The world’s largest investor, the $1.4 trillion Japan Government Pension Investment Fund, has restructured its active manager fees to pay only for alpha, and has urged managers to use artificial intelligence.

Speaking on a panel at the CFA Institute Annual Conference in Hong Kong, GPIF chief investment officer Hiro Mizuno said the fund was offering multi-year mandates in exchange for performance fees that get clawed back if targets are not reached.

“When we look at our portfolio, about 20 per cent is active,” Mizuno said. “I wanted to increase that but every time I looked at it I couldn’t find a good reason to increase it.”

He said in the history of the fund, across the portfolio, there has been no alpha added net of fees. At the same time, about 80 per cent of the team’s time is spent on active managers.

“This is not sustainable. We want to have more in active but we have to have faith in the active management industry,” he said. “We are known as the client with the lowest fee, but if you return zero, then I’ve got no money to pay you. I wanted my team to be more hands off but for that we need to have faith in active management and corporate governance. We asked managers to look at their own governance before they knocked on the door of listed company CEOs.”

As a result of this review of active management, Mizuno said it was clear the fee structure was not assisting with alignment of interests.

“We asked all managers what their value was, and they all said it was alpha. So I said you should only get paid when you deliver alpha,” he said.

GPIF is proposing an especially low base fee, like a passive fee, and a very generous share of alpha, which Mizuno did not disclose.

“In exchange, we will give them multi-year commitments but managers must accept clawbacks at the end if they don’t perform.

“We must get rid of short-termism, it’s a vicious chain. We have volunteered to take away any short-termism from our side, and have taken short-term performance evaluation out of our criteria for managers. Our managers won’t get fired if they have short-term underperformance.”

Mizuno said this was part of moving towards a more sustainable industry and that GPIF was asking for collaboration from other asset owners on this. In the four years since Mizuno has been at the fund it has diversified away from Japanese Government bonds into equities – and the recently approved up to 5 per cent in alternatives across the globe.

“We have a much more diversified portfolio and one thing I have learned is the inconvenient truth of modern portfolio theory: the more diversified we are, the less exposed to volatility we are but the more vulnerable we are to systematic failure,” he said. “So we have to pay attention to how the whole portfolio system can be sustainable. It’s why we are paying attention to ESG.”

Regulations prevent GPIF from building an in-house equities team, because of concerns it could become too big and too influential.

“We are going to remain an outsourcer to fund managers,” Mizuno said. “When negotiating with managers, we say we are guaranteed to be a manager’s biggest client forever, so we both need to spend time on the relationship.”

He said the large fund could be a good role model even for smaller asset owners, in the way it outsourced investment management.

Willis Towers Watson head of global content, Roger Urwin, who chaired the CFA conference panel session, said large asset owners typically had, on average, 0.5 investment professionals for every $1 billion in assets. At GPIF there are just 0.04 investment professionals per $1 billion.

“We have no choice but to leverage the expertise in the industry,” Mizuno said. “In alternatives, we are focused on optimising the skills of external managers.”

The fund has a fairly low return target – 1.7 per cent over the Consumer Price Index – but Japanese bond yields are negative, so “we need to find the return somewhere”, he said. This led to the recent approval of putting up to 5 per cent of the fund into alternatives.

“We have decided to go into private equity,” Mizuno said. “I came from a private equity background, but also if you look at the fact there are 8000 private companies in the US, this is no longer an alternative asset class. We need to access those companies if we want to invest in the US. We are affecting markets because of size. Our minimum cheque size is a couple billion, so we have no choice but to invest in private equity.”

AI insights

GIPF is also running two research projects on artificial intelligence. One is with Accenture on internal resources and how to do jobs better; the other looks more to the future.

“We use AI to see how managers are trading on a daily basis,” Mizuno said. “It’s information we collect anyway, so AI can analyse the data. So, for example, when a manager has a style drift we know about it immediately. If there is pricing pressure in an industry, then you should look to automate, so I don’t know why investment managers aren’t doing it. This is a heavy intelligence sector, so we should be using AI.”

With all the fanfare around exchange-traded funds, factor-based investing and robo-management, institutional investors might have forgotten that good active management can also be a worthwhile endeavour.

