“I’ve had easier weeks,” says Antony Barker, managing director and chief pensions’ officer of the £9.7 billion ($12.8 billion) Santander UK Group Pension Scheme, the defined benefit scheme for employees of the UK arm of the Spanish-owned bank, speaking the week after Brexit. But there was no suggestion that Barker was anything but prepared and poised to benefit from the UK’s decision to leave the European Union.

“The immediate impact of Brexit on the asset portfolio has been largely positive – gilt yields have depressed dramatically, but fortunately we increased our hedge ratios significantly and synthetically during the preceding weeks. Equities have recovered most of their initial losses, and as many of our mandates are global, unconstrained approaches, active management and a weakening in Sterling will have enhanced returns. Our real estate portfolio is tilted away from prime office accommodation and the private markets exposure is largely US dollar denominated. The themes in the portfolio were global ones, so the referendum result changes very little.”

It’s a robust position and “can-do” attitude, grounded in reforms that Barker introduced four years ago, when the fund shook off the stigma of being “a legacy HR problem” to become “a key business division of the bank,” innovating, demonstrating value for money and good governance.

The conservative investment portfolio of passive equity, index-linked gilts, and other conventional bonds was swept away for a more diverse risk-on investment strategy, combined with a reduction in overall risk by hedging the fund’s liabilities.

“We see two types of risk: unrewarded and rewarded,” Barker says. “We divide the opportunity set into economic or rewarded risk, and duration risk, which includes longevity and inflation and which is unrewarded, so hedged out at the best possible price. We identify the underlying investment thesis and then establish the best rewarded asset class to gain the exposure. It’s true that you can’t get more return without taking risks, but simply taking more risk doesn’t guarantee greater returns.”

Last year physical assets such as property and alternative investments were the portfolio’s best performing, with the $1.5 billion property portfolio posting gains in excess of 20 per cent net of acquisition costs and duties.

And it’s private markets where Barker has brought most transformation. Here investments are driven by individual stock selection considerations rather than macro level economics, he says.

The portfolio comprises global growth investments that Barker expects to double, or more, in value over a five-to seven-year period, even if economies and markets are stagnant. He focusses on smaller to mid-market opportunities and avoids speculative, highly geared or structured investments.

All direct acquisitions in private markets are driven by a theme or the “next big idea.” It could be in technology and digitisation; the ageing world or urbanisation and new consumer classes emerging in developing markets.

That’s entertainment

The fund has explored an entertainment theme with the acquisition of the Manchester Arena and The Brewery; another entertainment venue in London.

Barker likes the African middle class story, where changing consumer habits and technology take-up are creating opportunities in food distribution and mobile. In addition an energy theme doesn’t just stop with renewable generation, but includes energy consumption and transmission investments.

“A number of the strategies that we have in South America are looking at distribution of US-generated shale gas over a wider sphere.” Cybersecurity and handling big data is another theme.

“We recently invested in the leading company tracking epidemic diseases such as Ebola, which sells on their research to governments and insurance companies,” he says

And Barker believes Santander has the edge over other investors when it comes to off-market acquisitions.

“The reputation of pension funds is very much one of jilting people at the altar; we talk a good game, we have lots of meetings, but then we fail to come up with the goods at the right time. In off-market transactions, people want deal certainty.”

It’s something Santander can offer with cash in the bank and an ability to execute deals quickly.

“We have a longer time horizon than most, and having worked out how much cash we need to pay benefits over the next few years we can take on more complex projects and find extra value in ‘hairy deals’ needing true active management to extract that value.”

And he is quite prepared to put the work in to transform assets into a finished product. In today’s low return environment, improving the assets and then selling them on is proving a winning strategy.

Commercial property – so hot right now

“As the commercial property sector has been seen as increasingly hot, we have taken the opportunity to sell lower quality holdings at a very full price through a pro-active sales strategy, reinvesting the proceeds in new assets with demonstrable embedded value.”

Barker is a strong advocate of collaboration and shared services, linking up with other pension schemes in a variety of operating models, designed to enhance governance and execution and allow mutual participation in the best ideas.

It’s a strategy illustrated in Santander’s stake in Hermes’ infrastructure vehicle seeded by the $36.5 billion BT Pension Scheme.

