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Markets are constantly evolving, risk is being redefined, and new products are continuously being developed. As the older growth/value, large/small, domestic/international paradigm becomes less relevant to institutional investors, these new products often apply concepts such as behavioral finance, liability-driven investing, dynamic asset allocation, or risk parity.
aiCIO recently met with two individuals who believe the investment industry—CIOs, consultants, trustees, and money managers—should harness the power of change and embrace this evolution of investment thinking in order to best meet their—and their clients’—investment objectives going forward.
Margaret Towle serves in a volunteer capacity at IMCA—as a member of the board of directors and as editor-in-chief of the Journal of Investment Consulting—and as a member of the editorial board of Investments & Wealth Monitor. Michael Dieschbourg is a former IMCA board member and a current member of the editorial boards of the Journal of Investment Consulting and Investments & Wealth Monitor; he is senior managing director at Broadmark Asset Management.
aiCIO: Margaret, what is IMCA, and what is your role there?
Towle: IMCA is the Investment Management Consultants Association. IMCA was established in 1985 to deliver premier investment consulting and wealth management credentials, and world-class educational offerings through membership, conferences, research, and publications. Today, the association serves more than 9,000 members globally and is governed by a 13-member board of directors. The CIMA [Certified Investment Management Analyst] program was developed by IMCA in partnership with the University of Pennsylvania Wharton School of Business. Several papers will be referenced here, and at the end of the article we will let you know how you can retrieve them.
aiCIO: Mike, why is IMCA important?
Dieschbourg: I have been involved with IMCA since the beginning, and was part of the team that developed the CIMA program. From the start, it was always about learning more and challenging myself so I could better serve my consulting clients. When I moved to the asset management side of the business, the need for better investment solutions became more apparent—not just for consultants, but for investors and money managers.
aiCIO: What topics are you seeing coming through in these publications?
Towle: The two publications are quite different in orientation and content. The Journal of Investment Consulting is a refereed publication, providing content that is a fusion of theory and practice. The Journal editorial board consists of prominent academics and sophisticated investment professionals, and is more quantitative in nature than its sister publication, Investments & Wealth Monitor [IWM].
The articles in the latter are geared toward practitioners, especially investment consultants and advisors. In a recent IWM issue, a consultant at a leading firm wrote an article on how institutional investors can use a dynamic approach to allocate assets. Another theme that runs through both publications is the inherent weakness of using a mean variance optimization approach for asset allocation.
Last year, the Journal published an article called “Dynamic Beta: Getting Paid to Manage Risks,” co-authored by the in-house pension fund team at San Bernardino County Employees’ Retirement Association [SBCERA] and Arun Muralidhar, founder of AlphaEngine Global Investment Solutions. It contrasted standard mean-variance optimization and static risk-parity approaches. It is well-known that many public funds are underfunded. What is less well-known is how innovative funds are responding to this challenge. A few plan sponsors are recognizing that doing the same old thing is not going to move the needle toward achieving fully funded status. The article demonstrates how a dynamic beta program, utilized by San Bernardino County, may help pension funds manage primary beta risk and possibly lower the volatility and/or drawdown of their portfolios.
aiCIO: Mike, your firm applies a similar strategy, doesn’t it?
Dieschbourg: At Broadmark, we manage money this way, including using ideas that Arun calls “smart beta”. We believe dynamic beta lowers the overall risk of the fund—where risk includes volatility of returns plus drawdown—while earning a positive return. The introduction of dynamic beta seeks to provide substantial improvement on traditional investment portfolios, as well as portfolios with risk-parity approaches and allocations to alternatives. The SBCERA article proposes, and we concur, that dynamic beta is a more intelligent, more informed approach to dynamically managing risk and return. Having a pension plan CIO move from theory to practice to improve the funding status is something all plans can learn from, which is the key purpose of these articles.
aiCIO: Are there fiduciary risks inherent in this approach? And how do plan sponsors reconcile the proper execution of fiduciary duties with an approach based on a dynamic risk-driven allocation scheme?
Towle: Very carefully. To successfully do so requires the plan to adopt a new governance structure, which marries two seemingly divergent requirements. On the one hand, the board needs to exercise the highest possible level of control—i.e., fiduciary oversight—which it can at the board level. On the other hand, the investment staff needs the appropriate discretion to act quickly and effectively in ever-changing market conditions. The CERN [Switzerland] pension fund put just such a governance structure in place in 2011 when it gave the investment staff discretion to dynamically manage portfolio assets. I suggest that your readers take a look at how effectively CERN made this governance structure work for them. In both the San Bernardino and CERN cases, we are talking about a well-informed staff that uses cutting edge tools to dynamically manage portfolios, coupled with an appropriate governance structure to cover the fiduciary bases.
aiCIO: Is fiduciary duty becoming a larger issue going forward?
Dieschbourg: Yes, and it needs to be redefined. Work is currently being done to question the defense of being “willfully blind”—that is, not innovating because “that’s how it was always done”. Think MPT [modern portfolio theory] and passive investing versus adapting and evolving to the newer theories and strategies that seem to work better in today’s volatile markets. The CERN paper shows one has a fiduciary duty to search globally to solve for evolving risk issues. It was an in-depth analysis of why CERN innovated by moving away from traditional, static asset-allocation framework and by adopting a capital preservation approach based on dynamic risk-driven asset allocation. They are dealing with complex projects like construction of the Large Hadron Collider. Worst-case potential risk scenarios run all the way to instantaneous destruction of Planet Earth. I would say that CERN knows that real risk is failure to achieve a positive outcome. In our business that means minimizing drawdowns.
aiCIO: What else do you see as important areas of interest for institutional investors?
Towle: The theory and practice of behavioral finance seems to be working its way into many successful investment strategies. We recently conducted an interview with Nobel Laureate Daniel Kahneman, which is published in the Journal. The fact that Dr. Kahneman’s book on behavioral finance, “Thinking Fast and Slow,” became an international bestseller demonstrates how theory is morphing into practice when it comes to behavioral finance. Dr. Meir Stateman, a member of the Journal editorial board, has conducted some groundbreaking research to uncover what investors really want, which is conveniently the name of his new book, “What Investors Really Want.” Understanding behavioral finance theory is not enough to bring about change. The biggest challenge investors face today is taking it one step further and incorporating the practices of behavioral finance in the world of asset allocation and portfolio management. We need to move beyond designing questionnaires and identifying new risk bucket labels to actually using this approach to manage assets.
aiCIO: At Broadmark you seem to focus on “outcome-based investing” more than beating a benchmark. Why is that?
Dieschbourg: We believe you need to learn from the past and present, and avoid predicting the future. Warren Buffet said it very well: “You know, people talk about this being an uncertain time. You know, all time is uncertain.”
We focus on “outcomes” because we believe avoiding negative outcomes is our most important goal. Avoiding losses is three to four times more impactful to an investor, because of the power of compounding capital. You need capital to compound to pay your liabilities. If you draw down your capital due to negative market events and payout liabilities on a regular basis, you increase the risk of running out of capital earlier than planned. Being ahead of an index that is losing money, while still losing money yourself, is not going to help you reach your objective.
Our goal at Broadmark is to provide outcome-based results that help investors navigate through volatile markets to their stated objective.
