Pensioenfonds Metaal en Techniek, the €70 billion ($81 billion) Dutch pension fund for metal and technical workers, will introduce its own bespoke developed market equity benchmark at the end of this year.

The goal of the new benchmark for PMT isn’t necessarily to improve risk/return, although chief investment officer Inge van den Doel acknowledges this would, of course, be a welcome benefit. It is a requirement of the index that risk/return not deteriorate but the primary aim is to better integrate ESG considerations, particularly climate risk, and select companies with operations and activities that fit PMT’s long-term investment principles.

The developed market equity allocation is already passive and the fund is not increasing the allocation. Also, Van den Doel estimates that possibly half of the companies in the current standard benchmarks will fall out of the new index, which is now in the final days of construction by the fund’s in-house team, based at PMT’s fiduciary manager, MN.

“We think we are doing something innovative and are really excited about it,” she says in an interview from the fund’s headquarters close to The Hague. “It has taken us two years to get to this stage and we are almost there. After this, we might look at other categories, like emerging market equities.”

Aligning investments with beliefs

PMT’s push to develop its own benchmark is driven by a desire to better match investment beliefs and objectives with the fund’s listed equity investments. About $17 billion in equities will track the new index. It amounts to a distinctive view of what passive investment entails, in what van den Doel says is as an enhanced passive strategy.

“For us, passive doesn’t mean just following standard benchmarks bought off the shelf,” she explains. “Standard benchmarks follow certain rule sets that are unlikely to reflect our requirements and values. We are large enough to make a benchmark that fits our beliefs and objectives.”

It is a top-down process, explains van den Doel, who joined PMT five years ago from the Dutch central bank, where her roles included head of investments for the bank’s €20 billion portfolio.

“We started by looking at the companies in the standard benchmarks in our portfolio and asking what we think of their activities and operations,” she explains. “We want to select companies with activities and operations that fit our values. On that basis, certain companies may fall off the table.”

Full-scale review

The decision to custom-build an index is just one of the results of PMT’s full-scale review of its investment framework two years ago, a process that specified the fund’s beliefs regarding investment, policy and risk frameworks. They’re all pillars that feed into a central investment objective that targets long-term excess returns of 1.5 per cent a year above the change in the value of the fund’s liabilities.

“This really was new, and a number we reached after an eight-month analysis of our ambition and risk appetite,” van den Doel says. “PMT consciously chose a relative performance target that is innovative in two ways: most funds have absolute return targets and hardly any fund explicitly states a specific number. The chosen excess return target strongly influences the portfolio construction.

“We wanted to make our investment policy easier to explain to our members and show them this is how PMT invests their money. We also wanted to make more use of our beliefs and principles in our investment strategy, rather than just using quantitative models. The investment framework also helps us build a bridge between the two different worlds of trustees and investment professionals, and make it clear to the asset managers what it is we are looking for, so they understand how we want them to invest, and that it is not just a matter of allocation.”

Return folio and matching portfolio

The portfolio is divided into a return and matching portfolio. The return allocation is structured around three asset clusters of equity, high yield and real estate – not to be confused with asset categories, which lie within the clusters. The equity cluster includes private equity, developed market equity and emerging market equity; high yield comprises classic high yield but also others classes, like emerging market debt; real estate comprises a domestic allocation to homes, offices and retail and a foreign allocation to direct real estate funds and listed real estate.

“The asset clusters help us get a grip on complexity,” van den Doel explains. “Each cluster has its own objective in the portfolio and well-defined strategic characteristics so we know what kind of risk is allowed and what kind of return we want.”

It also allows easy evaluation of any new investment products.

“We can see whether they fit with the clusters and if they provide added value compared with the existing investments of a cluster. If they don’t provide any added value, we aren’t interested. Right now, we are not looking for new products in the return portfolio.”

Equity makes up roughly 60 per cent of the return portfolio. At the end of 2016, PMT had a 34 per cent allocation to all equities, for a total equity portfolio worth €23.2 billion ($27.1 billion).

In the matching portfolio, finding the right asset mix while interest rates languish at historic lows is more of a struggle and something she acknowledges could keep her up at night. It is a balancing act that involves measuring interest rate and credit risk. The latter is a particular problem because PMT, like other pension funds, is forced to move up the credit curve for non-negative yields.

“The longer the duration of an investment product, the lower the spread should be,” she says. “Having a 30-year bond that has a high spread above our liabilities is a big risk, because the duration means that if interest rates change, our loss will be much higher.”