Under this partnership, the Hermes fund has developed a number of renewable energy investments, as well as acquiring port sites. Most recently, Santander’s segregated account program supported Hermes’ successful bids for Eurostar and AB Ports.

And Barker is equally happy to collaborate with managers. In both private equity and the hedge fund space, Santander takes stakes in the managers so that the fund gets returns, both from a pay-off on its own investments and also from the broader success of the manager’s business through the cycle.

“In return for our investment, we enjoy a share of revenues in both the underlying fund managers and the selection business, doubling our return on the market beta exposure alone,” he says.

In private equity, the fund has worked with managers to create a low-fee fund of co-investments and a fixed fee non-discretionary account, where the manager brings due diligence, specific research and execution to ideas generated by either Santander or third parties. He also encourages more collaboration across the manager roster; for example the real estate managers work with private equity managers.

“This has reaped dividends in making ideas better, investments more profitable and execution more feasible. While good advice is always worthwhile, money paid away in fees is money that could go to pay pensions,” he says.

“The experience of pension funds generally over the past 20 years has not been good, and yet the appetite for change and innovation has been curiously limited, constrained perhaps by consultant and asset manager vested interests. If you always do what you’ve always done you’ll always get the same result.”

Canada’s Alberta Investment Management Corporation, (AIMCo), the C$90.2 billion ($69.4 billion) fund that invests on behalf of 26 pension, endowment and government funds, has more than three quarters of its assets in public markets, most managed internally.

This includes money market and fixed income allocations and a diversified mortgage portfolio, but the most sizeable chunk lies in a $27 billion sophisticated equity portfolio that combines passive low cost strategies with complex hedge fund allocations.

Internally managed equity investments include quantitative and passive strategies which currently invest in 45 countries around the world. Smart beta is one such allocation, and with it AIMCo aims to add 100-150 basis points every year.

“It’s been successful. I like smart beta,” says chief investment officer Dale MacMaster, in an interview from the fund’s Edmonton headquarters.

“We want to access beta as cheaply as possible.”

The smart beta ethos of breaking down returns into factors, and buying components like value or momentum, while isolating the remaining alpha is something he is now applying to an internally managed portable alpha strategy.

“We are adding more leverage to our own hedge fund strategies by customising the portable alpha allocation to a greater degree than before.”

Portable alpha combines leveraged exposure to an index with investments in a high-returning asset, or strategy uncorrelated to that index. The former provides the beta, the latter is supposed to deliver outperformance, or alpha. In a strategy that has evolved in recent years, MacMaster explains that a recent development is to create a global alpha pool that is then allocated across AIMCo’s beta exposure.

“We can have, say, Canadian beta and then receive alpha from a global alpha pool that has a diversified mix of exposures. It’s all about finding the most cost effective way to deliver alpha and beta.”

“I don’t want to pay exorbitant fees for straightforward hedge fund strategies that can easily be replicated. We try to be smarter in how we use hedge funds. A lot of what they can do we can do internally. Take a hedge fund that only trades volatility across every asset class – we can’t replicate exactly what they do, but there are strategies within that fund that we can execute on in-house, [on] a smaller scale, across a handful of assets.”

 

Many approaches to using hedge funds

MacMaster, who took over as chief investment officer in January 2015 and whose 17-year career at the fund includes its 2008 transition to the Crown Corporation, from Alberta Treasury Board and Finance, is, however, prepared to pay for enhanced strategies with high-conviction managers that promise to add a further 200-250 basis points.

These include long-only and hedge fund strategies with AIMCo using seven to eight hedge funds running uncorrelated strategies that bring real diversification and a deeper expertise than the in-house teams, while remaining cost effective.

“You have to acknowledge that you simply can’t do everything in-house. Currently you are seeing many pension funds divesting of their hedge fund holdings. There are many approaches to using hedge funds. We don’t look for especially high hedge fund returns; instead we look for diversified, uncorrelated alpha of modest returns, say between 6-8 per cent, on a basket of hedge funds overlaid with equity market beta.”

MacMaster uses hedge funds that specialise in leveraged credit, volatility and other diversified strategies.

