With so many asset owners looking towards long-term investing, it is considered for funds managers to ask how their business models are aligned with those client aims, or not.

In this research paper, Geoff Warren, research director for the Centre for International Finance and Regulation looks at how investment management organisations might be built to successfully pursue long-term investing.

A variety of recommendations and suggestions are put forward that address four building blocks: organisational; incentives; investment approach; and discretion over trading.

A key message is the need to manage the principal-agency issues that occur across multi-layered operations, with the aim of building alignment with investing for the long run.

 

To access the paper click below
Designing an investment organisation for the long-term

By 2018 AustralianSuper will be managing about A$50 billion ($38 billion) of assets in-house. Chief investment officer of the A$84 billion($64 billion)  fund explains the logic behind the move to David Rowley.

AustralianSuper is rapidly redefining the limits of what a large Australian institutional fund can be.  Projected to double its A$84 billion ($64 billion) size in four to five years’ time, it is turning itself increasingly into a self-sufficient investor. While many in the industry might marvel or be shocked at each step of its evolution – both Mark Delaney and head of equities Innes McKeand were treated with hostility at public conferences after the decision to manage some Australian equities internally was announced – Delaney talks about these changes in a calm, methodical manner, as if it was the most logical  and safest course of action.

A 45 bps target for fund management costs

Delaney has a problem that very few asset owners in Australia face. In fact only David Neal at the A$109 billion ($83 billion) Future Fund is tuned into the increasing difficulty of placing money with its chosen funds managers, due to capacity constraints. He describes the situation in a simple demand and supply way.

“You cannot get sufficient size with quality managers, which tells you there is excess demand for quality management services in the current marketplace.”

He is also aware of the disproportionate impact AustralianSuper has on the profit margins of funds managers and that it is not always enjoying economies of scale as the size of its external mandates increase. By contrast for managing assets in-house the economies of scale work the opposite way.

“The cost of building your capability (in-house) does not go up at the same rate as your fees go up,” Delaney says.

The role model for going in-house is provided by leading Canadian pension funds which have whittled down fund management fees to roughly 40 basis points. Delaney’s target is a 15 basis points cut in fund management costs, which would lead to total fund management costs of 45 basis points.

As each of the internal teams for Australian equities, global equities, fixed income, property and infrastructure becomes funded up to the point of their full capabilities then the savings in costs will be maximised. The fund has a target of running 35-40 per cent of its assets in-house by 2018. As of the end of June 2014, the fund disclosed a total of 9 per cent managed internally.

So, as Delaney admits, in the early years the costs of the internal team will be “a bit lower than external, but not substantially lower”.

The savings will also vary depending on the asset class.  The Queensland Motorways deal completed in April 2014, which is worth around $1.15 billion to the fund, has only required one extra person in the internal infrastructure team on the payroll. The moving in-house is happening in fits and starts; in one week in March, two large property deals in Hawaii and London worth about $1.15 billion increased the amount managed on a direct or co-investment basis by AustralianSuper by 1.7 per cent.

One criticism that might be made of this industrial-sized internal management is that it leaves asset allocation inflexible. Delaney is not too concerned.

“Will we always invest in Australian equities? Most likely. Will we always invest in global equities and fixed interest? Most likely,” he says. “In the 14-15 years we have been investing, not much has changed, but sure, you need to be aware of new opportunities and be flexible.”

 

Industry concerns

All this growth suggests AustralianSuper will one day be self-sufficient in funds management, but that is not in Delaney’s vision.

“If you are a quality manager you have nothing to be concerned about,” he says. “We are not proposing to terminate one of our existing managers because we are doing internal management. We want to hang on to those high quality managers.”

“We hire managers with the best intentions, sometimes it works very well and sometimes it does not. Or, our circumstances might change in terms of what we do with the whole portfolio. That is pretty much our business and we do not want to affect the manager’s business by making any public comment about what we do.

“If it were a modest fund manager and AustralianSuper withdraws a mandate it is a pretty big business for that firm. How would they like it if we then put out a press release saying we have withdrawn the mandate, because we have all these problems? That would just be terrible. It is not fair to the manager to do it. It will just kill their business. The trustees of other funds will say ‘AustralianSuper have done it’ why haven’t you?”

 

Staffing

The success of managing money internally rests on hiring the right people. Delaney estimates that around three-quarters of its 115 strong investment team come from funds managers, and recruiting them is not a problem.

