INVESTMENT RISK AND PERFORMANCE

by Stefan Whitwell, CFA, CIPM

Investment Management Fees: Act II

The author addresses the acute problems prevalent in institutional investment management fee structures. In addition, using the context of compensation structure as an illustration, the author shows how risk management, risk allocation, and investment management are inextricably woven together. Thus, boards of directors, chief investment officers, and executive directors must understand how incentive and compensation design influence risk taking in asset allocation, manager selection, and risk management.

n the modern practice of institutional investment management, compensation typically has nothing to do with risk taken to earn the returns and everything to do with nominal returns or a percentage of assets. Consider the following example: Investor A, investing in Program A, targets a 10% annual return in early January. In July, Program A plunges in value, down 20%, but it recovers on the back of a sharp late December rally that results in a 10% return for the year. Investor A is not happyrelieved, perhaps. Investor A spent the entire year doubting her decision to invest, concerned about the loss of capital, and worrying about the likelihood of further losses. In contrast, Investor B also earned 10% that year from Program B, which was stable and never had a drawdown greater than 5%. From the arbitrary vantage point of the calendar year, both investment programs had the same nominal returns, but they had radically different risk profiles.

Empirical Observation #1: As an industry, we reward managers without consideration of the degree of risk they took to generate the nominal returns that drive compensation. This practice is bad business. It is bad for pension systems because it creates an explicit misalignment of interests. And it is bad for the investment management profession because it underpays talent and rewards mediocrity. With respect to actively managed portfolios, at a minimum, fees should reflect nominal returns, the risk taken, and the ratio and consistency between the two. More consistent earnings should mean the more valuable the earnings stream. The more efficient the returns (as measured by the information ratio), the more valuable the return stream. Recommendation #1: Plans should negotiate and use fee structures that reward managers on the basis of both nominal returns and the degree of risk taken to generate the returns. Empirical Observation #2: What the term risk denotes is the source of a lot of confusion and debate. For example, some consultants have implored board members and executive directors to not worry during periods of significant drawdowns (such as 2008). The consultants advised them, You just have to hold these assets for the long term, and eventually they will come back. Today, these consultants look backward and feel vindicated.

A 2/20 fee structure (2% management fee and a 20% performance fee)or a 1/10, for that matterrewards the managers of Program A and Program B with nearly identical fees,1 even though the two managers did not protect investment capital to the same extent and, therefore, should not merit equivalent remuneration if both were also expected to manage risk.

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As Sam Savage brilliantly illustrates in his book The Flaw of Averages ( John Wiley & Sons 2009), risk is severely underestimated if you evaluate it by using a single point in time or a summary statistic (such as an average). Furthermore, using subsequent events to judge the riskiness of the interim return path is another example of underestimating risk that Savage warns against. To suggest that because the S&P 500 Index subsequently regained its watermark, the interim drawdown was not terribly risky understates risk. That suggestion minimizes the fact that from October 2007 to February 2009, the S&P 500 dropped more than 50%. Looking forward from February 2009, nobody, not even U.S. Federal Reserve Chairman Ben Bernanke, could articulate with certainty the degree and timing of a recovery in the markets. Consider the Nikkei 225 Index, for example, which was essentially flat for 25 years until its recent rally, despite a government that was actively expanding money supply to stimulate the economy and despite Japan being an advanced, modern, and educated country. The pension plan that takes the necessary steps to avoid large drawdowns both protects its capital and preserves dry gunpowder that can be used opportunistically to enhance its returns. Big pullbacks, although infrequent, are one of the best entry points into an asset class on a risk-adjusted basis and can substantially improve long-term returns if the pension fund has the financial and corporate governance in place to act.2 Recommendation #2: Instead of considering risk in the singular, pension plans should look at risk as a distribution: the frequency (time) and magnitude by which the returns fall below your baselinebe that zero returns or be that the minimum required returns needed to meet your future pension obligations. To generate a statistically reliable distribution and graph it as a histogram, you need to answer three big questions: (1) What is to be measured (returns or drawdowns are two useful candidates)? (2) Over what length of time are the data to be drawn to make the calculations (generally, the more data the better, although how best to use long data sets is worthy of its own paper)? (3) What time interval would be most insightful? The answers depend on what questions you are asking, of course, but two rules generally hold true. First, it is crucial to pick time periods and
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intervals that generate sufficient data that your resulting insights are statistically sound. Second, when managing liabilities (liability-driven investments, for example), it is useful to include in your process data sets whose interval matches those of the liabilities you are managing. Finally, when looking at drawdowns, for example, it is useful to evaluate rolling intervals to generate additional data and to capture drawdowns or return fluctuations that will probably not be captured when purely mutually exclusive calendar-year aligned intervals are used in your calculations. Empirical Observation #3: Notice that in Observation #1, I qualified some analysis as being relevant to actively managed portfolios. This qualification leads to Observation #3. The idea that one size fits all may work for socks, but it does not work with respect to compensation structure. The reason is that investment management work can differ substantially from one strategy to another. Clearly, for a passive allocation for which the goal is to track the benchmark, the greatest attention should be paid to lowering fees, regardless of whether the work is done internally or outsourced. In contrast, actively managed allocations should be judged on the basis of their value addedrisk-adjusted returns and nominal returnsamong other considerations. Risk level should also affect how you think about fees. If the program is targeting low nominal returns and low levels of corresponding volatility, then low fees are an absolute necessity. If you allocate capital to a high-risk investment process, the attention should be on performance and results. Recommendation #3: Public pension plans should consider varying the fee structures on the basis of attributes that distinguish one investment process from another, such as activity level (passive versus active), risk level (leverage, volatility budget, target returns), and so on. Empirical Observation #4:When buckets underperform (as have hedge funds over the past five years), consultants and boards are quick to try to salvage the situation by executing fee beat-downsthat is, fees are negotiated downward or even rebated. This quick fix, however, often occurs in lieu of facing the two most important questions that should be asked when evaluating

