis point of active risk than originally thought."
3. Are we always doing something?
When I worked as an investment manager, my best lessons in investor psychology were presenting client reports during 2000-2002 and 2008/2009. During these times of market stress I was routinely asked, "Should we be doing something?" If current market conditions are the trigger for change, it normally turns out badly. Therefore the best answer for long-term investors is to stay calm, prudently rebalance and stay the course. Although doing nothing was correct, it was a hard sale with few buyers.
The easiest sales pitch to panicked investors is to do something. Look back and recall how institutional investors bought dot.com in 1999, added absolute return hedge funds and bonds in 2003, went international in 2009, and so on. These were costly reactions at market inflection points driven by fear and greed.
Few institutional investors elude the do something trap. If it seems at every meeting there is always something to do- a new asset allocation study, considering a new asset class, managers on the watch list, searching for new managers- you are likely doing too much. It is no coincidence in all my due diligence work that the best performing investment consultant made the fewest manager and asset allocation changes over the study period.
4. Have our past changes added value?
Notwithstanding the last sentence immediately above, constantly making changes does not necessarily mean value is being lost. The problem is plan sponsors have no idea which decisions are profitable following their investment consultant's advice.
This makes sense given the only performance reports plan sponsors normally review are provided by the firm giving the advice. The simple truth is that these reports deliberately tell clients very little about the investment consultant's value-add.
For an in-depth explanation of this truth, read 6 Tricks Investment Consultants Use To Fool Their Clients. It also provides simple tips for discovering your investment consultant's true value-add.
5. Are we doing better than simple?
My first mentor was Deane Nelson, CFA. He grew up in Indiana, was an MP in the Marine Corps and a true, old school professional. He taught me how to use Microsoft Excel by creating a three-asset-class mean-variance model. Since our clients were pension plans I asked, "What is the best asset allocation for a pension plan?" I vividly recall him glibly saying with a dismissive wave of his hand, "It always ends up 60/40."
The 60/40 is a simple portfolio of 60% S&P 500 Index and 40% Barclays Aggregate Bond Index. The 60/40 used to be a common barometer for institutional investors to gauge risk and return. Curiously, it seems the 60/40 has fallen out of favor as I now rarely see it in performance reports. Maybe it has been too tough to beat to continue as a comparison?
The lessons for a pension plan comparing its performance to the 60/40 should not be lost on investors with different objectives. Consider the performance below and see if your complicated, complex and costly investment strategy beats a simpler version of yourself.
