Investors still rely, to a great extent, on past performance to assess managers’ future performance.

Rather than rely on past performance outcomes to predict future results, a new paper, The predictive power of portfolio characteristics, argues that it is possible to improve the ability to predict future long-term success by identifying and measuring selected portfolio characteristics that are embedded in each manager’s process. The authors look at active share (AS) and a concentration coefficient (CC).

Assuming these characteristics are relatively stable over time, this approach complements long-term performance and attribution analysis and should increase an investor’s ability to identify portfolios with future performance potential.

The key points in the paper are:

• Active Share has some predictive power in ranking prospective information ratios of funds in an equity universe

• Based on the Fundamental Law of Active Management, combining AS and CC appears to improve the Law’s predictive power. (The evidence is indicative, rather than conclusive, and needs additional research over extended periods and broader equity universes.)

• For investors and managers, this approach may provide a useful complement to their current methods of manager comparison.

• These preliminary conclusions suggest that achieving high AS by constructing increasingly concentrated portfolios (i.e., reducing the CC) may be counterproductive in terms of a prospective peer ranking. Instead, managers may do better by seeking to increase both.

• The implication is that making fewer but larger “bets” (increasing AS, reducing CC) may only be justified if the manager has (or at least believes it has) increased skill in making each of those bets.

• The corollary is that if a manager can maintain or increase its skill across a wider number of stocks (for example through additional analytical coverage), then it should benefit by increasing the portfolio’s CC (diversification) as long it also maintains its AS.

 

These preliminary conclusions suggest a modification of a presumption that seems to be common in the investment industry: that fewer, bigger “bets” will generally lead to a better outcome (and this presumption has been reinforced with the emergence of AS as a widely used metric).

The authors find that a better approach may be to increase the combination of AS and CC (as long as this does not diminish the manager’s stock-selection skill).

“This is not easy. It typically requires the manager to own a wider selection of stocks, but maintain or increase the weighting differences of those stocks from the index. The question for investors is whether the managers have the resources to do this effectively, maintaining the same level of stock-picking ability,” the paper says.

 

The authors acknowledge the limited scope of the data, and that these results are indicative, not conclusive. They invite other researchers including academia and practitioners to contact them to explore this concept further on a collaborative basis. The goal is to test this methodology across broader universes and more extended time periods, with the expectation of improving the model and its predictive power.

To access the paper by Barry Gillman who consultants to the Brandes Institute and Erianna Khusainova and Juan Mier from Lazard Asset Management, click below

The predictive power of portfolio characteristics

Governance experts say that paying competitive salaries for internal staff will have benefits across the entire fund. For some, including those working in public sector pension funds or profit-to-member funds, that is unpalatable. But a comparison of salaries and total investment costs, between two large, different and high profile funds – Ontario Teachers and CalPERS – has got me thinking about what value for members looks like.

 

The leading institutional investor magazine in Australia, and sister publication of www.top1000funds,com, Investment Magazine, has just published a comprehensive list of salaries of the chief executives, chief investment officers and chairs of the largest 50 funds in that country.

Transparency at this level is new in Australia, and the story has been a topic of much discussion. Who is the highest paid? What is the median and what are the outliers? What are investment staff getting paid for and should more money be managed internally? Do they get paid bonuses, and should they?

Across the board, insourcing asset management at Australian pension funds is quite new relative to how the funds have been managed in the past, and the question of executive pay is hot globally.

Ontario Teachers Pension Plan is considered to be one of, if not the, best pension fund organisations.

It manages the retirement income of 307,000 members and has generated an annualised rate of return of 10.2 per cent since 1990.

The fund manages 80 per cent of the $140 billion in assets in-house, and has 1400 staff.

Talent management is one of the organisations driving tenets, it knows that its people are its best asset.

In the 2013 annual report, chief executive Ron Mock, says: “Teachers’ is known for recruiting and developing smart people, and our employees deserve the credit for our accomplishments. Building internal expertise has been important in lowering costs and being a pension leader. We will stay a step ahead of competitors by giving our young talent exciting development opportunities and recruiting forward-thinking individuals.”

Management of its people comes in a variety of guises including intellectual development and opportunities, but also pay.

The fund’s “compensation philosophy and objectives” have been developed on a foundation of pay-for-performance.