bucket underperformance: (1) Why is our allocation to that bucket underperforming? and (2) are these allocations the best use of our capital going forward? Public pensions would do well to more aggressively pursue answers to these two key questions as they relate to the plans liquid alternative portfolios (e.g., hedge funds, managed futures). Variants of the first question include: (1) Why havent our liquid alternative allocations done better and (2) what is the best way for public plans to invest in hedge funds and managed futures? The second question is both material and timely, so I will examine it here. First, there is no such thing as a perfect hedge fund. Even the best hedge fund managers in the world have had substantial drawdownsand more than one. Institutional investors correctly invest in portfolios of hedge funds and managed futures to reduce their exposure to any one manager. When assembling a portfolio, the pension plan faces a crucial fork in the road that determines how subsequent decisions should be made: The pension plan can pursue a beta hedge fund strategy or an alpha hedge fund strategy. The beta strategy is essentially an index strategy, and its success depends on the lowest fee structure possible. Funds of funds thus do not make sense for this strategy; they typically use so many submanagers that they can generate only index (nonalpha) returns, and simultaneously, they are laden with an excessive expense structure. Furthermore, because funds of funds are beta vehicles, they often fail to achieve the diversification they promise. The beta strategy, such as using an S&P Index fund, is essentially passive. The alpha strategy takes a different tack. It recognizes that hedge funds are formed to pursue active management strategies, and although many fail, the evidence is that a small percentage of managers do succeed in generating absolute positive excess returns on a fairly regular basis. The alpha strategy consists in identifying the alpha-generating managers and dynamically managing the allocation of capital among those managers. The allocation must be managed dynamically because not all strategies do equally well in all seasons. Strong rationales may arise to increase or decrease allocations on the basis of forward-looking risk-adjusted assessments. Although both strategies for alternative investments target independent returns that do not correlate with stocks and bonds, the alpha strategy also aims to generate

