Investment committees have a significant flaw: the tendency to give up on a strategy during rough times, according to Russell Investments.
This act of capitulation can have “the most negative impact on investment results,” argued Michael Thomas, managing director of investment outsourcing for the manager.
“Capitulation can evolve into a pattern of selling low and buying high as the investor seeks to recoup foregone returns,” he wrote in a blog post. “Exiting a sound strategy after a stretch of bad performance is one of the biggest weaknesses of many institutional investment programs.
But investment committees can’t help but second-guess underperforming strategies, Thomas said, as a typical structure can create an environment in which it is difficult to stand by an investment once it begins to go south.
Take the California Public Employees’ Retirement System (CalPERS) and its divestment of tobacco holdings, for example.
After a review of its 15-year ban on tobacco stocks, the $300 billion pension fund’s consultant Wilshire Associates found CalPERS missed out on as much as $3 billion in potential returns as of December 31, 2014.
“Limiting the opportunity set for investments has a deleterious impact on performance over long periods of time,” wrote Andrew Junkin, Wilshire president, in the report. Continued divestment could result in a loss of $170 million annually over the next 20 years.
However, Thomas argued CalPERS should think twice before capitulating on its divestment.
“This sum is fodder for an attention-grabbing headline,” he said, “but since capitulating on this decision now doesn’t remove the impact from its actual performance experience, the question of whether to maintain its divestment policy should only be made from a go-forward basis.”
To avoid second-guessing—and even panic-selling—Thomas suggested investment committees frequently review objectives and investment beliefs, define how each investment contributes to these goals and beliefs, and ultimately understand possibilities of underperformance.