The compensation programs consist of base salary, annual incentives, and long-term incentives and are structured to ensure that there is direct alignment between the total-fund net value added (after expenses) and the compensation paid to senior management.

The philosophy and pay practices are based on the following key objectives:

• attracting and retaining high-calibre employees;

• motivating and rewarding top performance, encouraging teamwork, aligning personal and organizational objectives and rewarding successful performance over the long term;

• measuring and monitoring our investment incentive compensation framework relative to our risk budget and ensuring our compensation programs do not encourage excessive risk-taking; and

• targeting total direct compensation (base salary, annual incentive, and long-term incentive allocation) at the median of peers. Exceptional performance at the total-fund, asset-class, divisional and corporate levels will result in top-quartile pay relative to peers, while performance below board-approved financial and operational targets will result in pay below median levels.

All of this means that the senior staff get paid well, very well.

During 2013, salaries, incentives and benefits for the 1,038 employees was $262.1 million.

In his last year as chief executive, Jim Leech, got a base salary of $550,000 and total direct compensation of $8.568 million – which included long-term incentive payments of $6.5 million.

That same year 2013, Neil Petroff, the executive vice president of investments, got paid $4.45 million, including more than half in long-term incentives.

But, and here’s the clincher, the total investment costs of Ontario Teachers’ Pension Plan for 2013 were $364 million or 28 cents per $100 of average net assets. 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 identify, paid $159.3 million in salaries and wages in 2014.

But it spent $1.347 billion in external management fees last financial year. On its current asset size, that’s 45 basis points on external managers only.

In a 2012 cost review CalPERS, identified that $1.15 billion of the $1.26 billion total costs was from external asset management fees, and of that 87 per cent of those external fees were from private assets and hedge funds.

CalPERS, 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.

Its internal staff are motivated, professional and are delivering high, consistent returns to members. That’s worth paying for.

 

 

 

To see how Australian superannuation fund executives get paid click here

The giant Japanese pension fund, the Government Pension Investment Fund, continues its quest to move from bonds into equities and shift around 30 per cent of assets, or around $327 billion, out of domestic bonds and short term assets, appointing four new equities managers.

The new asset allocation, approved in October last year, sees the target for domestic bonds shift from 60 to 35 per cent, domestic equities increase from 12 to 25 per cent, international bonds increase from 11 to 15 per cent and international equities shift from 12 to 25 per cent. The allocation to short-term assets will be reduced from 5 to 0 per cent, with short-term assets incorporated into the other four asset classes.

Alternatives will also be incorporated into the asset allocation for the first time, with a 5 per cent allocation dependent on the development of a dedicated team. Infrastructure, private equity, and real estate will be classified as domestic bonds, domestic equities, international bonds or equities depending on the underlying risk and return profiles.

Last week, the ¥130,884 billion ($1,093 billion) GPIF announced it had appointed three domestic equities managers – Schroders, Daiwa SB Investments, Nomura Asset Management – and one international equities manager in UBS.

Over time the fund’s massive allocation to domestic bonds has been consistently coming down. In 2012 it was reduced to 60 per cent, with a target before that of 67 per cent.

One of the motivations for the recent, and more dramatic decrease to 35 per cent, is the relationship with the overall economic policy of the country.

The GPIF outlines that “in June 2014, Ministry of Health, Labour and Welfare published financial stability report (“actuarial valuation”) on public pension scheme, including several scenarios of targeted return for GPIF. Given that Japan is about to significantly transform itself from an economy of persistent deflation, GPIF accelerated the review process of its policy asset mix, which should be more compatible with the changes of long-term economic prospect, and has adopted its new policy asset mix.”

Since June last year, the GPIF’s investment advisory committee, which consists of finance and economics professionals appointed by the Minister of Health, Labour and Welfare, has conducted a thorough review on GPIF’s policy asset mix and intensely discussed optimal asset allocation.

The committee, and sub committee, met more than a dozen times last year to assess the policy mix, including conducting broad scenario analysis.

The return assumptions used were set around and upside scenario and downside scenario and for each asset class the ranges were: domestic bonds -0.2 to -0.1 per cent, domestic equities 3.2 to 3.1 per cent; international bonds 0.9 to 1.4 per cent, and international equities 3.6 to 4.1 per cent.

