Institutional investors act like momentum investors, chasing returns, even over longer time horizons according to Asset Allocation and Bad Habits, a new research paper that looks at the impact of past returns on asset allocation.

The paper commissioned by Rotman-ICPM and authored by Amit Goyal professor at Univeriste de Lausanne, Andrew Ang professor at Columbia Business School and Antti Ilmanen from AQR Capital Management, empirically documents that longer-horizon investors act like momentum investors.

While many large pension funds rebalance there are also many that let their asset allocation drift with relative asset class performance. This might reflect passive buy and hold policies or a desire to maintain asset allocation near to market cap weights but it can also represent more pro-active return chasing. The paper gives evidence to the latter, using data from CEM Benchmarking on evolving US pension funds’ asset allocations from 1990-2011. It shows return- chasing behaviour at asset class level over multi-year horizons.

One of the authors, Amit Goyal, says investors can be narrow-minded in their decisions around asset allocation.

“They are myopic in this behaviour, they don’t look at asset class returns over a long horizon or even over five years, but more like one year,” he says. “We know from empirical research that returns reverse over three to five years, failure to take that into account is detrimental.”

Goyal says that investors should be considering forward looking economic forecasts in their asset allocation decisions and put less weight on past returns.

“If you are going to make a decision on asset allocation then you need some forecast of future expected returns and risks. But it is like looking into a crystal ball that one doesn’t have. In forming estimates of the future maybe there should be more focus on economic factors and an investor’s own special situation rather than blindly focusing on past returns. Past returns are over-emphasised.”

The research used data from 573 US pension funds which had a median size of $3 billion and an average of around $10 billion. Collectively, the funds hold 30-40 per cent of the assets of US pension funds and about 4 per cent of US equity market capitalisations. The research looked at the funds actual and policy asset allocation weights.

For the period 1990-2011 the policy or strategic target asset allocations, averaged across all funds (equally-weighted) was 57 per cent for equities, 32 per cent for fixed income, 9 per cent for alternatives and 2 per cent for cash.

The analysis shows that policy weights for equities rose from 54 to 61 per cent peak in 1999-2001 before falling to 46 per cent in 2011. Fixed-income weights fell from a third to 29 per cent in 2004-2006 before rising to 35 per cent in 2011, and cash weights had a similar U-shaped time profile. Alternatives weights fell from 10 to 6 per cent in late 1990s before rising to 16 per cent in 2011.

The asset allocation of the funds is analysed alongside momentum/reversal patterns in financial markets.

The paper finds that: “Pension funds in the aggregate do not recognise the shift from momentum to reversal tendencies in asset returns beyond one-year horizon. Pension fund keeps chasing returns over multi-year horizons, to the detriment of the institutions long-run wealth.”

The authors’ hope is that by contrasting the evidence of multi-year pro-cyclical institutional allocations with the findings of multi-year return reversals in many financial assets that it will make at least some investors remedy their bad habits and reconsider their asset allocation practices.”

 

 

 

The ultimate combination of value and momentum strategies depends on the investors’ time horizon, with a new institutional theory rationally explaining these anomalies by investor flows. Dimitri Vayanos, professor of finance at the London School of Economics explains why this theory can add to the practical debate of what is the best asset mix for investors.

Most active investment management strategies involve the prominent market anomalies of momentum and value, and the question of how to best combine them depends ultimately on the time horizon of the investor.

Professor of finance at the London School of Economics, Dimitri Vayanos, says that momentum and value are puzzling, and hard to understand, within standard finance theory, with some studies explaining the strategies by looking at behavioural economics and some using market frictions including delegation and agency, and fund flows.

Explaining how or why these anomalies arise is important, Vayanos says, because then investors can exploit them.

Speaking to delegates at a London School of Economics roundtable, hosted by www.top1000fuds.com, Vayanos explained a flow-based explanation for return predictability, and the idea that momentum is driven by flows.

He defines momentum as the tendency of recent performance to continue in the near future, reversal as the tendency of performance over a longer history to revert, and value, closely linked to reversal, as the ratio of market price to book value of equity or earning predicting inversely future performance.

He says that understanding flows is important to understanding momentum.

Momentum, reversal and value are well-documented empirically, and form the basis for most active investment strategies but most investment strategies are data driven through backtesting and there is not a theoretical understanding of why momentum is indeed momentum. There is not an underlying framework for understanding the anomalies.

“Fund flows generate comovement. Following outflows from some funds, all assets held by the funds drop in price,” he says. “Fund flows also generate lead-lag effects. The price drop of one asset predicts that the other assets held by the same funds will drop in the short run and rise in the long-run.”

He says that momentum, reversal and comovement are larger for assets with high idiosyncratic risk

“Trading against mispricings in those assets subjects fund managers to high risk of underperforming their benchmarks,” he says. “There is evidence of associating earnings to predictability of returns – value stocks have high expected returns and low and declining earnings.”

The portfolio management implications include the question of how best to implement value and momentum, how they should be combined, and how the ultimate strategy connects with the time horizon of the investor.

