Institutionalized

Be Different ... But Not Too Different
From FundFire, an e-service that follows trends in institutional investing: "Be Consistent Or You're Fired, Managers Told."

That caught my attention because the last that I heard, the trend in institutional investing was to be inconsistent. The '90s featured searches for investment managers who conformed to strict style definitions and who therefore could be measured against narrow and appropriate benchmarks. The next decade brought a backlash. When most of the style managers who were hired ended up trailing their benchmarks, the new pitch became for freedom. Don't limit genius. Don't restrain managers by forcing them to buy certain types of stocks, or even stocks at all. Give them a broad mandate and let them do their thing.

You can see why investment managers would like that framework. "Go anywhere" pays more than style-specific. (The general rule in the investment industry is the broader the mandate, the higher the management fee.) But I always wondered if institutions could stomach holding such funds. After all, nobody is good enough to go anywhere with constant success. Even Warren Buffett has years where Berkshire Hathaway trails the stock market, or cash, or any other reasonable benchmark. It's one thing to maintain faith in Warren Buffett; it's quite another to stand by just some portfolio manager. Also, when managers with broad mandates trade different asset classes, that affects the client's overall allocation. I didn't see this working very well in practice.

Apparently, that's what institutional investors have decided. Per the FundFire story, lack of portfolio "consistency" is the second-biggest reason (behind performance) why institutional investors fire managers. "Asset managers will experience heightened scrutiny if they stray from what they have always done or what they were hired to do, according to Mike Hennesey, co-founder and managing director of Morgan Creek Capital Management. 'Investors are definitely more sensitive to changes ... There is a heightened awareness that if there is change, [investors] don't like it.' " The article also discusses how some managers have been fired for changing the client's overall allocation.

I doubt that the pendulum will swing fully in the other direction. There has been too much discussion about overly strict mandates suffocating investment managers, and the very large and very public success of flexible  PIMCO Total Return (PTTAX) argues that case as well. But I suspect that institutional investors will echo retail investors in favoring funds that are run on relatively short leashes. "Go anywhere" sounds good, but owning those funds tends not to feel good. 

The China Syndrome
There's a general belief that wealthy folk and institutions invest differently from the rabble--thus, the minimum-wealth laws that govern the purchase of hedge funds and the recent FINRA decision that institutions but not individuals be permitted to see back-tested results for exchange-traded funds based on newly created indexes. But that has not been my experience. Both retail and institutional investors like the concept of flexible funds but struggle with holding them; both chase hot asset classes; and both prune their worst-performing funds from their portfolios, even if those funds were bought for reasons of "strategic" allocation.

In autumn 2009, I was at an institutional conference, speaking on a panel on asset allocation. I was asked by an audience member if rebalancing had become passe, given how dramatically the world had changed over the past decade. What was the point of putting more money into the stocks of developed countries, she wondered, when the world was so clearly going the way of China. The Chinese were snapping up African farmland (or so she said, don't ask me!). Surely, prudent investing would be to emulate what the Chinese were doing, rather than invest in last century's winners. 

To my surprise, this comment was met by a murmur of approval. To my even greater surprise, my response about how the 2008 markets didn't change the basic math of rebalancing was greeted by mutterings and wry smiles, as if the conference had erred by letting this fossil into the room. 

Collectively, that audience left a massive amount of money on the table by not pursuing U.S. stocks more aggressively near that asset's bottom. As did retail investors. 

Finger Pointing
If you pony up $5 million, you can own shares in Morgan Stanley Global Real Estate Fund (MRLAX). However, you can't buy the separate account versions of the funds, which are for institutions that write even larger checks. The Wall Street Journal reports that since its inception, the 2007 version of that separate account has dropped 74% in value. Just as well that you couldn't own it. Unhappily for California teachers, however, the California State Teachers' Retirement System does hold that fund.

Yes, I know. I just did what I accused institutional investors of doing--pointing fingers at a poor-performing fund that was bought for reasons of asset allocation. Guilty as charged. It's not easy to avoid such behavior. That's why it persists, after all. Plus, the story is amusing. At least to me, because I don't own that fund. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.