We believe there is a strong link between patience and successful long-term investing, for two reasons. First, patience differentiates between long-horizon and short-horizon investors. Second, patience must be seen as a depreciating asset. Left unmanaged, it will erode and lose its value.

Our thesis comes from Patience: Not merely a virtue, but an asset – a paper I co-wrote with Geoff Warren of Australia National University and Liang Yin of the Thinking Ahead Institute – and has two main components.

First, patience has value, because it supports the ability to invest for the long term and allows the maintenance of losing positions. Second, patience running out is bad, because it can trigger a value-destructive sale (capitulation) and sends the wrong signals, which can undermine the capacity to exercise patience in the future.

Consider an investment that has a high chance of delivering a handsome return. The only problem is that we don’t know when. The return could materialise tomorrow or years down the track. What type of investor would pursue such an investment? Clearly, one with patience. They must not be too concerned with when the payoff might arrive. They must be able to stay the course if the payoff is delayed. Being able to pursue such investments opens a class of potentially rewarding opportunities that an impatient investor might overlook.

How does an organisation build and sustain patience? The query becomes somewhat more complex when there are multiple levels of two-way relationships and the need for patience to span those levels. Nevertheless, we suggest that a simple, generalised model with four elements can be used to explore solutions:

  • Two levels, such as principal/agent, or governor/executive, but more generally a high-level party and a low-level party. Exclude the single-level case of the principal investing on their own behalf. The two-level idea applies between board and in-house executive within asset owners, between asset owners and asset managers, and between boss and employee within asset managers.
  • The stock of patience resides with, and is controlled by, the high-level party.
  • The low-level party operates under a mandate while patience remains in supply. The manner in which this is done influences the principal’s stock of patience.
  • There may, or may not, be a shared understanding of the presence of patience, let alone agreement over the role it plays. We assert that the best relationships and investment outcomes involve mutual agreement over the need for patience.

It is important to note that patience alone does not lead to investment success. Patience is no substitute for skilled investment analysis but, assuming genuine investment skills are a given, what difference does patience make? The answer depends on how capital is allocated.

An investor has, broadly, three options for allocating capital:

  • Risk-free assets: these give a 100 per cent likelihood of a very low return.
  • Price-to-price investing: this is Keynes’s beauty contest game. It entails predicting the movement of the psychology of the market. The prices at which you buy and sell are what matter.
  • Price-to-value convergence: here there is a high likelihood of an attractive payoff, and skill relates to accurate assessment of the value. But there is also the possibility that price and value remain divergent. The divergence might even get larger before convergence occurs.

Clearly, for the first option, patience makes no difference. The second option is a noisy, zero-sum game and so doesn’t seem a natural place for patience to make any difference. For price-to-value convergence, however, we argue that patience is everything.

If price diverges from value, the investor has three options: sell, concluding that their analysis of value was wrong; do nothing; or add to the position, as the prospective return has increased. It is patience, an intangible asset, that allows an investor to pursue option the second or third option.

We believe the benefits patience brings are an expanded opportunity set, protection against value-destructive short-horizon behaviours such as selling low, and reduced transaction costs as a consequence of lower portfolio turnover.

We assert that, in all but trivial cases, patience will be tested. This is why it should be viewed as a depreciating asset. Hence, it is important to understand what causes patience to wear thin, and what can be done to build and maintain it. We recommend organisations build the stock of patience from the start. This can be achieved through: gaining organisation-wide buy-in; creating an investment process based on long horizons; hiring the right people; and building a long-horizon culture. The stock of patience then needs to be maintained by: working on retaining trust; offering the right incentives; framing performance in the context of long-term objectives; and having leadership from the top.

We do not argue that long-horizon investing is easy. Nor do we claim it is the only way to generate strong investment performance or that it is appropriate for all. Nevertheless, it can be well worth the effort for organisations that manage on behalf of savers with long-horizon goals, and that are capable of positioning themselves to do so. For such organisations, we believe it is helpful to view the building and maintenance of a stock of patience as essential.

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

The $29 billion Employees Retirement System of Texas is planning to increase its alternatives allocation over the next four years.

