May 8, 2013
Does the Output Match the Input? Capital Allocation Process Assessment
How should we judge a capital allocation process? Most people inevitably turn to the clean metric right under their noses. Did we outperform a certain benchmark, and by how much? Assessing a capital allocation process on performance alone will inevitably lead to the kind of break-down in decision-making that weakens the wealth creation process and causes return-chasing behavior. The answer instead lies with the efficacy of the process or the capacity to produce a desired effect.
As fiduciaries, investors should be able to distill the logic of their capital allocation process down to one or two sentences. For instance, at Hirtle Callaghan we are valuation-based investors. We start with the conviction that investing is solely about acquiring future streams of cash flow at the most attractive price. Therefore in judging Hirtle Callaghan’s performance, ask whether the firm has relied on our engineered process to determine when risk premiums across asset classes are high and offer attractive returns for the risk, and when they are low and not sufficient to justify the risk If the portfolio subsequently experiences a spell of underperformance of a market benchmark it will be because valuation is out of favor and sentiment and momentum are dominating the market causing assets prices to move beyond an attractive price. In this case the underperformance of an over-heated market is in fact a desired effect.
Therefore, the most important factor to consider in assessing a capital allocation process is whether the output (long term investment performance) is consistent with the input (asset management logic). Ask your manager how they make their capital allocation decisions, and don’t settle for answers that strike you as sentiment or momentum based (as if they alone have found a way to detect assets that are poised to move in a positive direction). Predictions of the future using economic indicators and analysis of past performance do not constitute a fiduciary-quality capital allocation process. If your manager can’t explain their capital allocation logic in a clear, concise manner than its likely they don’t have one. I’m reminded of what a favorite accounting professor of mine was fond of repeating, "if you can’t explain it to your mother, you don’t know it."
Finally, build up your psychological resources by continually striving to understand more about our valuation-based process, and ask searching questions regarding the rationale for active investment decisions. What’s most important in assessing performance is that your process is producing the effect you expected it would. Buying asset classes when they are out of favor and below their intrinsic value doesn’t require luck or market-timing, it only requires patience and consistency, and it is the only logical route to our desired effect of long term investment profit.
Bob is an Investment Officer with Hirtle Callaghan and works with the firm’s clients in Central PA, Eastern PA and New Jersey. Prior to joining the firm Bob worked with The Vanguard Group as a Registered Representative where he was most recently responsible for Institutional Retirement Plan education services. During his time traveling throughout the United States in this role, Bob engaged approximately 21,000 investors on the subject of prudent retirement savings and investment decisions. Bob also gained client service experience at the beginning of his career managing 400 high net worth client groups at Vanguard. Bob holds an M.B.A. from Penn State University and received his B.A. in Economics and Sociology from The University of Maryland.