In her recent article “OTPP makes paying well pay off”, Amanda White pointed to the success of the Ontario Teachers’ Pension Plan, which exceeded its policy benchmark by 1 percentage point over the decade ending December 31, 2016, using good, professional active management. Canadian research covering that same decade shows that this high level of outperformance, although difficult, is attainable, even for lesser endowed funds. In fact, good, professional active management should be able to add 0.5-1.0 percentage point in value at the total fund level for most institutional investors.

First, passive management most certainly leads to slight benchmark underperformance, as even passive investing has some fees (although minimal). As a result, the value of active management should not be underestimated, particularly in these volatile, low-return markets. One hundred basis points of value added in a low-return environment – for example, 1 percentage point of a 5 per cent return, meaning 20 per cent of the total – is proportionally worth considerably more now than in previous double-digit return decades (1 percentage point of a 10 per cent return is just 10 per cent of the total). It can be the difference between first- and fourth-quartile performance.

Skill in active management is generally a function of three factors:

  • Good manager or stock selection and retention
  • Timely changes to strategic asset mix allocation
  • Improved implementation (good execution, cash equitisation and favourable rebalancing).

Let me elaborate on the Canadian research a little further. Russell Investments has tracked actual, active manager return performance, by asset class, for more than 30 years in Canada (longer in the US). By comparing these manager returns by asset class relative to common passive benchmarks, rolling five-year, value added frequency distributions were constructed for all active managers followed. This enabled the calculation of the average median and first-quartile value added by managers in each asset category (see Table 1), for the major, liquid, traditional asset classes Canadian institutional investors commonly used over time. From that, the following table was produced, showing reasonable targets for value added, by asset class:

Table 1 – Reasonable value-added asset class targets

Asset class (1st quartile – median = difference) Value-added target
Bonds                     (48 bps – 18 bps = 30 bps)   40 bps
Canadian equities  (301 bps – 118 bps = 183 bps) 150 bps
US equities            (224 bps – 48 bps = 176 bps) 150 bps
Other equities    (364 bps – 145 bps = 219 bps) 150 bps

We then rolled up these active manager, bottom-up, asset class targets to the total fund level and compared them with top-down peer performance for the 10 years ending December 31, 2016. Fortuitously, most asset-class performance for that decade in Canadian dollars was about 5 per cent or below, with the S&P/TSX (Canadian equity) 10-year return at 4.72 per cent, almost identical to the FTSE/TMX (Canadian bond) return at 4.78 per cent. This allowed total fund peer comparison. The performance of three of the largest comparative institutional universes in Canada over that same decade ending December 31, 2016, is described here:

  • A large money manager survey contained the performance of numerous institutional, manager, pooled funds segregated by asset class and at the total fund level (i.e., aggressive, moderate and conservative balanced funds, based on equity allocation). Their 10-year median for balanced funds ranged from 5.4 per cent (conservative) to 5.9 per cent (moderate), while the first-quartile balanced managers provided average returns between 5.7 per cent (conservative) and 6.1 per cent (aggressive).
  • A major pension plan survey (PPS) we reviewed contained the performance of 88 sponsor defined benefit pension plans in Canada. Their total fund, median return for the 10 years was 6.0 per cent, while the first-quartile return was 6.4 per cent
  • The Canadian Association of University Business Officers Investment Survey (CAUBO) 2016 contains the performance of university endowment funds in Canada. Their total fund, median return for the 10-year period was 5.6 per cent, while the first-quartile return was 6.1 per cent.

A number of conclusions could be drawn from this:

  • Adding value to the passive benchmark, net of fees, through active management is usually no mean feat
  • Nevertheless, for the 10 years ending December 31, 2016, in Canada, even the median manager in all three major, institutional, comparative surveys was able to exceed the 5 per cent passive, common index target, net of fees, at the total fund level
  • First-quartile performance, usually considered a better standard for successful active management, provided even more convincing value-added performance net of fees
  • The relatively few basis points in net value added through active management lead to huge total fund savings, especially when you consider the power of compound interest.

In summary, through research and factual analysis (bottom up and top down), it has been demonstrated that good, professional active management has provided 50 bps to 100 bps in added value at the total fund level, relative to a passive benchmark. Good professional, active management can add value. Perhaps this is why we are seeing even passive luminaries such as Burt Malkielac reconsidering their stance on market efficiency.

Bruce B. Curwood is director, investment strategy at Russell Investments Canada.