“One of our hedge funds does nothing but buy positions of other hedge funds at a discounted rate in the secondary market,” he reveals.

“It’s probably easier to negotiate deals with new hedge funds that don’t have such a strong record. Most of our funds have long successful track records. If a fund has a 15-20 year record of shooting the lights out, it is difficult to negotiate fees downward. Some of our best managers have limited capacity for new money.”

AIMCo’s $19.4 billion private investment portfolio includes real estate, infrastructure, private equity and timber, where the fund is in the process of rotating land in timber to agriculture to maximise value.

The $10.4 billion real estate fund is still Canada focused with around 90 per cent of the portfolio in direct real estate with the pension fund only investing in funds when it needs the expertise or scale.

“We will invest with funds in specialist areas like, say, a total rehabilitation of a property in a geography where we have limited direct experience. We can’t do that so we find the guys that can.”

In a higher risk, higher return strategy, foreign real estate is increasingly focused on development opportunities rather than core, income producing real estate, he says.

 

In-house expertise

AIMCo used to only invest in private equity with funds, but once it built an in-house expertise and “hired the right people,” the portfolio evolved to combine fund investments, co-investment and directs.

Now the allocation is evolving again with MacMaster overseeing a strategy to target middle market private equity funds.

“There is fierce competition to invest in the large private equity funds – the biggest are turning away money. We can afford to fund the middle market funds and we can be the lead investor. The smaller funds do get the good investments too. There is a far greater choice in certain geographies and sectors.”

Private investments have also grown since AIMCo opened a London office. MacMaster says he has been amazed by the number of contacts and transactions that have come AIMCo’s way by people “attracted to our shop.”

Like so many other asset managers, AIMCo is benefiting from regulatory changes at banks.

“We have looked at opportunities in private debt and loan, collateralised loan obligations (CLOs) and trade finance. Some of these ideas are still being incubated,” he says.

“One challenge is that banks’ existing client relationships typically straddle numerous asset classes and can impinge on a pension fund’s specific investments. If you step in, you must make sure there is an alignment of interest, and that they have skin in the game.”

Sharing the risk is important and he prides himself on AIMCo’s deep relationship with a handful of partner banks.

“It takes time to structure things.”

“Canada has a very good reputation for pension management. Canadian funds have a very strong governance model with a blue-chip board operating at arms-length from government overseers,” he says.

“It was initially difficult to get the government’s attention that reform was important, but now AIMCo is a very successful story and I am proud to have been a part of it.”

A paper by the World Economic Forum’s Global Agenda Council on the Future of Investing, Innovations in Long-Term Capital Management, the Practitioner’s Perspective, examines the changing nature of investment decision making and governance and showcases investors who are innovating to take benefit from their comparative advantage.

It’s the age of the asset owner – which are more aware and better resourced than ever before. The paper highlights investors who have become significantly more conscious of the investment management value chain and the need for innovation. Many asset owners recognise that in order to sustainably reduce inefficiencies along their investment management value chain, they must first improve their own processes and capacity for innovation, the paper says.

The underlying premise of the white paper is that the future of investing lies in the ability to create new sources of wealth, rather than simply recycle claims on existing wealth. This means recognising where technology, demographics and inequality enable defensible profits and where they do not; and mitigating the greatest risk to sustainable new wealth creation – the insidious shortening of investment horizons that has been synonymous with rapid informational efficiencies.

The Global Agenda Council on the Future of Investing surveyed 21 major asset owners and managers to identify trends in their efforts to adapt to economic, financial and regulatory developments. While there were many variations in the way asset owners were adapting and innovating, in all examples, robust governance frameworks, rapidly advancing technological change and empowered leadership were enabling and driving innovation by these investors.

The WEF white paper, Innovations in long-term capital management: the practitioner’s perspective, outlines the result of that survey and showcases examples of how asset owners have invested in their knowledge capital, the resulting changes in their investments, and the implications for putting these new ideas into practice. Some examples are through responsible investing in real estate, investing in innovation, new approaches to asset allocation, thematic investing and manager flexibility.

The white paper clearly demonstrates the trend that asset owners are investing in their own capability and resources as a way of increasing their chances of success. From this increasingly self-sufficient and sustainable platform, they are innovating to both increase their operational efficiency and identify the areas in which their comparative advantages enable this wealth creation.