The increased portfolio, which will be funded by a reduction in public equity, will give ERS a 37 per cent allocation to a mixture of private equity and real estate, infrastructure and opportunistic credit, explains chief investment officer Tom Tull, speaking from the fund’s Austin headquarters.

Tull notes, however, that the fund’s long-term commitment to increasing the alternatives allocation is balanced by current market conditions. For now, ERS continues to sell down the private equity portfolio in the secondary market and kill more deals than it adds, because of manager fees and expenses. He likens this strategy to the fund’s mass liquidation in hedge funds last year, when it took a third of the portfolio off the books in a strategy that in no way reflected ERS’s long-term commitment to hedge funds.

About 83 per cent of ERS’s assets are in return-seeking investments versus 17 per cent in risk-reducing allocations of absolute return, rates and cash. The increased alternatives allocation will reduce public equity from 45 per cent of assets under management to 37 per cent.

 

Inside and out

Tull is combining the push into alternatives with building out ERS’s internal high-yield team to position the portfolio to benefit from the next credit cycle. The allocation will increase to between 10 per cent and 13 per cent of assets under management over the long term, he says.

“Most people farm out their high yield or credit with managers, but it makes sense for us to build an internal team, save on fees and add to returns,” he says.

The fund manages about 60 per cent of its AUM internally, spanning the credit book and most of the public equity allocation, bar a handful of external allocations with managers, including Templeton, BlackRock and Acadian. In fixed income, managers include Bain Capital Credit. Internal management saves on fees and adds to the return but recruiting and holding onto strong internal teams is challenging, as more institutional investors bring assets in house, Tull notes.

“We can manage money internally for 11 basis points, whereas if it’s done externally, it’s three to four times that,” he says.

Reflecting on the success of the opportunistic credit allocation within high yield, Tull notes it has done particularly well since Dodd-Frank, the US regulation that introduced stress tests and capital requirements for banks, which restricted their ability to lend.

“Lots of the banking community were forced out of segments of their business,” Tull says. “We were able to go in and pick up deals at very good prices, particularly in the energy sector, where we have [relevant] perspective coming from Texas, and are now reaping that harvest.”

Looking ahead, he expects to be opportunistic in pockets such as airline and real-estate financing, mezzanine finance, and distressed and structured credit.

“Given the capabilities we are developing internally, we will be able to reach some of this,” he says.

ERS has multiple manager relationships in private markets and alternatives; it invests with 49 private real-estate managers, 90 private equity general partners and 18 hedge funds, typically writing cheques of between $50 million and $200 million, and actively seeking roles on advisory boards and co-investment opportunities. Tull says that’s where his internal team gives ERS an edge over competing limiting partners.

“We can analyse a co-investment deal in a week because we have the internal people.”

Emerging managers, emerging markets

Emerging managers are also an increasingly important component of ERS’s manager roster, to tap diversity and talent. An active emerging manager program at the fund now aims to adopt emerging managers to represent 10 per cent of ERS’s manager base. Opportunities to invest are growing, Tull enthuses.

“These firms are much smaller, and they are more open-minded to fee negotiations,” he explains. “There are niches in the market place that they can exploit, and we can get alpha and more competitive fees.”

In private equity ERS invests with an emerging manager fund affiliated with GCM Grosvenor. In public equity, it invests with Legato Capital Management, which runs a fund of funds over small-cap international managers.

Tull is also planning to work with emerging managers in hedge funds. ERS is poised to invest in a fund of emerging manager hedge funds comprising absolute return and return-seeking strategies.

“It is a seeding mechanism, so we will have a revenue share,” Tull says. “Wherever we can get a revenue share – and we’ve done this on the ETF side in fixed income – we’ll take this opportunity if we are comfortable with the dynamics involved.”

The seed investment mirrors ERS’s wider hedge fund strategy, which combines return-seeking and diversifying, or low correlation, plays. Managers include biotech hedge fund OrbiMed, and Marshall Wace.

Allocating to emerging markets is also a growing priority in the fund. Tull likes the demographics and future spending power in many emerging economies and looks forward to developments such as Saudi Arabia’s possible reclassification from standalone to inclusion in MSCI’s Emerging Market Index. It’s in marked contrast to the often shrinking opportunities in developed public markets, he says.

