Good Risk Governance Pays

Good Risk Governance Pays

Investment Best Practices | Risk Management | Valuation

Investment Risk Management and Making the Bed

Posted in Investment Management, Risk Management

business travel

According to the character played by actress Ellen Page in “Smart People,” everyone should make their bed each morning as it sets the right tone for the day. In contrast, her freewheeling uncle (played by actor Thomas Haden Church) offers that not making one’s bed sends a message too.

The same thing can be said about investment risk management. As an asset manager or provider of other services to investors, your creation of a robust infrastructure speaks volumes. The converse is true as well. If your proverbial “risk management bed” is unkempt, there is a greater chance of things slipping through the cracks. Should that occur, your clients will likely pay in the form of losing money or foregone opportunities. Either way, future business can suffer when it is discovered that an organization could have taken steps preemptively to mitigate risks but declined to do so.

Over time, risk management has come into its own. A multitude of companies and financial institutions have recognized risk management as a strategic imperative. Yet there are still organizations that see risk management efforts as expensive and far removed from the act of growing revenue and profitability. In my experience, this mindset is dangerous in the long-term. With a heightened awareness of their fiduciary duties, enlightened beneficial asset owners understand that effective due diligence means (a) taking a deep dive of how their existing and prospective service providers seek to tame uncertainties and (b) satisfying themselves that things are tidy and neat.

The Perils of “Sort Of” Investment Risk Management

Posted in Compliance, Disclosure and Transparency, Governance, Investment Management, Risk Management

Be Clear or Be Vague Clarity Vs Confusing Message Commuication

As someone who writes all the time, I respect words. I acknowledge that being able to communicate clearly is a time-consuming labor and requires care. For those who strive for excellence in this area, keep up the great work. For those who have fallen under the spell of soundbite gimmickry, may I suggest that you stay away from the risk mitigation team? Here is why. Unless an organization is unusually lucky, spin and ambiguity set the stage for problems such as non-compliance, inadequate controls and opportunity cost.

The “sort of” approach to investment risk management is ill-advised because it limits the ability to apprise someone of “must know” information before a trade occurs. Sadly, the airwaves and printed page are chockablock with vagueness and timid declarations. Just the other night, I heard a television commentator use the words “sort of candidate” even as he acknowledged that only one person will be nominated by each political party to run for U.S. President in 2016. Aside from being devoid of content and plain silly, the term “sort of” is highly polysemous and can lead to confusion. What exactly is a “sort of” candidate or a “sort of” trading limit or a “sort of” check and balance on bad actors or acts?

This is not to say that investment risk management policies and procedures should be rigid and uncompromising. To the contrary, there is a need for flexibility that allows for changes in facts and circumstances. With the imposition of new rules about swaps clearing, an end-user is wise to review (and revise as needed) its standing arrangements with counterparties. An expectation of rising interest rates or tighter credit availability may warrant a check on existing collateral requirements and how quality and quantity is monitored. These are two of many possible scenarios that warrant a review and possible refreshment of a prevailing modus operandi.

I am reminded of an old joke. The owner of a company tells the landscaper to get rid of the excessive vegetation outside his headquarters building. The boss returns from lunch and finds, to his great dismay, that expensive trees and plants have been removed. Nothing is left but dirt. He demands to know what happened. The landscaper retorts – “You asked me to remove the excessive vegetation.” The angry executive spits back – “I wanted you to remove the weeds.” The landscaper throws up his hands and yells – “Why didn’t you just say so?”

The message is this. There has to be sufficient lucidity about objectives, constraints, red flags and authorizations (among other factors) before investment risk management procedures can be carried out in a meaningful way. With so much money at stake and heightened enforcement about how investment risk is measured, managed and monitored, allowing a proverbial Tower of Babel to exist is a gigantic “no no.”

