Editor’s note: Derek Bills received a New Strategy award from Markets Group and Institutional Allocator at our Institutional Investor’s Forum in Washington DC. Photo credit: Molly Stemwedel
If an investment approach has worked for decades, and the markets
change in a way people have never seen, should you consider changing your thinking
and investment approach?
That’s the question Derek Bills, Head and CIO, Investment Office, International
Monetary Fund (IMF), which manages over $15 billion in IMF’s retirement and
benefits plans (IMF Plans), has been asking his investment managers.
“Current market conditions are completely
opposite of what we have had for the last decade. At a minimum, investors need
to assess the resilience of their portfolios, and managers need to assess the
efficacy of their investment approaches in light of significant changes in the market
environment. They [managers] may be right [to stay the course]; however, they
need to assess and assure whether their investment approaches can continue to
respond effectively to the changing market environments.” Bills said. “Otherwise,
they run the risk of introducing uncompensated risks into the [client] portfolio.”
Talk of the new economy, and plans for
it, are becoming widespread. Former CEO, CIO and president of UTIMCO, Britt
Harris refers to it as the end of a 40 year era, in which there’s low supply, high inflation and reduced globalization. Others
point to the rising interest rate and chronic inflationary environment as a “regime
shift.” Bloomberg has a ‘new economy’ update
almost every day, across the globe, pointing to the increased volatility, the
threat of climate events, the emergence of strong artificial intelligence, the
burgeoning new regulations, among roiling governmental and geopolitical
changes. As early as 2020, Schroders
called it the end of free market capitalism.
And so, Bills is painstakingly picking
through his $15 billion portfolio and trying to dissect what each manager
intends to do [or not do] in the new economy. He’s charting their thesis, learning
their action plans, researching the efficacy of strategies, and questioning if
they are changing direction and adapting under the new market environments. In
doing so, he is re-assessing the fit and efficacy of each and every investment
strategy within the total portfolio context.
From his vantage point, managing risk means
knowing what you have in the portfolio; understanding how what you have in the
portfolio will respond to the changing market conditions; and knowing what your
managers actually do [in executing investment strategies] to achieve the long-term
return objectives. He has observed that there is a considerable understanding
gap between what the manager thinks the investor wants and what the investor
thinks the manager is delivering.
He’s systematically looking for places
where investment goals may be unintentionally misaligned with achieving the long
term return objectives, thereby subjecting the portfolio to uncompensated risks
that can result in giving up returns—e.g., whether it’s by introducing additional
constraints as a function of the manager’s corporate risk management policies that
go beyond investment guidelines; setting a fixed tracking error target that is
not a function of the current market conditions; not providing risk neutral
portfolio positioning [by active managers] through statistically replicating
the benchmark in times of excessive volatility or extreme uncertainty; passive
or random behavior with respect to sector or country allocation that offsets
the value-added coming from bottom-up security selection; and sitting on large
cash positions rather than returning the incremental cash [to the investor]
when the market conditions are out of favor. “I would rather provide cash [to
the manager] if the manager needs additional cash for portfolio rebalancing; I
look for rebalancing opportunities to effectively deploy cash any way. My
expectation is that cash should be fully invested in the market at all times
because time in the market always beats timing the market.” said Bills.
“It’s really not surprising at all that
many of us are biased by our past success; however, I would say that our tendency
to stick with what has worked well in the past can get in the way of objectively
analyzing how to reposition our thinking, the portfolio, and investment strategies
when the market environment is changing in a significant way. So shouldn’t we move
out of our comfort zone and objectively question whether what we and managers
do remain resilient, and that they will continue to work in an environment
that’s completely opposite?” he asks.
Bills is also working to change their approach
to private market investing. The “new” approach is to focus on longer term
return compounding rather than maximizing the short term internal rate of
return (IRR). In public markets, he lamented that it is possible to own a great
company like Apple in the portfolio for many decades and continue to compound
returns. In comparison, there is not a single great private company that he has
held for more than 10 years in his portfolio because of the typical private investment
term structure. If the time horizon is infinite, as is the case for the IMF
Plans, he questions whether private market investing is more about maximizing
the short-term return rather than maximizing longer term return compounding.
Now he is looking to overlay the enduring attributes of public market investing
onto private market investing to help focus on longer term return compounding
and allow for extended value creation that is freed from artificial time constraints
imposed by the typical 10-year plus two 1-year extension construct. Moreover,
he is looking for ways to better align manager interest with investor interest.
“It is no secret that investors bear a disproportionally higher downside risk
when it comes to private market investing compared to managers because managers
can continue to collect high management fees.” he said. To the extent feasible,
the IMF Investment Office is concentrating its efforts to develop customized
solutions for its private investment program that is better structured for
longer term wealth creation and fostering a better alignment of interest with
the manager.
Talking with Bills almost seems like exploring a Zen side of finance. His logic seems smooth, and is stated simply in a calm and candid manner
“I may give the impression that I am
off the beaten path. Be that as it may, my intent is to guide others to look at
things objectively and ask questions.” Bills said in parting..
By Christine Giordano
Upon publishing this article, we agreed to the following disclaimer:
The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management. Further, and note that the Investment Office operates behind firewalls from the IMF’s surveillance, lending, and CD activities.