Van den Doel won’t contemplate more risk in the return portfolio, despite PMT having an enviable funded ratio at just above 100 per cent.

“Our funded ratio has come up from 75 per cent a couple of years ago but it remains very fragile,” she says. “It is still below the level set by the Dutch central bank of a minimum funding ratio of just above 104 per cent, and it is well below our long-term target ratio of 120 per cent. We see other funds taking on more risk, but we don’t think this is the right thing to do for PMT.”

Fees slashed

The fund has also made huge progress in slashing fees, which are down by half the 2011 levels, through a process that works via her favoured top-down approach.

“We looked at all our asset categories and asked ourselves, ‘Do we want to invest in this and is it worth the fee?’ ”

This led the fund to shelve its hedge fund allocation, which was revealed as both expensive and not providing the required diversification. In contrast, private equity has proven its worth, with a 3 percentage point net return above public equity.

“In private equity, a 3 percentage point outperformance is worth the costs,” van den Doel says. “But that doesn’t mean we don’t look very sharply at private equity costs.”

A second phase of fee analysis involves looking at implementation. One way the fund has saved money is by switching to more passive strategies, particularly in the emerging market allocation, which used to be completely active but is now split between active and passive. In 2016, total management costs fell to €259 million (0.392 per cent), down from €273 million (0.445 per cent) in 2015.

“We thought we needed active implementation to get a return, but we now believe emerging markets are becoming much more efficient because liquidity has grown.”

She adds that she can envisage wholly passive management in emerging market equities two to three years hence. Emerging market debt is still actively managed she is looking at using more buy-and-maintain strategies there, to save transaction costs.

“We look at costs in all ways, not just fees,” she says.

A third step to keeping a lid on fees has been selecting only managers prepared to accept lower fees.

“Our fiduciary manager, MN, sharply negotiated with our asset managers on fees in 2012 and we divested from those that were not willing to move or accept a lower fee,” van den Doel says.

Against a backdrop of rising equity markets and falling bond yields, portfolios dominated by equities and bonds have produced exceptional returns over the last eight years. In addition, investors have enjoyed a long period in which equity and bond returns have been negatively correlated, providing a powerful diversification effect. Looking forward, however, investors need to be prepared for an environment of lower returns from equities and bonds, along with the possibility that the diversification effect will disappear as equity and bond returns become positively correlated.

The negative correlation equity and bond markets have exhibited for most of the period since the early 2000s reflects, in part, the risk-on/risk-off behaviour of markets in which economic disappointment has bred a flight to safety (with bond yields falling), while economic improvement has been positive for risk assets. This diversification effect is not a permanent feature of markets, however, and a much longer-term analysis shows that there have been long periods of time in which the correlation between equities and bonds has been positive (indeed, the long-term average is about +0.1).

A potential catalyst for a return to positive correlations could be a shift towards a more inflationary environment, in which tighter monetary policy and rising bond yields lead to equities and bonds falling at the same time. While higher levels of inflation are far from inevitable, the shift in policy discussions towards fiscal stimulus (evident in Canada, Japan, the US, and to a lesser extent the UK and Europe) at a time of synchronised global growth raises the likelihood of inflationary pressures emerging over the medium term.

This raises two important questions:

  1. What impact would a simultaneous sell-off in equities and bonds have on an investor’s financial position? This might be particularly important for investors making use of leverage.
  2. What actions can investors take to improve the robustness of their portfolios in an environment that poses significant challenges to both equities and bonds?

Know thyself

Before considering what portfolio changes might be appropriate, investors need to have a clear idea of the economic/market outcomes they are least able to tolerate. For example, investors who are sensitive to mark-to-market volatility, or who are cashflow negative, may be most concerned about large market moves and a dramatic reduction in liquidity over a short period of time. In contrast, long-horizon investors may be most concerned about the erosion of their purchasing power due to an extended period of higher than expected inflation.

The following questions will help investors narrow the range of scenarios that are likely to be of most relevance to them when reviewing investment strategy.

  • What time horizon matters most? Will it shorten during a period of market distress?
  • What are the key characteristics of the liabilities (for example, real vs. nominal, the shape of the cashflow profile, and any flexibility in adjusting cashflow levels in difficult times)?
  • What external support might be available, if required, in an unfavourable market outcome? Under what conditions is that external support most likely to be compromised?