One Size Does Not Fit All When It Comes To Pay

Posted in Compliance, Disclosure and Transparency, Financial Reporting, Governance, Key Person, Regulation

Little feet in big shoes

At a time when skilled talent is hard to find, business executives may want to resist the urge to socially engineer. One tech company CEO learned this lesson the hard way. According to “Seattle company copes with backlash on $70,000 minimum wage” (Seattle Times, August 1, 2015), across-the-board raises to establish a minimum base salary, and the reduction of the CEO’s million dollar pay package to make it happen, have been followed by several adverse outcomes. Two key employees quit, “spurred in part by their view that it was unfair to double the pay of some new hires while the longest-serving staff members got small or no raises.” One person opined that money was given “to people who have the least skills and are the least equipped to do the job.” Several customers took their business elsewhere, “dismayed by what they viewed as a political statement.” Even though the company’s stance led to “dozens” of new clients, they will not start paying their bills until next year. In the meantime, new workers had to be hired, now at a “significantly higher cost.” Competitors are agitated, fearing that their costs will be forced upward.

How much someone gets paid continues to be a hot topic although not always for the right reasons. A few years earlier, companies such as Ben & Jerry’s and Herman Miller moved away from salary cap initiatives in order to populate the C-suite with experienced people who might otherwise not consider a move. See “Limits on Executive Pay: Easy to Set, Hard to Keep” (Wall Street Journal, April 9, 2007).

Jump ahead to 2015 and the calculus begins anew with regulations that are meant to discourage big gaps. Hot off the press, on August 5, 2015, the U.S. Securities and Exchange Commission (“SEC”) announced the mandate (pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act) that a public company now disclose how much its chief executive officer makes relative to the median compensation of its employees. Click to download the 294 page final rule about this pay ratio disclosure rule.

Not everyone thinks that government intervention will help. Financial journalist and best-selling author Roger Lowenstein articulates what some say is blatantly obvious, i.e. CEO’s earn much more than the people they manage. In “Why the new SEC rule is the wrong way to fix CEO pay” (Fortune, August 7, 2015), he points out the following:

  • Lots of people besides CEOs make big money, including popular authors, athletes and private fund managers; and
  • A pay ratio rule does little to empower investors in getting answers to important questions such as whether pay is “in proportion to the value added” and a proper alignment of shareholders’ interests with managerial incentives exists.

He rightly intimates that a pay ratio will do little to enlighten anyone about whether board member conflicts exist and, if they do, how executive compensation may be tainted as a result. His recommendation is to grant the SEC the power to let shareholders have a true “say on pay” and improve the proxy system to facilitate the installation of independent board members.

Like others, I have my doubts about the value of the compensation benchmark data. A company that relies on higher skilled workers will no doubt report a lower CEO to median pay ratio than a company with an “hourly or seasonal workforce.” So what?

As the U.S. Chamber of Commerce points out in its August 5, 2015 “Statement on SEC Pay Ratio Rule,” the metric is “misleading, politically-inspired, and costly” and “fails to provide investors with useful, comparable data.”

I am reminded of a discussion I had with another tenured professor when I taught graduate level finance. He argued that all university faculty should get the same wage until he discovered that he would be receiving less money in order for the school to pay more to others. So much for the Karl Marx dictum – “From each according to his abilities, to each according to his needs.”

No doubt, political blowhards will use newly disclosed pay ratios to make hay about their view that capitalism is “evil” because some people earn more than others. (How about those Congressional pension funds that can begin at age 50 or earlier?) Hopefully short-term hype will give way to the voice of enlightened shareholders and board members who continue to push for objective performance-linked rewards that promote long-term wealth creation.

Investment Compliance and the Nanny’s Right to Sue

Posted in Compliance, Governance, Investment Management, Risk Management, Susan Mangiero

Frau bittet um Distanz

I admit to reading the gossip magazines whenever I want a few minutes of fluff. I am never sure what is accurate but the stories make for five-minute intrigue. One recent example says it all. In a not so private tussle, an alleged affair between the husband of a Hollywood power duo and the couple’s nanny underlies their recent divorce announcement. What caught my eye is a statement that the nanny was fired by Mrs. Mover and Shaker and has “met with attorneys to file a wrongful termination suit” against the wife since it was the mister who technically hired her. If true, the drama has Nanny contributing to a faux pas writ large and then blaming someone else for her questionable behavior. For the legal issues, I defer to the attorneys who no doubt will make the appropriate arguments for both sides. From a governance perspective, I am reminded once again that contracts count.

