Kylie Willment is well aware that she has taken on her first chief investment officer role at a time when the long-term outlook for markets is extremely challenging. But she sees big opportunities in being part of a global team with a shared vision to embed the concept of stewardship into mainstream investment practices.

Sydney-based Willment joined Mercer as its CIO for the Pacific region in October 2017.

She replaced Russell Clarke, who departed in May 2017 to step into the CIO role at Victorian Funds Management Corporation.

Willment says: “One of the things I’ve come to appreciate quite quickly about working at Mercer is being part of a global organisation and the depth and breadth of the resources that affords me.”

Mercer is a wealth-management and asset-consulting firm with $200 billion in funds under management globally. The firm has more than 1000 investment staff in 44 countries and is a wholly owned subsidiary of New York Stock Exchange-listed Marsh & McLennan Companies.

Sitting within such a large global organisation “brings huge scale benefits”, says Willment, who previously spent 17 years at New South Wales Treasury Corporation (TCorp). She held numerous roles at the state government’s institutional investment arm, culminating with senior manager, investment advisory and stewardship.

Promoting stewardship

Willment is a true believer in the importance of embedding considerations of ESG factors into investment decisions. Mercer’s position as one of the leading exponents of responsible investment practices globally was a major factor in attracting her to the role.

“It comes back to really having the belief that sustainable investment practices will have an impact on your long-term risk and return,” she says. “Once you believe that, which I do and Mercer does, then you see it not as a side activity but actually something that’s really integral to your investment process and framework.”

That’s critical to ensure the commitment to investment stewardship isn’t abandoned in tough markets.

“We still think the global growth environment is supportive of reasonably strong equity returns from here, but we’re also conscious that markets just don’t go up in a straight line forever and we’re in one of the longest-running bull markets seen for a number of decades,” Willment says.

She wants to act now to ensure the portfolio is positioned to demonstrate resilience in a downturn.

Triennial review

When Willment arrived in October, the Mercer Pacific investment team was “right at the pointy end” of completing its triennial strategic review. Mercer Pacific deputy CIO Philip Graham, who was acting as interim CIO prior to Willment’s arrival, led the review – very capably she notes.

“It was a great opportunity for me to very quickly become immersed in the portfolio and process,” she says.

Tweaks have now been made to the portfolio where holdings were inconsistent with the house view on the investment themes that are expected to be the most important in the three years ahead: the move from quantitative easing (QE) to quantitative tightening; the late-stage corporate earnings and market cycle; and an increasingly fragmented geopolitical landscape.

“We considered what each of the themes was likely to mean from a portfolio construction and investment strategy perspective, and how we needed to adapt the strategy to be positioned either to benefit from those themes or manage their risks.”

Willment says investors obviously have to be cautious as the experiment of unwinding unprecedented amounts of monetary stimulus plays out.

“Unwinding QE has to be recognised as one of the key points of risk over the next few years, because central banks have never done it before,” she says. However, Willment believes many people’s fears about how markets will respond to quantitative tightening are too simplistic. She’s not convinced that just because the proceeds of QE fuelled bull markets in certain asset classes, such as shares, those markets will deflate as the stimulus is unwound.

How it all plays out will depend on a range of factors, she says, demanding that investors remain vigilant about monitoring the risks in their portfolio.

“It is important to be more mindful of the risks in markets and have more scenario- and stress-testing of portfolios,” she says. “You need to be thinking about the portfolio’s sensitivities to interest-rate risk and inflation, making sure there are processes in place to help navigate through those changes as they occur.”

These processes need to be solid enough to empower investors to “look through the noise” and identify when changes are cyclical or more structural, she warns.

“Otherwise, you get over-reactions like we saw [in early February] in response to one or two single data points.”

Rethinking fixed income

Reflecting the magnitude of the risks associated with quantitative tightening, the most significant change in the portfolio following the recent review was to rethink the role of traditional defensive fixed interest.

“Cash and bonds have both obviously got challenges, from both a risk and return perspective, so we have moved out of some of those traditional defensive assets and into strategies that are more skills based,” Willment says. “Things like absolute return funds or multi-asset credit strategies, where you’re not just at the whim of duration exposure but managers are really using the skill to manage through bond market volatility and challenges.”

Another outcome of the review was that some additional capital was deployed into unlisted assets, although Willment notes that valuations were stretched across unlisted asset classes, meaning this had to be done cautiously.

