Suspicious Minds

Jon Grabel doesn’t consider himself a skeptic.

For the New Mexico public pension CIO, the word ‘skeptic’ brings to mind images not of a prudent investment chief, but of Statler and Waldorf—the elderly hecklers in the Muppets. “You know, the ones who are always like, ‘Oh, it’s terrible, it’s terrible, it’s horrible,’” Grabel says. “That’s an extreme position.”

Yet over the course of a 20-minute conversation, Grabel could name half a dozen things he was skeptical about: Asset-class divisions, using the same benchmark for different strategies, popular trends, alpha chasing, fee structures, and general-partner (GP) motivations.

He’s not the only one.

Skepticism—not Statler-and-Waldorf-style jeering, but a constructive mistrust of untested investment ideas—has always had a place in an institutional portfolio. Lately that mistrust seems to have grown, with investors questioning just about everything related to their portfolios. If asset owners have not actually become more skeptical, they’ve at least become more vocal.

In the last year alone, institutional investors have cut ties with hedge funds, demanded transparency from GPs, and questioned fees across every portion of their portfolio. Active management in general has drawn heavy scrutiny from funds, boards, and beneficiaries, as asset managers who promised excess returns failed to beat index funds.

“Active US equity management over the last seven years—it’s been a tough go,” says Russ Ivinjack, a senior partner at Aon Hewitt Investment Consulting. “And indexing has worked very well. For our clients, there is a trend of growing skepticism of active management in US equities, and whether it can actually add value.”

Eileen Neill, managing director at Wilshire Associates, seconds Ivinjack’s observation. “Plan sponsors have grown more wary in general of active management.” While in the past asset owners had been quick to approve an investment based on short-term relative performance, those same investors have been burned one too many times by strategies whose outperformance stopped, Neill adds. “Plan sponsors are willing to ensure that they really understand where a strategy’s performance is coming from before they buy into it,” she says. “They’re asking more and better questions today than in the past.”

More and better questions led the California Public Employees’ Retirement System, New York City Employee Retirement System, AIG, and MetLife to sell off hedge fund investments, after internal reviews of allocations determined the mediocre returns were not worth the fees (or, perhaps, the media scrutiny). Others have kept their hedge fund programs, but voiced concerns that interests are not so aligned as GPs claim.

“There has been a tremendous number of redemptions out of hedge funds,” says Jon Hirtle, CEO of outsourced-CIO (OCIO) firm Hirtle Callaghan. “Why is that? Because hedge funds have underperformed lately. Wouldn’t it have been better if people had been more skeptical about hedge funds five years ago?”

“Popular trends are popular trends. In investing, you usually want to catch the wave before it is popular.”Hirtle—company motto: “Always skeptical, never cynical”—believes portfolios are often hampered by recency bias: the human tendency to trust that whatever worked lately will continue to work in the future. “If hedge funds have underperformed, people expect that will continue to be true,” he says. “If indexing has outperformed active managers, people expect that will continue to be true.” Indexing, with its attractive cost structure and equally attractive current relative performance, is particularly overdone right now, Hirtle argues. Too many investors have already yielded to indexing in the ever-going debate of active vs. passive. “We think this is a time when you need to be more careful about what you own,” he explains.

While Hirtle is unabashedly anti-index, Ivinjack says asset owners are right to be skeptical of active management—or at least of new active investments. “Once investors make the decision to use active management, they have to be patient and truly have a very long-term time horizon in order to let active management be successful in their programs,” he says. “They made that investment believing that it could add value in the long term. They should be skeptical of their own instincts to move away from it when it doesn’t perform—in other words, be skeptical of your own skepticism.”

Patience and faith in one’s own convictions are necessary to long-term success as an investor, the Aon consultant continues. Success will often require tuning out the short-term noise of what strategy is doing well now or which trend is popular at the moment. 

“People should be skeptical about whatever the trend is,” Hirtle adds. “Whatever is really popular is where you need to have the most skepticism.”

“Popular trends are popular trends,” Grabel agrees. “In investing, you usually want to catch the wave before it is popular.”

At the New Mexico Public Employees Retirement Association (PERA), Grabel and his team tend to disregard trendy strategies or managers in favor of choosing investments via total-portfolio fit. Each new idea is met with questions like, “Is it additive to existing correlations?” “Does it take us away from being market neutral?” “What bias would it add to the portfolio?” The CIO says the portfolio is “the star,” not the underlying money managers. “There are a lot of good money managers out there, but I think too much credit is given to them in general.”

Which brings Grabel to another object of skepticism: Alpha.

“We spend too much time on this hunt for alpha,” he argues. “A couple years ago, we had a core fixed income manager come in and talk about how it’s generated meaningful alpha for PERA. To me, core fixed income is not the alpha engine in the portfolio.” Suspicious, Grabel parsed the contents of the manager’s portfolio to find this “alpha” coming from preferred stock, high-yield bonds, and emerging-market debt. “That’s not core fixed income,” he states. “That’s just different betas.”

The need to question what the true drivers of return are in any proposed investment—and whether or not those drivers are repeatable—is part of what makes skepticism an essential quality in any good investor, says Hirtle. “You’re always looking for how returns are created, not just what the returns were,” he explains. “A lot of people who have good investment returns were just lucky.” A healthy dose of skepticism, according to the OCIO chief, can go a long way to differentiating actual skill from mere luck.