Over the years, my work as a forensic economist and testifying expert increasingly looks to issues about who is contractually versus functionally tasked to do what, when and on what basis. Sometimes the primary allegation (and related work in calculating damages) is tied to contractual breach and not fiduciary breach. As a consultant, when I have had to negotiate business contracts, I typically spend considerable time with counsel. After all, a contract is meant to codify both commercial and legal terms and conditions. In other words, contracts are serious bits of paper.

Last year, I wrote about the importance of the fine print. In “Brown M&Ms and Investment Service Provider Due Diligence,” I described musician David Lee Roth’s approach. Apparently, each of Van Halen’s agreements includes “a rider … designed to force a promoter to pay attention to the band’s true objective about ensuring safety.” By including a provision to only stock certain candies in the dressing room, the goal is to have everyone read the entire contract and carry out all requirements, including the proper installation of equipment. No brown M&M candies is their red flag to further question the concert producer about risk management.

In the investment world, ideal contracts between institutional investors such as pension plans and their service providers are those which, at a minimum, are explicit, include easy-to-assess performance metrics and are well understood by both buyers and sellers. Otherwise, a dispute is possible.

Regarding the nanny, it remains to be seen whether she can file a tenable lawsuit. While seemingly upside down on its face, she might technically have the right to seek redress if her employment contract stipulates that romantic interludes with hubby are outside the scope of how “cause” is determined. One thing is for sure. The presiding judge will have a front row seat to an unfolding drama that goes beyond celluloid.

Trust, Ted and Norb Vonnegut

Posted in Ethics, FINRA, Key Person, Regulation

Trust icon

Having just signed up for a forthcoming webinar about the U.S. Department of Labor fiduciary proposal, trust is on my mind. Due to a recent introduction of like-minded advocates for good process, I had a chance to watch a TED Talk with Mr. Norb Vonnegut. (For those who have not had the pleasure, there is a large volume of interesting videos, courtesy of the Technology, Entertainment and Design nonprofit organization that began in 1984. Click to read about TED.)

During his talk entitled “How Do You Know You Can Trust Somebody With Your Money?“, Mr. Vonnegut asserts that individuals should be wary of relying too heavily on a financial organization’s brand. Even if a regulator like FINRA or the U.S. Securities and Exchange Commission has the purview to oversee a financial advisor or other type of intermediary, budgetary resources do not allow for examinations of everyone they regulate.

Mr. Vonnegut illustrates his cautionary tale for investors with a scary snapshot of a neighbor gone bad – someone who was running a Ponzi scheme and was eventually arrested and jailed. He urges investors to avoid wealth management “helpers” who appear conflicted or boast a troubled background, adding that one can handily visit as a first stop.

Given his many years as a senior financial advisor and now a successful author and journalist, Mr. Vonnegut recommends that investors download the Fiduciary Oath from his website and then do plenty of homework rather than relying blindly on name or where someone went to college.

Insights on Economic Analysis of Fiduciary Monitoring Disputes

Posted in ERISA, Fiduciary Liability, Investment Management, Litigation, Regulation, Susan Mangiero

Lee Heavner_Susan Mangiero

While I typically avoid republishing posts from my other blog, Pension Risk Matters, there are numerous topics that are important to all types of investment industry professionals and not just those who work with retirement plan sponsors and participants. One such topic looks at investment monitoring and the fiduciary responsibilities to oversee and make changes, as needed. Recently, the U.S. Supreme Court applied its judicial experience in opining about the relevance of how long to monitor investments for a trust fund such as an ERISA plan.

While there has been no shortage of informative write-ups by attorneys about this headline-ripping case, little had been written by any forensic experts until now. To fill this void, I wrote “An Economist’s Perspective of Fiduciary Monitoring of Investments” (Pensions & Benefits Daily, May 26, 2015). The interest in the topic of damages and the complexities of when and how to monitor led to a second article.

