Innovation is usually viewed by economists as a productivity-enhancing force, powering economic growth in modern capitalist societies.

Governments and companies talk of fostering a “culture of innovation” in which new ideas and new technologies can flourish.

Innovation is no less sought after in the investment industry, where new products are assumed to help consumers meet their individual financial needs.

This optimistic view ignores the damage that can be done by innovations, especially in the financial sector, where agency issues create the potential for negligence and rent extraction.

In a model put forward by Bruno Biais, Jean-Charles Rochet and Paul Woolley in the Review of Financial Studies, when a financial innovation enters the market, this initially creates high rewards for the innovator. These rewards attract imitators that may offer variants on the original product to meet the nascent demand from investors.

Over time, and in the absence of any major failure of the new product, confidence in its robustness and value to society grows.

However, agency issues, such as information asymmetry and misaligned incentives, enable some product providers to offer versions of the innovation that introduce unseen or unintended risks.

These risks might be in some sense unforeseeable, but they could also arise due to inadequate or negligent risk management on the part of less diligent or capable providers.

This failure to carefully evaluate and manage the risks associated with a new product – described as “shirking” by Biais, Rochet and Woolley – is partly caused by the opacity and complexity of financial products which make it difficult for investors to assess the relative competence of different providers.

The impact of an innovation at the macro level will be driven, in part, by the performance of the new products and the extent to which they are tested by challenging market conditions. Some innovations will be exposed to a stress event relatively early on in their lives, reducing the scale of imitation and limiting any potential damage.

But others may experience relatively benign conditions over many years, leading to substantial growth in the innovative sector and a relaxation of risk management efforts. The natural end point of this process is a potentially catastrophic build-up of risk that is not widely appreciated and therefore cannot be managed by investors or policymakers.

The Biais-Rochet-Woolley model helps explain the process by which the rapid growth of securitisation in the US housing market, together with the rise of new financial instruments such as collateralised debt obligations (CDOs) and credit default swaps, provided the raw materials for the sub-prime mortgage crisis of 2007-08.

Investor interest in various forms of structured credit in the early 2000s encouraged banks and other intermediaries to create a steady supply of assets to meet the growing demand. Instead of carefully scrutinising the credit quality of the underlying assets themselves, many investors and product providers were happy to rely on assessments made by credit rating agencies – a clear manifestation of shirking.

This absence of proper risk management created an environment in which mortgage originators and banks could structure complex and opaque products whose risk profile was widely misunderstood. The passage of time only increased investor confidence in the new products, leading to complacency and widespread exposure. When the US housing bubble eventually burst, the resulting crisis was global in nature and imposed substantial costs on society in the form of bank bailouts, unemployment and economic contraction.

The embrace of innovation

The Thatcher and Reagan administrations of the 1980s ushered in a multi-decade period of financial market deregulation and free market thinking which encouraged investors and policymakers to treat financial innovations as an unalloyed good.

This was particularly evident in the run-up to the financial crisis, when in 2005 at a meeting of central bankers, Raghuram Rajan (then chief economist at the IMF) was described by Larry Summers as a Luddite for raising the question of whether financial innovations might have introduced new sources of risk. Indeed, the academic community has long provided the intellectual support for a pro-innovation policy bias, with mainstream finance theory viewing the existence of demand for any new product as a sign that it must be welfare-enhancing.

The experience of the financial crisis clearly vindicated concerns such as those expressed by Raghuram Rajan and has led to some soul-searching within the economics profession. However, the generally positive attitude towards financial market innovation survived intact.

In contrast, the Biais-Rochet-Woolley model suggests that a healthier perspective on financial innovations would be to approach them with a degree of caution, reflecting the potential for shirking and hidden risks.

Technological innovations in any field are subject to risk, but financial innovations are particularly prone to abuse for two reasons.

First, the uncertainty and complexity associated with financial products means that it is difficult to know for some time whether a given investment is performing as expected.

This lag impedes a natural feedback loop that helps protect consumers of non-financial products. For example, if a new model of car proves to be very unreliable, this will be quickly identified by consumers and the information shared widely. This acts as a deterrent against sloppy craftsmanship given the relatively short time period in which disappointing results become apparent and impact business performance. Any such feedback effect in financial markets is inevitably much longer.

