Performance Monitoring

Family investors may be receiving performance reports from a variety of sources. Money managers send reports to their clients, bank custodians send reports, and if the family has retained an overall advisor, such as an investment consultant, that advisor will also be sending reports. With so many sources of information about performance, we might imagine that most investors do a good job of monitoring investment performance. But nothing could be further from the truth. The source of the failure lies in the complexity of performance reports, in the differing kinds of reports we receive, and in the inability of many of us to interpret the reports appropriately.

Money Manager Reports

All money managers send account reports to their clients, but that's about all that can be said. Some managers send monthly reports, some send quarterly reports, some (especially alternative asset managers) send only annual reports. However frequently or infrequently they send out reports, some managers show only account balances, while others show performance for that period, and some show performance as well for prior periods. Among those managers who show performance, some compare that performance against appropriate benchmarks and some do not. Among those who show performance against benchmarks, some managers use consistent measuring periods and some do not.¹ Finally, managers report only on their own performance, not the performance of other managers, so families who rely only on manager reporting will find it difficult—indeed, well-nigh impossible—to produce consolidated reports for the entire portfolio.

As a result of these deficiencies, investors who rely solely on money manager reports to monitor their performance are likely to experience poor results. The only investors who might possibly get by with manager-only reporting are families with very large and sophisticated family offices that can compute—and recompute—manager performance results in ways that are consistent across the portfolio.

Bank Custody Reports

As discussed in Chapter 22, it will be a rare substantial family investor who should even think about managing a complex investment portfolio without engaging a bank to serve as custodian of the investment assets. The main reason for this is to safeguard the funds, but consolidated reporting is an almost equally important advantage. Unlike money managers, a custodian will send monthly account reports on every account in the portfolio,² as well as a total value for the portfolio as a whole. Typically, these reports show account values, along with cost basis information for each security, statements of income, principal appreciation, a gain/loss report, and so on. Bank custody reports typically do not show manager or account performance, but only the actual values in each account and in the overall portfolio. Some custodians will provide performance reporting for an extra fee. In that case, the bank is acting not simply as a custodian but as an overall advisor, and is producing reports similar to those produced by investment consulting firms, as discussed below.³

Investment Consultant Reports

The main shortcoming of performance reports, from whatever source, is that they tell us in quantitative terms how we have performed, but they don't tell us whether that performance is acceptable or unacceptable or what, if anything, we should do about it. What we need, in addition to the quantitative reports, is qualitative performance reporting.⁴

Families who have engaged investment consulting firms or other overall advisors should be looking to those advisors for a qualitative assessment of their performance. Consultants also provide quantitative reporting, of course—indeed, the better firms will reconcile manager-reported performance with the account values and cash flows shown on the custodian's statements (but see Conflicts between Reports, below). But the real value added by an overall advisor on the performance reporting side is to give us an informed, objective, qualitative report on how we are doing, preferably in simple English. Performance reports from managers generally start with a description of what happened in the markets during the reporting period. That's fine, of course, but unfortunately the reports stop there. While we might be mildly curious about our managers' takes on what happened in the markets, our attention is actually galvanized by what happened in our own portfolio, and most advisors don't provide that information.

While asking for a qualitative analysis of our own performance seems a simple enough request, in fact the business of supplying investors with qualitative assessments of their performance is extraordinarily difficult to pull off. In the first place, the advisory firm must have no conflicts of interest that might corrupt its assessment of performance. This eliminates 99 percent of all the financial advisory firms in the world. Next, the firm must actually employ senior investment professionals who are able to assess investment performance. Just to take a simple example, imagine a small-cap value manager that has underperformed its benchmark for two consecutive years. Should the manager be terminated, or should the firm be given more of our capital? Either decision could prove to be brilliant or disastrous, and the decision is rarely straightforward.

Finally, the firm must assign to its individual advisors a small-enough client load so that the advisors can actually take the time to prepare qualitative assessments. Brokerage firms typically assign hundreds of accounts to each rep, while bank relationship officers must manage scores of clients. Any advisor who handles more than about two dozen accounts will be in way over his or her head when it comes to providing qualitative, customized assessments of performance.

Typical consulting firm performance reports will consist of monthly reports on manager performance and quarterly reports on consolidated account performance. The monthly reports simply take the performance reported by the manager and compare it to an appropriate benchmark for the period and, typically, the year to date. The quarterly reports will reconcile manager account statements with the account statements produced by the custodian; will provide performance data on each manager and account, as well as for the consolidated portfolio; will comment specifically on the performance of each account; and will make any recommendations that the client should consider for that period.

Conflicts between Reports

Family investors who engage money managers and a custodian will find that the statements produced by the manager and the statements produced by the custodian frequently show different balances. While these differences are usually small, they are nonetheless alarming. (Imagine that, at the end of the month, we received a statement from our bank showing that our checking account balance was “somewhere around $52,000!”)

The main culprit in discrepancies between managers and custodians has to do with the differing protocols used by each. When a security trade is made, the pricing of the trade is established by the trade date, but the actual proceeds change hands on the settlement date. For a money manager, it is the trade date that matters, because that date establishes the price the firm will receive from a sale or will pay on a buy, and it is that price that becomes a part of the firm's permanent track record. Hence, managers tend to prepare account statements using trade dates.

