If 2016 reminded us of anything, it’s that forecasting, especially political forecasting, is tough. With few pollsters or commentators having accurately predicted the outcome of either the Brexit referendum or the US presidential election, it would be wise to keep an open mind in relation to elections taking place in 2017. Growing nationalism, fragmentation and what some have dubbed “the death of liberal politics” are likely to remain prominent influences on the political landscape for some time.

Against this backdrop of geopolitical tumult, here are four themes it will be important for investors to consider when building portfolios in 2017.

  1. Fragmentation

Taken together, Brexit, the election of President Donald Trump, the rise of populism across Europe, and the increasingly nationalist tone of presidents Vladimir Putin and Xi Jinping, suggest a fragmentation of the prevailing global political order.

In an environment of heightened political risk and fatter tails, stress-testing portfolios against large moves in equities, bonds and currency will be important when assessing portfolio risk exposures. Volatility-sensitive investors may wish to consider approaches to managing their downside risk exposure via hard or soft hedges.

As the performance of sterling following the Brexit vote illustrates, political surprises create the potential for large currency moves. Protectionism and trade tensions could also lead to currency volatility. This increases the importance of having a clear policy on hedging currency risk and may also create opportunities for active currency or global macro-managers.

  1. Shift from monetary to fiscal stimulus

Last year may have brought the high point in monetary stimulation. Policymakers are increasingly recognising the limits and unintended consequences of quantitative easing and negative rate policies. At the same time, increasing calls for fiscal stimulus have been supported by both mainstream economic voices and populist politicians. The speed and magnitude of any shift from monetary to fiscal stimulus could have important implications for investors in the years ahead, not least in relation to the potential build-up of inflationary pressures.

Investors should, therefore, have a clear understanding of the impact that higher inflation could have on their ability to meet their objectives. For portfolios lacking in inflation protection, investors may wish to consider direct inflation hedges or real assets.

Regardless of the direction of yields, an increase in bond market volatility due to an increase in uncertainty around monetary and fiscal policy (following a period in which policy has been one-directional) should create more opportunities for strategies such as global macro, absolute-return bonds and unconstrained fixed-income.

  1. Capital abundance

Following eight years of central bank largesse and low levels of business investment, the world is awash in financial capital seeking yield. The exceptional returns of the past eight years will not be repeated and there is a scarcity of “easy beta” to be harvested. We believe portfolios dominated by traditional beta (that is, equities, credit and government bonds) offer a relatively unattractive risk/return trade‑off looking ahead. Investors will, therefore, need to prepare for lower returns or consider less familiar asset classes and more flexible strategies in order to deliver on their return objectives.

In this environment of low yields and low to moderate risk premia, we believe investors should place a greater emphasis on diversification of return sources. This can include systematic factor exposures (or “smart beta”) and idiosyncratic alpha (a function of manager skill) across a range of liquid markets.

While many private markets have had significant inflows in recent years, opportunities remain for high-quality managers to extract returns from a combination of illiquidity and complexity premia and direct asset management (or hands-on value creation). This is especially true for areas of the private markets where there is still a structural imbalance between the demand and supply of capital – notably private debt finance for smaller companies that have limited access to the capital markets.

Less familiar segments of the credit markets (such as asset-backed securities, private lending, trade finance and receivables) offer investors the potential to generate a premium to cash of 2 per cent to 4 per cent a year as compensation for complexity and illiquidity risk. Secured finance strategies provide one potential access route to such assets.

  1. Structural change

Amid the short-term discussion of politics and economics, longer-term structural forces, such as demographic trends, climate change and technological disruption, could also have far-reaching, if less obvious, implications for investors.

There is clearly some uncertainty around the future direction of US climate change policy under the Trump administration. However, climate change remains an issue of global importance, and we continue to believe investors should review portfolios’ exposure to carbon-intensive assets to assess the impact policy developments (such as carbon pricing or a carbon tax) could have on them. Carbon footprint analysis on listed-equity portfolios and recent developments in low-carbon indices can be valuable tools in addressing this source of risk.

The investment implications of demographic trends are far from clear, not least because changes in working patterns over the coming decades could mitigate the impact of ageing populations, thereby halting or even reversing any rise in dependency ratios. However, it is clear that some countries will be more challenged by these trends than others (either because their demographic trends are further advanced or because cultural factors make them less likely to be able to adapt in time). This will probably create differences in economic outcomes at a regional level.