Second, asymmetric incentive structures are ubiquitous in the finance sector, arising due to fee and compensation arrangements that provide high positive rewards to the supplier on the upside, with little or no penalty on the downside.

Asymmetric incentives are problematic since they create a situation in which the more knowledgeable party (the product provider) has little or no skin in the game. As a result, providers can reap large rewards without having to share in the downside if a product ultimately fails. Combined with the lag effect described above, asymmetric incentives create a large opportunity for rent extraction by incompetent or negligent providers.

A more thoughtful approach to innovation

Notwithstanding the argument above, innovations in the finance sector can clearly have hugely positive effects for society.

For example, wider access to credit and banking services (often facilitated by modern technology), low cost passive investment products, and private equity capital to support start-ups have all offered material benefits to savers and the wider economy.

However, investors and policymakers could benefit from a more cautious and thoughtful approach to financial innovation than the default position which assumes that all innovation is welfare-enhancing. In particular, the social costs and benefits of any financial innovation should be actively considered before embracing it with open arms.

In part this task will fall to regulators and policymakers. But asset owners also play an important role in scrutinising innovations, since their actions determine the extent to which new products or strategies are successful. In approaching this task, we suggest the following principles as a starting point for investors.

  1. Complexity carries a cost. Innovations that bring complexity and opacity are often described euphemistically as “more sophisticated”. However, such approaches tend to be harder for all parties to understand. This is not to say that complexity should be avoided entirely; rather that investors need to be clear on the expected reward from any additional complexity, while also viewing it as a source of risk. In general, simplicity is a virtue and sophistication a vice where financial products are concerned.

 

  1. Accept the limits of due diligence. A rigorous due diligence approach can help mitigate the risks associated with financial innovations. However, any analysis is inevitably constrained by our present understanding of markets. The emergence of new product-types will always change market dynamics in ways that are difficult, if not impossible, to predict. As a result, investors in new products will often be exposed to hidden or unforeseeable risks. The most obvious protection against such risks is to allocate less to new product-types than to those that have been time-tested.

 

  1. Be wary of fads and fashions. Popular innovations are in danger of running into various forms of shirking, whereby new entrants are tempted to launch products without appropriate risk management. Extra caution is therefore warranted in situations where innovations are attracting widespread investor interest and excitement. Such a stance has the added benefit of avoiding crowded asset classes or strategy types, where the returns available are likely to be reduced by the weight of assets pursuing the same approach.

 

  1. An early-mover advantage often exists. While the points above argue for a considered approach to financial innovations, this need not rule out backing new ideas or strategies that, after detailed investigation, are believed to offer an attractive risk-return trade-off. Indeed, there is often an advantage to acting beforea new approach becomes widely popular – the early-mover advantage – exemplified by the early moves into both hedge funds and private equity by the Yale endowment under David Swenson. Furthermore, the early-mover advantage often turns into a late-mover disadvantage, reflecting the re-pricing of undervalued assets or the elevated risks associated with crowded trades.

 

Over the last decade a range of technology-related innovations have emerged as important parts of the asset management ecosystem. ETFs, high frequency traders, factor strategies and robo-advisors (to name a few) have been enthusiastically embraced by various segments of the financial community. This is not to say that any one of these developments will lead to a future crisis or to deny that they offer some benefits to investors. However, we can be sure that they have each, to varying degrees, changed the dynamics of financial markets and introduced new risks that we do not yet fully understand.

Innovation in financial markets will not and should not stop. However, a more cautious perspective might help investors and policymakers better manage the risks that inevitably accompany financial innovations and contribute to more stable and efficient markets.

 

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

In what will be exactly a decade leading and transforming the Universities Superannuation Scheme investment office, Roger Gray will step down in September. Amanda White spoke to him about investments, governance, the self-possession needed to thrive in funds management, and what’s next.

In the 10 years he has been at USS, Roger Gray has overseen enormous change including the creation of a new investment management organisation, a shift in governance, diversification of the asset mix, de-risking of the portfolio, and a growth in internal investment-related staff by 150 per cent.

“I arrived at USS in September 2009, just after the GFC. We’ve had a few squalls in markets since – the Eurozone crisis being the biggest of those – but overall it has been a really benign period, after one of the more disastrous periods for financial markets. It has been aided and abetted by some extraordinary policy especially monetary policy support,” he says. “There has been a wind at our backs as far as assets are concerned.”