Risks and correlations were also factored in the scenario analysis, and a policy mix derived that “while preserving the necessary reserve asset” minimized downside risk and meet the investment requirement of a nominal wage increase plus 1.7 per cent.

The GPIF continues to make a radical transformation of its portfolio, both in its asset mix and the way it implements.

Back in July last year the fund decided it would use factor investing, or smart beta, as a third way of implementing equity mandates, alongside active and passive.

A six-month research project conducted by MSCI, which sits in the context of the massive asset allocation changes, analysed the implementation opportunities particularly given any limitations due to the fund’s enormous size.

In April, the fund announced it had awarded 14 active and 10 passive mandates for its domestic equity funds, and introduced some performance based fees. At that time it also decided to implement a wide range of indices. Based on the research “Effective implementation of non-capitalisation weighted index/benchmark”, conducted by MSCI, the GPIF introduced a new category alongside passive and active, called “smart beta active investments – an investment approach to effectively capture mid to long term excess returns through indexing strategy”

At that time the new domestic equities manager appointments were:

Traditional active management:

Eastspring Investments

Invesco Asset Management

Seiryu Asset Management

Natixis Asset Management

Nikko Asset Management

FIL Investments

Russell Investments Japan

JP Morgan Asset Management

DIAM Co

Smart beta active management:

Goldman Sachs Asset Management

Nomura Funds Research and Technologies (Dimensional Fund Advisors)

Nomura Asset Management

Passive:

DIAM Co

Sumitomo Mutsui Trust Bank

Mitsubishi UFJ Trust and Banking Corporation

BlackRock Japan

Mizuho

 

How much has pension fund governance changed in the past 16 years? Not much!

A survey of pension fund governance by Keith Ambachtsheer and John McLaughlin, which asked respondents the same questions in 1997, 2005 and 2014 reveal that the same “sources of excellence shortfall” exist today as they did 16 years ago.

Pension fund governance has not evolved much, but needs to if investors are going to do a better job of investing for the long-term, the report concludes.

The survey asked respondents to rank statements about governance, management and operational effectiveness in their organisations.

A set of 23 consistent questions were asked of respondents in 1997, 2005, and again in 2014, when 81 senior executives of major pension funds from around the globe participated. The most recent survey also had some questions regarding long-term investing.

The surveys reveal that the lowest-scoring statements in 1997 were still the lowest scoring statements in 2014 – identifying the clearest indication of where the challenges with pension governance continue to lie, and the consequences they lead to.

The lowest scoring statements, and where the most improvement is needed from a governance perspective, are:

  • ‘Compensation levels in our organisation are competitive’
  • ‘My governing fiduciaries examine and improve their own effectiveness on a regular basis’
  • ‘I have the authority to retain and terminate investment managers’
  • ‘Our fund has an effective process for selecting, developing and terminating its governing fiduciaries’
  • ‘Performance based compensation is an important component of our organisational design’

Back in 2005, when the survey was completed, the authors outlined some recommended actions that could be taken to address these issues.

They recommended:

1. Redesign pension contracts to eliminate any existing incompleteness, over-complexity, and/or unfairness problems.

2. Create a board skill/experience matrix to reflect the reality that while pension boards need to be seen to be representative and hence legitimate, that is not enough. They must also possess the requisite collective skills and experience to be an effective governance body.

3. Initiate a board self-evaluation protocol in order to identify and address weaknesses.

4. Ensure clarity between board and management roles. Lack of clarity causes organisational gaps, compressions, and a great deal of frustration.

5. Adopt a high-performance stance throughout the organisation and ensure it has the necessary human and technical resources to turn aspiration into reality.

6. Make board effectiveness a regulatory requirement. It would be a simple matter for pension regulators to require that pension organisations disclose the steps they are taking to ensure that an effective governance function is in place.

Clearly not many of these recommendations from 2005 have come to fruition, with the 2014 findings showing “much work still needs to be done”.

In particular, the most recent report by the authors outlines that board selection and improvement continue to be flawed in many cases, the board oversight function in many organisations needs to be more clearly defined and executed, and competition for senior management and investment talent is often hampered by uncompetitive compensation structures.

In addition to questioning pension funds about governance statements, the 2014 survey also asked respondents to rank their agreement/disagreement with 22 statements relating to the organisation’s attitudes and practices regarding long-horizon investing.

The survey revealed a dichotomy between aspiration and implementation with regard to long-horizon investing.

