Most asset management firms, private and public institutional investors and family offices have investment committees. Poorly designed boards can potentially destroy substantial value in the investment management industry, yet little research is available. I would like to propose a new way to think about the governance of investment committees.
The chief investment officer typically chairs a monthly discussion between senior portfolio managers and economists on how to invest, given the current opportunities. At the end of each committee meeting, the CIO aggregates the investment opinions by finding a consensus among members. In my experience, investment committees suffer from biases (group polarisation) as well as incentive (free-rider) and aggregation (does the final portfolio equal the group consensus?) problems. Group polarisation occurs when group members become more extreme in their assessments after interacting with each other. In investment teams, polarisation can lead to suboptimal investment decisions, as committee members may become overly confident in their views and ignore alternative perspectives or information. Aggregation problems occur when we can not ensure that all investment views enter the committee equally. Incentive problems arise when the individual contribution is difficult to evaluate. Who was responsible for swinging the investment committee to take an equity overweight in March 2020?
In ‘Noise: A Flaw in Human Judgment’, authors Daniel Kahneman, Olivier Sibony and Cass Sunstein describe a series of controlled experiments where committees amplified noise by making more extreme decisions than the average opinion across team members would have implied. By noise, they mean that similar groups would make different decisions, or the same group would make other decisions due to minor changes in the way information is presented. The authors argue that information sequencing (informational cascades) and group polarisation can shift teams towards drastic decisions. Information cascades describe a situation where the sequence in which information enters the decision-making process matters. Suppose the CIO comments first and enthusiastically makes his or her investment case. This might influence other team members out of respect for the CIO or because they see their impact on the committee outcome as minor.
We know from research in behavioural finance that individual investors are reluctant to realise their losses and, at the same time, sell winners too early. How does this so-called disposition effect impact the way investment teams make decisions? There is evidence that team-managed US mutual funds display more significant disposition effects than those managed by individual managers. Investment teams show more significant disposition effects than individuals in experimental settings. The most likely cause is the prominent role investment committees play, and the heightened attention their decisions attract, both from inside and outside the organisation.
Bonuses and costs
While individual performance is relevant for bonus payments, investment committee performance is often not. Even if it was relevant, the impact of a team member on performance is small, and the efforts in forming an educated investment opinion are unobserved. Team members do not often feel that their opinions have the same weight as the other members. It is unclear that all team members are sufficiently incentivised.
Traditional investment committees do not scale well. Coordination costs increase nonlinearly with team size. For five team members, 10 mutual discussions will take place before we find a consensus portfolio. The large number of required bilateral exchanges is not realistic for large committees. Rising complexity will also limit the size of the committee as the marginal costs of adding a new team member will increase exponentially.
Finally, it is virtually impossible for a CIO to consistently aggregate the positions and views on various assets across many team members without losing information or adding new biases.
Mitigating the biases
Some of these issues are partially addressed with conventional means such as encouraging diversity and selecting equally strong-minded team members to ensure diversification and reduce group shift bias. Other methods including inviting outside speakers to unanchor group think; the creation of a team red and blue or a devil’s advocate to argue different investment cases; the analysis of past decisions; standardised meeting material; and the random assignment of speaker slots to avoid the same person repeatedly framing the discussion.
However, none of these measures ensures that team members make independent and fully incentivised decisions and contribute equally to the debate. Nor do these method avoid the pitfall of adding additional bias.
Identifying true consensus
How can we find better rules to govern decision making? Decisions by experts are noisy, and it is no different with investment professionals. Portfolio managers in the same organisation have different investment views and positions. The objective of the modern CIO is to ensure the organisation makes better decisions by removing as much noise as possible and aggregating alpha information effectively between all decision-makers.
I suggest two modifications to better identify the common consensus within an investment committee. First, each team member anonymously provides a long/short vector of active positions. Rescale each vector to carry an identical tracking error to make each vector equally important. Second, replace consensus building through group voting by averaging equally risky long/short vectors, so that portfolios are scaled to carry the same tracking error.
How do these changes impact investment committee decisions? Averaging comes with a mathematical guarantee to reduce noise in individual choices, while the provision of portfolios by each team member maintains the maximum incentive to perform well.
Clearly defined decision rules improve performance, even for amateur teams. The anonymity in decision-making – only revealed to the CIO at year-end for compensation purposes – ensures diversification between portfolio managers. It also helps eliminate group shift bias (no polarisation and no reputational hedges) and removes the free rider problem (each team member has the maximum incentive to perform well).
In my experience at the firms where I implemented the approach, the portfolios submitted anonymously by investment committee members show a much more significant position variation. The average pairwise correlation between team members is typically low, and it was always difficult for me as CIO to imagine that I could have unveiled this difference in opinion via a group discussion in an investment meeting. Since each committee member manages their long/short portfolio, a group disposition effect is much smaller. In short, the proposed change to governance leads to voluntary and fully incentivised sharing of investment ideas that are consistently aggregated with many biases removed.
While investment committees based on these principles have a better chance of performing well, communication is one weakness. Finding a coherent narrative that builds on a consistent top-down view is problematic because consistency across positions is neither enforced nor desired.
Dr Bernd Scherer is a research associate at EDHEC Risk Institute and CIO and executive board member at a large German asset manager