In 2014, the Ontario Teachers’ Pension Plan (OTPP), considered by many to be the best pension plan organisation in the world, paid salaries, incentives and benefits to its 1109 employees of C$300.5 million.

As chief executive, Ron Mock, got a base salary of C$498,654 and total direct compensation of C$3.78 million – which included long-term incentive payments of C$1.961 million. Neil Petroff, the executive vice president of investments, got paid C$4.48 million, including C$2.722 million of that in long-term incentives.

These sound like grand figures. And indeed they are. However, what is behind the figures is more interesting than the numbers alone.

The total investment costs of OTPP, including staff salaries was C$460 million. On assets of C$153 billion, that’s about 28 basis points.

Conversely, the $295 billion CalPERS, which is restricted in what it can pay staff due to its public sector identity, paid $159.3 million in salaries and wages in 2014 – around US$60 million less than OTPP. But it spent a massive $1.347 billion in external management in the 2014 financial year. Which means it is paying costs of about 45 basis points on external managers alone.

In a cost review, CalPERS identified that 91 per cent of total costs were from external asset management fees, and of that 87 per cent of those external fees were from private assets and hedge funds. The fund, which has a 20-year investment return of 8.5 per cent, has since been recalibrating its portfolio, including its private equity and hedge fund programs, to bring costs down.

But OTPP doesn’t need to compromise investments in potential high-alpha generating investments – 38 per cent of its portfolio is in natural resources, real assets and absolute return strategies, and the 45 per cent in equities is split between public and private markets.

It has generated an annualised rate of return of 10.2 per cent since 1990.

Why the differential?

The comparison of these two funds reveals so much about organisational design and strategy, the inputs to pay structures, and the subsequent value generated. It is naïve to consider salaries on face value.

The difference in the cost structures of these two large pension organisations is largely due to internalisation, particularly of private assets investments, which means paying high salaries to investment professionals. But as much analysis has shown, it is this exact function that is the differential in excess return between funds.

The article Is Bigger Better? Size and Performance in Pension Plan Management by Alexander Dyck and Lukasz Pomorski, shows that a significant source of excess total fund return is the large-scale implementation of private markets investment strategies by specialised in-house pension fund investment teams.

And going deeper, the major driver of success was a reduction of overall fund costs, with external funds management costs considerably greater than the differential in in-house investment staff pay.

Seemingly then, pay differential among organisations is often dependent on the active versus passive management component of a fund’s investments, the extent to which it is insourced, and the private versus public assets split.

OTPP advocates that to get upper-quartile performance, you need upper-quartile people, and to get upper-quartile people you have to pay them upper-quartile salaries. OTPP is the best-performing fund in the world, by many measures. So some attention should be paid to this argument.

Global pay practices

Keith Ambachtsheer’s new book The Future of Pension Management, has a chapter on the pay practices in the investment functions of 37 pension funds from three continents with assets of $2.2 trillion.

Ambachtsheer observes that the biggest driver of high pay is the total headcount of employees directly or indirectly involved in the investment function. And this is tied to the strategic decision by funds, mostly Canadians, to insource private market functions.

“It comes down to organisational culture and the approach to what the job is. Pension funds need to define the business model, the metrics of success and how they relate to pay. Canadians are clearly the outliers in how they pay their people. Why? It is driven by the governance model of needing to be competitive within the organisation. It doesn’t work to have smarter people on the outside. It’s a competitive environment and they want to decide whether to outsource or insource,” Ambachtsheer says.

“We now have a lot of data through CEM that shows if you internalise high cost areas, like those investments charging 2 and 20, then costs reduce by 90 per cent. That’s a 4.5 per cent competitive advantage. Then the question becomes: if the board knows that competitive advantage can exist, what should they do? This will only work if a board truly understands what the economics looks like and they have the people to make it happen.”

Wealth across the globe is more concentrated than at any other time in human history, including the Roman times, with Oxfam reporting that 62 people in the world have the same wealth as the bottom half of the population.

Pay, and what you are paying for, are very sensitive issues.

The global pension study by Ambachtsheer reveals the median of the top five executives’ average compensation was $416,000, which is around 10 per cent of the average compensation of the top five executives for major commercial financial institutions.

 

Investment management comparisons

In Australia, Macquarie Bank’s chief executive, Nicholas Moore was the highest paid executive from a listed financial services company, in 2015 he got paid A$16,495,070. And of the top 50 highest-remunerated executives from the ASX in 2015, nine worked in financial services.

