Investment strategy at the United Kingdom’s Coal Pension Trustees Services is characterised by a sizeable equity allocation and a growing portfolio of illiquid investments, including shipping assets, to generate cash flow.

CPT manages the pension pots of the British Coal Staff Superannuation Scheme (BCSSS) and the Mineworkers Pension Scheme (MPS), two defined benefit pension funds with combined assets of £20 billion ($25 billion) that are among the few lasting legacies of the UK’s once-vibrant coal mining industry.

All management is outsourced, and apart from the passive equity allocation, none of the assets are pooled. The two funds are run as separate pension schemes with separate boards of trustees. Nevertheless, they are bound by a shared strategy developed over the past five years by CPT chief investment officer Stefan Dunatov, for whom a primary task is aligning trustee objectives with investment strategy.

“My job is to give impartial advice to the trustees on investment strategy and implementation – including manager search and selection – and ensure the asset allocations are geared towards achieving the two schemes’ objectives,” Dunatov says.

Over the last year, CPT has boosted its exposure to illiquid assets, including private debt, special situations debt, shipping and property, in a growing allocation funded primarily from cash and equity sales. It’s a strategy Dunatov likes for the high cash flows, comparing it to holding long-term bonds. Along with private equity, each scheme now has between one-third and one-half of its assets designated for illiquid investments.

The private-debt allocation, grown from zero when Dunatov arrived to about 10 per cent of assets in both schemes, comprises direct secured loans to businesses based in the UK, Europe and the US. The return-seeking strategy deliberately targets riskier corporate debt, often below investment grade, in mandates outsourced to four managers, including Goldman Sachs, Sankaty Advisors and Apollo Global Management.

“We make it quite clear what risk we are prepared to take but we are not involved in actual company calls,” Dunatov explains. “However, we can veto or stop investments anytime we like. In private debt, we do rule out managers that are not prepared to put skin in. The more we have our interests aligned with our managers, the more comfortable we are with the mandate.”

A 6 per cent target allocation to special situations debt is held through limited partnerships via a combination of segregated and pooled funds. Here, the underlying investments are principally loans made to corporations of all sizes in Europe and the US, capitalising on opportunities in niche segments of the debt and credit markets, including distressed debt.

‘Floating property’

Also in the illiquid bucket is a target 1.5 per cent allocation to shipping assets, comprising about 20 tankers that bring “high” income, but are also more of a “deep value buy”. This allocation was also introduced under Dunatov’s watch. He likens it to floating property.

“You own the ship and lease it out. The credit risk is more volatile than for property, but we are compensated for this very well,” he says, declining to comment on the allocation’s latest returns. He does say slow global trade “hasn’t been a problem” for the portfolio, which is poised to gain as commodity prices pick up again. He also likes the fact the allocation fits CPT’s industrial past: one of the ships is even called Sheffield, the northern city that is home to CPT.

CPT’s real-estate investments are directly owned, mature commercial property investments, all in the UK and, again, chosen for their high income. Although the bulk is in offices and shopping centres, “a small slice” is going into residential property.

“Very little” of the portfolio is in London, Dunatov says, where prices have recently come under pressure since Brexit.

“There is nothing distressing about this portfolio; there are no alarm bells ringing,” Dunatov says.

Both BCSSS and MPS share large listed equity allocations, particularly MPS, at 51.1 per cent, versus BCSSS’s 36.7 per cent.

“We forecast our expected return for all asset classes based on various economic scenarios,” Dunatov says. “Our allocation to equity isn’t because of a love of equity. It is because it’s the best way to achieve our aims.”

That’s something CPT has been doing. Both schemes beat their benchmark for the most recent annual reporting period, posting a 2.7 per cent return. The annual return over three years is above 8 per cent.

Fewer, more meaningful, managers

The equity portfolio is divided three ways: between a passive allocation, a quantitative allocation in factor strategies, and a more traditional active allocation. Because all management is outsourced, Dunatov has no stock-level views, although he is increasingly questioning of the extent to which active equity outperforms low-cost beta strategies.

“Active managers are having a hard time, but they are killing themselves by not responding with lower fees to the passive alternatives.”

The number of managers the fund uses has grown with new asset classes and Dunatov says CPT now has about 15-20 “important” relationships, excluding managers in private equity and special situations debt. The fact that he highlights only “important” relationships is indicative of his intention to have fewer, more meaningful manager relationships in the future. He also says asset manager fees are set to fall.

“Asset managers have to show why their margins should be so high in a world of low returns,” he says. “Technology is taking over and I don’t know why this isn’t shown in the fees. Nor should managers charge the same basis point fee for all the money coming in, or across the asset class. A large amount of fat needs to be cut out of the asset-management industry.”