Alison Tarditi, chief investment officer of Commonwealth Superannuation Corporation, who is chair and member of the WEF’s Global Agenda Council on the Future of Investing, says there are a number of variables forcing asset owners to look at different investments. These include: the prospect of an extended period of low returns, the life stage and professionalisation of institutional asset owners, regulation, technological innovation.

“Asset owners are investing in their own capacity for innovation and governance is the key,” she says. “Good governance is all about strong organisational self-awareness; the simple but powerful realisation that the way the organisation is structured will affect its ability to leverage knowledge adaptively and be successful. We don’t have to all be the same but we do all need to have a candid self awareness, reflected in a focus on our purpose and unique comparative advantage.”

What the innovators have in common

The common thread among those funds that were innovating were governance first, that diversification relates to risk not assets, implementation remarries ownership and control, and extending connectivity outside the traditional investment ecosystem.

All of the asset owners in the survey reported having culled their external relationships and increased the size of their mandates to a smaller number of investment partners.

“Complete internalisation of the entire investment manufacturing chain is still considered counter to the dominant trend of identifying and exploiting comparative advantage. What has changed is asset owners’ ability to identify, price and react to inefficiencies within their supply chain. This should support innovation across the investment ecosystem, enable capital to be efficiently allocated to previously unexploited opportunities…” the paper says.

This paper is all about the long-term practitioner’s view, and the idea the industry needs to slow down and push back on the “insidious shortening of time horizons,” Tarditi says.

“The short term nature that some companies exhibit is failing to satisfy,” she says.

“The whole premise of the paper is that the future of investing is in the creation of new wealth, not the recycling of claims on old wealth. Asset owners are increasingly focused on the most efficient ways to finance real economic activity to productive ends.”

The paper “clusters” asset owners into three groups on how they innovate: by leveraging first-mover advantages; by leveraging the tenet that diversification relates to risk, not assets; and by remarrying asset ownership with control.

While the approach taken by each institution was different, five principles of effective investment governance were common. All the innovators had:

Strong organisational awareness. The simple but powerful realisation that the way the organisation is structured will inevitably affect its ability to create, maintain and leverage knowledge adaptability

Clarity and consistency of purpose

Candid self-awareness. This is reflected in a realistic assessment of areas of comparative advantage (to which they purposefully resource) and areas of weakness (which are either avoided altogether or outsourced)

  • Transparency. This supports accountability that, over time, build credibility with all stakeholders and underpins the appropriate extension of the investment horizon

A culture of learning and recognising failure early on. This enables organisational flexibility and empowerment from the bottom up.

 

The WEF white paper, Innovations in long-term capital management: the practitioner’s perspective, is available here: WEF_GAC Future of Investing Executive Summary

The case studies are available here: GAC16_Future_of_Investing_Case_Studies

Today’s highly quantitative risk management industry is the product of simultaneous advances in computing power and finance theory since the 1960s.

Exponential increases in computation speeds have allowed academics and practitioners to create a wide range of mathematical models, able to process vast amounts of historical data and create large numbers of projections of the future.

While undoubtedly useful when used appropriately, the resulting tools (now ubiquitous across the industry) have created an over-reliance on numerical estimates of risk.

The language of risk is dominated by the terms “volatility” and “value at risk” creating an unintended blind spot in relation to risks or trends that are inherently difficult to measure or quantify.

The following quote from Lord Kelvin – inscribed on the wall of the social sciences building at the University of Chicago – could quite easily be the slogan of today’s risk management industry:

“When you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind.”

This very scientific perspective (Lord Kelvin was after all a physicist) encourages a belief in numerical measures as a mark of understanding, while disparaging insights that cannot be expressed in numbers.

However, as Andrew Lo and Mark Mueller pointed out in their paper “Warning: Physics Envy May Be Hazardous To Your Wealth!” some aspects of the world around us involve such a great degree of uncertainty, they simply cannot be quantified or captured in mathematical models.

As the author and philosopher G.K. Chesterton said:

“Life … looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

We believe that an appreciation of the inherent “wildness” of economies and markets, and an acceptance that this complexity cannot be easily measured or captured in mathematical models, is an important first step towards arriving at a more robust outlook on risk.

