—Yogi Berra

“The only reason for the assets are the liabilities” is a mantra that used to be heard frequently, but not so much anymore. Why hold back, or save, or avoid spending money, unless you have a reason or purpose for that money sometime in the future? Those future needs, for which we hold funds, are simply liabilities. For pension plans, it’s easy for your actuary to assume the future benefit payroll attached to each employee, then once that total future payroll is estimated, discount it back at some assumed rate of return to today. That number can be compared to the assets on hand. For endowments and foundations, it is a much more direct proposition. They have a required payout that must be met, and often target a higher number to account for inflation or they have a specific budget amount that needs to be met. These requirements are the liabilities that must be covered and are the only reason for the assets.

Do employees or grant recipients really care if the S&P or some “policy” index got beat? Do benefit checks or grants get paid in dollars, or “relatives to the index?” On every check I’ve seen (and the only ones we want), that long middle line always ends in “dollars,” never “relatives” or “frontiers” (efficient or not). The first and only goal of a pension plan must be to pay those bills—now and future. The first and only goal of a foundation or endowment is to pay their obligations and fund their programs—now and future. So how do trustees measure how well they are doing? How do they evaluate the need for change, and just how do they manage the fund?

First, and foremost, they have to define their job. Presumably, they did this in their governance document. It should not be to beat some popular index or even a policy index, nor is it to beat Dallas Police and Fire, Yale, or your favorite competitor, nor is it to do better than other “funds like ours.” Their first job is to pay those liabilities when they are due. They must fund their programs and budget share. Anything else is not acting in the best interests of the fund, is disloyal, and shows a lack of care.

Yale professor emeritus James Tobin writes: “Trustees are the guardians of the future against the claims of the present. Their task is to preserve equity among generations.”¹

The only true benchmark is therefore the liability (benefit) itself—but that slippery devil is different for each particular fund. In theory, it should be simple; just figure out what checks will be needed from now until “far in the future” and calculate an average rate of return needed by each contribution to get to that number. From the trustee’s point of view, all that is needed is to earn that rate or better—right? In a world where crystal balls work (or towers are ivory) the answer would be yes. Otherwise, no.

The current fad is the “policy index,” where the investment committee takes the preselected asset allocation weights multiplied by their individual indexes or benchmark returns to create a unique benchmark return that reflects “policy.” Since that policy benchmark is calculated with average asset class returns and the investment committee would never hire or keep a below-average manager (at least in theory), it becomes a virtual guarantee that the fund will beat that policy index and will be successful. Unfortunately, much of the time many funds simply don’t exceed the policy index, and when they do there may be no real success because they don’t meet the required return.

Example: Not long ago, a state-run pension plan had beat its policy benchmark by over 200 basis points, and for that stunning success its staff awarded themselves almost $2 million in bonuses. Just too bad the fund missed its required return by almost 300 basis points. Better luck next time, employees, and thanks for the new car.

The questions that are almost never asked are, “Why is this the policy?,” “What is the purpose of this policy?,” “Where did we get this policy?,” and most importantly, “Will this policy get us where we need to be?”

Another common evaluation tool is the watch list. A manager underperforms for some specified period of time, therefore he is put on a “watch list” (what, no one was watching before?). Then he is given some specified period of time to improve. The question never asked is Why? Why is he underperforming? Is there a reason? Could it be due to their philosophy, and the failure should be expected given the current market conditions? Is the intellectual capital gone? If so, why wait to find a new manager? Is it something that can be fixed? If so, what are you (or the manager) doing about it, and if it’s not fixable, why wait? This brings up a corollary: Why is the consultant or your investment officer reluctant to fire this manager now? They may have a reason, but this is a reason that must be explained and justified to the committee.

Change is one of the key elements you should be tracking. First, are there changes to your goals, requirements and restrictions? Are there changes to your feelings toward risk, and how might that affect the portfolio? Next, are there changes at the managers? Is performance not what it should be or was expected to be? Did someone holding the intellectual capital leave, are there other changes at the firm, or has the firm been sold? The list is almost endless. The only thing you can be absolutely sure of is that things will change, and you must be out in front of them if you can, and not far behind if you can’t.

The real benchmark is that minimum or required return. Are you getting there? Are you keeping that compound return over multiple periods of time—one, three, five or more years? If you did or did not get the required return this evaluation period, was this one of those left-hand-tail events and you are keeping up the required compound return over the life of the portfolio, or not?

Your portfolio is a team of real people making decisions and performing each and every day. They are not unlike a ball team when individual players under- and overperform in a particular game. Their performance this month or this game is part of the evaluation, but not all of it. Yes, comparing each manager to his peers and to benchmarks can be helpful in managing the portfolio, but only in a general way. It is not uncommon to find good managers that simply do not look like the index they are paired with. They don’t track nor do they have many of the characteristics of that index. We know one small-cap growth manager that sometimes has a decided value component (growth at a price?) and will let the cap size rise without selling. One name we remember ran from a small capitalization to a large capitalization because it could produce significant growth for the portfolio. The manager was more interested in managing our money than he was in maintaining a particular look for the consulting industry—by any definition, a good manager.

As fiduciaries and members of the governance of a fund, your benchmark is the goal of the fund. Is your investment office, the management of the investments, meeting that goal? All the other benchmarks, comparisons, and statistics are simply flags or point to questions for that investment officer. Does he or she know the answer? Can they say why? Are they out in front or just sitting back and waiting? They are for you to monitor and evaluate—manage—while they monitor, evaluate and manage the investments.

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¹James Tobin, “What is Permanent Endowment Income?”, American Economic Review 64, no. 2(1974): 427-432.