“Anytime you look at a fundamental opportunity—a deal, a transaction—what you should really be trying to do is see where the returns are coming from, what you’re paying for them, what the likelihood is they’re going to repeat, whether you can buy the same thing elsewhere cheaper,” Hirtle says.

“The idea that no one can forecast anything—in general, I think that’s a good starting point.”Atlas Capital Advisors’ Ken Frier takes a similar approach to evaluating investment advice. Frier—whose pedigree includes CIO roles for United Auto Workers’ health fund, Stanford University, and Hewlett-Packard—says he tries to always be data- and evidence-driven when making investment decisions. “If someone offers you advice, saying, ‘This is how you should decide on asset allocation,’ or, ‘This is how I think markets will play out,’ it’s important to ask how that decision was made and whether that decision is repeatable,” he says. “It’s not a foolproof way to decide which advice has merit and which advice does not, but it’s better than just taking it at face value.”

Taking views at face value would be to disregard one’s fiduciary duty, argues Rosalind Hewsenian, investment chief of the $6 billion Helmsley Charitable Trust. “As a CIO there are so many things that come across your desk that make all kinds of promises,” she says. “To be skeptical of those promises—that’s what due diligence is all about.” An asset manager is always going to provide a “bright and shiny” record, Hewsenian continues. “Rarely is it actually that bright and shiny.” 

“Mark Twain said it best,” Aon Hewitt’s Ivinjack quips. “It’s all ‘lies, damned lies, and statistics.’ Any good investment firm will be able to promote its strategy with numbers. That doesn’t mean it’s actually going to work going forward, or that it’s actually credible.”

And it’s not just asset managers who perpetuate bad math. Many asset owners could benefit from skepticism over their own return targets, Frier argues. “There are many institutions that have target returns of 7% to 8% nominal, or more than 5% real, who might be challenged to actually achieve those returns in the next 10 years,” he says. “A CIO who is told their configuration can achieve 7% or 8% should be skeptical and should have a backup plan.”

Frier’s skepticism of return targets derives partly from disenchantment with the endowment model—and largely from a belief that returns in general just won’t be great going forward. “When you look at the higher-than-normal valuation of the US equity market and the higher-than-normal valuations of many private markets… There’s going to be some giveback in the future,” he says. As further evidence, Frier points to recent studies by organizations in the business of forecasting asset-class returns, such as McKinsey, GMO, and Research Affiliates. “Most of the commentary about current asset prices suggests that we’re going to face a lower return environment,” he says.

But just because something is forecasted doesn’t mean it will actually come true. “I’ve been around long enough to have had plentiful experience in receiving well-reasoned arguments for what might actually happen in financial markets only to have something very different actually transpire,” Frier admits.

Take emerging-market equities. For years the asset class has been labeled undervalued and pointed to as a sure source of cheap returns. And yet emerging markets continue to trail US equities, which are supposed to be overvalued. Oil, too, has often been the subject of less-than-stellar forecasts: While more than $100 a barrel, oil prices were expected to remain in the triple-digits. But once oil dipped below $30, analysts were suddenly predicting that prices would fall even lower. “The idea that no one can forecast anything—in general, I think that’s a good starting point,” Frier says.

But since a complete disregard for all market forecasts would not be particularly productive, Frier instead advises investors to seek out additional evidence before accepting a forecast as likely. “Receive an argument for what markets ought to do, but await action in the market,” he says. “See whether action is consistent with that advice before committing capital to it.” 

“Due diligence can reach a point of inevitability—you’ve put all the time and effort in, so you might as well commit to it. That’s ridiculous. There has to be someone who keeps it real.”Better yet, don’t do anything without seeking additional evidence. At the Helmsley Trust, Hewsenian says that for every single proposition presented to her investment team, someone is assigned as a dedicated skeptic. “We have someone whose responsibility is to think the worst of an investment, no matter what,” she says. “This is part of our standard due diligence.” On the other side of the spectrum, a team member will play the role of sponsor—a person whose sole job is to identify the positives. “It comes down to who convinces whom that this is a good investment,” the CIO explains.

“I’ve seen people conduct due diligence where it reaches a point of inevitability—you’ve put all the time and effort in, so you might as well commit to it,” Hewsenian says. “That’s ridiculous. That’s no way to invest. There has to be someone who keeps it real.”

Keeping it real is, after all, the point of skepticism, and the reason why it is so essential to the success of a portfolio. “All of us in the investment business are seekers of the truth,” Frier says. “What is real, what is reliable, and what are the inputs I’m receiving? Of the approaches I could use to make an investment decision, which ones have merit?” 

The trick, he explains, is to make sure you actually are identifying the strategies that have merit. Or to paraphrase the Hirtle Callaghan motto: Be skeptical, not cynical. “Skepticism is absolutely a fundamental ingredient of any reasonable investment analysis,” Hirtle says. “But if skepticism passed into cynicism, then you’re going to miss opportunities.”

PERA’s Grabel agrees. “Skepticism is an attribute that should be part of all the tools in the toolbox that we use to craft a portfolio,” he says. “But you can’t just use one tool. You can’t just be skeptical.” At the end of the day, an asset owner can’t be a Statler or a Waldorf who finds fault in everything that appears before them. As a CIO and as a fiduciary, you have to be constructive.

“We invest for a simple reason, and it’s a really important reason,” Grabel says. “We invest to provide benefit payments for our 100,000 members. Remember that every time you make an investment decision, and you’ll hopefully make the right ones.”