“In the US, there are now more ETFs than publicly traded companies. Over half of US-listed companies trade less than 100,000 shares a day.”

Elsewhere, ERS has found emerging-market opportunities in real estate from call-centre businesses relocating to the Philippines from India.

“We have helped provide bridge financing for some of these call centre developments in the Philippines,” Tull says.

Sometimes change is hard to swallow. This is especially true when there is nothing wrong, so to speak. In organisations whose business is managing superannuation assets, change seems to be a particularly hard concept to embrace. But across all industries and all pursuits, the best-performing businesses are in constant evolution.

HESTA, the $43 billion fund for health and community workers, has performed well. It has served its members, generating 8.82 per cent since its inception about 30 years ago.

The fund is one of the more established in Australia and grew up in the old-school industry fund era, with a strong focus on its members, who are mostly women and low-paid workers. In 2015, Debby Blakey became chief executive, when Anne-Marie Corboy left the fund after 16 years in the top job. Under Blakey’s reign, HESTA has embraced change, including a fundamental look at its investments.

This began about 18 months ago, with a project of transformational change led by Willis Towers Watson, developing ground-up investment beliefs and an examination of what would drive the fund’s competitive advantages and governance framework.

An investment committee was established 12 months ago, and former head of the Future Fund, Mark Burgess, was appointed independent chair; previously, HESTA had never had such a committee, with the whole board performing this function.

In more change, Angela Emslie, who has been on the board for 24 years and chair of the fund since 2010, will step down at the end of her term.

The final piece of the investment puzzle was to choose a new chief investment officer; Sonya Sawtell-Rickson, former investment director at QIC, was appointed last July.

“The world has evolved materially and we thought our success in the future would be based on different things than in the past,” Sawtell-Rickson says. “Scale will allow different opportunities and my job is to help implement that. We are still very much focused on members.”

Total-portfolio approach

The fund is expected to grow to $100 billion in the next couple of years. Sawtell-Rickson’s role is to look at the whole investment management function, which up until now has been mostly external and organised around siloed asset-class functions.

“My role is to turn strategy into action. We had a blank sheet of paper, which was one of the exciting things for me in joining,” she says.

The team identified a number of things it wanted to address. The first, and arguably the most important, was to reorient the business to a total-portfolio approach. Many large funds use this model to great success, notably world-class organisations Canada Pension Plan Investment Board, the Future Fund and New Zealand Super.

Willis Towers Watson global head of investment content Roger Urwin, who led the transformation with HESTA, says there are benefits to a fresher approach to capital allocation.

“Mandates are subject to tracking error but that is not the risk the fund is really interested in,” Urwin says. “Total portfolio management is worth about 50-100 basis points [above] strategic asset allocation.”

A move to a total-portfolio approach (TPA) has meant reorienting teams away from asset classes. Sawtell-Rickson says the advantages of this include the ability to be more agile with opportunities, and flex up and down the risk curve.

“As an example, we didn’t want an Australian equities manager playing a theme we thought was meaningful but that didn’t get out of the asset class and so didn’t affect the total portfolio,” she explains. “We have changed the way we approach ideas so we can get to the total-portfolio level. For that, you need the right benchmarks, incentives and behaviours.

Cultural shift

“The core of TPA is a mindset and cultural shift. The first step is to get people to understand the case for change.”

To that end, monthly strategy forums have been introduced where the whole team is part of the conversation.

“These meetings differentiate between strategy and risk. They enhance idea generation and encourage action across asset classes,” Sawtell-Rickson says. “We are focusing on harnessing our collective intelligence – how can we do things better, differently and be more adaptive.”

As part of the cultural shift, the fund will introduce incentive pay for the first time. While the specifics are yet to be determined, it will apply to the senior investment team and be focused on the total portfolio.

“This is an area of focus for industry funds and we’ve taken it seriously and carefully. But we’re in a competitive market and would end up paying higher bases if we didn’t pay incentives,” she says.

Similarly, benchmarks are being reviewed, with a move away from static strategic asset allocation and more towards deciding how much risk the investment committee wants to take on. (The Future Fund uses equity beta and bond beta. HESTA will use a similar concept.)