He claims that his modelling can help answer those questions by looking at the response of mutual fund flows to performance and the price impact of those flows.

The results show there is a negative correlation between momentum and value, and diversification benefits from combing the two.

In terms of risk, momentum is a series of individual events so the long-run risk of momentum is a sum of short-run risks. But value is a long term game, if a stock does poorly in one year it will become even cheaper.

“The long-run risk of value is smaller than the sum of short-run risk, so value overtakes momentum for long investment horizons,” Vayanos says.

One of the delegates, Olivier Rousseau, executive director of the $50 billion Fonds de reserve pour les retraites, asked why investors should bother with value, when “you can get all the goodies from momentum over and over”.

But Paul Woolley, founder of the Paul Woolley Centre for the Study of Capital Market Dysfunctionality at the London School of Economics and a co-author of Vayanos, says that momentum is flattered because it is data driven.

“It is treacherous, it is fool’s gold,” he says.

Vayanos says that funds should invest in both momentum and value but the combination depends on the time-horizon of the investor.

“If there is a shorter horizon then a focus on momentum, a longer horizon then there should be larger weights on value,” he says.

In addition, from the point of view of a long-horizon investor, momentum’s attractiveness is further reduced because it has an anti-hedging property.

“Momentum does poorly in our framework when mis-pricings decrease which is when investment opportunities worsen. In particular poor performance of momentum predicts poor future performance of value. When momentum performs poorly, therefore, investors are not compensated by having access to other investment opportunities that are expected to perform well.”

Wilma de Groot, vice president and portfolio manager of quantitative equities at Robeco, said the presentation was excellent in understanding the drivers of momentum and value that are used in investing.

“It helps to rationalise the momentum and value effect when usually they are related to irrationality, it is a very good model,” she says.

Tony Broccardo, chief investment officer of the $30 billion Barclays UK Retirement Fund asked how the delegated relationship between asset owners and fund managers relates to the momentum and value phenomenon.

“Our theory emphasises performance-driven flows, but flows can also be for other reasons. There is empirical evidence that more delegation causes more momentum, although more study is needed. If there is more institutionalisation then other things change so it is hard to define each characteristic but we should also look also at benchmark design,” Vayanos says.

 

 

Investors were challenged to think differently about their portfolios by the latest academic thinking from the London School of Economics at a one-day investment roundtable in London last week.

 

Chief investment officers from UK and European public and corporate pension funds convened at the London School of Economics for a highly interactive one-day investment think-tank facilitated by conexust1f.flywheelstaging.com and supported by Robeco and Lexington Partners.

 

 

 

Delegates

Ciaran Barr, investment director, RPMI Railpen

Tony Broccardo, chief investment officer, Barclays UK Retirement Fund

Pierre Collin-Dufresne, professor of finance, director of the doctoral program of finance, Swiss Finance Institute, EPFL

Neil Cooper, chief investment officer, Greater Manchester Pension Fund

Ronald van Dijk, head of developed market equities, APG

Frank Drukker, senior account manager, Robeco

Stefan Dunatov, chief investment officer, Coal Pension Trustees Investment

James Duberly, chief investment officer, BBC Pension Fund

Elizabeth Fernando, deputy chief investment officer, USS

Anthony Garton, principal, managing partner, Lexington Partners

Wima de Groot, portfolio manager, quantitative equities, Robeco

Sunil Krishnan, head of market strategy, BT Pension Scheme Management Limited

Anders Lundgren, head of manager selection, NEST Corporation

Christopher Polk, professor of finance, director financial markets group, London School of Economics

Kerrin Rosenberg, chief executive, Cardano UK

Pal Ristvedt, partner, Lexington Partners

Olivier Rousseau, executive director, Fonds de reserve pour les retraites

Yazid Sharaiha, head of implementation strategies, Norges Bank Investment Management

John St Hill, principal – portfolio management, Pension Protection Fund

Colin Tate, chief executive, Conexus Financial

Dimitri Vayanos, professor of finance, director of the Paul Woolley Centre for the Study of Capital Market Dsyfunctionality, London School of Economics

Amanda White, editor, conexust1f.flywheelstaging.com

Paul Woolley, chair of the Paul Woolley Centre for the Study of Capital Market Dsyfunctionality, London School of Economics

 

Ciarán Barr, investment director, RPMI

Ciarán is an investment director at the £20 billion ($33 billion) RPMI. He is jointly responsible for managing the various investment functions, ranging from advising on client strategy to researching investment ideas, asset allocation and portfolio construction.

He joined RPMI in 2009 and was previously responsible for leading the strategy team in generating views and ideas on international economies and financial markets, as well as recommendations across the portfolios. As part of his role, he regularly presents to the trustees on a wide variety of matters.

Most of Ciarán’s previous career was spent at Deutsche Bank, including the role of chief UK economist. He holds an honours degree in Economics.

