February 2004
In today's economic environment, we think it is timely to discuss what risk means to us and how our definition impacts our approach to investing. Over the past 10 years, the American public has seen a truly unique phenomenon, beginning with the meteoric rise in stock prices during the mid-to-late 90s and along with it a euphoric sense of easy riches, only then to witness a three year, crushing bear market that all but erased the earlier gains. And now? A rebound in stocks over the past 15 months that is spurring latent thoughts of how good it all felt a few years back to be a stock investor. This big move in stocks brings us to the topic of risk, and more importantly, the challenge to manage risk in today's financial markets.
Risk is a central concept of investing and the way an investor defines it seriously influences how money will ultimately be managed. When looking at the industry as a whole, we find it useful to categorize investment professionals into two distinct groups. While over-simplifying, this partitioning of our industry isn't too far from reality and we've seen it first hand. In one corner, we have money managers who define risk as being out of step with the market and in the other corner we have those that primarily view risk as the possibility of losing money for their clients. How one defines risk and, more importantly, how investors manage it sets the tone for how investment professionals go about doing their jobs.
Managing Money Under The Threat of Being Too Wrong
Given the huge responsibility of monitoring large pools of money intended for public or charitable use, it makes sense that most money managed on the institutional side of our industry is largely controlled and monitored by a committee. Think of the investment committee members as people who are ultimately responsible for the hiring and firing of investment managers that actually manage the money. As you can guess, it is a tough job that has little upside and monumental downside.
For the most part a committee is made up of important and responsible community members whose backgrounds include prior leadership positions, possible finance experience and impeccable reputations. While generally familiar with investing and finance most committees are not capable, nor are they interested in making investment judgments. Naturally, they hire it out. But, in the end, they still retain the risk of failure. Their general definition of failure is doing something different than other similar committees and having it turn out poorly. Examples include holding too many long-term bonds when interest rates rise or being too light in stocks when a bull market takes hold. But even more likely, failure is defined as having the portfolio perform differently than the benchmarks or indexes that are set up ahead of time. And it is this risk that significantly impacts how investment managers approach their jobs when working for institutional committees.
Imagine for a moment that you are sitting on a committee that is responsible for monitoring the management of $20 million held by a community foundation. The committee hires an institutional consultant who has recommended that the S&P 500 Index should be the benchmark used to measure the performance of a chosen investment manager and it turns out the foundation's investment return comes in at twice the return of the benchmark last year.
This type of performance difference would seem incredibly acceptable in hindsight, but it begs the question, "Was this an acceptable risk to take?" The committee may conclude that, given the brilliance of the chosen investment manager, or possibly more accurately, given the brilliance of the committee to hire this brilliant manager, the risk of performing differently than the index was certainly an acceptable one to take. In other words, risk that doesn't result in harm, in retrospect, doesn't feel like risk at all.
But anyone using common sense knows this couldn't be further from the truth. And if you were, in fact, a member of that foundation's investment committee, you would likely never have consciously hired a manager whose portfolio could be so out of sync with your chosen benchmark. Why? Because the risk of being wrong and choosing an investment manager whose returns could come in at not double, but half, of the return of the benchmark last year would be far too much of a risk to take, especially to your impeccable reputation. So, naturally, you would shy away from hiring a money manager who shows a willingness to be out of step with the "market" for any reason, even a good one.
As a result of this thinking, most institutional money managers define risk as the possibility of being fired for not closely mimicking an index, no matter what. They gloriously mimicked the market's gains during the late 90's and sadly mimicked its losses in 2000, 2001 and 2002. As bizarre as it sounds, in the end, risk was properly managed and resulted in a form of success for all the parties involved; the institutional money manager likely kept his job (and fees!) and the committee followed the path of reasonableness by fulfilling their fiduciary responsibility of not being too wrong.
A similar story can be told when it comes to investment professionals that manage mutual funds whose performance drives the entire mutual fund marketing machine. We have had direct conversations with former mutual fund managers that intimately describe performance pressures for marketing purposes that led to truly idiotic investment decisions at the peak of the bubble in the late 90's. Of course they made these decisions to keep their jobs, to placate their bosses who were focused on managing the business and to try to keep their performance records intact. The risk here was defined as not having a competitive product to sell and the goal was to manage the business-end of things rather than to worry about their shareholders' hard earned money. Considering that most mutual fund managers don't personally know their shareholders, it makes sense that they aren't generally seen as the most important constituency to serve.
The same situation, although in a more benign form, exists at trust departments and advisory firms around the country that primarily limit their investments for client's accounts to large, established companies in the name of "safety" and "they-will-be-around-in-twenty-years" justifications. Unfortunately, many of these recognizable stocks are now selling for less than 50% of their highs. It is clear that the risk being managed in these organizations, again, was not that of losing money, but in losing their reputation in the public's mind as a conservative operation. In other words, when Disney, Intel and GE fall 50%, no manager is likely to be labeled as reckless, but when a smaller, lesser known company drops 50%, that investment manager is certain to be blamed.
It almost goes without saying that the second group of investment managers in our industry can be described as the type that continually guards against defining risk as anything other than the possibility of losing money. Of course, regardless of focusing on valuation, doing the necessary due diligence of product strategy and financial analysis and understanding the macro economic circumstances at play, even these types of managers make mistakes. But, through proper diversification (not over-diversification), active monitoring of value versus price and having the guts to sit still when attractive opportunities are sparse, these types of managers show time and time again that they are interested in the only type of risk management that matters most in the end; just don't lose it.
Jason P. Tank, CFA
jason@frontstreet.com