“People are attracted to the sense of mission we have at AustralianSuper to grow people’s retirement savings,” he says. “You do not have to focus on returns and the profitability of your funds management business and sales, or returns to unit holders and shareholders. For those that really love investing, this is a nice niche for them – because all we do is investing.”

The remuneration offered for such staff is “competitive”, but for those that have come into funds management driven to make enormous amounts of personal wealth, this is clearly not the place to come to, admits Delaney.

 

Building the global equities team

If the moves to co-own property and infrastructure are unexceptional, the moves to run large and small-cap Australian equities in-house and to seek an opportunistic role in bank loans  are logical, the area that most looks like new territory is running a global equities team in-house.

Delaney admits to being nervous. “There is an anxiety as everyone is watching us and we cannot fail, but that is no different to investing anyway,” he reasons. “If you fail you should not be in the business.”

The move has been in the planning stage for a while. Richard Ginty was hired as a strategic advisor for global equities almost a year ago and by the end of 2015, AustralianSuper plans to have a nine-strong internal global equities team in place. Ginty had worked for close to 20 years at Mondrian Investment Partners in London, firstly as a research analyst and European portfolio manager, finally as a global equity portfolio manager, where his team at Mondrian managed $20 billion in non-US equity global equity portfolios.  The plan is that he will run a vanilla global equity portfolio for AustralianSuper out of the Melbourne office.

“We are not proposing to have a large style bias,” says Delaney. “It will not be a value, growth or quant approach. It will be a core style, based upon fundamentals with a medium-term perspective. The exact working out of how that gets manifested will depend on the team coming together.”

Ginty is building some of the team from his contacts in London, some from around the world and some from Australia.

“The Australian market for international analysts for equities is improving, but it is still relatively small, relative to the global market,” says Delaney. “Richard’s natural starting point was talking to people in the UK.”

Some of the anxiety about taking on such a venture has been tempered by the success of the Australian equities team.

“You learn by doing,” says Delaney. ‘We hired the people, Shaun Manuell (the portfolio manager for Australian equities) is experienced, the performance is solid. We realised we could hire people, they would fit in, it is not too different from what we currently do and they will integrate with the total investment approach.”

Governance

Many would say the extra responsibility of these in-house teams poses an extra governance burden onto the AustralianSuper board and that they should have greater resources, such as independent investment specialists to join an oversight committee.

Delaney does not think that is necessary. Firstly, he says, the oversight of the investment team by the board has changed.

“You focus more responsibility on oversight and where it should take place,” he says. “So rather than every investment decision going to the investment committee which is what used to be the case, that is no longer the case.”

As such there has been a drive to maintain the same quality on the investment committee and to internally delegate more of Delaney’s decision making to the investment team.

“I used to make all the investment recommendations when the fund was $3 billion in size, but that is not sustainable or a sensible approach at $90 billion, because all the other talented people we have got working in the team can do as good a job.”

The role of the investment committee at AustralianSuper is to set strategic asset allocation ranges for each investment option, to monitor performance and the risk and liquidity constraints of each investment option. It approves investment guidelines, asset class strategies and large direct investments and makes recommendations as appropriate to the board.

“Part of this process involves expanding the platform and processes to enable the fund to invest in around 50 international markets.”

AustralianSuper is exploring the possibility of following in the footsteps of large Canadian pension plans such as Canadian Pension Plan Investment Board by opening up overseas investment offices. This is not so much about acquiring new assets overseas, but managing them.

“As the asset base overseas increases then so will the case to have an overseas base,” says Delaney. “Once we have these co-investments we will have to manage them  as a co-owner, not as an investor.”

Additionally, sending team members over for months at a time is not ideal.

“If you are looking at a UK property asset and someone has got to go for three months and they have a young family and they have to go back again for another two months,  that is not really a sustainable outcome.  You have to live there for two years and  do the job and then come back.”

The large property assets would be best managed from offices in Europe and the US, but these offices might also be used for implementing currency trades. Delaney says such hedges and trades are probably best done in the time zone of the relevant currency.

Back in Melbourne, AustralianSuper has now expanded over the three floors of its 50 Lonsdale Street location; of these, Investments takes up one floor. Delaney says the team structure is pretty much the same as it was in 2009, just with more people. The only change to the structure since that time has been the appointment of Carl Astorri who has joined in the role of head of macro and portfolio construction in the last year.  He works alongside Alistair Barker, who shares a similar role.