This is not to suggest that quantitative tools should be abandoned altogether; rather that we should elevate a more qualitative perspective on risk to sit alongside the quantitative perspective that often dominates risk management discussions today.

‘Numbers’ failed to predict the GFC

It is important to acknowledge that we already place significant weight on qualitative views in many aspects of the investment decision-making process.

For example, stress tests and scenario analysis, manager research ratings, dynamic asset allocation views, operational due diligence assessments, environmental, social and governance views and ratings, and many other important investment activities are partially or largely qualitative in nature.

However, at a strategic level, many investors and financial institutions rely heavily on the numerical outputs of stochastic models, while qualitative considerations are treated as supplementary or of secondary importance.

We believe that a more robust approach to risk management should do two things to address this short-coming: first, it should raise the importance assigned to a qualitative perspective within the decision-making process, while correspondingly reducing our faith in the output from quantitative models; second, it should provide a broader perspective by expanding the types of risk considered as part of the strategy-setting process.

Adopting this broader perspective on risk is consistent with the direction of travel in the wider economic community since the financial crisis.

In recognition of the failures of modern economic thinking in predicting the financial crisis, complexity economics (a branch of economics that had until recently been largely ignored by mainstream economists) has been receiving an increasing degree of attention from both practitioners and policy-makers.

In short, complexity economics suggests a view of the global economy as an inter-dependent complex system that will experience periods of stability and – possibly extreme – instability. Needless to say, complexity economics views the world as is inherently difficult to model or forecast.

Developing a forward-looking risk management framework

The World Economic Forum produces an annual Global Risks Report that puts forward a survey-based, qualitative perspective on the major risks facing the world over the coming decade.

The report acknowledges the challenges of making such wide-ranging, long-term forecasts and uses a simplifying framework with five broad categories of risk:

Economic

Environmental

Technological

Societal

Geopolitical

Within each category, a number of important “global risks” are identified and their relative likelihood and impact are assessed.

We have adopted this framework as the starting point for creating a qualitative risk dashboard. This dashboard identifies a handful of potentially significant risks under each of the five categories.

Against each risk, we propose a number of possible mitigation actions, as well as approaches that might capture the upside opportunity arising from the market’s under-appreciation of a given trend.

The appropriate actions that follow will vary by investor, depending on time horizon, risk appetite and governance budget. However, in broad terms, we believe that three categories of action warrant discussion:

At the board level, investors should be clear on the time horizon and categories of risk that matter most to them. A clear set of beliefs is a pre-requisite for effective decision-making.

At the strategy level, investors might identify specific areas of risk that could present a material threat to their objectives and consider actions to mitigate or manage those risk exposures.

At the portfolio level, investors should seek to ensure that the time horizon of their underlying managers is consistent with their own time horizon. In addition, strategies with a focus on delivering sustainable long-term returns are likely to adopt a broader perspective on risk, by considering factors such as environmental, social and governance and other risks, as a natural part of their portfolio construction process.

In an increasingly complex and inter-connected world, we believe that a broader perspective on risk is essential in helping investors navigate an uncertain future.

When Robin Diamonte became chief investment officer of the pension fund for US technology giant United Technologies Corporation, (UTC), in 2004, 85 per cent of the portfolio was in growth assets and 15 per cent was in fixed income, with no hedging element at all.

UTC, which develops and manufactures high-tech products, particularly for the aerospace industry, has a global workforce of some 196,000 and boasts a defined benefit plan of $24 billion. Through the course of the past 10 years, Diamonte has introduced diversity and risk management to the defined benefit portfolio with sophisticated and complex liability driven investment (LDI), risk parity and portable alpha strategies with a keen focus on the fund’s liabilities.

“When I took the job we set about integrating the pension fund strategy closely with the corporate strategy. The size of the pension fund is large, versus the market cap of the company, and if I could reduce volatility in the pension fund, it was clear it would be good for the company. I’ve been in the business for a long time. In the 1990s most pension fund chief investment officers had no idea what a liability even was: they just focused on investment returns.

“2003 was a major shock, then came 2008. I’d say some have adapted but some haven’t,” she says in an interview from the fund’s Connecticut headquarters.