Options-based risk-management overlay strategies are also running across the portfolio, a decision Willment tips will prove valuable when, sooner or later, volatility ticks up. Ensuring foreign exchange exposures are right has been another a priority.

Looking to be more nimble

The biggest impact of the review, potentially, will come not from new investment decisions but from changes in how those decisions are executed.

A top priority for Willment is to reduce the lag between when investment decisions are made and implemented.

“It’s not a major overhaul, we’ve already got a good DAA [dynamic asset allocation] capability,” Willment says. “There is still some work to be done from an operational perspective to make sure the lag time between decision and execution is as small as it possibly can be.”

Willment was coy about revealing what the lag time is now, or what she hopes it will be eventually.

“It’s never going to be quite in real-time but you certainly want to make sure that gap is as small as it can be,” she says. “Particularly if you are doing market-sensitive trades, or trying to be opportunistic in response to market movements.”

Those sorts of scenarios will probably occur more frequently as market volatility ticks up.

“We’re not trading the portfolio. I mean, even our DAA views are one- to three-year positionings, but when you get significant market moves, that is a good time to work out whether it is time to readjust.”

Raising standards

Asked to share what she would most like to achieve as a CIO, Willment says simply that she hopes to have a positive impact on the lives of those people whose money she is entrusted with investing.

“I think for any investment professional with fiduciary responsibility, that is what it all boils down to; it’s a really privileged position and it comes with a high level of responsibility,” she says. “If we remind ourselves of that every day, it can hold us in really good stead.”

She says the broader industry has more work to do to lift educational and professional standards.

“We need to ensure those people in trusted positions of advising people on their investments, and making decisions on behalf of other people, have actually got the skills and knowledge they need to be able to do that in the best possible way,” she says.

Willment has earned a master’s degree in applied finance from Macquarie University and is a Certified Investment Management Analyst. She has been a director on the local arm of the CIMA Society of Australia (previously the Investment Management Consultants Association of Australia) since 2014.

“The CIMA certification is specifically targeted at people who are advising on or constructing portfolios at a multi-asset, multi-manager level,” she says. “I think it has got incredible application within the Australian industry, right across the institutional funds space but also for financial advisers.

“From a CIMA Society perspective, the minimum adviser standards are not high enough…and the impact of that on real people’s lives can often be significant.”

Long-term plans, presented by chief executives, are becoming a valuable tool for corporations in communicating with their long-term investors. Such investors are underserved by earnings calls and have an unmet need for information directly from investee companies on their long-term plans.

So far, 19 companies, representing more than $1 trillion in market capitalisation, have presented long-term plans at CEO-Investor Forums convened by CECP’s Strategic Investor Initiative (SII). Participants have included Aetna, Delphi, IBM, Johnson & Johnson, Medtronic, Merck, Prudential, Telia, Unilever and UPS.

The chief executives and their teams preparing these long-term plans seek guidance from SII regarding the appropriate components. This is understandable, as a long-term plan will not look like an earnings call and there are no existing venues that are fit for this long-term purpose, including a corporation’s annual general meeting.

As the chief executives we speak to often ask, what do investors want to know?

Investors’ guidance to chief executives

To this end, SII, led by co-chair Bill McNabb and the investor members of our advisory board, has developed a guidance letter to chief executives that sets out key elements of a long-term plan, including identifying megatrends, risk factors, capital allocation, material sustainability factors, and governance issues for at least five years forward. In feedback, investors have made clear that the long-term should be described in terms of goals, metrics, and milestones, to enable a deeper understanding of the strategy and to track progress as it is implemented.

This letter seeks to help companies meet BlackRock’s Larry Fink’s repeated request that corporations share their “strategic frameworks for sustainable value creation”. Communicating a long-term value story is something that, in the words of Financial Times editor Gillian Tett, chief executives ignore at their peril.

Corporations do have room for innovation in the topics they choose to disclose in their long-term plans, and our guidance letter seeks to give chief executives the flexibility to tell their long-term value story in a way that’s authentic and appropriate for their business and sector. As a result, it is important that each CEO-Investor Forum is a learning moment. We identify here the key themes addressed in presentations so far.

Emerging themes in company presentations

  • Talking about transitions: disruption, opportunity and capital allocation

Talking long-term – a horizon of at least five years forward – means talking about megatrends and their implications for business strategy. The long-term trends chief executives have identified in their presentations to date represent a formidable set of financial, operational, governance and policy challenges. These involve: the effects of climate change and the related transition to a low-carbon economy; technology disrupting and democratising product markets (as described by UPS’s David Abney); and technology amplifying corporate risk from cyber-security to reputational concerns (as described by Delphi chairman Raj Gupta).

