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LILY ROBERTSON: To start, can you share a bit about your role at Vanguard and the research effort you’re currently involved with?
CATHERINE GORDON: I have been at Vanguard for over 16 years, in a variety of roles, all investment related. The current role is overseeing our Institutional Advisory Services group. We manage about $13 billion for institutional clients on a discretionary basis. It’s a group of about 25 people, about half of whom are investment professionals actually helping clients work through an investment strategy—things like asset allocation, holding hands in difficult market environments, working with defined-benefit plans on liability-driven investing. We’re really an investment management firm within an investment management firm in terms of advising clients. The people in my group are really focused on managing the client portfolios and relationships.
The broader committee research initiative at Vanguard is a more collective effort than something coming out of my group, although my group certainly contributes. In all of our careers, we’ve seen thousands of investment committees, and in our collective experience, the number-one question we get from clients is, what do you see other people doing? I’m referring here to finance committees and retirement benefit committees as well—I’m using “investment committee” as a universal term. So the initial research was really a stake in the ground on what Vanguard thinks are best practices for investment committees. It was essentially a compilation of experiences.
From there, and over the last seven years, we’ve been doing actual research, expanding beyond just Vanguard’s manager’s experience. This has been done collaboratively with our research teams. It’s been an overarching research effort to capture how investment committees make decisions. The more we know about committees and how they work, it puts us in a better position to help clients adopt best practices. We’ve written a number of research papers, conducted surveys, and developed a number of tools to help committees do self-assessments.
In this process of examining how investment committees operate, what are the areas you come across in which committees most frequently need improvement?
For the most part, committees are doing a good job. But there are certain areas where it can be beneficial for them to drill down into their process. The first thing to look at is, are they using their process to structure a conversation around the manager and the investment strategy? We’ll often start by asking where the investment policy statement is. Usually someone will look around the room and say, “I think it’s in so-and-so’s desk drawer.” We actually had one situation a couple of months ago with a defined-benefit client, where one of our attorneys was looking at the investment policy statement and her eyes opened wide. It was as though she had uncovered something in an archeological dig; the language was from the 1970s, in terms of regulations that were being cited. It’s important to use your processes—meeting agendas, investment policy statements, manager guidelines—as effectively as possible.
The second area is one for which we’ve developed a tool to help clients and committee members assess how they spend their time. In one of our surveys, we asked the committees how, on a percentage basis, they spend their time in a typical investment committee meeting. They spend 40% of their time—by far the largest percentage—evaluating past performance. We’re not saying they shouldn’t spend any time on past performance, but it’s problematic when that dwarfs any kind of investment strategy conversation, or discussions about transparency or strategic asset allocation. In our opinion, too much time was being spent on something over which the committee basically had no control. The takeaway is, spend more time on the things you can control, such as, how much are we paying for this investment strategy? What is our asset allocation?
The third area has to do with the whole behavioral piece of committee dynamics. This is a group of people making decisions about money, which is a pretty emotional topic for most people. You’ve got group decision making combined with behavioral finance influences at work here. In our survey we found out that there’s a tendency to be overly confident. Eighty percent of survey respondents considered their investment knowledge above average, and about two thirds said they seldom make mistakes. Confirmation bias is another theme, this is the idea that we look for pieces of information that confirm our view of the world. Here’s an example in the investment committee world: “I’m convinced inflation is going to double digits tomorrow, so I’m going to pull together every article and report I can in order to prove my point to the committee. I’m going to confirm my view of the world.” Then the person on the other side of the argument says, “I’m not really worried about inflation at all.” That person is going to find everything he or she possibly can to confirm that view of the world. We see this play out on committees when a strong opinion gets put on the table. We live in an age where anyone of any political or world outlook can find some newspaper, blog, TV channel, column, or radio host that confirms their view of the world. There’s a professor at MIT, Nicholas Negroponte, who called this phenomenon “The Daily Me.” This whole behavioral dynamic has become very interesting to us.
How can committees strike a balance between encouraging informed, differing opinions and yet not allowing people to become too isolated in their own bubbles?