Canada Pension Plan Investment Board and Caisse de dépôt et placement du Québec are both bullish on Asia, allocating investments and people on the ground, delegates at the CFA Institute Annual Conference heard.

The C$350 billion ($272 billion) CPPIB has about $8 billion invested in the region, including $2 billion onshore in China.

“We see China onshore as a deep market with quality stocks and getting better,” CPPIB senior portfolio manager, external portfolio management, Amy Flikerski, said. “There is a lot to like in Chinese equities. We are very long-term constructive on the opportunities for managers, keeping in mind stock selection can have a high dispersion.”

Similarly, the C$300 billion ($233 billion) Caisse, which first invested in Asian hedge funds in 1999, has a growing presence in Asia, with offices in India, China, Singapore, Australia and Hong Kong.

Mario Therrien, senior vice-president, external portfolio management, public markets at Caisse said there were many opportunities in Asia across liquid and illiquid asset classes.

“Alpha is not only to be found at the corner of 52nd and Madison Ave,” Therrien said. “There are many opportunities in this region. More and more, I feel like we will wake up one day and the talk will be more about what the central bank of China says and not the Fed. This is important and can affect how credit is priced and traded. This is an area where we spend a lot of time, thinking about how to trade macro in this region.”

Caisse invests in private equity, infrastructure, real estate and equities. Within equities, Therrien said, it has been easier to find managers with stock picking skill on the long-only side.

“We seek managers with more of a neutrality on long/short,” he explained. “The question is how you capture this once-in-a-lifetime opportunity for stockpicking without taking too much risk.”

In choosing managers, Flikerski warned that size can sometimes be an enemy of future returns.

“We are very sensitive to manager growth, especially capacity-constrained strategies,” she said. “We tackle this by having a core portfolio and emerging managers. We invest in large, established managers, where there’s scalability, and then also in emerging managers.”

With a hedge fund, Caisse starts investing with the premise it will allocate $100 million, with the idea that amount can grow to $175 million.

“We can be up to 50 per cent of a manager’s assets,” Therrien said. “We are more comfortable with it being concentrated if it is in a managed account.”

Therrien works in Caisse’s strategic relationship group, a team he is building.

“The idea behind this new little team is to make sure our relationships are optimised,” he said. “We want to make sure we address some of the opportunities, especially those that fall through the cracks. Traditionally, the structure of pension funds is siloed and we miss opportunities. The aim of this group is to get closer to these relationships, which can be with public companies, sovereign wealth funds, family offices or private companies. It’s about collaboration to source opportunities in a more efficient way.”

For investing in hedge funds in the region, both investors emphasised the importance of transparency and using separately managed accounts (SMAs).

“We want our team to be better investors and better understand the strategies we invest in, so transparency is very important to us,” Therrien said.

Caisse successfully re-negotiated fees with two-thirds of its managers last year, including moving to a 1-or-30 model or a variation thereof.

“The alpha share is very important, especially in a low-return environment,” he said. “We want the proportion we keep to be closer to 70 per cent.”

Flikerski said the baseline transparency of hedge funds had improved since the global financial crisis. CPPIB invests via commingled accounts and SMAs.

In addition to its outlook on China, Flikerski said CPPIB was also positive on India and had a Mumbai office. The opportunities in India were mostly in real estate but there was some private credit, she said.

The CFA Institute’s new publication, Investment Firm of the Future, launched at the organisation’s annual conference in Hong Kong, sets out the shifts investment firms need to make to survive and thrive in the next 5-10 years.

It looks at alternative business models and strategies investment firms need to embrace across operations, people, investment and distribution models.

Launching the paper, Willis Towers Watson head of global content Roger Urwin, the strategic director of the CFA’s future of finance initiative, said investment firms face a future where change is accelerating.

“Change is a very [anxiety-inducing] word,” Urwin said. “We tend to over-estimate it in the short term, but severely underestimate the change needed over 5-10 years. This is an extraordinarily fast-moving industry with many moving parts.”

The paper is designed to help firms face reality, manage risks and craft alternative pathways for the future. It follows on from the work the CFA did on the future state of the investment profession and constructs various narratives using five models.

“It’s important to look at all of these narratives together,” Urwin said.

In the paper, the CFA uses scenarios and the narratives to suggest shifts that individual investment firms, and the industry as a whole, can make to prepare for future challenges.

