Looking less at the scoreboard

“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.” – Warren Buffett (2014 annual letter to shareholders)

Performance monitoring reports play a central role in supporting investor decision-making, providing a snapshot of the returns achieved on a portfolio over time. While their content and format vary widely, they invariably contain a summary of fund and benchmark performance for each underlying strategy over a range of time periods. By emphasising benchmark-relative performance, these reports encourage procyclical decision-making that reduces returns and contributes to destabilising market dynamics.

In The Intelligent Investor (1942), Ben Graham wrote that “price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.” Here Graham hints at a monitoring approach that de-emphasises price data, focusing instead on the underlying health of the businesses within the investor’s portfolio.

Benchmark myopia

As we have described elsewhere, we believe that procyclical dynamics in financial markets are both privately and socially damaging. A powerful driver of procyclicality is the tendency for asset owners to hire managers after a period of strong performance and fire managers after a period of disappointing performance. One of the primary inputs into this decision-making process is the manager’s performance versus their stated benchmark, often reported to investment committees on a quarterly basis.

Such performance monitoring reports are often adopted without much thought given to the usefulness of the data provided. Do the benchmark-relative performance numbers provide information on whether the manager is doing a good job? Do they provide any insight on the manager’s skill level? Do they provide a useful trigger for reviewing the mandate? Over anything less than a five-year period it is difficult to answer “yes” to any of these questions.

The fact that managers know that performance data is presented to asset owners on a regular basis also creates a commercial incentive to ensure that short- to medium-term benchmark-relative performance is controlled, to avoid the appearance of incompetence. This in effect embeds procyclicality within asset managers’ decision-making, since to avoid significant underperformance, a manager will at times need to chase the best-performing securities or sectors within their benchmark.

As a result, traditional performance monitoring reports do more harm than good. They encourage an excessive focus on performance data and contribute to procyclicality in decision-making by asset owners and asset managers. Some have suggested that altering the presentation of performance data – to give greater prominence to longer-term figures – might help address the issue. However, minor tweaks to the existing approach are unlikely to achieve very much. Instead, a more fundamental re-think is necessary.

Monitoring without procyclicality

The first step towards developing an effective monitoring framework is to recognise that short-term performance data has very little informational content for strategies that have long-term objectives. Whether the manager or the benchmark has produced a greater return over the last quarter or year tells us more about market sentiment than it does about the manager’s ability. Even over periods of five years or longer we should be wary of drawing overly strong conclusions.

We suggest that instead of trying to gauge manager success based on regularly updated performance data, investors seek to make an assessment of whether the underlying portfolio is delivering what might be expected, given the manager’s stated philosophy and approach. This requires investors to shift their sights away from performance numbers and towards the fundamental characteristics of the stocks held in the portfolio. This can be broken into two parts:

  1. Has portfolio activity been consistent with the stated philosophy?
  2. Do the fundamentals of portfolio holdings provide evidence of skill in stock selection?

The first element is a backward-looking analysis intended to confirm that the mandate is being managed in line with expectations. In relation to a listed equity mandate, important elements of this assessment would include turnover statistics, active share, an analysis of changes to portfolio holdings over time, and stewardship activity. The portfolio holdings analysis would primarily be intended to determine whether the manager has an unstated momentum (performance-chasing) bias that could be motivated by career risk or commercial considerations.

The second element builds on Graham’s suggestion that investors focus more on the operating performance of their holdings than on price movements. For an equity mandate, the characteristics of interest could include measures such as the growth in cashflow, earnings, book value or dividends of the portfolio. These measures are likely to be less volatile than performance data driven largely by market prices, while providing a more useful indicator of the ongoing success of the strategy.

It is important to note that the most relevant measures of success will vary from one manager to the next – the objective here is not to achieve total uniformity in the monitoring approach. Indeed, performance-chasing at the asset owner and asset manager levels can be traced, at least in part, to the homogenous performance monitoring reports produced across the industry on a quarterly basis.

In some respects, the proposed approach mirrors the way in which a private equity general partner has to monitor their portfolio. Without access to a frequently updated market valuation, the private equity owner instead focuses on the operating performance of the underlying businesses and their ability to influence outcomes by engaging with management. While there is plenty to criticise about the private equity business model, public market investors could become better long-term investors by borrowing some elements from their private market counterparts.

