Across the institutional investment community, disclosure and transparency of costs continues to be evolving, but not fast enough. A paper by Commonfund Institute reveals only 18 per cent of respondents in an endowment survey reported incentive and performance fees paid to asset managers despite the fact that nearly 85 per cent of respondents reported having asset allocations to alternative investment strategies. There is still more work that remains to be done.

 

Commonfund Institute, which is dedicated to the advancement of investment knowledge among non-profit organisations and serves institutions, foundations, health care institutions and other charities, has written a paper for the long-term investor community on the costs of investment management in a bid to empower non-profit invest

The paper aims to help fiduciaries understand why there is this deviation in reported costs, provide an overview of the different types of costs, both undisclosed and disclosed, and give fiduciaries well-informed questions to ask their managers.

The CUBO-Commonfund study of endowments in 2014 showed that the median all-in cost reported by respondents was 50 basis points. Very few of these institutions were able to provide specific breakdowns, although most could name the components of those costs by category. Only 18 per cent included incentive and performance fees paid to asset managers despite the fact that nearly 85 per cent of respondents reported having asset allocations to alternative investment strategies.

A more detailed estimate of total costs comes from Commonfund’s investor services group, which analyses costs for around 80 client organisations, which suggests costs are more like 100 – 175 basis points, and even more for more complex portfolios.

The paper explains that fees are known – and frequently set out in detail in a manager’s or service provider’s invoice – and can, therefore, be analysed and controlled. But Costs are not necessarily invoiced and can be much harder to understand and control. The problem is exacerbated by the fact that different types of long-term investment pools report their investment performance in different ways. Non-profit organisations such as colleges, universities, and independent schools, foundations, operating charities and healthcare organisations generally report their investment results net of costs. The practice among public pension plans, however, is typically to report returns in gross terms.

“Because fees and costs – both disclosed and undisclosed – determine what institutions get to keep and spend in support of their missions, it is important to understand their nature and range,” the paper says.

“Furthermore, as a fiduciary matter, several compelling reasons exist to support a better comprehension of cost issues.”

The paper says, in particular, that it is incumbent on fiduciaries to have some understanding of the fee structures in limited partnerships, highlighting that they contain compensation structures that include incentive fees and other forms of potential income for the general partner, many of which are undisclosed.

 

To access the paper click below

Understanding the Cost of Investment Management – A Guide for Fiduciaries

 

Head of the global union movement, Sharan Burrow, has called on asset owners to “stop talking about constraints on fiduciary duty” and take the lead on the transition to a green economy. Burrow was part of a panel at the Fiduciary Investors Symposium in Chicago that told delegates the next wave of stewardship is not just engagement with companies but also policymakers and intermediaries.

Burrow, who is general secretary of the International Trade Union Confederation, said that “thoughtless investment in fossil fuels” was a major loss to pension funds.

“The issue is not just about divestment; if we were sensible about fiduciary responsibility we would demand a carbon plan for the companies we invest in,” Burrow said.

“Disorderly exit from fossil fuels will create instability and loss of jobs. The broad spectrum of the impact of climate change is loss of lives. There is a market here.”

She said there is urgency around green finance – particularly energy – that needs regulation.

“This is a joint responsibility and is part of the due diligence base of responsibility for investors,” she said. “Stop talking about the constraints on fiduciary duty and take the lead on the risk curve – and I’d argue, the moral imperative curve as well.”

“We need to make sure engagements are wound up in a carbon plan and due diligence in human rights.”

Similarly Martin Skancke, chair of the Principles for Responsible Investment Advisory Council (PRI), called on investors to step up to the conversation about the systemic risks such as carbon risk and long-term stability of markets.

“The asset owner perspective is missing. Asset owners are not necessarily in the market daily, they are removed from the market, but are paying the costs of an inefficient market,” he said.

“You should be asking ‘What does a good trading place look like for me? Who should be allowed to trade? How should information regarding trades be made available and to whom?’ These are really important questions and asset owners are absent from the conversation.”

Skancke said some of the perceived conflicts between environmental, social and governance (ESG) and fiduciary duty come from a misconception.

“For me it’s about the stability and usefulness of the financial system itself,” he said.

“It is seen as responsible investment limiting the investment universe. All investors exclude assets for various reasons; for example, you don’t believe in the business model, don’t like the market, the investment doesn’t meet cashflow requirements. It’s just another constraint.

“For me it’s about widening your information set, not limiting the investment universe. How do you organise the information set and take a broader view of the risks you’re taking?”