 

Tony Broccado, chief investment officer, The Barclays UK Retirement Fund

Tony Broccardo is the chief investment officer of Barclays Pension Fund and is the head of Oak Pension Asset Management Limited which is the inhouse asset manager for the Barclays pension fund. This circa £18 billion ($30 billion) fund is highly diversified and global.

Broccado’s team is responsible for the asset allocation process, investment management, implementation and risk budgeting of the fund. The fund uses a significant number of external asset class specialists. with 30 per cent of assets under management invested in alternatives.

Broccado’s previous experience includes being an executive director and chief investment officer for F&C Asset Management PLC, and as a global partner and institutional chief investment officer for INVESCO Asset Management Inc. In both roles, over a period of 15 years, he chaired the global asset allocation committee.

Broccado has a MA in Finance and Investment from Exeter University, where he is also a Fellow and lecturer in Investment.

 

Ronald van Dijk, head of equities developed markets, managing director, APG Asset Management

Ronald van Dijk is a head of equities – developed markets for the €343 billion ($473 billion) APG Asset Management, and a member of APG’s Capital Markets Investments management team.

He is responsible for all equity investment activities in global developed markets overseeing internal portfolio management teams in fundamental equity and quantitative equity strategies, and manager selection teams. These multi-strategy investments exceed €100 billion ($136 billion). He functions as a head of the quant equities group having direct oversight responsibility for systematic investment strategies in developed and emerging markets. Ronald is based in Amsterdam, the Netherlands.

 

Pierre Collin-Dufresne, professor of finance, director of the doctoral program of finance, Swiss Finance Institute @ EPFL

Pierre Collin-Dufresne joined the SFI @EPFL in 2011 from Columbia University where he held the Carson Family Professor Chair since July 2008. Prior to Columbia, Collin-Dufresne worked three years as a senior portfolio manager in the quantitative strategies group of Goldman Sachs Asset Management.

His research on topics such as credit and fixed income security markets, securitisation, and asset allocation has been published in leading academic journals.

He is a research associate of the National Bureau of Economic Research (NBER), an associate editor of several academic journals including the Journal of Finance and a co-editor of Finance & Stochastics.

 

Neil Cooper, investment manager, Greater Manchester Pension Fund

Neil Cooper is an investment manager at the £13 billion ($22 billion) Greater Manchester Pension Fund, with particular responsibility for private equity and alternative investments. A 17 year capital markets career has involved working across all asset classes and asset allocation.

A Fellow of the Chartered Institute of Securities and Investment, Cooper graduated from the University of Durham with a degree in Economics.

 

Wilma de Groot, vice president, portfolio manager, quantitative equities, Robeco

Wilma de Groot is a portfolio manager within the quantitative equities team. Her primary focus is Robeco’s quantitative emerging market strategies. She specialises in quantitative stock selection and portfolio construction. De Groot joined Robeco as a researcher in 2001.

She has published among others in Journal of Banking and Finance, Financial Analysts Journal and VBA Journaal, and she is a guest lecturer at several universities. Mrs. de Groot graduated in Econometrics from Tilburg University. She is a CFA charter holder.

 

Frank Drukker, senior account manager, Robeco

Frank Drukker is  senior account manager within the department of institutional sales and account management. He is responsible for covering Dutch and international institutional clients.

Before that Drukker had several managerial and commercial client responsibilities at Deutsche Bank and ABN AMRO Bank covering public sector and mid cap clients. His last responsibility was managing the mid cap department of Deutsche Bank in Amsterdam. In previous roles he was covering international clients in multiple industries like oil, telecom and banking.

Frank has a M.Sc. in business and economic law from the Rijks Universiteit Utrecht.

 

James Duberly, director of pensions investments, BBC Pension Trust.

James Duberly is responsible for the in-house investment team which recommends and implements investment strategy on behalf of the trustees of the BBC’s £ 11 billion (18.5 billion) pension scheme.

Prior to joining the BBC Pension Trust in June 2011, James worked at Russell Investments, the Bank for International Settlements and GH Asset Management. He is also the treasurer of the Neuroblastoma Society in the UK.

 

Stefan Dunatov, chief investment officer, Coal Pension Trustees Limited

Stefan Dunatov is chief investment officer at Coal Pension Trustees Limited, which is responsible for £20 billion ($34 billion) of investments of the Mineworkers’ Pension Scheme and the British Coal Staff Superannuation Scheme.

Prior to Coal he was a director at Deutsche Asset Management, portfolio strategist at Equitas, an advisor at the Reserve Bank of New Zealand and economist at HSBC. He holds undergraduate degrees in both law and economics from the University of Auckland and a Masters in Economics from The London School of Economics.

He is a member of the 300 Club, a group of global investment professionals whose aim is to raise awareness of the impact of market thinking and behaviours in order to improve investment governance and strategy.

 

Elizabeth Fernando, deputy chief investment officer, USS

Fernando joined USS in January 1995 as head of European equities and was promoted to deputy chief investment officer in January 2006. She has been involved in the development of the investment department and the long term investment strategy of the fund, and completed the fund’s first direct private equity investments.