There is no perfect way to monitor an asset manager. Separating luck from skill will remain deeply challenging and it is impossible to eliminate all principal-agent problems. However, it would be difficult to design a performance monitoring system more likely to encourage procyclical decision-making than the current one. By looking less at the scoreboard and focusing more on the playing field, we believe that investors can incentivise a shift towards longer horizons within financial markets that will be both privately and socially beneficial.

Philip Edwards is co-founder and chief executive of Ricardo Research

 

As concerns about climate change reach fever pitch, Harvard Business School has published a report that shows investment strategies that “aggressively” reduce carbon emissions can significantly boost fund performance.

The university paper, Decarbonization factors, found that returns from investing in so-called decarbonisation factors went hand-in-hand with institutional flows. In other words, buying one one or more of the factors when flows are positive and selling when flows turn negative led to “significantly superior returns.”

There is a “significant contemporaneous positive relationship between decarbonisation flows and decarbonisation returns,” the authors of the report, which include business professor George Serafiem and Alex Cheema-Fox of State Street Associates, wrote. “This suggests that demand for stocks with low carbon intensity has pricing effects. This could be because flows of institutional money carry information about changes in the anticipated fundamentals.”

A record amount of money is already pouring into sustainable investments amid fears about the speed of climate change. Harvard pointed to a mountain of evidence that showed that the rise in carbon emissions to the highest levels in over 800,000 years was a direct result of human economic activity. Citing analysis from Moody’s, it said that if warming gets to 2 degrees Celsius, the economic fallout would reach $69 trillion by 2100.

Last year more than $31 trillion was allocated to sustainable assets across developed markets, according to the Global Sustainable Investment Alliance. Of that, Australian and New Zealand investors accounted for 63 per cent.

The paper also found that investment returns from decarbonisation factors were much stronger in Europe than in the US. This was partly due to a stronger response by European governments to climate change and a pricing system for carbon emissions which incentivised businesses in Europe to reduce emissions.

“Buying the factor when flows are positive, while selling the factor when flows are negative, yields even larger and more significant alphas between 1.48 and 4.43 per cent in the US and 2.50 and 8.51 per cent in Europe,” Harvard said.

“Our paper contributes to a growing literature on how climate change impacts investor expectations, capital allocations and thereby pricing and returns,” the report concluded. “Our results provide actionable insights into how to decarbonise portfolios and what are the likely performance and carbon exposure differences across strategies.”

Fees have declined significantly in a number of asset classes since 2016. According to the latest report from specialist investment consultancy bfinance ‘Investment Management Fees: Is Competition Working’ there are particularly noticeable reductions in sectors where industry developments have strengthened price competition. For example, an expanding manager universe, weaker investor demand, greater visibility on overall costs and the emergence of comparable-but-cheaper strategies have all had an impact.

Fund of hedge fund fees have fallen by more than a quarter since 2016, followed by absolute return fixed income, where median management charges have declined by 15 per cent. Other areas demonstrating the downward trend include emerging market debt (-10 per cent), emerging market equity (-6 per cent) and certain niches of the private market investment landscape such as European open-end real estate (-12 per cent). The published figures are based on actual fees quoted by asset managers for live competitive mandates from investors – not surveys or ‘rack rates,’ which tend to be somewhat inflated.

Private markets

Private market strategies have been among the most resilient from a pricing standpoint, with a wall of money continuing to chase private equity, infrastructure, private debt and other illiquid investments. Yet pricing trends here are considerably more opaque due to the complexity of fee structures. For example, while management fees appear to have declined slightly in certain private equity strategy types, we have observed reductions in hurdle rates which may, depending on future performance, leave investors shelling out more than before. We also see some managers hiking their pricing tiers, meaning that an investor is expected to make a larger commitment than before in order to obtain the equivalent discount.

In addition to the visible costs – management fees, performance fees, administrative fees and so forth – payable by investors, private markets also exhibit particularly high ‘hidden costs’: leakage which may not show up as a visible expense to investors, such as certain property charges in real estate.