ESG as a fiduciary duty is about raising the standard of corporate behaviour generally, he said.

The PRI is approaching its 10th anniversary, and Skancke said the six PRI principles are primarily about ESG integration.

“If we drafted them today they would be more emphasis on more systemic issues such as the nature of the marketplace itself.”

Colin Melvin, chief executive of Hermes EOS told delegates that ESG and fiduciary duty are connected because “making money and doing the right thing converge in the long term”.

“Making money is driven by intermediation in the short term. When I started in funds management 22 years ago found they were amoral, that morality didn’t come into it. They analysed historical financial information and tried to make decisions on whether to invest. It struck me the short term ruled the behaviours of intermediaries and that was a problem. From the PRI launch nearly 10 years ago we are still talking about fiduciary duty and whether ESG is part of that.”

 

Delegates also heard from Ed Waitzer, partner at Stikeman Elliott, and professor and director of the Hennick Centre for Business and Law at the Osgoode hall Law School in Toronto; as well as Beth Richtman, portfolio manager for infrastructure and global governance at CalPERS on the fund’s story of progress in advocacy, engagement and integration of ESG.

Regardless of moral and scientific arguments, the “risk of policy action” on climate change is enough reason for institutional investors to consider climate risk as having real impact on their portfolios. As an example investors at the Fiduciary Investors Symposium at Chicago Booth School of Business were told that investment-grade bonds in the coal sector have been down 20 to 25 per cent this year. A panel discussed the path to de-carbonisation of both investors’ portfolios and the financial system as a whole.

“Take the moral, and scientific, arguments off the table. Climate change is on the global policy initiative already – the risk of policy action exists. There is also an argument for a structural shift in the energy sector as well,” Alex Bernhardt, head of responsible investment, US at Mercer said, and this should be enough impetus for investors to take action.

Christina Figures, executive secretary of the United Nations Framework Convention on Climate Change (UNFCCC) wrote a letter to delegates at the Fiduciary Investors Symposium calling for them to take action. (UNFCCC call to action for Fiduciary Investors Symposium Chicago)

“Your vision and voice have powerful impact, giving courage to world leaders to aim for the most ambitious agreement. Your visible, visionary support can inspire confidence that shifting the trillions and an orderly transition to climate neutrality is a path to prosperity. Your vocal advocacy for this move signals it is time to point policy towards long-term certainty that allows us to update the economy for this century,” she said.

“This is your moment to demonstrate leadership on climate change, and in this moment there are more options available for action than ever before. I encourage you to join a transformational cooperative action such as the Montreal Pledge or the Portfolio Decarbonisation Coalition or sign up to the Low Carbon Investment Registry.”

Mercer’s Bernhardt says the challenge for the industry when faced with the complexity, and interconnectedness of these risks, is how to implement it.

The critical question for institutional investors, he says, is whether they can be future takers (climate unaware) through to future makers (climate aware).

David Russell, co-head of responsible investment at the £41.6 billion ($62 billion) USS, says the fund is both a future taker and future maker.

“We don’t have a top-down on view on what managers should do in buying and selling stocks. But we have been looking at climate for a while. We do not have any more pure-play coal in the portfolio, and we actively engage with policy makers to have an active voice to counter the voice that policymakers get from companies.”

Ulf Erlandsson, senior portfolio manager of global macro trading at the SEK310 billion ($36 billion) AP4, says the fund is a founding member of portfolio de-carbonisation project, which looks at how to de-carbonise portfolios in a way that is not detrimental.

“We need more quant frameworks to better measure carbon in the portfolio,” he says. “I want to impress on the audience that this is not that tricky.”

He says between 70-80 per cent of coal reserves can’t be excavated and burnt if the 2 degree goal is to be reached.

“If you were long the coal sector this year you would see the effect of that,” he says. “For example investment grade bonds in the coal sector down 20 to 25 per cent this year. This is a matter of trying to protect your portfolio. As fiduciary investors when there is a permanent capital loss in your portfolio – like stranded assets will get written down – it should scare you.”

According to Martin Skancke, chair of the PRI, not having a price on carbon is a serious problem of market failure.

“This is likely to affect all sectors that use energy, which is a large part of the portfolio and it will play out over the long term.”

He says such disruptive events – where there will be full scale transformation of energy – are a threat and an opportunity.

Skancke’s view is that the market failure is an extension of government failure.

“No-one owns the earth’s atmosphere in order to set a price to use it to store carbon dioxide. The only way to get a price is through policy and government,” he says.

“Managers of fossil fuel companies are incentivised to make decisions that are not in the interest of long term shareholders. So investors should be addressing that.