The 2015 Dawson Partnership survey of investment management industry salaries in Australia found chief executive officers’ fixed component varied from A$320,000 to A$800,000 with a short-term incentive component of between 20 and 150 per cent, and a long-term component of 10 to 150 per cent. Chief investment officers’ fixed component salary varied from A$350,000 to A$700,000 with a short-term incentive component of between 50 and 30 per cent, and a long-term component of 50 to 300 per cent.

P&I recently reported that Larry Fink, chairman and chief executive of Blackrock, got paid $26 million in 2015. This was made up of a $900,000 base salary, an $8.72 million cash bonus and deferred equity of $4.095 million. The remaining $12.285 million was a long-term incentive.

But you can’t compare the salary of a chief executive of a pension fund to a broader listed company or even a financial services company, says Justine Turnbull, partner at Seyfarth Shaw and a specialist employment lawyer who has worked for listed companies and superannuation funds in Australia.

She says traditionally, super fund CEOs have been more like administrators than a typical CEO, with little need within the businesses for change and innovation, the usual domain of a CEO. Rather, super fund CEOs have been conservative.

“The CEO has no work to do in getting the money into the fund. But there are certain aspects such as managing people, technology, and a level of sales and marketing that are similar functions,” she says.

But the purpose of superannuation is investing over a long time horizon which is very different to a trading investment environment and requires a different skill set and focus.

More global comparisons

The total amounts paid to executives in Ambachtsheer’s global pension study varied significantly, as did the structure of pay including the base and variable components.

Ambachtsheer found the median top-five total pay, across the 37 funds, was $461,000 with a wider middle 50 per cent range of $362,000 to $669,000.

The median chief executive pay is split 50:50 between base salary and compensation based on organisational/personal and investment performance.

For investment professionals the split is more like 25 per cent base and 75 per cent variable.

CEM Benchmarking, which specialises in benchmarking cost and performance of investments and administration of pension funds globally, conducts an annual benchmarking of what it calls the “global leaders” group.

In 2014, CEM asked the group some ad hoc questions regarding remuneration, and specifically about bonuses paid to staff.

Of the 22 funds involved in the study, staff at 21 of the funds were eligible for bonuses, based on non-investment objectives, portfolio or asset-class performance and total fund performance.

Some of the funds – about eight – had secondary targets to meet before the total fund performance bonus was paid. This included that the total fund performance had to be positive, and if it wasn’t the bonus was deferred until the returns were positive. Others required that individual targets must be met before they could receive the total fund bonus. In some cases the individual targets were non-investment objectives related to compliance or ethical issues.

The median level of bonus a chief executive at these funds could earn was 188 per cent, and for a chief investment officer it was 90 per cent; and all of them had a cap on their bonuses.

Mike Heale, partner at CEM, says whether an organisation pays variable incentives can be cultural.

“In Sweden it is 100 per cent fixed pay, it’s in their culture. In the Netherlands it is about 80 per cent fixed pay. In the US there is a politicalisation of pay, and Canadians have about 25 per cent base and 75 per cent variable.”

[In the Netherlands, Heale says, there is the “stupid man rule” which means no public service employee can get paid more than the Prime Minister – which is around $150,000. President Obama’s salary is around $395,000].

Australian remuneration structure

In Australia, executive pay and structures at superannuation funds are also highly variable.

On the bonus front, the heads of the investment teams at AustralianSuper are able to earn performance pay up to 40 per cent of their base pay, or 60 per cent for the chief investment officer. At UniSuper the maximum performance based remuneration available to any executive officer, including the chief executive, ranges from 30 to 100 per cent of their fixed remuneration. Some Australian funds, such as Cbus, don’t pay bonuses at all.

It is the structures of pay, particularly how bonuses are constructed and benchmarked, that needs much work in the superannuation executive arena.

Importantly, observers of governance and organisational structure, such as Ambachtsheer say that the variable component of pay should be spread over at least four years.

Turnbull is in favour of long-term incentives with some deferral of a short-term incentive. This is particularly relevant, she says, in the context of superannuation business linking incentive pay to the goals of the member, and that members’ interests are met over the longer term.

“Generally in Australia there is an over-focus in the exec rem space on short termism, and we would do better in all industries including the superannuation industry to have a longer-term focus,” she says.