Identifying the scenarios of most concern to an investor and then testing the portfolio’s most likely response to plausible future outcomes is a critical step in risk management.

Seek robustness

Building on the discussion above (which will necessarily be investor-specific), we suggest investors consider potential action at three levels:

  • Explicit hedges: Adopt defensive exposures designed to provide explicit protection against one or more market outcomes. This category would include government bonds (nominal and inflation-linked), synthetic hedges (such as option strategies and swaps) and tail-risk hedging strategies. Nominal government bonds still have a role to play in defending against weakening economic conditions and deflationary environments (especially for investors sensitive to those outcomes). Inflation-linked bonds (where they are issued) will offer some exposure to rising inflation alongside their interest rate exposure, and synthetic hedges can be tailored to meet individual needs.
  • Defensive tilts: Recognising the return drag typically associated with explicit hedges, investors should also consider tilts (whether in the growth or defensive portfolio) that might improve robustness in scenarios to which the investor is sensitive and potentially exposed. This could include allocations away from equity or nominal bonds, in favour of defensive hedge funds, senior private debt or real assets with contractual income streams. Low-volatility equity and sub-investment grade credit might be more defensive than broad equity market exposures, but both would probably be highly correlated with equities in a crisis.
  • Additional flexibility: Cash may have a role to play in reducing the risk of having to crystallise losses to meet cash output requirements or collateral calls in stressed conditions, while also acting as dry powder, offering the ability to re-deploy assets at more attractive levels. The latter activity will be available only to investors with a strong governance process and a willingness to act in a dynamic fashion. Investors wishing to delegate this dynamic asset allocation activity might consider idiosyncratic multi-asset strategies or multi-strategy hedge funds.

Investors face a market environment offering the prospect of lower returns and fatter tails. Portfolios dominated by broad market equity and bond exposures are likely to face significant headwinds, not just in terms of the level of returns achievable, but also given the potential for a shift in equity-bond correlations.

In short, sovereign bonds proved helpful during the financial crisis but investors can no longer rely on bonds bailing them out in the next market meltdown.

Phil Edwards is global director of strategic research at Mercer.

 

The $323 billion California Public Employees Retirement System (CalPERS) has embarked on a detailed analysis of the use of leverage in its investment portfolios, as it grapples with meeting return objectives and seeks to lift its 68 per cent liability-funding ratio.

The chief investment officer for CalPERS, Ted Eliopoulos, said an examination of leverage in the system’s asset allocation process is “really one of the core components in our ALM [asset-liability management] process this year”.

Eliopoulos said there are pros and cons to using leverage at the total fund level, with greater risk to consider as well as potentially enhanced returns.

“But the board and your investment staff was very keen to look at this topic, again under the rubric of kicking every tyre, looking at every possible tool in the toolkit as we face the various pressures [of having to] deliver a portfolio construction that will meet our various objectives,” he said.

However, the CalPERS board of administration has been told that leverage will have at best a marginal impact on its ability to improve investment returns, while leaving its underlying portfolios’ risk profiles unchanged. It was told there is currently no way to tell the total amount of explicit and embedded leverage already in CalPERS’ portfolios.

Managing investment director Eric Baggesen said there is “no agreement on what is the definition of leverage”.

“So a piece of the work that [CalPERS investment director] Ron [Lagnado] and I will be laying out is really trying to [present] a set of definitions, and then build a set of reporting [mechanisms],” Baggesen said to the board. “But [inherent in] all that is really establishing” what we’re talking about.

A road map in the works

Lagnado said the CalPERS investment office is developing a “road map initiative”, which he said is designed to create a more effective and centralised governance and operating model “if potentially we want to move forward with using leverage in a more explicit way”.

At the board’s offsite held on July 17 in Monterey, California, chief executive Marcie Frost said investment returns had improved CalPERS’ funding ratio by 3 percentage points, to 68 per cent.

On July 14, the system reported an 11.2 per cent return for the 12 months ended June 30, 2017, following strong performances from its public equity program (19.7 per cent) private equity (a preliminary return of 13.9 per cent) and real estate (a preliminary return of 7.6 per cent).

“We really are at a critical juncture for the fund,” Frost said. “We are maturing as a system. The membership is getting older. We are in a negative cashflow position, which you all have been hearing many discussions about, and we are currently 68 per cent funded – so we’re up three points on that with the latest returns [and] the discount rate change that came in December, [which] is bringing in new contributions.