He concludes: “It is not obvious we are out of this low-beta return world, despite the Donald Trump effect. After the financial crisis of 2008, there was a clear theme of support for risk assets. Now, after so many years of strong equity returns, it is about how to consolidate that wealth.

“Given the illiquidity in our portfolio, we also need to understand how best to change this allocation in the future, as and when we need to.”

There are many great things about working as a finance journalist for a global publication. One that certainly features highly is the access I have to incredible people.

The world lost one such incredible person last week. Steve Ross, the Franco Modigliani Professor of Financial Economics at the Massachusetts Institute of Technology and a professor of finance at the MIT Sloan School of Management, unexpectedly passed away on Friday, March 3, at the age of 73.

I had the privilege of working with Steve over the past few months in preparation for our Fiduciary Investors Symposium, which will be held at MIT in October. As with many academic institutions, we need faculty support to be on campus. Steve was introduced to me by John Skjervem, chief investment officer of the Oregon State Treasury, and I had the privilege of working with him in securing event space and academic speakers for our event.

Steve didn’t know me and didn’t have to help us, but he was generous and thoughtful with his time and contacts and was interested and engaged with what we were trying to achieve.

Steve was an intellectual and a gentleman, and I am grateful for the short period of time I knew him.

In recognition of his work, and life, I wanted to share the communications from MIT and the California Institute of Technology (Caltech), where Steve was a trustee and alumnus, which beautifully describes his many contributions.

 

To the members of the MIT Sloan community

MIT’s motto of “Mens et Manus” [Mind and hand] purposefully combines rigorous academic thought with practical applications to address the world’s greatest challenges and opportunities. For illustration and inspiration in this regard, during the last two decades we have needed to look no further than to our colleague, Professor Steve Ross. The hallmark of Steve’s scholarship was a rare combination of deep insight, academic rigor, intellectual elegance, and a keen sense of practical relevance, which has made his contributions equally central to the theory and practice of finance. Steve was a discoverer of the first order. He was also a master practitioner. Indeed, as Steve once put it, “There is no other way of doing it.”

Steve Ross passed away on Friday, March 3, at the age of 73. His passing was unexpected and much too early for all who knew him. He leaves behind his beloved wife Carol, his two children, and two granddaughters, whom he adored. Steve also leaves distinct contributions to the field of financial economics, to MIT and to his many students. Trained in mathematics and economics first at Caltech and then at Harvard, Steve joined the MIT community in 1997 as the first Fischer Black Visiting Professor, after serving many years on the faculties of the University of Pennsylvania’s Wharton School [of business] and Yale. In 1998, he decided to join the MIT Sloan faculty on an ongoing basis – and we have been so much the better for it.

Steve Ross will be remembered as an intellectual giant. What is known today about the science of finance and its application owes much to Steve’s pioneering work, ranging from asset pricing to investment management and corporate finance. Steve did not believe in narrow specialisation and intellectual boundaries. It is difficult to imagine the discipline of modern finance without Steve’s contributions.

Steve made seminal contributions to the theory and practice of option pricing. His work on the risk-neutral method and the binomial model in option pricing provided a powerful tool in the modelling and valuation of financial derivatives, widely used in the financial industry. Steve’s work on the term structure of interest rates has had an equally profound impact on fixed-income markets. It has laid the theoretical foundation for the modeling and pricing of bonds and their derivatives. It has also inspired the development of dynamic equilibrium models of asset prices and the real economy. Steve pioneered the use of signaling theory and agency models in corporate finance. These models have become a cornerstone in our analysis of corporations, organisations and economic relationships.

Steve may be best known for his Arbitrage Pricing Theory, commonly known by its acronym, APT. This theory provides a general framework for analysing risk and return in financial markets. In addition to its immense influence on the theory and practice of asset pricing, the APT is ubiquitous in investment management and performance evaluation.

In addition to all his achievements in science, Steve is probably the single most influential mentor and teacher in all of financial economics today. His Socratic approach to teaching encouraged students’ ideas and enthusiasm, assisted them in developing an independent analytical mind as a scholar, and helped them find their own voice. His former students can be found in almost all major finance departments.

In this time of sadness, let us remember his leadership and what a tremendous privilege it was to count him among our ranks. We will always remember the generous and cheerful friend and colleague whose talents were so immense that he never needed to prove anything to anyone. Plans for a celebration of Steve’s life are forthcoming. In the meantime, please join me in offering our deepest sympathies to Steve’s friends in our community, and to his family.

