I am a Trustee for a philanthropic institution which has an investment portfolio worth several hundred million dollars. This morning, I attended an Investment Committee meeting at which we discussed the management of the endowment’s portfolio. As is customary, the consultants we hired to help us select managers for the fund presented their report. The report wasn’t good.
The third quarter was brutal on all but one of the endowment’s managers (we have about eight). Bond managers had been defensive, as instructed by our investment policy, and therefore trailed during the huge bond rally that (ironically and surprisingly) followed a rating agency downgrade of US sovereign debt. Performance for equity managers seemed to vary according to each manager’s relative exposure to financial sector stocks. Those that held less than an index weighting performed better. It was a horrible quarter for bank stocks.
Banks look amazingly inexpensive, but nobody seems to care. Most banks are selling at prices equal to or below book value. Meanwhile, bank liquidity, reserves, and capital levels all appear very strong. There is not much prospect for organic growth in the near term, but they are really cheap, and the thinking is that as macroeconomic uncertainties recede (whenever that may be), banks could see a strong rally back closer to more historical valuation levels. To date, early adopters of this thesis have gotten hurt in what has proven to be something of a short-term value trap. But successful investors must look beyond the short-term.
In any event, the Committee deliberated over the selection of a new manager for a portion of the portfolio. The consultant presented several options consisting of historically strong managers, and we narrowed the field to three. The discussion among Committee members seemed to favor the best-performing and more defensive of the managers presented. Everyone was expressing concern for the recent market uncertainty and volatility. Not terribly surprising given everything that is going on.
Trustees of a fund need to make sure that the fund’s investment policy is consistent with the risk posture and time horizon of the organization. Managers should be selected based not only on past performance but also on future expectations and how an individual manager will fit into the stable of existing managers. Emotions need to be avoided. Just as is the case with individual stocks, managers posting the worst performance over a recent time period could very possibly turn out to be the best performers in the future. Considering these factors, we were back on track.
Even with more than ten years of historical performance data that had been sliced and diced in mind-numbing ways, we had to recognize that all managers enjoy and endure both good and bad periods of relative performance. It might be that the manager we decided to hire this morning is at the beginning of five bad years. This is another way of recognizing that past performance is nice but not predictive. Past performance (especially over just a short time period) does offer some evidence of a manager’s experience and consistency with its stated investment discipline. But it most definitely does not guarantee results in the future.
A client called yesterday and said he was not panicking but that he was exhausted. He said the volatility of the past six months had worn him out and that at age 63, he thought about going to more cash. There is longevity in his family, and he expects that current easy monetary and fiscal policies will result in significant inflation in the future. He really had no idea what he wanted to do other than stop the raucous rollercoaster. My client does not have the luxury of a perpetual time horizon, and I’ve suggested we meet to re-evaluate his strategy. I don’t think we will decide on any significant changes.
I guess the point of this missive is to suggest that doing what feels good and right very often can be exactly the wrong course of action. Trading in or out of an individual security or asset class based on emotions, or hiring a manager based solely on recent performance, can both be counterproductive to long-term investment goals. A solid investment strategy, discipline, and courage are the best tools to help investors weather difficult times like these. Stick to your discipline and avoid emotional decisions. This too shall pass.
The past few years have been as tough for investors as any I remember. It is important to keep in mind that though the Dow Jones Industrial Average fell to 6700 in February of 2009, it has rallied back some 77%. Earnings and balance sheets have become remarkably stronger. While the global environment remains stormy, a bumpy recovery seems underway.
Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.