“That 68 per cent is the lens that our leadership team at CalPERS is looking through as we are managing the organisation, and it also informs our efforts around reducing risk, cost and complexity.”

Eliopoulos added: “We’re looking at every possible tool in the tool kit either to increase the potential for return or moderate or reduce the amount of leverage in our portfolio construction.”

Leverage an oft-discussed tool

Baggesen said leverage comes up regularly in discussions about asset allocation. He explained that about 18 months ago, the CalPERS’ board authorised a borrowed liquidity allocation and the intention was to “bring this topic of leverage back up into the discussion and insert it into the dialogue we’re having around our asset-liability management exercise”.

He said CalPERS is often “pinned” between prevailing market conditions, the rates of return that it needs, and the level of risk the plan is able to take. Leverage may be able to help the fund achieve its target returns while also managing risk.

“It is important to recognise that leverage…like most of the other tools we’ve been speaking about…should probably be thought of only as providing some kind of marginal change,” Baggesen said. “This is not a step-function change or a huge sea-change. Even if the desire of this board were to apply a tremendous amount of leverage, that would probably not be achievable given the size of CalPERS.

“The greatest opportunity around this is a marginal opportunity; we think it can have an influence, but it is not ultimately going to be a panacea for some of the challenges that are out in front of this organisation.”

He acknowledged that leverage is not a free lunch and brings risks with it. He added that those risks come from both the sources and applications of borrowed capital.

The managing director of Pension Consulting Alliance, and one of the fund’s consultants, Allan Emkin, told the board leverage must be managed at the total-fund level, which is not how institutional investors traditionally look at it.

“They’ve looked at leverage on an asset-class basis, or an individual asset basis, but not systemically,” Emkin said.

He said there are three critical aspects to an effective policy on leverage: who sets the policy, who implements the policy, and how large the range and when is it imposed? A policy that works for one system may not work for CalPERS.

“You have a unique board, you have a unique liability stream, you have unique staffing, and all of those things have to be incorporated into decision-making on the use of leverage,” he explained. “There are far more moving parts in your investment portfolio when there’s leverage, and it takes a level of knowledge, sophisticated analytics and oversight to make sure you’re getting what you want out of leverage.”

Emkin said leverage calculations and examples often quote average expected returns. But the challenge in using leverage, he explained, is to consider what happens when those averages prove to be overly optimistic, and “you’re on the left-hand side of the distribution” of returns.

The effect of leverage is to increase the potential return from an asset, but also the variability or volatility of returns.

“You as policymakers are probably much more concerned about the left-hand side of that distribution than the right-hand side,” Emkin told the board.

Leverage is tempting

The professor of finance at EDHEC Business School and director of EDHEC Risk Institute, Lionel Martellini, who also presented to the board, said investors such as CalPERS must “define a strategic leverage target at the total-fund level, including both directly controlled and embedded leverage, and explicitly measure and manage the associated risks, as opposed to having an uncontrolled amount of leverage opportunistically defined at the level of internal and external program managers”.

Martellini said the best way for asset owners to consider leverage is from the perspective of the impact it will have on the payoff from an investment.

“One’s ability as an institution to modify the payoff and make it more consistent with the needs of the institution is a key component of what financial engineering and asset-allocation decisions can bring in terms of potential benefits eventually to the beneficiaries,” he said.

He said increased access to upside using a leveraged strategy requires a lower level of performance from the underlying portfolio to achieve a given performance target at the fund level.

Conceptually – and notwithstanding the discount rate applied to the system’s liabilities over time – if a pension system is 68 per cent funded, it has to increase its funding ratio by 47 per cent to become 100 per cent funded.

Martellini continued: “I’m thinking about the funding ratio, and not pure asset value, so it’s relative to the liability performance, which is itself – given liabilities are mark-to-market – a function of the discount rate, which indeed is not constant over time.”

Using leverage to alter the payoff of an investment strategy is, therefore, tempting.

That’s on the upside, or the right-hand end, of return distributions. Looking at the left-hand end, Martellini said, “You come to the opposite conclusion, or a similar conclusion, in a way: it takes only a small or mild negative performance, a mild decrease in asset value in your underlying portfolio, [and] that’s going to translate into a decrease in the value of the levered portfolio.”