Sincerely,

David Schmittlein | John C Head III Dean

MIT Sloan School of Management

 

 

Caltech mourns the passing of trustee Stephen Ross

Alumnus and senior trustee Stephen A. Ross (bachelor of science, 1965), whose work helped shape the development of the field of financial economics, passed away on March 3, 2017. He was 73 years old.

Ross was perhaps best known for his arbitrage pricing theory and agency theory. The first –considered a cornerstone of modern asset pricing theory – holds that price changes of all assets are driven by a limited number of underlying influences, such as gross domestic product, inflation and investor confidence.

Agency theory applies to situations that involve a principal – for example, an investor or a stockholder – who has employed an agent to make decisions on their behalf. Since the agent might be motivated to make different decisions than the principal would, the theory involves creating incentives that make it more likely that the agent will make decisions that are desirable from the principal’s perspective. This theory is particularly appropriate for large corporations, where executives often make decisions on behalf of shareholders.

Ross also helped develop techniques for pricing derivatives that are widely used on Wall Street and in other financial centres for determining the value of complex financial instruments.

“Steve Ross unstintingly applied his deep knowledge of financial economics and complex organisations to help guide Caltech,” says Caltech president Thomas Rosenbaum, the Sonja and William Davidow Presidential Chair and professor of physics. “We will sorely miss his keen insights, his generous spirit, and his infectious sense of humour.”

Ross was first appointed to the Caltech Board of Trustees in 1993. At the time of his death, he was a member of the investment committee, which he had formerly chaired. He also served on the Executive Compensation Committee and was on visiting committees for the Division of the Humanities and Social Sciences.

“As Steve was the chair of the Investment Committee when I arrived at Caltech, I had the honour and privilege of working closely with him,” says Scott H. Richland, Caltech chief investment officer. “Steve had a rare combination of brilliance, kindness and humour. His devotion to Caltech and his contributions to guiding the endowment will be greatly missed.”

For his contributions to finance and economics, Ross was the recipient of the 2015 Deutsche Bank Prize, given [every two years] to “internationally renowned economic researchers whose work has a marked influence on research concerning questions of financial economics and macroeconomics, and has led to fundamental advances in economic theory and practice,” according to the Center for Financial Studies, which awards the prize in partnership with Goethe University Frankfurt, in Germany.

Ross was born on February 3, 1944, in Boston, Massachusetts. He received his bachelor’s degree in physics, with honours, from Caltech in 1965 and his PhD in economics from Harvard University in 1970.

At the time of his passing, he was the Franco Modigliani Professor of Financial Economics at MIT and a professor of finance at the MIT Sloan School of Management. He previously held faculty positions at Yale University and the Wharton School at the University of Pennsylvania.

In addition to his academic positions, Ross worked as an adviser to various government departments – including the US Treasury, the Commerce Department, and the Internal Revenue Service, as well as the EXIM Bank. He was also a consultant to a number of investment banks and major corporations. He was a former chairman of the American Express Advisory Panel and served previously as director of General Reinsurance, the Federal Home Loan Mortgage Corporation (Freddie Mac), and the College Retirement Equities Fund.

Ross was a cofounder and principal of Ross, Jeffrey & Antle LLC, an investment advisory firm specialising in using options to enhance the performance of institutional portfolios.

Ross was the president of the American Finance Association in 1988. He was widely published, authoring more than 100 articles and co-authoring an introductory textbook on finance. He was also an associate editor of several of the field’s journals.

In addition to the Deutsche Bank Prize, Ross was the recipient of the Morgan Stanley Prize (2014), first prize in the Roger F. Murray Prize Competition (2013), the Onassis Prize for Finance (2012), and the Jean-Jacques Laffont Prize (2007), among other honours. He was a fellow of the Econometric Society and of the American Academy of Arts and Sciences.

He is survived by his wife of 49 years, Carol Ross, his children Katherine Ross and Jonathan Ross, and other family members.

A quarter of companies in the MSCI All Country World Index have a large tax gap, paying an average rate of 14.3 per cent versus the 31.8 per cent that would be expected, based on the jurisdictions where they generate revenue.

A new report from MSCI ESG Research shows that MSCI ACWI Index constituents with a tax gap would have faced additional annual tax liabilities of up to $220 billion if the entire tax gap had been plugged by regulatory reform.

In the report, MSCI ESG Research states it has seen growing demand from institutional investors for data and metrics to assist in understanding their exposure to emerging risks from global tax policy shifts. In response, it has addressed tax transparency under the corporate behaviour theme and developed a new data set and scoring mechanism within its ratings framework.