Now the portfolio is divided between growth assets (65 per cent) and hedging assets (35 per cent). The hedging element is shaped around a liability driven investment strategy that consists of a portfolio of long corporate bonds tracking a customised Merrill Lynch index, shaped to suit UTC’s specific pension liabilities. It currently accounts for around 40 per cent of the fund’s interest rate risk.

“Our LDI strategy is focused on building a hedging portfolio and de-risking over time. It’s moving slowly because of low interest rates, but we are hedging a great deal more than we ever did.”

The remaining 65 per cent of the portfolio is in growth assets, divided between global equity, private investments – that include private equity and distressed debt allocations – real estate, risk parity and structured equity, or so-called portable alpha.

The 14 per cent allocation to portable alpha, grown from an initial 5 per cent but unlikely to get much bigger, is designed to combine alpha over time with an underlying beta that contributes to the fund’s liability driven investment strategy.

By simultaneously hedging the fund’s liabilities and achieving an excess return – the portable alpha produced 3 per cent alpha last year – Diamonte is adamant the strategy “allows us to have our cake and eat it.”

It gives “some juice” in an arching de-risking trajectory and steady increase in the funded ratio.

“We are targeting a funded ratio of over 100 per cent,” she says. The plan was 83 per cent funded in 2004 when she joined and ended last year at 88 per cent funded, but has spiked above that during her tenure.

The portable alpha allocation was originally set up so the beta portion came from long bond futures, but this was changed to a global equity futures exposure.

“We have the underlying beta in futures and cash with hedge fund managers. The hedge fund managers are all market neutral and low volatility; they are alpha generators, but because they are market neutral they haven’t blown up,” she says, using a term often associated with hedge fund failures.

 

‘Jumped’ on urban, small and luxurious real estate

“What we are trying to achieve is an uncorrelated alpha stream that has low volatility. We only expect between 2-3 per cent from the alpha. We never took away from our equity allocation and put it into hedge funds,” she says in reference to the guiding principles, and expectation, behind the allocation.

In the past year, UTC’s allocations to private equity and real estate performed the best.

“Our private equity does well when the equity market does well, but has less volatility and higher returns. Private equity managers can take a longer-term view, have more flexibility and control, and don’t suffer from as much regulation,” she explains. The fund’s 6 per cent allocation to real estate returned 16 per cent last year.

“The main reason real estate has done so well is because it has come off a very low base,” she says.

The fund seeks high-quality, low-risk investments, with assets including 35 properties owned outright. Diamonte has found a particularly strong investment theme co-developing urban, small and luxurious complexes characterised by common spaces, security and gyms for residents.

“We jumped on this and it’s done very well. One of our properties is up 36 per cent, another is up 80 per cent.”

In contrast, risk parity hasn’t fared as well.

“The risk parity allocation underperformed the total fund in 2014 and 2015,” says Diamonte. “The commodity component, added to help the portfolio in rising inflation markets, has been a drag on performance. However the portfolio has done well since its inception in 2005. It has provided diversification and has performed as expected in the various environments.”

Be nimble and be quick

The majority of the fund is in active allocations bar a few exceptions.

“We still have passive allocations but for the most part it’s active.”

Diamonte only has an eight-strong internal team and all assets are externally managed.

She says it’s a challenge finding managers for active strategies that add value over time, but welcomes a trend among managers to develop pension solution departments. As well as an increasing appetite among managers to be more of a partner with pension funds rather than just selling products.

“Hedge fund and private equity firms are more willing to listen and negotiate on fees. They are definitely more buyer-friendly”, she adds.

The fund uses some 40 managers, excluding the private equity allocation, and another 40-odd in private equity.

“That number has come down. We increasingly use the same manager to manage different portfolios. We spend a lot of time understanding our managers and seeking how to combine their different styles.” She says that because United Technologies is a large portfolio it can negotiate better fees, which come in at around 30-40 basis points.

But Diamonte doesn’t believe insourcing would offer the fund any benefits.

