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Columnist Frederick C. Bruckner argues that trustees can afford greater patience with the investment managers they choose.
May 31, 2010 — 4:40 AM UTC by Frederick C. Bruckner, Guest Columnist
“Performance measurement challenges for investors who live in a perpetual time horizon world,” by Frederick C. Bruckner was originally published in Investment Management Consultants Association’s January/February 2009 issue of Investments & Wealth Monitor. To access more articles, visit IMCA’s Web site: www.IMCA.org. Bruckner received the an honorable mention in the 2010 Stephen L. Kessler Writing Award contest for this piece. The award honors IMCA members for their excellent editorial contributions the previous year to IMCA’s Investments & Wealth Monitor.
Time is on my side, yes it is (1). Almost everyone knows this lyric from the song made famous by the Rolling Stones. The investors’ time horizon is one cornerstone of a well-constructed investment portfolio. Time most certainly is on the side of nonprofit institutions such as endowments and foundations, given that they exist to provide support to their beneficiaries over extremely long time periods. Indeed, most are designed to last forever.
The Performance Measurement Dilemma for Nonprofits
So that begs the question: How relevant is the Sharpe ratio—the key statistic used for measuring manager and composite portfolio performance—in the endowment and foundation world when the time horizon is in perpetuity?
Conventional investment wisdom has attempted to educate investors to measure performance on the basis of risk and return. However, one could argue that the time horizon afforded these types of investors largely alleviates the normal concerns regarding risk, suggesting return alone could be the key measure of performance. Would it be fair to say that an investment with Manager A was superior to one placed with Manager B, simply because A had a higher Sharpe ratio, even when B produced a higher return? Maybe, maybe not. Should portfolio performance be measured on a relative Sharpe ratio basis for certain types of investors and measured solely on a return perfor- mance basis for all others? The overriding question will be explored in greater detail using actual manager return data in a hypothetical consulting situation.
It would seem reasonable to ask the opening question, based upon the time horizon involved, which may seem somewhat dramatic, but is in fact for almost all benevolent institutions until the end of time. Periods of under- or negative performance by the investment portfolio most likely will put downward pressure on an institution’s ability to provide financial support to its underlying causes. However, doesn’t an extremely long time horizon suggest the probability of mitigating both risk (i.e., volatility) and realizing an actual capital loss? Indeed, trustees should take comfort in the fact that over the long run the markets tend to rise, not fall, as evident in the long-term performance of the Dow Jones Industrial Average. But for a few exceptions, various rolling multiyear returns for the Standard and Poor’s 500 historically have been largely positive, too.
Small investors’ time horizons differ from nonprofits’
For the small investor, time horizons are finite and therefore require accounting for risk when constructing an investment portfolio. On that basis the yardstick used to measure how an investment portfolio has performed on a risk-adjusted basis is the Sharpe ratio. It is startling how many investors look merely at their portfolio’s nominal and relative returns as the sole criterion for judging performance. They fail to examine the degree of risk that was taken in order to achieve those returns. But considering the original underlying question, maybe the small investor knows something advisors don’t.
Striving for financial independence or for a comfortable retirement most certainly includes factoring a time horizon into the investment plan. Beginning with the moment when one enters the workforce, reaching all the way to that point in time when the boss sings your praises to your fellow colleagues, asks you to say a few words of thanks, cuts the cake, and then hands you the gold watch before you head off to the beach house. But even in retirement, the retiree’s time horizon still is highly significant as estimates to one’s own mortality are factored into the invest- ment management equation.
The small investor must weigh the returns sought against the risks taken. Can a 65-year old afford the risk of losing capital—and therefore purchas- ing power—by incorporating managers seeking higher returns and taking risks considered “high” by conventional wisdom? Given the timeframe involved and probable income needs, most likely the answer is no. Herein lies one key difference between the small investor and certain institutional investors: time.
Investment Manager Risk–Return Data Analysis (2)
Consider the relationship between the return and the risk taken to achieve that return. Do managers who produce the highest returns necessarily take on the highest risks? Do they produce superior Sharpe ratios as well? Normally, we equate lower returns with lower risks and higher returns with higher risks. Looking at random time intervals for various assets classes revealed the following observations:
• In the 10 asset classes examined (i.e., large-cap value, large-cap growth, etc.) for a 10-year average annualized return, 70% of the categories’ top performers (as measured by rate of return) did not have the best (highest) Sharpe ratios.
• In these same asset classes for a seven-year average annualized return, 40% of the categories’ top performers did not have the best Sharpe ratios.
• In these same asset classes for a five-year average annualized return, 70% of the categories’ top performers did not have the best Sharpe ratios.
• Evidence across various asset classes and time periods revealed certain managers whose rates of return were higher than other managers’ but had Sharpe ratios that were either the same or lower.