“Carbon risk is the risk that some assets will be uneconomical under policies of a carbon policy specifically less than 2 degrees. It is the risk companies are making investment decisions not economically viable under those conditions.”

To this end, he says, investors should be asking questions of companies about their business plan in a 2 degree scenario.

“If investors are not happy with the plan then they should ask to get their money back in dividends,” he says.

“The primary role of investors should be engagement, that’s where the effects are the strongest.”

Skancke also asked investors to distinguish between the carbon risk in the financial system as a whole – “there is an over-investment in carbon and it needs to be de-carbonised” – and de-carbonisation of an individual portfolio which is achieved by shifting the risk around by selling stock holdings.

“We need a more coherent set of engagement policies to address the overall risk in the system,” he says.

Mercer has modelled a sample asset allocation and showed the impact on asset classes over 10 years of various scenarios. In a “transformation scenario” developed market equities shows a depletion, with emerging markets and real assets benefiting.

“In this scenario there are winners and losers so you can hedge. But in other scenarios – like fragmentation and coordination there’s only losers.”

 

Self-reliance on asset allocation and employing a partnership style with its managers – based on the mutual exchange of ideas – are the cornerstone of New Zealand Super’s evolved investment approach founded on the confidence of its investment ideas. David Rowley visited the NZ$29.6 billion fund to find out how it does this. 

On the climb towards the optimal investment set up New Zealand Super has taken more strides than most. It is self-reliant on asset allocation and manager selection processes, so no longer uses the services of an investment consultant; it has created its own system for justifying the worth of any transaction it undertakes in comparison to another. It also prefers to employ a partnership style with its fund managers, involving an exchange of ideas and a respect for each other’s knowledge.

For this it has negotiated flexible mandates with managers, under which it has the ability to control future allocations of risk capital. Matt Whineray, chief investment officer of the fund, sums up the change by saying his team has become “a smarter purchaser of fund management services”.

 

Internal consultant

At the root of NZ Super’s advanced approach is the confidence and ownership of its investment ideas. Since 2013, NZ Super has not used investment consultants. It carries out its own investment analysis in-house and subscribes to information services to get data on managers. This is a considerable feat considering that, of the 115 staff NZ Super employs, around one third are in the back office, one third are in the middle office, and the remaining 40 staff are in the front office. The fund also leverages the knowledge of its managers, but the core investment decisions arise from within the fund.

Part of the thinking is that the business of choosing the best manager does not return enough for the effort applied, compared to the returns received from the hours spent finding good investment bets or diversification.

Whineray reasons that every investor is trying to find a top quartile manager, and they cannot all be right: “We want to spend a lot more time on identifying the opportunity and take the pressure off getting the absolute best manager, because one of our investment beliefs is that skill is rare.”

Instead, the investment team spends most time working out if a market, or on occasions an individual security, is mispriced versus long-term market trends, and whether it offers diversification benefits to other assets.

To make the process robust, NZ Super has even analysed to what extent it can be confident about bets. The team concluded that it can have more confidence if it can see and articulate the drivers of the opportunity, and there is a clear rational basis for that.

The fund’s chief executive, Adrian Orr, articulates the business logic of this exercise.

“The only place with any true economies of scale is intellectual thought and that is where we spend most of our time, and where we can have a competitive advantage,” he says.

A further help to the ‘clear rational’ basis for its ideas is the use of a reference portfolio. This is a passive portfolio of 80 per cent equities (including 5 per cent in New Zealand equities) and 20 per cent fixed income that, on long-term trends, has been calculated as meeting the fund’s return goals.

Every investment decision that differs to the reference portfolio is measured to see if the time, expense and opportunity are worth it. The actual portfolio is currently 67 per cent global equities (including 5 per cent in New Zealand equities), 12 per cent fixed income, 6 per cent property, 5 per cent timber, 4 per cent infrastructure, 3 per cent private equity, 2 per cent ‘other private markets’, and 1 per cent farmland.

“Every strategy has clarity around the horizon, the expected return, the hurdle rate for getting involved and its proxy what are you going to sell to buy,” says Orr.

“We can measure exactly the value we are adding per strategy.”

Once this process has been completed for an investment opportunity, the smartest work has often been done.

“How you get access to your idea becomes mechanical then; we are interested in the opportunity first and foremost, how we access it becomes a very secondary issue,” he says.

The mechanical issues are whether external expertise is needed to access the idea and whether that is worth it after fees, or whether in some cases it can be accessed through derivatives placed by the internal team.