He said leverage is a tool to help investors reach a return target without increasing the risk of the underlying portfolio. Leverage increases risk, he said, but the increase in risk attributable to leverage is less than the risk that arises from trying to meet the return target without leverage and by increasing risk in the underlying portfolio.

“The bottom line is, there’s a trade-off,” he said. “Whenever you want to increase expected return, you always need to increase risk. But we have two choices: one with leverage and another one without leverage.”

The managing director of Wilshire Consulting, Patrick Lighaam, told the board that for many asset owners, and possibly for CalPERS specifically, leverage is underused, “especially if you think about how powerfully and how broadly it can be applied to your current portfolio”.

Lighaam said leverage is thought of as “one of these funky, weird and misunderstood tools…because it comes in so many shapes and forms. Maybe one of the reasons leverage is being frowned upon a little bit is because it’s not so easily defined. There might be a misperception…that leverage is much more risky than it actually is.

“That old view that introducing leverage is increasing the risk is very much linked to the way we were applying leverage in the old days.”

There is no appreciable difference in the returns of asset owners that do pay performance fees and those that don’t, so what’s the point of these fees?

That’s the question to ask, based on a research paper from Maastricht University and De Nederlasche Bank, in the Netherlands. The researchers looked at 218 Dutch pension funds between 2012 and 2015. They found no difference between the investment performance of those that paid performance fees and those that didn’t.

The paper, Does it pay to pay performance fees? Empirical evidence from Dutch pension funds, claims to be the first that examines the relationship between performance fees and the net investment performance of a pension fund and, in doing so, shows whether it pays for pension funds to pay performance fees at all.

The research looks at total returns, excess return and performance fees for the total portfolio and six major asset classes, and finds that those investors that paid performance fees do not produce higher, or lower, returns than those that don’t.

(There is one minor exception. Pension funds that pay performance fees for hedge funds report a net excess return 3 basis points higher, on average, but that disappears when the authors correct for risk.)

In 2015, the funds, whose combined assets are €985 billion ($1.1 billion), paid €1.5 billion ($1.7 billion) in performance fees, across a variety of asset classes but most commonly in private equity and hedge funds. These fees represented a 36 per cent increase from 2012, when the funds paid €1.1 billion ($1.25 billion) in performance fees.

Paying performance fees could be “economically rational”, the paper states, if they enable pension funds to enhance their overall net performance by recovering these costs with superior returns or higher diversification benefits. The findings show this isn’t necessarily what happens.

The authors observed that “performance fees primarily relate to gross excess returns for equities and hedge funds where investors pay 2.1 basis points and 30.5 basis points, respectively, for every 100 basis points of gross excess return”.

The 218 Dutch funds’ total return over the period studied was 9.72 per cent, with a 0.11 per cent excess return over the benchmark, after costs. For private equity, the total return was 11.54 per cent, with an excess return of 1.4 per cent, and for hedge funds it was 2.64 per cent, with an excess return of 0.12 per cent.

The paper further calls into question the relevance of performance fees by showing that pension fund size and specialisation are “economically more important for net returns than paying performance fees”.

Specialisation is positively correlated with net returns for private equity and hedge funds, the paper demonstrates; pension funds with an allocation to these asset classes 1 percentage point higher than their peers’ reported a 1.31 and 1.37 basis point, respectively, higher net total return.

As for size, the research also supports the notion that bigger is better. It finds empirical evidence that larger and more specialised pension funds pay less in performance fees for a given level of excess return in alternative asset classes, possibly as a result of their better negotiating power. Larger funds also apply performance fees more often, and pay significantly less for the same performance by asset managers.

The authors did recognise that, in theory, performance fees could be a valuable tool to minimise the principal-agent conflict between pension funds and asset managers.

The research paper cites academic studies outlining the benefits of performance fees, including aligning the managers’ incentives with the pension fund’s interests, and linking the manager’s reward to performance. Ideally, this should increase the effort from the manager and translate into higher investment returns.

The drawbacks are that the manager receives the same performance fee whether the performance comes from skill or luck, and the payments create a skewed incentive structure, as the manager benefits from excess returns but does not suffer from losses.

“We find no statistical evidence that paying fees for most asset classes adds or subtracts value,” the authors conclude.

The paper is by Dirk Broeders, Arco van Oord, and David Rijsbergen.

Migros-Pensionskasse (MPK) the CHF21 billion ($21.9 billion) pension fund for Switzerland’s largest retailer, Migros, distinguishes itself from peers with its large domestic real-estate allocation. It also remains an exception in Switzerland’s Pensionskassen landscape by still running a defined benefit scheme that is open to new members.