Lastly, technological disruption will create winners and losers at a corporate level. This should generate opportunities for long/short equity investors, perhaps particularly on the short side of the book, as identifying the losers from technological change may be easier than picking the winners. An extension of this point is that market cap indices may be at particular risk of technological disruption, given that they hold large weights in the incumbents across many sectors.

The year ahead is sure to bring its share of challenges and opportunities. Investors who seek a clear understanding of their exposure to various sources of risk and build portfolios able to capture opportunities as they arise will probably have a more positive experience than those who do not.

 

Phil Edwards is European director of strategic research at Mercer.

Ten years ago, the UK’s £20.9 billion ($26.1 billion) Wellcome Trust, the charity established in 1936 with legacies from pharmaceutical magnate Sir Henry Wellcome, had a budget of about £500 million to spend on its medical and scientific research. Today, that has doubled, thanks to the success of an investment strategy split across public and private equity, hedge funds, property and infrastructure. Most recently, the fund has also been buoyed by slashing exposure to sterling ahead of the Brexit vote. Wellcome has just reported its investment portfolio added £3.5 billion in the year to September 2016, posting a return of 18.8 per cent.

Calling sterling correctly ahead of Brexit, as well as reaping the benefits of a steadily reduced home-country bias, are key components behind the latest returns. It means more money to fund initiatives such as developing vaccines, fighting drug resistant infections and mining patient data.

“Tactically, we viewed the risk to sterling from the referendum to be asymmetric and reduced our sterling exposure (including hedges) to a [record] low ahead of the vote. Sterling’s subsequent depreciation – and generally steady performance in underlying assets – enabled us to record a sterling return in the year of 19 per cent,” the fund’s trustees state in a recent report.

The Mega Cap Basket

Another reason behind Wellcome’s success is a substantial public-equity allocation. An internally managed Mega Cap Basket (MCB) which, at £5.2 billion accounts for 45 per cent of Wellcome’s 50.5 per cent public-equity exposure, drove returns. Unlike external managers with a bias towards smaller, higher-beta companies, the MCB is characterised by solid, large enterprises. It has intrinsic advantages that include the absence of management fees, an ability to use long-term market timing (for example, in 2015, the fund added consistently to unpopular resource stocks) and all the benefits that come with patient capital. Of the 27 stocks in the basket, 25 were first bought in late 2008.

“We have only rarely sold shares in any of these,” the trustees explain. “We have sold out of 10 companies completely; we have added three new ones, one of which (Facebook) we had held since it was private. We have 10-year absolute return targets for each company and no focus on market or sector comparisons. Each member of our investment team covers no more than four MCB companies and we have regular and constructive engagement on long-term themes with senior management. Hence, we buy and sell businesses, not share prices.”

This success has thrown a harsh spotlight on the fund’s external managers, whose returns have been much poorer. Wellcome’s 11 external equity managers are responsible for £4.2 billion worth of equity investments between them; eight underperformed against their reference benchmarks, by at least 5 per cent in each case.

“Although nine of the 11 are still ahead of their benchmarks over five years, warning bells are sounding,” the trustees note.

Over the past decade, the fund has reduced its external active management mandates in global and developed equity markets from 85 per cent to about 20 per cent of total public market exposure.

Hedge funds ‘underwhelming’

Today’s large 10.7 per cent allocation to hedge funds has been steadily halved from 23 per cent in 2008. Strategy includes a broad allocation that considers a variety of approaches but avoids funds that employ substantial leverage to achieve returns. It is also an allocation that is struggling.

“Hedge funds had a poor year and performance over three and five years is now underwhelming,” the fund’s trustees note. “Among the multi-strategy funds, it is evident that a number of firms, if not all, simply grew their assets too far and too fast. Among the equity long/short funds – even those with the discipline to remain hard closed to new monies, as virtually all of ours do – many are … being caught in ‘crowded trades’ [like] long-only managers. For them, after strong performance in 2014-15, it was a particularly disappointing year.”

Nevertheless, the trustees note that hedge funds should soon benefit from reinvestment risk rising elsewhere, as prospective future returns diminish from equities and, notably, from bonds, making long/short funds more competitive. However, the headwinds still appear strong.