With Gray at the helm of investments, USS assets have increased by two and a half times, shifting from around £26 billion to £67 billion.

At the end of 2018, the fund had outperformed the scheme’s strategic asset allocation, or reference portfolio, over every cumulative period and in the five years to December 2018 outperformance added £2.3 billion.

“The added value has been a material piece, but most of the increase in AUM has been because of the benefits of rising markets. Overall returns are higher than we would have expected when I started, so that’s good,” he says modestly.

It’s unlikely that natural rise will continue, with the fund’s forward-looking return estimates showing that every asset class will have lower returns over the next 10 years. It’s a different environment for incoming USS Investment Management CEO, Simon Pilcher.

Diversification

One of the key legacies of Gray’s time at USS has been the diversification of the asset mix. A decade ago, the strategic asset allocation was what he calls “more 20th  than 21st century” with broadly 80 per cent in equities, 10 per cent in bonds and 10 per cent in property.

The financial crisis was “a shocking experience” for the fund, which lost 27 per cent of its value, when it was early days on its path of diversification which centred around reducing equities and increasing alternatives (ex Property) to 20 per cent when Gray arrived.

“When I started the direction of movement was obvious. At that time the allocation was 72 per cent equities, 8 per cent private equity and infrastructure and 10 per cent each to bonds and property,” he says.

While private market investments have grown more than initially planned, there was some rowing back on original plans  that hedge funds would grow to 6 per cent of the fund, and today they sit at 2.5 per cent.

Moving forward a decade, the USS trustee have set a Reference Portfolio as a risk and performance benchmark for the manager, at the end of 2018 with 60 per cent public equities, 7.5 per cent property, 15% other fixed income (non-government bonds, emerging market debt and US TIPS) and inflation linked gilts 27.5 per cent . The actual portfolio implemented by USSIM, by comparison, holds about 40% in public equities

“When I started the portfolio held concentrated risk in public equities. We are on a gradual slope towards further de-risking and over nine years we’ve taken 20 per cent out of equities in the strategic benchmark. A gentle slope in that direction is likely to persist,” he says.

But a lot of the de-risking has been offset by the fact the liabilities are also so big now. Relative to the Higher Education sector’s balance sheet, both the pension liabilities and assets have grown strongly over the past decade, which is an argument for continued de-risking of the portfolio.

Governance

Gray was appointed CIO of USS in September 2009 and became also the chief executive of the wholly-owned investment management subsidiary, USS Investment Management, when it was established in October 2012. The formation of that subsidiary marked a significant change in the governance over the resources dedicated to investment management and positioned it for oversight of what was becoming a more complex allocation and organisation.

The investment management company now employs 150 people, a big jump from the 65 Gray inherited in the investment team.

Under his guidance the fund has also developed capabilities internally including a central strategy division,  specialist emerging markets and credit teams, as well as expanding the private markets team.

As a result, one of the biggest changes has been the growth in direct investing in private markets, with the fund now employing about 50 people in private markets.

“The fact the private market activity would develop as far as it has, we would not have expected that at the time,” he says.

In part that has been facilitated by the new USS Investment Management governance structure that meant more decision-making delegated to the investment team with oversight from its board.

“We have a reference portfolio and the granular decisions like what agents we use and how we allocate resides in the investment management company rather than the investment committee,” he says. “In the past, to make strategic asset allocation changes the CIO would make a recommendation to the fund’s investment committee, which was a bit more cumbersome and less responsive to markets.”

As with other investors that work to a reference portfolio, there is a big difference between how the fund allocates capital and the reference portfolio allocation. The implementation of that requires trust from the investment company and pension fund boards.

“Delegation is certainly efficient and it requires trust, transparency and reporting. Creating USS Investment Management was necessary for a number of reasons, but one of the benefits is that this is a complex range of activities and needed an oversight body,” he says. “Trust, transparency and oversight are importantly intertwined. Trust is justified by management and the calibre of the oversight. But there is not one answer to this, each fund has different circumstances and constraints,” Gray says.

Investing directly in private markets has also been a contributor to USS’s fee schedule coming down.

“We are lower cost because we have more internal management and the biggest saving is in third-party private market fees. At our scale what we have done has been cost effective. But our goal is returns after cost, not just costs,” he says.