Urban transit megatrends were the focus of the presentation by Delphi chief executive Kevin Clark. These have required Delphi to respond to trends across dimensions, including in-car driver technology, the transition from petrol to electric drivetrains, and the emergence of autonomous vehicles. Addressing such trends required extensive commentary on Delphi’s capital allocation priorities for implementing its strategy.

Shareholder engagement and the role of the board

For many presenting chief executives, institutional investors’ increasing scale and rising levels of year-round engagement are making it necessary for corporations to develop frameworks for effective interaction with shareholders.

Prudential’s presentation, by chair Marc Grier, outlined a set of corporate governance practices it has adopted, including designating its lead independent director as the primary point of engagement with shareholders. Prudential has also sought to describe its approach to shareholder engagement, quantify such engagement, and account for its outcomes in expanded proxy statement disclosures.

Chief executives have demonstrated a growing awareness of the diverse constituency of investors that own their stock and their varying time horizons and outlooks. Paul Polman was clear that he had set out to “choose his shareholders” by establishing Unilever’s sustainable living plan and ending practices such as delivering quarterly earnings guidance.

Chief executives also highlighted board composition as a focus, particularly in terms of diversity and gender parity (as highlighted by Voya chief executive Rodney Martin). Both Merck’s Ken Frazier and Medtronic’s Omar Ishrak looked to dive deeper into the thinking about the composition of their board, its compensation, and how those tie into future strategy and business needs.

Human capital: productivity through stakeholder investments

Human capital is a top priority for investors, especially in terms of improved corporate disclosure of metrics. Presenting chief executives consistently identified employees as “mission-critical” stakeholders and highlighted different approaches to improving employee health and productivity, fitting into a broader narrative about developing corporate cultures of health and purpose. Aetna chief executive Mark Bertolini had overseen a raising of the wage floor and the leveraging of Aetna’s own healthcare programs to boost the wellbeing of employees and their families. Alex Gorsky, of Johnson & Johnson, described how the company’s foundational credo was implemented, measured, and converted into learning moments for management across the organisation.

Stakeholder investment has been deemed key to long-term value across the presenting companies. However, chief executives have described different frameworks (at different levels of the organisation) for thinking through stakeholder relationships in the context of long-term strategy. For instance, Telia chief executive Johan Dennelind explained how the board had adopted a statement of significant audiences and materiality, in which it reflected on its key stakeholders essential to enabling a sustainable business model over the long term. In the same vein, Merck’s Frazier discussed its materiality matrix, for prioritising its stakeholder relationships in a way that reflects its operating model. It is clear that preparing long-term plans can enable operational enhancements within corporations, as teams collaborate across functions and develop new data for disclosure.

What’s next?

Investors representing more than $25 trillion in assets under management have provided extensive feedback on the presentations of long-term plans so far, which we will fold into the briefings we provide to presenting companies. Investors want to see a longer time horizon addressed, supported by more specific goals, metrics and milestones. They also seek a more detailed understanding of corporate governance arrangements, in terms of board composition, diversity and their alignment to strategy. This requires supporting commentary on how incentive structures align with long-term strategy. Further, investors have identified priority themes on which they require enhanced disclosures – from human capital to climate change.

Our forums seek to enable long-term plans to become a mainstream fixture in corporate-shareholder communications. If broadly adopted, these plans can help reorient the focus of our capital markets towards the long term, benefitting both investors and corporations. At our CEO-Investor Forum in San Francisco on April 19, 2018, long-term plans will be presented by the chief executives of Wells Fargo and PG&E (following PG&E’s presentation from February last year).

Brian Tomlinson is research director of CECP’s Strategic Investor Initiative.

 

 

Finding best in class local partners, tapping into demographic mega-trends and making investments that can easily be scaled up are core tenets of the Asia-Pacific strategy of APG Asset Management – Europe’s largest investor – says the fund’s Asia-Pacific chief, Wim Hazeleger.

Dutch pension fund APG has €475 billion ($585 billion) of funds under management as of January 31, 2018. The fund has been investing in Asia for more than 20 years. Most of its early investments, in real estate and infrastructure, were as a passive investor or in co-mingled funds; however, direct investments now make up almost all of the firm’s Asia-Pacific real estate and infrastructure deals.

