Why do we spend so much time and effort in looking at past performance and making sure that the numbers we view are correct, when ‘past performance is not necessarily a guide to the future’?
Increasingly, the Myners review is seen as a best practice guide for pension schemes, and contained in those chapters are two pertinent principles. One of these states that ‘trustees should arrange for the measurement of the performance of the fund’, another that ‘trustees should arrange for a formal assessment of performance and decision making delegated to managers’.
The principles do not go so far as to stipulate who should measure performance, or what should be included. However, it is incumbent on trustees to have their performance independently measured, either by the investment manager or another qualified body. In addition, the Pension Act requires trustee bodies to consider diversification and suitability of investments, a task that is easier to justify with the benefit of performance and risk measurement.
Performance and risk statistics form part of a wider set of information that can help trustees confirm whether the role envisaged for their investment manager is in fact fulfilled. These statistics are useful in so far as they support the trustee’s qualitative assessment of the manager’s abilities, but should never be the trustees’ sole measure of their managers’ success.
The key purpose of performance measurement is to show how a portfolio performs relative to the prescribed benchmark over differing time periods and allows trustees to check whether investment managers are performing in line with expectations, in many cases when compared to performance targets. In the case of multi-asset or multi-region portfolios, performance attribution should be included, as the resulting analysis gives an indication of where performance was derived. At its most basic level this analysis will show whether performance can be attributed to pure stock selection or tactical asset allocation decisions.
Asset allocation numbers also go hand-in-hand with performance measurement, showing whether or not the manager has been able to stay within the constraints of an asset allocation policy.
Risk measurement is another major function of monitoring portfolios, which is seen as increasingly important following the recent events of the well-publicised Unilever versus Merrill Lynch Investment Managers court case. Investment managers will define their investment style and philosophy to their clients at the outset, together with expected levels of risk. Quantitative analyses may reveal style biases in a portfolio, for example, tendencies to hold smaller capitalisation stocks or value stocks and importantly, indicate how much risk there is or has been in portfolio relative to a benchmark.
These are important due diligence checks, which not only aid the explanation of returns, but confirm (or otherwise) that portfolios are run in accordance with managers’ stated investment process and philosophy.
Another important question being asked is whether today’s pension fund trustees should rely solely on their investment manager to do the performance calculations? Given the importance attached to this area by the Myners review, we think not. Many investment managers are either compliant with the Global Investment Performance Standards (GIPS), or are getting there. But that is not necessarily enough. The standards are certainly comprehensive, but interpretation of the presentation rules can still leave managers in control and allow them to shift the focus off periodic underperformance. Using an independent performance measurer would ensure the verification of managers’ numbers, however, there would still be the possibility of error if the numbers were not independently confirmed. This is not the end of the story.
Independent measurement reporting is particularly useful for those schemes with multi-manager structures. Typically these structures produce disparate and inconsistent data for trustees, which may accurately reflect ‘the part’ but could be ambiguous for ‘the whole’. With reporting such as this coming from a number of different sources, it is then left to the trustees to best estimate the combined performance and asset allocation, which is certainly not an ideal situation.
Independent measurement reporting avoids this situation because not only are all the numbers verified, they are also presented over the same reporting periods and in the same format allowing for easy comparison. It is then possible for trustees to draw informed conclusions having also reviewed performance results and risk measures in a uniform and consistent format. Saving time, avoiding a mine-field of confusion and reducing information overload can’t be a bad thing!
Importantly though, the performance measurer is also then able to accurately combine the underlying manager portfolios that show the overall fund performance, asset allocation and breakdown of the asset class performance, which may be obscured using another approach.
Who to choose for independent management reporting? There are a number of organisations that can do this work which are basically broken down into either specialist firms or custodians. Investment consultants are able to give certain advice, based on their previous experience of working with these organisations and individual client suitability.
Regardless of who presents the underlying performance and risk statistics to the trustee body, there is clear benefit in being able to interpret the numbers and compare them to the way each portfolio is expected to be managed. The interpreted performance and risk statistics are an excellent aid for trustees to use in discussion when they have their periodic meetings with managers. Additionally, at a combined portfolio level for multi-manager structures, trustees can gain comfort that the manager structure they have implemented continues to meet their original requirements.
As pension fund information becomes more accessible and the demands on trustees to raise their awareness of investment issues greater, there is a heightened need for data providers to be multi-dimensional in their product offerings; straight forward performance data is no longer enough. Data on risk within portfolios, compliance with investment guidelines and costs of transactions are just three examples of information that is becoming increasingly sought after. As demands on trustees become greater it is more important that the information they receive is in clear, consistent formats and free from the bias of conflicting messages.
Past performance and risk statistics are not necessarily a guide to the future, but they are certainly more than just numbers.
Colin Rainbow is an investment consultant at Watson Wyatt in London