The paper sets out 30 building blocks for the investment firm of the future, including themes such as technology, culture, product design and business models.

Urwin said investment firms could not rely on the growth they had in the past.

“The shift from active to passive, and smaller flows, mean revenues are moving sideways,” he said. “This suggests different behaviours are needed.”

Urwin said technology would play a big role in the investment firm of the future, and that the industry needed to face that fact; for example, the “people model” needs to adapt and recognise that a different set of skills will be needed to harness technology.

“Are we behaving like we understand that?” he asked.

The paper’s emerging trends for the next 5-10 years are based on changing client expectations. In particular, the demand for solutions mandates will grow, alongside an increased demand for products that incorporate personal values.

“There has been so much focus on the alpha part of investments,” Urwin said. “The future will be more focused on solutions.”

At the moment, about 92 per cent of global revenues from investment firms is in alpha-related products, and only 8 per cent is in outcome-oriented products such as target date funds and liability-driven investments.

“The industry is not aligned with the purpose here,” Urwin said.

About half of the finance industry works for asset management firms, while only 5 per cent works for asset owners. How investment firms organise themselves and face change will have an impact on how they can service their clients, and indeed survive the future.

The paper can be accessed here.

The role of securitisation is now fairly benign, and the opportunity for mischief in financial markets is small, says Steve Eisman, managing director of Neuberger Berman and one of the subjects of The Big Short.

“I see risks but I don’t see systemic risks,” he told delegates at the CFA Institute Annual Conference in Hong Kong. “Citi used to be leveraged 35 to 1, now it’s 10 to 1. The Dodd-Frank [reform legislation] has altered the landscape in the US dramatically.”

Eisman describes the financial crisis in one paragraph: there was too much leverage, the subprime asset class blew up, systemically important firms owned that asset class, and the role of derivatives skewed reality.

“The financial crisis was inevitable once subprime collapsed,” he said. “The red flags were there for years, but the gong for me was on May 8, 2006 at 7.00am, when Golden West [Financial] was sold. They were probably the best mortgage underwriters in the country, and I had a long history with them. The fact they were selling out meant, to me, the mortgage game was up.

“God could not have prevented my trade from working,” he says of his move to short subprime mortgages, which started in October 2006. “For once in my life, my timing was impeccable.”

Conviction came through anger

Psychologically, it was a difficult trade. The rest of the world was on the other side, and Eisman said having the fortitude to say everyone else was wrong was difficult.

But he was angry.

“That anger held me in good stead to bet against it,” he recalled. “I thought what was going on was disgusting, from an ethical perspective.”

The structure of subprime mortgages was such that they locked in customers at a teaser rate, of say 3 per cent, that lasted for two to three years. Then the mortgage rolled over to the “real” rate, of about 9 per cent. But the customers couldn’t pay this.

“The industry underwrote the 3 per cent, and knew the customer base couldn’t pay 9 per cent,” Eisman said. “So why issue a 30-year loan when the customer can only pay the first two years and they would have to refinance and be charged for that? Wall Street was getting paid on volume, so they loved it and securitised it. Incentives trump ethics every time. Securitisation desks were all incentivised on volume not quality. Everyone in the chain was incentivised to produce as much stuff as possible.”

In the scheme of things, he said, the decision to let Lehman Brothers fail was almost biblical.

“The system had to go to the brink to get the money to bail out the industry,” he said. “Someone had to be sacrificed, unfortunately for Lehman it was them.”

Eisman said a number of systemic issues led to the crisis. For one, an entire generation of Wall Street executives “mistook leverage for genius”.

“They made more money every year because their firms were making more money, and their firms were making more money because they were more leveraged every year,” he explained. “To say the entire paradigm your career is based on is wrong is difficult. It’s especially hard [for them] to say they’re wrong when they think they’re god because they’re making $50 million a year.”

Greenspan’s folly

Before the crisis, he said, “the problem was Alan Greenspan”.

“He was the worst chairman of the Federal Reserve in the history of the United States; there is no one who is even close – I say that with all due respect,” he said. “Because of his ideology, he abdicated his responsibilities. He let the shadow banking industry grow with no supervision, he actually thought people on Wall Street knew what they were doing. But history [had already] taught us, and we had to learn again, that an unregulated financial system is prone to boom and bust. Banks need to be heavily regulated and don’t fool yourself otherwise.”