Like many other Swiss funds, MPK applies a core-satellite approach to managing assets. Typically, this strategy means more than two-thirds of assets lie in a core, primarily passive, portfolio, with the rest in satellite vehicles aiming for either higher returns through active investments, or a lower risk profile, in comparison with the core.

At MPK, assets are split between a 40 per cent allocation to fixed income, a 30 per cent equity allocation and a 30 per cent real-estate allocation, with about 5 per cent of each allocation in satellite investments. Internal portfolio management oversees the core allocation, and external managers oversee the satellite.

“In the satellite, externally managed allocations, we aim to add additional asset classes we don’t have in the core allocation,” says Adrian Ryser, head of asset management and chief investment officer at the Zurich-based fund. “So assets here are different; core and satellite comprise different universes. Satellite allocations could be more detailed, or smaller, allocations that improve the risk-return profile and diversification effect. Examples are small-cap equity, high yield, senior loans, and foreign real estate.

“Over the last few years, we have increased the portfolio position in the satellite allocation, but not across all asset classes. For example, our small-cap equity allocation is the same; however, because of the negative yield curve in our core allocation to Swiss Government bonds, in the satellite fixed income allocation we now invest more in sub investment-grade credit and high yield.

“We also recently introduced senior loans. This is a long-only allocation. It brings a credit spread at the top of Libor [the London interbank offered rate], it is short duration and it is below investment grade. It is a significantly higher yield than Swiss fixed income investments, even after hedging the currency risk.”

Infrastructure joined the satellite asset mix about three years ago via a new infrastructure platform; this was done in conjunction with five other Swiss funds to create an economy of scale.

“We invest only in infrastructure funds; we don’t do any direct investments in infrastructure. We are still building up the allocation,” Ryser explains. “We add a little every year, and at the moment the allocation accounts for 1.5 per cent of our assets, so it is still small. We prefer open-end funds and have one or two secondary market investments. It’s a big market and we are making careful and slow progress.”

MPK’s large allocation to real estate, of which 25 per cent, or CHF5.2 billion ($5.3 billion), lies in Swiss properties, helps give stable returns. The Swiss allocation is managed in-house each step of the process, from the original acquisition through to management. Investments are made in residential and commercial properties, developments and undeveloped land. Outside Switzerland, MPK invests through funds.

There are six internal portfolio managers. A further internal team of four runs the manager selection, monitoring the mandates for high yield, senior loans and small-cap equity. All these mandates are long-only and have market benchmarks.

“We prefer long-term, stable manager relationships and review results every three years,” Ryser says. “We don’t give up after 12 months. Most of our existing managers have been with us for over five years.”

Challenges and adaptations

MPK has successfully adapted to the challenge of changing demographics and decreases in investment returns and fixed contributions by raising the retirement age. Currently at 64, it has been progressively raised from 62 in 2005.

“Changing the retirement age is an efficient solution to financial stability because it increases the period people pay contributions and decreases the time they are paid pensions,” MPK director Christoph Ryter says.

Such flexibility isn’t as easily applied to investment strategy, where regulation informs Swiss funds’ asset allocations, especially the 15 per cent cap on alternative investments. It leaves some Swiss funds feeling over-regulated, although Ryter says there is room to manoeuvre.

“The regulator set up some limits for investments in different asset classes,” he says. “Investors can either comply with these limits or explain why they want to have a higher allocation. It is, therefore, not a hard limit in most cases. It is more based around the idea of ‘comply or explain’.”

Other investment regulations include a 50 per cent cap on equities and a 30 per cent cap on real estate.

For 2017, the fund has no plans to change its asset allocation. MPK shed hedge funds following in- depth analysis of fees and expenses in the wake of the Swiss Government introducing full transparency on asset management costs and mandatory total-expense-ratio reports for all Pensionskassen investments.

It meant being “convinced” of a high net return to “explain high management fees” and this was no longer “justifiable for hedge funds”, Ryser says. MPK’s mix of asset classes can go through difficult times without hedge funds, he concludes.

It may seem like a hidden truth but asset owners are in competition with one another.

They are in competition for the best alpha ideas, the best manager products and the best research – all with the aim of improving risk-return trade-offs to increase the likelihood of meeting their liabilities.

As a result, many asset owners find it difficult to collaborate, even on initiatives that may prove mutually beneficial.

