Investment management is a people business. That statement seems quite obvious, but the point is a critical one.

Investment management, whether fundamentally or quantitatively based, derives its value from the intellectual capital of the principals.

Technology, assets under management and process are used as differentiators for investment groups, but none of that matters if you do not have the right people and the culture to support their development.

In the end, the most important job of a chief investment officer is talent management. While many aspire to be the smartest person in the room, and some succeed, it is not enough. A sustainable investment program is never about one individual. It is about a team working to its potential, under the guidance and support of a policy-focused and supportive board.

Success within the investment management industry is, therefore, dependent upon execution by skilled professionals.

However, talented individuals do not always reach their potential, resulting in suboptimal execution. This means talent management is the critical element in creating excellence. This is best facilitated by establishing an environment that fosters learning, collaboration and competition as a team. Culture makes this possible.

The wrong culture will destroy a team or organisation. The right culture will create sustainability of process and allow for individuals and the organisation to thrive and grow. The organisation is as strong as its individual members, who must be able to grow with a clear vision, mission and delineation of roles.

The key elements for the development of an optimal investment management culture within a multi-asset class fiduciary pool are the following: functional governance structure; a supportive learning environment; adequate technical and research resources; aligned and reasonable incentive structures; and a long-term investment horizon.

You will notice from the above list that the focus is foundational. If you establish the proper structures to support individuals and teams, success will follow, leading to a self-renewing pattern of achievement. I will expand my thoughts on the key attributes necessary for success in the following paragraphs, with the hope of providing practical insights into optimal team structuring and management.

Functional governance

Success is not possible without functional governance. I use the term “functional” with intent. Many organisations have bloated and complicated governance structures, which often results in mission drift and poor performance.

A multi-asset class fiduciary pool’s core objective is to make money to support the mission of the organisation.

Governance should be set up to help, not hinder, that objective. Boards should set policy that supports successful asset management and allow the investment staff to invest the money.

Clear delineations of roles and responsibilities for all parties and autonomy for the investment team are essential. Checks and balances and accountability are important, but trust must underpin the entire governance structure. This ‘trust effect’ is the most critical piece of the optimal investment management culture.

Supportive and resources

The landscape is always changing, and having personnel with intellectual curiosity is critical to establishing a culture of success.

My organisation’s first foray into active equity management was in microcaps. This was a result of staff feeling empowered to conduct research independently and then having a structure that provided support, resources and, eventually, funds to execute.

If people know they are expected to learn and develop and leadership is committed to that objective, success and innovation will happen. In this case, it has led to the creation of two additional equity strategies and a fixed-income strategy.

Our internal asset management now covers more than 30 per cent of AUM and that’s increasing. Millions of dollars in fee savings and alpha have been generated for the fund. Most importantly, the team’s job satisfaction has increased and new research continues.

Staff members know they are encouraged and expected to learn and develop continually, resulting in positive structural changes to the portfolio. Retention rates are high because the work environment is positive and intellectually challenging.

Remuneration

Now to compensation.

Above I mention that a key element of success is talent aligned with appropriate compensation structures. Investment management as an industry pays its talent well and competition for that talent is fierce.

Unfortunately, the history of many pension funds was inadequate compensation for internal investment professionals and paying more than necessary for consultants and external investment management. Even though the cost-benefit analysis supports building out internal teams.

My view is that if you hire talented investment professionals internally and have established the right culture and governance structure, then additional layers of oversight prove costly and often counterproductive. Compensate your talent appropriately, allow them to operate in a challenging yet supportive environment, hold them accountable, and they will stay and produce successful outcomes.

Attracting and retaining top talent within the pension industry does not require aggressive compensation.

The asset owner side of the business is stable, mission focused, intellectually challenging, and does not generally require sales activities. It is a lifestyle assignment and, with appropriate compensation, retention is high.

With respect to alignment, incentive compensation is important. Investment professionals are competitive. The ability to earn a bonus brings the team together and focuses action on achieving the goal of higher returns.

Therefore, I remain a firm believer that incentive compensation should be linked to long-term successful outcomes and collective, rather than individual, success. Being reasonable is the key. Incentive compensation needs to be meaningful but not excessive.

A long horizon
Fiduciary pools are often perpetual in their mission.