This will be rolled out in phases over the next few years. The first phase is focused on flagging companies potentially facing high regulatory, legal and reputational risks on tax-related matters, based on MSCI ESG Research’s assessment of the gap between the companies’ reported tax rate and the estimated statutory rate based on where a company generates revenue.

Investors can use this tax-gap analysis for possible engagement and to develop a more targeted set of companies from a broad, diversified universe for further due diligence.

The research also outlines the attributes that would make a company place poorly in rankings from the analysis: a high estimated tax gap; a lack of transparency around the geographical breakdown of revenue (for example, if less than 50 per cent of total revenue is disclosed in country-by-country form); and involvement in tax-related controversies in the last three years, such as regulatory fines or ongoing litigation.

 

The full report, The Tax Gap: Regulatory responses and implications for institutional investors, can be accessed here.

 

It is important to play games. We view gameplay as imperative for children because it helps with cognitive and physical development. Competitions teach children patience, social skills, negotiation, strategy, confidence and how to win and lose. Games are also important for adults. As we age, these activities help relieve stress, maintain brain function, stimulate creativity and help us feel young and energetic. In addition, games enhance our professional development. For example, the military conducts war games to teach our soldiers the complexity of their craft and prevent catastrophic outcomes. Airlines make a significant investment in flight simulators so the 87,000 flights that cross our skies each day take us safely to our destinations. Lawyers hone their skills in mock trials to better advocate for their clients. Professional athletes go through preseason games so they can deliver more victories to their fans. Throughout our lives and across settings, games benefit us in multiple dimensions.

In this spirit, the $14.5 billion Public Employees Retirement Association of New Mexico (PERA) investment division has an internal investment competition. Each member of the team constructs a hypothetical portfolio based on agreed-upon criteria. The portfolios run throughout the calendar year, with weekly checkpoints. This annual exercise began in January 2015 as a way to facilitate an esprit de corps and instil incremental investment acumen and discipline. It is a highly productive exercise, as it creates an environment in which all members of the team can challenge one another’s hypotheses. Moreover, this atmosphere facilitates constructive feedback in which people formulate ideas and defend their positions. Improving investment knowledge, skill and discipline across the team benefits PERA’s 100,000 members, as we continually strive to improve the processes through which we administer the pension trust fund. As we near the end of this year’s competition, several themes and behaviours have emerged that are similar to those we see in the institutional investment marketplace. Thus, our friendly simulation has become a microcosm of the asset management space. This virtual reality helps flag behavioural biases across PERA’s roster of money managers and allows us to minimise the impact of potential adverse influences.

 

 

The rules

Each participant begins the investment period with a fictional $10,000 portfolio. A virtual exchange prices securities and processes trades. Accounts must contain at least three distinct asset categories, hold 10 positions of 5 per cent, have no single holding greater than 20 per cent and have one-third of assets invested internationally. Eligible investments include indices over stocks, bonds, real estate, real assets and commodities. Team members can invest in publicly traded securities and exchange-traded funds (ETFs). Players must choose their own portfolios and cannot adopt actively managed mutual funds. In addition, portfolio rebalancing is required each month. To create a dynamic competition, the portfolios must change by at least 10 per cent as part of this monthly rebalancing exercise. Moreover, the competition does not allow borrowing funds against assets. The group serves as its own watchdog and monitors compliance.

Performance

Observing how fluctuations in the markets affect each player’s portfolio teaches a great lesson about investing. The year 2016 had a horrific start. The broad MSCI All Country World Index was down more than 10 per cent through the first six weeks of the year. Markets also exhibited dramatic drawdowns across most asset categories in June, with British voters’ unanticipated decision to leave the European Union. In addition, there was volatility on either side of the US presidential election. Due in part to these and other market gyrations during 2016, the investment challenge highlighted the benefits of broad asset category diversification.

Recalling the guidelines, portfolios could have no position greater than 20 per cent (including cash) and had to maintain diversification across asset categories and geographies. As a result of these guidelines, the virtual portfolios weathered the difficult environment. The philosophy behind the guidelines is consistent with that of the real-world PERA fund. PERA diversifies its investments across asset categories and geographies. The fund does not try to time markets; asset category diversification provides risk mitigation across cycles.

The rebalancing the game requires is another critical element to success in uncertain markets. It is the process of realigning the weightings of a portfolio of assets. This involves periodically buying or selling assets in a portfolio to maintain a desired asset allocation and risk tolerance. Specifically, an investor would sell above-weight investment strategies in order to buy those that are below the target amount. This is another key investment tenet of the PERA fund. As the virtual portfolios generated gains following market downturns, so too does the PERA fund benefit from rebalancing over the course of a full cycle.