In August 2012 she was appointed head of equities which is a new role at USS. The head of equities has responsibility for total equity performance as well as planning, resourcing and budgets for the function and is a member of the executive committee of USSIM.

Prior to joining USS, Fernando worked at Lloyds Investment Managers Ltd in a variety of roles including UK smaller companies and later European equities.

She holds an MA in Philosophy, Politics and Economics from Oxford University and is an associate member of the UK Society of Investment Professionals (UKSIP).

 

Anthony Garton, principal/managing director, Lexington Partners

Anthony Garton is a principal of Lexington Partners primarily engaged in investor relations.

Prior to joining Lexington in 2013, Garton was a principal in the fundraising and investor relations team at Cinven. Prior to that, he was a vice president in investment banking at Credit Suisse and an associate director at UBS Investment Bank’s leveraged finance and M & A groups.

Mr. Garton graduated from the University of Bristol with a BA in Hispanic and Latin American studies and is a qualified Chartered Accountant.

 

Sunil Krishnan, head of market strategy, BT Pension Scheme

Sunil Krishnan joined the BT Pension Scheme in June 2011 as director and head of market strategy. He is responsible for assessing the implications of market and economic conditions for the scheme’s overall investment strategy, and for proposing dynamic changes to the scheme’s asset allocation stance.

He also works on developing the investment process to deliver that strategy.

Prior to joining the scheme, he worked for 10 years at BlackRock and predecessor companies as a manager of multi-asset portfolios, research director and adviser to institutional investors including pension schemes.

He holds a MSc in Economics from Birkbeck College, London and an MA in Philosophy, Politics and Economics from Balliol College, Oxford. He is a CFA Charterholder.

Anders Lundgren, head of manager selection, Nest Corporation

Anders Lundgren has an MSc in Theoretical Physics from Chalmers University, Sweden. He also holds an MBA from Imperial College, London and the Certificate in Quantitative Finance.

Lundgren started his career in 1999 at Bloomberg where he worked as an analyst. In 2000 Anders joined Credit Suisse Asset Management as a risk analyst and later worked in the fixed income team serving a wide range of institutional and pension investors. In November 2010, he joined Nest Corporation where he focuses on manager selection and asset allocation. Nest forms the universal occupational pension scheme in the UK.

 

Christopher Polk, professor of finance, director of financial markets group, London School of Economics

Christopher Polk is professor of finance and the director of the Financial Markets Group Research Centre at the London School of Economics. Professor Polk has also taught at Northwestern University’s Kellogg School of Management and Harvard University’s Department of Economics.

He completed a Ph.D. in Finance at the University of Chicago, where he studied under 2013 Nobel Laureate Professor Eugene Fama. Professor Polk is currently an Associate Editor of the Journal of Finance and a Research Fellow at the Center for Economic and Policy Research (CEPR). Professor Polk has published extensively in leading finance and economics journals, including winning paper of the year at the Journal of Financial Economics.

He is an expert on the behaviour of security prices and investment strategies, having advised a wide range of institutions including hedge funds, the EU European Securities and Markets Authority, and the Bank of England on these topics.

 

Pal Ristvedt, partner, Lexington Partners UK Ltd.

Pal Ristvedt is based in Lexington Partners’ London office where he is responsible for Lexington’s secondary activities outside the United States and leading a team focused on the sourcing, valuation and negotiation of secondary purchases of non-US buyout, venture and mezzanine private equity partnerships.

Prior to joining Lexington Partners in 2001, Ristvedt worked in the investment banking department at Morgan Stanley in London and New York where he was involved in mergers and acquisitions transactions and in the execution of large leveraged financings for private equity funds as a member of the firm’s Financial Sponsor Group.

Ristvedt holds an MBA from INSEAD and a BS in business administration from the University of California at Berkeley.

 

Kerrin Rosenberg, chief executive, Cardano

Kerrin heads Cardano’s UK team and has overall responsibility for the UK business.

Prior to Cardano, Kerrin was an investment consultant at a major actuarial adviser. He built up a client base of UK pension funds with over £50 billion ($84 billion) assets.

Rosenberg is widely accepted as one of the UK’s thought leaders in the provision of investment advice. His clients have been early adopters of many investment concepts that are commonplace today. This has included quantifying investment objectives relative to liabilities, the use of swaps to manage liability risks, unconstrained equities and alternative assets.

He graduated from the University of Manchester with a degree in Economics, and qualified as an actuary in 1995.

 

Olivier Rousseau, executive director, Fonds de reserve pour les retraites

Olivier Rousseau was appointed as a member of the management board of the French Pension Reserve Fund (FRR) in November 2011. FRR is a pension buffer fund with €36 billion ($50 billion) in assets. The Board comprises of a non-executive chairman and two full time executive members. Rousseau also chairs the asset manager selection committee.

After graduating from the French National School of Administration (ENA) in 1986 he joined the French Treasury in Paris. He also holds a degree in political sciences and master degrees in law and economics from the university of Aix-en-Provence.

