Step 5: Monitoring

It’s self-evident that as a trustee you need to keep an eye on your scheme’s investments.  First we are going to highlight some potential pitfalls to fall into when monitoring.

Potential pitfalls

• Passive ‘tick-box’ exercise

It is very easy for trustees to gather a lot of data about what has happened, and then just note it for their minutes without really considering the implications or even the usefulness of the information.  One way to mitigate this is to collect less data, but make sure that it is all important.  One useful exercise is to consider before the monitoring, for each item of data what action you would potentially take based on the results?  If the answer is “nothing”, then don’t bother collecting that particular piece of data in the first place.

At your trustee meetings try to treat the monitoring as a decision making exercise (even if that decision is to maintain the current strategy) rather than a “for information” slot.

• Frog in the pan

Apparently if you put a frog into a pan of hot water they will leap out, put if you put them into a pan of cool water and then gradually heat it up they will stay in the pan until they boil to death.  If an aspect of your investments gets steadily worse quarter by quarter there is a danger that you fail to recognize the severity of the problem because of familiarity.  One way to combat this is to add a second question to the exercise above.  Record in advance what actions you will take based on specified results of the monitoring.  There is a case for monitoring certain aspects less frequently, but in more detail.

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• Focusing on the wrong areas

Human nature dictates that we tend to measure what is easiest to measure rather than what is important.  There is a tendency of trustees (and investment consultants in the past) to focus on the performance of the fund manager.  However, this is not the most important decision.  Try to spend more time monitoring whether the asset allocation strategy is still appropriate.

• Knee jerk reactions

Another aspect of human nature is to “close the barn door after the horse has bolted”.  A WM Company survey found that in 85% of cases, trustees sacked their manager because of poor performance; but in 67% of cases the new manager underperformed the old manager in the first twelve months of the change.

• 20:20 hindsight vision

Journalists, fund managers and investment consultants are all very polished in explaining why markets behaved in the way they did.  Typically the language used suggests that this was always the only possible outcome that could have happened.  Do not believe that fiction.  Markets are chaotic and (almost) unpredictable.  What actually occurred will have been only one of countless possible scenarios that could have unfolded.  There is a huge amount of luck involved in investments.

Would you class the man who picked the six numbers for last week’s lottery correctly as an investment genius?  His performance figures would certainly suggest that he is one.  How about the woman who saved money by not insuring her house last year, and didn’t suffer a burglary or a fire?  Both of these people had good outcomes, but the decisions that were made were not necessarily smart.

Conversely you may have a sensible strategy given your needs, investment objectives and liabilities, but this was still not successful. Alternatively, your fund manager might have made sensible ‘bets’ in your portfolio given the information that was available at the time, but achieved disappointing results.  Sometimes you can just be unlucky.

• Short-termism

If you focus too much on the short-term it can lead to knee-jerk reactions.  However, you do not want to boil in the pan either.  It is a fine balancing act.

Our recommendation

How do we recommend that you avoid all these potential pitfalls?

Firstly through attitude: approach monitoring with these questions:

“If I were going to put my strategy together again from scratch, with the additional information I have gleaned since the last monitoring exercise, would it be any different from my current strategy?”

“If it is different, is the difference great enough to warrant the costs of changing?”

We advocate a structured process for formulating your strategy.  We recommend a similar structure (just scaled down) for monitoring.

• Step 1: Setting investment objectives

The most likely change is that your attitude to risk can change.  The main things that can affect this are changes within the sponsoring employer, and changes to the funding position of the scheme.

Many boards of trustees have regular updates from the employer about its financial health (and so the strength of the covenant).  If you do not already do this, we recommend that you give it consideration.  To avoid the danger of this being a passive tick-box exercise we recommend that you, as trustees, formally decide each time whether to retain your current investment objectives or to change them.  There are also potential implications for your funding strategy.

Imagine you had accepted a high degree of risk because you need strong investment returns to close a large deficit, and the risks had paid off and your funding position had improved dramatically.  Fantastic!  Would you still want to take so much risk?  Probably not.  We think that one of the most important aspects of your investment monitoring is to keep an eye on how your assets are faring compared to your liabilities.  This is much more important than the absolute performance of your scheme’s investments.

• Step 2: Setting your strategy

We help trustees set their investment strategy by taking account of their objectives and liabilities, modeling our understanding of how the investment world works and finding the most appropriate investment strategy from the range of products available for a scheme of that size.

So what can change?

- Your objectives: see above.

- Your liabilities: This is worth reviewing each time a new actuarial valuation is performed.  Usually this will be every three years, but a significant change to the scheme might trigger an ad hoc valuation.

- Our understanding of the risks: an analysis of the reasons behind the changes in the funding level can act as a useful feedback loop to ensure that we are on the right lines.

- The range of options available:  Your investment consultant should be alerting you to any new asset classes or products that might be a useful addition to your strategy.

• Step 3: Selecting fund managers

Looking at past performance in isolation is a poor way of picking fund managers.  So it is also a poor way of monitoring them.  You cannot easily separate luck from skill in looking at the data alone. 

We concentrate mainly on five factors when assessing fund managers (philosophy, process, people, research and risk control) and we recommend you do the same when monitoring.  Your investment consultant should be regularly reassessing your managers on that basis (or something similar).

The main use we make of performance figures is to check:

- Is the fund manager taking an appropriate level of risk?  If you are paying active managers’ fees then you should expect and deserve for them to be taking enough risk to give a fair chance of meeting their outperformance target.  However, we would not want them to be taking too much risk either.

- Does the fund manager’s explanation of their performance correspond with their stated philosophy and process?  Comments made by the fund manager after they’ve performed well are often more illuminating as they tend to be less guarded.

Just because “past performance is not necessarily a guide to the future” is a cliché, does not mean that it isn’t true.

Remember that if you are sitting on a loss (either from your fund manager or your strategy), then that has already been suffered.  We cannot undo the past.  It is difficult, but healthy to draw a line under what has happened.  Try to make monitoring a forward-looking exercise (based on new information).