“On the one hand pension funds seem to have good policy intentions and strong beliefs that long-horizon investing is a potentially promising value-adding activity. And on the other hand, survey respondents indicate they have considerable difficulties with such implementation activities such as creating proper incentives for long-horizon investing, participate in constructive ESG related and engagements strategies, and designing effective performance monitoring and measurement systems.”

“The comfort with, and the aspirations for the concept of long-horizon investing has yet to be matched with the design and application of an effective suite of implementation strategies that can realize those aspirations,” the authors say.

The question of why these two questions – governance and long-horizon investing – should appear alongside each other in a survey, can be linked back to a separate 1995 study that the authors were involved in where 50 senior US pension fund executives were surveyed on what they estimated the “excellence shortfall” to be in their organisation.

In writing about this in the 2014 survey report, the authors say “in other words, if the known barriers to excellence could be lifted out of their organisations, by how much might long-term investment performance improve? The median response was 66 basis points. When asked to identify the sources of excellence shortfall, respondents most frequently cited poor decision-making processes, inadequate resources, and a lack of focus and clarity of mission”.

In a low-return environment, 66 basis points is not to be sneezed at.

To access the full report click below

Pension Governance and LT Investing

Keith Ambachtsheer is director emeritus of the International Centre for Pension Management (ICPM) and academic director of the Rotman-ICPM Board Effectiveness Program at the Rotman School of Management, University of Toronto. He is co-founder and president of KPA Advisory Services, and co-founder and board member of CEM Benchmarking Inc.

John McLaughlin is co-founder and board chair of CEM Benchmarking Inc. He is also a board member of a number of public and private enterprises and a graduate of the ICD / Rotman Directors Education Program and a holder of the ICD.D designation.

 

 

 

A candid feedback loop from asset owners to managers following a tender process will help raise the standard of transparency and appropriate offerings in the industry. Chief financial officer of Denmark’s Lønmodtagernes Dyrtidsfond (LD), Lars Wallberg, who has just overseen a full manager overhaul after a rigorous and deliberate tender process has advice to both managers and asset owners on how to improve the process.

 

One of the most important elements of success for an investment tender process is for an asset owner to know exactly what it wants. It sounds simple, but is not necessarily a standard across the industry.

Asset owners need to spend time on the strategy of their fund, set appropriate asset allocation to reach that strategy, and then tender for specific strategies within the asset allocation that it believes will satisfy its needs. At LD, these topics are clearly anchored in the board of trustees.

LD, which outsources all of its asset management to third party providers, prides itself on clear strategy and manager contract requirements when tendering.

The most recent tender process, required by legislation, was completed last year and resulted in a highly concentrated manager lineup.

Part of the confidence in this approach stems from the clear requirements it requires of its managers.

Chief financial officer of Denmark’s LD, Lars Wallberg, believes his fund is setting a new standard in conducting tenders which is resulting in a better outcome.

“As an asset owner you have to be clear and precise in what strategy you want. It’s also important to be clear on the selection criteria and which criteria are important,” he says. “You might as well decide before the process begins what is important for you.”

Wallberg says he often hears from managers that they don’t get feedback from the process and in many cases even informed that the tender is over.

“We need to be fair and transparent. We need to outline what we want, the conditions with which we want it, and then give feedback to managers, tell them the reasons behind the decision,” he says.

“It is my conviction that we learn a lot as an asset owner going through that process, and we can improve competition even more by giving feedback from the experience.”

The fund’s asset allocation, set by the board, is 40 per cent high grade bonds, 35 per cent equities, 20 per cent credit, and 5 per cent private equity.

The tender process resulted in a concentrated manager lineup, and Wallberg says this was the topic of discussion internally.

“We discussed this quite a lot. Given we are a small organisation, with only 15 people, we wanted to be able to discuss the mandates intensely with our chosen managers. So we decided we wanted only a few managers. Of course this comes with pros and cons. For many asset classes this means large mandates, for example in emerging markets there is only one mandate.”

He says one of the reasons for the success of the process, was its rigour with a very detailed questionnaire of qualitative and quantitative questions that was deliberate to ensure that managers actually tendered the right strategy for the required mandate.

“We have a combination of requirements from legislation and also our own business decisions. We have a very strict process which means we have to be very clear in our own minds before we begin. This adds a lot of transparency and managers know exactly what strategies to tender for,” he says.