He worked for 11 years for BNP Paribas in international banking and finance in Paris, Tokyo, London, Singapore, Hong Kong and Sydney.

His postings spanned asset swap portfolio management in Tokyo, head of fixed income origination for French issuers, head of corporate and institutional banking at BNP London, chairman of the management committee of BNP Prime Peregrine, group managing director of BNP Paribas equities Australia.

He also served on the resident board of directors of the European Bank for Reconstruction and Development in London (2004-2006) and as regional economic counsellor at the French embassy in Stockholm (2006-2011).

 

Dr. Yazid M. Sharaiha, head of implementation strategies, Norges Bank Investment Management, and Adjunct Professor, Imperial College Business School

Yazid Sharaiha is head of implementation strategies, Norges Bank Investment Management, and Adjunct Professor, Imperial College Business School. His career spans both academia and industry.

Prior to his current role, he was managing director and global head of the quantitative and derivative strategies at Morgan Stanley.

He was previously a University Lecturer at Imperial College, London.

He has published over 30 articles in the fields of operations research and quantitative finance, and co-authored/edited two books.

His research interests include asset allocation, enhanced indexation, market microstructure, risk management, and design of derivative strategies in fund management.

Sharaiha holds Masters’ degrees in Engineering and Management Science from UC Berkeley and Imperial College (respectively), and a PhD in Operations Research from Imperial College.

 

John St Hill, principal – portfolio management, Pension Protection Fund

John St Hill is the principal responsible for equity and fixed income portfolio management at the Pension Protection Fund. He is responsible for choosing investment managers, selecting the benchmarks and constructing the portfolio.

He has 20 years experience in investment management and started his career in equity research. Prior to joining the PPF he held various roles at SEI including head of UK fixed income and head of UK risk management.

St Hill is a graduate of the University of Chicago MBA program. He also holds the CFA and FRM professional designations. His professional interests include measurement of fund manager risk aversion and portfolio construction.

 

Colin Tate, chief executive, Conexus Financial

Colin Tate has been an investment industry media publisher and conference producer since 1996. In his media career, Tate has launched and overseen dozens of print and electronic publications.

Tate is the chief executive and major shareholder of Conexus Financial Pty Ltd which was formed in 2005, and is headquartered in Sydney, Australia.

The company stages more than 20 conferences and events per year – in London, New York, San Francisco, Los Angeles, Amsterdam, Beijing, Sydney and Melbourne –  and publishes five media brands, including the global website and strategy newsletter for global institutional investors conexust1f.flywheelstaging.com.

One of the company’s signature events is the bi-annual Fiduciary Investors Symposium.

Conexus Financial’s events aim to discuss the responsibilities of investors in the context of wider societal, and political contexts, as well as the long-term stability of markets and sustainable retirement incomes.

Tate served on the board of Australia’s most high profile homeless charity The Wayside Chapel for seven years, and has underwritten the welfare of 60,000 people in 28 villages throughout Uganda via The Hunger Project.

 

Dimitri Vayanos, professor of finance, London School of Economics

Dimitri Vayanos is professor of finance at the London School of Economics, where he also directs the Paul Woolley Centre for the Study of Capital Market Dysfunctionality.

He received his undergraduate degree from Ecole Polytechnique in Paris and his PhD from MIT. Prior to joining the LSE, he was faculty member at Stanford and MIT.

His research focuses on financial market liquidity, limits of arbitrage, bubbles and crises, and policy implications.

He is an editor of the Review of Economic Studies, a director of the American Finance Association, a research fellow at CEPR and a past director of its Financial Economics program, and a research associate at NBER.

 

Amanda White, editor, conexust1f.flywheelstaging.com, director of content, institutional, Conexus Financial

Amanda White is the director of institutional content at Conexus Financial. She is responsible for the content across all Conexus Financial’s institutional media and events.

She is the editor of conexust1f.flywheelstaging.com, the online news and analysis site for the world’s largest institutional investors. White has been an investment journalist for more than 18 years and has edited industry journals including Investment & Technology, Investor Weekly and MasterFunds Quarterly.

She was previously editorial director of InvestorInfo and has worked as a freelance journalist for the Australian Financial Review, CFO, Asset and Asia Asset Management.

She has a Bachelor of Economics and a Master of Arts in Journalism and is a columnist for the Canadian publication, Corporate Knights, which is distributed by the Globe and Mail and The Washington Post.

 

Paul Woolley, chair, The Paul Woolley Centre for the Study of Capital Market Dysfunctionality

Paul Woolley founded (in 2007) and chairs the Paul Woolley Centre for the Study of Capital Market Dyfunctionality at the LSE, the University of Toulouse and UTS in Sydney. Their objective is to replace the paradigm of efficient markets with a theoretical framework that takes account of the principal/agent problems of finance. The policy implications are profound.

Dr Woolley’s career has spanned the private sector, academia and policy-oriented institutions.  He worked at the IMF for many years, was on the board of Barings in the 1980’s and started, and headed for 18 years, the London office of GMO.