One of the antidotes that we put forth when dealing with confirmation bias is to play devil’s advocate. Some people come by that role naturally while others are just argumentative—if someone says the sky is blue, make sure someone on the committee says the sky is green. The goal is to have reasonable conversations that are based on the facts that have been presented, and hold people accountable. Sometimes it’s really more about the awareness that some of these behavioral influences are at work in a committee. For example, there’s a name for when people get too caught in their own bubbles: social loafing. They check out and distract themselves with their BlackBerry. One of our clients told us that in response to people not paying attention in committee meetings, she now tells everyone to check their BlackBerrys at the door. These are committees that are making big decisions about a foundation’s spending, or whether to freeze or terminate the defined-benefit plan. We can’t really afford to have senior people doing something else while these decisions are being made.
Have you found that certain backgrounds and/or types of experience tend to create good committee members?
We’ve been asked, “Should all members of the investment committee be investment people?” Our answer is that whoever you have on the committee, make sure they have a comfort level with the issues being discussed. If they don’t have an investment background, part of the on-boarding process for the committee should be to sit with an investment professional to get introduced to the concept. Everybody has to have either an investment background or a willingness to learn about the portfolio so that they’re able to make informed decisions. The other critical factor is that you want people who are good thinkers, and people who are passionate about and committed to the mission of the organization. This is especially true in the non-profit world, where the foundation or the endowment exists for a social purpose. Finally, it’s important to find people who are willing to commit the time.
Do certain institutional investors have more of a need than others for an investment committee, or do you think it’s always important to have that sounding board?
Even at the very largest institutions, it’s important that there is some type of investment committee to provide oversight to the in-house staff—either as a sounding board or to provide some direction. At some institutions, the committee might be more strategic in nature, leaving the day-to-day of manager selection and rebalancing to the in-house staff. In smaller organizations, where there may be an executive director and a very small staff with no one dedicated to investments, the investment committee basically does that job. A lot of small committees will hire consultants or another firm to handle investments, but in general, as the size of the organization gets smaller, the role of the investment committee grows in importance. Committees can play different roles depending on the size of the committee, but I don’t think any organization should say they don’t need one.
What’s your take on how often investment committees should be meeting?
Different organizations take different approaches, but in general, I would say that it’s not necessary to be meeting every month. Particularly for the larger organizations, if the role of the committee is to be thinking strategically, that doesn’t change all that much on a month-to-month basis. If there’s an in-house investment staff, they might send monthly updates to the committee—maybe a one or two-page update on the portfolio and market, just to keep committee members informed about what’s going on. The more people meet, it’s just human nature to feel that they should be doing something. If we’re here monthly, doesn’t that mean we have to do something monthly? It’s really about finding a balance between keeping the committee informed and making time for strategic discussions. In terms of best practices, I think it’s important for organizations to look at how much time their committees are devoting to continuing education.
Regarding DB plans and the move to liability-driven investing, how are your clients working through the process of implementing those changes?
We’ve been having LDI conversations with clients for a better part of the past five years, really since the Pension Protection Act was passed. One of the interesting things is that most of us who’ve been in the DB business for a while grew up in a total-return environment—here’s my asset allocation; here’s the expected return; I don’t really have to worry about the market in any given year. Now we’re asking the people who grew up in that world to understand that it’s not just about total return anymore. It’s about the liabilities and interest rates. It’s been a long education process for many plan sponsors to get their heads around the idea that they need to care more about interest rates than stock returns. However, over the past year or so, we have seen an acceleration of people interested in and committed to implementing the process.
We’ve seen some committees where 99% of the people are saying, “We should do this, we should do this, we should do this.” And one person is the holdout, and that one person is a CFO or the treasurer, the decision maker. Until he or she gets it, nothing’s going to happen. We’re asking people to think about portfolios in different ways. I think now that funding levels are generally better than they were a couple of years ago, plan sponsors are feeling a little bit better about the funding status. That said, people are reluctant to jump in with both feet, wondering, “Why would I do this now when I know interest rates are going to go up?” That’s another piece of the conversation.
In terms of portfolio construction, do you have a view on where investors should be realigning their interests? Are there any particular areas that people should avoid?
In the DB world, we’re certainly encouraging people to modify their investment policy statements. Rather than have it be to a specific asset allocation, as the funding level changes, the asset allocation will change as well. So, sort of hard wiring the idea that when the plan is at 90%, we’re going to have X percent in equities and X percent in fixed income; when the plan is at 95%, we’ll change that asset allocation based on the funded status. We’re referring to that as dynamic asset allocation. Others are doing this as well, but it’s a novel concept to have the asset allocation actually shift as the funded level shifts. These liabilities are interest-rate sensitive, so depending on the funding status, it may be a heavily fixed income oriented portfolio.