APG’s Hong Kong office manages investments throughout Asia and Oceania and has just over €19 billion ($23 billion) in funds under management, up from about €7 billion ($8.6 billion) in 2012, when Hazeleger became chief executive of APG Asset Management Asia.

“Most investments that we’ve done over the last seven years are direct investments through joint ventures, club deals with like-minded investors, direct co-investments, or managed accounts,” Hazeleger tells top1000funds.com.

The Hong Kong office’s assets are split into roughly 43 per cent emerging equities, 51 per cent real estate (a roughly 50-50 split between private and listed) and 6 per cent infrastructure.

 

Avoiding the crowds

Hazeleger says APG’s strategy is to decide on a sector and market where it wants to invest, do extensive due diligence to find best-in-class local partners, then work with them to create investment platforms that can be scaled up over time. It does this by setting up a company, joint venture or club structure with the local partner to execute the strategy. When the allocated capital is mostly invested, it then considers allocating more to expand the venture.

This bespoke approach allows the firm to build up a more diversified portfolio – through targeted exposure to particular sectors or assets – than it would be able to achieve through co-mingled funds.

It also enables APG to negotiate lower fees, increase control over existing investments through stronger governance rights (such as approval rights on any new investment or divestment), and better implement its ESG standards. In addition, replicating the existing structure in ensuing commitments saves on the cost of due diligence, legal services and structuring.

“Getting the right local partner is the single most critical success factor,” Hazeleger says.

When he joined APG Asset Management Asia as general counsel at the tail end of the financial crisis in 2009, quantitative easing from various countries, including the US, Europe and Japan, was having an impact on private real estate and infrastructure, leading to stiff competition for the limited opportunities available.

APG decided a bespoke approach would allow it to better tailor investments, pay lower fees and step above a competitive environment “where everybody is chasing the same kinds of deals,” Hazeleger says.

“We took a step back and said maybe we should approach our investment strategy differently,” he recalls. “As opposed to waiting for an opportunity to present itself, why don’t we just look at what’s in our portfolio and, more importantly, what do we like to add.”

Asia is the most rapidly growing region in the world, in terms of both economy and population. More than half of the world lives there. Hazeleger says the outlook for real assets such as private real estate and infrastructure is positive and driven by a growing share of global GDP, a more prominent middle class, increasing savings and a strong trend of urbanisation.

“These developments are observable not just in China and India, where many people focus when they talk about Asia; Indonesia and the Philippines are also developing rapidly,” he says.

 

Asia strategy in action

Hazeleger says Asia is estimated to require more than $25 trillion over the next 15 years to fund new infrastructure projects and maintain existing ones, creating a growing need for private funding. He names several examples of APG strategy informing deals in China and India.

In India, for example, APG has set up a platform to provide mezzanine funding to infrastructure companies. The mismatch between demand and supply of capital in India, and the availability of attractive pools of assets with predictable cashflow profiles as security for the mezzanine loans, reassured APG the risks were minimal.

“The owners of these assets are generally not willing to dilute their equity stake and give up control, because they are typically very optimistic about future growth prospects,” Hazeleger says.

This means they are willing to obtain relatively expensive mezzanine capital, he explains, because it can be obtained quickly and doesn’t dilute their control.

Hazeleger would not provide return figures, as he says APG does not disclose the returns of individual investments.

Another partnership that APG has been working on is with China’s E Fund, with an initial focus on investing in China A shares. (APG Asset Management Asia has been investing in Chinese companies directly since about 2010.)

Taking on E Fund as an investment adviser is part of APG’s goal to build what Hazeleger calls a “concentrated, high-conviction portfolio” of China A Shares. The allocation will contain about 50 or 60 stocks, with a focus on ESG strategy. E Fund will assist with stock selection and also facilitate trading and settlement. This is just a “first step”, Hazeleger says, and the partnership could later expand to include other asset classes.

“We are going to be looking at which companies score very well based on a number of ESG metrics, and also those that do not score so well but have the potential to better these metrics through active engagement with our portfolio managers and our ESG specialists,” Hazeleger says.

A concentrated portfolio better facilitates this goal, he explains, as a small group of companies can potentially act as examples of good corporate governance more easily, while also being attractive investments.

E Fund is one of China’s biggest asset-management companies, with more than $189 billion of assets under management. It states that it is the largest mutual fund manager in China.

“Given the scale of the opportunities that China represents, E Fund can help us build local knowledge, and promote sustainable investment at a much faster pace than would have been possible had we gone out on our own,” Hazeleger says.