 

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The allure of potentially higher net returns from portfolios precisely tailored to values, beliefs and risk appetite is hard for any asset owner to ignore, yet needs to be balanced against the many challenges associated with managing assets in-house.

To this end, it is worth outlining the key benefits that in-house asset management can offer. Several academic studies (see note 1) have shown that funds with more internal management (as a proportion of total assets) have achieved improved net returns, largely due to a significantly reduced cost-base.  According to the research, this does not just apply to the more esoteric realms of private equity; these cost savings can be seen across more traditional asset classes too. In an industry where most outcomes are uncertain, any reduction in costs is compelling.

Tailoring of portfolios

While cutting costs is, in itself, persuasive, another driver of internal management is to re-take control of decision making to enable the more precise tailoring of portfolios to stakeholder objectives.  Matching asset owner’s goals and philosophies with their investment decisions should result in improved, sustainable investment outcomes over the long term.  When combining a series of external mandates to form a portfolio, there are inevitable imperfections, whether gaps or overlaps.  This could be a duplication of investment research, cross-over of asset selection, or missed opportunities to name a few.  There need not be such compromises when managing investments in-house. Furthermore, internal management can improve direct access to investment opportunities, for example, in private markets.  Large funds may be able to leverage their size, credibility and “brand” to find investment opportunities that might not be available to others.

Better alignment

In-house asset management can provide better alignment. One of the major issues for asset owners using a largely outsourced model is the leakage that can arise from a chain of principal-agent relationships.  This can result in the original intentions of the asset owner as principal being lost among the priorities of various agents as misalignments (such as different time horizons) creep in. The compounding effect of even small distorting misalignments can have far-reaching implications at the end of the investment chain and in the outcomes achieved. The impact of better alignment may be hard to substantiate quantitatively, but this does not mean that it should be overlooked.

The decision to take on internal asset management is not a simple one and the implication of doing so is significant change, particularly in terms of resourcing and risk management. Additionally, there is a question of size – is the fund big enough for in-house management to be feasible?

Choosing in-house management (to whatever degree) naturally requires a fundamental belief in its long-term benefits. But for it to be truly effective it should not only be etched into a belief system, but must flow throughout the organisation and systems. This makes good organisational design imperative. So the time and effort invested in properly establishing this framework are essential if internal management – and overall risk management – is to be successful.

Culture

While investment beliefs and organisational design can be made more tangible through audit, articulation and agreed process, culture – an element of no less importance for successful investment – remains far more difficult to pin down. In essence, culture is the mechanism for allowing values and investment beliefs to permeate an organisation’s behaviours. For internalisation to work best, this culture must encourage accountability and sound risk taking.

A shift from external mandates to internal management requires a significantly different organisational structure and resource model.  Asset owners need to attract, retain and align the right talent in the competitive world of investment management, where there is a well-known international war for talent.  Asset owners need to consider where their competitive advantage lies, what type of people they are best at attracting and how they might best motivate and reward them.  This is a vitally important topic, and as such we will explore it further in a future article in this series.  The challenge extends further than the front office too. Middle-office and back-office resources are highly specialised and should be considered alongside the appropriate infrastructure and systems.

Using in-house management brings more control but can be a less comfortable ride. Risk management is already at the top of many asset owners’ agendas but internal asset management adds layers of operational and reputational risk.   It exposes them more directly to the complex and often unforgiving investment world.  Having the right leadership and culture in place to manage these risks effectively is critical to the success of an internal management approach.

Asset size

Asset size is often regarded as a key factor for determining whether in-house asset management is viable. It makes logical sense that the biggest asset owners are in a stronger position to take advantage of in-house management as they are able to absorb set-up costs, attract investment talent and manage infrastructure requirements. In our experience, and supported by empirical data, this approach starts becoming more attractive for funds with around US$10billion in assets under management. Smaller funds, however, need not exclude themselves from the debate, as partial internalisation is an option, in particular building strategic capabilities in-house. For larger funds the internalisation will likely extend beyond strategy to the direct management of portfolios. This could involve internalising certain asset classes ahead of others. To take this point further, the separation of the management of different asset class or elements of the investment process – such as strategy, research, asset selection and execution – could be attractive to many funds. At each point, responsibilities could be either internalised or outsourced to achieve an efficient design.  Such decisions should be a function primarily of where asset owners see their competitive advantage.

There is a trend towards internal asset management among large asset owners which is hard to ignore.  The internal versus external debate is complex and also context dependent. Asset owners will know themselves well, but may not be instinctively drawn to one approach or the other. As such, hybrid models of partial in-house management and partial outsourcing can offer an attractive proposition, or at least a starting point, for many asset owners wishing to raise their investment game.

Notes
1. See for example:
• “How large pension funds organise themselves: findings from a unique 19-fund survey”, MacIntosh and Scheibelhut (2012) published in the Rotman International Journal of Pension Management.
• “Principles and policies for in-house asset management”, Clark and Monk (2012)

Carole Judd is director of investment organisational change at Towers Watson

Investors don’t have access to all the information they need today. Raj Thamotheram, Mark Van Clieaf and Alan Willis ask: why aren’t investors (and their clients) demanding it?