Investment operations emerged as another key element in the competition. For example, the virtual exchange we used to manage our friendly competition failed to account for stock splits. It also did not properly return cash for an ETF that was delisted. These operational flaws affected the reported values of several portfolios in the simulation. As our team is quick to note, investment operations should be front and centre. It is naïve to refer to these important functions as back-office; they are critical to the proper function of a complex institutional investment program. Good investment performance is dependent upon the right operational infrastructure.

 

Observations and lessons

Many patterns emerged from the 2016 investment competition. These items stimulated much debate among the group. Here are some of the issues we discussed, our observations on them, and lessons they taught us.

Active v passive strategies

Observation: The principal difference in the portfolio models employed by the group was the use of active versus passive investment strategies. Active strategies try to beat a market benchmark through skilful security selection. Passive or indexed strategies embrace a benchmark predicated upon the belief that markets are efficient over time, especially when adjusted for risk and fees. Many people invested in a collection of passive indices. Others created concentrated portfolios of individual securities. The latter group embraced volatility and the former shied from it. There were nuances across implementations. Some of the participants were active within their asset category specialty and passive across other strategies. Others took the opposite approach and embraced risk in the areas outside their subject matter expertise.

Lesson: We believe asset allocation is the principal driver of the variance in performance for diversified portfolios. While picking an individual security may be more exciting, it is not the winning solution over an extended period for a public pension plan. Absent proprietary research, broad exposure to multiple asset categories is a better long-term investment approach for an institution such as PERA. Our mandate is to distribute benefit payments today and into the future. Accordingly, spreading capital across various asset category indices or betas provides better downside protection. The decision to invest in an index versus picking individual securities provides valuable insight into the actual marketplace. For efficient asset categories, such as large-capitalisation US public equities, active managers have trouble beating the comparable passive strategy. Moreover, those managers who beat the index in a given period often trail it in subsequent ones. Yet, active managers have an allure that is akin to a good story. From a marketing perspective, these story-based strategies attract much attention because they are fun and appeal to the adventurer in all of us. We all want to win and active strategies give us a chance to beat the odds. At the same time, many of these stories belittle passive strategies as boring and pedestrian. The manager’s challenge is to rise above the noise by optimising the expected return per measure of expected risk. Adventures are fun, but for the most efficient asset categories over extended periods, indexing may be the optimal strategy.

Crowding

Observation: Another behavioural theme relates to crowding. Each portfolio in the competition is transparent and visible to every participant. Crowding exists when many people invest in similar securities and strategies. With similar trades come like outcomes. Like outcomes yield blurry information and a lack of differentiation. Said differently, there is safety in numbers.

Lesson: As we see with commonplace trades in the money-management space, crowding benefits money managers through consistent peer performance. As a positive, this may allow someone to win by not losing. Alternatively, this is akin to benchmark hugging (when an active manager closely mimics its underlying index) or survival through conformity. One motivation for such risk-averse professional portfolios is asset and fee maximisation. Specifically, managers that move with the herd may have a better survival rate. Clients may not fire them based on undifferentiated peer comparisons.

From the perspective of the PERA portfolio, our most significant form of risk management is diversification. In addition to diversifying our investment strategies, we also employ multiple money managers to avoid organisational risk within a single investment firm. Our money managers’ peer rankings are not particularly relevant. We do not benefit from overlap or crowding within like mandates. Crowding helps only our money managers. It shifts the focus from what is an optimal investment structure to what is safe in the context of peers and universe rankings. Where we employ active money management, we expect our managers to express an educated point of view and develop the best collection of securities in a category. We encourage our managers to think and execute, as opposed to just surviving against their peers. We want our managers to be hungry and motivated to generate appropriate risk-adjusted returns for PERA. We are vigilant towards this end. We structure tight investment guidelines with each money manager. Investment guidelines are a list of do’s and don’ts for them. We also hold the vast majority of our investment securities at PERA’s custody bank. This account structure gives us greater visibility throughout the whole PERA fund and helps us avoid unintentional positional biases such as crowded trades.

Quartile rankings

Observation: In contrast to the crowded portfolios, some within the investment challenge went their own way and tended to perform at either the high or the low end of the spectrum. People in this group changed in the standings throughout the year and readily moved from top 25 per cent to bottom 25 per cent and vice versa. It is noteworthy that some within the go-it-alone cohort tended to reduce risk and join the benchmark huggers after periods of success.