Apparently, there are managers who produce better (i.e., higher) returns, but don’t necessarily have the better (i.e., higher) Sharpe ratios, too. But should the risk side of the equation matter as much to institutional investors such as endowments and foundations when they have elongated time horizons? When we talk about risk, we’re talking about standard deviation, which is the degree of variability or volatility around the mean and does not necessarily signify taking an actual capital loss. And, as we increase the number of observations (that is, hold an investment over a long period of time and increase the number of plot points to observe), the distribution clusters closer to the mean with smaller distribution tails. History has shown that volatility tends to dampen the longer the time period.
Moreover, investors usually take risk to mean the possibility of actually realizing a loss. But some investors can afford to hold investments that may have soured initially yet still offer attractive investment opportunities, especially when their time horizons are extremely long. This further minimizes the possibility of taking an actual loss on the investment. Time does heal all wounds or, in this instance, poor investment choices.
So with this timeframe in mind for certain institutional investors, one could argue that trustees should judge portfolio performance largely on a nominal and/or relative return basis. When Manager 1 produces higher returns than Manager 2—even if Manager 2’s Sharpe ratio is superior and consequently means returns were produced by taking less risk—then it would seem that Manager 1’s higher return should be the only thing that matters. The Sharpe ratio is the risk–return equalizer to judging portfolio and/or manager comparative performance. But when $1 given to Manager 1 10 years ago produces a higher absolute dollar value in the portfolio, which therefore can provide more tangible, financial support for the endeavors of the organization, then aren’t perhaps Manager 1’s results really superior? Perhaps superior, at least, in the eyes of the trustees?
Hypothetical Consulting Case (3)
Consider the following hypothetical situation, though for some consultants it may be a situation that at times is all too real. After investment manager research and due diligence, trustees decide in June 1998 to invest in two large-cap growth managers: Manager A and Manager B. For purposes of this analysis, assume mandatory spend- ing requirements are calculated as of the previous year’s ending balance, withdrawn on the first trading day of the year.
Now fast-forward 10 years and consider the following results. As indicated in figure 1, the Sharpe ratio over the 10-year period ending June 2008 for Manager A was much better than for Manager B, better by 16 % (0.58 vs. 0.50). This indicates superior risk- adjusted performance by Manager A. But now look at figure 2.
Figure 2 represents the growth of $1 million. A million dollars invested with Manager B outpaced Manager A by almost 43% ($4,431,178 versus $3,098,626), which translates into a dollar value difference of more than $1,332,552.
To be sure, investors who experienced Manager B’s higher return also experienced higher volatility than with Manager A (Manager B’s standard deviation over this 10-year time period was 25.5 versus 14.8 for Manager A). But the question remains, should the trustees be concerned? Should they care that Manager A’s Sharpe ratio was higher when Manager B produced higher returns, so long as the results and the selection of Manager B were produced within the context of a prudent investment process?
Consultants are put to the test with this scenario to answer the question of who performed better, especially when the trustees believe they were better- served by Manager B (higher return, but lower Sharpe ratio). And perhaps they were. If you’re the president or trustee of an endowment or foundation, the incremental dollars generated with Manager B clearly further the funding available for the causes your organization supports.
This analysis cannot account for the real-world emotions that often cloud investors’ investment decision-making. Would trustees have been able to stomach the drop in value that the portfolio with Manager B would have witnessed between September 2000 and December 2002 versus Manager A’s relatively flat performance (see figure 2)? It’s impossible to tell. Nor can one factor in the possibility of changing managers if the original due diligence and basis for investing in the first place were to have somehow changed. Nevertheless, we can think of a handful of investment managers that, on the basis of their historical propensity to pick stocks that produce positive results, would have well-served investors who would have taken a long-term, buy-and-hold strategy.
As an investor, the rationale behind the Sharpe ratio is compelling; that is to say, invest in managers who produce the best excess return per unit of risk. But as a trustee, and after taking into account all the investment variables, it is compelling to simply want to maximize the returns of the portfolio. One thing is clear: From the outset, it is important that the consultant and the trustees mutually agree upon what will be the investment criteria for measuring portfolio performance.
Again, thinking about the time horizon that endowments and foundations enjoy, trustees can afford greater patience with the investment managers they select. Given this, the greater challenge would seem to be finding good managers from the outset, and then being disciplined to stick with them through the entire investment cycle. In the end, trustees would seem likely to be rewarded with higher returns on the portfolio, risk be damned.
Frederick C. Bruckner, CIMA®, AIF®, is a vice president and the portfolio specialist group leader for Wachovia Securities’ Investment Management Consulting Group in St. Louis, MO. He earned a master of finance from Saint Louis University and a BSBA with a concentration in finance from the University of Tulsa. Contact him at firstname.lastname@example.org. Research assistance provided by Richard H. Schoenborn, vice president and portfolio specialist with Wachovia Securities, St. Louis, MO.
1 “Time Is on My Side” was written by Jerry Ragovoy under the pseudonym Norman Meade. It was first recorded by jazz trom- bonist Kai Winding and his orchestra in 1963, then covered by both soul singer Irma Thomas and The Rolling Stones in 1964. (Wikipedia, July 2008)
2 Data researched through the Informa Investment Solutions, Inc. (IIS) database, as of August 9, 2008.
3 Data used in the manager comparison is based upon actual results of two investment managers.
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