That means embedded within their structures should be the ability to take a truly long-term approach. Maintaining this long-term view and linking it to governance, policy and incentives can be a powerful competitive advantage.

The markets are often painfully slow to reward long-term investments, so ongoing effective communication of strategy and execution between the investment professionals and the board is critical to maintain trust.

The board needs to support taking a long-term, valuation-based approach and compensation should incentivise the investment team to strive for consistent success over a business cycle, not a quarter.

Jeb Burns is chief investment officer at the Municipal Employees’ Retirement System of Michigan.

Stringent regulatory constraints dictate investment strategy at French public service pension scheme Régime de Retraite additionnelle de la Fonction publique, a €26.2 billion ($28.0 billion) mandatory fund for French civil servants and members of the judiciary, established in 2005.

By decree, the scheme’s manager, ERAFP, has to invest at least 50 per cent in bonds; diversifying assets in listed and private equity and infrastructure are capped at 40 per cent. Real-estate investment is limited to only 10 per cent of assets. This leaves the fund with a current strategic asset allocation of 60-62 per cent in bonds, 30-31 per cent in diversified assets (the bulk of which is listed equity) and 9-9.5 per cent real estate – at a time of historic low interest rates.

It is the restrictions governing the fund’s allocation to illiquid assets that chief investment officer Catherine Vialonga finds particularly frustrating.

“As a recently created mandatory pension fund, we are in the very uncommon situation of having predictable and sizeable positive net cash flows for several decades,” Vialonga says in an interview from ERAFP’s Paris headquarters. “Thus, we think we should be able to take advantage of our long-term investment horizon and our particularly low need for liquidity to benefit from the illiquidity premium resulting from investments in real assets. This is why we advocate extending the investment threshold in real estate [beyond] current levels of 10 per cent.”

She is heartened by a gradual diversification of fund assets since 2005, when allocations to sovereign bonds dominated strategy. It suggests a trajectory towards increased diversification and flexibility in years to come.

“Let’s keep in mind that ERAFP is a young scheme and that we have already implemented a policy of gradual diversification,” she says. The fund achieved a 4 per cent annualised internal rate of return, by market valuation, in 2015.

Two years into new investment rules

A landmark change came when new investment rules were introduced two years ago that increased the equity allocation from 25 per cent and introduced allocations to private equity and infrastructure. Other new assets were also added, including short-term credit instruments in order to manage treasury, and allocations to private debt and loan funds. ERAFP is now allowed to invest on its own in any kind of open-ended fund, and is also permitted to use derivatives, although only for currency hedging purposes.

“These changes are important for asset diversification and with regard to matching the duration of our liabilities,” Vialonga explains. “We also want to provide long-term support to the economy via smaller investments.”

The fund recently awarded a 10-year private equity mandate to Access Capital Partners, targeting $213 million in a range of unlisted small and medium-sized (SME) European companies.

ERAFP invests only in developed equity markets, and there is a heavy euro bias, with 70 per cent of the variable asset allocation (comprising public and private equity and infrastructure) invested in euro assets.

Other allocations include a multi-asset portfolio that Amundi manages. It was an important diversifying allocation before the 2015 rule changes and although it accounts for less than 2 per cent of assets under management, Vialonga still likes the allocation for its “decorrelation and a positive performance”.

ERAFP gives Amundi an annual risk budget and generous fixed asset guidelines within the portfolio.

“Within those wide guidelines, Amundi can change the fund’s allocation quite easily,” Vialonga says, adding that political uncertainty in Europe has, in fact, made for a cautious strategy.

“The fund manager is particularly cautious since the beginning of 2016 because of accrued potential volatility risks of Brexit, Grexit, Italian polls and the US presidential elections,” she says.

As of February 2017, equities represent 55 per cent of the portfolio Amundi manages (mainly Asian equities). Bonds represent 42.5 per cent (mainly investment grade). The remainder is equally split between emerging market debt and high yield.

 

Manager selection and SRI

ERAFP’s manager selection has to comply with France’s strict public procurement code.

“When we want to invest in a new asset class, or to renew existing mandates, we launch a public RFP [request for proposals] aimed at selecting one or more asset managers. The different steps and corresponding deadlines of the process, as well as the selection criteria, are pre-determined and closely enshrined in law.”

