|
© Copyright 2000 Rogers Media. The following article first appeared in the September 2000 edition of
BENEFITS CANADA magazine.
Performance Anxiety
Plan sponsors are pressuring value managers to keep pace with growth managers in a booming economy.
This is a troubling trend that could see members' retirement income drop with a market correction.
By Doug Burn
The extended bull market is subtly, yet fundamentally, turning pension funds into high-risk investments.
The traditional balance between value and growth investments is being skewed to growth as defined
contribution (DC) plan members and defined benefit (DB) plan investment committees screen out
fourth-quartile performers in their selection of mutual funds and investment managers. Meanwhile, the funds
and managers that hold value stocks have underperformed the markets by such a wide margin lately that they
no longer make the cut.
Performance anxiety among value investors has become so great that many are style drifting to growth. DC
plan members and DB plan investment committees that believe they have a good balance between value and
growth may be surprised to find that they are holding Nortel Networks and other growth stocks in the value
portion of their portfolios.
The bigger issue at hand, however, is the fact that pension plans are intended to provide employees with a
secure source of retirement income. By their very nature they should be oriented towards value investments.
But if the share prices of today's growth companies tumble, overweighting in growth could jeopardize the
retirement incomes of DC plan members and trigger the need for a significant contribution hike by DB plan
sponsors.
Pension investors must be concerned about capital preservation and long-term growth. That is the specialty
of value-oriented mutual funds and investment managers. They buy and hold great companies at average prices
and average companies at great prices, for the long term. Their portfolios exhibit lower price-to-earnings
and book-to-market value relative to the overall market and are less volatile than growth portfolios.
So, why are DC plan members and DB investment committees deliberately or inadvertently pressuring the
managers of value-oriented mutual funds and DB investments to match or exceed the returns of the overall
market? Industry experts attribute the growing demand for short-term performance to a multitude of recent
developments, but the Toronto Stock Exchange (TSE) 300 composite index is the most widely cited culprit.
The targeted rate of return on a DB pension fund may be 7% and the investment manager may be earning 10%,
but investment committees focus on the TSE 300 and wonder why their active managers can't match the 50%
performance of this index (52 weeks ending Aug. 3, 2000).
Growth investors, in contrast, have done exceptionally well with their heavy weightings in the high-tech
sector. Meanwhile, value investors note that Nortel's heavy weighting in the TSE 300 index (34%) and its
stellar growth since 1997 make that index an unfair benchmark for evaluating their investment style.
Paul Carter, research analyst with Frank Russell Company noted earlier this year in the firm's Quarterly
Commentary that "the 19.2% difference between growth and value is the second largest margin between the
two indicies (Russell 300 Value Index and Russell 300 Growth Index) since Russell began calculating them in
1988." Carter added that the biggest difference was 44% in the fourth quarter of 1999.
PARADIGM SHIFT
Value investors are occasionally fired--but more often their assignments are not renewed--because they
don't make the short lists of investment committees based on their recent performance.
Bob Tattersall, chief financial officer at Howson Tattersall Investment Counsel Limited in Toronto, says
"two years ago, when our performance was in the first quartile, I made presentations every week. Investment
managers don't get interviews when they're in the fourth quartile." Tattersall adds that investment
committees tend to "switch out of a style just as it's at the bottom of a market cycle."
"It's very difficult for a committee to buy low because they can be judged harshly if things don't turn out
well," says Geri James, principal, relationship development at Toronto-based Barclays Global Investors.
"So, they hedge their bets by hiring a manager with good recent performance."
Murray Leith, a 37-year veteran of the investment industry and president of Vancouver-based Leith Wheeler
Investment Counsel Ltd., adds that investment committees are fearful of acting prematurely by switching out
of good performance. "Wanting to win all the time is human nature," says Leith. "No one wants to leave the
party too early."
Until about two years ago, the conventional wisdom held that the stock market bubble wouldn't last.
Analysts only differed as to whether there would be a soft or hard landing, and when it would happen. Alan
Greenspan, U.S. Federal Reserve chairman, attributed sky-high share prices to the "irrational exuberance"
of investors. Economists, stockbrokers and mutual fund managers urged investors to capitalize a portion of
their gains, move these funds into cash and wait for buying opportunities following the inevitable market
correction. Those who did so are still waiting.
Now, Greenspan has embraced the view that the economy has undergone a paradigm shift, and that even at
today's much higher prices, stocks are not overvalued. The old paradigm held that inflation and recession
were certain to follow an extended economic expansion because as unemployment fell, employers would hike
wages to retain staff and these costs would translate into price increases. The demand for capital to
invest in new plants and equipment would drive up interest rates. Faced with higher costs for mortgages,
car loans and consumer goods, the public would cut back on spending and the recovery would collapse into
recession.