The fund’s total MER is around 31 basis points, which compares favourably to its CEM Benchmarking peer group which averages around 42 basis points.

What’s next

About two years ago Gray set his sights on his 10-year work anniversary at USS, identifying it as an appropriate time to step down.

“It was a good idea because it’s nice to know how far you’re running. It’s good to put a stake in the ground and plan for the organisation, it’s good for succession planning.”

USS has typically had long tenured CIOs with Gray only the third since the London Investment Office was established in 1981. Not to put pressure on Pilcher.

Gray sees his tenure in three distinct stages, all of which he’s found “fascinating”.

“Investing has been the constant, but otherwise the beginning was about establishing trust, the middle about the governance arrangements, and then more recently, as I’ve prepared to dip towards the tape, it’s been to make sure the platform is robust and in as good as shape as possible.”

“The run out afterwards,” he says, continuing the running analogy, “that’s important for the organisation too”.

But for Gray, this move isn’t just about leaving a job, it’s also leaving a full-time executive role in an industry where he has spent the best part of four decades. His career includes 18 years in commercial funds management, 4 as an advisor and a period as CIO at Hermes before joining USS for the past 10 years.

“Asset management is a lot about conduct under the circumstances rather than outcomes,” he says. “I’ve conditioned myself to ask ‘have I been balanced and focused on whatever challenge arises?’. And I’m proud I’ve used my abilities as best I could”.

“I’m also very grateful for the trust placed in me. It has been challenging but gratifying – the commitment and trust are closely related. At USS we couldn’t have achieved what we have unless there was plenty of support for that. In the asset management industry, it’s not always the case that there’s affinity, purpose and trust.”

Creative space

Gray had somewhat of an academic career before he went into funds management. He spent seven years at university, starting at Oxford where he ended with a degree in Philosophy, Politics and Economics. But it wasn’t clear that economics was his path. He had an instrumental scholarship (he plays the Oboe) and switched between music and PPE. He then went to Harvard University, having received a Harkness Fellowship supporting post-graduate studies, where he also juggled music and economics. He eventually decided on economics as the basis for his career, and was a teaching fellow on two courses: International Trade and Finance and also Commodity and Securities Markets.

Now, it seems Gray’s creative side is pulling at him again.

“I’m giving up a fascinating and brilliant role. Thankfully I’m in reasonably good shape, and I hope still to be of some service to the world. I’m not looking for something else just yet; I’ll have some decompression time first. But If things work out I’d look at doing three things: something good for the world, something commercially interesting, and something good for the soul,” he says. “My creative parts have been squeezed, like reading, writing and music. Parts of me want a bit more space.”

Gray says maybe he’ll “pick up” the manuscript of a book he wrote 18 years ago about what he’s learnt in asset management and life.

“A lot of that is about self-possession. Being present, calm and taking decisions in the face of uncertainty is the core of the job,” he says.

“Investment is like boxing with an unlimited number of rounds, you know you’ll get hit and can land a counter punch. Finding a source of resilience and equanimity is very important, and they’re conjoined.”

 

The EDHECinfra/G20 survey of infrastructure benchmarking practices, which included representatives of 130 asset owners accounting for $10 trillion, has found that existing performance monitoring benchmarks are self-defeating for asset owners and managers. But improvement, in the form of a more representative, better defined benchmarks, may be possible thanks to recent progress. This is the second in a three-part series examining the results of the survey.

Infrastructure investment requires customised performance benchmarking

Performance-monitoring benchmarks differ from the asset-allocation benchmarks insofar as they should represent actual investment choices made when implementing a fund’s investment policy.

In the case of infrastructure, the difference between policy and performance-monitoring benchmarks is all the more significant in that the ability to implement any given style or tilt is itself uncertain: infrastructure markets are notoriously illiquid and in part driven by public procurement and other policy decisions that are not easily predicted.

The implementation of a broad policy allocation to infrastructure may take multiple incarnations: different levels of geo-economic, industrial, or business-risk exposures are likely to require dedicated sub-allocations and will be fully known only after the fact. For instance, the high degree of specialist industrial knowledge required to make investments in any infrastructure sector usually militates for individual sub-strategies or mandates.

Perhaps even more importantly, building large, well-diversified positions in any segment of the unlisted-infrastructure space remains difficult today, given the average time and size of individual transactions.

