This article is forthcoming in The Journal of Performance Measurement (Summer 2016)
The performance industry has evolved considerably over the past decades. Concepts such as performance calculation, presentation, evaluation and attribution have become more complicated than ever. This is due to a changing investment industry, which has evolved from one mostly focused on traditional investment strategies to one with many complex alternatives.
Despite progresses, the investment performance practice remains at its infancy. Department heads such as Chief Risk Officer and Chief Compliance Officer are common place nowadays in most large investment firms but performance lags behind and the question asked should be: “why?”
Is it a lack of education or expertise? No, not at all. Performance has come a long way in the academic space and specialists in this field are the best positioned to be able to thoroughly evaluate the related results. The CFA Institute has developed a designation focused on performance, the CIPM (Certificate in Investment Performance Measurement) that consolidates industry academia in the area of performance and provides a unique training ground not available anywhere else.
Is it because the front office too often controls the aspect of returns? Perhaps, given that portfolio management professionals are greatly pressured as their professional identity is heavily associated to the performance that they generate. While the front office may not have issues with a Chief Risk Officer (CRO) and Chief Compliance Officer (CCO), the area of performance receives pushback to have a position of equal stature because it is tied so much to personal (and even firm-wide) remuneration. This pushback is naïve thinking. Sure, bonuses may benefit in the short term under the current non-Chief Performance Officer structure but in the long-run firms are missing out on greater gains. The following article will provide a framework for the advocacy of the Chief Performance Officer (CPO) role.
Why the current structure is not optimal
Although many performance departments are independent of the front office, in far too many cases the firm’s final evaluation is dependent on the front office’s analysis and judgement. Meaning, the numbers calculated may have been vetted by the performance team but the interpretation of those numbers are still kept in the hands of Chief Investment Officers (CIOs) and Portfolio Managers (PMs). The issue with this practice is the lack of objectivity, independence and victim to various biases resulting in minimal benefits to investors and managers for that matter. How does it impact both stakeholders, it does so by holding on to alpha pretenders and failing to recognize alpha generators.
What most firms and investors fail to realize is the significance of the impact biases tend to have on performance. Many times managers will go out of their way to look for and accept only data that supports their story. They will avoid any other data that may contradict their story. These biases are referred to as “confirmation bias” and “biased assimilation”, respectively. Imagine big pharma using protocol that only looks at positive test results and avoids all the negative ones. How many bad drugs would we have out there today? It would end that firm’s business immediately. In the investment industry the opposite is true.
Another issue lies in “the story” many firms have to sell. They focus so much on “the story” that they tend to lose focus on the numbers behind it and this message is relayed to the investors. Firms will focus on how all the successes were due to skill, any failings were out of their hands and that they knew all along about the reasons behind the outcomes. In behavioural finance these are referred to as the “narrative fallacy”, “self-attribution bias” and “hindsight bias”.
Operations and Risk
Since the bad old days of “writing in your numbers”, performance has come a long way by being placed under the guise of Chief Operating Officers (COO) and CROs rather than held directly under the CIO as done in the past. The change in positioning within the firm has provided some independence to performance measurement functions but these alternatives are still impediments to fully realizing the potential.
Under Operations, performance becomes focused on processing numbers and producing reports only. The firm and its investors miss out on the specialized analysis and skill of qualified performance specialists gained over years of experience and education (CIPM, CFA, etc.).
A better solution is for performance to be under the responsibility of the risk department and the CRO but this is not ideal either. Risk takes on a dual role in most firms where it focuses on past/present and future risk. Moreover, the CRO takes an active role in the portfolio management process by providing feedback on decisions impacting portfolio management. This is in contrast to performance, which is historical-looking and evaluates the quality of the investment strategy and its execution. As a result, once performance becomes forward looking it leaves the area of performance and enters portfolio management because it loses its independence and objectivity. The advantages of an independent and objective feedback mechanism that performance provides to the front office are lost.
To truly benefit from performance, firms need to adopt the Chief Performance Officer role and empower this individual with the necessary tools to properly execute their role. Freeing up the skills of smart, analytical and mathematically inclined performance professionals would provide a higher level of insight that firms are not currently exploiting. Not only will the firms benefit from this in the long-run, so will the investors in increased confidence and wealth.
Benefits of a CPO
The advocacy of a CPO should be much more pronounced but regrettably it is not because of the comfort with the status quo. The advantages of having the CPO office far outweigh the disadvantages for both firms and investors.
