Why the investment industry needs to reconsider how it measures success

Investors make decisions every day about how to allocate the monies entrusted to them, including choices which asset classes, which markets and which managers to select. Asset allocation and asset liability studies help to determine the trade-off between risk and return, which translates into an asset mix. From there, investors decide on how to invest the money and with whom. Naturally, they want to measure the success of all of those decisions.

Institutional investors have agreed on some common approaches and principles for measuring success. At the level of the total fund, they often use absolute returns, targets that consider the consumer price index plus a real return and weighted average benchmarks that are an amalgam of the underlying asset class exposures. They may also add an alpha expectation to account for active management and the fees associated with it.

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At the manager level, investors use benchmark indices to determine whether our public market managers achieved a return comparable to that of the market. If actively managed, they add an alpha target to account for active management and the additional fees. They also use peer rankings to measure the opportunity cost of having selected one manager over another. For private market investments, they sometimes use public market equivalents, inflation plus a real return or an index plus an illiquidity premium. They also measure the opportunity cost through peer comparisons, usually by vintage year and investment type.

So far, so good. Where most investors have difficulty is determining the appropriate time frame over which to measure success. Many Canadian investors’ statements of investment policies and procedures use either a four-year measurement period or a three- and five-year comparison to determine success. (It’s worth noting that that approach really only applies to the total fund, investments in public markets and those in private market strategies delivered through open-ended funds. Investments in private market strategies delivered through closed-end funds can only be measured properly upon the fund’s termination.) If someone asked investors the reason behind those measurement periods, they’ll often not know why. Some have suggested that a business cycle used to be four years, which is why that duration became the measurement period.

In 2015, Manning & Napier published a white paper that attempted to quantify a market cycle using data from the S&P 500 index from 1926 onwards. It defined a market cycle as including a bear market, a recovery period and a bull market. Its analysis showed that a market cycle, defined as market peak to peak, is on average 6.9 years, whereas a cycle measured as trough to trough (or bear market to bear market) would, on average, be 8.6 years. That’s far longer than the usual four-year or even five-year measurement period that most Canadian plan sponsors use.

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In 2016, MFS Investment Management Canada Inc. surveyed 220 institutional investors to find out how they’d define a market cycle. The average response was 6.1 years, which is relatively close to the average peak market cycle. The largest group of respondents, 36 per cent, defined a market cycle as seven years. When the survey asked the same group of investors how they measured their managers, the average response was 3.3 years, with 57 per cent measuring managers over a three-year period. Clearly, there’s a big disconnect between a market cycle and how investors define success.

That has led to an increase in funds with shorter time horizons, namely hedge funds. A 2015 American Finance Association meetings paper found, on average, short horizon funds hold stocks for 1.9 years, whereas those with long horizons hold stocks on average for about 6.9 years. It also found those with long horizons have outperformed short horizon funds by between 2.4 per cent and 3.8 per cent annually. Long horizon funds are often concentrated, high-conviction strategies with high tracking error but less volatility than the market. The funds can underperform for periods of time in order to achieve longer-term outperformance.

It would seem that investors should measure success over seven years or so, so why don’t they? There are a number of reasons. Accounting and regulatory requirements for pension plans often look to one- and three-year time horizons, which naturally leads to shorter measurement periods. As such, plan fiduciaries have an incentive to invest for shorter time periods. Another reason could be that tenure on a fiduciary body (board, investment or pension committee) usually doesn’t extend to a seven year range. So there’s no incentive for board or investment committee members to take longer-term investment decisions that could result in short-term underperformance during their tenure. Clearly, this is agency conflict, but people are human and no one wants to look bad. The consulting industry has certainly contributed to the issue as well, with manager evaluation focusing on shorter time periods.

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It’s clear from the above analysis that it’s time to rethink how to measure success. It’s important to have a thorough understanding of the strategies employed and under what environments and time frames they’ll succeed. To some degree, investors have already gotten there as it relates to closed-end, private market strategies. However, the industry has yet to extend that thinking to the level  of the total fund. It’s important that plan fiduciaries begin the dialogue in order to breach the disconnect.