“Very careful attention to bottom-up selection will remain key,” they advise.

Premium return from private equity

Private equity accounts for 25.2 per cent of the portfolio, in an allocation that has “continued to provide a premium return after costs and fees for illiquidity”. In 2015-16, large buyout funds led the way, with a 16 per cent return in US dollars. Although venture realisations have slowed after a couple of “spectacular” years, things could be about to improve. The fund’s 10 largest venture exposures have a substantial discount to the valuations their latest round of capital raising implies, the trustees note, adding, “There would appear to be plenty of latent value.”

Property interests of £2.4 billion are overwhelmingly UK-based and had a stable year, although the impact of the referendum vote is still being assessed.

More disruption ahead

Going forward, Wellcome’s trustees note, disruptive forces will continue to affect the part of the portfolio invested in higher-risk assets such as venture funds, direct private investments and multi-asset partnerships in selected emerging economies. These forces will include tailwinds such as the shift to e-commerce, the sharing economy and the impact of social networking.

On a sectoral basis, Wellcome will maintain its high exposure to technology-based companies and financials, especially in the US, for which prospects are “robust”. Wellcome is also betting on increased consumer demand, tilting towards China, India and other developing markets.

“Our increased investment in 2015 – both in energy and mining companies and in long commodity financial instruments – has been well rewarded in 2016, as commodity prices have rebounded. Overall, we are comfortable, but certainly not complacent about both the shape of our portfolio and its component parts,” the trustees conclude.

Malaysia’s Kumpulan Wang Persaraan (Diperbadankan) fund for public officials, known as KWAP, will continue to diversify its asset allocation, increasing investment in private equity, real estate and other alternatives.

“We believe a diversified asset mix puts us in better stead to benefit from changing market cycles to ensure sustainability over the long term,” the RM126.8 billion ($28.3 billion) fund’s chief executive, Dato’ Wan Kamaruzaman Bin Wan Ahmad, says in an interview from KWAP’s Kuala Lumpur headquarters. “We have to recognise the fact that the prospect for returns is not as good compared with what we saw in the last 20 years. We expect returns for equity and fixed-income securities to be lower, due to the all-time low interest rates, modest global growth prospects and high valuations of financial assets.”

It’s an outlook that is leading the fund to “explore and widen” its opportunity set, he says.

One reason KWAP can push into long-dated private markets is because the fund, established in 1991, still has no liabilities.

“Once we assume liability obligations, our investment strategy would have to be re-oriented and reconfigured to ensure that we have sufficient funds to manage the real cash-flow demands and pension pay-outs,” he says.

Alternatives including property, private equity and infrastructure account for 4.4 per cent of assets under management.

Alternatives pay off

Most recently, KWAP’s international alternative investments have added most to the portfolio, posting the highest return on investment, at 8.82 per cent, as of September 2016.

Domestic private equity has also been one of the fund’s best-performing allocations in recent years.

This is a factor Dato’ Wan Kamaruzaman, who joined KWAP as chief executive in 2013 following his role as head of treasury at Malaysia’s Employees Provident Fund, attributes to “the turnaround of venture capital”.

Venture-capital returns within the private-equity space outperformed other strategies at a level not seen since the height of the dot.com boom, he says. Yet he remains mindful of the challenges that come with private equity.

“Private equity has a long gestation period and is, in general, a challenging asset class,” he explains. “It creates a natural barrier to entry into this space.”

The challenge, and the opportunity, is to buy at the right price, creating value – something he calls “fixing what needs to be fixed” – and exit at the right time via the right route. He cites KWAP’s sale of a stake in Malaysian power producer Malakoff in its 2015 initial public offering as an example of handling all these factors.

“Done right, private equity can be a lucrative addition to the traditional asset classes in a pension fund, providing the much-needed alpha in this low-return environment,” Dato’ Wan Kamaruzaman says.

Other alternative forays include the fund’s first investment in domestic property, when it acquired land in the heart of Kuala Lumpur city centre in 2015. That investment brought the number of properties KWAP owned or co-owned to 14. Eight are in Australia and three are in Britain.

As of October 2016, assets are split between fixed income at 52.6 per cent, equity at 37.3 per cent, the 4.4 per cent alternatives allocation and a 5.7 per cent allocation to cash. Much of the public equity allocation is actively managed.

