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A Crisis in Measurement

As institutions pursue more esoteric investments in search of yield, grading their performance becomes that much tougher.

  • Imogen Rose-Smith

How do you measure the performance of a blueberry farm? Or a whole portfolio of blueberry farms?

That was the challenge facing one chief investment officer of a major endowment one day this spring as he reviewed an investment opportunity that had been pitched to his fund. The thesis was simple enough: Investing in the farming and production of blueberries in the U.S.’s Pacific Northwest could yield a return on investment of four times capital expenditure, or an annual rate of return of about 20 percent. But how do you benchmark a blueberry?

In the end, the CIO decided not to bring this particular opportunity before his board. The benchmarking quandary wasn’t the only reason for his decision not to go ahead with this investment; the complexity and due diligence involved simply weren’t worth it in comparison with other, more compelling possibilities. But the problem the benchmark issue posed was big and real: how institutional investors can judge the performance of these types of idiosyncratic, special-situation investments, which have become increasingly popular as investors search for higher yields and returns uncorrelated to the broader markets.

Other CIOs confirm the quandary. “We had a situation where a private equity manager owned an organic dairy farm and the market changed,” says Chris Bittman, who runs Agility, Perella Weinberg Partners’ $8.4 billion outsourced CIO business. The investor needed to sell out of the investment, so they had to figure out how much it was worth. Bittman says he and his team were able to find comparisons to give the farm a valuation. But it wasn’t as simple as selling a stock or even a stake in a private equity fund on the secondary market.

Bittman and other investors who spoke to Institutional Investor for this story all agree that they would never pass up an opportunity purely because the asset or fund was hard to measure, but they assert that benchmarking is an increasingly complex problem that is fast becoming as much an art as it is a science.

“I’ve spent an enormous amount of time thinking through this whole benchmarking challenge,” says CIO Scott Pittman, who oversees the Mount Sinai Medical Center’s $1.6 billion endowment. “It is very much an issue that doesn’t get the level of attention that it deserves.”

This used to be much easier. When institutional investors were mostly invested in a 60-40 mixture of stocks and bonds, benchmarking investments and overall portfolio performance was a relatively simple matter. Over time, however, investors have sought to diversify their portfolios, first adding private equity and real estate, then turning to other alternative investments, such as hedge funds and real assets, including farmland and infrastructure. That trend has gained steam in recent years. Particularly since the market meltdown of 2008, institutional investors have sought to do more of their own direct investing in money managers and real assets, while money managers and allocators alike have been seeking more bespoke investment opportunities and esoteric return flows in their search for yield and uncorrelated returns. The upshot: Not only are portfolios more complex, but measuring the performance of those portfolios, both on a deal-by-deal and fund-by-fund basis and at an overall level, is increasingly difficult.

Making matters worse, it turns out that the underlying indicators used to judge and measure economic growth — the consumer price index (CPI), unemployment figures, even GDP — are all more or less faulty. As Zachary Karabell puts it, “We are very good at measuring a mid-20th-century industrial economy, which is not the system we have today.” Karabell — author of the recently published book The Leading Indicators: A Short History of the Numbers That Rule Our World — argues thatour system of metrics has failed to catch up with the way the world is changing.

The result is a profound crisis of measurement, all the way from the very micro portfolio level — as with the blueberries — to how investors think about the world at its most macro level. Around the world, investors are getting by with imperfect fixes to measure the performance of various strategies and asset classes, while governments and economists are making do with the data they use to measure and project economic growth and outcomes. This make-do-and-mend approach to investment metrics might not be disastrous; sophisticated investment managers and asset owners have rigorous risk management and performance-­monitoring systems in place in even the most esoteric portfolios. But it nevertheless has significant and sometimes unintended consequences for investment processes. This includes how decisions are made and what kind of investment behavior gets rewarded.

Factors like job security are more often than not at the mercy of benchmarks, for example.

“For a lot of institutions, how an investment committee views whether an investment office has done a good job or not is solely based on meeting a benchmark,” says Mount Sinai’s Pittman. That benchmark can include not just investment performance but, particularly in the case of university endowments, peer-to-peer comparisons. A consequence is that few endowments are willing or able to stray from the herd. That can lead to dangerous groupthink, as was evident in the market sell-off of 2008, when many universities found themselves overly exposed to highly illiquid assets.

Another problem stems from allowing benchmarks, including poorly constructed ones, to drive investment decision making. Investment managers and asset owners alike say some investors will pass on attractive investment opportunities because they don’t fit the return profile needed to meet a certain benchmark. This is a particular problem in private equity. Traditional private equity funds project returns in the high teens or low 20s. But some low-risk long-term strategies, such as infrastructure investing and asset-backed lending, have similar characteristics. Because, however, these strategies typically don’t have such high return projections, many investors will pass on them, afraid of not meeting their private equity benchmark. That sounds logical, but in certain investment environments, and for diversification purposes, these types of lower-risk strategies might be beneficial to investors. As a result, some good ideas are left on the table.