“Many public tenders are not equally clear. We believe if there is clear communication then we get a better process and outcome, with strategies closer to our requirements. Full information between the buyer and seller ensures we don’t waste time with inappropriate strategies and neither does the manager.”

Wallberg says LD is very clear on the most important criteria for its assessment process. Important criteria include a performance, track record, clear investment process, portfolio construction, the composition of the team and dedication to the strategy.

“We look closely at minimum size and time the manager has managed assets in that strategy, track record, and conviction. By having very clear requirements set out it is easier to select, we can more accurately compare managers and strategies, and there is less noise,” he says.

LD places less emphasis on costs, attaching about 15-20 per cent of the assessment criteria to price, and Wallberg says the rigorous questionnaire and process means there is already price competition in existence.

“Of course cost is important to us, but the processes, large mandates and global selection means price competition is there, our process ensures that. We don’t want to reduce the process to price competition.”

As part of its tender process it includes a provision that the manager must accept a final and non-negotiable fee structure and accept a standard contract defined by LD.

The LD team had access to a very large number of managers through this process, with more than 300 managers from around the globe requesting mandate information.

He says the good news is since the fund last tendered in 2010, there is a marked improvement across the industry, especially with regard to risk management.

“We clearly saw that the risk management is an internal function with a very good specialist that can inspire and inform portfolio managers and help them control risks. This is very convincing for us from an investment perspective. In addition senior management are more involved in risk management than in the past which gives us confidence. The industry really learned the lesson.”

The LD tender questionnaire is long and includes qualitative and quantitative information. Wallberg says the fund “wants strategic business partners, so it should be a demanding process”.

Managers that didn’t do well in the tender were those that wanted to change the rules or push the boundaries.

“My advice to managers is make the assumption the asset owner has made the necessary deliberations before setting up the questionnaire,” he says. “Some we didn’t select had a more opportunistic approach and tried to convince us to appoint them where their strategy was removed from our own requirements. Those that tried to convince us of another approach were deselected at an early stage.”

Wallberg also advises managers to be specific and transparent in their submissions.

“Add some flavour to your answers, outline where do you really make a difference to your competitors. Be specific, where is your approach unique and how does it work? Differentiate yourself, describe how investment approach works. Tell us when the strategy works and when it doesn’t and show it in the data, because we will find out.”

 

 

 

With a total assets of about € 5.5 billion ($6.2 billion) the fund awarded the following mandates:

  • Two high grade (gilt edged) bond mandates: Danish, Nordic & Northern European government , mortgage 6 covered bonds awarded to Nordea Investment Management and Nykredit Assett Management
  • Danish short-term high-grade bonds awarded to HP Fonds (Danish boutique manager)
  • Global equity mandate with a defensive profile awarded to MFS Investment Management
  • Danish equity mandate awarded to Carnegie Asset Management
  • Emerging markets equity mandate with a top-down approach awarded to Fisher Investments
  • Environment and climate equity mandate awarded to Impax Asset Management
  • Global inflation-linked bond mandate awarded to Fischer, Francis, Trees & Watts
  • Investment grade euro corporate bonds mandate awarded to AXA Investment Managers

 

The balance between the allocating to the right number of asset classes and over-diversification is a concern for pension fund investment executives and committees. A new paper by professors at the US Air Force Academy examines the relationship between fees of diversifying asset classes and their diversifying benefits. The paper finds that, in many cases, extra fees completely overwhelm the diversification benefit of that investment.

One of the implications for investors to come out of the paper is that it may not be best practice to separate asset allocation and manager selection and investment vehicle discussions.

“Too often, fees change the relative attractiveness of diversifying asset classes. Fee levels need to be part of asset mix decisions and strategic asset allocation,” the paper says.

In particular the analysis suggests the need for sceptical and fee-aware scrutiny of hedge funds, private equity, narrow mandates in public equity, and global bonds.

“By comparing the incremental benefit of diversification with the incremental cost, we show many seemingly attractive investments become unacceptable as diversifiers. We also show that fees re-arrange the relative attractiveness of many diversifying asset classes.”

Instead, the authors say, investors might be wiser to increase their equity allocation than to seek additional returns from diversification to expensive alternative assets.

 

To access the paper click below

Fees eat diversifcation’s lunch