“We encourage active management in our public equity portfolio, with stringent risk and compliance monitoring,” Dato’ Wan Kamaruzaman says. “Our team of in-house analysts and experienced portfolio managers conduct in-depth due diligence and research that enable us to identify undervalued stocks with the potential to generate good returns over the long term.”

Eyes on foreign opportunities

KWAP has only about 11 per cent of the fund invested overseas, something Dato’ Wan Kamaruzaman is keen to increase.

“Under our existing strategic asset allocation, we had hoped to increase our overseas investments to 19 per cent of our AUM,” he says. “However, we had to defer this plan in 2014, following government directives. Our international investment would have been much higher than where it is now had our investments abroad resumed according to our transition strategy. We will resume with our international plans once the restrictions are lifted.”

Nevertheless, he insists restrictions do not completely inhibit the fund from investing overseas. Global investment opportunities are looked at on “a case by case” basis, with the most compelling getting approval.

“We are constantly communicating with our stakeholders and relevant authorities whenever we see compelling investment opportunities abroad … So far, we have been able to get the requisite approvals to invest in these specific opportunities.

“In the meantime, we are [also] raising our level of readiness by conducting the necessary groundwork and corresponding measures – research, analysis on investment strategies and asset classes – to ensure that we are already able to execute our investments effectively once the restrictions are lifted.”

Any increase in global investment has to be balanced with the fund’s keen priorities back home.

“KWAP remains committed to supporting the domestic economic agenda to the extent that it will also benefit the fund commercially without compromising our risk appetite,” Dato’ Wan Kamaruzaman asserts. It is a strategy that manifests particularly in KWAP’s proactive role in helping to build a sharia-compliant domestic bond market.

“Consistent with our long-term strategy to convert into a fully sharia pension fund, we have been investing in Islamic bonds underlying our efforts to deepen the country’s capital markets. This change is aimed at attracting more global investors, especially long-term investors like sovereign wealth and pension investors, to invest in the local market and at the same time enhance market vibrancy and boost investor confidence.”

Sharia strategy

KWAP’s steps towards Islamic law include building sharia-compliant portfolios with external managers. The fund has appointed five external fund managers to manage its domestic sharia equity mandate, six external fund managers to manage its domestic sukuk mandates and four external managers for its global sukuk mandates.

“On our internal side, we continue to support sharia instruments and deepen the Islamic capital markets. As of the end of September 2016, our sharia-compliant investment represents 49.7 per cent of the total assets. KWAP’s sister fund, The Employees Provident Fund, is offering an Islamic retirement plan, something KWAP is also considering,” Dato’ Wan Kamaruzaman says.

“KWAP has completed a readiness assessment to set up a sharia fund within KWAP or to convert [the fund] into a fully sharia pension fund. We don’t have a specific timeline for this, as the local and global Islamic finance eco-system must improve and develop further to support our sharia ambition,” he says, linking it to the fund’s own efforts to deepen the local market.

External management, internal expertise

The bulk of the portfolio (85-90 per cent) is managed internally, due to substantial holdings of domestic assets.

“These are areas in which we have strong conviction and expertise,” Dato’ Wan Kamaruzaman says. However, he is in favour of more external management for the diversification and increased opportunity it would bring the fund.

“Using external managers diversifies KWAP’s portfolio, expands the range of investment opportunities available and taps on their expertise,” he explains. “In the long run, we hope to leverage their expertise through these relationships to further develop internal talent, especially in managing more complex investments.”

Using external managers to build internal expertise boosts skills in Dato’ Wan Kamaruzaman’s growing team and helping the fund thrive is his favourite part of the job.

“I truly enjoy sharing my experience in the private sector and capital markets with the young team in KWAP,” he says.

 

 

Impressive statistics from Canada’s OPTrust, manager of C$18.4 billion ($13.9 billion) in assets for 87,000 former and current public-service employees in Ontario, make enviable reading for pension funds weighed down by deficits and low returns. In 2015, the fund returned 8 per cent and remained fully funded. Over its 21 years of operation, its investment portfolio has realised an average annual return of 8.4 per cent and, on average, 73 cents of every pension dollar paid to beneficiaries in the mature plan is generated by investment returns.