Further complicating matters: The challenges are different for investors of different sizes. The measurement issues for large institutional investors, such as multibillion-dollar pension plans and sovereign wealth funds, that have to hold the overall market are different from those of sub-$25 billion foundations and endowments, which have the relative liberty of being more nimble and opportunistic.

“Most endowments and foundations are absolute-return-­oriented, not relative-return-oriented,” explains Jim Dunn, chief executive officer and CIO of Verger Capital Management, an outsourced CIO firm that was spun out of, and manages the endowment assets for, Wake Forest University in Winston-Salem, North Carolina.

For pension plans and other large investors, which more often than not track the global economy, the past few years have been especially tough. It’s hard for the California Public Employees’ Retirement System to explain to its board and other stakeholders why it has returned only 8 percent for the fiscal year through March 31, 2017, when the S&P 500 was up 13.7 percent over the same period. Sure, CalPERS beat its internal benchmark by 11 basis points. But many external observers, including California taxpayers, are puzzled as to why, during a bull market in equities, their state pension plan isn’t doing better.

To judge overall returns, John Skjervem, CIO of the Oregon State Treasury, says most pension plans default to the Russell 3000 index plus some amount of outperformance. “The Russell 3000 plus 300 basis points 20 years ago was pretty easy to beat; now it’s pretty tough,” he says. Given the nature of the stock markets, the unprecedented low-interest-rate environment, and the way risk assets have performed, “I don’t know anyone in the past couple of years who has beaten the Russell 3000 plus 300,” says Skjervem. He leads the team that manages $94 billion in state assets, including the $71 billion Oregon Public Employees Retirement Fund, which is managed by the state treasury under the direction of the Oregon Investment Council. Most institutions have lowered their expectations to 200 or even 100 basis points of outperformance; others use the CPI plus a certain stipulated amount. But, Skjervem says, it is difficult to know where to draw the line. “Who am I to say that the threshold has got to be 300 or 200 or 100 or even 10” basis points, he asks. “Because 10 basis points, last time I checked, is kind of real money.”

Skjervem is one of many investors disappointed with the benchmarking options available to him, especially when it comes to private equity and other nonpublic market investments. “We have done some work on this issue,” he says. “The work that we have done hasn’t so far revealed a better or even a more satisfactory approach.”

One of Oregon’s biggest challenges with using a standard, off-the-shelf benchmark for its private equity portfolio is its composition. Take the Cambridge Associates private equity index, which is used as a measuring tool by many foundations and endowments. Skjervem notes that the index includes a significant allocation to venture capital, making it a not entirely apples-to-apples comparison for funds like Oregon’s: “For a program of our size, where your council doesn’t want you writing checks under $100 million, VC isn’t really an option.”

Indeed, plans like Oregon’s are almost forced to invest in the biggest leveraged buyout managers because those are the firms that can absorb and invest the multimillion-dollar checks a fund of Oregon’s size needs to write if it is to commit $3 billion or more in new capital to private equity every year.

The solution, as Skjervem sees it, is to educate his board about the challenges and trade-offs. “At the end of the day, what is most important?” he asks. “Is the sanctity of asset allocation more important than the performance relative to a commercial benchmark?” If the answer is yes, he adds, “you have to let go of performance concerns relative to a commercial benchmark, because your portfolio construction is totally different.”

The danger is that performance — or, more likely, underperformance — can then be used as a tool by stakeholders or outsiders, such as union beneficiaries or legislators, to exert pressure or criticize certain investment behaviors. Skjervem says the Oregon Investment Council, which has one of the most established private equity portfolios in the U.S., has never experienced that kind of pushback. But it is a concern.

Certainly, a version of this problem has played out in recent years for public pension plans invested in hedge funds. Many have come under public pressure to redeem from the money mangers, who are perceived by some as charging high fees for less than impressive returns. As a group, hedge fund managers have consistently failed to beat the S&P 500 since 2008. Hedge fund managers and their investors contend that these funds should not be judged against U.S. stock markets, as hedge funds have very different return and risk profiles and are looking for differentiated sources of alpha, not just making beta bets on the market. But the performance disparity has caused many investors to wonder why they are bothering with hedge funds at all instead of simply putting their money into the stock market. Most institutional investors that stick with hedge funds, including a large majority of foundations and endowments, tend to benchmark their funds against some kind of hedge fund composite benchmark. These benchmarks, however, have their challenges and limitations, dependent as they are on the underlying universe of reported fund manager performance and the fact that the aggregate figure includes returns for a broad number of divergent strategies.

Mount Sinai’s Pittman says board education is paramount in addressing these issues. When it comes to looking at investment opportunities, he says, “I’m not ignoring returns, and I’m not ignoring how those returns look in comparison to other opportunities, but I’m not focused purely on returns. You look at an operational review, you look at the quality of the team, you do research, you get a feel for their ideas” — all types of qualitative due diligence that a benchmark cannot capture.