Space for ideas, research

HESTA is still a small organisation and the agile decision-making this allows is not lost on Sawtell-Rickson.

Her focus is on improving alignment, building collective intelligence and contributing to the deal flow, all with the purpose of better outcomes for members.

“As a woman in finance, having a membership that is 80 per cent female is very special,” she says. “It’s wonderful having the one purpose – solely to produce strong investment returns to members.”

Under her leadership, HESTA will launch a research and innovation lab where all ideas can be captured and the team will vote on them. The priority ideas will be those that have conviction, are measurable and actionable.

There will also be longer-term research priorities, with themes such as climate change, demographics and long-term investing.

“The ideas can come from managers or internally and we’ll use them in a practical way; for example, [we’ll ask if we] can amplify trades that managers are doing or if there’s a theme more broadly on one of their trades,” she says. “It’s around differentiating ourselves in the investment market – how can we be a strong and respected partner, and articulate our thinking and edge clearly.”

One of the research pieces being undertaken is called “level playing field”. This will compare, for example, unlisted real estate, high-yield debt and insurance opportunities.

“We can be nuanced and timely with how we approach that. We can make strategic decisions every day,” Sawtell-Rickson says.

TPA is one of four workstreams Sawtell-Rickson has been driving. The others are long-horizon investing, the investment value chain, and the investment operations and internal model.

HESTA employs 17 investment professionals. With its ambitious growth plans, it expects to double this over the next 12 months; in particular in quantitative analysis, research and execution. The fund is also in the market for a new general manager of quantitative solutions and risk, and will add top-down risk analytics to the team.

Sawtell-Rickson will then have four general managers reporting to her: Andrew Major, who looks after unlisted assets; James Harman who is responsible for listed; Gary Gabriel who is in charge of strategy and risk; and the new quantitative solutions general manager.

Underneath that structure, there will still be investment managers who specialise in asset classes, but the focus will remain on the total portfolio.

“Part of the challenge is how we bring them together; the listed markets skillset is different to the unlisted,” she says.

Dynamic asset allocation is a daily process, in which the team looks at where the markets have moved and

makes decisions around that. Unlisted assets, however, are more medium to long term and it’s more difficult to make decisions around market movements.

“As a broad principle, we don’t have a skill edge in predicting markets over 12 months,” Sawtell-Rickson says. “Our forward-looking valuations over three to five years are more predictive, and we have an advantage with our patient capital.”

Patience pays

Long-horizon investing has been identified as one of the advantages of the fund, and Sawtell-Rickson says it provides unique opportunities.

The most obvious of these is the illiquidity premium, which doesn’t just mean allocating to unlisted and other long-term investments; the fund also can be a provider of liquidity and access sellers and buyers of assets at different points in the cycle.

“We are challenging ourselves to think about some of the structural things in the investment chain,” Sawtell-Rickson says.

As an example of this, she points to infrastructure and whether direct investments, and more evergreen exposures, make sense.

Engagement, alignment

The fund is also focusing on better alignment of its investment managers and other agents to the long term.

Last year, HESTA’s engagement partners – the Australian Council of Superannuation Investors, Regnan,

and Hermes EOS – conducted 464 meetings with companies. HESTA is encouraging its investment managers to elevate engagement as a priority.

The fund is also looking to work with managers differently. And while there is no set target for internal management, the fund buys into the potential improvement in alignment, costs and insight that in-house work can bring.

HESTA has 81 manager relationships. “We want to re-craft our partnership engagement,” Sawtell-Rickson says. “We want fewer and deeper relationships, and to be an investor of choice.”

HESTA also wants to leverage its scale on costs.

“We want to make sure where there is scale it is being used as operating leverage. There has been profit capture the partner side as FUM has grown. We want to take a fresh look at that.

“We want to work with managers to develop improved fee models, which reward strong performance, long-term partnerships and member alignment – with a focus on not inappropriately leaving cost on the table. HESTA has differentiated itself through its incredibly strong purpose and unique membership and we are looking for alignment through agents and partners who want to share in that.”

 

TCorp has undergone a revolutionary reorganisation of its investment team that has resulted in many of its staff having to re-apply for their jobs.

