interview

IFA's Quote of the Week - 17 (Jack Meyer)

interview

Q: How can individuals find managers who can beat the street?
A: Most people think they can find managers who can outperform, but most people are wrong. I will say that 85% to 90% of managers fail to match their benchmarks, if you properly specify their benchmarks.

Q: That's pretty pessimistic.
A: Yes. But because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value . The investment business is a giant scam. It deletes billions of dollars every year in transaction costs and fees.

Q: So what should individuals do?
A: Most people should simply have index funds to keep their fees low and their tax down. No doubt about it.

Jack Meyer, former Harvard Management CEO
(Harvard University Endowment), credited with tripling the endowment from $8 billion to $27 billion during the 10 years he was at the helm. Excerpted from BusinessWeek interview, "Husbanding that $27 Billion", December 27, 2004

 

Jack Meyer’s assessment of the investment business and his conclusion that managers fail to even match their benchmarks are well supported in numerous studies. Specifically, a recent study conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University reveals the pitfalls associated with hiring managers based on their recent returns above benchmark. The study, "The Selection and Termination of Investment Management Firms by Plan Sponsors" found that manager hiring and firing decisions made by plan sponsors on behalf of retirement plans, endowments, and foundations was a complete waste of money and the board members’ precious time.

The professors built a unique dataset comprised of the hiring and firing decisions of approximately 3,700 plan sponsors over the 10-year period from 1994 to 2003. With data representing a whopping $737 billion allocated to hired investment managers and the withdrawal of $117 billion from fired investment managers, they concluded that plan sponsors hire investment managers after large positive excess returns up to three years prior to hiring. However, this return chasing behavior does not deliver positive excess returns thereafter as post-hiring excess returns were indistinguishable from zero.

The results of the study, as set forth in the figure below, reveal that during the ten-year period from 1994 through 2003, consultants and boards that based their fund manager hiring decisions on recent above benchmark past performance were largely disappointed with subsequent results. IFA incorporated into the study the estimated annual 0.5% management fee and an annual 0.5% cost of transition in the after-hiring manager returns.

The professors also determined that plan sponsors often fired their current managers in favor of another group of recent top performers, repeating the cycle again. This cyclical motion undermines their investment policy statements and the opportunity of achieving market rates of returns (index returns) commensurate with the risks they take.

In addition to analyzing the selection and termination of investment managers, the study also examined a set of round-trip firing and hiring decisions, tracking the subsequent performances of the fired managers as well as the hired. In reference to their findings, the study concludes, “the post-firing returns of fired investment managers are generally larger than the post-hiring returns of hired investment managers. Given the magnitude of the return differences, and the transactions costs associated with transitioning portfolios from fired investment managers (legacy portfolios) to hired investment managers (target portfolios), our results suggest that the termination and selection of investment managers is a costly endeavor".

The figure below illustrates the study’s determination that plan sponsors terminate investment managers after underperformance, but the excess returns of these managers after being fired are frequently positive. The chart set forth a matched sample of firing and hiring decisions, showing that if plan sponsors had stayed with their fired investment managers, their excess returns would be larger than those actually delivered by their newly hired managers.

The chart below reflects the results of manager picking by plan sponsors that hire and fire investment managers based on performance. In a larger context, this chart also illustrates, with abundant clarity, the cost of manager picking, the outcome of which is captured losses and missed opportunity — a bad combination!

The “Discussion” at the end of the study states, "How does one interpret this evidence? One way to think about this is in terms of opportunity costs and frictions. For hiring decisions that are necessitated by the termination of an existing investment manager (due to performance, organizational or reallocation reasons), the opportunity costs of hiring can be identified as the returns that the fired manager would have delivered relative to what the hired manager actually delivers. Our round-trip results suggest that these opportunity costs are positive."

Further evidence of the underperformance of institutions is found in the average investment performance of university endowments as determined from information provided by the National Association of College and University Business Officers (NACUBO). NACUBO’s membership totals more than 2,500 U.S. colleges and universities. In part, NACUBO provides comprehensive annual data that reports on the financial status of university endowments, and is the industry standard for such information.

The charts below show five and ten-year comparisons for the average nominal rates of returns for various levels of asset pools versus comparable IFA Index Portfolios. The specific IFA Index Portfolios were selected based on the average percentage asset allocation to fixed income/cash equivalents, as provided by NACUBO. For each of the time periods shown, and at all asset levels, the comparable Index Portfolios outperformed the average endowment's returns. This demonstrates that across all asset levels, it is a superior strategy to buy the asset class benchmarks rather than to attempt to beat them. Additionally, the Index Portfolios' returns were derived through global diversification, risk and return optimization, investment transparency and no use of speculation or leverage.

The passive rebalancing of index portfolios is a very low-cost and low-maintenance investment strategy that minimizes need for in-house investment staff, board member involvement, consultant involvement and the time consuming, useless and costly process of manager selection and termination.

Finally, given that this week’s investment lesson begins with the sage words of Jack Meyer, former investment manager of the highly regarded Harvard University endowment, it seems most fitting to include an interesting comparison of an index portfolio to the two most widely respected university endowments.

Most investors, institutional and otherwise, would consider themselves quite successful to mirror the performance of world-class endowments such as Harvard and Yale. In fact, their investment performances are considered second to none, and are likely the envy of every endowment investment committee. The very nature of the size of the two endowments enables them to invest in investments that are simply not available to endowments that do not have tens of billions of dollars to manage. In addition to fixed income and equities, big endowments heavily invest in alternative investments in order to further diversify their portfolios, purchasing private equities, hedge funds, commodities, natural resources, real property, etc. They hire expensive staff to implement their complicated investment policy statements. The risks of the portfolios of the behemoth endowments are incalculable, but their returns are not. 

The chart below is a 23-year comparison between the average annualized returns of the Harvard and Yale endowments and the IFA Index Portfolio 100. As you see, over the 23-year period of time, there is scant difference between the returns of the three portfolios. However, the Harvard and Yale endowments carry risk that cannot be quantified, mostly due to leveraged positions in hedge funds, whereas the IFA Index Portfolio carries with it 80 years of risk and return data, without leverage.

The fundamental lesson to be learned by each of these studies, and the hundreds of other studies that reveal a similar conclusion, is as follows: stock market returns are compensation for risk, not speculation. The risk taken is the best explanation of the returns earned. Looking forward, the risk you take is the best determinant of the expected return. The key is to avoid all forms of active management, and instead become a passive rebalancer by investing in risk-appropriate allocations of index funds that carry long-term risk and return data for optimizing returns, rebalance to maintain that risk exposure, and call it a day. It’s that simple.

 

Index Funds Advisors specializes in matching individuals and institutions, including corporations, foundations, endowments and perpetual care entities, with risk-appropriate blends of indexes that have shown to deliver the rarely exceeded risk-appropriate returns over time.  To learn how you can implement a low-cost, risk-optimized passive rebalancing investing strategy, visit www.ifa.com.