As a direct result, while policy benchmarks focus on long-term rewarded risks, performance-monitoring benchmarks may require being tailored to an investor’s or their manager’s actual portfolio, and achieving sufficient granularity is very important to benchmark the investments made fairly and accurately.

As discussed in the first part of this series, in a core-satellite context (no relation with ‘core infrastructure’), investors can monitor and manage the performance of asset managers and investment teams by defining a core portfoliowhich is representative of the expected behavior of a given investment style or strategy and a satellite portfoliodefined in terms of its tracking error relative to the core.

In the case of highly illiquid asset classes like unlisted infrastructure in which a well-defined ‘core’ is not directly investible, this distinction remains valid because it gives investors a way to monitor the dual objective given to asset managers: to deliver the core strategy (deal by deal) and to outperform the average as captured by the core benchmark.

An implementation of this approach to monitoring unlisted infrastructure managers can make use of the tracking error given to a manager as a representation of the construction of the infrastructure portfolio: the younger the portfolio, the larger the tracking error. As a portfolio of infrastructure debt or equity increases in size and representativeness, the tracking error should be reduced to only represent the space within which the manager can deliver alpha.

 

Investors acknowledge serious issues with infrastructure performance monitoring benchmarks

 

In the 2019 EDHECinfra/G20 survey, 50 per cent of respondents declared using the same benchmarks for performance monitoring as they do for strategic asset allocation and around 75 per cent of infrastructure equity investors reported using absolute benchmarks for performance monitoring.

In light of the comments above, this is highly problematic. While absolute benchmarks can be a good indicator of target returns, in order to monitor performance adequately investors should use a benchmark that represents their choice(s) of investment policy explicitly defined in terms of risk profile.

In effect, the practices described by investors in this survey correspond more to the definition of a hurdle rate rather than a benchmark.

About 70 per cent of respondents acknowledged that the benchmarks they use for performance monitoring do not allow investors to measure risk-adjusted performance.

When the same question was asked to asset owners only, more than 75 per cent of respondents reported similar concerns.

Almost 40 per cent of respondents also agreed that the use of another asset class as a proxy for unlisted infrastructure equity is a challenge.

Close to 30 per cent of respondents also acknowledged that current private benchmarks tend to report smoothed returns i.e. not to capture risk exposures.

Around 30 per cent of asset owners also said that current industry-peer, money-weighted benchmarks do not allow for a fair comparison of asset managers. Indeed, such indices are sensitive to the timing of cash flows, which can vary across fund managers and can even be manipulated to achieve higher returns.

In this survey, nobody liked their performance monitoring benchmark and would like to use a more representative, better defined benchmark that is informed by actual market movements and risk factors.

 

Better benchmarks can reconcile asset owners and managers over infrastructure investment

 

As in other alternative asset classes, asset owners and managers have long been at odds when it comes to demonstrating value and performance with illiquid asset classes like infrastructure. Managers say they have better deal making skills, while asset owners point to their high fees.

As is well documented this has pushed a number of large asset owners to internalise infrastructure investment decisions because they believe they would be better off investing directly in infrastructure than through third parties.

However, as the answers to the survey demonstrate, asset owners still do not know where they stand when it comes to infrastructure investing because they do not use representative, mark-to-market benchmarks that take their actual strategy and risk exposures into account. Their internal investment team continue to report the same ill-suited metrics they used to get from external managers.

In effect, existing benchmark practices are self-defeating for infrastructure asset owners and managers alike.

Delivering a portfolio of unlisted infrastructure asset in line with a given mandate is hard work and requires skills, time and commitment, whether executed through a manager or internally. As discussed above, delivering the ‘core’ portfolio (as in ‘core-satellite’) creates value and justifies rewarding managers or investment teams.

Furthermore, the lumpiness and average size of infrastructure assets means that even a reasonably well-delivered core portfolio still offers opportunities to create alpha through asset selection and operation.

Hence, a customized benchmarkthat would represent a well-defined investment policy or strategy would help investors determine the value created by the manager or team that creates this portfolio, as well as measuring any outperformance relative to this strategy. In this context, managers can demonstrate the value they create twice: by creating a portfolio that tracks a well-defined benchmark and by outperforming it.

