Wrong is right…. Guest Blog by Steve Delo

The financial crisis has changed the financial landscape and had a dramatic impact on all investment decision making. Slap bang in the firing line are company pension schemes. And if you’re a trustee of such a scheme, you have onerous responsibilities, strenuous knowledge requirements and a tightrope to walk between various potential conflicts of interest. Your risk exposure is probably increasing by the week. The investment future has always been something that is hard to predict but now the stakes have been raised. Every move a trustee of a pension scheme makes could be scrutinised in hindsight and any inappropriate action questioned (even if it looked appropriate at the time!). If you are in this position, time to manage your rising “career risk” with some professional advice.

Common sense says get the most innovative, forward thinking, imaginative and proactive advice you can. But this is the world of pensions and acting on such advice will INCREASE your career risk, not reduce it. Yes, when it comes to being a trustee, one must remember the maxim that “it is better to be wrong together than right alone”, particularly when taking investment decisions.

Consider: world investment markets are driven by an amalgam of information, misinformation, sentiment and opinion. Arguably, the short-term distortions caused by such drivers have become even more significant in the volatile world circa 2011. Within this, there is “herding” – a tendency for investors to follow others, an ultimately self-destroying tendency that leads to “bubbles” forming and bursting. Investment gurus know that the way to take advantage of mispricings in investment markets – and therefore to maximise investment return – is to use counter intuitive thinking to come up with investment decisions that exploit these herding weaknesses. Alas, perfect timing of such investment decisions is almost impossible and, therefore, if you take a position that is contrary to “the norm”, your decision may well look a bad one until such time as your decision comes right. During that period, the
precise length of which you can’t determine, career risk increases.

Advisory and fund management organisations face the same risk if they advise clients – or manage clients’ money – in a way contrary to the accepted norm. Until the decision comes right, they are exposed to “business risk” – i.e. looking like they don’t know what they are doing. Business risk is bad, so there is also a tendency for investment advice and management techniques to herd.

What does this mean in practice as we move forward into 2012 and beyond? It means that although the best investment advice – the advice that is most imaginative, forward thinking and innovative, which one might call “New right advice” – represents the best investment opportunity for trustees, it also represents MAXIMUM CAREER RISK. Only the boldest of trustees will seek out and follow such advice. (Think about trustees at end 1999/early 2000 when the UK stock market was booming. The few that cleverly switched out of equities at what proved to be near the top of the market were initially vilified!)

More modest, but still forward thinking and risk taking trustee boards will lag behind the aforementioned boldest trustees, probably waiting for some initial evidence that the advice works before they follow it. Of course, by then, the advice will have dated somewhat – it will be “Old right advice”. Even with some of the timing advantage gone, modest trustee boards will still benefit from acting on the advice – but those doing so will represent only a fraction of the trustees out there. (Think about the first schemes following Boots’ much publicised move in to bonds in the early 2000s after equities had already started their fall but proved to have further to go).

Most trustee boards, however, will not act on such advice at that early stage. Too much career risk! They will wait for the advice to become an “industry standard” and “best practice” before acting on it, by which time the investment advantage may well have been lost. It may have become “Wrong advice”.

This scenario is the risk we face in the current investment climate and something that CEOs of employers sponsoring defined benefit schemes should watch for. They need to be proactively working with trustees to support and enable them to take confident, timely decisions. Alas, the very nature of trustee boards, where lay scheme members and management meet infrequently and have to grapple with a mass of technical issues, totally works against such effective, proactive investment decision-making. This cannot continue which is why trusteeship is set to move into a professional phase, where either expert independent professionals are appointed to drive the trustee board – or where investment governance experts are brought in to streamline decision making and focus the trustee board onto priorities – or where emerging fiduciary management solutions are employed. For those schemes that are big enough, a dedicated Chief Investment Officer, charged with ensuring nimbleness and innovation, can greatly improve outcomes. In short, positioning a scheme to at least be acting on “old right advice” or, with real boldness, “new right advice,” whilst helping the trustees/sponsor keep their nerve as they wait for the benefits of that advice to flow through.

Of course, CEOs and trustees should be wary of past investment performance when considering investment solutions – past performance is rarely a meaningful guide to future as it may be wholly attributable to random effects(to quote an old colleague of mine – past performance is probably not even a decent guide to the past!) Scepticism regarding the source and nature of superior returns will therefore be essential for successfully evaluating and selecting prospective investment options. A rounded awareness of this – and an ability to critically evaluate every investment solution or investment manager presented to you – will in my view be a key part of the skill set for pension fund leaders over the next decade (starting now!). Only then, will wrong stop being right.

Steve Delo is Chairman of Moorland’s Capital; this blog also appears on Moorland’s Capital’s website which you can linke to by pressing on the coloured bit!

 

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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1 Response to Wrong is right…. Guest Blog by Steve Delo

  1. Chris Wagstaff says:

    Steve – on your point regarding past performance not being a decent guide to the past, I’d like to offer the following insights:

    In many human endeavours, outcomes are a combination of skill and luck. In sport, even if a player’s skill remains consistent, their results will be affected by changing luck. An exceptional performance is rarely repeated as the good luck that boosted this performance will typically be absent the next time around. Poor outcomes can reflect a lot of skill being offset by a run of bad luck. However, over time, as luck evens out, skill shines through.

    That said, skill can suddenly or progressively deteriorate. In the case of athletes, skill deteriorates with age. That is to say, very few systems remain stable over time, not least those subject to “tipping points”, such as financial markets. That is, when small incremental changes in the system lead to large scale non-linear system-wide effects. Within financial markets this is when increases and decreases in investor diversity reach critical inflection points. These factors should be, but are rarely, taken into account when making decisions on systems that combine luck and skill.

    Another problem decision makers face in failing to distinguish luck from skill in many fields, is failing to appreciate the concept of reversion to the mean. Reversion to mean was discovered by Francis Galton, cousin of Charles Darwin, in 1886. Any system that combines skill and luck, not least fund management, reverts to the mean, in that an outcome that isn’t average will be followed by an outcome that has an expected value closer to the average.

    Suffice to say, ignoring reversion to mean results in making bad decisions. For instance, which investment manager would you rather hire: the one who recently beat the index or the one who didn’t? There’s no easy answer as luck clearly plays a large but elusive role in short term performance. (That said, counter-intuitively, all the evidence points to choosing the latter manager).

    Despite this, many institutional investors fail to incorporate this into their decision making, ie their intuition suggests that the manager’s performance, rather than an examination of the manager’s underlying process, provides sufficiently objective and prima facie evidence of a good process.

    However, where the outcome of a process involves probability, ie skill and luck, a good process can lead to bad outcomes and visa versa, at least for a while due to luck, which will even out/mean revert. Therefore, it’s better to focus on the process.

    Of course, discerning the contributions of skill and luck is not an easy task, even if analytical tools are available. A simple test of whether an activity involves skill is to ask if you can lose on purpose. You can’t at the casino wheel as this is pure luck, but you could at chess as this is a game of pure skill and at poker and fund management as these are games of luck and skill (not that I’m suggesting they are any way connected!). You should, therefore, be careful when drawing conclusions about outcomes from activities that involve luck, especially short term results. Indeed, the more luck that contributes to the outcomes you observe, the larger the sample you need to distinguish skill from luck. For example, good investment track records can run for some time simply as a result of good luck. You only have to observe how a flip of a coin 10 times amongst 1,000 people will almost always produce a winner – a consistent flipper of heads – through pure luck. Therefore, taking the time to qualitatively evaluate a manager’s investment philosophy and process is time well spent.

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