Lesson: Once again, this is a common observation in money management. Managers often gain attention subsequent to a period of outperformance. Asset owners and their advisers flock to investment managers based on historical performance. However, mediocre performance often follows success, as a manager may have incentives to play it safe. We see this in sport when a team with a large lead starts playing less aggressively and taking fewer risks. In investing, like sport, there may be a victory despite a change from successful tactics. Specifically, the money manager may gain additional investors. With additional clients come additional wealth and fame. Losing this source of income would not be a rational action by a money manager. Unfortunately for incremental investors, the desired outcome may be disappointing, as the previous success often yields mean reversion. S&P Global publishes data on this in its persistence scorecard. This report details the lack of consistent placement in the top quartile by money managers. In many cases, the passive strategy produces the most reliable performance.

Distribution

Observation: The dispersion of portfolio returns over the course of the year is somewhat related to the preceding theme, yet this observation is different. Typically, the majority of balances resided in a tight band throughout the year. The median portfolio (the middle one) moved up and down based on overall market conditions and at of the year it generated a positive return. The concentrated nature of the set of portfolios is representative of a distribution curve taught in an introductory statistics class. The shape, however, was not normally distributed. There was a significant difference between the median and the mean (average). In our case, more people performed above the average. The underperformance was greater than the outperformance, indicating the risk-taking incentives for those in the bottom quartile.

Lesson: Our virtual world is instructive as an analogue for the real one. The existence of a distribution curve is also highly relevant for institutional investors. Too many mangers and institutions refer to their portfolios as being in the top quartile. Mathematically, not everyone can even be above the median, let alone in the top quartile. There is excessive marketing accompanying peer standings. Institutional investment mandates are too important to award participation trophies to all managers. Balancing qualitative and quantitative factors in an unemotional manner enables investors to better position a portfolio.

Risk-taking incentives

Observation – As illustrated above and much like the ending scene in Thelma & Louise, team members with diminishing chances of winning the competition took uncompensated risks as we neared the end of the year. Whether it was panic or a refusal to accept defeat, this group dramatically increased risk. By investing in higher beta strategies such as IPOs, companies in crisis and countries with geopolitical turmoil, these participants hoped for a big pay-off. These last-chance strategies had mixed success, but were arguably rational decisions from the point of view of game theory.

Lesson – In a simulation, it is easy to adopt the mantra “go big or go home”. The PERA investment team realises that we cannot take this type of cavalier approach to managing a portfolio as important as the PERA fund. The lessons from the investment competition are vital to remaining humble, focused and disciplined. As for the takeaway, it is imperative to understand manager or strategy underperformance and evaluate it in the context of a larger portfolio. Underperformance can be a result of an out-of-favour strategy detracting from returns, such as energy in 2015. Alternatively, poor performance can be an indicator of excessive risk within a strategy. Judgement based on experience and collaboration is necessary to recognise that out-of-favour strategies may be attractive in the future. This is the premise behind rebalancing programs that foster a buy-low/sell-high philosophy. In contrast, it is prudent to avoid managers that incur excessive risk, like Thelma and Louise, in trying to elude a bad outcome. Hope is not an investment strategy and may lead to unintended consequences. At PERA, our systems and processes help determine the positive and negative contributors to performance. We recognise that positive returns require the same level of review as negative ones. Specifically, a true performance evaluation requires a comprehensive analysis that evaluates both risks and returns. This multi-dimensional framework helps us flag and eliminate excessive risk-taking motivations among our managers.

Conclusion

We are nearing the end of our second annual investment competition. With a minimal commitment of time, the exercise yields impressive results. The challenge helps us better interact as a group. We find common ground around our core function as stewards for PERA members. Investments should occupy the majority of our discourse and the challenge enhances that commonality of purpose. It also creates a healthy desire and discipline to be the best at what we do by enabling us to identify behavioural biases that exist in the broader investment world. The resulting awareness improves our overall skill and judgement as a team. We look forward to continuing this competition in 2017 and beyond.

Jon Grabel is the chief investment officer of the Public Employees Retirement Association of New Mexico.

Any discussion of fees and costs for pension funds should be within the context of “value for money” and not in absolute terms, Keith Ambachtsheer says.

“It is value for money that matters in pension fund management, not whether costs are high or low relative to those of a comparable group of peers,” Ambachtsheer argues. Are the benefits of scale being passed through to better member outcomes? This is the type of question that should be asked of the pension industry, he says, rather than focusing on fees.

In the February issue of The Ambachtsheer Letter, he quotes a report Australia’s Productivity Commission recently handed down that outlines criteria for assessing how efficient and competitive the superannuation system is at delivering the best outcomes for members.

He summarises the “sensible pension efficiency benchmarking proposals of the Australian Productivity Commission and offers a fast-track route to their implementation around the world”.

How the commission did it

The Productivity Commission’s approach was to define system-level objectives and formulate assessment criteria based on these objectives, then identify indicators to facilitate the assessment.

