Bruce Curwood
corporate risk
Cashbox: How Smaller Investment Funds Can Overcome Cognitive Bias | Canadian Insurance

Cashbox: How Smaller Investment Funds Can Overcome Cognitive Bias

Closing the gap between mega-funds and smaller players

In my last column, I noted there’s currently a risk management revolution taking place in the investment industry. Unfortunately, this more comprehensive approach to risk management, termed “enterprise risk management,” has been adopted so far mostly by the mega-funds (those well-governed funds in excess of $10 billion). But the mega-funds have numerous competent staff, and can have 20 professionals devoted to risk management alone. Smaller funds still compete with their larger counterparts and unforeseeable markets to survive, but they have to overcome their governance gap (fewer resources, lack of scale, etc.) and their cognitive biases to keep pace with industry advances.

Investment fiduciaries will make mistakes in the market. What they can do to compensate is identify situations where their biases and false perspectives can hurt them the most. They need to recognize who they are, preconceptions and all; control the environment where they display such behavior; and establish frameworks to apply judgment so they can make informed decisions, or at least be fully aware of the consequences. So risk management is key, and better governance is the control. Good governance is all about better preparedness, discipline, stakeholder communication and a prudent fiduciary process.

Read: More Investors Going After Advisors to Seek Recovery 

The Chief Investment Officer and Chair play extremely important roles, as they must determine where the fund is today and where they wish to take it in future. Clearly leadership comes from the Chair, who must cultivate the common vision for the fund with the CIO, and together they must help mentor committee members to clearly articulate and realize that goal, while removing potential impediments at the same time. But Chairs are often chosen haphazardly, rather than for their skills.

As I noted earlier, smaller investment funds are at a competitive disadvantage in terms of resources (staff & tools), proprietary research and riskmanagement practices. But, investing is a search for returns, paid for through operating costs and the assumption of risks: costs are more predictable than risks, and risks are more predictable than returns.

Read: Institutional Investors Look for Better Risk Management

Stock market returns will always shock and surprise us, but smaller investment funds do have the ability to be more nimble than their larger counterparts without tipping their hand to the market. With fewer assets under management to transition, they can make timely decisions. Larger returns can be made by not giving in to emotion, being more counterintuitive, investing more heavily in bear markets and being more conservative in the euphoric stages of bull markets. That said, smaller funds must have a governance structure that corresponds to the dynamic investment strategies adopted, as well as effective implementation, to be successful.

Without adequate staff, in most cases, and with top execs meeting only infrequently, smaller funds must fathom better ways to meet their primary objectives. An outsourced CIO model (partnering with sophisticated investors who can provide the costly risk management tools, research and staff to implement on their behalf) or keeping it simple to focus on the big levers (like risk analysis and asset mix, while utilizing passive investing to reduce complexity, decrease costs and implement expeditiously), are ways for smaller funds to think outside the box and narrow the scale gap.

Read: Stock or Mutual: Does Ownership Influence Risk?

The financial crisis in 2008 exposed many deficiencies in investment literature and fund governance practices. Making investment decisions in turbulent economic times is no easy process. It requires vigilance, objectivity and a culture of risk-adjusted decision-making, which many better-managed mega-funds have adopted. Smaller funds, which lack the economies of scale, need to be more deliberate in thinking about what may work best for their fund. They must think outside the box and establish frameworks by insourcing strategic partners with diverse perspectives, and timely access to critical information that would help balanced-thinking and overcome cognitive bias.

Bruce Curwood is the direct of investment strategy at Russell Investments Canada.

Copyright 2014 Rogers Publishing Ltd. This article first appeared in the November 2014 edition of Corporate Risk Canada magazine