The EDHECinfraindices released quarterly from June 2019 onwards can help achieve the objective of better defining and benchmarking individual investors goals and asset managers value creation in unlisted infrastructure investments.

 

 

ATP is one of only five pension funds globally to officially adopt the FX Global Codeby signing the “statement of commitment to the FX global code”. In addition, ATP is taking part in the Scandinavian FX Committee.

With DKK 838 billion ($125 billion) under management ATP is a significant market participant in the Scandinavian FX market but due to its systematic strategies and global investment universe, our hedging and funding needs span G10 and the most liquid emerging market currencies.

Unlike listed equities that are typically traded on a single exchange during the opening hours of the exchange, the FX market is fragmented into multiple venues with trading 24 hours per day over all time zones. Traditionally, buy-side institutions do not have direct access to these venues but trade FX OTC (over the counter) with their sell-side bank.

The bilateral nature of FX trading calls for fairness and ethical conduct to assure a resilient market, as the sell-side generally has the upper hand in understanding where the market is. Unfortunately, in the past decades there have been several examples of misconduct on the FX market like, for example, the manipulation of fixing orders which has negatively impacted a well-functioning market of mutual trust.

The FX Global Code aims to re-establish and maintain trust among market participants and level the playing field between the buy-side and sell-side.

The FX Global Code is the result of a public-private sector collaboration in which central banks and market participants from 16 jurisdictions agreed to a set of global principles of good practice in the FX market. The code consists of 55 principles split up into six categories or leading principles as they are called in the code: ethics, governance, execution, information sharing, confirmation and settlement and risk management and Compliance.

At ATP we support this effort to promote ethical conduct and a resilient market by signing the statement of commitment. Not only does signing the statement signal what conduct is expected of each market participant but it is also a great opportunity for each market participant to review their own internal business processes.

ATP now has a seat on the Scandinavian FX Committee, which is a local forum where representatives from the central banks, sell-side and buy-side meet to discuss the implementation of the code in the region and the functioning of the Scandinavian FX Markets.

By participating in the Scandinavian FX Committee, we get the chance to discuss relevant matters like for example the market structure and handling of transaction data with peers from a geographically relevant area. At the same time, it is an excellent opportunity to strengthen and enhance our relationship with the central banks and other market participants

FX Global Code is based on six leading principles:

  • Ethics:
    Market participants are expected to behave in an ethical and professional manner to promote the fairness and integrity of the FX market.
  • Governance:
    Market participants are expected to have a sound and effective governance framework to provide for clear responsibility for and comprehensive oversight of their FX market activity and to promote responsible engagement in the FX market.
  • Execution:
    Market participants are expected to exercise care when negotiating and executing transactions in order to promote a robust, fair, open, liquid, and appropriately transparent FX market.
  • Information sharing:
    Market participants are expected to be clear and accurate in their communications and to protect Confidential Information to promote effective communication that supports a robust, fair, open, liquid, and appropriately transparent FX market.
  • Risk management and compliance:
    Market participants are expected to promote and maintain a robust control and compliance environment to effectively identify, manage, and report on the risks associated with their engagement in the FX Market.
  • Confirmation and settlement processes:
    Market participants are expected to put in place robust, efficient, transparent, and risk-mitigating post-trade processes to promote the predictable, smooth, and timely settlement of transactions in the FX market.

 

Thomas Bengtsson is a senior portfolio manager at ATP and the fund’s representative on the Scandinavian FX Committee.

 

 

 

LGPS Central, one of the United Kingdom’s eight new mega funds, will cut the number of asset managers in its £45 billion portfolio from 250 today to around 50 over the next 10 years.

LGPS Central Limited inherited a long list of managers via its nine member funds which ran their own portfolios prior to the government’s decision to create fewer, bigger pension funds for it local employees. According to LGPS Central Limited CIO, Jason Fletcher the list comprises “some good and some not so good relationships. Looking at consolidating the number of managers it uses is consistent with the fund’s priorities which includes cutting investment costs while maintaining returns. And the process is already underway.

In one global equity allocation Central recently chose just three managers (Schroders, Harris Associates and Union Investment) to run a £2 billion global active equity fund. In emerging markets, it has also replaced member funds’ multiple relationships with three managers (LGM Investments, a subsidiary of BMO Global Asset Management, UBS Asset Management and Vontobel Asset Management) and in March it selected Fidelity and Neuberger Berman from more than 70 fund managers bidding to run a global investment grade corporate bond fund.

