By: Russ Kamp, CEO, Ryan ALM, Inc.
I’m going to divert from my normal focus on cash flow matching (CFM) and the defeasing of pension liabilities to write about a subject that I love and one that doesn’t get nearly the air time that it should. I was reminded of this topic at the FPPTA’s latest TLC program in Orlando, which I’ve thoroughly enjoyed participating. If you aren’t aware of the TLC (Thought Leadership Council) this is the FPPTA’s newest advanced educational program for experienced pension trustees. The program is limited to 20-25 trustees who get to roll up their sleeves with highly experienced coaches/mentors. I’m grateful to be included.
On Monday, one of the discussions centered on active managers, particularly US domestic equity managers, who have an incredibly challenging job trying to outperform their respective benchmarks, especially given the concentrated nature of the U.S. equity stock market during the last couple of years. Asset consultants have an even more challenging job trying to figure out which of those active asset managers will actually provide alpha NET of fees. As mentioned during one particular session, there are many aspects of the investment management process that are evaluated by consultants in an attempt to try and identify those few outperformers. These screening criteria may include the depth and consistency of staff, overall experience in managing the strategy, AUM in the product, and of course, performance. However, just because a manager outperformed (provided an excess return vis-a-vis the benchmark) an index at one point doesn’t mean it will happen again. Was the outperformance the result of skill or luck or a little of both?
As I explained to the TLC participants, stock selection factors (indicators or ideas) used to “pick” stocks to be included in the manager’s portfolio have an information content that can be measured. The “value-added” from an idea/factor can ebb and flow depending on a number of factors. Is the “deterioration” in the information coefficient (IC) an indication that the factor is losing it’s forecasting ability or is it just currently out of favor? As investment management firms get larger, the AUM that they control can overwhelm those insights diminishing the forecasting ability of that idea. Other investment management firms have bright people looking for an edge, too. They might just capture the same or similar insights rendering everyone’s use of that idea less robust, which I witnessed first hand in 2007’s quant manager meltdown. Below are two posts that touch on this topic. I hope that my ideas prove useful to you.
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In a previous life, I was the CEO of Invesco’s quant business, which featured roughly 50 incredibly bright team members located both here and abroad and we managed about $30 billion in AUM. During our time together, we developed roughly 55 different strategies (optimizations), mostly U.S. equity mandates for which we had specific return/risk characteristics such as our Structured Core Equity product that was designed to achieve a 2% return for a 3% tracking error or a 0.67 information ratio versus the S&P 500.
We also thought that it was critically important to determine what we believed was the natural capacity of each strategy, as we didn’t want to arbitrage away our own insights. For instance, our Small Value product’s capacity was <$500 million, while many of the larger cap offerings had abundant capacity equal to billions of $s. Trustees should ask their managers what they believe is the natural capacity of the strategy(ies) that they are invested in and how they determined it.
Lastly, I would ask each manager to discuss a stock selection idea (factor / indicator) that they once used, but no longer do and why. Furthermore, I’d ask them to discuss an idea that they are now using to help them choose their portfolio constituents that they might not have been using 3-5 years ago. I’d make sure to understand how often they review every aspect of their investment management process. If that isn’t a normal part of their process, I’d be very concerned. For standing pat means that you are likely falling behind. It will be interesting to hear the replies.
Given how challenging it is to identify value-added managers as a consultant or consistently add value as an investment manager, I’m glad that Ryan ALM focuses on defeasing pension liability cash flows of benefits and expenses with asset cash flows from bonds (principal and interest). There is little uncertainty in our process. It is truly a sleep well at night strategy for all involved.
Ryan ALM Blog 