“Our investment strategy is based around the interests of our members, first and foremost,” explains Hugh O’Reilly, president and chief executive of the fund. “We are investing … to protect the funded status of the plan; we are not beating a benchmark. We take risks to generate returns but we will not jeopardise our funded status or our level of contributions. We see ourselves as a pension fund and not an asset manager.”

Prioritising members has led to a member-driven investing (MDI) strategy that O’Reilly contrasts with better-known liability driven investment (LDI), in which strategy is shaped around the cash flows needed to fund future liabilities.

“Some pension funds have adopted LDI, while others seek to maximise their returns,” O’Reilly says. “There is no right answer. We are driven by our members, by demographics and by what makes sense to us. If one looks at the Canadian model, therein lies a recipe for success founded in a few factors. Our plans are governed independent of the government and unions. We have internal investment teams, which allows us, generally speaking, to run the pension plan at a low cost, and our contributions are strong.”

Putting members first lay at the heart of last year’s successful navigation of volatility and low returns.

“Last year, we assessed the funded position and, seeing that we had a surplus, we set about steps, from an investment perspective, to preserve that surplus.” O’Reilly’s strategies included protecting the fund against Canada’s depreciating dollar, hedging the public-equity exposure and ensuring a strong alternatives portfolio, all mixed with a resolute belief in his team’s ability – although he does acknowledge some good fortune.

“We have skilled investors and it’s important to recognise those skills,” he says, but adds that “markets have a way of humbling you.”

Looking ahead, he sees continued uncertainty, which he plans to counter with strong alternative allocations.

“While US markets have reacted positively to the incoming administration, we are somewhat concerned [that they] may be overly optimistic,” he says. His strategy is to continue to hold robust allocations to real estate, private equity and infrastructure, which together account for a third of the fund’s assets. All are internally managed.

Infrastructure involves strategic partnerships and accounts for 12 per cent of assets under management. Through 2017, O’Reilly will look particularly at mid-market opportunities around the $100 million-$150 million mark.

“The market is expensive for larger assets like toll roads; we have changed our focus to smaller projects.” In 2015, he committed to four new infrastructure investments in North America, Europe and Australia, totalling $636 million; the portfolio generated a net return of 7.0 per cent in that year.

For private equity, O’Reilly has a sanguine approach, at a time when opportunities to invest are competitive and expensive.

“There is no pressure on us to put money out the door,” he says. “Only where we see opportunities that make sense to us do we pursue them.” Private equity represented 9.2 per cent of net assets at year-end 2015, up from 7.3 per cent at year-end 2014. The private-equity portfolio generated a net return of 14.4 per cent for 2015.

The public-equity allocation is managed externally but O’Reilly and his team are in the process of bringing the bond and foreign exchange allocations in-house. It’s a strategy designed to bring the fund closer to the market.

He explains: “We want to better understand where the trends are going in fixed income and foreign exchange, and bringing management in-house is the best way to achieve this. If you use external managers, you can’t react to secular trends. We also believe that this will save on fees and transaction costs.”

He is also steadily building the hedge fund allocation from 2.5 per cent of assets in 2015. The allocation now favours style premia and momentum strategies, although O’Reilly stresses a dynamic approach here – changing the allocation according to the needs of the total portfolio.

“Hedge funds are a way to harvest returns without owning the underlying asset,” he says. “We work to make sure the fee exposure is reasonable and look actively to make sure the strategies make sense for us.”

Responsible investment is integrated across every asset class in the fund. O’Reilly points to the latest suggestions from the Financial Stability Board’s Task Force on Climate Related Financial Disclosures. The task force is calling for companies to publish their potential losses from climate change. He says this is the latest step in an evolving movement. It’s an observation that leads him to ponder the growth of environmental, social and governance strategies.

“It is no longer about screening securities [over whether] they are good or bad,” he argues. “It is about engagement and due diligence and monitoring, and this is an exciting and important change. It’s here to stay.”

Among the 10 different pension and insurance schemes within the $16 billion Kentucky Retirement Systems portfolio lies one of America’s most distressed pension plans.

At only 17 per cent funded, the Kentucky Employees Retirement System (KERS) Non-Hazardous Plan is the biggest headache for chief investment officer David Peden. Speaking from the fund’s headquarters in Louisville, Kentucky – the US state best known for its horse racing and fried chicken – Kentucky-native Peden is under more pressure than the average pension fund CIO.

