How do you measure the measurables? Being objective about strategic advice
Kerrin Asks: should you judge investment consultants as doctors or therapists?
In a recent client meeting I was asked one of those questions that puts you on the spot. So simple and undeniably reasonable, the question “how should we measure whether your strategic advice adds value?” can instil the fear of dread in the faint-hearted investment consultant. Across the industry it is widely appreciated that ‘strategy’ is more important than ‘manager selection’, yet few trustees feel able to judge the quality of the advice they’re receiving – as the FCA has also observed.
Over the past few years this topic has come under the scrutiny of a Competition and Markets Authority enquiry, which focused on the apparent lack of value added by consultants in manager selection. After nine years of strong economic expansion, during which most risky assets have performed very well, a very different set of market challenges may well be looming on the horizon, which could challenge the resilience of many investment strategies.
Objective criteria for measuring the strength of investment strategies is required to assess the quality of advice given. It’s necessary to consider the objective outcomes of the process – as one might do following medical advice. It is much harder to assess more nuanced, subjective advice provided by therapists or marriage counsellors. In my mind, investment consultants are more like doctors than therapists and the quality of their work should be judged in a similarly clinical manner.
Using risk and return as objective criteria
The easier part to tackle is returns. Trustees are managing an asset/liability problem day-to-day, so it makes sense to express their return target in terms of asset outperformance versus scheme liabilities. Theses liabilities can be proxied by a portfolio of gilts and index-linked gilts. The return target could be expressed as “outperformance of x% relative to a liability matched portfolio of gilts or index-linked gilts”, often shortened to “gilts + x%”. Discounting liabilities on a gilt yield in this way is very conservative and most trustees are taking some allowance for future investment returns.
For many schemes, this isn’t a problem. If the actuarial discount rate is “gilts + 1%”, then the return target needs to be higher: “gilts + 2%”. A return of “gilts + 1%” is needed to satisfy the prudent actuarial assumption, and the extra 1% contributes to improvements in the funding ratio.
On the other hand, the risk component of our objective criteria presents more of a challenge. If two strategies deliver similar returns, the one delivering with less risk is superior. But risk itself is not clearly defined. Many trustees use Value at Risk (VaR) as a metric, but more often than not no-one actually knows the VaR. At best, trustees can hope to know the estimated future VaR, which is based entirely on a set of assumptions. The accuracy of a VaR estimate can never be confirmed or denied. Thankfully, however, there are two measures of risk that offer an objective measure after the event: tracking error* and drawdown**, which are used frequently.
By defining and agreeing the strategy for both return and risk upfront, trustees can ensure their investment strategy is integrated with their covenant assessment (Integrated Risk Management). Schemes can ensure that the framework set around the target return does not imply outcomes that cannot be supported by the covenant. Moreover, trustees can objectively test whether their goals have actually been achieved. For example: the investment goal could be “to outperform liabilities by 2% p.a. with a tracking error of 4%”. Trustees have immediate feedback on whether the strategy has delivered the goals.
Assessing the value added by the advisor is, therefore, fairly straightforward, but how did the recommended strategy perform relative to other plausible alternatives? Trustees can open a can of worms with this next question, underscoring the importance of ensuring that strategies are clearly labelled and do what they say on the tin.
* Tracking error is the standard deviation of the assets versus the liabilities
** Drawdown is the actual loss experienced in a bad scenario