Spin Cycle

Face Time
Yesterday, I met with the two senior managers of a small investment firm that creates indexed target-date funds for 401(k) plans. I asked them how things were going. The responses were wry smiles and shrugs, accompanied by the explanation that clients were skittish. Plan sponsors needed reassurance that they hadn't made a mistake when hiring the company several years back. Fortunately, from the investment manager's perspective, all of its customers had so far remained on board.  

Such is life at a money manager that has suffered bottom-decile returns over the trailing three years--playing defense rather than offense; seeking to retain existing clients rather than to acquire new ones; constantly on the road, settling customer concerns. While an investment manager with strong numbers rarely if ever is fired for poor communications, those with weak numbers almost certainly will. The investment wicked receive no rest. They are forced to enter the spin cycle.

It's an exhausting experience. As occupations go, investment management is about as good as it gets--great pay, reasonable hours, comfortable working conditions. It sure beats clambering down into a coal mine. However, remaining polite and upbeat while fielding the same skeptical questions, day after day, from people who doubt is no fun at all. (I had a small taste of that in college, being an English major at a predominantly pre-professional institution. No, I would repeat, I do not know what I will do with that degree or with my life.)  

No Mas
Such pressure has chased many managers out of the business. I noticed years ago while serving as Morningstar's lead analyst for Fidelity funds, that whenever a Fidelity manager retired, it came during a period of relatively weak performance. The younger managers, having no choice, would stay the course when their funds lagged the averages over the trailing three years, but almost inevitably the 20-year veterans who had amassed enough personal wealth would opt out. The hassle just wasn't worth it. (Which may help to explain why the percentage of English majors has been halved since I was in school.)

It's hard to see what investment-management firms can do to change the process. There were no surprises with this particular 401(k) series, none at all. The funds were created and sold as being a distinctly conservative option--a low-cost series for plan sponsors who wanted to err on the side of caution. The series' funds have relatively low levels of stock exposure and they favor mainstream asset classes. The funds were built to be transparent, easy to understand, to outperform during bear markets, and to trail during bull markets. The clients knew that would be the case. That the funds are indeed lagging at time when stocks have been thriving and when higher-risk, lower-credit bonds have beaten short Treasuries is completely predictable. There could have been no other outcome.

Over the past 25 years, tremendous advances have been made in distinguishing between the performance achieved from an ongoing investment strategy (often described as a fund's "betas") and that coming from managerial intervention. This trend has been strengthened by improved portfolio disclosure and the explosion in indexing. Whereas once investors might be pardoned for not understanding why their funds trailed their peers, there is now an army of information, consultants, and tools to give them what they need to know. Yet still the questions persist.  

This occurs at the highest levels of investing, as well as at lower levels. In this particular instance, the involved parties are termed "institutional," although that label is dubious when applied to 401(k) plan sponsors who are not investment professionals, and who act as investment fiduciaries only because they are required to do so by law. But it certainly does occur among true institutions as well. They, too, are served by consultants, and they, too, ask hard questions of three- and five-year laggards. (I once served on the board of a multibillion pension plan, and the process was no different. Twice a year, the money managers trooped in to tell their stories; those with strong numbers received few if any hard questions, and those with weak numbers were placed on the "watch list" and grilled.)

Market Effects?
It's possible that the spin cycle affects securities prices. This thought, admittedly, is a stretch. The path that leads from the attitude expressed during institutional investment-manager reviews, to the pressure felt by money managers--pressure that might lead them to change what they are doing, or at least soften their convictions--and then to the behavior of securities prices, is a long path indeed. Nonetheless, it is worth pointing out that the academic finding on stock prices is that they follow trends over the short term, but reverse that trend over intermediate-term three- to five-year periods. That is consistent with the communications of investment committees, which use a similar time frame for their sell decisions (buy decisions tend to use a longer period).

Thus, in 2008-09, plan sponsors looked most fondly on the most conservative of target-date series, which had the highest trailing returns at that time. In contrast, aggressive target-date fund families had their feet held to the fire. T. Rowe Price, for example, was frequently accused by the business press for having a relatively high stock allocation not because of investment beliefs, but rather because it charged higher management fees on its stock funds than it did for bond or money market funds. Now the situation is reversed. T. Rowe Price is silently congratulated for its acumen--its aggressive equity posture leading to category-topping performance--while the conservative series are nudged, perhaps, to purchase more stocks.

Again, just a thought. But the cycle of the three- to five-year institutional review is, I think, worthy of further study. Investment managers are often criticized for herding behavior, in their attempt to avoid standing out from the crowd because of a particularly bad performance. This herding behavior, it is claimed, may have the effect of increasing market volatility. Such an argument becomes more credible when observing the spin cycle in action. As do the findings of intermediate-term reversion in securities prices. 

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.