“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”
– Warren Buffett (2014 annual letter to shareholders)
Performance monitoring reports play a central role in supporting investor decision-making, providing a snapshot of the returns achieved on a portfolio over time. While their content and format vary widely, they invariably contain a summary of fund and benchmark performance for each underlying strategy over a range of time periods. By emphasising benchmark-relative performance, these reports encourage procyclical decision-making that reduces returns and contributes to destabilising market dynamics.
In the Intelligent Investor (1942), Ben Graham wrote that “price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.” Here Graham hints at a monitoring approach that de-emphasises price data, focusing instead on the underlying health of the businesses within the investor’s portfolio.
Benchmark myopia
As we have described elsewhere, we believe that procyclical dynamics in financial markets are both privately and socially damaging. A powerful driver of procyclicality is the tendency for asset owners to hire managers after a period of strong performance and fire managers after a period of disappointing performance. One of the primary inputs into this decision-making process is the manager’s performance versus their stated benchmark, often reported to investment committees on a quarterly basis.
Such performance monitoring reports are often adopted without much thought given to the usefulness of the data provided. Do the benchmark-relative performance numbers provide information on whether the manager is doing a good job? Do they provide any insight on the manager’s skill level? Do they provide a useful trigger for reviewing the mandate? Over anything less than a five-year period it is difficult to answer “yes” to any of these questions.
The fact that managers know that performance data is presented to asset owners on a regular basis also creates a commercial incentive to ensure that short- to medium-term benchmark-relative performance is controlled, to avoid the appearance of incompetence. This in effect embeds procyclicality within asset managers’ decision-making, since to avoid significant underperformance, a manager will at times need to chase the best-performing securities or sectors within their benchmark.
As a result, traditional performance monitoring reports do more harm than good. They encourage an excessive focus on performance data and contribute to procyclicality in decision-making by asset owners and asset managers. Some have suggested that altering the presentation of performance data – to give greater prominence to longer-term figures – might help address the issue. However, minor tweaks to the existing approach are unlikely to achieve very much. Instead, a more fundamental re-think is necessary.
Monitoring without procyclicality
The first step towards developing an effective monitoring framework is to recognise that short-term performance data has very little informational content for strategies that have long-term objectives. Whether the manager or the benchmark has produced a greater return over the last quarter or year tells us more about market sentiment than it does about the manager’s ability. Even over periods of five years or longer we should be wary of drawing overly strong conclusions.
We suggest that instead of trying to gauge manager success based on regularly updated performance data, investors seek to make an assessment of whether the underlying portfolio is delivering what might be expected, given the manager’s stated philosophy and approach. This requires investors to shift their sights away from performance numbers and towards the fundamental characteristics of the stocks held in the portfolio.
This can be broken into two parts:
- Has portfolio activity been consistent with the stated philosophy?
- Do the fundamentals of portfolio holdings provide evidence of skill in stock selection?
The first element is a backward-looking analysis intended to confirm that the mandate is being managed in line with expectations. In relation to a listed equity mandate, important elements of this assessment would include turnover statistics, active share, an analysis of changes to portfolio holdings over time, and stewardship activity. The portfolio holdings analysis would primarily be intended to determine whether the manager has an unstated momentum (performance-chasing) bias that could be motivated by career risk or commercial considerations.
The second element builds on Graham’s suggestion that investors focus more on the operating performance of their holdings than on price movements. For an equity mandate, the characteristics of interest could include measures such as the growth in cashflow, earnings, book value or dividends of the portfolio. These measures are likely to be less volatile than performance data driven largely by market prices, while providing a more useful indicator of the ongoing success of the strategy.
It is important to note that the most relevant measures of success will vary from one manager to the next – the objective here is not to achieve total uniformity in the monitoring approach. Indeed, performance-chasing at the asset owner and asset manager levels can be traced, at least in part, to the homogenous performance monitoring reports produced across the industry on a quarterly basis.
In some respects, the proposed approach mirrors the way in which a private equity general partner has to monitor their portfolio. Without access to a frequently updated market valuation, the private equity owner instead focuses on the operating performance of the underlying businesses and their ability to influence outcomes by engaging with management. While there is plenty to criticise about the private equity business model, public market investors could become better long-term investors by borrowing some elements from their private market counterparts.
There is no perfect way to monitor an asset manager. Separating luck from skill will remain deeply challenging and it is impossible to eliminate all principal-agent problems. However, it would be difficult to design a performance monitoring system more likely to encourage procyclical decision-making than the current one. By looking less at the scoreboard and focusing more on the playing field, we believe that investors can incentivise a shift towards longer horizons within financial markets that will be both privately and socially beneficial.