positive absolute returns. If the public pension and/or its consultants make the classic mistake of allocating to too many managers, then they will inadvertently frustrate the ability of the alpha strategy to generate meaningful returns. Ideally, an alpha portfolio will have 812 managers. The more managers you use, the more likely your returns will skew toward a beta outcome; too few, and the idiosyncratic risk will be unacceptably large. The biggest and most common mistake made by pension funds and other large institutional investors is to intend to pursue the alpha strategy but either fail to allocate capital to it on a dynamic basis or have exposure to too many submanagers and thereby unintentionally morph into a beta bucket. The key to success when allocating to hedge funds in an alpha strategy is to think and act like a trader. When successful traders put on a trade, they always predefine their risks on the upside and the downside. They determine (1) what they will do if the trade moves in the intended direction (such as putting on a trailing stop or identifying the level at which to take profit) and (2) at what level they will execute a stop-loss to preserve capital. Essentially, at the trade level, a trader is merely allocating capital on a dynamic basis. The portfolio manager or chief investment officer (CIO) is doing the same thing at the manager level instead of the trade level. To effectively allocate and deploy capital on a dynamic basis requires approved corporate governance policies and procedures so that dynamic allocations can be made using predefined parameters but in real time rather than arbitrary calendar-based intervals. What does a dynamic allocation process look like in practice? First, it requires clarity as to whether the pension plan wants to pursue an alpha or beta strategy. Second, the investment consultant or risk adviser identifies the conditions under which allocations should be increased and the conditions under which allocations should be decreased and by how much. One of the biggest benefits of predefining these action triggers is that doing so removes much of the emotion from making on-thefly decisions during stressful and rapidly moving market conditions. Removing emotion makes the job easier for the board, executive director, CIO, consultants, and staff. In dynamic asset allocation, the best action to take is sometimes counterintuitive, but this reaction stems from the data-driven habit of looking backwards. Dynamic allocation requires making forward-looking decisions.
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For example, sometimes the logic for reducing an allocation is precisely because of its positive performance. Consider, for example, hedge fund manager John Paulson, who successfully bet against commercial-mortgagebacked securities in 2008 and, after earning dramatic gains, subsequently experienced significant drawdowns. On a risk-adjusted basis, is the beneficiary of one-off outsized gains best served by reducing the allocation after the gains or choosing to stay invested? This example illustrates the benefit of predefining the criterion by which capital should be allocated and divested. Similarly, one of the most favorable times to systematically increase allocations to prequalified managers is when they experience significant drawdowns on a risk-adjusted basis. In practice, however, managers whose recent performance has faltered are frequently penalized by consultants or put on a watch list to see if their performance improves, which completely misses the point. Penalties and watch lists are a good idea when you discover red flags through operational or investment due diligence but not necessarily when looking at recent performance in the liquid alternatives space. Furthermore, when you take high-water marks into account, the process of divesting from good managers who are merely suffering a drawdown and reallocating to new managers will more than likely increase your fee burden because the new manager starts with a clean slate and, therefore, a lower performance hurdle. Recommendation #4: When you observe underperformance among your existing managers, before trying to fix the situation by executing a fee beat-down, stop and answer these questions: Why is our portfolio underperforming? Is it our static (risk-agnostic) allocation process, or is it the managers? Are the current manager allocations the best use of our capital going forward? Are there performers who need to be cut back? Do drawdowns beckon increased investment, or do they indicate a violation of the investment thesis? In this case, divesting, not a fee beat-down, is the right answer. Lower fees do not justify keeping allocations to investment managers that should not be in your portfolio. Empirical Observation #5:The previous observation leads to the point that because not all trades or managers work out, predefining the conditions
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under which the plan should fully divest from a manager is crucial. Monumental human effort goes into selling investment products and investment services to plan boards and CIOs. In contrast, comparatively little energy goes into defining the exit. The triggers for divesting from a manager include fraud, poor performance (distinct from recent performance), material staff turnover, regulatory fouls, substantial style drift, failure to manage risk, and misrepresentation. Predefining the triggers for action enables the public or corporate plan to take swift and timely action to protect plan capital. As Jennifer Cooper, CFA, observed recently in personal correspondence, Some institutions function more like collectors than investors. Some organizations, at the time of placing capital, think more about getting into investments than determining exit points. She added, A meaningful, independent (and, better yet, internal staff ) due diligence barrier is needed to effectively push against the external marketing efforts to ensure that the organization is empowered to function fully as an investor. Recommendation #5: Because the CIO and board have a fiduciary duty to protect plan assets, every public plan needs a well-defined exit strategy for each allocation to internal and external investment managers. Empirical Observation #6: Despite all the sales puffery to the contrary, the fact is that public plans and institutional investors bear the majority of investment risk. Todays fee structures only exacerbate the poor alignment between the investor and the larger investment managers, who often derive significant profits from management fees alone. Recommendation #6: Do not rely on sales literature or marketing spiels that imply that your interests are aligned with those of the investment manager. Instead, regularly and formally conduct detailed reviews of managers. For example, in the United Sates, you should conduct formal U.S. SEC Form ADV reviews of your investment consultant and all your hedge funds and investment managers. Form ADV has information that is not available elsewhere and is substantially more reliable than marketing material because of SEC enforcement actions. The objective is not to look for or to