Fee trends are always of interest, not least because sector-wide declines can present a broad opportunity for investors to renegotiate improved terms. Yet there are many other ways of obtaining better value for money on a case-by-case basis, even in asset classes where average terms are not improving overall. Many of these approaches essentially involve finding ways to create or re-frame the contest between asset managers, such that the investor can become a price-maker rather than a price-taker. The investment management industry is not one in which price competition functions efficiently. Yet in an imperfectly competitive market competition can be encouraged, enhanced and even engineered.

Granular approach

One approach that we see more investors pursuing is more granular, detailed benchmarking of the fees they’re paying. Rather than relying on high-level asset class averages and survey data, there is growing demand for comparison against more specific manager peer groups which also takes into account the investor’s region and type, as well as the current fundraising dynamics. Newer techniques for performance analysis, such as risk factor attribution, can also be helpful in obtaining an understanding of whether a manager’s fee can be considered fair and appropriate, helping investors to understand whether they’re paying for what they would consider ‘real’ alpha.

A second route that has proven popular in recent years is mandate consolidation: awarding larger sums of money to fewer managers. While this can generate savings, tiering patterns vary greatly depending on the sector. For example, while global active equity investing offers consistent price reductions between $50 million and $500 million as mandate sizes increase, global fixed income discounts become far less substantial north of the $100 million mark. Conversely, significantly larger mandates are required to extract meaningful scale benefits in certain illiquid asset classes.

A third approach, and one that has been heavily advocated by some consultants and asset managers, involves moving towards fee structures that may theoretically improve alignment between investor and manager. For example, recent years have seen the rise of some more aggressive performance-heavy fee structures for active equity, with proponents arguing that anything beyond a near-passive price should be based solely on outperformance. Good PRF alignment requires complex implementation of caps, floors, high watermarks and more, as well as appropriate cultures and incentive schemes among portfolio managers. To adapt a familiar idiom, culture eats structure for breakfast. Executed poorly, PRFs can create more problems than they solve. Other adjustments that may improve overall efficiency include greater use of alternative access points such as co-investment or direct investment.

Finally, investors can consider how best to encourage price competition when selecting and reviewing external asset managers. The reality is that institutional manager selection activity often does not allow managers to compete effectively on price. For example, investors and consultants may employ relatively narrow manager lists, or may not address the issue of price until the field has been whittled down to a small handful of contenders. Managers frequently express frustration that they do not know how various strategies are priced relative to their peers. Running open searches with a broad universe of providers vying for mandates can enhance price competition, as can tackling the subject of costs with managers earlier in the process rather than leaving it until the final hurdle. Understanding total costs (not just fees), including hidden costs, helps investors to compare providers more effectively.

Above all, notwithstanding interesting developments on the fee front, it is important not to let a focus on price overshadow the bigger picture. Pursuing cost reduction with insufficient regard for investment outcomes can be a dangerous pursuit. Net return – not price – is the most important metric.

This article includes data and material from Investment Management Fees: Is Competition Working? (bfinance, 2019). The full report can be found here.

Kathryn Saklatvala is director, investment content and thought leadership at bfinance

The Fiduciary Investors Symposium at Harvard University brought together more than 85 asset owners from 20 countries to discuss globalisation, human capital, inequality, longevity, technology, medicine and ethics, and the role of institutional capital in creating real change in the world.

We were joined by many distinguished speakers and have put together a podcast series of our favourite sessions.

 

The NZ$43 billion ($27 billion) New Zealand Super Fund is undergoing its five-yearly review of its reference portfolio, an innovative and unique asset allocation reference point that allows the fund to benchmark the performance of its actual portfolio and any value added through active management.

Chief executive of the fund, Matt Whineray, said the process should be completed by June next year and that there were two to three more meetings with the board, and risk testing required, before any decisions were made on changes to the reference portfolio.

One of the key challenges in the process according to Whineray is the calibration of long and short-term return expectations for the portfolio.

“One of the challenges is we have a long run expectation of returns which is cash of 5, risk premium of 2.7 and plus 1 per cent of value added – so we expect 8.7 per cent over the long run. Over the short term that might look very different. We are not in that environment now, the cash rate is not there and we are not taking active risk, so we are maybe expecting about 5 to 6 per cent on the reference portfolio,” he said.

