Asset categories are defined, benchmarks established, and measurement standards set within the framework of the IPS. Process is clearly the key to sound fiduciary oversight, but this fiduciary process raises a simple question…a $64,000 question. Can the process go too far and hinder the ultimate objective – to help participants grow their accounts?
Are there limitations to selecting managers when constrained by style boxes dictated by an IPS? Should an IPS for a participant-directed retirement plan mandate that plan investment choices be diversified among certain asset categories?
With almost all 403(b) plans being participant-directed, one question we continually wrestle with is maintaining style-specific menus while finding managers that consistently beat benchmarks, recognizing that it is important for plan fiduciaries to offer an investment menu with options diversified across multiple asset classes.
Is There an Answer?
I think it comes down to achieving the right balance between maintaining style-specific investing and capitalizing on a good stock picker that offers reasonable expenses. One can support the argument that active management is of no value and that indexes historically produce better returns, net of expenses. Many academics hold this to be a truth, but then how do you explain Warren Buffett or the fund managers who have consistently produced results? My answer would be: the same way you explain Michael Jordan or Tiger Woods – they are good at what they do.
What if you took half the clubs out of Tiger's bag? Would he still be great? What if you restrict a manager to investing in only certain types of companies? Will his or her skills still stand out? Clearly, if a good stock picker has their universe of choices reduced, it is only logical that the results may be impacted. But by how much? So you make Tiger hit off the tee with a four wood. You make Jordan shoot foul shots from the side. In either case, each is still going to be above standard, regardless of conditions.
Evaluating a manager's ability to add value is both art and science - part qualitative and part quantitative. The challenge is determining which part should be art and which part science. One criterion to look for is a manager following a repeatable process that has been proven successful. It may sound simple, but it is uncommon in practice. As a consultant with skin in the game as a fiduciary, I also want a manager who understands what he or she is investing in.
In the late 90s, I interviewed a manager that had refused to invest in Enron. Almost every other mutual fund manager competing for assets in his space had a position in Enron. And why not? The stock had skyrocketed, making investors lots of money on paper. This manager had a very simple answer as to why he had not bought Enron: He couldn't understand how they made money. What a statement. Simple, powerful, and in the long run, successful for investors.
Despite arguments to the contrary, I believe it is rather intuitive that good managers do exist, and that they consistently generate above average returns over time. The challenge is in identifying them and understanding their processes, their insight to know when the winds are about to change, and their ability to navigate stormy weather.
However, sometimes good managers underperform. What happens when all qualitative assessments are solid, but a manager lags its benchmark for several quarters? According to a study done by Morningstar of the top performing Large Cap Value managers that had beaten their benchmark over a ten-year period from 1996-2005, 64% had at least one three-year period where they trailed the benchmark by 5% or more. As a consultant, sometimes the hardest thing to do is nothing.
In the end, selecting good investment managers is about the skill in combining the art and the science in a dynamic world where change is constant. There will always be good managers, diversification will always be an important part of fiduciary oversight, and IPSs will continue to specify asset categories, but there will also always be average managers, and sometimes consultants will select managers that turn out to be average.
Almost as if a law of nature, establishing clear objectives and following a sound process that is consistently evaluated and modified as necessary will produce positive results. A 403(b) committee that implements appropriate fiduciary oversight is helping participants invest with the best fund managers…which will make a difference in how they retire.
- Jeb Graham, Retirement Plan Consultant, CapTrust Advisors, LLC
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