“What we are trying to do is reduce the need to be able to identify managers that have skill. If we can get access to an underpriced market in a passive or a synthetic way, then that is good for us,” Whineray says.

The fund uses derivatives because the cost to implement (buy or sell) is materially lower than buying or selling physical securities. Implementation of equity tilts, for example, physically costs circa 10 bps, but only 1-2 bps for futures.

“The futures markets we use are also very liquid and operate longer (extended) hours relative to equity exchanges, thereby giving us more flexibility in terms of when to execute,” says Whineray.

 

Flexibility

The certainty about why the fund is allocating to an opportunity and what they want to get out of it inevitably leads to a different conversation with a fund manager.

Whineray explains how the fund not only chooses an investment, but gets to dial it up or down as the team’s level of confidence in it changes. “We want control over how our risk is allocated,” he says.

“A black-box, closed-end fund where you make your commitment and you hope you get your money back in 10-15 years’ time, where you have no ability to change that allocation or see what is going on inside, is a much less interesting prospect for us than a flexible mandate with a manager, where we say ‘we really like this opportunity – you help us get access to this’,” he says. “If that mandate dries up we do not have to keep funding it.”

He contrasts this with the traditional private equity model or unlisted asset fund model, where there is a three to five year lock in and the investment manager is incentivised to get that money invested.

NZ Super has flexible mandates with Elementum ($50 million) and Leadenhall ($150 million), where it decides on the amount invested twice a year based on the attractiveness of the market or as a reaction to a market dislocation, in consultation with the managers.

“In our view,” says portfolio manager Greg Slusarski, “the risks involved in this market do not change over time – but the price we are getting paid for taking those risks does.”

For this reason the investment team keeps a very close tab on the pricing as well as soft indicators such as capital flows, which would be informed by the number of new funds being set up, the dollar value of alternative capital flowing into the market, and how much exposure is being reinsured.

The desire for flexibility might appear to create more work, but often it means taking the simpler path. Given the fund’s belief that confidence in a market outranks faith in an active manager, often this leads to an allocation to a passive manager, particularly for global equities.

“Those markets are very efficient with lots of active managers trading against each other,” says Whineray. “We look at that and say we do not think, on average, an active manager ends up delivering positive returns after fees.”

The public markets that NZ Super believes are conducive to active managers include emerging market equities and New Zealand equities. Even the average active managers in New Zealand are able to deliver positive net returns, notes Whineray.

“We like those markets as we do not have to be able to choose the best managers,” he says. “We still try to choose the best managers, but if we miss and hit the second quartile because we chose an opportunity that was rich rather than choosing a skilled manager in an efficient market.”

Passive equity managers will generally cost the fund in the region of 5 bps, depending on the size and nature of the investments. The cost of active management varies enormously but can be more than 10 times the price of a passive manager, depending on the type of mandate and the manager’s track record.

This belief in the process and its logic is such that the fund gave up on its tailored debt index, which included high yield, emerging market and inflation linked bonds, originally created as a means to deliver broader market representation.

“We have gone back to the Barclays Global Aggregate. After the hassle and cost [of creating the index and the process] we do not think it makes any difference,” he says.

“For the size it was in the portfolio it was not worth it to make a difference.”

 

Cultural shift

Not all fund managers want to work this way. While in public markets separate tailored mandates have been commonplace for years, this is not the case in unlisted markets.

Whineray says unlisted managers will need to have greater sophistication around which assets are allocated to their pooled fund and which to the separate accounts.

“Not all want to do it, as it is much easier to put all the investors in one fund, with one annual report and meeting,” he says.

The fund’s success in gaining such deals leads Whineray to believe that it is not only fund size that helps in getting them, but that there is a cultural shift happening.

“Some managers get it while others do not, but we can see the market moving that way,” he says.

 

Partnerships

In the past few years, NZ Super has moved toward bigger and closer relationships with a smaller range of fund managers. This has depended on the willingness of each manager to work in partnership, not just in delivering flexibility over future risk allocations, but also in a strategic sense. For example, the fund’s NZ$300 million mandate with Bridgewater Associates, which has been in place for nine years, has delivered important add-on benefits through knowledge sharing and assistance.

“Managers are more than just return and fee streams,” Whineray says. “We look for a willingness to share information and perspectives.”

Central to the fund’s partnerships is a team, formerly called manager monitoring, but now referred to as portfolio intelligence. Run by Paul Gregory, the team’s responsibility is to bring in external intellectual property from fund managers and be a champion of that internally, connecting it with the investment analysis and portfolio completion teams. This can play a part in influencing portfolio tilting.