According to a recent Business Wire press release about these follow-on insights, “Economic Analysis in Fiduciary Monitoring Disputes Following the Supreme Court’s ‘Tibble’ Ruling” (Pensions & Benefits Daily, June 24, 2015), Dr. Lee Heavner (Analysis Group Managing Principal) and Dr. Susan Mangiero (Fiduciary Leadership, LLC Managing Director) explain that what constitutes a reasonable monitoring process may be influenced by plan- and investment-specific factors, as well as by the expected benefits and costs of different monitoring activities. They are quoted as saying that “The monitoring of investments is a broad and complex topic. There is no uniform process that is appropriate in every situation. To the contrary, the list of potentially relevant risk factors is long and subject to revision as circumstances change.” These two economists (both of whom have worked as expert witnesses) also discuss how complexities arise when calculating economic damages due to the wide array of alternative actions and the substantial variation in timing that may be consistent with a prudent monitoring process.

Click to read the U.S. Supreme Court May 18, 2015 Tibble opinion. Jurists emphasize the significance of the topic of investment monitoring for both buyers and sellers of financial products and services.

Good Players Pay For Other People’s Bad Investment Compliance

Posted in Compliance, Financial Crisis, Governance, Investment Management, Municipal Bonds, Pension, Regulation

Tree Lands On House Roof Crushing It

Much to my chagrin, I am told that it is my responsibility to pay for the removal of my neighbor’s tree after it fell in my backyard. Never mind that the tree is old and was left untended for many years until a bad storm destroyed its ability to stand. Ignore the fact that I diligently prune my trees on a regular basis and otherwise provide for their care and maintenance. While my leafy plight is trivial in the grand scheme of things, this notion of paying for the inaction or bad action of others appears likely to stay. Its unhappy companion is the idea that “free” goods and services can magically appear.

There are so many examples in recent news about questionable economics that it is hard to know where to begin. Just tonight, ABC News announced that the City of Chicago has contributed $634 million to its teacher pension plan, thereby forcing a “cut in classroom spending.” According to Mayor Rahm Emanuel, there is an inequity because the State of Illinois “makes the employer contribution to teach pensions for districts outside Chicago.” Elsewhere, it was announced that five million more individuals could be eligible to receive overtime pay, notwithstanding the upset on the part of small business owners who predict layoffs to pay for the mandate.

Then there is the issue of sovereign debt, notably Greece. It is heartbreaking to see the photos of retirees who are desperately seeking reassurance that there will be money to pay them. There is a human face to the creditors as well. Banks, supranational organizations and hedge funds that have lent money to this Hellenic nation, Puerto Rico and other self-declared borrowers in trouble owe an allegiance to their investors to collect. Think about the millions of pensioners and hard-working individuals who will likewise face a diminished checkbook if any of this debt remains unpaid.

At an industry-level, the truism that there is “no free lunch” equally applies. Every action has a consequence and a cost. In an ideal world, interested parties evaluate the risks and expected rewards and decide on a course thereafter. It is not left to governance-focused advocates to pick up the expense. Yet here we are, continuing down the path of often being forced to dive into the deep end when “pushed” by organizations with a lesser focus on good process. How often do we hear regulators address the sins of others as a catalyst for a new rule or regulation? A good example is the current debate about fiduciary standards. If conflicts of interest were less of a concern on the part of some, would the U.S. Department of Labor proposal look as it does now? If organizations with anemic compliance were singularly penalized by the marketplace with no spillover of ill effects on good players, the operating environment would differ from today’s reality. Money spent on risk management and internal controls would exclusively benefit the clients and shareholders of the party that writes the check.

Alas, there is no unfettered free market that purely rewards or impugns. This means that the issue of subsidization is far from trivial since it guides how much money an organization such as an asset manager, bank, advisory firm or insurance company should pay to influence the deeds of industry “peers.” As things currently stand, too much of an isolationist stance could end up plaguing even the most solid of stewards. Said differently, there is an advantage for everyone to strive for integrity in financial dealings, even if it means that some organizations pay more than others, absent a proper price signalling device. It may not seem fair but bad trades, like felled trees, can cost disciplined individuals and businesses real money.