Every shortlisted candidate is invited to submit an offer, which is assessed according to the quality of their investment process, the track record and experience of the management team, risk management and internal control systems and costs, comprising management and brokerage fees.

Socially responsible investing (SRI) integration is also a deciding factor in manager selection. An SRI charter “persistently and permanently” takes account of the pursuit of the public interest and applies to all “financial management transactions”, whether ERAFP performs them directly or agents perform them on its behalf.

Just under 20 per cent of the equity portfolio tracks a replicated low-carbon index based on the Scientific Beta Efficient Maximum Sharpe Ratio method.

“The aim of the index is to maximise the Sharpe ratio of a Euro SRI carbon-efficient universe,” Vialonga says.

Last year, ERAFP extended the calculation of carbon exposure to its government and corporate bond portfolios as well. This means the fund now measures the carbon output of about 87 per cent of its total assets. In another endeavour to measure carbon, ERAFP now compares the energy mix in its equity portfolio with “a current typical portfolio” and to an energy generation breakdown using the International Energy Agency’s 2°C Scenario (2DS) for 2030-50.

“This measurement is the first step in shaping ERAFP’s zero-carbon strategy. We cannot manage what we do not measure,” Vialonga says. “We will continue to use other tools to measure ERAFP’s climate risks and opportunities.

“One of the most important challenges for climate risk management is the development of robust indicators that provide a comprehensive picture of companies’ direct and indirect emissions. Most available methodologies cover only part of [indirect] emissions. Thus, in some sectors, such as the automotive industry or the financial sector, global emissions tend to be underestimated.”

ERAFP’s board of directors comprises 19 members from various trade unions, the public sector and qualified investment professionals. It is a mix that has particularly championed ERAFP’s integrated and award-winning SRI policy, Vialonga says.

“Since its inception in 2005, the board of directors [has believed] that investment based solely on maximum financial profit fails to account for social, economic and environmental consequences,” she says.

President and chief executive of the Federal Reserve Bank of St. Louis, James ‘Jim’ Bullard, has told a gathering of Melbourne’s business elite that he is more inclined to let the central bank’s massive bond-buying program run off in 2017 than rush to hike interest rates.

He also noted the United States is “a closed market when compared with Australia and other countries” and its financial leaders do not track global events to the extent that more open economies do.

Bullard illustrated his point by arguing the recent US air strike on Syria would have little impact on the US economy nor on the Federal Reserve’s macroeconomic outlook for 2017.

He made the comments during a presentation on his views on current US economic and monetary policy at an event hosted by the Australian Centre for Financial Studies (Monash Business School) in Melbourne on Monday, April 10, 2017.

Bullard sits on the Federal Reserve’s federal open market committee (FOMC), which meets eight times each year to set the direction of US monetary policy.

Key to productivity still out of reach

His presentation played down the likelihood of a hike in global interest rates for investors or people living on fixed incomes. Bullard warned faster productivity was the key to gross domestic product growth and was the only sure way for the US and global economies to expand. But “no one seems to have the answers as to why productivity [is] so low”, and no one seems to have the solution to the problem either.

“There is no shortage of ideas but no good answers,” he said. Until someone comes up with the answers, the US and the global economy are stuck with very low interest rates, he added.

Bullard’s speech also focused on the US’s current low real GDP growth and low real interest rates.

“Real GDP has been growing about 2 per cent, inflation is near the Fed’s 2 per cent target and the unemployment rate has been slowing,” he said. The first-quarter 2017 figures show GDP growth was below 2 per cent and hard data suggested that “things don’t look good”.

“The US policy rate can remain relatively low and still keep employment and inflation targets,” he said.

Although post-Trump fiscal policies for regulation, infrastructure and tax reform could have an impact on growth, Bullard said the Fed would wait and see how these policies developed. He added that if growth or inflation started to pick up, then the Fed could start raising official rates.

Bullard dissented from many of his colleagues on the Fed Reserve Board over its bond-buying program. Instead of going for another rate rise or two this year, he said now might be a good time for the FOMC to consider allowing the balance sheet to normalise by ending reinvestment.

“The Federal Reserve can reduce its $4.5 trillion balance sheet by ending reinvestment in the good times,” he argued. “Just let stuff mature and not replace it. It would not be a major issue for global markets. It would allow for a more natural adjustment.”

