By: Russ Kamp, CEO, Ryan ALM, Inc.

I’m on my way home from another terrific FPPTA conference. The only issue I have is with the weather Gods. How is it that Orlando had weather similar to what New Jersey experiences during January? Yes, I was in a conference room from dawn to dusk, but it still wasn’t fair, especially since temps are set to hit 70+ today, while I’m now sitting at the airport. 

Okay, enough of my complaining. As mentioned, I just attended FPPTA’s Winter Trustee meeting in Orlando. They continue to do an excellent job providing critical education for trustees of all experience levels. As I’ve written, they have also developed a higher-level program for a select group of pension trustees that truly want to roll up their sleeves and like Dorothy and her friends, get behind the curtain. I’ve been fortunate to be a part of the first two TLC classes. As the FPPTA continues to develop their use of AI and the self-contained bot currently under construction, Florida public pension trustees will have critical information at their fingertips that few other states, if any, can provide. Great job!

Despite the robust curriculum, there is still much more that needs to be covered and comprehended by the trustees. For instance, there was a lot of discussion surrounding hiring and firing of managers during a particular case study. As I’ve observed over the years, the fortunate investment manager that gets hired usually has the best performance and a reasonable fee that doesn’t offset the performance advantage. Do pension trustees truly understand what they are buying? Often the manager selected is large and likely growing in terms of AUM. But are those advantages?

Worse, when a manager underperforms, which they will eventually do, whether that underperformance is related to a style rotation or something specific to that manager’s process, a decision must be made as to that manager’s fate. Do you keep the manager or let them go? On what basis are you making that decision? Again, you hired a manager because they had good performance. Did you understand their security selection process (insights) and how those insights were working? Did recent strong AUM growth fuel a positive response in the stocks that they owned? As we know, cycles in the investment industry are driven by cash flows, both positive and negative. More money chasing a few ideas drives up returns, while an exodus from those same ideas can tank an investment manager’s performance.

During one exchange of ideas, I asked the TLC participants if any of their funds were using performance fees for their long-only assignments. Only one trustee said that they had – too bad. We’ll discuss that issue in another post. Regarding the one affirmative response, they initiated a performance fee after an extended period of underperformance. Was that action correct? Paying asset-based fees with no promise of delivery on forecasted alpha is wrong, but retaining an underperforming manager may be just as bad whether they are on a performance fee or not. How did this trustee and his fellow board members know whether the manager had skill or if they once did, were their insights still robust?

Investment managers choose their portfolio holdings based on certain insights, and those insights can be measured as to their predictive ability (information coefficient or IC). An information coefficient is the correlation between predicted returns (or rankings of one stock versus another) and the subsequent results (realized returns). If an advisor is a growth manager, they likely swim in a subset of the U.S. equity universe. They then apply their insights to that subset of equity stocks. Each month they can array their portfolio holdings with the balance of the names in the universe that they did not select to see how their ideas stacked up.

You might be surprised to read that a monthly IC above 0.05% is considered fairly strong. An IC from 0.05% to 0.15% would be very strong and likely lead to consistent alpha generation. However, even the best investment ideas can go through challenging times when market dynamics are just out of whack with historic observations and relationships. But there are also times when ideas can get arbitraged away either by that managers growth or the broader investment community latching onto the same insight rendering it less effective or in some cases a negative forecaster/predictor.

So, I ask, when your manager is underperforming, do you know whether it is a market dynamic that is rendering the insight temporarily weak or has that manager’s forecasting ability been diminished? In the case of the manager who maintains strong forecasting ability, but the insight is just out of favor, you would likely want to retain them after a period of underperformance and maybe give them more assets to manage, but I would not recommend putting them on a performance fee (regression to the mean tendencies). However, if after your careful analysis you identify that the manager in question has seen their insights arbitraged away, that should lead you to terminate the manager, whether you like them or not! Let me know if you’d like to discuss his concept in greater detail.