Now the industry is far better at managing its risk. And after the big short, Eisman said, it became much harder to extract alpha out of financials than it was before the crisis. Previously, he traded only long/short financials, but he now looks at the entire S&P 500.

“My strategy was always long/short financials,” he said. “But in a zero-rate world, it’s hard to get alpha. I went to Neuberger Berman to learn everything else. I still believe in long/short, but don’t limit it to financials.

“There are no systemic shorts at the moment. There are individual shorts, but I don’t have any ‘end-of-the-world’ shorts. I did that, I’m done,” he said. “I don’t worry about the US financial sector these days. It’s not systemic.”

He said the thing to watch the most was credit quality statistics.

“That stuff shows up in the financial system before it shows up on planet earth. But I don’t see much trouble right now.”

He describes quantitative easing 2 (QEII) as an experiment, but the problem he sees is that it gave incentives for companies to buy back stock, rather than put money back into the economy, and rates were so low that real people didn’t spend or save.

“It was monetary policy for rich people,” he argued. “How it unwinds is still very unknown. QEII has caused asset inflation, and it will be interesting to see which asset classes correct. The biggest risk at the moment is that interest rates go up too quickly.”

Predictions

Eisman said there would be three rate hikes in the US this year, and three next year.

In addition to the rate at which interest rates increase, other potential risks he cited included the existence of too much high-yield debt and corporate debt.

“It’s possibly where the problems are, but it’s not a systemic problem,” he said.

Eisman also predicted that the theme of disruptors and disruptees would continue for a long time. He is bullish on info-tech stocks because of this disruption. But he is most bullish on financials, because of regulation.

“Incentivising people in any business so they do the right thing for the long term is a problem we have to solve,” he said. “The only solution for the banks is that they become more heavily regulated. I don’t think they are over-regulated at all.”

Eisman maintains 100 per cent of his wealth in a separately managed account that mimics the SMAs of his clients.

Remuneration incentive schemes are at the heart of problems in finance, and need to be overhauled to reflect long-term effort, Mihir Desai, professor of finance at Harvard Business School and professor of law at Harvard Law School told delegates at the CFA Institute Annual Conference in Hong Kong.

Corporate governance is the most important problem in modern capitalism, Desai said, pointing to the fact that 150 years ago ownership and control were not separate, so the corporate governance issues that exist today were not present.

“Why do investors trust managers with their money? All of finance is one big daisy chain of principal agent problems,” he said.

At the heart of the issue, he said, is remuneration incentive programs.

“The massive experiment of modern finance is incentives as a way of aligning interest but it hasn’t worked out that well, and now we are in an incentive bubble,” he said.

Desai advised that incentives need to be changed to apply to the “extremely long run”, and suggested that they measure 10-15 years.

“Why have we bought into this logic that you have a liquidity moment in three years?” he asked. “We should be thinking 15 years out – it’s absurd.”

Further, Desai said quarterly reporting in itself was not a big deal, but the incentive structures tied to it could be destructive.

“I’m more interested in changing the incentive programs,” he explained, and suggested that this needed to be a structural shift in finance leadership.

In his book The Wisdom of Finance: Discovering humanity in the world of risk and return, Desai argues that the disciplines of finance and humanities can work together to better explain the value, and values, in finance.

“Finance is special in many ways; if you invest, you get feedback every day. There is “attribution error”, in which people interpret every good outcome as their doing and every bad outcome as the world’s fault.

“In finance, you believe you are really good at what you do, but you need a lot of data to prove that,” Desai said. “You never know if you’re skilled until the end of your life. Better to act as if it is luck than skill.

Desai also argued that finance needed “humanisation”.

“The gulf between finance and humanities is a real loss,” he said. “We need to demystify finance for people and humanities can play a role in that, via storytelling. Finance needs humanisation. If it’s all about screens and graphs, you lose a touch on humanity.

“We need to own up to the problems we created, to acknowledge that there is value extraction going on.”

For its part, he said the humanities area needed to lose its caricature of finance as greedy and evil, and argued instead that finance was “a noble set of ideas, no matter the current state of practice”.

“The most important issues humans face are finance – their homes, their education and their retirement and it needs to be de-demonised,” he said.