TCorp, is the third largest institutional investor in Australia, behind the Future Fund and AustralianSuper, and manages the assets of the state of New South Wales. It was formed in 2015 by the amalgamation of State Super, TCorp and insurance funds.

The fund has been undergoing a comprehensive organisational restructure, under the guidance of Roger Urwin, global head of content at Willis Towers Watson, which has resulted in the re-organisation of its investment functions.

The TCorp investment team, previously organised along sector lines, will be more centralised around investment advisory, portfolio construction, exposure management and partner selection, chief investment officer Stewart Brentnall said.

The current positions of a number of staff will be terminated and those employees will be invited to join the new partner selection or portfolio construction teams, Brentnall confirmed.

The A$92 billion ($70 billion) TCorp investment team numbers 35 and will grow to about 55 in the next two years, Brentnall said.

Under the previous structure, TCorp’s strategic asset allocation work was centralised and the portfolio then passed on to sector teams to populate, with each team responsible for finding the right fund managers.

“This meant we had de-centralised portfolio construction and a large number of manager search and management processes,” Brentnall said.

Under the new structure, the investment and asset allocation team will be split into an investment advisory function – headed by Steve McKenna – and portfolio construction function yet to have a head appointed.

The investment advisory function will be where the initial set of investment decisions will be made with TCorp’s three clients – NSW Treasury, State Super and icare. This includes establishing investment objectives, liability analysis and determining the client’s detailed risk appetite.

“It is critical to understand the client, in a lot of depth and what their needs and constraints are,” Brentnall said.

The next phase in the new structure is portfolio construction, with a new leader for that function to be hired from outside the organisation.

TCorp’s portfolio construction team will be responsible for building a client-centric portfolio, analysing and constructing this from a “whole-of-portfolio” perspective, considering risk, cost, liquidity and “complexity” budgets.

“In my view, two things needed to change,” Brentnall said. “We needed portfolio construction to be fully centralised, where previously much of it was decentralised down to the sector level. And we needed partner selection to be a single, consistent process.”

Where individual sector teams were previously responsible for manager selection and monitoring, a partner selection team has now been established that will be responsible for all lifecycle management for all managers. A new head of the partner selection team, also yet to be appointed, will design a process to be consistent across all sectors, Brentnall said.

The partner selection team will also be responsible for embedding stewardship and environmental, social and governance concerns – led by Lucy Thomas – and for building and managing a strategic partnership program.

TCorp has about 80 manager relationships, and Brentnall said it was expected that there would be fewer managers, and more deep relationships, in the future as the model evolved.

The partner selection team will also be responsible for developing a peer engagement strategy for idea sharing, collaboration and co-investement.

TCorp manages about $25 billion in Australian cash and bonds in-house, plus about $12 billion in direct property and infrastructure.

There are no immediate plans to bring more assets in-house, Brentnall confirmed. Direct investments and cash and fixed income will not be affected by the restructuring and will remain direct reports to Brentnall.

The other change to the structure is that exposure management, which was previously outsourced, will now be managed in-house.

“The implementation of strategic asset allocation, tactical asset allocation, managers, daily cash flows and rebalancing will all be done internally,” Brentnall said.

This means investment implementation will move from operations into the investment team. General manager, investment implementation and operations, Jonathan Green, will leave the organisation after 13 years, and investment operations will now report to chief operating officer Paul Smith.

Green was instrumental in moving TCorp from three custodians to one custodian following the merger.

TCorp is also prioritising its technology strategy and delivery and will move that function from reporting to the COO to a seat at the executive committee level, reporting to chief executive Deverall. A new head of technology will also be recruited.

Brentnall said many organisations build their investment processes, measures, objectives and incentives around decentralised activities and measures that are not necessarily consistent with client objectives.

“What we are trying to do with our new structure is have clearer alignment of activities and processes so each part of the structure and operating model better relates to and serves our clients.”

Brentnall will have seven direct reports in the new structure, three of which are yet to be hired.

The aim is to have the first phase of the new structure complete by July 1 this year, with the expectation that several of the leadership positions may take a little longer to fill.

There will be a team of five in partner selection, a team of 10 in portfolio construction increasing to about 16 in two years, a team of six in investment advisory, a team of three in exposure management, a team of 10 in direct investments and a team of eight in cash and fixed income.