Without relevant, timely and reliable information, investors are unable to make informed long-term investment decisions. The efficiency of capital markets in allocating invested funds – the only real value of markets today – is thus compromised.

The consequence is that money goes where it shouldn’t; economic growth is impaired; the market focus shifts to things that don’t matter in anything other than the short-term (such as total shareholder return [TSR] growth and relative returns); and at worst, society impedes government and companies in what they need to do, such as: hiring and training engaged staff; investing in innovation and in research and development; investing in infrastructure; investing in future-oriented – not just maintenance – capex; and mitigating and adapting to climate change.

The legitimacy of democratic capitalism is ultimately at risk and the recent European elections are an early warning of how fast public sentiment can change.

Historical statements

Historically, investors’ decisions have been based on historical financial statements. But such information gives an incomplete and at times dangerously misleading, picture of a company’s health and future potential to create value over the longer term

In the 1970s, more than 80 per cent of a company’s value was linked to its physical and financial assets. By 2010 this figure had fallen to less than 25 per cent, with “intangible” assets – and what are often termed environmental (E), social (S) and governance (G) factors – playing an increasingly central role in driving market value.

These factors are often called, rather inaccurately, “non- financial”, when clearly they are anything but non-financial – as those who have examined “preventable surprises” like Barclays, BP, Citibank, Enron, Lehman, Rentokil and WorldCom know only too well.

They include both internal intangible assets (such as innovation capacity, management structure design, incentive pay design, human capital management and employee engagement) and external ones (such as constraints on natural resources, brand value/reputation, and social license to operate).

Investors sort of know this is important, having experienced the surprises and collapses, but today can still get away with claiming such blow-ups are “exogenous risks” when in fact the reality is that many are preventable surprises

For example, consider two high street retail companies. One has a change in management and starts to show a big drop in employee engagement and twice the staff turnover of its competitors. No loss of customer sales…yet. These feedback loops impact revenue, but with a delay. So shouldn’t a long-horizon investor want to know about these leading versus lagging indicators of risk to revenue and cashflow?

Comparable information

A big part of the problem is investors don’t have ready access to comparable information about these “non-financial” issues in the same way they have access to financial statement data, presented according to well-established measurement and disclosure standards, and then independently audited.

A 2014 Ernst & Young study found that two-thirds of global investors evaluate non-financial disclosures. However, only half of this group uses a structured process to make their assessments.

We need a standardised way of getting this other information to investors in a user-friendly format that readily links it to data about longer-term financial performance, risk and company valuation.

Some companies have been reporting on E&S performance for a considerable time, but often for the benefit of stakeholders other than investors, with too much focus on good news, photos of happy children, green flora and fauna, and so on. Similarly, there is some reporting on G performance but with a tendency toward box ticking.

Measurable disclosure

What investors need are reliable, measurable disclosures from which to create insights and recognise trends. The fact that so few companies disclose any decision-useful information on investment in R&D or human capital or capex should be of concern to long-horizon investors and their clients. And these disclosures need to be in accordance with global standards for global capital markets.

The good news is that it’s not an insignificant group of investors who should want this. More than 10 per cent of mainstream institutional investors have signed up to the Principles of Responsible Investment (PRI), making a formal commitment to integrating ESG factors.

Moreover, there are good reporting initiatives underway. But sadly they are often regional: the Sustainability Accounting Standards Board (SASB) in the United States (the SASB now has additional leadership by Michael Bloomberg and Mary Shapiro); the European Federation of Financial Analysts Associations (EFFAS); or the European Union’s new directive on ESG disclosures.

No way to manage

This is no way to manage global financial markets. Moreover it repeats the same mistakes from the debate about financial reporting, where we have had so much trouble harmonising different standards (Financial Accounting Standards Board versus International Accounting Standards Board). In the case of SASB, while its intention is undoubtedly good, its standards are too disconnected from disclosures about core finance drivers such as return on invested capital (ROIC), effective capex, innovation, or management layering disclosures and their impact on cash flow sustainability over the longer term, i.e. enterprise viability. Companies can’t really be sustainable if they are not financially viable.

Consider a company that has five years or more net negative ROIC – that is, where the ROIC is less than the weighted average cost of capital (WACC). Such a five-year plus cumulative negative economic profit is clearly not a financially viable business model for long-horizon investors. Add in the known, likely or potential impacts of material ESG risk and performance factors, or a better, deeper understanding about the lack of R&D or capex investments (investing to maintain assets versus new investment in assets). Surely investors in this company would want to know about these additional dimensions of risk and performance?

