Investment strategy challenge

Two presenters at the recent Fiduciary Investors Symposium in Chicago, Roger Urwin of Towers Watson and Jaap van Dam of PGGM, report on a productive workshop session in which delegates brainstormed ideas for the ideal investment model for the future. The session led them to conclude that the industry has creative hands and smart heads.

Conferences can be dry affairs but this workshop session produced some full-on participation and demonstrated how fast-changing our investment environment is.

The delegates worked at tables in teams and responded to a case study with ideas for the ideal investment model for the future in the form of the investment strategy and the governance budget to get the strategy implemented. The key question was how the delegates would design a new pension fund or sovereign wealth fund with a size of roughly $50 billion or more.

We also surveyed a number of key investment beliefs in the asset owner area in a “clickers-fest” which yielded some very interesting conclusions about governance arrangements in particular.

The results of the beliefs survey proved to be helpful to the interpretation of the chosen investment model and the understanding of their evolved governance. The key results on the frameworks used are in table 1 below. The “reference portfolio” framework is increasingly used by large asset owners. It is essentially a benchmark decided by the asset owner board for the strategy of the fund captured in a low-cost and low-complexity portfolio. This is not radical thinking but has proved effective in improving the accountability of the investment executive functions. The reference portfolio frames the investment executive’s mandate through guidance from their boards on what amounts of risks are seen as consistent with the mission. The “strategic portfolio” is a benchmark decided by the executive team which aims to add value over and above the reference portfolio.

Table 1
The “reference portfolio” concept and framework % The “strategic portfolio” concept and framework % The ideal decision-making flexibility is a risk budget of: %
I like it 65.3 I like it 64.7 1% pa tracking error 8.2
I can live with it 30.6 I can live with it 21.6 2% pa tracking error 40.8
I don’t like it 4.1 I don’t like it 13.7 3% pa tracking error 51.0


FIS delegates showed support for both concepts, with a large majority of delegates seeing their merit. But a significant minority see benchmarks, particularly the strategic portfolio, as necessary but sub-optimal tools in effective governance. This reflects the sense that the best investment management follows a predominantly absolute return unconstrained style. The mantra mentioned was: “Bad benchmarks produce bad portfolios”.

FIS delegates also supported the reference portfolio being less of an anchor, with preference for higher tracking errors and less “benchmark hugging”.

Another area of consideration was the resourcing needs of large funds and how that resourcing is organised. The data from these questions are in tables 2 and 3 below.

Table 2
The desirability of internal resourcing in CIO/strategic skills/board liaison is: % The desirability of internal resourcing in the area of portfolio management is: % What cost structure is preferable for a fund of this size? %
Very important 76.0 Very important 55.1 5 bps of internal plus 70 bps of external 15.4
Important 24.0 Important 26.5 7.5 bps of internal plus 60 bps of external 36.5
Unimportant 0.0 Unimportant 18.4 10 bps of internal plus 50 bps of external 48.1


The underlying assumption is that large funds can now acquire significant internal resource and relevant expertise, but the key question is where that resource is most critical. The delegates’ preference favoured the high-level capability in strategy, rather than for portfolio management, where funds can continue to search out the best external firms. The underlying premise is that alignment of internal teams matters more at the CIO and board level than at the portfolio manager level.

The delegates had clear preferences for a larger internal capability that enabled the board to concentrate on its high-level role. A fund of the size envisaged ($50 billion) would more commonly operate at an overall expense of much less than 5 basis points per annum or $25 million, but delegates saw the merits in a stronger internal function with a significantly larger operating budget.

Governance principles suggest the splitting of roles between board and executive has a high impact on effectiveness. Boards’ abilities with the determination of the highest principles – mission and goals, values and beliefs – mark out the best funds. But with the strategic competency assured in the fund’s executive team, the arrangement settles naturally into a combination of the CIO deciding on strategy with the board assuming the oversight of that decision.

Table 3
In the board role, where is their greatest potential to add value? % What role/influence should the board assume in strategic allocation? %
Establishing mission and fundamentals 56.9 Primary decision maker 0.0
Operating governance including CEO+CIO selection 31.4 Decision ownership shared with executive 25.0
Investment strategy decisions 5.9 Decision oversight of executive recommendation 75.0
Oversight of executive investment decisions 5.9


The delegates’ second task was to set both governance budget and strategy in response to a case study.