 

The value of a local presence

Equities and listed real estate are a focus for APG across the entire Asia-Pacific region. Infrastructure investments are predominantly in India, Australia and the Philippines but with an increasing focus on South-east Asia, mostly in renewable energy and roads. Returns in other parts of the world, particularly countries in the Organisation for Economic Co-operation and Development, are often less attractive, due to increased competition and excess liquidity, which lead to yield compression, Hazeleger says.

Private real-estate investments are in India, China (including Hong Kong), South Korea, Singapore and Australia, but Hazeleger is also keen to expand this into South-east Asia.

Countries such as Cambodia, Laos and Myanmar are deemed too risky for now, and it is also difficult to find opportunities in those nations that are large enough to make a meaningful contribution to APG’s portfolio.

Having a presence in the region, however, is crucial, Hazeleger says, and about two-thirds of APG’s Hong Kong-office staff are investment professionals specialising in private and listed real estate, infrastructure and emerging-market equities. The remainder are support staff.

Some of APG’s investments in the Asia-Pacific region are managed out of other offices; its New York site deals with private equity investments and the Amsterdam office is responsible for developed-market equities and fixed income.

For private real estate and infrastructure, however, having a local presence allows the company to source deals and manage its existing investments in a more active and efficient way than would be possible without people on the ground. It also helps the fund negotiate better terms and conditions.

On the capital markets side of the business, the reason for a local presence is slightly different. It allows for closer relationships with companies APG invests in, relevant government policymakers and other market participants, for easier access to liquidity.

“It also helps us achieve our longer-term responsible investment goals, through better understanding of the local nuances, which makes communicating our goals and our targets much more effective,” Hazeleger says.

It’s a busy time for Mark Mansley, chief investment officer of the Brunel Pension Partnership, one of the eight new mega funds to emerge as England and Wales’ 91 local government pension schemes pool their assets. The government fires the starting gun on portfolio transition in April, meaning new asset manager Brunel must begin transferring into its single pool the combined £28 billion ($39 billion) worth of investments from the 10 local authority schemes it now manages.

“We’re expecting to receive FCA [Financial Conduct Authority] authorisation any day now,” says Mansley, who has joined Brunel from the Environment Agency Pension Fund, one of the 10 entities now heading into the pool. There he led an award-winning responsible investment strategy known for its leadership and innovation; it included allocations to real assets, smart beta and active managers with high-conviction approaches. Brunel, structured so that its 10 member funds are also shareholders with a 10 per cent stake each, will carry on that mantle.

Transitioning assets is complicated and time-consuming. It takes two to six months for each portfolio, in a process that involves three stages: preparation; manager selection and appointment; and finally asset transition. The process for the entire portfolio will take about two years and will be completed in an order agreed upon with Brunel’s shareholder client funds.

“It is based around pragmatism, ease, benefit and our client funds’ greatest need in relationship to their changing investment strategies,” Mansley says.

First up is the £7 billion ($9.8 billion) passive portfolio, where equity allocations will include developed and emerging markets, smart beta and low-carbon stocks, and fixed income investment, mostly in gilts (UK government bonds). That portfolio will be followed by active equity, active fixed interest and liquid alternatives. Mansley anticipates that “a couple” of the seven portfolios covering a total of £8 billion ($11.2 billion) of active equity will be safely transitioned by the end of this year.

Re-tendering the entire portfolio is triggering a clamouring among asset managers, and the 10 member funds have delegated all decisions around manager selection to Brunel. It’s still early days, the asset manager is only in the “evaluation phase” of awarding mandates for the passive allocation. Much more lies ahead.

“We are inviting incumbent managers to tender as part of this process but will not be limiting this to just the incumbent managers,” Mansley says. “However, using incumbent managers may well mean lower transition costs, which will be an advantage when we are evaluating our manager options.”

New possibilities for asset allocation

The portfolio will also include new options for asset allocation for client funds, such as private markets, where Mansley says he is planning mandates to a secured income allocation and to legacy assets. The private market portfolio will be about £5 billion ($7 billion) and investment strategy will also focus on direct and co-investment, partnership and collaborations with other investors.

Mansley is considering using consultants to help ease the burden of manager selection.

“We have a large agenda to get through and we may be going into particularly technical areas where the consultant’s expertise is worth bringing to the table,” he says.

As examples of where consultants could help, he highlights operational due diligence, preparing shortlists of quality managers, and evaluating the expertise of managers in markets where Brunel hasn’t researched as much as it would like.