This leaves the team underneath Delaney as follows; head of equities, Innes McKeand, head of property, Jack McGougan, head of infrastructure – Jason Peasley, head of income assets John Hopper, head of investment operations – Peter Curtis  and co-heads of macro Carl Astorri  and Alistair Barker.

 

This story first appeared in Investment Magazine, the sister publication of conexust1f.flywheelstaging.com

 

 

A group of 16 UK asset owners with combined assets of more than £200 billion ($269 billion) have developed a guide to responsible investment reporting in public equity. The aim of the guide is to clarify the investors’ reporting responsible investment requirements as they seek to include it in RFPs, manager searches, due diligence and investment mandate terms.

The guide will be used by the asset owners supporting it, to inform their engagement with, and monitoring of, current and perspective managers.

“It is hoped the guide will be particularly useful for smaller pension funds, and once a mandate has been awarded to a fund manager, where reporting will help us to monitor how well the fund managers’ approach to RI is aligned to the broader investment strategy,” the report says.

The purpose of the guide is to encourage improvements in the quality of RI reporting for individual mandates.

While in the past many managers are reluctant to take on more reporting, the asset owners believe long-term benefits that stem from greater transparency and accountability will outweigh any short-term incremental reporting costs.

The report breaks reporting into two parts – ESG integration and stewardship – and outlines the expectations and guidelines for managers in their reporting of these two activities.

Within ESG, the guidelines cover both identifying and managing risks and opportunities, and includes benchmarking relative portfolio level ESG analysis, stock or sector decisions, identification of long-term trends and changes to the ESG integration process.

Within stewardship the guide covers both process and outcomes with regard to engagement and voting, looking at progress against engagement objectives and the attribution of engagement to portfolio risk or return.

The asset owners which support the guide believe that better reporting can help to build a better understanding of the extent to which responsible investment factors and activities can help to explain both short and long-term investment risk and performance in public equity.

The guide is designed to initiate discussion and dialogue between asset owners and their managers on the reporting metrics and whether they are applicable to other asset classes.

“Fund managers should regard these reporting expectations as a guide to help kick-start a process of reflection regarding their approach to responsible investment,” the guide says.

The asset owners supporting the guide are BTPS, PPF, Kingfisher, West Midlands, Strathclyde, SAUL, Environmental Agency, Merseyside, Northern Ireland Local Government Officers’ Superannuation Committee, Pensions Trust, Lothian, USS, Unilever, BBC, NEST and RPMI Railpen.

 

To access the guide click here

 

 

Investors should re-consider their investment processes in order to achieve the needed “step-change in efficient portfolio construction” in a low return environment, the chief executive of the A$109 billion ($83 billion) Future Fund, David Neal, says.

“It is the investment process that turns the universe of opportunities into a portfolio, and right now that process needs to be as efficient and effective as it can be,” he said.

Specifically Neal said that long-term investors should look beyond the traditional characteristics of a long-term investor – the ability to take on greater levels of market risk and the ability to accept the risk of not being able to sell.

“If the reward for the higher risk is not there, it doesn’t make sense to accept that risk,” he said, urging investors to think critically about the risk/reward trade-off, not blindly accept it.

In addition he points out that just because there should be a return for illiquidity doesn’t mean a return premium is always there in practice.

Neal advocates that investors “add to their armour” and the first thing to think about is not just where to take risk, but when to take it.

“One advantage of being a long term investor is that the task is to generate the return over the long term, which means that the portfolio does not have to be constructed to achieve that target return all the time. If the reward for risk is low, it is perfectly reasonable to take lower risk (and accept an even lower return) for a while, waiting for the time when the reward for risk is once again higher,” he said.

“This introduces the concept of inter-temporal risk management – allocating your risk taking through time.”

In addition he says the way pension funds (specifically superannuation funds in Australia) organise themselves, places considerable constraints on the allocation process which leads to less efficient portfolios.

He said the tradition of strategic asset allocation, and asset buckets, is restrictive.

“I would encourage all funds to think deeply about their processes. Do they have this ability to identify great strategic opportunities, and if so, do they have the ability to right-size them in the context of the total portfolio?”

The Future Fund has a target return, but adopts a benchmark unaware approach with no strategic allocations to individual asset classes.

Its sits alongside NZ Super and the Canadian Pension Plan Investment Board in this way of thinking, allocating assets according to a total portfolio view.