“Our investment decisions are under the microscope because of the funded status of the KERS plan,” he explains. “It’s a challenging place to be because even good investment returns will really have little impact on the health of the KERS system.”

And the investment returns Peden is dealing with are poor.

Rock-bottom bond yields and lacklustre equity gains have taken their toll on the portfolio, which reported a loss of 0.52 per cent in 2015. The worst performers were non-US and emerging market public equity (the allocation to emerging markets was axed through 2016) and hedge funds, in a result that falls short of the portfolio’s actuarially required rate of return of 7.5 per cent. Two of the 10 plans require a lower rate of return of 6.75 per cent.

Yet together with a new five-strong investment team, Peden is determined to turn Kentucky Retirement Systems’ fortunes around. He’s midway through altering the portfolio along fresh guidelines to cut costs and complexity and reduce risk.

“This is a complicated problem and we are putting as much intellectual firepower on this topic as we can,” he says, although he does acknowledge the challenge of recruiting dynamic teams in Kentucky. “We are not fully staffed; it’s a difficult place to recruit because Kentucky has only a small investment community.”

A first step has involved cutting the allocation to hedge funds by $800 million. Kentucky first invested in hedge funds five years ago and Peden stresses that this year’s lacklustre results are less of an issue in ditching the allocation than the desire to cut costs.

“Half of the hedge fund allocation will definitely be sold; the other half is under review. It is hard for hedge funds to sit within the context of a less complex and less expensive philosophy. It doesn’t mean they are wrong. In a [time of low inter-bank lending rates], while many may still be doing their job, it is difficult to justify the fee.”

Peden and his team will jettison the allocations that are duplicated in the main portfolio and don’t provide “enough bang for their buck”, such as equity beta, and credit beta in fixed income.

Global macro and trend followers, fixed income arbitrage and convertible arbitrage will remain for now. Peden is also exploring using managed accounts, rather than limited partnership structures, to improve transparency.

“I can’t say where we will invest the money from the hedge fund allocation yet; I don’t know the answer. I will in the next month or so.”

KERS Non-Hazardous has just over half its portfolio in equity, comprising a passive core with active management. The fund has increased its allocation to equity in recent months to try to achieve the 7.5 per cent long-term return goal; 2015’s best-performing allocations were US equity, private equity and real estate. Nevertheless, gradually reducing the equity allocation in line with a more risk-averse strategy is another of Peden’s priorities going forward.

“Over the last three years, the non-US equity allocation, and the dollar impact of that, have been a big drag on the portfolio. It is time to have the conversation about what is the proper allocation between US and non-US equity.”

The current allocation of the pension assets is 25.6 per cent to US equities, 25.2 per cent to broad market international equities, 10 per cent to private equity, 10 per cent to absolute return strategies, 8 per cent to real return strategies, 7.2 per cent to credit fixed income, 6.8 per cent to global fixed income, 5 per cent to real estate, and 2.2 per cent to cash or short-term securities.

The fund has relationships with 105 managers and about half of those are in private equity.

“We are looking to have fewer, more meaningful manager relationships,” Peden says.

As of June 2016, KERS Non-Hazardous had $3 billion of commitments across 42 private equity managers (66 partnerships) gaining exposure across the spectrum of strategies, including buyout, venture and growth, and credit-oriented strategies.

Peden is hopeful that the first signs of a rotation are under way as a consequence of the US election result. The selloff in bonds and rally in US equities led by sectors closely tied to economic growth, like banks, plus surging treasury yields, could be the beginning of a new era.

“[For] three years prior to the US election, it has been a very difficult period to have a diversified portfolio,” he says. “Value is doing better [since] the US election. To me, it seems that the psychology of the market has tipped, post-election; it is saying we are coming out of recession. The traditional stock-picking market is coming back.”

If he’s right, it could be just the change Kentucky needs.

Investors are scouring the world searching for ways to eke out a few more basis points in returns in an environment characterised by low prospective performance. Generally, they are having to push out along the risk spectrum to do this, so success is far from guaranteed.

For many investors, a more promising path to improving returns lies right at their doorstep. It’s not an easy route to travel but it is one they have a high degree of control over. This journey involves strengthening the governance arrangements they employ.

Let’s start with a definition. The Chartered Institute of Public Finance and Accountancy states that governance comprises the arrangements put in place to ensure that the investor’s mission is both defined and achieved.

