In my last post I suggested that most investors over-manage their portfolios. In other words, the inability to remain patient and allow long-term strategies and quality managers to do their jobs is harming our returns. Those returns are damaged in the first place by the costs associated with frequent portfolio changes, especially transaction costs and taxes. But in addition, most changes tend to harm our long-term returns as we:
- depart from our long-term strategies for short-term reasons,
- fire managers who will outperform the replacement managers, and/or
- engage in market timing under the mistaken impression that we are making sensible tactical moves.
Of course, all portfolio changes aren’t suboptimal, but most are. If that’s the case, how can investors arrange their affairs in ways that will minimize the temptation to be over-active?
One thought would be to dispense with the quarterly meeting schedule most families follow.
It’s interesting, in fact, to consider why it is that most families convene quarterly face-to-face meetings for in-depth reviews of their portfolios. My guess is that families are imitating the portfolio review schedule followed by institutional investors. But of course that merely begs the question why institutional investors would engage in such suboptimal behavior. I say suboptimal because finding a date when everyone can meet around one conference table is a monumental job, especially in these days of Air Travel Hell. Once everyone has turned the world upside down to get to the meeting, the temptation to justify that effort by doing something can be overwhelming.(1)
The answer to the question why institutional investors meet quarterly is that trustees of institutional investors are fiduciaries, and breach of fiduciary duties is measured according to procedural standards. To take an extreme case, imagine a university whose investment committee meets every month. During those meetings, huge numbers of changes in the portfolio are approved, resulting in very serious long-term damage to the portfolio. If challenged, the trustees behavior is unassailable because they carefully followed all the procedural touchstones, reviewing the portfolio regularly.
The UMIFA,(2) in other words, doesn’t care a whit whether an endowment portfolio has done well or poorly (or even spectacularly poorly), but only whether the trustees papered over their screw-ups appropriately. Did the trustees “make a reasonable effort to verify facts relevant to the management and investment of the fund?” Are you kidding? We met every month! Did the trustees consider all eight factors the UMIFA believes are appropriate in the course of “making management and investment decisions” regarding the fund? Check out the investment committee minutes, pal! Did the trustees run the portfolio into the ground by making hundreds of portfolio decisions, most of them wrong? Uh, sure, but so what?
In other words, procedural, documented prudence is what matters, and if all that busywork leads to ugly results, well, so be it.
But families aren’t institutions. If university portfolios perform poorly, they just raise more money. Try this if you’re a family. No, a family needs to go easy on the procedural niceties and hard on substantive niceties, because if the family’s capital goes away, it isn’t coming back.
Of course, some family portfolios are fiduciary in nature, and the trustees of those portfolios are going to want to act like institutional trustees, because, of course, prudence in the family trust context is also measured procedurally. If the trustee is a bank, you can be sure you’ll be under serious pressure to meet quarterly (this being also a terrific time for the bank to try to sell you something else).
Families are therefore stuck between the Scylla of institutional mimicry and the Charybdis of procedural fiduciary requirements.(3) I can think of two ways out.
One approach might be to conduct less frequent portfolio reviews. We could, for example, convene an in-depth, face-to-face portfolio review with our advisor once a year. We might schedule this meeting off-cycle, at a time when we are less busy with other matters. April, let’s say.(4)
In between, brief conference calls – much easier to schedule – could be held, mainly to give family members a chance to ask questions. Note that an infrequent meeting schedule would also encourage advisors to make recommendations in-between meetings. Under the quarterly meeting regime, advisors are tempted to hold their ideas until the next quarterly meeting, since there is always one coming up.(5)
If meeting in person only once a year makes your stomach go all queasy, you could schedule a second meeting six months later, but limit that meeting to educational issues – an outside speaker or a group discussion of some longer term issue.
But maybe you have a litigious son-in-law. In that case there is always the option of the investment committee operating manual.(6) Unlike an investment policy statement, the operating manual specifies details like how often meetings will be held and what the agenda will be for those meetings. Following a carefully drafted operating manual – along with an investment policy statement –helps insulate the family from challenges based on procedural prudence while simultaneously focusing the family’s attention on substantive prudence (by fending off the temptation to make too-frequent changes based on little more than, “We’re all gathered here so let’s do something.”)
For example, the operating manual might note that most frequent portfolio changes harm returns and that the family intends to discourage short-term thinking. The manual would then specify that changes in the portfolio would be considered only at the annual meeting in April. Departures from that policy would be required to be evidenced by a written rationale for why the trade needed to be made out of cycle and the period of time over which the trade would be monitored to determine if it was successful.
Naturally, there would be exceptions. Private equity managers and many private real estate managers raise capital for a brief period of time, then close. Or maybe you’re waiting in line for an allocation – or an increased allocation – to a closed hedge fund. But note that these “exceptions” have nothing to do with a quarterly meeting schedule, either.
If it’s true that family (and institutional) portfolios tend to be over-managed and therefore underperforming, it behooves us to figure out ways to minimize the activity and the associated damage. We need, in other words, to keep firmly in mind the words of that terrific investor, Blaise Pascal: “Most of the damage to our portfolios arises because we are unable to remain quietly in one room.”
(1) At last count I’ve served on more than fifty investment committees over the years. I know whereof I speak.
(2) The UMIFA is the Uniform Management of Institutional Funds Act, promulgated by the National Conference of Commissioners on Uniform State Laws in 2006 and already enacted in 46 states. The UMIFA Drafting Committee was made up entirely of lawyers – not an investment professional in sight.
(3) As I’m sure you’ll remember from your Homer, Scylla was a rock shoal just off the coast of Italy in the narrow Strait of Messina, and Charybdis was a whirlpool off the coast of Sicily on the other side of the Strait. Poor Odysseus had to choose which of these dangers to steer closer to, giving a wide berth to the other. He chose the Scyllian rocks, figuring he might lose a few ships, rather than the Charybdian whirlpool, which might swamp the entire fleet. Homer nodded here, if you ask me, or maybe it was Odysseus.
(4) Investors sometimes object that, by April, 12/31 values are very stale. But there is nothing sacred about arbitrary end-of-year values. In fact, the rush to try to meet as quickly as possible after 12/31 is itself an indication that bad decisions are about to be made.
(5) These between-meeting delays result, over time, in serious opportunity costs.
(6) The investment committee operating manual was invented a decade ago and is now used by many families. See Greycourt White Paper No. 31 – Reinvigorating the Investment Committee: Introducing the Investment Committee Operating Manual (2003). That paper is, unfortunately, seriously out-of-date. Someone should remind me to update it one of these days.
Next up: Democracy and Its (Charitable) Foundations
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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.