How to uncover investment biases

Investment Biases: How OCIOs Can Help Institutions Avoid the Bad & Embrace the Good

Regardless of the processes in place within an investment analysis and selection process, it is impossible to entirely eliminate biases from human decision making. Outsourced Chief Investment Officers (OCIOs) are no different, and the teams making decisions on behalf of your institution will surely have certain preferences that drive their decision making and process development. Certain biases and traps are clear to spot and should be avoided, but others may benefit non-profit institutions because they meet the specialized needs of long-term investors. This article explores these influences with the thesis that decision makers should be aware of biases when selecting their investment advisor. Knowing the biases inherent to a particular OCIO or consultant may help non-profit investors identify potential strengths and weaknesses of their approach.

OCIO Bias Pitfalls to Avoid

 

OCIOs are run by people, therefore the risk of human error and the biases that the investment teams may hold are always present. There are certain common biases that even seasoned investors may succumb to, and while they may seem evident, evaluation of your provider is paramount. We find it prudent to review the performance, allocation, manager selection, and market commentary provided by your advisor to ensure that they have a disciplined process to avoid the following:

The Endowment Effect

This emotional bias, often referred to as divestiture aversion, occurs when an individual assigns a higher value to an owned asset than the asset’s true market value. This bias may adversely affect investment decision making and lead an institution to incorrectly value assets or hold assets that do not align with its investment objectives. An OCIO should have processes in place to regularly analyze and re-underwrite portfolio holdings and should expect the same from third party managers working on behalf of their clients.

The Bird in the Hand

A reference to the adage, “A bird in the hand is worth two in the bush,” this bias causes investors to overvalue the immediacy of present returns and undervalue future opportunities. Instead, institutions should progressively evaluate investment opportunities with an eye toward the future which is more aligned with the perpetual nature of most non-profits.

Hindsight Bias

Hindsight bias, in addition to its cousin, confirmation bias, must be deliberately counteracted through sound and consistent investment philosophy. Hindsight bias causes us to believe that past events were predictable, while, in reality, there was no way to foresee them. This works hand in hand with confirmation bias, the tendency for investors to seek out information that supports their existing beliefs. The best OCIOs and advisors will help investors avoid the hindsight trap and actively seek information that contradicts, rather than confirms, their biases.

OCIOs Are Partial to Certain Investments and Strategies

 

While the term “bias” tends to carry a negative connotation, not all partiality is inherently bad. An investment firm holding certain ideological preferences may better align them with the needs or mission of their clients and provide long-term benefits to their portfolios. Strategically employed biases can help long-term investors block out market noise and focus more directly on strategies and investments that may deliver more consistent outcomes for their clients.

Diversified Portfolios

Given the perpetual nature of endowments, an OCIO must have an approach that considers the unique needs that result from long investment time horizons. At times, investors may be tempted to ignore consistent application of a long-term strategy in favor of chasing fads or short-term success. An OCIO can help avoid this pitfall by holding a bias toward broad diversification across asset classes, geography, capitalization, etc. Such portfolios have the potential to provide less correlated and more consistent return streams that may perform better during times of market stress.

Alignment of Interest through Fee Transparency & Terms

Most organizations understand that fees associated with OCIOs and individual managers can vary widely. Your OCIO should provide transparency not only regarding the fees they charge, but the underlying manager fees within your portfolios. Negotiating the best fee terms with managers is one of the many important functions an OCIO provides. It may be surprising for some that finding the best terms doesn’t necessarily mean selecting the manager with the lowest fees. For instance, OCIOs may be comfortable engaging managers with higher fees if they believe a particular manager can deliver more alpha than their peers. Additionally, managers whose fees structures are based on their delivery of performance may be better aligned with the client.

Strategic Implementation of Private Market Investments

Private markets encompass a wide range of investments across many sectors, so there are a variety of strategies from which to choose. However, one thing they all have in common is the goal of providing an illiquidity premium – outsized performance to compensate for the illiquidity an investor must accept. This illiquidity is also something that must be managed as non-profits require liquidity to fund their operations, and this can be of utmost importance during periods of market turmoil. Thus, it is imperative that an institution maintains a measured and diligent approach to this strategy by creating a diversified portfolio of private investments (private equity, venture capital, private credit, etc.) while also considering the liquidity timelines of investments being considered.

Identifying and Partnering with Managers with Outsized Alpha Potential

An OCIO may prefer to engage with managers who align with the values and the missions of the organizations they serve. Additionally, some OCIOs have a bias toward specific managers or fund structures who they believe can better provide outsized alpha and performance. This may mean avoiding “mega funds” for whom alpha may be more difficult to achieve due to the amount of capital they must deploy and focusing more on smaller or emerging managers who can be agile and potentially exploit market inefficiencies and dislocations.

When evaluating your investment provider, whether a consultant or OCIO, it is important to reflect on the philosophy driving the investment decisions and strategy of the team managing your institution’s assets. Some biases, both positive and negative, are easier to spot than others, but they will likely become apparent during times of stress on the portfolio. Through this evaluation process it is important to practice prudence and ask questions designed to uncover biases that may be held by any potential advisor. The knowledge of these characteristics will help you better understand which investment partner may best support your organization’s goals and which may be adding unnecessary risk.

Explore our blog to learn more about how to evaluate whether your OCIO is best serving your institution’s needs.

Subscribe to Our Blog