CFA Institute chief executive Paul Smith is pretty clear the industry has had a “good ride” and that a fundamental shift in some behaviours and practices will be needed to regain trust from clients, probably including a reduction in salaries.

“The old saying is true, trust takes a lifetime to build and a second to lose,” Smith says. “We have arguably destroyed it over time but 2008 was the last straw. It’s going to be a lifetime of rebuilding trust with the public and will have to include looking at the old structures and recruiting practices. What are the incentives for the old guard to change?” he asked.

Smith was speaking with Top1000funds.com in his hometown of Hong Kong and feeling nostalgic for the smells and sounds of the vibrant city, where more than 2000 delegates attended the 71stCFA Institute Annual Conference, which had closed just an hour earlier.

At the beginning of the year, he moved to Charlottesville, Virginia, where CFA is headquartered, keen to be closer to the majority of the team. He is three-and-a-half years into his five-year commitment as chief executive of the organisation, and has some firm agenda items set out for the next 18 months.

Initiatives to rebuild trust

He says the steps for rebuilding trust include increasing the number of charterholders from the current 150,000 in 65 countries.

“Professionalism is at the core of what we do, and we need to talk more loudly about that,” he says. “We deserve a thrashing if we can’t self-police, what other option is there other than regulation. A professional body is the answer, as it has an element of self-regulation. That can complement the regulator, which should be the backstop. Instead, the regulator has been forced onto the frontline all over the world.”

The CFA Institute has a number of initiatives in the works, including the Future of Finance, and publications the Future State of the Investment Professionand the Investment Firm of the Future, which are aimed at the industry taking on some responsibility for the trust crisis.

“At the moment, we have an industry rather than a profession; people are selling something, not providing a service,” Smith says.

He believes cognitive diversity in the industry is central to changing this, which means changing hiring practices.

“The industry is anchored around alpha, and a male, testosterone-fuelled ethic. We need to centre it around people who are motivated by service,” Smith says. “The skills of the future will be more soft, around empathy and how to translate solutions for people. Employment will be based on an ability to talk to people.”

CFA charterholders make up only 9 per cent of the industry that looks after other people’s money. But there are many benefits a professional body can bring, Smith says.

“Our charterholders have to sign an annual statement,” he explains. “If we keep reminding people about their commitment, they behave better. Ethics are situational.”

Every year, the CFA takes charters away from about 10 charterholders who it deems to have misbehaved. It suspends a great deal more than that.

“We also look at about 350 conduct cases every year,” he says. “All are public, and about one-third are proved.”

A metric for motivation

A 2016 report commissioned by the CFA Institute in collaboration with the State Street Center for Applied Research, Discovering Phi: Motivation as the hidden variable of performance, examines the motivations of finance industry participants. The report measures phi, which it outlines as the combined motivational force of three key ingredients: purpose, habits and incentives. It shows that a 1 per cent improvement in phi can be associated with a 28 per cent increase in the odds of excellent organisational performance, a 57 per cent increase in the odds of excellent employee engagement, and a 55 per cent increase in the odds of outstanding client satisfaction.

The report states that 53 per cent of asset managers and other intermediaries say that although they originally pursued their career because they were passionate about financial markets, they feel that the industry has disconnected from its true purpose.

Just 28 per cent of respondents worldwide said they remain in the investment management industry to help clients achieve financial goals.

“Wanting to help people is not on the list of what motivates finance professionals, but if you look at other professionals, like doctors, helping [people] is high on their list of motivations,” Smith said. “Our profession has created real value for our clients, societies and ourselves. We don’t say that enough, or explain it enough. We must proclaim our sense of purpose. If the industry rediscovers its sense of purpose, we can martial the finance in the world towards its problems, like financial inclusion, poverty and climate change.”

Lower salaries

The industry is also changing in ways, Smith says, not the least of which is that investment management margins are under pressure.

“We will have to pay people less,” he asserts. “Automation will bring more consistent advice to people at a cheaper price. This is a very fat industry. But the good news for young people wanting to work in it is that there is still a very good standard of living and you’re not down a coalmine.

