Don’t put the cart before the horse
For over a decade, I have had discussions with CEO’s and board members contemplating their first dedicated investment person. My advice is simple...don’t do it. Given the general surprise from that comment, I clarify by saying:
- Firstly, if you hire a CIO, then you better budget on a couple of analysts to do the “work”
- Secondly, it is likely that your new investment team will want to invest in assets and structures that you do not have the investment operating capability to administer
It is not that hiring investment decision making resources is a bad idea, quite the opposite. It just shouldn’t be your first hire. Your first hire should be a Chief Operating Officer or investment operations manager. Without excellence in investment operating capability, good investment ideas are either:
- Dangerous, assuming they are implemented
- Just theoretical ideas, as you choose not to implement
You can lead a horse to water, but you can't make it drink
If I rated my success as an adviser by the number of funds that have followed my advice and built operating capability first, then I would be giving up my day job. I can count on one hand (probably one finger!) the number of funds that have followed my advice. Perhaps, it was always a rhetorical question and they didn’t really want my opinion...anyway, that’s my excuse!
Does the Australian super system have a gambling problem?
Let’s consider the bet being wagered on manager selection:
- Average pay-off: Loss of 0.5% per annum. No, it’s not a zero sum game. There are just a few fees and costs to be paid along the way
- Range of outcomes: loss of 2% to gain of 1%. This assumes a great outcome is a pre-fees gain of 1.5% and a bad outcome is a pre-fees loss of 1.5% for the default investment option
In many ways, the task of selecting managers is akin to gambling:
- There is large upside potential from picking “winners”
- The tote (service providers) always win
However, it is different from gambling in that there can also be significant downside if you pick “losers”. And you don’t just lose your bet (fees and costs); you may also lose member’s capital or underperform the benchmark.
Why is everyone backing the long shot?
There are a range of behavioural and psychological drivers motivating the resource allocation to investment decision making skills:
- Enjoyment and self interest: It is far more interesting talking about stocks (and the potential for personal profit) than discussing the minutia of tax regulations
- Relate to it: Board members and CEOs will most likely have their own portfolio of stocks and can relate to the content
- Over-confidence: Individuals over-rate their ability and skill – most of us are above average!
- It’s our job: This is what we are paid to do
- Investment consulting conflicts: Business models are built around helping funds select active investment managers (click here for more details on investment consulting conflicts)
Under-investment in operating capability
The GFC shone the spotlight on the under-investment in investment operating capability. How many of the following did you experience (and more importantly not think likely) over the past couple of years.
Liquidity problems, frozen funds, counterparty issues, deferred tax asset accounting issues, excessive switching, valuation uncertainty (listed and unlisted), disputes on product terms, breaches of asset allocation ranges, currency hedging problems, unit pricing anomalies, securities lending issues
Hopefully, you didn’t just scream out BINGO!
My tip for the Spring carnival
Now let’s consider the bet that could be wagered on investment implementation and operational capability:
- Average pay-off: Gain of 0.25% per annum. A very conservative estimate of potential value to be extracted from investing in investment implementation and operating capability
- Range of outcomes: Gain of 0.1% to gain of 0.5%. No science here, just a conservative estimate based on many years of observations
There are a range of implementation and operational activities that do not receive the attention they deserve. Areas such as cash management, foreign exchange execution, tax management, portfolio transitions, brokerage, securities lending and portfolio emulation, are all examples of opportunities that receive insufficient attention.
Whilst these areas often require significant effort, the pay-offs are far more certain. So my tip for the Spring carnival is to invest more in implementation and operating capability.
So, which investment (resource allocation choice) is the sure thing paying great odds?
Which horse are you going to back when you next set your budgets?