“The philosophical objection to bonuses falls aside when you can link performance goals for bonuses to members.”

She believes incentives play a crucial part of pay and can drive performance but the industry needs improve in terms of how hurdles are set, the time frames of incentives and how they are aligned with the member interests.

“This is a competitive environment for talent, superannuation funds need to step up,” she says. “If the remuneration structures don’t evolve we just won’t get the talent that we need. There’s non-monetary benefits in those environments and the funds are seen as nice places to work, and we shouldn’t undervalue that, but if we want to try and drive top performance there has to be an at-risk component of pay.”

 

 

The ongoing debate on smart beta strategies has led to a number of misconceptions. In a recent paper in the 2016 Journal of Index Investing, Smart Beta is not Monkey Business, Noel Amenc, Felix Goltz and Ashish Lodh analyse some of these misconceptions.

In this article, we provide a summary of selected results concerning the sources of outperformance of such strategies.

Misconception 1: Anything beats cap-weighted market indices

Some have argued that the limitations of cap-weighted indices are so strong that any alternative index construction, including randomly generated portfolios (so-called monkey portfolios), will do better.

Moreover, it has been claimed that smart beta strategies would not be different from such monkey portfolios and their actual product design would not matter.

This is sometimes supported by saying that when inverting the strategy of popular smart beta approaches one gets similar or better outperformance.

Here we summarise results from Amenc, Goltz and Lodh, who empirically assess the validity of such claims for a range of test portfolios which employ stock selection to obtain a given factor tilt and different weighting schemes.

Such strategies correspond to common offerings in the area of smart beta indices.

The results show that inverting the strategy not only turns the weights upside-down, but also changes the performance.

For example, while a score-weighted value-tilted strategy leads to a positive outperformance of 3.94 per cent annualised, the inverse of this strategy leads to -2.07 per cent returns relative to the cap-weighted reference index. Similar results hold for other factor tilts.

These results of contrasted performance between factor-tilted strategies and their inverses contradict the claim that anything will beat cap-weighting.

Indeed, designing exposures to negatively rewarded factors (such as growth, low momentum or large cap) moves away from the cap-weighted reference index but does not lead to outperformance.

Thus, rather than relying on a supposedly automatic effect that moving away from cap-weighting will deterministically improve performance, investors in smart beta strategies need to analyse the factor tilts and diversification mechanisms employed and identify which smart beta strategies correspond to their investment beliefs and objectives.

Misconception 2: All smart beta performance comes from value and small cap exposure

Some argue that once we deviate from selecting and weighting stocks by their market value, as is done in cap-weighted market indices, this will necessarily lead to value and size exposures and these tilts suffice to explain outperformance.

While this may obviously be true for some smart beta strategies which – by design – will lead only to small-cap and value exposures, this notion is inconsistent with evidence on a wide range of smart beta strategies.

In particular, Amenc, Goltz and Lodh show that typical factor-tilted smart beta strategies can have exposure to factors other than small-cap and value.

This finding may not be surprising, and is fully consistent with the academic literature, which has documented the importance of various equity risk factors beyond value and small cap.

Additional relevant factors include most notably the momentum and low-risk factors, as well as additional factors related to the so-called “quality” dimension of firm fundamentals such as the profitability and investment factors.

Amenc and colleagues show in particular that the low-volatility and momentum-tilted portfolios, irrespective of the weighting scheme, derive a large portion of their performance from their exposure to low-beta and momentum factors, respectively.

The contributions of factors other than value and size to portfolio risk and return invalidates the claim that there is nothing beyond size and value exposure in smart beta strategies.

Moreover, they show that many smart beta strategies present a considerable portion of unexplained performance, which suggests that the portfolio construction of these indices captures effects that cannot be explained fully by the relevant factors.

Possible explanations of this unexplained part of performance are that the improved diversification scheme allows value to be added beyond the explicit factor tilts, or that yet other additional factors, which are omitted from the factor model, are at work.

However, while the findings in Amenc, Goltz and Lodh are in line with this literature, they stand in stark contradiction to the claim that there is nothing beyond value and small-cap exposure in smart beta strategies.

Instead, these results suggest that different smart beta strategies derive performance from different exposures to several factors that may go beyond size and value.

In fact, the claim that all smart beta strategies lead to size and value exposure ignores the past few years of product development in the smart beta space.

