Double Secret Probation

Of the many classic one-liners from the movie Animal House, one of the my favorites is when the dean decides to put the Delta house on double secret probation:

I’m always reminded of this clip when I hear about a common practice in the institutional asset management world. Whenever the boards of the various pensions, endowments and foundations get together for their quarterly investment committee meetings they go through their roster of outside money managers to check on their performance. And because they always have to feel like they’re doing something to their portfolios, many of these committees — along with help from their consultants — have created different categories for their managers. Some use color-coding, while others create various names to get a sense of where the managers stand. Basically, what it comes down to is you have a pile of good performers and a pile of poor performers and the poor performers are almost always put on a watch-list of some sort.

I was reading a story in Pensions & Investments recently that details how this works for a pension plan in Oklahoma:

Oklahoma Teachers’ Retirement System, Oklahoma City, put opportunistic real estate manager Landmark Partners and domestic all-cap equity manager Epoch Investment Partners “on alert,” said Tom Spencer, executive director, in an e-mail.

Being put on alert is a step below being placed “on notice,” which is the last step before termination.

So being put “on alert” is like being put on probation while being placed “on notice” is like double secret probation.

I guess in a sense it’s nice of these funds to let their managers know that they’re walking on thin ice. And they can’t just ignore performance issues. But this type of performance exercise probably causes more harm than good because it leads to potentially misaligned incentives and short-term thinking. It’s the law of unintended consequences:

Oh, we’re on alert now? OK, now we’re REALLY going to try harder to outperform.

So we have two quarters to get our act together or we’re fired?

But if we do better over the next year we’re in the clear and off the list?

This process actually incentivizes poor performing managers to take bigger and bolder risks with your money because they really have nothing to lose. Why not swing for the fences if it looks like you’re going to get fired anyways? It’s not like more pressure from investors is going to magically cause these funds to start performing better.

Really this whole process exemplifies the herd mentality and performance chase that we see over and over again in the institutional investment world.  Managers can be put on these watch-lists for other reasons, but the majority of the time it’s all about performance. Institutional funds tend to fire the money managers who are performing poorly and bring in new managers who have shown better performance lately. This hiring and firing process basically makes the performance-chasing circle of life complete.

The problem is that very few asset allocators have a good decision-making process in place to determine when and why to let go of a poor-performing fund or manager. In many ways this is just like trying to determine when to sell a poor-performing stock. Plenty of investors can tell you when to buy, but very few have a solid process in place about when to sell, especially when things don’t go as planned.

I’ve always thought that one of the hardest conundrums in the investment business is figuring out the following:

  • Are we being stubborn and holding onto a fund that is past its prime?
  • Are we being disciplined and holding onto a fund that is experiencing an expected period of poor performance?

Either you agree with the process and understand that there will be periods of poor performance or you have lost faith in the managers or the process and it’s time to move on. This is not an easy thing to do, but no one said picking the best money managers was easy.

It’s very easy for asset allocators to pick new funds or strategies to invest in because there are so many choices out there today and the majority on your list will likely have better performance than the ones you’re looking to dump. The difficult side of the equation is knowing when to bail, and more importantly, when to stick it out and be patient with a period of poor performance.

Oklahoma Teachers puts 2 managers ‘on alert’ (P&I)

Further Reading:
In Pursuit of Past Performance