Importantly he points out that 8.7 per cent is not a forecast but a long run expectation, a gentle nuance, and one of his challenges is how to communicate that fine distinction to various stakeholders.

The reference portfolio is the most simple form of how the fund could achieve its stated risk/return goal and is expressed in a passive allocation of defensive and growth assets. The current reference portfolio set in 2015 is global equities, developed markets (65 per cent), global equities, emerging markets (10 per cent), New Zealand equities (5 per cent), and fixed income (20 per cent).

How NZ Super actually allocates is a deviation from that reference portfolio and can be expressed in active decisions both in allocations and style of management. It’s a similar approach to CPPIB and allows for very clear attribution.

“In figuring out if we are going to make any changes to the reference portfolio we have to ask if relativities have changed or is everything lower?” Whineray says. “If everything is going to be lower then we may have the same percentage allocations. Now we think bonds are really expensive and equities are a bit expensive.”

In NZ Super’s tactical positions, which has been a good source of active return, the fund has been short bonds for quite a while.

“The other question is where do we express our opportunities. In the reference portfolio we don’t express prices, we do that in TAA – it’s an important design construct of the reference portfolio.”

In December 2018 New Zealand Super appointed a new chief investment officer, Stephen Gilmore, a local Kiwi who had spent nine years at Australia’s sovereign wealth fund, the Future Fund, most recently as head of strategy.

“Stephen’s arrival has also given us fresh eyes to ask why do we or don’t we do certain things,” Whineray says. “Stephen has sat down with all the investment staff (about 55 people) and uncovered their previous experience and how that might be used now in their current jobs.”

The arrival of Gilmore has also prompted a review of the use of hedging. Historically the fund hedged 100 per cent to the New Zealand dollar, and got paid a bit to do that.

“Now with the interest differentials at zero or flipped, we don’t get paid to do that. So with Stephen we’re looking at that.”

The fund is also looking at its active risk in a bid to diversify it and “not be too beholden to a single thing”. Currently the active risk is in direct investing, catastrophe bonds, distressed debt, and dynamic asset allocation, or tilting, which is the biggest active risk.

The DAA, which sits under David Iverson, began in 2009 with the only trades the New Zealand dollar versus other currencies and bonds versus equities. But the breadth of the DAA has increased a lot since then. It now includes nine equity markets versus themselves and cash, nine currencies, nine bonds, credit, and commodities.

“At one point with our currency tilt we were 40 per cent short the Kiwi versus the portfolio. We have changed so that there is no single thing that has really as much risk.”

Two years ago the fund included carbon exclusions in its reference portfolio, which was a bold move expressing the fund’s view of carbon risk (NZ Super cleans out its carbon). The fund is now almost at its 2020 targets.

 

Outstanding returns 

New Zealand Super has returned 14 per cent per year over the past 10 years, and in the year to June 2019 returned 7.02 per cent. But Whineray sees this as a reason to be cautious.

“This is one of the reasons why we are not as confident of the future, we think we should expect to see some lower years in terms of returns,” he says.

With the portfolio made up of around 80 per cent equities, volatility is part and parcel of the future.

“My message since becoming CEO is there is a lot of volatility inherent in our portfolio so we shouldn’t be surprised by that. Our risk is not that we’ll have volatility, we know that. The risk is people will lose their nerve in that volatility, it’s not the time to lower risk.”

While the fund returned just over 7 per cent for the year, for the six months to Christmas day it was down by that much.

“That shows what a ripper of a first quarter we had,” Whineray says.

“I have tried to be clear in the messaging about the difference between risk and volatility. Volatility means you have to take risk to generate returns but that means you might not generate returns. Risk is someone takes the keys off you.”

He points out that the board is tasked with the statutory obligation of making the maximum return without taking undue risk, but that it has no help in interpreting that.

“What’s the point at which the sponsor might not be willing to continue? Because you don’t want to get that far,” he says. “Size the strategy at which its serviceable, you have to live with the journey.”

Whineray started at the fund in 2008 as general manager of investments and spent four years as chief investment officer before coming chief executive in July 2018.

In the new role the main shift for him has been the time spent on stakeholder management, more dealing with the board and more time on strategy, culture and talent. And he’s been busy with new projects for the fund.