At the Thinking Ahead Institute’s recent Sydney roundtable, asset owners highlighted the top three barriers to successful collaboration with peers: difficulties being transparent; lack of time and resources; and difficulties aligning interests. At the same time, however, attendees agreed on the value to funds of collaborating on industry structure, regulation, and a universal agenda for alignment of owners’ interests.

The word ‘co-opetition’ was described in Adam Brandenburger and Barry Nalebuff’s 1997 book of that name and refers to the ability of competing businesses to co-operate for mutually beneficial outcomes. The authors took insights directly from game theory, which also applies to the myriad investment decisions pension fund boards need to make in efforts to fulfil the requirements of several potentially misaligned stakeholders.

The pursuit of rational but non-collaborative strategies generally produces poorer outcomes (prisoners’ dilemma) whereas better payoffs can often be produced through effective methods of collaboration or government influence.

Proof in the research

There are numerous academic articles and research projects that prove this assertion. Here are three examples:

In the 2009 article titled “Improving pension management and delivery: an (im)modest and likely (un)popular proposal”, Ron Bird and Jack Gray argue that excessive competition among retirement savings providers has undermined their key objective of maximising net returns to members in three main ways, namely:

  • Inefficient pricing: The race to outperform one another (largely but not exclusively through listed equities), often forces asset managers to rely heavily on momentum and other non-information-based strategies. This causes mispricing away from fundamental values, leading to sub-optimal capital allocation, which lowers long-term returns.
  • Agency costs: The growth of intermediaries and other agents has led to increased complexity and uncertainty, and substantial increases in costs. And given that active management is, in effect, a negative-sum game after fees, aggregate returns are reduced.
  1. Excessive choice: Bird and Gray refer to Joshua Fear and Geraldine Pace’s 2009 article “Australia’s ‘choice of fund’ legislation: success or failure?” in arguing that despite the plethora of investment strategies available, a large portion of Australian institutional retirement savings funds are essentially identical, with little investment choice exercised. Therefore, members bear the direct and indirect costs of competition-induced excessive choice. Additionally, the average fund size was seen to be well below that needed to benefit from economies of scale including lower fees. (There is a trade-off involved here, between economies of scale enjoyed by larger funds, and the ability of smaller funds to express conviction and flexibly alter their positions. Better outcomes would have been achieved with better default design for workers who ‘choose not to choose’.

Bird and Gray suggest that these leakages can be plugged by rationalising the retirement savings industry and its agents and through greater co-operation (such as through joint research efforts) while retaining the genuine benefits of productive competition.

In universal owners’ interest

Willis Towers Watson’s Roger Urwin, in his 2011 paper “Pension funds as universal owners: opportunity beckons and leadership calls”, argues that it’s in the interest of universal owners, which through their portfolios own a slice of the whole economy and the market, to collaborate with other asset owners to ensure the health of the investment ecosystem as a whole. In a nutshell, while universal owners adapt their actions to try to directly enhance the value of their portfolios, they indirectly help the whole economy secure a more prosperous and sustainable future.

Finally, in its survey this year of 15 best-practice asset owners carried out on behalf of the Future Fund, Willis Towers Watson observed the following trends:

  1. Some participants have developed more strategic partnerships and have seen benefits in sharing information in areas such as operations, human resources and technology. All participants agreed that peer collaboration had proved valuable to some extent, but noted that further work needed to be done to crystallise these opportunities.
  2. The participants were cognisant of their external profiles, and greater success was aligned with where their profiles had been deliberately and carefully cultivated, often through proactive and highly visible strategies. Willis Towers Watson noted that there were growing expectations of leading asset owners to exercise positive influences in pursuit of their financial goals in co-operation with others, and to consider environmental, social and governance issues through their ownership interests. Peer relationships and collaborations are particularly helpful in this regard.
  3. Many participants outlined explicit goals to enhance collaboration, whilst some described instances of co-investment success, although most saw this as more limited in reality than they had initially hoped. Several are now looking to be more discerning and targeted in their collaboration activities, aiming to make one or two relationships much richer and deeper. The limits to senior time and bandwidth are clear constraints.

Effective collaboration without sacrificing the genuine benefits of competition requires clearly defined objectives and goals. It also requires a mindset shift among asset owners that recognises these strategic partnerships have the potential to be mutually beneficial.

Marisa Hall is senior investment consultant in the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.