In my last post I discussed several strategies institutions and families have employed to keep investment committees focused on their stewardship obligations. A number of readers have written in to ask what sorts of errors investment committees tend to make, and so in this post I will describe some of the more common problems.
The investment committee goes into full panic mode. In 2008, many investment committees panicked, allowing the equity portion of their portfolios to fall far below the prescribed ranges. In a few cases, the committees sought board or family approval to reduce the allocation to equities, but in most cases the limits were simply ignored. The rationale for these decisions was often something like this: the size of the portfolio was being reduced so far that required spending needs were becoming unconscionably high as a percentage of the remaining capital.
But portfolio allocations should always anticipate that spending will have to continue even during prolonged extreme market conditions. In the event of such conditions, spending will be made out of bond and cash allocations. If those allocations are too small to support spending during adverse markets, then the portfolio was misdesigned from the outset. The problem, however, was not that the equity allocation was too high, the problem was that the bond/cash allocation was too low.(1)
The investment committee is convinced it consists of geniuses. Near the end of every Bull Market many investment committees become convinced that they are investment geniuses. Sure, they are thinking, the maximum equity exposure under the policy statement is 70%, but that’s for ordinary investment committees. Within the last four weeks an investment committee I know but won’t mention (you know who you are!) blithely violated the upside boundary for equity exposure in the portfolio it oversees – for the third time in four meetings. The markets promptly tanked, shearing $35 million from the portfolio.
The investment committee specializes in death-by-a-thousand-cuts. Most members of investment committees are busy people and when they take the time to show up for an investment committee meeting, the last thing on their minds is doing nothing. Yet, in the huge majority of cases, that’s precisely what the committee should be doing – nothing. Most investment committee meetings are scheduled as promptly as possible after the end of calendar quarters, and hence the committee is intensely focused on the recent quarterly results. Unfortunately, the actual fact is that any quarterly result is mainly noise. Actions the committee takes in response to that noise are likely to be suboptimal at best.
The investment committee doesn’t respond as the family evolves. An investment committee appointed by, say, G2, tends not to evolve as quickly as the family it is serving is evolving. As a result, G3 (and sometimes G4, who are often young adults) find themselves estranged from the committee and its activities, even as these generations struggle with the infantilizing effects of well-intended but suffocating trusts. Instead of managing a seamless transition from G2 to G3, and thence to G4, a great deal of misunderstanding, miscommunication, and mischief results. None of this does the family’s capital any good.
The investment committee doesn’t know who its client is. Especially for family investment committees, the committee members often have difficulty identifying the client(s) on behalf of whom they are working. Is it the patriarch who appointed them? Is it all adult generations? What about the many family trusts and other tax and estate planning entities? Is it all of the above? If so, how does the committee manage conflicts between them? A common conflict will be something like this: the senior generation, as it ages, becomes ever more cautious and pressures the committee to ratchet back on risk. But younger generations, and vehicles such as generation-skipping trusts, need to have a lot more octane in their portfolios.(2)
The investment committee has conflicts of interest. Some families and institutions recruit investment committee members by offering them the opportunity to co-invest with the family in deals they would not otherwise see or have the capital to access. But these arrangements quickly result in the committee advocating investments that are of interest to the committee members, but not necessarily in the interests of the family. There are also conflicts of interest that are less obvious but which also skew decisionmaking in unhelpful directions.
In my next post, I’ll outline a very different approach to helping investment committees better discharge their responsibilities. (I know, I promised this last time, too. A blogger’s promises are generally not worth the bytes they’re written on.)
(1) In other words, if the portfolio called for 65% equities, then the investment committee should have been rebalancing back to that percentage all along. Spending would have been accomplished by selling bonds or using cash. Even relatively aggressive investors should have enough bonds and cash to cover three years of spending, and most investors will want more. A family with a high tolerance for risk – a very long time horizon – might spend only 2% of its assets each year and, therefore, own bonds and cash totaling less than 10%. An institution with a 5% spending rule should almost certainly keep 20% of its portfolio in bonds and cash, in order to permit the reallocation to equities during Bear Markets.
(2) Thanks to Jay Hughes for reminding me of these issues. The opinions expressed, however, are mine, not Jay’s.
Next up: The ICOM, Part 4
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