Pittman warns that some allocators and managers can game the system by setting benchmarks that are too easy to beat. When taking into account human psychology, he says, “if there is an incentive that is going to make them look good, they are probably going to maximize that incentive.” If a benchmark is poorly constructed, making it too easy or too hard to beat, then the incentive is to over- or underweight it. “Benchmarks are needed,” Pittman says. “Benchmarks are helpful, benchmarks are a good tool that is used in many levels of the process. But if a benchmark is driving the process, then it becomes a tool that leads to misalignment of interest.”

Maybe the answer is not to sweat the small stuff. Though all the investors who spoke with II agreed that finding appropriate ways of measuring managers and investments in areas such as private markets, real assets, hedge funds and infrastructure is challenging, they are able to manage with what they have, while hoping for better down the road. Far more of a concern, from an investment perspective, is how particular asset classes do in comparison with other asset classes. If an allocator is going to make an investment in blueberry farms, is it worth taking money out of public equities, and what is the opportunity cost compared with other strategies?

For an illiquid private market investment, Agility’s Bittman says, after the right risk analysis and adequate stress testing, investors can construct a custom index and a proxy for what the public market equivalent might be. Then the question becomes whether the risk and the illiquidity are worth the premium. “There is always a hunt for good investments, and they are not always traditional,” says Bittman. “There is no set-it-and-forget-it portfolio in this world anymore.”

For Skjervem, a primary concern is how his investments are performing relative to simply leaving his capital in the public markets. “Private equity in one sense is easier because you can do a calculation versus the S&P 500 or the Russell 3000,” he says. “When we get into the other parts of the private portfolio, it’s nearly impossible because it’s cats and dogs.” So instead of creating a custom benchmark composed of “a little bit of this and a little bit of that,” he says, “our inclination is to say it’s CPI plus 400 basis points.”

Other institutions are also defaulting to using the CPI plus outperformance as a yardstick. Verger Capital’s Dunn says a lot of schools use CPI plus 500 basis points to measure their private equity portfolios. “That seems appropriate right now,” he says. “But with growth back in the world, you are looking at a 10 percent hurdle rate.” In other words, if and when growth returns to the economy in a meaningful way, investors should be asking more of themselves and their managers. But it’s possible that growth will never come back in the way investors are used to.

The consumer price index — the biggest, most general way investors can think of to measure the performance of their portfolios — has its own problems, as Zachary Karabell explains in his book. The CPI is a basket of goods and services used to gauge the overall heath and growth of the economy. The price of a loaf of white bread in the U.S., for example, is $1.32 today, compared with $0.50 in 1980, according to government statistics. The CPI, however, is not a static document. It recognizes that certain goods and services become more or less valuable over time and that new ones get added. The Bureau of Labor Statistics, which oversees the index, tries to set policy accordingly, but it’s still a subjective process run by bureaucrats. It is not especially nimble, and there are things it is not very good at measuring.

In particular, Karabell says, the CPI and other broadly used economic indicators have a hard time accounting for stuff that costs nothing or very little. “We don’t entirely know what to do with things that are, for the end user, free,” he explains. “Google, phone conferencing lines, things that are changing the way we live, are not measurable.”

One consequence is that the economic output of a country like the U.S. can look more negative than it is, says Karabell, because the system is designed to reward growth and to define growth as spending. If, for example, you replace all the lightbulbs in your home with energy-efficient ones, “that initial replacement will look very good,” but the subsequent numbers will look negative because you’re spending less on energy. Some economists assert that the disconnect doesn’t matter because the money saved on energy is spent elsewhere. But Karabell argues that this failure to account for the savings is a problem.

“It is not necessarily going somewhere; we are all just spending less,” he says of the aforementioned energy savings or the money we don’t spend when we read free online newspapers. “The economy is just contracting even though the needs are being met. We don’t have a way of gauging that other than as a negative.”

For investors this transformation in consumption and growth, and the failure of our current systems to accurately measure that, may have profound consequences — even if it is hard to see what those consequences could be. But Karabell says this focus on what is effectively backward-looking data has the effect of making most investors poor long-term thinkers.

“We project the future all the time; we just do it from a baseline that takes past factors into account,” he notes. “None of us do that good a job planning on a ten-year horizon, and that is certainly true for investors,” even those, like private equity and venture capital firms, that are meant to see into the future.

But if, as Karabell predicts, the future economy is, at least in most developed countries, not dominated by global economic growth (even as the cost of living goes down and most people’s standards of living improve), the way that investors extract value, and where they seek out returns and how they think about the future, is going to have to change dramatically. “For the most part, capital is much more short-term than the needs we have,” says Karabell. “We overinvest in the present and underinvest in the future.”

How do you measure the performance of a blueberry farm? Or a whole portfolio of blueberry farms?