In other words, it asked, as Ambachtsheer puts it, “What are relevant…criteria? Or, stated differently, ‘How should pension system performance be benchmarked relative to the goals of adequate long-term net returns and pension protection?’ ”

The commission’s search for a suite of performance benchmarks led to five system-level objectives and 22 assessment criteria, supported by 89 unique indicators.

Assessing how competition affects efficiency is challenging. On the supply side, one must determine whether market concentration is a good thing or a bad thing. Meanwhile, on the demand side, competition is often driven by irrelevant information and unhelpful product proliferation.

Given these questions and considerations, Ambachtsheer says, the Productivity Commission suggests focusing on time series analysis – meaning asking questions such as whether competition is leading to a decline in industry fees and profit margins over time – or checking whether the benefits of economies of scale are being applied to benefit members.

The Productivity Commission report defines three types of efficiency in the development of performance indicators: operational, allocative and dynamic.

Ambachtsheer explains that net return is an example of a key system-level operational efficiency driver. Actual long-term net returns versus those of reference portfolios and CPI+X benchmarks are relevant indicators, and segmentation by member phase, asset class and geography are also relevant.

Another variable in operational efficiency is cost. Total costs should be captured and reported. They should also be separated into components, so the effects of such factors as fund size, investment policy and implementation strategies can be assessed and better understood when comparing efficiency.

Not reinventing the wheel

Ambachtsheer commends the Productivity Commission’s approach to the value-for-money question and explains that the wheel does not need to be reinvented in order to implement the commission’s recommendations.

CEM Benchmarking, of which Ambachtsheer is a co-founder and co-owner, has already designed and implemented many of the Productivity Commission’s recommendations. For example, on the cost side, CEM has extensive multinational net return, cost, organisational scale, structure/location, and reference portfolio databases, with information covering more than a decade for a group of 133 globally dispersed funds.

This data can be used to look at operational efficiency, which Ambachtsheer defines as net value added (NVA), or net return minus the reference portfolio return. Using the CEM data is revealing. For instance, when 10-year net value added is plotted against average operating costs, it reveals no correlation.

In other words, Ambachtsheer says, on average, paying more for asset management did not raise the net value added for the 133 funds measured in the database.

“Other recurrent research findings include a positive correlation between net value added and fund size, between NVA and proportion of assets managed internally (especially private-market assets), and between NVA and governance quality,” he says. “There is now a realistic opportunity to benchmark pension system efficiency – value for money – around the world, in a logical, consistent, comparable manner.”

In the week leading up to the 2016 US presidential election, members of UniSuper, Australia’s second-largest industry fund, made the biggest switch to cash the fund had seen since the panic at the height of the global financial crisis in 2008.

That was enormously frustrating for the chief investment officer of the A$54.7 billion ($42 billion) default fund for Australian university employees, John Pearce.

“The thing I always try to impart to members is that the best long-term strategy is to stay the course,” Pearce says. “To me, it is quite problematic positioning a portfolio for those big one-off type geopolitical events; even if you had perfect foresight of how the election was going to unfold, it would have been impossible to predict the impact on markets.”

Most members who switched in the GFC did so too late and, more vexingly, then left it too late to switch back to growth assets and missed the recovery. With the US elections, many of those members who ‘got it right’, and moved to cash in anticipation of Donald Trump’s win, might be feeling pretty smug. The problem is that, in terms of investment outcomes, they still got it wrong – they would have been better off sticking with their balanced or growth options.

The ‘risk-off’ sentiment in global markets following Trump’s surprise victory lasted just one day before many asset classes got a bump. US bank stocks, in which Pearce’s UniSuper had topped up its holdings throughout 2016, added 15 per cent in the three weeks following Trump’s victory.

Internal strength and ‘fortress assets’

UniSuper is Australia’s sixth-largest super fund overall. It consistently ranks as one of the best in terms of investment performance. Pearce’s tenure at the fund has been defined as much by his leadership skills as by his investment chops.

Most super funds complain about a lack of member engagement but UniSuper is dealing with a different set of challenges, stemming from a membership that is inquisitive and active. Engaging with members via investment updates over email and video is a growing part of Pearce’s remit.

Also, Pearce began insourcing investment management seven years ago, and today his internal team of 35 managers runs 55 per cent of UniSuper’s assets in-house. That ratio is tipped to swell.

“We have a very scalable operation so we could take on a lot more FUM [funds under management] without hiring a lot more people,” Pearce says.

The internal team is focused on “mainstream domestic assets”, such as its large-cap Australian shares portfolio. Local small-cap mandates are delegated to external managers and most global stock picks are also outsourced.

