In the coming weeks, Towers Watson will be writing a series of articles, exclusive to conexust1f.flywheelstaging.com, that look at key challenges facing large asset owners. These will focus on specific practicalities that many global funds are encountering such as the role of internal teams.

To put these challenges in context, this first article by global head of content, Roger Urwin, explores six overarching issues that Towers Watson believe will shape the investment landscape for the world’s large asset owners in the coming years.

 

Thomas Piketty’s study of wealth is receiving intense attention, but little has been said about the new place of the world’s big asset owners. The biggest 100 such funds (let’s call them the ‘biggies’) make a fascinating group and carry critical significance for our future. At the start of 2014, these funds had assets amounting to over $15 trillion, and titles to wealth for a significant proportion of the whole planet.

In previous eras these funds have tended to use a core investment strategy, such as 60 per cent equities and 40 per cent bonds to transfer wealth over time. Making a decade-long projection of this strategy starting with current values one would expect returns of around 3 per cent per annum in real terms.

The ‘r’ of return on capital being higher than the ‘g’ of global economic growth is the most significant mathematics from the Piketty book. While in previous decades the asset owner ‘r’ was normally around 5 per cent per annum and economic growth was around 3 per cent, the current era makes that norm doubtful. The ‘r’ of the simple 60/40 strategy may not exceed the ‘g’.

 

This produces the first issue facing the biggies.

The pension funds in the list – around 80 of the 100 – have defined liabilities to meet, and their solvency is premised on achieving returns exceeding global growth.

The sovereign wealth funds in the list – the remaining 20 or so – aim to grow wealth for a future generation at a rate above world economic growth rate.

A real return of 3 per cent per annum is not sufficient to meet these requirements either. So it is no surprise that the strategies of both groups are evolving.

More significant investment in alternative asset classes like real estate, private equity and infrastructure is one consequence. In addition, there has been the growth of alternative strategies such as factor investing and other smart betas. These require investment skill from the asset owner entity itself rather than from outside investment firms.

 

Issue two for these funds, therefore, is their organisational design and investment governance to adopt these strategies successfully and achieve their desired results.

The early structure of asset owners involved heavy reliance on their boards and investment committees, which, in turn, relied on external investment mandates.

The biggies increasingly see the development of in-house capabilities as necessary; in the ‘war for talent’ endemic to financial service organisations, they have had to secure key ‘C-suite’ positions: chief executive officer, chief investment officer, chief operation officer and chief risk officer, for example. In building the skill of asset owners, leadership roles are critical.

For organisations used to running small operations, this expansion carries significant opportunities and challenges.

The asset owner must create a highly skilled organisation that has strong culture and leadership; is driven by human-capital practices that attract and retain talent; operates with clear responsibilities and accountabilities; and creates motivational energy through performance management and personal development.

It is hard to understate the significance of this step for funds that need to quickly build the qualities that their asset manager counterparts have developed over the past half century. It is fair to say this is work in progress.

 

Issue three is the adjacent point of how to develop successful private market strategies.

The biggies must extend their reach into private markets beyond the equity and bond public markets to achieve their target returns.

Such an extension to strategy can add to return, in part because of the leverage employed in these markets, but need not change the overall risk exposures.

The biggies’ exposure to private markets now averages around 20 per cent, up from 5 per cent around the turn of this century. These funds are now seeking to settle the level at which allocations should stabilise and which of the private equity, real estate, and absolute return sets should be included.

Funds have not found this change of strategy simple to implement in terms of the optimum blend of internal and external management, leading to issue four.

 

Early implementation involved heavy reliance on outside expert investment firms. A combination of very high costs and complexity in oversight of these mandates has prompted the biggies to consider in-house alternatives. The challenge is how this internalisation of investing can be accomplished.

Many funds in this situation have come to resemble big complex investment institutions. Examples of this specialisation can be found at funds like CPP where, for example, private market resources have developed into three figure teams, enabling the range of activities to include direct and co-investment deals. But the benefits of specialisation come with issues of maintaining coherence and control.

Some funds have fought against creating asset class specific silos. The organisational design that keeps the team together on all decisions is often referred to as the one portfolio approach. In this approach each investment idea is considered as a contest for capital against all other ideas, with comparisons on a risk-adjusted basis.

Specialists join with investment leadership colleagues to make the go/ no go determination instead of being asked to fill a pre-agreed strategic allocation. Examples of organisations preferring this approach include the likes of Future Fund Australia and New Zealand Superannuation Fund.

The allocation process itself has attracted innovation.

New methods increasingly frame the process in risk allocation terms, deriving overall portfolios that best balance risk factors.

 

This introduces our issue five. This development has made funds diverge in their strategies as their segmentations differ and they reflect different underlying beliefs.

A notable example of the divergence appears in exposures to investment factors and themes often referred to as smart betas.

The narrow version of smart betas involves systematic exposures to factors such as value, momentum and small cap. The wider version considers those themes where structural mispricing may exist. Examples include themes positioned around the emerging growth markets and longer-term change in resources, the environment and demography.

The control of factors suggests a shift of responsibility, at least partially, from the external manager to an internal team.

The biggies vary widely in their reliance on external firms, but almost all use them to produce skill-based returns (‘alpha’).

The nature of these relationships has shifted, reflecting better appreciation of the value proposition that mandates and external firms can demonstrate.

 

Issue six then is the effective management of alpha derived from fusing internal skills to the external marketplace.

The more successful examples of alpha generation seem to come from mandates that are lightly benchmarked, institutionalise longer-time horizons, and embed wider knowledge transfer.

 

The biggies have to think hard about how to compete successfully. Asset owners in most cases have access to permanent capital. Their competition is not for capital but for talent and returns.