Many of the first generation approaches (Smart Beta 1.0) – by deviating from standard cap-weighted indices – may indeed introduce implicit factor exposures (such as value and size, and potentially others).

However, the more recent Smart Beta 2.0 approach allows the issues with such uncontrolled implicit exposures to be addressed.

In fact, research on the Smart Beta 2.0 approach shows that methodological choices can be made independently for two steps in the construction of alternative equity index strategies: the constituent selection and the choice of a diversification-based weighting scheme.

They show that, even though some argue that the risk and performance of diversification-based weighting schemes are solely driven by factor tilts, it is straightforward to correct such tilts through the selection of stocks with appropriate characteristics while maintaining the improvement in achieving a risk–return objective that is due to a diversification-based weighting scheme.

Such a Smart Beta 2.0 approach provides controls over deviations in terms of factor exposures, which invalidates the claim that all strategies simply tilt to value and small-cap, and also goes beyond simple Smart Beta 1.0 approaches in allowing for additional flexibility and explicit risk control.

Misconception 3: The rebalancing effect explains smart beta performance

In a smart beta strategy, rebalancing takes place at regular intervals to ensure the weights are in line with the strategy objective.

This has led some to argue that “rebalancing” is the main driver of smart beta outperformance.

To assess this claim, it is useful to look at two separate questions.

A first question is whether a positive performance effect necessarily arises from rebalancing.

A second question is whether smart beta strategies necessarily capture such an effect.

On the first matter, empirical research has shown that rebalancing effects are highly dependent on the time horizon.

There is ample evidence not only of return reversal effects, but also of return continuation momentum effects.

It is well known that rebalancing effects typically occur at a frequency which is much higher than typical index rebalancing frequencies.

One should recognise also that there is no consensus in the literature on the existence of a positive rebalancing effect.

Whether a rebalanced portfolio will outperform a buy-and-hold portfolio or underperform it will depend on the behaviour of the component assets.

Given this dependency of a rebalancing bonus on specific conditions, it is perhaps not surprising that standard asset pricing models such as the widely used models of the Fama-French-Carhart type do not include any rebalancing factor.

A second question is whether smart beta strategies gain exposure to such rebalancing effects.

On this matter, it can be noted that no convincing attribution of smart beta performance to rebalancing effects has been provided to date.

In their 2016 working paper, Ten Misconceptions about Smart Beta, the authors provide an illustrative assessment.

They draw on empirical finance research that has come up with a range of “reversal” factors, which simply move out of stocks that had strong price appreciation and into stocks that had weak returns relative to the average stock, and can thus be seen as related to rebalancing effects.

In particular, researchers have documented that there are positive returns to tilting to past one-month loser stocks (short-term reversal) and past five-year loser stocks (long-term reversal or contrarian) strategy.

We investigate the explanatory power of such reversal factors when omitting more standard factors.

In particular, we look at unexplained average returns (alpha) in a model that only includes such reversal factors in addition to the market factor, but excludes the more standard size, value and momentum factors.

We attempt to capture the returns to several smart beta indices.

Our results suggest that the different smart beta indices show high and significant alpha when accounting for the reversal factors.

Thus, the reversal factors do not fully capture the high average returns of such strategies.

This result suggests that the performance of these strategies is not primarily driven by the reversal factors and the associated rebalancing effects.

Also, when including the reversal factors on top of standard factors (market, size, value and momentum), such reversal factors have hardly any marginal explanatory power.

Overall, there are serious uncertainties concerning the existence of a positive performance effect from rebalancing in general.

Moreover, there is no evidence suggesting that smart beta performance is mainly driven by the mechanics of rebalancing.

Given these doubts on the relevance of rebalancing effects for smart beta performance, it is unreasonable to expect guaranteed outperformance of smart beta from a deterministic rebalancing effect.

Instead, factor exposures and diversification properties of such strategies need to be analysed carefully.

Towards a differentiated understanding of performance drivers

A careful analysis shows that, more often than not, superficially convincing claims about smart beta performance drivers stand on shaky foundations.

In fact, all too often, claims about performance drivers of smart beta abstract from the large variety of approaches that exist.

In a nutshell, our analysis cautions against oversimplification and calls for a detailed analysis of smart beta strategy performance taking into account the specific properties of the respective strategy.