An example of how this works, is that a property investment is not thought of in terms of filling a real estate allocation, but whether it is better than staying in equities.

This approach allows investors to be opportunistic. Neal says after the global financial crisis, banks were capital constrained and so companies were finding it hard to get financing.

“With the help of our managers and other relationships, we were able to identify the opportunity and build a specific private lending strategy. This didn’t appear in any benchmark, but it forms a large proportion of our debt allocation (we have $4 billion in this strategy).”

Neal says that the process evolution he is advocating requires substantial internal resources.

“This is not an argument for building internal sector implementation which is more about cost reduction. That is fine but won’t on its own deliver a step change in efficient portfolio construction.”

At the end of December 2014, the Future Fund’s asset allocation was Australian equities 8.8 per cent, developed market equities 20.9 per cent, emerging market equities 9.4 per cent, private equity 9.5 per cent, property 6.3 per cent, infrastructure and timberland 7.4 per cent, debt securities 10.8 per cent, alternative assets 14 per cent, cash 12.8 per cent.

David Neal was speaking at the ASFA Investment Interchange.

While divestment is a useful tool to communicate concerns of climate risk to stakeholders, it is not an optimal investment strategy, in part because it ignores short-term benchmark risk. A research paper by MSCI provides a framework for evaluating ways to reduce two dimensions of carbon exposure – current carbon emissions and potential future emissions embedded in fossil fuel reserves – and explores new and more financially viable ways of managing carbon risk.

Institutional investor responses to how to tackle climate change have tended to centre around probing the long-term portfolio implications of “carbon stranded assets”.

As MSCI outlines companies’ carbon exposure consists of two dimensions: current emissions and fossil-fuel reserves which represent potential future emissions.

In the MSCI ACWI Index, utilities, materials and energy companies accounted for more than four-fifths of the total current carbon emissions. Not surprisingly, Energy companies represent more than 80 per cent of total fossil fuel reserves.

Up until now, much of the pressure to manage carbon stranded assets risks has focused on divesting from companies in the fossil fuel sectors. But MSCI argues that from a financial perspective, the strategy is not optimal as it can create significant short-term risk by potentially deviating sharply from market risk and returns.

In addition, such an approach largely ignores fixed assets from non-energy sectors in the portfolio that are at risk of being stranded due to their dependence on burning fossil fuel reserves, such as coal-based power plants.

The shortcomings of the divestment approach have led major asset owners to seek more financially practical solutions to managing carbon risk.

Instead, investors are starting to turn to strategies that re-weight the market-capitalisation portfolio to effectively minimise broad carbon exposure while using optimisation to reduce tracking error. These approaches take into consideration both current emissions and fossil-fuel reserves, thus aiming to capture a broader exposure to carbon-intensive companies while seeking to minimize short-term risk.

To read the full research paper click below

Research_Insight_Beyond_Divestment_Using_Low_Carbon_Indexes

A neat little story of investment flows, asset allocation changes, and relationship and service demands is emerging from the third annual Top1000funds.com/Casey Quirk Global Fiduciary CIO Survey. If you’re a CIO of an asset owner what that means is more control but also more responsibilities and the demands of more internal resources. For managers it means changing your proposition for a more customised approach.

The third annual Top1000funds.com/Casey Quirk Global Fiduciary CIO Sentiment Survey seeks to measure the sentiment of asset owner investment teams around the world.

Conducted with the expertise of the financial services management consultant, Casey Quirk, the 2014 survey looked at the changes in asset owner structures and investments, and specifically measures the behaviour of internal investment teams, their outlooks and corresponding asset allocations.

The survey included responses from more than 110 investors, from a wide range of participants including pension funds, sovereign wealth funds, insurance companies, endowments and foundations, with a combined assets of $2.1 trillion.

The overwhelming trend emerging from the survey is that investors are shifting in two ways. There is a broad divergence in risk on versus risk-off investing, driven largely by the investor’s investment objectives and how far they are from meeting those objectives. Secondly there are changes in how asset owners are building portfolios ranging from full investment outsourcing to significant investments insourcing.

The combination of these two dimensions means many asset owners will need to rethink their operating model to appropriately resource and govern the investment engine and many investment managers will need to tailor their client engagement model to reflect diverging preferences.

One of the key findings of the survey is that risk and return objectives are being driven by unique outcomes.