“Over time, this industry will be less well paid than it is today. My generation has been in the right place at the right time. But the positive message is to do it because you love it and want to deliver something to your clients.”

CFA is addressing the changing skill-set finance professionals require by offering courses for charterholders after they complete the CFA curriculum.

“A profession is not a one-and-done thing, but needs a commitment to ongoing learning. We are offering courses in soft skills, such as empathy and strategic thinking.”

One example of this is a CFA workshopwith the Royal Academy of Dramatic Arts that teaches self-expression and presentation skills.

But Smith also admits that the core CFA curriculum will need to be extended beyond just technical competencies.

“We believe the CFA charter is the appropriate level for people who look after other people’s money, and we will try to get the message out about the CFA, and our role as a professional body,” he says. “Our success can be measured by [whether the number of charterholders grows], but also by things like whether we can detect policy intricacies that we put forward being adopted. The softer side is more interesting but slippery by definition. For me, it’s about the level of discourse. I like BlackRock’s Larry Fink talking about the future of capitalism and the fact there are now a lot of events [regarding] connecting finance to a sense of purpose.”

 

Canada’s C$95 billion ($74 billion) AIMCo is already renowned for its willingness to experiment and an eclectic mix of assets that includes a Chilean utility and BBC Television Centre in London. Now the asset manager is pushing innovation further, taking ownership stakes in energy groups and hedge funds, using new technology to boost efficiency, and going after private equity with renewed gusto.

“Winning in today’s market is about trying to be a little [more clever] in what you do and looking harder, rolling up your sleeves, and also optimising costs,” says chief investment officer Dale MacMaster, speaking from the fund’s Edmonton, Alberta, headquarters.

Package deals

Just under a quarter of the portfolio lies in inflation-sensitive assets, where strategy is undergoing a shift. Rather than invest in an individual infrastructure asset, AIMCo increasingly seeks out investments that bundle together a developer, existing assets and a deal pipeline, all in one. Earlier this year, AIMCo invested in two wind-energy projects in Alberta with the renewable energy division of Milan-listed global group Enel. This first step will lead to transactions in other regions. Similarly, in one of the largest clean-energy deals to date, AIMCo partnered with AES Corporation to buy US solar energy giant sPower from hedge fund Fir Tree Partners late last year. That partnership is also fuelled by an ambitious growth plan and follow-on acquisitions.

“It is no longer just about buying a bridge or buying a road,” MacMaster says. “It is about partnering with like-minded people who share your outlook on due diligence and risk and return, are good at operating assets, and can be nimble.”

It’s a similar theme in the real-estate strategy. In 2016, MacMaster oversaw the purchase of a 27 per cent stake in US real estate investment trust WPT Industrial, which invests in industrial properties such as warehouses and logistics and distribution centres. It means AIMCo can access one of the fastest-growing real-estate sectors in the US, tap into WPT’s expertise and share costs, rather than buying assets directly or using expensive external managers. It also opens the door to transactions with WTP involving assets that may not necessarily go into the REIT.

MacMaster has even applied this principle to the hedge fund strategy, some of which is run in-house – such as volatility- and event-driven plays – and some of which is with external managers, including global credit firm Blue Mountain and multi-strategy firm Paloma Partners.

Mindful of both costs and the fact that AIMCo will never have the resources to develop internal expertise in all strategies, the fund has bought a minority stake in US hedge fund DFG, which specialises in structured and leveraged credit. AIMCo had already invested in the equity, mezzanine and rated tranches of DFG’s collateralised loan obligations. Purchasing the ownership piece, in 2016, took that participation one step further, optimising the cost structure in the process.

“We would like to do more of these platform investments, where we can access specialised teams, but don’t want to pay 2 or 20 or even 1 and 15,” MacMaster said. “By owning a share of the company, we are able to optimise this. Private debt will be another growth area for us. We may look to do something there.”

MacMaster is taking the private debt allocation down paths where few pension funds have ventured in other ways, too. Strategy will now include fund lending, adding to existing allocations to private mortgages, and middle-market loans in Europe and the US. AIMCo will extend credit facilities to private equity firms via a subscription funding strategy in partnership with a large UK bank hitherto focused on mid-market loans. Fund lending is a downshift in risk from mid-market loans, which MacMaster believes are frothy thanks to the extended credit cycle.