 

Felix Goltz, head of applied research, EDHEC Risk Institute, research director, ERI Scientific Beta

Jakub Ulahel, quantitative research analyst, ERI Scientific Beta

 

Two years on from the US regulator firing a warning shot across the bows of the $3.5 trillion private equity industry, things are beginning to change.

The Securities and Exchange Commission’s important “sunshine speech” demanded more transparency around fee reporting in the opaque and controversial asset class, describing many of the industry contracts as a grey area that allowed managers to charge investors and pension funds hidden and backdoor fees.

Private equity has always been one of the most expensive asset classes for investors, but faced with new pressure for free transparency from beneficiaries and trustees, and needing to slash costs in the tough investment climate, pension funds are following the regulator’s lead with their own initiatives to increase transparency in a sector that’s been shrouded in secrecy for years.

Landmark progress includes the influential $280 billion California Public Employees’ Retirement System (CalPERS) unprecedented revelation that it paid $3.4 billion in performance fees to private equity managers over the past 25 years.

Most funds have avoided disclosing payouts because accounting rules haven’t demanded it, and high returns have mitigated cost concerns. In another development, the Institutional Limited Partners Association (ILPA) a global trade organisation representing some 300 institutional investors in private equity, has drawn up the first ever standard fee reporting template for the industry in direct response to its members’ demands. Developed in consultation with investors but also managers and advisers, the template simplifies how fund managers report fees to investors.

ILPA members invest around $1 trillion with private equity managers, yet pension funds have been slow to demand clarity on fees for reasons that range from ignorance at how large or extensive they have become to a reluctance to challenge managers that provide some of the best returns available, and where requests for information could affect their access to the best funds. Now investors need private equity to start behaving more like the mature asset class it has become.

“If you look back over 15 years, private equity was a much smaller industry accounting for a much smaller part of investors’ balance sheets,” explains Anders Strömblad, an ILPA board member and head of external management at the $35 billion Swedish buffer fund AP2, which has a 5 per cent allocation to private equity via some 80 funds in Europe, North America and Asia.

“As private equity has delivered good returns, so is it growing as an asset class. What we are now seeing around fee transparency is a natural development and sign of the industry maturing.”

No uniformity

Most private equity funds are organised as limited partnerships with managers serving as general partners, GPs, and institutional investors providing the capital as limited partners, LPs. GPs typically charge LPs a 2 per cent annual management fee and take 20 per cent performance fees, gains known in the industry as “carried interest,” for which there is no industry standard or uniformity. Like performance fees, monitoring fees are another bugbear.

These consultancy fees are paid by the portfolio companies to the GP and can last for as long as a decade. In an effort to recover what would be lost revenue, GPs levy a lump-sum fee ahead of a sale, or when they take a portfolio company public, slashing the value of the portfolio company to the detriment of investors.

It’s a practice for which Blackstone, the world’s biggest private equity manager with $300 billion funds under management and which invested a record $32 billion in private equity in 2015, picked up a $39 million fine from the SEC last year.

ILPA’s template will require GPs flag these fees but also capture expenses and the incentive allocation paid to managers and their affiliates.

As the chief executive of ILPA, Peter Freire, explains, investors will be able to compare fund performance going back to inception, plus a whole range of advisory, placement and deal fees. “In particular, this data will support LPs’ internal allocation decisions, help steer their manager selection processes – both for new managers and for re-ups – and will feed up into top line organisational assessments of value across the portfolio.”

It is the kind of transparency investors hope will help them to both negotiate better deals and level the playing field which currently lets the biggest LPs, with the best relationships, also get the best deals. “I think the larger investors tend to get what they want,” says Henrik Nøhr Poulsen, chief investment officer, equities and alternatives at Denmark’s PFA, which is growing its allocation to private equity in an alternative asset allocation that will reach 10 per cent of its DKK550 billion ($82.1 billion) assets under management.

Yet even the biggest and most seasoned LPs believe the pendulum has swung in GPs favour as competition for the best deals soars with declining returns in public markets.

Oregon State Treasury, which runs $90 billion worth of state investments including the $70 billion Oregon Public Employees Retirement Fund, was one of the first pension funds in the US to invest in private equity back in 1981, but chief investment officer John Skjervem says GPs now have all the power.

“In private markets Oregon has historically held a competitive advantage due to commitment size and reputation. But now good GPs enjoy all the market power as most LPs have raised their PE allocations, creating heightened demand for and often well oversubscribed commitments to the top funds,” says Skjervem.