“If you are all in passive strategies and if you are immunised, it makes sense to be internal. But we want to be nimble and we are de-risking overtime. If we were to manage our assets in house, it would require research, trading facilities and compliance to meet regulation. We’d build up, for example, an emerging markets desk, but then we’d be getting rid of emerging markets as we de-risk, so it wouldn’t make sense. As it is, we can hire and fire and be nimble if our managers are losing their competitive edge,” she says in a nod to the ability to change and adapt that lie at the heart of her strategy.

“My background was in electrical engineering. I was the only female back then but I didn’t really notice. I think women do think about things differently. We are more willing to change our minds if something isn’t working.”

After Amanda White’s now famous interview with Eugene Fama last October in Chicago, in which Fama describes a belief about active investing as a “statement from the moon,” I think that Fama must look at long-horizon investors as a crazy bunch.

When I went to university, I studied finance. I was taught efficient markets theory, the capital asset pricing model (CAPM) and arbitrage pricing theory (APT). No mention of fundamental investing at all. It was like a religion. Lots of Fama, Ross, Sharpe. And I subscribed to the religion.

To do Fama right, efficient market theory has brought a lot to investing that is extremely valuable to most investors in the world. And he is right to wonder why there are not more people investing passively.

A few good things to mention: Market efficiency as a reference point for thinking about investing is a very good idea. A broadly diversified portfolio as a starting point for portfolio construction is smart. And the use of passive investing and benchmarks has brought better and more efficient investing to an enormous amount of people and institutions. A lot of wisdom in a simple package. It transformed intelligent investing into a cheap and efficient commodity, like cars and radios.

So, a move to passive is smart from many points of view: it is cost effective, transparent and simple. Theory applied effectively.

But at the same time, there were some things that haunted me. And as it goes with religions, I have long thought that I was a sinner by even thinking these things.

Keith Ambachtsheer was very important to me in that respect. He is the first person I met who hammered home the term: “turning savings into wealth,” as the core objective of investing with pension money. And he always refers to his source, Keynes’ General Theory of Employment, Interest and Money, chapter 12. A great read.

 

Investing has everything to do with the real world

So Ambachtsheer does not say: pension funds should be harvesting the market return. Not beta and alpha, no, he says: “turning savings into wealth.” The very important meaning of that statement is that investing has everything to do with the real world.

In efficient market thinking of course, there is no such thing as a good price, a high price or a low price. There is only one price, and that’s the right price.

There is no connection at all between the market price and the underlying economic activity, because the market is always right. Thus, the financial markets can float freely and independently of the real world. I now think this idea has contributed to grave accidents in the financial markets like the global financial crisis.

Also, efficient market thinking has led us to believe that the market, by its invisible hand, will magically steer corporate management towards creating maximum long-term shareholder wealth, by allocating the capital of the firm in the most productive way possible.

I think this is not the case, and also more and more companies themselves feel they are forced into short-term behavior by the myopia of investors.

So it seems to me that there can be too much of a good thing. Efficient markets are pretty good, but I think of it as a partial description of reality. A beautiful room in a bigger house.

Now these things are all fine and not to worry about when you are an “atomic investor,” who really should act as a price taker and depend on others to set the price right.

But together pension funds and sovereign wealth funds own a very substantial part of the world’s productive long-term capital. It would be strange if they acted only as price takers.

Because of their scale, their knowledge and their position in the long financial chain – from the actual saver of capital to the user of capital – they can do things differently, to a certain extent.

And they are important, because they represent the saver and they can, at least in theory, control everything further downstream in the financial chain, such as asset managers and how they operate.

Long-term investing, or being a long-term investor, means different things to different people. Key elements of a good definition of long term investing are to me:

Value and price are not always the same. You have to go back to fundamentals.

  • Allocate capital where it will be productive. This implies that you have to have an idea of where value is created in the real world.
  • Value creation will (largely) determine price on the longer horizon. Therefore, it is long-term value creation you should focus on, not short-term market returns.
  • Be selective about what you own, and be an involved owner.

These simple statements have profound consequences for the way asset management should be organised.

The million dollar question therefore is: can we be reasonably certain that we will be rewarded for being a long horizon investor? Because, if we’re not, then why bother?

A sound answer to this question will determine whether long horizon investing will really take off among asset owners or not.

 

Jaap van Dam is principal director of investment strategy at PGGM.