There are many voluntary disclosure initiatives but the bottom line is they haven’t delivered and, by themselves, can’t. Governments have to show they want these accounting and disclosure shifts to happen, and soon. Short of government action on a global scale (unlikely any time soon), the Sustainable Stock Exchange Initiative (SSEI) may be a far more promising step towards the necessary disclosure requirements. The SSEI is global in reach, and engages key committed international institutions and a growing number of national exchanges to implement suitable disclosure rules.

Integrated business report

We certainly don’t need a complementary reporting system or additional reports. Rather, we need a new type of integrated business report which takes into account economic value creation, core innovation and core value creation metrics like revenue growth and ROIC as compared to the cost of capital – not to mention other ESG factors and impacts on other forms of capital (such as human, social and natural) that may be key value drivers but which never appear in financial statements. The IIRC’s December 2013 Integrated Reporting Framework is an important step in this direction, already being experimented with by several major corporations globally, including in the US.

How soon will responsible investors – those responsive to the true interests of clients and beneficiaries – really demand the information they need, not only from the companies they invest in but also from the capital markets and financial standards regulators who set the disclosure standards and rules?

As public scrutiny of fiduciary investors increases, this demand must surely grow to meet the need for better investment returns, balanced by more effective, comprehensive risk management and stronger corporate governance.

Dr Raj Thamotheram is chief executive officer of Preventable Surprises. Mark Van Clieaf is a partner and chief knowledge officer of Organizational Capital Partners. Alan Willis, CPA, CA, is an independent adviser on sustainability and business reporting. The co-authors are members of the Network for Sustainable Financial Markets (NSFM).

Regulatory proposals announced in April mean that in October foreign investors will be able to buy the top shares listed on the Chinese mainland stock exchange within annual quota limits. The momentum of market liberalisation is such that MSCI is considering using such A shares in its emerging market indices, a move that will take Chinese shares from an 18 per cent share of the index up to 30 per cent.

But to be able to purchase shares today and to be able to access smaller shares – those who might grow into tomorrow’s Alibabas or Taoboas – funds will need a QFII, an acronym commonly pronounced as “kewfie”.

Most holders of the 261 Qualified Foreign Institutional Investor licenses issued by the Chinese Securities Regulatory Commission so far are investment banks, but currently 18 insurance companies, 12 pension funds and nine sovereign wealth funds hold licenses.

Those institutional investors with the largest quotas (US$1.5 billion) are the Government of Singapore Investment, Temasek, Norges Bank, Kuwait Investment Authority. The Abu Dhabi Investment Authority has a quota of US$1 billion, the Canada Pension Plan Investment Board US$600 million, Caisse de Depot et Placement du Quebec US$500 million, National Pension Service US$400 million, Ontario Teachers Pension Plan Board US$300 million and Andra AP-fonden $200 million. One motivation for Kuwaiti and Singapore investors on this list, is that their countries have negotiated capital gains tax exemptions for investors, which means they do not pay the 10 per cent of profits other investors pay.

Such foreign owners of mainland listed shares in China currently represent only 1.35 per cent of the entire market, a limit set by the Chinese government, but one that most believe will increase as the authorities become more comfortable with foreign investors.

Credentials checked

All QFII license holders go through the process of having their credentials checked. All will have hired a locally situated custodian such as HSBC or the Bank of China to submit their application and all will have hired a local broker and most peculiarly all will have filled out a form stating their investment view of the Chinese market.

Charles Salvador, director of international solutions at the Shanghai based Z-Ben Advisors, advises international investors on the process of getting QFIIs, and he has has seen a dramatic rise in the number of licenses handed out since 2010, with the largest  appetite for investing coming from sovereign wealth funds.

To Salvador, the hardest part of gaining a license comes from co-ordinating all of an investor’s service providers around a deadline from the very start of the process. He estimates a preparation time of 3-5 weeks and a one month wait for the application to be processed.

One of the few ways a fund could be denied a license, is if it declares that it has a short-term view of its involvement in the Chinese stock market or that it intends to carry out shorting activity – hedge fund managers have been kept out for this reason.

Key to business

In Chinese society long term relationships are key to business, so the encouragement of long term investment is understandable. While the nature of central planning makes the fear of volatility caused by short selling understandable too.

“You should word it in a way that shows you are a long-term investor,” advises Salvador. Investors’ investment activity is expected to match the view of the market in their application and it will be monitored as such.

One teething problem for QFII holders is the T plus 1 rule, which means the owner of a license cannot buy and sell the same security on the same day. For those using several fund managers, it means if manager A wants to buy a stock and manager B wants to sell it on the same day, only the manager that goes first will be allowed to execute.

Salvador says: “We are lobbying [the Chinese government] to put this on a mandate level, so it only applies to one manager.”

Other restrictions are that equities must form 50 per cent of investments, with preferred shares, bonds, warrants, IPO being the other alternatives.

There are also restrictions designed, it would appear, to keep investors money inside China. Those who have a QFII license must keep as least US$50 million invested and revenue from sales can only be repatriated on a monthly basis and only once tax has been settled. There is also a 20 per cent limit on a QFII holder’s quota being repatriated in any month, no more than 20 per cent of the quota can be kept in local currency too.