“It will help to ensure we find the best managers for the job and garner the best investment results for our clients,” he says.

But it will also have an impact on costs. Spiralling operational and transition expenses are a risk he is wary of, and he doesn’t expect the cost savings and economies of scale from pooling to appear for a while.

“We expect to see £27.8 million ($38.9 billion, 8.9 basis points) of fee savings, while maintaining investment performance, by 2025, and savings before performance growth of £550 million [$769 million] by 2036,” he predicts. “There are clear economies of scale to be gained by pooling, as well as added value through centralising expertise.”

Navigating the fund through Brexit uncertainty is another risk on Mansley’s radar.

“Brexit naturally creates a risk, especially in a hard Brexit scenario, with local equities affected,” he says. “Market dislocation could affect more complicated transitions. We need to be nimble in our investment thinking, and Brunel is particularly adept at that. We’re making good progress and are prepared for the challenges ahead.”

Ultimately, Brunel will run about 24 portfolios, from which clients set their own asset allocation.

A careful evolution

“We have done this to provide a reasonable level of consolidation but, at the same time, to give our clients more choice about how they allocate their assets, rather than just thinking in terms of bonds, equities and alternatives, or something similar.”

The process will evolve carefully as Brunel gains greater insight into each investment strategy’s requirements and performance.

“There will be greater opportunities to optimise the portfolios,” Mansley says.

All management will be outsourced for now, with each portfolio allocating to up to five managers. Brunel’s investment team is nearly in place, including important hires such as new head of private markets, Richard Fanshawe.

“Five more members of staff are joining in the coming weeks, and we have one more role still to fill,” Mansley says.

He stresses that transparency and communication with the 10 member funds must lie at the heart of successful transitioning. An oversight board reports back to the individual funds and meets quarterly, and he oversees monthly meetings with the client group.

“Our 10 shareholder client funds all have an equal vote, and there are a number of special reserve matters that require 100 per cent agreement,” Mansley explains. “In this sense, they are in control of their own fair treatment. We also have dedicated client relations teams that keep the information flow going in a timely, open and transparent way.”

Asset owners examining whether to set up long-term mandates should look for fund managers with business skill, not financial skill, an expertise not commonly found in asset-management firms.

Two Dutch authors, Jaap van Dam and Lars Dijkstra, who have written a paper on long-term investing, call for managers who can truly analyse industries and companies, because they say intrinsic value is the key to wealth creation, an essential ingredient of long-term investing.

In the paper, Long Term Investing in Public Equity Markets: What does success look like and how to organise it?, published by The 300 Club, van Dam, who is head of strategy at PGGM, and Dijkstra, who is chief investment officer of Kempen Capital Management, outline steps for shaping a long-term mandate and measuring its progress.

“The investment process of asset managers should focus on long-term industry trends, and building a concentrated portfolio of companies within those,” the authors state. “The development of intrinsic value of these companies over time is one of the most important metrics, in our view. By intrinsic value, we mean one or more measures of the value creation by the company. Hence, focus on the quality and the operating metrics of companies, instead of their share price metrics.

“To improve the long-term value creation of companies, portfolio managers need to maximise their impact through engaged active ownership. This means portfolio managers must act as engaged owners of the companies they invest in.”

The authors point to the culture and skill set of a manager that would be well equipped to achieve this. They say the people who run the mandate should be seasoned, innovative, patient, passionate and long-term committed professionals.

“Hence, we strongly prefer people who are experts on industry trends [and] know how to run companies, above people who know how to trade securities,” the paper states. “This requires a fundamentally different set of skills than most people in the financial industry have.”

Dijkstra says there is too much focus on finance skills, not business skills, within funds-management firms.

“Within asset managers, we need active owners who are in a dialogue with the chief executives of companies, so they need to know a lot about the industry and have strategic dialogue,” he explains. “This is a very different skillset to looking at a Bloomberg screen in your office.”

Van Dam and Dijkstra spoke at the Focusing Capital on the Long Term conference in New York last month. At that event, Dijkstra said it was evident that chief executives of companies thought analysts with spreadsheets were irrelevant to the strategic outlook of their company.

How to monitor mandates

The authors’ paper proposes a number of metrics that provide a better insight into the risks to operational development for the companies in a portfolio, and asks the question: What is the probability that this intrinsic fundamental value development and the expected cash flows will not materialise as predicted? The paper states that scenario analysis of a number of important profit and value drivers is important.