Dinosaurs and Investment Risk Governance

Posted in Compliance, Fees, Governance, Investment Management, Pension

Tyrannosaurus rex

Call me grumpy. I just wasted $10.50 and two hours of my time watching “Jurassic World.” Yes, I know the film is close to raking in a billion dollars (although “Gone With the Wind” is supposedly still number one when revenues are adjusted for inflation). No, I did not count on such excessive product placement or gratuitous violence. That said, my husband enjoyed his popcorn and celluloid raptors as did many others in the audience. If you do buy a ticket, I hope you have fun.

Like multiple movies, this 2015 tale about dinosaurs was predictable enough to know early on who would be gobbled up and who would survive. In the investment world, the ability to forecast the future is not always as straightforward so it is helpful to understand what experts foretell.

In a recent publication entitled “Asset Management 2020: A Brave New World,” PriceWaterhouseCoopers (“PwC”) cites its expectation that pension funds, high net worth individuals and sovereign wealth funds will drive a large rise in assets under management, much of which will remain in the hands of active asset managers. At the same time, PwC chronicles continued pressures on fees earned by asset managers, dovetailed with clarion calls for better transparency. The study makes it clear that cost containment will be a big priority, pointing out that fees and customer care will likely have to differ across market segments. For example, the “mass affluent” will be offered “more self-directed services” as “it will simply be too expensive for many firms to service retail investors.” Simpler products could be offered so that financial advisers can “spend less time explaining strategies.” To the extent that hedge fund and other types of alternative fund managers can reduce fees, there is a chance for them to gain a stronger foothold in the defined contribution plan arena.

The Boston Consulting Group describes the asset management sector as “among the most profitable industries” with steady growth in operating margins in the neighborhood of forty percent. Expanding on the theme of change, its research emphasizes (a) “a tsunami of regulatory tightening and public pressure for change” (b) greater reliance on technology for both portfolio activity as well as operations (c) demand for customized solutions (d) intense global competition with U.S. and UK managers being especially focused on serving non-local customers and (e) a shift away from “traditional active core assets.”

In yet another recent study, Casey Quirk and Evestment spotlight trends that include heightened competition among asset managers, “in particular for traditional mandates,” as well as a “long-term desire of asset owners worldwide to design policy allocations around specific objectives, which differ from investor to investor.” Their take is that successful investment management firms are those that recognize disparate client segments and design products for each of them. Client service and thought leadership could be part of the offerings. The awareness of differences among investors such as corporate defined benefit plans versus public pensions versus defined contribution plans and so on is reflected in the published assessment of key concerns. While rising interest rates are on the agenda for multiple groups, regulations are more stressful for consultants versus end-investors. Somewhat disturbing to me is that risk management and volatility appear to be of less concern to these institutional investor survey-takers than meeting target returns or addressing market corrections. See “A Tailored Approach: Positioning to Outcome-Oriented Global Investors” for detailed graphs and tables.

Business strategists have a lot on their respective plates. Deciding how best to tame the uncertainty beast is no doubt going to be tricky. How does an organization offer a customized and typically expensive product to a coveted client base while keeping fees in check? Over time, technology typically creates efficiencies but can cost a lot upfront to develop. Will technology be a help or a hindrance in search of higher profit-margin customized deliverables to pension funds and other large asset owners? Then there is the challenge of doing “enough” to satisfy clients while being mindful of an increasingly litigious and regulatory environment. Taking shortcuts could destroy customer goodwill and increase an asset management firm’s exposure to being sued and incurring the attendant costs of defense. How will businesses strike the right balance between compliance, good governance and customer hand-holding versus curtailing costs?

The dinosaurs with big scary teeth are showing up everywhere and not just in movies.

Marshmallows and Financial Fraud

Posted in Compliance, Ethics, Fraud, Governance

Portrait of cute joyful boy with a marshmallow

Long deemed to be a seminal assessment of delayed gratification, the Marshmallow Test was designed by then Stanford University psychology professor Walter Mischel (now at Columbia University) and remains popular today. In a typical experiment, youngsters are told that they can have one sweet now or wait awhile and receive two as compensation for their patience. Repeating the experiment in different locations by different researchers has generated results that continue to link childhood discipline with later life accomplishments. While the test has its critics, its architect shared insights in a 2014 interview with The Atlantic‘s Jacoba Urist. Citing from his book entitled The Marshmallow Test: Mastering Self-Control, Dr. Mischel explains that anyone can learn to impose limits on himself but cautions that willpower fatigue can lead to a sense of entitlement or an inability to parse the trade-offs between risk and return. As a result, poor decisions may follow.