On the other hand, the new paradigm suggests that the flood of capital into new technology is raising
productivity and driving down costs so that the expansion can continue indefinitely--without inflation or
recession. "There is a lot written in the industry regarding the paradigm shift and the permanent demise of
value management. I have a big problem with that," says Harry Gibbs, vice-president, investments at the
Workplace Safety & Insurance Board in Toronto. "I firmly believe in value investing--buying equities
with the best value. But investment committees are seeing value managers falling deeply into the fourth
quartile and that worries me."
STYLE DRIFT
Even if an investment committee accepts the paradigm shift, it would be foolish to fire the value
investment manager or pressure the manager to buy growth stocks, says Colin Ripsman, senior investment
consultant and head of the DC consulting group at William M. Mercer Limited in Toronto. "It would be wiser
to transfer a portion of your portfolio to your growth manager or if you don't have one now, to bring in a
growth manager as a style offset and assign him or her a portion of the portfolio."
According to Roger Phillips, vice-president of Toronto-based Hydro One's pension fund, "style drift is
dangerous [because] it puts the entire investment strategy at risk." Why? "The investment manager [is]
telling you an inconsistent story and casts doubt on the entire management structure. The plan sponsor has
constructed a portfolio based upon diversification of asset classes and investment management style."
The most common form of style drift among value investors is half-weighting in growth stocks, that is,
buying enough of a security such as Nortel to equal half its weight in the TSE 300 index. This confounds
the potential returns of a value portfolio in the long term, and requires the manager to chase performance.
The desperation that prompts a value manager to half-weight in growth may be accompanied by even more
disturbing behaviour. "In our attribution analyses of underperforming portfolios we sometimes find that
style drift is but one of the problems," says Ripsman. "You may find [for example] that a very conservative
manager has made a huge shift out of bonds and cash into equities."
The traditional safeguard against style drift has been the ongoing relationship between investment
committees and managers. But the relationship is breaking down due to high turnover among investment
managers and committee members. Barclays' James says turnover has made committees reactive and prone to
questioning past decisions they don't understand. He adds that some committees are switching managers every
two years.
The situation is further complicated by the trend to delegate fund oversight to busy senior executives.
Committee members tend to rubber stamp rather than debate the proposals of such an executive, even when
they run counter to the established investment strategy. One of the more common proposals of these chairmen
is to consolidate investments with fewer managers--particularly those that can match the performance of the
TSE 300.
PRINCIPLES AND BELIEFS
Fundamental changes are needed to improve the relationship between investment committees and their
investment managers. Paul Owens, chief executive officer of the Mississauga, Ont.-based Colleges of Applied
Arts and Technology (CAAT) pension fund, recommends investment committees develop a statement of investment
principles and beliefs (SIP&B).
Cortex Applied Research Inc. of Toronto worked with CAAT's investment committee last year to develop a
SIP&B. John Por, founder and president of Cortex, says his approach with CAAT, as with his other
clients such as DuPont, Shell and IBM, involved a candid discussion with committee members to confirm their
convictions about such issues as acceptable levels of risk and the value of diversification.
Por doesn't stipulate which principles should be adopted, but he does question members' beliefs with
empirical data drawn from the stock market and their own investment decisions. "Even if we disagree with
their beliefs, it's their document," he adds.
Barclays' James suggests that if the principles and beliefs of investment committees and DC plan members
really favour investments that track the TSE 300 and other markets, they should consider investing a
portion of their portfolios in the indexes. "Barclays offers both passive and active management. Although
[investors] can opt for 100% active or 100% passive, most choose a combination of the two in varying
proportions."
Bill Ashby, president, Beutel, Goodman & Company Ltd. in Toronto, dislikes passive management but
introduced a Core Value portfolio in early 1999 for clients who are looking for returns that more closely
match the indexes. His traditional value portfolio of 40 stocks lacks exposure in some sectors such as
high-tech. But the risk-controlled Core Value portfolio includes the 40 value stocks as well as 30 to 50
others with half-weighting in such companies as Nortel to ensure exposure across all sectors.
The investment strategy that emerges from a principles and beliefs process with an individual DC plan
member or a DC plan investment committee may be better or worse than the existing strategy--but it has a
greater likelihood of being pursued consistently over the long term. A more disciplined commitment to an
investment strategy would also relieve the performance anxiety felt by investment managers.
In today's market, growth stocks are a high wire act and value investments are a safety net. The higher the
market goes, the more you're going to be relying on that safety net to remain secure. Review your value
investments to ensure that they truly represent value. Don't wait for a sharp market correction to find out
your safety net has unravelled.
Doug Burn is a Toronto-based freelance writer. dougburn@home.com.
|
News
News