In addition to the five-yearly portfolio review, the government has given the fund a new mandate to develop the New Zealand venture capital market. It also has a light rail project with CDPQ Infra in Auckland, and in the past two years there have been a bunch of appointments. In fact the HR group has made 50 appointments, 20 of which were internal and the fund is now approaching 150 staff across the organisation.

The fund also moved to the cloud last year, and added tech, operations and risk functions across the teams. All of which has kept him busy.

Since Whineray took the helm, NZ Super has also done a “values” refresh. Previously the funds values were outlined as integrity, inclusiveness, and innovation (coincidentally the Reserve Bank of New Zealand, where former head of NZ Super Adrian Orr is now Governor, has the same set of corporate values).

The fund was due for a values refresh, Whineray says, because not only has it grown and changed a lot, only a handful of people now at the fund were there when the values were created.

Whineary and the team took a novel approach to getting staff input into the corporate values. They used an APP, Sense Maker, that the fund uses on its farm investments to try and understand core issues. The APP collects stories and then finds common issues in the stories. It asks people to do things like tell a story about the time you were proud, or not proud, or a time you made a particular decision.

For the values project the fund collected 120 stories and categorised them across people and process, clustering them to get common themes and from that, values.

What came out was:

  • Stand strong – frameworks, coping through times of difficulty and be principled
  • Support each other – very personally supportive culture
  • Team not hero – commitment to the whole
  • Future focused – what would the future me thing of this decision

Those values were then turned into cartoons, as a visual aid, and are listed in the annual report.

“We got a common story and connection from people’s narratives. Now we can use those values to solve dilemma.”

Whineray and his team have also been commended for taking a leadership position around their dealing with social media companies in response to the Christchurch massacre (NZ investors act on terror attack.).

It has now signed up 89 organisations with NZ$13 trillion in support, and to engage directly with social media companies Facebook, Google and Twitter to encourage them to strengthen controls that will prevent the live streaming and distribution of objectionable content.

The collaboration supports the Chirstchurch call, facilitated by the New Zealand and French governments, which is a commitment by governments and technology companies to eliminate terrorist and violent extremist content online.

 

The Netherlands’ $1.5 trillion pension industry has been named the best in the world for a second year running, boosted by an increase in the net household saving rate, according to the annual global study, the Melbourne Mercer Global Pension Index.

The Netherlands and Denmark, which came in second, both held onto their A grade after achieving overall scores of 81 and 80.3, respectively. Countries with the top grade are considered to have a “first class and robust retirement income system that delivers good benefits, is sustainable and has a high level of integrity.”

“Systems around the world are facing unprecedented life expectancy and rising pressure on public resources to support the health and welfare of older citizens,” said David Knox, author of the report and a senior partner at Mercer. “It’s imperative that policy makers reflect on the strengths and weaknesses of their systems to ensure stronger long-term outcomes for the retirees of the future.”

The Dutch retirement income system is made up of a flat-rate public pension and a quasi-mandatory earnings-related occupational pension linked to industrial agreements, according to Mercer. Most employees belong to the occupational defined benefit pension schemes with earnings measures based on lifetime average earnings.

The Netherlands has consistently held the first or second place for 10 out of the last 11 reports. Denmark had the highest score for sustainability at 82 in 2019, but scored 82.2 for integrity compared to The Netherland’s 88.9. The Danish pension system is made up of a public basic pension scheme, a means-tested supplementary pension benefit, a fully-funded defined contribution scheme and mandatory occupational schemes.

Australia was ranked third with a B+ grade and an overall score of 75.3, followed by Finland’s B grade and a score of 73.6, lower than last year. Thailand had the lowest value of all 37 retirement systems included in the 2019 report with a D grade and a score of just 39.4.

The US, the world’s largest pension system with some $24.7 billion in assets, was given a C+ grade, meaning it has some “major risks” that should be addressed.

The Melbourne Mercer Global Pension index compares 37 retirement systems that cover almost two thirds of the world’s population. It uses the weighted average of the sub-indices of adequacy, sustainability and integrity to measure each system against more than 40 indicators. This year the index also included the Philippines, Thailand and Turkey for the first time.

The average index value among all the retirement income systems included in the report was 59.3. Mercer said sustainability continued to highlight the weakness of many countries.