For other funds it is difficult to cut costs when private equity fees remain so baffling.

“We have done a lot of work across our portfolio to make sure that we understand our costs. The fees we pay are now 35 per cent lower than they were four years ago as a percentage of our assets under management, but when it comes to private equity, it has involved a lot of work and the information that comes back is not easily comparable,” said James Duberly, director, pensions investments at the UK’s £12.5 billion ($18.8 billion) BBC Pension Trust with a 5 per cent allocation to private equity. Fee disclosure via the ILPA template may be a condition of investment going forward, he says.

“At this stage we are talking to all our managers to see what comes back but I can see a scenario whereby filling in this type of form becomes a condition of us hiring a manager.”  the road to better terms

And, of course, transparency will see investors negotiate better terms.

“Disclosure will mean investors will be able to put pressure on fees where pressure can be applied. Although it will depend on the manager, I think it will give LPs more negotiating power,” says Geoffrey Geiger, head of private equity at the £49 billion University Superannuation Scheme (USS), the UK’s pension fund for university and higher education staff. Ludovic Phalippou, finance professor at the University of Oxford Saïd Business School believes disclosure will lead to LPs avoiding GPs with more aggressive fee structures altogether.

“Our data shows that investors are rewarding GPs that don’t charge hidden fees.”

Transparency around fees could also act as a catalyst to streamline and improve the industry in other areas, like the introduction of standardised contracts, something AP2’s Strömblad wants.

“LP and GP contracts vary a lot in the industry, often around different wording because of different legal advisors. This could also become more uniform as the industry matures,” he says.

ILPA is convinced its template is in GPs’ favour too. GPs, many of whom have remained noticeably quiet as the fee debate has raged, have broken their silence in support of the template with 25 organisations providing input and expressing their support for the Fee Reporting Template, with The Carlyle Group and TPG among those expressly endorsing the template’s adoption.

The idea is that standardisation will reduce the compliance burden of running a wide variety of bespoke template formats for different LPs. And better disclosure will ultimately benefit the industry as more money flows into private equity.

Over the past decade, private-equity investments out-earned all other pension-fund holdings with an annualised 11.9 per cent compared with 7.7 per cent for real estate and 7.1 per cent for stocks, according to the Wilshire Trust Universe Comparison Service. Yet secrecy around fees alarms investors to the extent that they haven’t allocated as much to the asset class as they could have.

“Fee transparency will help solve one of trustees’ and stakeholders’ biggest qualms about the asset class,” says the BBCs’ Duberly.

Which leads to the next challenge: making sure disclosure improves given that using the template is voluntary.

“The responsibility for determining how the template can be used to support their needs lies with individual LPs and their managers,” explains Freire, who insists it is already taking root due to investor pressure.

“LPs are in direct dialogue with managers to request that they use the template and managers are responding positively to those requests.”

But the lack of coercion is a source of concern for Eileen Appelbaum, senior economist at the Washington-based Center for Economic and Policy Research, who believes only regulation will sort the problem out, as private equity firms won’t voluntarily open the door to the prospect of lower fees.

“I applaud the ILPA but it is unlikely that LPs will be able to force GPs to do anything they don’t want to. For whatever reason, private equity firms have the upper hand.”

A slow and painful process

As investors demand more transparency from GPs, so they have begun the slow – and painful – process of totalling their own private equity bills in response to pressure from trustees and lawmakers demanding clarity on fees and the impact on returns.

CalPERS, for whom private equity is a top-performing asset involving relationships with some 700 funds, has revealed its costs along with others in New Mexico, South Carolina, Kentucky and New Jersey.

New York City Pension Funds is also on the case having written to all 117 of its private equity managers demanding that they reveal all fees and expenses – or be dropped from its portfolio. Now the spotlight is on $188 billion CalSTRS with a $20.3 billion private equity program which began in 1988.

But extracting historic data from managers is a challenging process and many investors won’t have a record of performance fees paid to funds that have matured, facts that lead ILPA’s Friere to caution investors to “take a considered and thoughtful approach” to requesting information for older funds.

“The operational requirements to provide it could very well exceed the value of having deep historical data,” he says.

While progress on fees drags, some funds have seized the initiative to lower costs through direct and co-investment programs in a reminder that managers don’t hold all the cards.

