How much should a retirement fund trustee know about investments?

Given the enormous fiduciary responsibility that trustees of retirement funds carry, one vexing question, which they have to consider is: "How much should I know about investments?" This is a particularly important question in the defined contribution environment, where members are carrying the investment risk and can no longer rely on the employer to make up for any shortfall when they reach retirement age.

A simple response to the question is to say, "less is more". Effectively, this means that it is not the quantum of knowledge that is important for a trustee, but rather what knowledge the trustee possesses. There is much emphasis on trustees either having an understanding of the nitty gritty of investments or, alternatively, relying on their investment consultants and asset managers to "inform" their investment understanding.

A risk of relying purely on the investment experts to inform the trustees on investments is that trustees could potentially be accused of abdicating their fiduciary responsibility. The reality is of course that investment experts will (and should) always have a level of knowledge far superior to the average trustee.

So, given that trustees will always be at a disadvantage to the experts, what should they know? If one draws an analogy with swimming, we can see that swimming can in fact be quite a complex activity. For example, there are many different strokes that one can swim; different outfits that one can wear and different types (contexts) of water that one can swim in.

But all this complexity around the seemingly simple activity of swimming is meaningless if you cant get one thing right - learn how to float.
 
Similarly there is great complexity in investing. Many different styles of investing; different investment instruments; different investment contexts; different investment cycles; a multitude of micro, macro, social, political, technological and economic factors that impact on investing. Given this complexity, what then is the equivalent of floating when it comes to investing? If we can identify this, then we can clarify what it is that trustees need to know.

In essence, I believe that trustees should know the eternal investment truths. Those things that dont change no matter what happens in investment markets. In the same way that no matter what changes in the world of swimming, if you can't float you can't swim.

In my view, at the heart of it, there are five truths of investing that trustees must know. The first is that the future is always uncertain. Despite the fact that I think we all know this to be true, the first thing that trustees, and in fact most investors ask of the experts, is about the future. What is going to happen to the rand? Is the price of gold going to rise or fall? These are nonsensical questions because nobody knows the answer. Not only should trustees not be asking these questions, but they should be on their guard whenever one of their investment experts predicts what is going to happen in the future.

The second truth is that investing is a means to an end, it is not a competition. Most investors are induced into thinking that investing is a competition because of the incessant publication of performance tables, and the ongoing comparison of asset manager performance. This way of seeing the world is exacerbated when it comes to member investment choice, where members will either make choices based on comparative performance or on the fear of losing money.

By accepting that investing is a means to an end, trustees should be aware that the focus of their investment strategy should simply be on meeting the needs of their members, and they should not be concerned about the performance of other retirement funds or other asset managers - usually ones with whom they don't have money invested!

This will make the lives of trustees much easier because they don't have to worry about relative investment performance. All they have to worry about is whether their investment strategy is appropriate to the needs of their members, and that the appointed asset managers are acting in accordance with mandates designed to meet those needs.

As the Myners Review of the Pension Fund industry in the United Kingdom pointed out in 2001: "Members of a defined contribution scheme can take little comfort from discovering that their fund has beaten the returns of the peer group average or median, if the result is below the level required to produce the pensions that they expect."

The third truth is that trustees should not pay attention to market commentaries, which invariably explain historical activities and present information in a way that often implies that such explanations were anticipated. Bob Veres, a US financial commentator, refers to commentaries provided in the media as "financial pornography. Such commentaries are not good for one's investment health, and if you ever doubt the wisdom of this truth, refer back to the first truth of investing, because these commentaries often refer to future events.

The fourth truth of investing is that an individual's risk profile is not helpful for investment decision-making. What does this mean? Most investors, at some point in their lifetime, are asked whether they are a conservative, balanced or aggressive investor. Invariably retirement funds that offer member choice will have choices categorised in this way, or according to life stages. Life staging has parallels to risk profiling, as it implies that as people get older they should invest in more conservative portfolios. The reality is that two investors of exactly the same age can have very different investment needs, and consequently cannot be labelled narrowly, either with respect to risk profile or life stage.

Risk of an investment is, however, something different. For example: We can quantify the likely risk of investing into different asset classes, and trustees can make decisions based on the risk of the investment, rather than on their own risk profile or that of their members.

The fifth truth is that past performance is not an indicator of future performance. This message is probably the most consistent message that the investment industry communicates. However, it is the one message that does not seem to get through to investors. Hence trustees will often make decisions about hiring and firing asset managers based on past performance, usually short-term relative performance, rather than on whether the needs of their fund are being met, or whether the managers are acting in accordance with their investment mandate.

Ironically, rather than past performance, probably the biggest driver of future performance is the behaviour of investors. In this case, the trustees and members of retirement funds. Once swimmers have learned how to float, they will participate in swimming events with clear parameters: a particular stroke over a set distance. We do not see swimmers changing stroke in the middle of a length because somebody looks like they are going faster than them. In the same way, trustees of retirement funds should be adopting investment strategies that are designed to meet the objectives of their fund. These strategies should not be changed mid-course.

When trustees are reviewing investment strategies, they should do so with reference to the five investment truths. Doing so, will keep them afloat amidst the ever-changing, and seemingly complex world of investments.

Robert Macdonald, Head: Xchange Solutions