“It's only when the tide goes out that you learn who's been swimming naked.”

This is the popular quote commonly attributed to Warren Buffett.  The last 12 months have highlighted that we have all been swimming naked to some degree, and much more than so than I’m sure any of us care to admit.  Many funds have found themselves exposed, or at the very least close to being exposed, on a large range of operational implementation issues including liquidity management, unlisted valuations, rebalancing, unit pricing, reserves, stress testing (or lack thereof), cash flow management, counterparty concerns, securities lending, and the list goes on.

However, the question for boards and senior management is, have you heard the wake-up call?

Over the last three months, I have published three newsletters covering a range of strategy and operational implementation issues:

Unlisted valuations: Real lessons or distraction?

Liquidity management: Legislated dehydration, with an excessive choice chaser

Transition managers in transition

Whilst each newsletter focused on a specific issue, the common theme is that boards and senior management need to step up their focus on business and operational strategy and its implementation.  This requires funds to firstly recognise that they have strategic choices (rather than just mimic the competition) and secondly, to think much more deeply about these strategic choices and their implications.

I had the pleasure a few years ago of taking renowned investment thinker and author of “Winning the loser’s game” Charlie Ellis to lunch.  Whilst I am sure Charlie was more fascinated with the architecture of 333 Collins Street than our conversation, it was a memorable experience for me and I clearly remember one of Charlie’s key lessons:

“The great success in long-term investing is to avoid serious losses”.

For funds or investment managers that weren’t able to maintain currency hedges during the recent exchange rate volatility, the spectre of serious loss is all too real.  But how do funds avoid serious losses?  Was this an isolated issue, or is there a more fundamental problem?

If you think about a successful investment program, and one that avoids serious losses, it has four critical elements that all need to receive significant attention:

·         Investment policy decisions e.g. philosophy, objectives

·         Investment decisions e.g. strategies and managers

·         Investment implementation

·         Risk management and monitoring

Over the years we have got better at focusing on policy, yet there is always room for improvement.  However, our obsession with the second element, investment decisions, has continued to be the overwhelming focus, with more and more time and resources applied.  Many funds have now appointed in-house investment professionals, including Chief Investment Officers.  By virtue of these appointments, and the evolution of investment opportunities, the complexity of investment strategies being implemented by funds has dramatically increased.

There is almost universal acknowledgement that it is hard to find and access good investment managers (i.e. alpha is scarce).  Yet, unfortunately, innovation and expertise around implementation and operational risk management amongst funds is equally scarce, yet often by passive choice.  That is, by boards and senior management not appreciating the risks and issues that need to be addressed, and therefore not making the necessary investment in people, processes and systems.

Boards and senior management need to ask themselves...

Has our operating capability, including risk management, kept pace with the complexity of our products and investment strategies?

So if you thought you already had too many Chiefs, here’s two more:

·         Chief Implementation Officer responsible for efficiently capturing the alpha potential that you think you have discovered, and making sure you don’t lose actual alpha, and beta, via ineffective implementation

·         Chief Risk Officer, a title commonly seen in banks, insurers and hedge funds. Custodians may be able tumble the numbers, and consultants may help set up policies, however, risk management is ultimately a fund's responsibility and needs to be given internal focus.

Well perhaps you could get one new Chief to start with, but the key message is that your operating capability needs to keep pace with your investment complexity and capability.  Otherwise, funds will find that they are swimming naked, and in the media headlights, egos may naturally suffer a degree of shrinkage!