Sovereign wealth funds need to become more democratic if they want to reduce citizen action against them.

Even the most responsible and ethically minded sovereign investors have come up against citizen campaigns, causing them to change investment practices. But the implementation of citizens’ desires can be problematic, particularly after investments have been made.

Installing democratic processes into the funds increases transparency, engagement and accountability, keeping problems from blowing up later, says Dr Angela Cummine, the director of The Wealth Project at Oxford University.

Investment practices aren’t the only contentious issue for sovereign wealth funds at the moment. Citizens are expressing strong feelings about the purpose of the funds as well.

While economist and philosopher Adam Smith first proposed state-controlled investment funds in the 18th century, it was not until the turn of the 21st century that the number of sovereign wealth funds boomed. Today, more money exists in sovereign wealth funds than ever, upping the stakes, and governments and citizens both consider the money to be theirs.

Cummine argued that classical political theory holds the key to deciding whose money it is. According to that theory, citizens are the principal and government is merely the agent.

“If you accept that basic insight of classical political theory, then sovereign funds are only ever in the custody of the government,” Cummine said at a Lowy Institute event on sovereign wealth funds. “This does not mean governments can’t or shouldn’t manage the money on our behalf, but we should have a clear understanding of who is the ultimate owner.”

But the typical sovereign wealth fund does not involve much direct citizen participation; in fact, many citizens are not aware of their existence.

This means citizens have decisions made on their behalf with no exit options, which can generate a backlash if the investments do not match social and ethical expectations, Cummine explained.

Trouble for New Zealand

The issue has already cropped up.

New Zealand is one of the most responsible and ethically minded sovereign investors, yet this hasn’t shielded it from facing some real citizen opposition to its investment practices, Cummine said.

New Zealand, like Norway, held some equity investments in mines in Papua New Guinea that ran into trouble in terms of labour rights and demonstrations that the police put down. Huge environmental destruction was going on around these mines, as well as questions around destruction of indigenous land rights practices.

These concerns led the Norwegian fund to divest from that particular investment.

New Zealand Super, which also has in its mandate strong obligations to respect human rights and preserve the country’s reputation as a responsible investor globally, took a different approach.

The management and trustees of New Zealand Super decided a better outcome could be achieved by actively engaging with the management of the mine company – a recognised form of ethical investing.

Unfortunately, when New Zealand citizens became aware of the investment, they were extremely uncomfortable with the fact that their universal retirement pension was being funded by this particular investment.

“They did not want, in effect, blood money in their retirement funds,” Cummine said.

After pressure and debate, the sovereign fund divested from the mines.

More pressure on the Future Fund

“That sort of problem can be avoided if you open up these funds to more consultation about what values we hold as a community, and what sort of values we like to see become accepted investment practices through our sovereign funds,” Cummine said.

In Australia, the $127 billion Future Fund is likely to feel the heat of  increased citizen engagement as it grows.

The former chair of the Future Fund, David Murray – who was on the event panel with Cummine – said the implementation of ethical investments was difficult for the nation’s sovereign wealth fund.

“The government wanted to ban the Future Fund from investing in tobacco, but does that mean that [we exclude] trucks on the road carrying the product? It gets very hard to implement,” Murray said.

To help guide the implementation decisions, a catch-all rule was created: the Future Fund cannot diminish the reputation of the Commonwealth Government in financial markets because of its operations.

“On the other hand, we decided that [when the] government had expressed its view by legislating or forming a treaty, for example on landmines, that was much easier for us to follow,” Murray explained.

 

Ericsson Pensionsstiftelse (EPS), the Stockholm-based SEK21 billion ($2.3 billion) pension fund for employees of the Swedish technology company, has recently added active long-only managers in its equity allocation. In a break from the last five years, stock picking is back because of what chief investment officer Christer Franzén calls a “probable” low-return environment from index strategies coming up.

“We haven’t used long-only managers in equity recently because we saw the stock market as a beta market,” he says. “Now, however, because the market is so expensive and future returns are probably low from here, we assume there will be a greater dispersion within indices.”

EPS will work with external managers using a concentrated portfolio of 30-50 shares, not the usual 100, he adds.