The case study fund background was set up to be similar to the proposed “British Wealth Funds” drawn from the 89 local government funds and was profiled as:

  • $50 billion in assets and with positive cash flow and a long time horizon
  • Public sector defined benefit liabilities with funded status of around 90%
  • Current investment goal is CPI+3.5% per annum after costs
  • By reference to their size and capabilities, the fund has an “average” executive team and board
  • The asset allocation is also relatively average:
  • equities 50%
  • government bonds 25%
  • credit 15%
  • real estate 6%
  • private equity 3%
  • infrastructure 1%
  • The fund is looking to evolve its investment model, having regard to both its governance arrangements and the direction of its investment strategy.


The first task for delegates was to set the high-level parameters. The workshop results are in table 4. The fund’s stated goal was to achieve CPI + 3.5% per annum. The 50–50 equity-bond reference portfolio left 1.5% of added return needed; the 70–30 portfolio left 0.5% per annum needed. Delegates preferred the explicit reference portfolio specification and the higher risk portfolio arguing that the longer-term orientation would support the higher drawdowns that would occur.

Table 4
Reference portfolio choice % New investment strategy choice %
Reference portfolio = 50% equities, 50% bonds; CPI + 2% target and vol of 7.5% 22.2 Alternatives allocation 5–10% (mostly RE); active management exposure low; active risk vs RP of c.1%, active return c.0.5% 0.0
Reference portfolio = 70% equities, 30% bonds; CPI + 3% target and vol of 10% 77.8 Alternatives allocation 10–20% (RE + PE + infra + abs rtn); active management exposure medium; active risk vs RP of c.2%, active return c.1.0% 44.4
Reference portfolio not specified; all focus on strategic portfolio; no targets 0.0 Alternatives allocation 20–30% (RE + PE + Infra + Abs Rtn); active management exposure high; active risk vs RP of c.3%, active return c.1.5% 55.6


The choice came down to the preference between more bulk beta in the return (that all funds can achieve) or more skill-based value added to the return (that only some funds will achieve). The most popular combination added the 70–30 reference portfolio to the 2% active risk portfolio. The next most popular choice combined a 50–50 reference portfolio with the higher active risk. The differences come down to investment beliefs of course, and here the critical differentiation lies in funds that have the greatest confidence in their comparative advantage to generate skill-based returns.

When it came to how to evolve the investment model, delegates were asked to build a combined proposition around both governance and investment strategy. Results are shown in table 5.

Table 5
Governance budget choice % Strategy choice %
Build executive capabilities in insourced portfolio management in public markets 2 Develop active management line-up including engaged partner model (managers with widened/aligned role) 31
Build executive capabilities in strategy skills 6 Build smart beta research and allocation 7
Build executive capabilities in private markets 16 Build private market strategy using external firm mandates 15
Strengthen board capabilities and effectiveness 6 Build internal private market strategy – co-investing/direct 6
Strengthen risk management capabilities and culture 27 Develop ESG and sustainability policies and strategies 0
Build executive team culture and employee value proposition 16 Develop absolute return strategies 6
Evolve mission and beliefs clarity in the fund by significant “socialisation” and collaborative process in the board and exec 27 Develop long horizon investing commitment, through better long-term mindset, process and mandates/KPIs 35


The difficulties of board and executive team alignment figured heavily in discussions on governance, as did the deepening of the risk domain.

When it came to strategy, a fund’s focus on long-horizon investing had the result of making the individual allocation of time to ESG much lower. Funds appear to prefer to see ESG as a particular part of sustainable investing. Delegates’ commitment to active management, with a desire to allocate more time and design to these relationships, was also considerable. That said, the biggest resource allocation to active management is in private markets where active approaches are necessary.

The starting assumption for the session was that investment strategy is a complex, governance-challenged existing in a battle-for-return and war-for-talent world. The case study discussions supported this view, and the FIS delegates demonstrated a wish to think ahead so as to meet these challenges and to work together to produce better solutions.