PGGM, the €186.6 billion ($204 billion) Dutch fund which manages money on behalf of PFZW, a pension fund for Dutch nurses and social workers, has introduced its own remuneration guidelines for all its external managers and is building an in-house team to invest in companies directly.

“These kind of co-investments are becoming more important because they are a means to cut costs and exert control. We expect to do 10 co-investments this year,” said Maurice Wilbrink, a PGGM spokesman.

In another development, PGGM also bought a stake in a new private equity firm Nordian Capital Partners in exchange for better terms on fees. USS is pursuing a similar strategy.

“Like turning an oil tanker, it takes time to adjust the mix but we are aiming to increase the relative proportion of directs over time whilst remaining a significant fund investor,” says Geiger.

Fee disclosure won’t happen overnight and larger, developed funds with sophisticated systems will find it easier to introduce the template than smaller funds. But things are changing as private equity tries to come up with a self-regulatory response before the SEC gets really involved.

David Villa, chief investment officer at the State of Wisconsin Investment Board (SWIB) likens the current investment climate to the depths of winter: something to be endured and survived until spring arrives, of which there is little sight yet.

“The current environment is heavily influenced by monetary policy and slowing growth in emerging markets and China: nothing works in this environment. Assets that are valued on their growth, and the growth of their cash flow, are not doing well and there is a high level of financial stress in credit markets. The prospects for growth are modest to negative.”

Villa’s answer is to “not try and be too clever” or stretch for a return, but hold tight until things improve.

And even what opportunities do exist are difficult to tap because of SWIB’s $106.2 billion size and limited ability to be fleet of foot.

“There was a brief opportunity to buy investment grade credit in February. We have to move our capital quickly to take advantage of these opportunities and our strategies are more long term than this,” he says.

Founded in 1951, SWIB is responsible for managing the combined assets of the Wisconsin Retirement System, the State Investment Fund and various other state funds.

As winter continues to bite, Wisconsin is working on two longer-term strategies.

The fund is building a portfolio of hedge funds that will provide “a higher quality source of alpha” on top of existing market beta exposures.

“We only have 3.5 per cent of the fund in this strategy and it is growing slowly because the low volatility hedge funds we like are rare. It takes a lot of due diligence to identify the right hedge funds that fit into our program.”

The strategy aims for a policy return of between 5 and 6 per cent plus an alpha of 2 to 3 per cent, he says.

The other strategy at the fund is to continue building an internally managed, multi-asset division to provide a diversified source of return generation.

Here the idea is to “take the best ideas” across the whole portfolio and express them within a single portfolio able to take advantage of opportunities that other allocations can’t because they are tied to their particular asset class or industry.

“Some portfolios are one-trick ponies. In this case we are trying to create a circus,” says Villa.

SWIB has $1.5 billion in multi-asset strategies and $3.6 billion in the alpha beta overlay that includes hedge funds, making a total of $5.1 billion in these two new strategies.

Villa finds himself in unprecedented territory in that for the first time in SWIB’s history, half of the fund’s assets are in passive strategies.

“The fund is configured around the lowest active risk profile in its history,” he says.

The reason is simple: today’s markets don’t offer any reward for risk, and for this reason Villa explains SWIB’s passive allocations are a sign of the times, rather than any broad rejection of active management.

“The prospects for active management are not good at the moment but that doesn’t mean you give up on active management. It just means it isn’t good today and when the environment changes, we will take on more risk.”

Villa describes a market best suited to active management as one that has different time horizons, points of view and opinions; a sensitivity to multiple factors, rather than one that clusters around a single theme with a diminished opportunity set.

“When a market tends to herd, and I’m talking lemmings here, the prospect of active management breaks down.”

He is also quick to articulate that SWIB’s current passive allocation is not a particular nod to cutting costs, something SWIB has done successfully in recent years.

“Costs are important and we do think in terms of the return we get from active management and if it’s not attractive then we’ll index. However if there is a prospect of a return net of costs, then we are happy to incur costs.”

The fund has added $1.17 billion above the policy benchmark over the past five years and is considered a low-cost manager, managing more assets internally and passively than its peers, translating to $63 million in savings according to an independent review.

Another ongoing strategy at the fund is to build and maintain its 75-strong internal team.

Villa describes attracting and retaining the best investment professionals as a “war” where fierce competition merits SWIB’s compensation structure benchmarked against private sector banks and asset managers.