Across all respondents, 59 per cent of investors have an absolute return target which is up from 42 per cent the year before.

The funded status among pension funds is creating a divergence in risk appetite. The best funded plans are reducing their international and high-yield exposure, and anticipate a large shift into domestic and non-domestic fixed income.

Tyler Cloherty senior manager at Casey Quirk says there is a push towards absolute return metrics, with more institutions pushing an outcome-oriented approach.

There is a pretty significant de-risking among the better funded plans, which is having an impact on asset allocation. When this is explored further, there is a difference in the activities of pension plans according to type.

“The better funded plans are corporates, and they are de-risking and moving towards LDI. But the public pension funds are pushing towards more aggressive assets,” Cloherty says.

Within the aggressive assets, alternatives usage is beginning to bifurcate by channel and objectives, with the de-risking corporates increasing fixed income and real assets, and public plans increasing alternatives at the expense of equities, with a projected increase in alternatives of 3.1 per cent by 2017.

Among the investors surveyed, in-sourcing continues to rise due to cost and control benefits. In particular the larger funds are planning more in-house management of investments. Around 36 per cent of assets for large funds are now managed internally, and 60 per cent of respondents plan to increase this. The largest shift in insourcing is in core equity and fixed income.

In 2014 respondents showed that around 40 per cent of fixed income assets are managed in-house, up from 22 per cent in 2013. In domestic equity around 23 per cent of assets were managed in-house, up from 9 per cent.

“Insourcing continues across plans of all types,” Cloherty says. “The downstream impacts on CIOs of this will be around staffing, internal operations, investments whether active or passive. All of this will have an impact on career risk. It’s hard to find the talent, and an easier route might be to use a third party.”

The use of passive management is heaviest among in-house managers, which is also effecting the huge dispersion in costs between external and internal mandate costs.

In 2013 the difference between external and internal costs was 46.3 basis points for external versus 7.1 per cent for internal, a difference of about 6.5 times.

This difference has doubled to 13 times, caused by the reduced cost of more internal management coupled with more alternatives being managed externally. The 2014 average costs were 53.4 basis points for external mandates and 5 basis points for internal.

Partner at Casey Quirk, Jeff Levi says the further spread of fees is due to the growth in alternatives and more esoteric asset classes, where there is less fee pressure.

“With the alpha and beta separation and more passive management of core assets in-house, there is a story of polarisation of where investors are willing to spend on alpha,” he says.

“This has huge implications for managers to alter their capabilities.”

Interestingly while cost is a driver for investors to bring assets in-house, it was control of assets that was the number one reason for insourcing.

“With the increased focus on risk and absolute return investors don’t always have complete transparency especially in unconstrained strategies. By bringing assets in-house they have more understanding of, and control around, what they are managing,” Cloherty says.

The in-house trend is not without nuance. Casey Quirk identified that a bifurcation of in-house capabilities is creating new institutional segments, and identified four types of investors.

The “in-house investor” where on average 44 per cent of assets were managed internally with internal staffing of 15. These investors conducted investment and manager screening in-house and used co-investment as well as direct investment for alternatives.

The “sophisticated investor” that had in-house manager selection capability and used consultants selectively. On average they had 9 per cent of assets managed in-house and a team of around 6 split between investment and research.

The other two types of investors were the “mainstream investor” which was consultant driven and used traditional products and asset allocation, and an “outsourced investor” which third parties having investment discretion. Both of these types of investors didn’t manage money in-house.

As the dynamics in the industry change, the survey finds chief investment officers will need to manage a growing array of investment methods, from co-investment to in-house management, to execute on their allocation guidelines.

Casey Quirk predicts that in the future, asset owners will measure the success of their in-house asset management capabilities, not by business profitability, but by the cost savings against external mandates and by their ability to meet cash-flow objectives.

Meanwhile, external parties, including managers and consultants will be expected to provide growing customisation and knowledge sharing.

The survey found that investors consistently valued deep knowledge of investment strategies as the most important trait in a manager, followed by access to investment professionals.

“A lot of consultants are being forced to rethink their business model as many asset owners diverge in their investments approach: either more in-house discretion where consultants provide input and data or a more outsourced model where consultants may be asked to act as a fiduciary.” Levi says. “There are also big implications for managers, as each investor group wants different products and research focus. Managers need to plan and think about out how to service the different groups, whether the service they are giving is too technical or not technical enough, this could lead to a lot of challenges.”