First and foremost: “the story”. Be it the sell side or the buy side, “the story” is always in focus. A comprehensive, well-rounded independent and objective performance analysis would set the manager apart from others. Engaging a CPO can assist with marketing an investment strategy by enhancing published returns’ credibility towards outside investors or to a board in cases of pension funds, endowments and the like. The report would include:
• Thesis Review
• Return Analysis
• Portfolio Breakdown
• Risk and Risk Adjusted Performance
• Portfolio and Benchmark Characteristics
Moreover, this kind of comprehensive reporting function that the CPO will put into place will ensure that the proper feedback is in place to describe whether the investment management thesis is correct and being properly executed. It will also overcome all biases inherent in analyzing the very same portfolios a manager is managing. This will be accomplished:
• Confirmation Bias: Identify logical flaws into the thesis.
• Biased Assimilation: Look for evidence that proves the thesis wrong.
• Narrative Fallacy: Focus on the story and the data behind it.
• Self-attribution Bias: Equally analyze up and down markets based on quantifiable evidence.
• Hindsight Bias: Document performance assessments over time and avoid reassessed versions of what happened.
The CPO’s segregation from the remuneration structure designed to compensate the portfolio management activity would enable the office to focus on the link between the quantitative data and how well it does or does not support “the story”. Avoiding these dangerous biases that are currently impacting many firms would provide the insight and perspective for them to effectively analyze the strategy and its execution.
Best practices in performance often take a back seat to other departments’ own policies and procedures. Although performance personnel do raise issues and propose solutions, more often than not this message gets drowned out by other departments. A CPO would champion performance centric policies that would decrease the risk in the performance operations/analysis gap that currently exists in most firms. For example, an accounting department may have their own error correction policy that takes precedent but that may also be detrimental to performance return measurement. The CPO would be able to champion performance’s own error correction policy that would improve the quality of returns calculated and reported.
Investors would have a great deal to gain from the establishment of a CPO. Not only would it provide additional information but it would also provide an independent scorecard about the firm’s returns. Performance is a significant factor in investors’ and allocators’ decision-making process when selecting an investment manager. Far too many investors take returns at face value when in fact they should be demanding more comprehensive information about the returns, the management process and the tie in between the two.
A CPO would be an important step towards achieving this. Moreover, investor confidence would increase because it would demonstrate the willingness of a firm to be self-critical of its portfolio management rather than the usual “everything is great, trust us” approach that far too many firms take. The independence of this office and the specialized expertise it would bring would also lead to an increase in quality reporting and transparency. Investors and investment committees etc. would gain access to performance specialists rather than generalists that are often assigned the task of performance. Investment firms would benefit because they would:
• differentiate and endear themselves to investors
• be further assisted to successfully manage investment portfolios over the long-term
With a CPO, a firm can create a “one-stop shop” for performance related information, such as reporting, methodologies, operations and calculations (returns and any derived measurements). It would provide consistent and transparent performance related information to investors and assist them in their due diligence process.
Complex Investment World
The investment world today is a far cry from what traditional investors are used to. With the low interest rate environment new assets classes have sprung up. For example, a decade ago, the asset mix of a pension plan materially differs from today. In the past, there were mainly two asset classes: fixed income (lending) and equities (ownership). Today, pension fund asset classes include among others: private equity, infrastructure, real estate, and hedge funds, etc. This kind of complexity requires the specialized services that the CPO office can provide.
These asset classes bring another layer of complexity in which a CPO can navigate through and provide in-depth performance information. For example, in private equity, the returns bear little correlation with traditional asset classes and provide a better portfolio diversification and portfolio efficiencies. In addition, topics that need to be addressed in private equity include valuation, timing of committed capital and method of calculating returns. In private equity, committed amounts are not invested immediately, the investment manager makes capital calls to investors over a period of time. Moreover, the private equity valuation component of a thorough performance reconciliation is left out of the hands of performance. The CPO’s position would provide a seat at the table with respect to such sensitive areas and bring the objectivity required to ensure the security of the firm’s assets.
Early adopters with true alpha generators running the ship will have the most to gain from engaging a CPO since it will shed a greater light on the quality of portfolio management they have been providing. They will be able to better distinguish themselves from alpha pretenders who only can focus on a story but can never back it up with quality information. Capital will move accordingly and these firms capital raising efforts will be handsomely rewarded. It is a very competitive environment and any strategic advantage has to be jumped on if you don’t want to be left behind. The most likely scenario for such a position to be introduced would be demand from investors, regulators and academic institutions such as the CFA Institute. Investors should demand and incorporate in their due diligence process that an investment management firm has in place a qualified and independent CPO.
This article is forthcoming in The Journal of Performance Measurement, Summer 2016.
 James Montier, “The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy”, John Wiley & Sons, Ltd., 2010Version PDF