Several years ago, New York Times reporter John Tierney wrote a piece about exhaustion and its relationship to compromise, when to change things and why temptation beckons for some but not others. In “Do You Suffer From Decision Fatigue?” (August 17, 2011) readers are told that “Once you’re mentally depleted, you become reluctant to make trade-offs, which involve a particularly advanced and taxing form of decision making.” He credits various behavioral reviews for showing that too many choices can lead to exhaustion and that “once decision fatigue set in, people tended to settle for the recommended option…”

Borrowing from these experiments, numerous questions for the financial service industry arise, a few of which are listed below.

  • Are markets “too complex” and, if so, does that make it harder for persons to decide as to how to measure risks, let alone manage them?
  • Is there too much of a skew towards short-term compensation that encourages “excessive” risk-taking and possible fraud (i.e. opting for a marshmallow now rather than waiting for a longer-term reward)? A May 2015 survey entitled “The Street, The Bull and The Crisis: A Survey of the US & UK Financial Services Industry” laments the need for further reform, post 2008, to ensure good ethics and compliance with prevailing laws.
  • Should key persons be encouraged to take vacations and otherwise embrace work-life balance to ensure that their decisions emanate because of clear thinking and not fatigue?

It is no surprise that behavioral psychology has found a home in the world of finance.

Investment Transparency Now Required in Rhode Island

Posted in Disclosure and Transparency, Fees, Hedge Fund, Investment Management, Pension, Uncategorized

Time for Transparency Clarity Honest Forthright Clock

Just a few days after the U.S. Securities and Exchange Commission (“SEC”) voted to officially propose that certain registered funds provide a lot more information about their operations, the State of Rhode Island has followed suit. In a May 26, 2015 press release, General Treasurer Seth Magaziner describes the Ocean State as a leader in public pension fund transparency, adding that “Rhode Island will only invest with fund managers that agree to public disclosure of performance, fees, expenses and liquidity.” Other initiatives include the creation of a website for public access, the signing of an “Investor Code of Conduct Pledge” by every investment manager and the debut of “full governance reviews of the State Investment Commission and the Retirement Board” by late 2015.

A draft version of the “Transparency in Government Agreement” acknowledges that asset managers may provide some proprietary information that the Employees’ Retirement System of the State of Rhode Island (“ERSRI”) will hold back from the public. However, details about asset managers that allocate to mostly illiquid assets will be disclosed. Facts such as drawdowns, vintage year, management fees, direct expenses and “cumulative net internal rate of return” will be visible with monthly, quarterly or annual reporting requirements, depending on the variable. Visitors to can download data about the various Rhode Island retirement plans and see for themselves how billions of dollars are being allocated. The newest report is based on data from April 29, 2015 and includes a fund-specific breakdown of $1.347 billion in alternative investments.

It is unclear whether this move towards enhanced reporting is related at all to an April 16, 2015 decision by Rhode Island Superior Court Associate Justice Sarah Taft-Carter regarding settlement of a benefits-related lawsuit brought by municipal workers against the Governor. Another motivation could be the repeated headlines about the extent to which Rhode Island pension plans should be invested in alternative investments that include hedge funds. The Providence Journal reported a 14.4% or over $1 billion exposure to hedge funds as of August 2014. See “Raimondo sees no reason to follow California’s lead, exit hedge funds” by Katherine Gregg (September 16, 2014). Things are changing, presumably on an as-needed basis. Earlier this year, Ms. Gregg wrote that the State had terminated one contract with a hedge fund manager. See “Rhode Island dropping stake in low-performing hedge fund” (March 2, 2015).

It remains to be seen whether heightened access to data will garner intense interest and whether a clamor for even more granularity follows. It is hard to see a downside of providing copious amounts of information as long as it is (a) accurate (b) timely (c) representative of the financial well-being (or lack thereof) of any or all of the municipal benefit plans and (d) clear about the process being followed by trustees to arrive at key decisions on behalf of participants.