The bigger, closer relationships occur with the managers most willing to share ideas, or those that are simply the most strategically useful.

“Where do we think the best value from those manager relationships can come? Let’s spend more time on those,” says Whineray. “And let’s spend less time on the ones that don’t have any great input into the rest of the opportunities we are looking at.”

 

This paper investigates the extent to which the delegation of funds management prevents long-term information acquisition, inducing short-termism in financial markets. The authors, Catherine Casamatta and Sebastien Pouget also study the design of long-term fund managers’ compensation contracts.

Under moral hazard, fund managers’ compensation optimally depends on both short-term and long-term fund performance.

Short-term performance is determined by price efficiency, and thus by subsequent fund managers’ information acquisition decisions.

These managers are less likely to be active on the market if information has already been acquired initially, giving rise to a feedback effect.

The authors say the consequences are twofold: First, short-termism emerges. Second, short-term compensation for fund managers depends in a non-monotonic way on long-term information precision. We derive predictions regarding fund managers’ contracts and financial markets efficiency.

The paper can be accessed below:

Fund managers’ contracts and financial markets’ short termism

 

Paul Smith, the Hong Kong based chief executive of the Global CFA Society is on an evangelical mission to change the culture within the investment industry. Not only is he looking to curb the frequency of excess behaviour that leaves the public cynical of high paid finance professionals, but he is a persuasive advocate for change that can lead to improved investment outcomes. At the heart of the problem, he believes, is an industry that is led by people who look like himself – white, middle class, middle-aged – who grew up in a developed world country with access to good education. Unless this demographic changes then reform is less likely: “We are from the same backgrounds, we incentivise them in the same way and yet we are expecting different outcomes,” he says.

Smith is informed by perspectives gained from working in China, where  savings are more crucial to lives owing to a less generous welfare system and the outcomes more precarious owing to less established financial providers and products. It has given him a stronger sense of the importance of customer outcomes.

“In the developed world you lose our moorings. It is a very self centred industry that focuses on itself, where a lot of financial activity is not geared towards any economic end and where organisations have forgotten what they are in the business to do, which is to serve the clients,” he says.

Service before profit

One of the more surprising comments uttered by Smith is his bluntness that the finance industry should not focus on profit maximisation; his point being that the client’s needs should come first, not the needs of those investing on behalf of the clients.

“We are stewards of other people’s wealth, we should not think of our end client as someone we can make money out of, we should think of ourselves as a fiduciary and a steward of their interests and of someone who is trying to deliver a professional service to them,” he says. “If we cannot prove ourselves to be professionally orientated then I fear that regulation comes in to take up the slack because government realises that what we do is important that we are our fiduciaries of other people’s money.”

The dangers of not acting are already visible, he says, in the way individuals are already bypassing traditional finance products and services to buy property, ETFs or to use robo-advice, but he admits, the challenge will be hard. “I think our industry has the head in sands when it comes to that,” he says.

He advocates the finance industry focusing around the idea of selling a service with an outcome, similar to goals of the medical profession and that this should be done honestly and transparently.

“To help people help accomplish their retirement goals I should not be making fees from burying things in those products that you do not know about,” he says.

Another step on this change in mindset is reengineering incentives. He would like to see companies explore the idea of giving incentives for ethical behaviour, rather than just meeting or exceeding financial targets.

To achieve such outcomes, the CFA wants its members to be agents for change within their companies, rather than just to see their qualification as simply a path to a good career. For this the CFA has developed a set of ethical frameworks for its members to apply in their workplaces and has urged its members to do such acts on a voluntary basis, rather than for payment.

“Members should ask ‘how do I make the business I am working in to be a better steward of people’s money’ and ‘how can we use the tools to transform the ethical culture within our business’,” he says.

Diversity

Smith see greater gender and ethnic diversity as central to this change. For this the CFA has undertaken research on how the recruitment processes is structured, from the way adverts are written for jobs, the way interviews are conducted and the criteria used for promotion. One finding is that men are far more likely to apply for a job for which they do not meet all the stated criteria than women.

“Greater gender diversity is good for the member outcome, because the more rounded the team that is thinking about the investment problems the more likely you are to get a solution,” he says. “It is not about women being more or less risk takers, but if you put people of different backgrounds together they are likely to come up with a better decision, than if you have five people who all look the same and think the same.”

Smith also draws parallels with the last financial crisis and the look of those running the industry. “If we want to change the outputs we have to change the inputs. If we continue to hire pale, male and stale then you are going to get the same results.”