EPS is seeking to differentiate itself from the herd. Franzén explains: “Everyone flocks into passive today. It is great for the low fees, but we favour, in general, an active approach. This could be [achieved through] our own in-house activities via derivatives or specialist ETFs, or by using active managers. Regardless of the reasons – from low costs to regulation – you always need to question the wisest route to take and if there is alpha to be found elsewhere.”

A model focused on capital preservation

Strategy at EPS is focused on capital preservation and absolute returns. It is a model afforded by the fund’s structure, whereby EPS’s collateral comes under a mutually owned insurance company, PRI, which secures the defined benefit schemes for larger corporations in Sweden.

“EPS is a pool of assets; liabilities stay with the sponsor, in this case Ericsson the company,” Franzén explains.

Most recently, the fund has been focusing on cash-generating investments, rather than capital gains, in a strategy focused on lowering portfolio volatility and achieving a higher Sharpe ratio. Asset allocations start with a projection of future defined benefit liabilities and the return rate needed to meet them.

“From this, we do a classic asset liability management-study, where we assume the next five-year returns for all the asset classes, which then gives us a total possible return rate.”

The fund mirrors this analysis in a risk-factor model so it can discover if there are any risks that need to be mitigated.

“When this is done, we apply a macro overlay, which helps us decide if we should take more or less risk for the coming year. The board then decides on return targets and the proposed allocation for the year.”

There is a mandate for Franzén to deviate from that decided average within certain limits.

EPS’s current allocation is 35 per cent in fixed income, 15 per cent in credit, 20 per cent in real estate/infrastructure, 10 per cent in alternatives and 20 per cent in equities.

The equity allocation is divided between a 10 per cent allocation to public equity, 5 per cent to private equity and 5 per cent to equity long/short strategies. The fund has lowered its return targets over the last couple of years. It also divested from emerging markets four years ago, although it has started “to look at this again on a very selective basis”.

Strategy up until now has been focused on investing in companies from developed markets that could have exposure to emerging markets, due to stronger corporate governance and compliance.

Franzén doesn’t have a specific allocation bucket for hedge funds. He argues instead that traditional hedge fund strategies are “just another way of expressing an active and flexible approach, rather than being a separate asset class”.

He explains: “Returns from equities are normally, over time, the risk-free rate including inflation plus 4 per cent. This is more a common return target for many hedge funds these days; if higher returns are needed, leverage will be involved.

“Hedge fund fees are generally lower in Sweden compared with, say, London, where [a 2 per cent management fee plus 20 per cent of profits] has been the standard, even though it’s starting to change now.”

Bonds replaced with real estate

The real-estate allocation, three-quarters of which is in Swedish assets, includes social infrastructure such as court buildings and housing.

“We started 2009 searching for stable, cash-generating investments and Swedish social infrastructure and multifamily homes drew our attention. At the time, these assets were overlooked due to low returns and because they were seen as having less of a capital gain possibility. We thought it was perfect since they offered a decent cash flow with long durations, and a low probability for capital loss. After all, we were looking for assets to replace our low-generating bonds.”

EPS also manages the real-estate allocation.

“When we were searching for managers, we realised they were pretty expensive and most of the time the investments were more risky than what we wanted. It meant we started to talk to peers, and that led to starting several real-estate companies with them, which took our costs down significantly.”

EPS counts 20 managers on its roster, down from 35 a few years ago. Franzén considers the fund’s small size an advantage.

“We are…able to pick up stuff that the bigger funds can’t because it doesn’t move their needle. Some players are so huge they are, in practice, indexed themselves. We are small but we are also big enough to move around and take opportunities.

“We are a small organisation and pride ourselves on establishing strong relationships. We tend to stay with managers for a longer period of time if they perform within the top quartile. It’s important to understand how a manager makes money and whether it suits our philosophy. I don’t care too much if a manager has a bad year as long as I understand what is driving the returns. Not shopping around between managers too much saves us a lot of time.”

He also doesn’t use consultants, referring to them as “a layer of unnecessary cost”. The fund manages 40 per cent of its assets in-house, predominantly in fixed income and equity derivatives.

“I believe we need to be able to take care of our own fixed-income risk. My background is as a fixed-income trader, so anything on the macro front we are good at. In the equity allocation, we use derivatives as an overlay and are active if the market gives us the opportunity.”