There is now general acknowledgement that effective governance plays an important role in the success of organisations. But does improving the quality of an organisation’s governance improve the chances of it meeting its mission? In a recent paper, The Investment Case for Better Asset Owner Governance, Willis Towers Watson set out to determine how much better governance is worth to institutional funds.

The short answer is that it’s hard to be definitive about the answer. Measurement is difficult. If we had an objective score for governance recorded over many years, then we might, in conjunction with empirical data, be able to answer the question definitively. But we don’t.

Building on studies first initiated in 1994, Canadian pension governance expert Keith Ambachtsheer has argued that an improvement from poor to good governance is worth 100­-200 basis points a year. Moving from good to great may be worth another 100 basis points or more.

CEM Benchmarking has developed a database of net value add (a like for like measure) of contributing pension funds with more than 20 years of continuous history. Over the last decade, the difference between a first decile and 10th decile fund is about 140 basis points a year.

None of this work is conclusive about the value of better governance but it gives a broad estimate to which an investor might apply both their belief in the strength of the evidence and arguments supporting such value and the gap between their current and target governance state.

Because the link between governance and performance is not conclusive, the degree to which better governance leads to better performance is best expressed as a matter of belief. Many leading funds have an explicit belief about the importance of good governance. For example:

CalPERS CalPERS will be best positioned for success if it has strong governance
NZ Super Fund Clear governance and decision-making structures that promote decisiveness, efficiency and accountability are effective and add value to the fund
Railpen We value effective governance, leadership and strong culture as essential for a world-class investor

How strongly an organisation holds a belief about the value of governance will be a matter of some introspection. In addition, organisations will have their own inherent view of the quality of their governance. The danger with self-assessment in this area is the human tendency to be over-confident in one’s own abilities. Few funds will be willing to admit they have below-average governance, even though half must, by definition.

A common feature of better-governed funds is that they have organised themselves to counter inherent human tendencies that can contribute to value destruction through behavioural biases affecting how they invest, such as over-confidence and representativeness. Various studies looking at average investor performance in sharemarkets point to a drag of 100 basis points or more from behavioural biases.

Successful investors start by being clear about their mission, their organisational strengths and their beliefs about what drives investment markets and returns. They have a highly competent board and executive; the latter builds clear frameworks to guide their investment decision-making and applies them under clearly delegated authorities. They make decisions in real time, able to respond to opportunities as they arise. Finally, they never assume they have investing fully worked out; they are always learning. In short, they tend to score well across 12 factors highlighted in the landmark work on best-practice governance undertaken by Oxford University’s Gordon Clark and Willis Towers Watson’s Roger Urwin. These 12 factors can be attributed to the four broad areas where we believe asset owners can either create or destroy value.

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A governance rating framework, developed at Willis Towers Watson, allows us to rank organisations’ governance from C (very weak) to AAA (global best practice) across these factors. Using this framework, we can help funds make a realistic assessment of how much governance improvement is within their grasp.

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The attractive aspect of focusing on better governance is that it is a relatively inexpensive exercise – at least in dollar terms. An assumed $25 billion fund aiming for a lift from moderate to strong governance might expect to spend no more than 1-2 basis points up front to re-engineer itself to a stronger governance platform. This initial investment triggers the potential for a multi-year delivery of superior returns. Discounting reasonable expectations about what the future payoff might be demonstrates attractive returns on the initial investment.

If the investment case for better governance is so strong, why doesn’t everyone do it? It’s surely not a cost issue. As we have seen, financial costs to transform governance are relatively small in the context of other decisions funds routinely make.

The reasons are diverse. Some funds are constrained by legislatively enshrined poor institutional structures or are burdened by competing multiple objectives. Some lack the awareness to recognise that there are better governance models available and some that are aware simply might not know where to start. While the financial cost is relatively low (especially when viewed against other investing costs), the psychic costs of change can be high. Boards and their staff have to commit to a transformation program that will shake up the ways things have been done.

In our view, the case for continually improving how funds are managed holds through any environment. However, at a time when investors are faced with historically low expected returns, the case seems overwhelming. By combining how strongly they believe in the proposition that improved governance adds value with an objective assessment of where they currently sit in terms of best practice, funds can develop a strong business case to strengthen their governance.