In the non-profit world—and this probably applies to the DB world as well—there is an opportunity to rethink how committees define risk and liquidity, and how regulatory changes have affected things. It creates a heightened awareness of things that were always there but now warrant a more explicit conversation when the committee gets together. Particularly in the investment world, there’s a tendency to rely on statistics. So, what’s risk? That’s the standard deviation. Well, that’s one definition of risk, but it’s really a multidimensional issue, and it’s same thing with liquidity.
This goes back to what we were talking about earlier: If 40% of committee time is spent on past performance, that’s time not being spent on defining risk and liquidity. These are the things that committees can have a strong influence over. How much risk are we willing to take in this portfolio beyond the standard statistical measures of standard deviation? How much transparency do we demand from our investments? Are we asking enough questions of our investment managers? How transparent are the holdings? These kinds of questions help re-orient where time is being spent.
Based on recent regulatory changes, how are you advising your clients with regard to encouraging transparency from managers?
At Vanguard, we spend a lot of time trying to understand the manager’s business. Rather than focusing on performance or strategy, we look deep into the manager’s business itself.
In terms of transparency, there’s a continuum. For example, in the mutual fund world, by law we are required to disclose holdings. So you can pretty clearly see that the fund owns, for instance, 500 shares of Exxon Mobil and 300 shares of Pfizer. Moving through that continuum, there are people who have separately managed accounts, and their custodian will have all the holdings. They can look at them and that’s pretty transparent. It’s when you get into some of the alternative strategies that it’s a little less transparent. It’s not to say that there’s anything wrong with those strategies, just that they’re not as transparent as a mutual fund which is required to disclose. So again, in terms of where committees spend their time, they will want to focus on those managers who have less-transparent holdings and strategies. I once had a boss whose directive to his team was “no surprises.” I think that’s a good change for committees to ask of their managers.
There tend to be two camps regarding consultants: those who rely on and value them heavily, and those who think consultants require as much due diligence as the least transparent managers. What’s your take on the value that consultants bring to investment committees?
I agree that committees should do as much due diligence on their consultants as they do on their managers. There is such a wide range of resources that consultants can bring to bear. Some consultants have manager search and research departments that number in the hundreds, while others don’t have much at all in the way of manager research. Committees should probe into that. What is the consultant’s manager selection process? Tell us about succession planning at the firm. What’s the organizational structure? Just within the past year, we’ve seen many consolidations within the consulting business, so you need to ask questions to get clear on what’s happening inside that firm.
Consultants are paid to have the time that the committees don’t have. I’m a volunteer investment committee member, so I don’t have time to be traveling around the country interviewing all these managers, or doing attribution analysis and statistical analysis. That’s what I expect the consultant to do, so that when they come to the committee meeting, we’ve got background on the three growth managers we’re thinking about. Consultants can be very helpful in doing a lot of the research work. Another way I’ve seen them be very helpful is essentially as a paid arbiter, or tiebreaker. If there’s a division on the committee, effective consultants can help facilitate the process of arriving at a decision. They also serve as a sounding board for committee members, someone to turn to when you need an impartial overview or viewpoint.
Do you work with clients on continuing education for their investment committees?
We’ve really been encouraging clients to look at how much time committees commit to education. It’s important that all committee members be up to speed on investment strategies in the portfolio. For example, is everyone up to speed on LDI, or portable alpha? And what about investment strategies on the horizon? Too often, the people who present these ideas to the committees are the people who have an economic interest in the committee adopting that strategy.
Our advice to committees is to make sure to educate your members by getting impartial experts to come in. For example, maybe a finance professor from a local university, or someone from the CFA Society, can come in to talk about portable alpha. This way, then when the person presenting products comes to the committee, everyone knows what questions to ask. We’re seeing clients take the initiative to get up to speed on investment strategies and regulatory issues, and making this kind of commitment to continuing education is a trend we’d like to see continue.
Can consultants serve in that role of objective expert?
They could, but to be perfectly safe, I’d bring in a second opinion—presumably one that doesn’t cost you anything. There are resources available in the community and through professional networks, where there’s no financial interest at stake. With consultants, there might be some economic interest there. That’s fine, and it’s not illegal; we all get paid to provide advice or to do certain things. You just want to make sure that the committee’s in a position to get objective information so that they’re then prepared to ask good questions about whether a new strategy makes sense.