Complexity is everywhere. And nowhere is its forward march more evident than in the field of investing. Seemingly unabated, the complexity of new products, processes, financial engineering and innovation grows.

And if you think investing is complex, take a moment to reflect on the dynamics of family relationships. Families evolve organically and acquisitively. And with every generation or addition, new personalities and opinions can emerge, complicating matters through conflicting agendas and differing priorities.

The coalescence of these domains – family and investing – can be the catalyst for the establishment of a family office. Few vehicles can assist in managing the complexity that families of scale face as effectively as a family office. Families aren’t homogenous and, depending on where they are in their lifecycle, may have myriad needs: formulating a family constitution; reviewing investment governance; undertaking estate planning or philanthropic activities, to name but a few. The family office agenda can be wide, dynamic and, well, complex.

Psychologist Daniel Kahneman, Nobel laureate in economics (2002) and author of Thinking, Fast and Slow, has evidenced how the framing of complex problems affects our decision-making. So why is complexity so pervasive?

Jason Hsu and John West argue that, “Complexity is almost hardwired into investors…and their asset managers.”

We know complexity costs more, perpetuates the belief that complex problems require complex solutions and, as Edsger W. Dijkstra, winner of the 1972 Turing Prize, opines, “…to make matters worse: complexity sells better”.

Complex doesn’t equal better

Traversing from Kahneman’s insights to the wisdom of Occam’s razor, it is important that we challenge the idea that complex problems require complex solutions. One lesson from the global financial crisis (GFC) is that complexity and fragility are almost constant bedfellows. As a trusted adviser, how can we best frame the right questions to ask families, at the right time? How can we help families set their sights on a metaphorical North Star (a set of objectives) that can help them navigate safe passage across the generations? We offer the following questions to start the conversation:

  • What is my role?
  • How can I see the whole picture?
  • How do I enable future generations? What is my legacy?
  • How can I step away from the details but still stay in control?
  • Who will make the decisions when I am no longer able to?
  • How could I manage my wealth more effectively to achieve the outcomes that matter?
  • Do I really understand my investment approach?
  • What level of risk should I be taking? How do I know if it’s correct?
  • How much is enough? For myself? For my children? For my giving?
  • How can I make the most impact with my giving?
  • The framing of these questions places the family’s objectives at the heart of all we do. It is an approach that, without apology, embraces simplicity and discounts complexity. These questions provide a basis for the challenging, but necessary, conversations needed to provide the family office with clarity of mission. The result is a laser-like focus on what is important and what is not.

In too many instances, complexity is used as a foil to avoid an uncomfortable reality. In the low-return world in which we live, the truth may be that the investment objective the family office sets is simply not attainable without taking on an unacceptable level of risk. Without doubt, it’s a tough conversation. Simplicity or complexity – let’s sit with this choice for a moment:

  • Frame A: We are unlikely to achieve the investment objective.
  • Frame B: We have found an opaque process that works well in expectation. It seeks high returns uncorrelated with the S&P 500, with a base-and-performance fee. Oh, and it comes with a side of unicorn, Q.E.D.

Maybe we shouldn’t sit with this too long.

Establish a clear mission

My research agenda with Adam Walk, head of investments at The Myer Family Company and a senior research fellow at Griffith University, has examined the tension between simplicity and complexity in the context of investment governance. We have argued that mission clarity is necessary to achieve family outcomes:

What is a sustainable, real withdrawal rate, for me, my family and my foundation?

What proportion of the corpus should be performance seeking?

How can I stay focused on the asset allocation decision?

What is my planning horizon?

What is the impact of fees and taxes?

The GFC hurt; are we scenario testing our investment approach?

Who is watching when I’m sleeping? Do I have institutional-grade risk-management processes?

Is my family office striving for best practice in investment governance?

Seeking simplicity can help us align the investment process to the priorities of the family. Such an approach challenges unnecessary complexity and calls out misadventure – it is robust and repeatable over time.

Complexity has important implications for family offices and their investment processes. We know that complexity can conceal the true level of risk. Consider the words of the late Steve Jobs:

“Simple can be harder than complex: You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.”

When seeking intergenerational wealth transfer, simplicity can illuminate the path for the family office to deliver on its mission.

Michael E. Drew is chief investment officer for The Myer Family Company and professor of finance at Griffith University.