assume perfection but to see the incentives created by existing financial arrangements and compensation structures with a clear eye. Empirical Observation #7:Returns today are measured in nominal terms instead of net real terms, which more accurately measure the real gain or decline in the buying power of your plan assets. For example, with the 10-year U.S. Treasury bond yielding the current rate of inflation, once transaction costs and investment management fees are taken into consideration, net real returns on the 10-year bond are somewhere between zero and negative, which is not apparent if you look only at the nominal 2.5% yield. Recommendation #7: When evaluating fees, make sure you understand how much of your net real gain is being paid out in fees because this information shows you most accurately how much of your net real gains are being shared with your investment manager. If, for example, the nominal returns from your fixedincome manager are 4.5% (derived from a highly rated medium-term corporate portfolio), inflation is 2.5%, and fees are 35 bps, the real net returns are 4.5% minus 2.5% minus 0.35% equaling 1.65%. In this example, you would be paying out 17.5% of your real gains in fees. If this portfolio was a buy-and-hold portfolio, you would be wise to either negotiate a much lower fee or consider bringing the portfolio in-house. In short, looking at returns on a net real basis is both more accurate and more informative than looking at nominal returns when determining by how much your pension fund increased its purchasing power through a given investment program. Empirical Observation #8: Attribution analysis is a recognized core tool in the performance measurement toolbox and for reasons I will cite, it also has a role to play in fee discussionsbut not in the obvious way that probably first comes to mind. One of the ways that attribution analysis can and should be used is to make sure that public pensions are not paying excessive feesfor example, unknowingly paying active management fees for essentially passive asset allocations. Consider the bond market in the past 10 years. Much of the return from long-only fixed-income

portfolios was passive (interest payments and capital gains from declines in interest rates), but the fees that pension funds were paying in many fixed-income funds were surprisingly high3in fact, what one might expect to pay an actively managed fund. A better way to price fees is to pay a blended rate based on the relative percentage of active versus passive gains based on market rates for each return category (active or index level fees). The reason fund managers were able to get away with these surprisingly high fees is that fee analysis is still nascent and attribution analysis is not always provided by the manager. You can get the data, but you have to ask for it, know exactly what to ask for, and specify how you want it calculated. Then, you need to make sure it was calculated correctly. Investment consultants who receive fixed fees will not volunteer to do this work because it decreases their profitability, and pension systems that are leanly staffed, even if they have in-house expertise, sometimes simply do not have the time. If pension systems start working together collaboratively, however, as proposed by Girard Miller, CIO at the Orange County Employees Retirement System (OCERS), their influence will grow and they will be able to demand higher standards of disclosure and fee attribution analysis. As long as pension systems remain underfunded, every dollar counts, and to the extent that pension systems invest in externally managed funds, they need to use attribution analysis to understand the underlying nature of the return stream. Then, they can evaluate whether they are overpaying or not. Rare is the fund that will openly disclose these data in a useful format, but total transparency in this respect should be a condition of your investment. Otherwise, you need to ensure that your consultant will do this analysis and share the results with you. Recommendation #8: Use attribution analysis to help distinguish between the core nature of returns so that you can be sure that you are not paying active management fees for essentially passively generated returns. In the case of fixed income, for example, distinguish between recurring income (passive sources of bond income may include interest payments, accruals, and capital gains in a trending market) and active income (trading gains).
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 Empirical Observation #9:Fee levels, which are essentially the price of the investment managers service, are set before the quality of the service is known. This practice goes against the idea of paying a higher price for higher quality results and paying a lower price for lessor results, even though pay for performance is a readily accepted best practice in many other areas of business. Paying 20% of gains regardless of the risk taken makes no sense if protecting capital, for example, is truly an important consideration. Recommendation #9: Demand fee structures in which the pension plan pays a higher fee for higher quality results and a lower fee for lesser results. That is, pay only for what you get. Empirical Observation #10:Although from a market perspective, relentlessly seeking the satisfaction of your own interests has merit, sometimes we can find better value, in the short run and long run, by making sure a trade creates value on both sides of the equation. Therefore, fee negotiations that do not consider both sides can generate negative unintended consequences. Ultimately, one-sided agreements will always come to an endand usually an unhappy oneso if the goal is to motivate the investment manager and also get the best fee terms possible, think creatively and frame the issue like a Venn diagram to look for mutually profitable solutions. An example of this principle in action can be observed in the leadership shown by Miller at OCERS. Although he is vocally committed to OCERS and other pension systems aggressively cutting the fees they pay, he is exploring ways to do so that also create value for investment managers. For example, he has championed the idea of multiplan cooperation to increase buying power, which has been dubbed the public pension portfolio procurement network or P4 network. The idea is that in return for the network allocating substantial volume to a manager, the public pension would receive significantly reduced fees and other favorable nonprice terms. From the vantage point of investment managers, working with the P4 network is tenable because, although they are agreeing to lower fee rates, they are receiving larger chunks of business and thus saving time and marketing expense. A similar idea is to create partnership-like arrangements between pension plans and retirement systems, on the one hand, and investment management firms, on the
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other hand. The same spirit of mutual gain applies; the arrangement can reduce the expense base of both parties and promote the trust needed to justify increased and sizable mandates. The Teachers Retirement System of Texas is active in this arena, as is the Texas Permanent School Fund. Recommendation #10: While aggressively representing the interests of your pension system, also take the time to find creative solutions that will benefit the plan beneficiaries and the investment manager. You will be rewarded with longer-term and more prosperous relationships that will benefit the plan. Similarly, in seeking fee concessions, aim for those that benefit your plan but still preserve the upside incentive for the managers to deliver the highest quality returns possible. They will always take your capital, guaranteed, but there is something to be said about preserving the incentive to go the extra distance.