It’s a shrinkage that will speed up when Central turns its focus on private markets, says Fletcher who adds that liquid assets are typically managed in Authorised Contractual Schemes (ACSs) structures and illiquids in LP structures.

“Change is always challenging, and we need to work with our partner funds which have good relationships with their asset managers to prove the cost and return benefits of switching to fewer managers. It’s not an easy process because there are multiple stakeholders to deal with,” he says.

So far around £20 billion of the member funds’ total of £45 billion is under the stewardship of LGPS Central Limited; a handful of niche portfolios will remain outside the pool including illiquid legacy assets and partner funds’ local investments, he says.

The Cost Transparency Initiative

The Cost Transparency Initiative and its drive to introduce new templates which standardise costs, and charges information for institutional investors, has become an important tool in Fletcher’s toolbox for accurately analysing investment costs.

Most importantly it informs his ability to recommend new funds to the pool on a like-for-like basis, he says.

“The Cost Transparency Initiative has become critical for making investment decisions on the basis of “true” costs. This then better informs investors whether the manager can outperform after costs,” he says.

The fund is targeting £250 million in cost savings by 2034, but needs to balance the need to cut costs with maintaining returns. Asset manager fees also pale in comparison to the steep costs Central has incurred in the pooling process like appointing business partners to provide back office and middle office functions, audit services and full regulatory compliance.

“Setting up a Financial Conduct Authority-regulated single entity has associated costs, but we are fully confident that our investment savings will cover that expense and we will generate better net returns and more robust governance.”

In-house ambition

Another factor impacting the size of the external manager roster is Fletcher’s ambition to run a high portion of Central’s total AUM in house.

“We are very hopeful that our partner funds will look to more in-house and direct investments over time where we believe we can really add more value,” he says.

That said, he recognises the challenge of finding in-house “investment professionals that are better than those that are out there.” Nor is he expecting to do “everything in-house.”

When the fund was formed 18 months ago, 15 staff originally transferred from the partner funds to LGPS Central’s investment office. That number has now grown to around 50 through external hires in an ongoing recruitment drive to build out the investment team and the back office.

“We aim to have 70 employees across LGPS Central Limtied by the end of the year,” says Fletcher, formerly CIO of the £15 billion West Midlands Pension Fund. He is keen nurturing internal talent over external recruitment in the longer-term.

“As soon as possible we want to develop talent from within, and one of our key objectives is also building an investment capability in the Midlands. It’s easier finding talent at the trainee level and here we will look to the talent of the students coming out of local colleges.”

The pooling process will also increase access to new asset classes for some of the partner funds. Partner funds are still responsible for setting their own asset allocation which is typically split between 60:20:20 to growth, stabilising and income generating assets respectively.

Boosted, and in some cases new, allocations will include infrastructure and private equity but also strategies offering downside protection like LDI, says Fletcher.

Central launched a private equity platform earlier this year through which five of the nine member funds have already made two co-investments and some fund investments.

“Those partner funds that are not invested in private equity are starting to consider it. We are looking to make investing here more flexible and lower cost using our economies of scale and again ensuring that cost cutting is not to the detriment of expected returns. We have already made considerable cost savings through a combination of negotiating lower fees and co-investing. It’s also secured better access to the best investment ideas and managers.”

It is worth stating up front that, for us, the value creation boundary is an abstract concept. However, we believe it is a powerful concept, with the potential to re-wire our thinking and re-shape our behaviours.

We value order in our lives. We will pay to have our homes cleaned, but not to have them messed up. It is similar for goods. We will pay up for the highly-ordered final product, but not for the raw materials it is made of. Next, we note that economics has long recognised the concept of externalities – costs or benefits that fall on people not directly involved in the economic activity. From here two things follow. First, that there is a value creation boundary which lies between these innocent bystanders, and the parties involved in the economic activity. Second, that value is created inside the boundary and destroyed outside it. In other words, the externalities are, in aggregate, negative. Several questions spring to mind: who are the insiders, and who are the outsiders? Where should we draw the boundary, and are there consequences to that decision?

