A 10-Step Process of Improving Portfolio Return: Part II

by: Kendall J. Anderson, CFA

<< Return to Part I

On May 25th, 2010 Dr. Paul Woolley of the London School of Economics laid out ten policies that he claims could increase annual returns (after inflation) by 25% and long term returns by at least 50%. As promised we are taking a few weeks to cover these points in more details. Dr. Woolley was addressing his steps to large institutional investors but we feel as if they are just as well suited for individuals. This weeks commentary is provided by Justin Anderson, Vice President, Anderson Griggs Portfolio Management.

Step 5 – Don’t Pay Performance Fees

Performance fees are something many of us may not be familiar with as individual investors. They are primarily employed by portfolio managers of hedge funds, and are simply an extra fee (usually 20%) that may be charged to the investors of the fund when the fund outperforms a certain level of return. In theory you may look at this and find it justifiable. “My manager did great this quarter and outperformed the market by 10% so I see nothing wrong with him taking a portion of those higher returns for his outperformance…”

Despite the fact that fees are always dilutive to returns, and any individual investor should know what fees they are paying and try to limit them as much as possible, the performance fee is quite a conflict of interest between the manager and the investor. Why would this be a conflict of interest when the manager is only trying to do a good job and outperform his benchmark? Well, it is money that that portfolio manager either makes, or doesn’t make.

20% is a very large bonus paycheck. The portfolio manager wants that bonus. When the only way to receive that bonus is to outperform, you can see where taking additional risk and shooting for the moon with investment funds that are not personally theirs could be a problem. So if you have interest in some of these “Giant Funds” Dr. Woolley speaks of, these pension and charitable funds, do some homework. Find out if any of the investments are held where performance fees are employed, and start asking if those fees are justifiable.

Step 6 – Do Not Engage in Alternative Investments – Hedge Funds, Private Equity, Commodities

These three asset classes may not be as familiar to us as individual investors; again however, if you have interest in the Giant Funds, these “hot investments of today” will most likely be present. This again comes back to risk. We already spoke about the excessive risk employed in hedge funds due to the performance fee conflict of interest. One of the largest risks involved in all three of these is the use of leverage (borrowed money).

Hedge funds will use leverage seeking outperformance. Leverage is the bread and butter of private equity, which is already by nature a high risk investment and subject to trading within illiquid markets. And although commodities trading use to be highly tied to supply and demand of the commodities themselves, it has now become a betting booth business, employing leverage to such amounts that the underlying commodity is never truthfully represented. The fast swings in commodities’ prices are detrimental to a long-term “investment” mentality.

Finally, leading us to point 7 of Dr. Woolley’s manifesto, transparency within private equity and associated investment vehicles is next to nonexistent. Although what is owned within these vehicles may be known, the amount paid for and the “carried value” of the underlying assets is known only to the seller and the buyer, but rarely known by the secondary investors.

Step 7 – Insist on Total Transparency of Agents’ Strategies

Would you like to know how the person you have hired to manage your investments is doing it? Would you like to know what he is doing with your money, and where your money is being invested? Or would you rather be in the dark, and settle for simple assurances? When asked like that I do not believe anyone would answer be in the dark. It’s the same as giving someone on the street $10 because he said he will be back here in 2 hours to give you $20. Can you answer those questions now?

You need to be in agreement with your investment professional. There needs to be a reason for you to use your money for company ownership, or to lend your money out and charge interest. This keeps you from joining the “buy high sell low club.” That reason should be meaningful and accepted by you. But if you do not understand and know what you own (your investments), how will you ever gain the confidence needed to make rational investment decisions?

Lack of transparency is one of the most important factors involved in investment fraud and Ponzi schemes.

Disclosure: No positions