Conclusion
An understanding of how incentive and compensation design influence risk taking is central to risk management. This understanding is why the examination of fee structures is so important and why systematic, documented, and recurring reviews of SEC ADV forms by investment consultants and investment managers are considered industry best practice. Conflicts of interest are rifeespecially because most fee structures consider only nominal returns and ignore inflation and return attribution. Many public pension systems are underfunded, and they can no longer count on the federal or state governments to bail them out. Moreover, the deterioration in public balance sheets is obvious to those of us in the business. Thus, risk management is vital to public pension plans. The following simple mathematical examples vividly prove why risk management is crucial: 1. Beginning-period losses create larger-than-apparent problems. If a fund loses 30% upfront, it must earn 43% to get back to even, and thus it has 43% net more to earn (43/30) to climb to get out of the hole (interestingly, the calculations are symmetrical: 43/30 = 143%). As you can see, upfront losses have a big impact. If the plan is paying management fees along the way, then the actual gross return target to get back to breakeven is even bigger, even with high water marks.

2. End-of-period losses can also cause a surprisingly large impact. For example, earning a 10% return for ten years produces an annualized return of 10%. Nine years at 10% with a 30% loss in Year 10, however, reduces the annualized return to slightly more than 5%, which represents a nearly 50% reduction on an annualized basis. In this example, if your return horizon were ten years, then a loss in Year 10 would be catastrophic to your financial objectives. Because, as these examples demonstrate, risk management is crucial to the financial future of any pension system, the issue of compensation structure is both relevant and urgent. Compensation structures today do not take risk explicitly into account. Thus, the investment profession needs your help to transform how compensation is structured. At the heart of compensation should be the notion of pay for performance. Performance has a minimum of three key dimensions: absolute return, risk taken, and value added. The most widely used fee structures today totally ignore two of these three key factors.

If even a few of the great minds in this business will take a stand on these issues, pension plan beneficiaries will benefit and will do so while preserving the incentive for the best and brightest in our business to be fairly rewarded.

Notes
1. Over the year, Program As manager would have received 95% of the total fees received by Program Bs managersimilar compensation for a materially worse job of risk management. 2. See Michael Covels book Trend Following: Learn to Make Millions in Up or Down Markets (Pearson Education 2009) for examples and historical data on this topic. 3. For comprehensive data on fees in fixed-income funds, see Gerstein Fishers Creating Investment Excellence: The Gerstein Fisher Approach to Managing Fixed Income (http://gersteinfisher.com/ gf_article/creating-investment-excellence-the-gerstein-fisherapproach-to-managing-fixed-income/), p. 8.

Stefan Whitwell, CFA, CIPM, is managing director and head of risk management at Empirical Solutions, LLC.

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