The planetary reality

The tightest boundary we can draw is around a single individual. So I derive value from my home being cleaned but tend not to think about the impact outside my boundary. These impacts include, first, the production of chemicals used to clean my home, and their escape from my home as waste; second, my share of CO2 emissions from the electricity powering the vacuum cleaner; and, third, the fact that most of the vacuum cleaner will end up in land fill at the end of its life. Having considered my impact outside the boundary I have a choice to ignore it, or to adjust my cleaning mandate (only lemon juice and vinegar? More sweeping and less vacuuming?).

Switching to the widest possibility, we could draw the boundary around the earth’s atmosphere. In this framing, we recognise the earth as a largely-closed system (so a good idea to maintain the life-support systems) with the free input of solar energy, and the ability to costlessly dump excess heat into the universe. If I adopt this mindset then I probably do need to limit my cleaning chemicals to lemon juice and vinegar, and in aggregate we will only be able to extract lemon juice at the rate the earth is able to replenish the crop. In addition, I ought to ensure my electricity comes from renewable sources, and that my vacuum cleaner was designed with a circular economy mindset (rather than a linear use-then-throw mindset).

Where to draw the boundary?

The logic of the value creation boundary is that the more tightly we draw it, the larger the domain over which we are having a negative impact (this doesn’t mean the negative impact gets bigger). Further, this engenders an adversarial, negative-sum environment. To create value for our small group, we need to be able to dump harm on some other group. However the other groups know this, and have the same incentives. In case this is too abstract, think about the choice between divestment and engagement. Divestment is nothing other than my group dumping unattractive securities on another group. Not wrong, but not positive sum either. Engagement runs the risk of still holding securities with a collapsing value before business models can be adapted. But it can be a positive sum activity, and it signals a ‘wider boundary’ mindset.

The more we expand the boundary the more of humanity we include. This carries the advantage of reducing the antagonism between groups, but the substantial disadvantage of removing cheap dumping grounds for the waste of the economic activity we invest in.

If we choose not to draw the value creation boundary that widely, we are identifying that we hold one or more of the following beliefs or values:

  • My investment time horizon is sufficiently short that I do not have to worry about potential negative consequences over the longer-term
  • I am subject to fiduciary duty, which I interpret to mean my responsibility is solely to maximise the next period’s risk-adjusted return
  • I am powerless to influence externalities so there is no point expending any such effort
  • I recognise the importance of addressing externalities but prefer to be a free-rider on the efforts of others
  • My ideology does not support this action. I believe unconstrained free markets produce the best outcomes, so if the externalities matter that much someone will create a profitable business to address them
  • My values do not support this action. I care passionately about my group [ie clients / members] but have no regard for anyone outside this group.

The above list does not reflect my values and beliefs, but they are valid – at least somewhat. The point is that the value creation boundary is a thinking device. Each investment organisation, whether asset owner, asset manager or other service provider, will need to work out where to draw their own.

Back to the planet

There is a growing recognition of the validity of ecological boundary conditions (eg Rockström et al (2009), Future-Fit Foundation, Doughnut Economics (2017) etc). Due to the scientific foundation of these boundary conditions we do not need a values-based discussion to support them. We accept that beliefs may differ but, by definition, valid beliefs must be consistent with the available data, and so the range of disagreement is constrained.

If we return to people, then drawing the value creation boundary around the atmosphere includes all of humanity. We are saying that value must be created for all humans, not just subsets. This is the UN’s sustainable development goal. Accepting some degree of responsibility for these social goals is necessarily (but not exclusively) values-based. And values can legitimately vary widely. For our part (ie mine and TAI’s value creation working group members), we believe that all investment organisations should develop the beliefs and values to support this social floor, as well as the ecological ceiling.

So what?

Where we choose to draw the value creation boundary will impact our subsequent actions. It will determine which business models are appropriate to be in the portfolio, and which should be excluded. It will influence decisions over the provision of new capital. And how seriously to take voting and engagement. It may influence new thinking over the structure of incentive arrangements. Where and how organisations choose to draw this boundary is carried forward in new research, published by the Thinking Ahead Institute, entitled Mission critical: understanding value creation in the investment industry.

We believe the zeitgeist is shifting such that society will increasingly expect corporations to take greater responsibility for a wider set of issues affecting a bigger group of stakeholders. The value creation boundary is a powerful concept to help guide the thinking regarding which issues, and which stakeholders.

 

Tim Hodgson is head of the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute (TAI).