“In addition to all sorts of quantitative measures, the story that goes with the portfolio is also an important aspect here. Why is the company in the portfolio?” the paper explains.

The monitoring of these mandates should be less frequent and less focused on market prices or share prices than in traditional reports. The authors say it should also provide insights into:

  • The realised progress on the objectives
  • The activities and turnover that have taken place in the portfolio
  • The current characteristics of the portfolio, to show the logic of meeting your objectives in the future
  • The attribution of the portfolio return over a long period/the reporting period (at least seven years), to show that the building blocks of the strategy ultimately achieve the intended goal.

“The long-term value creation can, in our view, be well summarised by the concept of intrinsic value. If the price of the share differs strongly from the intrinsic value development of the company, a patient investor will also have good opportunities for the long-term value creation.”

The authors say monitoring of a long-term mandate requires a different approach because its nature and structure are so different from a traditional active mandate. It requires trust between the asset owner and manager, and a constant building of shared insight into process and results.

A close relationship between the manager and asset owner is essential, and may require shortening the length of the investment chain.

“We need to shorten the distance between manager and asset owner, and perhaps get rid of some of the other players,” van Dam says. “Once the mandate is in place, do away with consultants and allow for a very intense dialogue between the investment committee of the asset owner and the manager. Trust between the asset owner and manager is very important, something to fall back on in difficult times.”

Long-term investing is not for every asset owner, nor every asset manager, he says.

“If you don’t have the conviction and beliefs, and the governance budget, for really understanding what you’re trying to achieve [by getting] away from short horizons, then you shouldn’t start this,” van Dam says.

The paper also outlines some guidance on incentives and alignment through various fee models; however, the authors point out that “incentives can never compensate for the lack of the right people in the right culture. Financial incentives are, at the most, a means of strengthening the already agreed-upon alignment in goals and approach.”

 

In 2016, Ontario Teachers’ Pension Plan (OTPP) paid staff more than C$360 million ($276 million) in compensation. This is a huge figure in anyone’s world. But when it comes to salaries, the OTPP story is one of value, not absolute figures, and it’s a good case study for investors looking at their own compensation structures.

OTPP has the advantage of being a relatively new organisation, at least compared with some pension funds globally, such as the largest fund in the US, California Public Employees’ Retirement System (CalPERS), which is more than 85 years old. The benefit of this youth is a clean sheet of paper to design an organisation that can be fit-for-purpose and capitalise on governance best practice.

Since it was formed in 1990, OTPP has maintained many of the elements that are now known as the “Canadian model”, which have been identified as tenets of good organisational design and investment practice. These include independence, strong governance, direct investing with world-class teams and the ability to attract and retain talent.

Many other funds have grown up with more complexity, legacy issues – and in some areas naivety around these tenets – than the slick operations of OTPP.

The fund argues that its people are its edge and that only through hiring and remunerating good investment professionals has it been able to implement the ideology that has made it so successful – innovation, low cost and good, consistent returns. Paying good people good money is, and should be, a key part of an organisation that has 80 per cent of its assets managed in-house.

OTPP is 105 per cent funded and has C$180 billion ($138 billion) in assets. It employs 1100 people in its offices in Toronto, London and Hong Kong, and another 1500 in its real-estate subsidiary, Cadillac Fairview.

Its investment strategy is built on innovation and a bedrock of strict risk management, with a large allocation to private assets managed directly (65 per cent of the portfolio is in natural resources, real estate, infrastructure and private capital).

Investments have been the most significant contributor to the success of the fund’s mission. Since 1990, 78 per cent of the pension funding has come from investments, 12 per cent from government and employer contributions, and 10 per cent from member contributions.

Over the last 10 years, OTPP has returned 7.3 per cent against a benchmark of 6.3 per cent. Since inception, it has posted an annualised return of 10.1 per cent.

In contrast, the average 10-year investment returns for US state pension plans to June 30, 2016, was 5.7 per cent. The best-performing state plan returned 7.1 per cent over that decade.

The role of salaries and incentives

Consistent with the fact the vast majority of assets are managed in-house, salaries dominate investment expenses. In 2016, salaries to staff made up 64 per cent of investment expenses at OTPP – C$290.1 million of a total expense of C$451.2 million, its annual report states. (Note: the 2017 OTPP annual report will come out in April).

OTPP paid a further C$33.1 million in compensation to key personnel, including the chief executive, chief investment officer and critical investment staff.

In total, that’s C$323.2 million ($247.5 million) in salaries, benefits and incentives.

