I attended a large foundation’s investment committee meeting the other day to learn about its investment strategy.
One of the active fund managers the foundation uses for large-cap U.S. stock investments attended to discuss their methodology for achieving better returns than the Standard & Poor’s 500.
In brief, the fund manager explained that they identify companies the market undervalues and invest in a select few. Evidently this has worked for them over a number of years, though they did not share the level of outperformance. Nonetheless, this struck me as a very illogical way to invest.
It’s certainly possible to find large U.S. companies whose stock price – based on key business performance measures – has been relatively low when compared with the averages of similar companies. But while those stocks may be truly low-valued, it is anybody’s guess as to whether or not they are undervalued.
Think about how hard it would be to generate a higher return from such a stock. First, other market investors would also have to reach the same conclusion that the stock is undervalued. Then they would have to start buying more of its shares as compared to all the other stocks in the benchmark.
Finally, all of this activity would have to occur after the investment manager had identified and purchased the stock. And at some future time, the manager would need to replace the stock with another because its outperformance would have eliminated its previous undervaluation. Imagine getting all that timing correct.
The biggest downside of trying to beat the market is the added risk one has to incur, particularly with respect to volatility. And the relationship between return and risk is not linear. To target an additional 0.5% return, for example, could result in an increase in volatility of 25% or even more depending on market conditions.
In other words, the actual return you get from one year to the next could be much higher but just as equally much lower than the market benchmark’s return.
To their credit, foundation reps made it clear that their investment strategy is diversified across multiple asset classes to mitigate overall portfolio risk. But they especially prided themselves on doing a good job of fund manager selection. I don’t see much value in spending time and effort trying to evaluate and select managers whose methodology is based on trying to beat the market.
Research from Dimensional Fund Advisors and from Oppenheimer using standard statistical tools suggests that it would take upward of 40 years to determine whether a manager who has consistently beaten the market has done so through skill or through luck. None of the foundation’s current investment committee members is likely to be around that long.
As individuals, we invest for the purpose of growing our savings in order to pay for the lifestyle we want to enjoy when we’re retired and no longer able to earn income. But that lifestyle has to be affordable based on the amount of savings we’ve been able to accumulate. Trying to grow our savings at a rate higher than the market to try to achieve an unrealistic retirement lifestyle isn’t investing, it’s gambling. And the consequences are the potential for losses that could put even a basic retirement in jeopardy.
While a foundation is different in that it grows its investments for the benefit of donors and the nonprofit groups its supports, the risk model is the same. Because no one has control over investment returns, focusing on risk ought to be a prudent strategy even for foundations.