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.