To put this in perspective, CalPERS spent only $69 million on investment salaries in 2017, about 20 per cent what OTPP paid.

Comparisons are always fraught, but in trying to uncover value for money, it’s worth exploring the differences between these two funds a little further.

The $345 billion CalPERS, which admittedly has a very different governance structure, including a lay-person board and a government-imposed cap on salaries, has the vast majority of its private equity and real assets managed externally and does not have anywhere near the proportion of direct or private assets that OTPP does. CalPERS has only 20 per cent of its portfolio in private equity and real assets, compared with OTPP’s 65 per cent.

In 2017, total investment expenses for CalPERS were $871.3 million. So while internal staff were paid $69 million, CalPERS spent a whopping $598.8 million on external investment managers and a further $6.6 million on consultants’ fees.

To be fair, CalPERS has been on a cost-cutting exercise for some years now, and in the last four years has reduced its external manager fees from more than $1.34 billion in 2014. But the point remains; on every measure, OTPP outflanks CalPERS, despite its exorbitant staff compensation bill.

CalPERS’ total costs are much higher than OTPP’s, CalPERS is only 68.3 per cent funded, and its 10-year return is an annualised 4.4 per cent versus 7.3 per cent for OTPP.

Salary structures

In 2016, the chair of OTPP, Jean Turmel, received C$170,000 in compensation. In the same year, CIO Bjarne Graven Larsen received C$3,153,728 and CEO Ron Mock earned total compensation of C$4,087,974, making him the highest-paid executive in pension management globally (at least based on what can be gleaned from publicly available information).

But it’s the way OTPP structures its salaries, including strict benchmarking and design principles, that make this an interesting story.

OTPP is fully aware that to attract and retain the talent needed to run its portfolio, it must compete with fund managers, banks and insurance companies within Canada and, for some jobs, globally. So it explicitly makes its salaries competitive with those organisations.

Salaries are made up of a base, an annual incentive plan (AIP), a deferred incentive plan and a long-term incentive plan (LTIP).

The mix of fixed and variable compensation varies by role, with the more senior leaders having a higher percentage of variable pay; for example, for the CEO and CIO, the mix is LTIP (37.5 per cent), AIP (37.5 per cent) and base salary (25 per cent).

Each employee’s incentive pay is designed around the risk budget and the board approves the active risk allocations, which in turn establish expected annual dollar value-added performance goals each year. There are other design rules, too, like an upper limit on annual payments and clawback provisions for wrongdoing.

Depending on the job function, the annual incentive plan (AIP) for executives is a combination of: fund performance, division performance, four-year total fund performance, four-year investment department performance, and individual performance.

Further demonstrating that the incentive scheme aims to align employees with the total plan, staff can choose to allocate all or part of their AIP to a total fund plan, a private capital plan, or a combination of the two, for up to two years.

The deferred amount will increase, or decrease, by the actual rates of return of the plan.

So, similar to how investment management firms align staff with their investment decisions, employees of OTPP can allocate their own pay to the fund. Note again, the fund’s performance since 1990 has been 10.1 per cent, annualised.

The fund’s LTIP is designed to reward employees for delivering total fund net value-added and positive actual returns, net of costs over the long term.

Each year, a small percentage of the year’s total net value added forms an LTIP pool, which is allocated to individuals’ notional accounts.

Individual LTIP accounts are adjusted annually, based on the total fund’s actual rate of return; then, each year, active employees are paid 25 per cent of their individual account balance as LTIP.

Of CEO Mock’s total compensation of C$4,087,974 in 2016, for example, the largest component was the long-term incentive payment of C$2,208,000.

At the beginning of 2016, Mock’s notional account balance was C$7,237,730. The account earned 4.24 per cent, consistent with the total fund performance that year. So Mock was paid C$2,208,000 from this account and so was left with a balance of C$6,623,805.

Mock’s pension value increased by C$771,600 in 2016 and at the end of the year he had a balance of C$5,946,300. This will give him an estimated annual pension benefit at age 65 of C$387,800.

There’s no question the staff at OTPP are paid handsomely, but the incentive structure that has them rewarded through, and invested in, the total fund is a sophisticated alignment of interests.

This has produced stellar investment returns, reduced costs and sustained good performance. But the model’s success can also be expressed in another measure of value.

In 2016, the average starting pension for an OTPP member was C$45,000, this is a significant improvement from when the fund started, in 1990, when the average starting pension for a teacher in Ontario was C$29,000. After all, it’s what goes back to the members that matters.