However, he qualifies that “a significant part of compensation” for the team is discretionary incentives.

“These have to be earned. We are not paid for showing up.”

It is a risk-sharing culture at the fund that is rooted throughout its structure, right down to beneficiary payouts also being connected to the fund’s returns.

“Schemes that have been structured with professional governance and staff, and are willing to invest in asset management to the extent that they are almost indistinguishable from private asset management firms, these are the ones we admire and aspire to be like,” he concludes.

 

The United Kingdom’s local government pension scheme, the £11.5 billion ($16.2 billion) West Midlands Pension Fund, runs a diversified portfolio of assets consisting of equities, fixed income and alternatives; nearly three quarters of the fund is managed by an in-house team with a clear, return-seeking strategy.

Current priority areas include boosting internal management as well as allocating more to infrastructure.

West Midlands is also focused on meeting the mid-year submission deadline around asset pooling with other local authority schemes, part of government policy to create half a dozen wealth funds in place of the current 89 local authority schemes.

“There’s a lot to do,” says Geik Drever, strategic director of the fund which she joined from West Lothian in 2012.

The fund dates from 1972 and provides pensions for some 450 public and private-sector employers in the region.

One strategy, still in its “early stages”, is to develop an in-house actively managed equities portfolio.

Drever, who describes the West Midlands as “a strong believer in the benefits of internal management,” says the decision is motivated by cost cutting and follows on from West Midlands withdrawing from various management relationships it believed didn’t offer the best value through the course of last year.

“We have generated savings of almost £25 million a year on investment management fees,” she says.

“We have looked at all our mandates and rationalised and renegotiated fee structures.

“We are grateful to our managers for rising to the challenge of helping us reduce costs.”

West Midlands has a 48 per cent allocation to equity which it will maintain until an actuarial evaluation later this year.

“Our equity exposure is diversified and not as huge as other local government schemes,” she says.

The global active portfolio has also been inspired by the success of the fund’s internally run UK and overseas passive equity portfolios.

Costing less than 2 basis points and therefore a fraction of what it would in outsourced mandates, the strategy is characterised by investment in five regional index funds that involves frequent monitoring and tracking errors to ensure the minimum deviation from target.

“The benefits of internal passive management include a fixed fee that doesn’t increase in an ad valorem manner and the ability to extract further value through being able to have stock available for stock lending,” says Drever, adding that West Midlands’ passive managers are currently exploring smart beta strategies too.

Along with its public equity allocations, West Midlands runs private equity and fixed income allocations in-house.

The fixed income allocation is split between stabilising assets and an allocation to return-seeking fixed income including high-yield and corporate bonds and unsecured loans.

Another area Drever is keen to build is infrastructure, underweight at 3 per cent versus a strategic 6 per cent allocation.

“We are mindful of the need for yielding assets that will closely match the liabilities of the fund, particularly if they have an inbuilt linkage to inflation,” she says.

“Finding opportunities is difficult and we are not alone in this as the desire for such assets is strong not just in the pension fund world but in the wider investor universe.”

One opportunity will come through West Midlands membership of the Pension Infrastructure Platform, PIP, a government initiative to encourage funds to invest more in infrastructure, which has secured more than £1 billion in commitments from pension schemes so far.

Drever has overseen a buoyant year at the fund which returned 15.1 per cent in 2015, outperforming its benchmark return of 11.6 per cent.

The main contributors were US equities and private equity, with the fund’s 12 per cent allocation to private equity returning 24.6 per cent over the year – the best-performing asset class.

“We have been a long-term investor in private equity and the higher weighting in this area combined with a number of good funds has paid dividends,” she says.

Now Drever’s priority is to ready the fund to join the £35 billion pool of eight other local authority schemes across the Midlands, in accordance with government pooling policy.

The process is going well, she enthuses.

“We’re really pleased with progress so far and we’re excited by the prospect of having a much wider resource to call upon as well as the potential cost benefits arising from economies of scale.”

The pool benefits from a regional fit and has already clarified common values like the role ESG will play across the portfolio.

The eight separate funds will decide their own asset allocations, and then delegate management to the pool, she says.

The 2nd edition of Robeco’s Factor Investing Book is out, which brings together ten articles that Robeco researchers have published over recent years. The book consists of three parts: strategic allocation to factor premiums, understanding the factor premiums and how to implement factor investing in an efficient way. Request a hard copy of the book »