3. The choice of active or passive management. How important is it that they strive to do better than the average investor (with the same risk posture)? In other words, how much effort do they want their investment managers to put into the outperformance game?
4. Downside risk. Is the institutional investor willing to accept more frequent small losses in exchange for less frequent large losses (hopefully minimizing their exposure to the next “2008-like” disaster)?
5. Peer comparisons. How important is it for them to look like their peers? (In other words, how different can they allow themselves to become and still remain comfortable?)
These five factors are in direct conflict—some are emphasized at the expense of others. So compromises must be made.
All too often, overenthusiastic investment salesmen will promise you can have it all—low cost, superior performance and limited downside risk. Unfortunately, such claims are nothing more than blatant over-promises that inevitably result in under-delivery. Any one of the five factors can be emphasized, but such emphasis is at the expense of the other four.
The Pros And Cons
Let’s consider the major pro and con for each of these factors for implementation of a policy allocation:
1. Minimizing costs.
The advantage of working to minimize cost is that it ensures the investor will do better than the average investor (and potentially two-thirds of all investors), after accounting for fees and expenses, over the long term.
The disadvantage is that an intense focus on minimizing costs requires you to set aside the other four factors. You cannot have it all.
2. Minimizing taxes.