At the core of the in-house strategy are what Pearce refers to as UniSuper’s “fortress assets”, which include major holdings in toll road operator Transurban, Sydney Airport, and various shopping centres.

Recent target reductions

In early November last year, UniSuper lowered the return target on a number of its conservative investment options, including dropping the five-year target on its capital stable option from CPI +2 per cent to CPI +1.5 per cent.

“The mandate for the capital stable option dictates it must be invested in 70 per cent defensive assets, so we can’t avoid having a lot of government bonds in there,” Pearce says.

With real interest rates at zero, it would be “both impractical and imprudent” to target a decent margin, so members have to be warned to lower their expectations. This is especially important for retired members who may have to adjust their spending habits.

The fund’s balanced and growth options have not been lowered, although they remain under ongoing review. A much longer time horizon on balanced and growth options, of between seven and 10 years, gives investment managers more opportunity to meet the average targets.

“People panic when they see market corrections, but these are healthy,” Pearce says. “If we didn’t have market downturns, we would have to keep adjusting expected returns because we would be in a bubble situation. I’ve been in the market for 30 years and you’ve just got to keep reminding yourself that things are never as good as they seem, and never as bad as they seem.”

Watch the housing market

As for 2017, the dominant force shaping global financial markets, “without a doubt”, will be what happens to US Treasury yields, Pearce predicts.

He also tips European politics to throw up “a fair bit” of volatility over the year ahead. Closer to home, he has a watchful eye on the local housing market.

“The question is whether we’ll see a correction or an orderly working through of the excess supply of apartments, particularly in [capital markets] Melbourne and Brisbane,” he says.

That is one of the reasons UniSuper reduced its holdings in Australian bank stocks over the past year, redeploying that capital into US bank stocks.

Over the past 12 months, UniSuper has also deployed more capital to its US-focused global healthcare share portfolio managed by Janus Capital Group, and to its global resources portfolio managed by Henderson Global Investors. It has also handed a new Indian equities mandate to a Schroders affiliate on the ground.

More recently, UniSuper has been researching how to invest in emerging-market Asian credit for the first time, and is in the final stages of reviewing a shortlist to select an external manager for the new mandate.

Pearce remains hungry for more good infrastructure assets but prefers to invest in listed vehicles.

“We tend to stay away from any of the big unlisted deals that look like they are going to get overly competitively bid,” he says, explaining why UniSuper didn’t lob bids in the recent auctions for the Port of Melbourne or electrical infrastructure company Ausgrid.

Looking after life savings

Not one for fancy mission statements, Pearce says the closest thing he has to an investment philosophy is simply that “superannuation equals life savings”.

“That sounds quite motherhood,” he squirms, but it has proven a valuable guiding principle. “It actually rules out a lot of things.”

It’s why UniSuper does not invest in opaque hedge funds, frontier markets, complex highly leveraged structures or private equity and venture capital funds, he explains.

The aversion to private-equity funds should not be misinterpreted as a lack of appetite for private assets. Far from it. Pearce just wants more control and transparency at a lower cost than is possible via a fund structure.

He also says he recently almost signed a “really exciting deal in the tech space” with an undisclosed “global business that just happens to be based locally”.

“Unfortunately it fell over; I mean, it’s not dead, but it’s a complex deal and there were a few details we couldn’t get our mind around,” he explained.

Having built a successful in-house team, Pearce is in a better position than ever to drive a hard bargain on fees.

UniSuper has external mandates with 14 Australian equity managers, 11 global equity managers, 11 property managers, eight fixed-income managers and a handful of managers across other asset classes.

“We have always had the scale to negotiate pretty sharp deals with external managers. I think the in-housing has just added to that competitive strength of ours,” he says. However, he thinks investment management fees in Australia are “pretty sharp” and “takes umbrage” with the finding of the David Murray-led 2014 Financial System Inquiry that superannuation is a high-cost industry.

George Clapham, managing partner at Australian boutique firm Arnhem Investment Management, has been doing business with Pearce for nearly a decade. He runs an Australian small-cap mandate for UniSuper and says the investment chief probes his fund managers on a lot more than fees.

“John is very active in talking to us about why we make the decisions we do about certain companies,” Clapham says. “He takes an active view on things like executive remuneration.”

UniSuper was one of the institutions that succeeded in putting pressure on Commonwealth Bank of Australia to dump controversial culture bonuses in its latest remuneration report.

Australian Securities Exchange-listed companies should consider themselves on notice that Pearce will continue to push back about executive pay structures that are not aligned with shareholder value.

This article first appeared in Investment Magazine, sister publication to conexust1f.flywheelstaging.com.