“Many loans are covenant-light, and companies are getting credit extended that probably shouldn’t,” he says.The strategy has a return of about Libor plus 160 basis points. It is also dominated by major banks.

In-house for equities

Although about 80 per cent of AIMCo’s assets under management is handled internally, MacMaster uses external mandates in equity more than in any other allocation. Here, the split is 65/35 internal versus external management, with allocations to about 10 managers, including UBS and Blue Harbour. Managers tend to run high-conviction strategies in smaller portfolios, an approach that has done well recently since correlations in equity markets have dropped, creating more of a stock-pickers market.

AIMCo’s internal equity teams focus mostly on factor-based approaches, selecting stocks using value, momentum and quality, although innovation to add value to existing quant models is a constant theme; for example, staff recently added additional factors to the minimum variance portfolio, employing a value tilt and a quality tilt to outperform the benchmark.

“Our ability to refine our quant models is keeping us ahead of the curve,” MacMaster says.

He hopes to run the same kinds of quant strategies in-house for the Chinese market, where he is increasingly focusing the equity portfolio in anticipation of explosive growth ahead. AIMCo recently invested in BlackRock’s fund targeting China A-shares, a market dominated by retail investors. BlackRock’s active strategy sifts through a potential universe of 3000 stocks, using traditional quantitative insights along with big data and machine learning. Investing in the fund could lead to a similar internal allocation in the future.

“It follows a model we’ve used for years when we extend into new geographies and new asset classes,” MacMaster says. “We tend to use a manager, then co-invest, and as we develop expertise, we may bring those strategies in-house.”

AIMCo is also using data and artificial intelligence (AI) to develop its operational efficiency, exploring a more sophisticated tactical asset allocation model via an early-stage partnership with experts at the University of Alberta. The partnership is also looking into how AI and quantum computing could develop a more robust rebalancing model. AIMCo rebalances when equities are about 3 per cent overweight, but MacMaster says this could be refined.

“It’s about finding that optimal spot between rebalancing too frequently, and the cost of that, versus letting your winners run,” he explains.

Private equity’s middle market

AIMCo has a 4 per cent allocation to private equity, where recent strategy has focused on investing in smaller funds of between $500 million and $1 billion, instead of big funds often 10 times the size, which are less plentiful. It means a reduction in operational capability and more key-person risk, but it also allows access to top-quartile mid-size managers, which is easier than getting into top-quartile large-cap funds, where demand outstrips opportunity and trillions of dollars of dry powder make fee negotiation almost impossible. Strategy also includes co-investment, where AIMCo has a proven in-house capability to go direct and can position itself as one of the larger limited partners in smaller funds.

Indeed, accessing top-quartile managers in the middle market now lies at the heart of a private equity strategy MacMaster wants to expand to 10 per cent of AUM. AIMCo’s member funds decide their own strategic asset mix and convincing their boards to increase allocations will be a long process, but MacMaster is convinced of the benefits.

This follows on from AIMCo revisiting the private equity portfolio three years ago in an analysis with Bain Consulting. The process examined the difference in performance between top-quartile and medium-quartile managers, revealing that the best outperform those on the rung below by as much as 10 per cent.

“If you can access top-quartile managers, you can do really well, and this is what attracts us,”MacMaster says, adding that this large difference is unique to private equity. In other asset classes, the difference between top and medium managers is much more compressed – in fixed income, for example, it is just 25-50 basis points. The analysis also reaffirmed private equity’s persistence of performance, which also distinguishes it from other asset classes.

“Top-quartile private equity managers in a first, second and third fund are also very likely to be in the first quartile, or at worst second quartile, with their fourth. This contrasts to public equity, where you actually get a reversal to the mean,”he explains.

AIMCo has begun to adjust its allocation, build relationships and sell itself to general partners. It has met with about 350 mid-market funds and carried out a deep dive with 50, which has resulted in seven or eight commitments totalling about $800 million so far.

“We want to build the allocation because, from where we sit, it has the most attractive characteristics,” MacMaster says. “Over the long run, private equity outperforms everything else.”