From the perspective of a custodian, however, what matters is whether the proceeds from a trade are successfully received into the account, and what the value of those proceeds is. Until the proceeds from a transaction are actually received into the account, the matter is purely hypothetical. Hence, banks tend to prepare accounts using settlement dates. Managers, in other words, are engaged in a performance game, while custodians are engaged in a money-counting game.

Inevitably, some securities transactions will straddle the closing date for the preparation of account reports. If the trade date for a transaction is September 30, the manager who made the trade will show the proceeds of the trade in its account statements. As far as the bank is concerned, however, no proceeds from the trade have been received into the account. Hence, the bank will not show those proceeds on its account statements for the period ending September 30.

Other discrepancies can arise as the result of decisions about accruing dividends and interest payments, the use of different securities pricing services, and so on. As noted earlier, many kinds of investment assets can't be held in a traditional custody account, and will be carried as a lone item entry by the bank. These line items are often not updated in a timely way.

Unfortunately, when we simply look at differing balances sent to us by managers and banks, it is impossible to know whether the discrepancies are related to harmless protocol-timing issues, or whether the errors may be more serious. Very large family offices will reconcile manager and bank statements, but most families will need to engage someone to handle this chore (and a chore it is!) on their behalf. The usual “someone” is an investment consulting firm that has built a sophisticated back office that downloads account data from the custodian on a daily basis.

Interpreting Performance Reports

As noted above, quantitative performance reports tell us very little. If our three U.S. large-cap managers all underperformed the S&P 500 for the month or quarter, should we be alarmed or not? It's impossible to know without knowing a great deal about the nature of the managers and the nature of the markets during that quarter. If our small-cap value manager suddenly begins to outperform its peers by substantial margins, should we be moving more capital to the firm or should we be deeply worried about style drift? What sort of benchmark should we be using to measure the performance of our overall portfolio, and should that benchmark be different over shorter and longer periods? If a blowup has occurred at a hedge fund included in our hedge fund of funds, should we be worried or is it inevitable that occasional blowups will occur?

As these questions suggest, interpreting quantitative performance reports is not a game to be played in short pants. The difficulties associated with interpreting performance reports have led family investors to make one of two opposite mistakes. Some families terminate managers or revise their portfolio strategies based on apparent-but-unreal performance deficits, resulting in excessive and expensive manager turnover and in sudden, amateurish changes in investment strategy. Other families, faced with the difficulties of interpreting performance, simply don't do it at all, living for years with underperforming managers and portfolios until some horrible event awakens them from their slumbers.

Unless a family is extremely experienced, or unless it can afford a very sophisticated family office, most private investors will need to engage an advisor to help interpret performance and make recommendations based on those interpretations.

Monitoring Manager Performance

We have touched on this topic before (see Chapter 17), but I would be remiss if I didn't emphasize the important point that most manager terminations are costly mistakes. Mistakes in the simple sense that the terminated manager outperforms the replacement manager over the next market cycle; costly in the sense that we not only give up the superior return produced by the terminated manager, but we must also pay the transaction costs, taxes, time, and emotional costs associated with moving from one manager to another.

Most manager terminations occur for what we imagine to be performance reasons. But in fact only a small minority of managers who are terminated really deserved to be terminated—and it is we investors who bear most of the costs associated with unnecessary terminations. Effective manager monitoring requires that we take each of the following steps:

• First, whenever a manager is engaged, we should prepare guidelines (see sample on the companion website for this book at www.wiley.com/go/stewardshipofwealth) for that manager and have those guidelines approved by the manager. The guidelines need not be extensive or elaborate, but they should cover such issues as:
  • The manager's acknowledgement that the account will be managed in accordance with the family's investment policy statement.
  • Performance expectations, including the benchmark, manager universe, and time horizon that will be used to measure the manager's performance.
  • The timing and nature of reports the manager will submit.
  • An agenda for meetings to be held with the manager, and the frequency of those meetings. Managers are superb at coopting the agenda of meetings, spending most of the time talking about the state of the markets, the view of the Federal Reserve Bank, the outlook for interest rates and the economy, and so on. Everything, that is, except the manager's performance.
• If the manager's performance is to be measured over an entire market cycle, it should be a very rare case that the manager would be terminated for performance reasons before that time has expired. Otherwise, we are probably overreacting to temporary market events or transient underperformance.
• We should take care to measure the manager against appropriate benchmarks and appropriate manager universes. A manager can produce lousy absolute performance and still be someone we want to keep in our portfolio: If the sector in which the manager works has produced dismal results, all managers working in that sector are likely to be doing the same. Trading one manager for another will accomplish nothing.
• On the other hand, substantial changes in the management firm itself should be cause for alarm even if performance has not deteriorated. Substantial changes mean that we are no longer dealing with the firm we engaged, but a somewhat different firm. The following changes should be of special concern:
  • Very substantial growth or shrinkage in the manager's asset base since the firm was engaged.
  • Loss of key professional personnel.
  • Sale of the firm or sale of a significant interest in the firm (significant enough to put lots of cash in the senior professionals' pockets).
  • Significant personnel turnover or disarray even below the senior professional level.
  • Failure of the senior professionals to provide for the continuation of the firm by bringing along younger professionals and sharing equity with them.
  • Any (repeat any) ethical failure.