Their future progress will be determined by their competitive response to these six issues: the investment goal itself; organisational design and governance; private market investing; internalisation; capital allocation and smart beta investing; and alpha.

The common thread through all these six factors is the degree of change and greater skill needed to bridge the gap between the bulk beta returns and these organisations’ needs and aspirations.

 

By Roger Urwin, global head of investment content at Towers Watson

 

This paper by the Becker Friedman Institute for Research in Economics at the University of Chicago finds that the active management industry has become more skilled over time. But despite this rise in skill, average fund performance has failed to improve.

To access the paper click below

Scale and skill in active management

 

Pension fund boards are complex, evolving, collective bodies and the individuals that serve them face unique challenges. The Rotman-ICPM Board Effectiveness Program is a week-long course designed specifically for pension fund trustees that showcases how an effective board looks and behaves.

Pension management beneficiaries are delegating to a body that then delegates to an executive, it is a consensus body that is unique in design and function.

The role of, and skills required of trustees and the collective board is constantly evolving, and to be effective requires training and evaluation.

On four occasions the International Centre for Pension Management at the Rotman School of Management at the University of Toronto, has brought together 128 participants from 52 pension organisations and 11 countries for its “Board Effectiveness Program”.

The course, which is held over a week-long period guides trustees through courses on organisation mission, fiduciary duties, board dynamics, role of the board versus management, investment beliefs, risk management, organisation design and HR management and compensation.

They are asked to do role play exercising board dynamics with a particular case study dealing with the issue of incomplete information.

“We give delegates a problem to solve but not everyone gets the information. The only way to solve the problem is by sharing the information,” Ambachtsheer says. “It’s a shocker, most groups fail.”

Critically, through case studies and exercise, it equips graduates with an integrated framework to critically examine how these issues are all linked together.

Keith Ambachtsheer, who is the director emeritus of the Rotman International Centre for Pension Management and academic director of the course, says one of the key differentials in the Rotman School’s offering is it is “deliberately strategic” and not just reciting facts.

“We look at case studies and exercises on how to implement the reasonable judgment rule. What does success look like and how do you measure it?” he says.

One of the reasons this training is so important now, Ambachtsheer says, is the evolving nature of fiduciary duty.

“But now rather than a cooker cutter fiduciary duty it is a “reasonable expectations” standard, it is contextual,” he says.

“Boards need to understand the nature of the agreement, who’s contracting who to do what, not just about the here and now but future parties, so how do you do that?”

At the Rotman-ICPM Board Effectiveness Program, participants get to learn from doing.

Ambachtsheer says one of the more interesting exercises is an assignment whereby the chair of a fictitious dysfunctional board asks participants to help fix the board.

“It gets you into the question of why the board is dysfunctional,” he says.

It also raises the element of representation and the idealism of trustees and who they are representing.

“Representation is ok up to a point, boards need to be seen to be legitimate,” he says. “But there is an “and and” as well. It is not enough there also needs to be a collective skill and experience in the requisite skills.”

Ambachtsheer advocates the skill/experience matrix as an easy practical tool to assemble and manage a board.

“If the board needs to make decisions in these areas – it might be strategic decisions, audit experience, risk management, HR function – then what is the skill set that is needed to do that,” he says.

Interestingly, Ambachtsheer believes it is best practice for the entire board to be the investment committee, and points to organisations such as Ontario Teachers’ Pension Plan where this is the case.

“This means you need people on the board who can play a role, they are not experts but need to ask the hard questions.”

Drawing from the Peter Drucker management philosophy, Ambachtsheer believes that one of the key roles and responsibilities of a board is to hire and assess the chief executive.

“You don’t do their job but a board finds and evaluates the chief executive, and holds them to account.”

Ambachtsheer believes the best tenure for a board member is three terms of three-years, and that this ensures not only that an individual’s skills are evolving but the board as a collective is evolving.

“Nothing is forever,” he says. “This structure is long enough to get to know the organisation but know there’s an end. We had a governance committee that was working on who’s leaving and what we were losing when they left.”

While measuring good governance, decision making and delegation may very well be the holy grail in pension management, it is hard to quantify.

“I’ll know it when I see it,” he says.

However Ambachtsheer can say that a functional board will have passion for the cause, collective skill, a diversity matrix which by definition includes behaviour, and a blend between being collegial and individual integrity.

Ambachtsheer is currently working on the third global board effectiveness survey, which measures the responses of pension fund executives to their board’s functionality.

The survey was done in 1997, 2004 and will be initiated later this year, asking a series of statements to reflect the function or dysfunction of the organisation.

Rigorous Environmental, Social and Governance (ESG) management can deliver an extra 40 basis points per month according to Saker Nusseibeh, CEO and head of investment at Hermes Fund Managers.

“Where it [ESG] really matters for performance is in consistently avoiding bad governance. You can add 40 basis points per month… Per month!” Nusseibeh told a crowd of Australia’s top 50 superannuation funds and asset consultants at the Conexus Financial Australian Fiduciary Investors Symposium last week.

Nusseibeh talked about the importance of weighing up a company’s sustainability when considering whether to hold it in portfolios. Governance issues, he said, should be a mandatory part of the process, while environmental and social issues also weigh heavily despite being harder to measure.

“Think in terms of its ability to consistently offer stable returns for over 20 years, because that’s the investment time frames of your members. That’s how long they can be invested for, not one, two, or three years,” he said.

“Look at Lloyds of London. It successfully insured against world events for over 200 years… Then it went belly up, not because they couldn’t calculate risk. They were pretty good at that, but they didn’t successfully calculate the environmental risk of asbestos.”

Nusseibeh also urged trustees and managers to think more broadly about the future implications for fund members in a world devoid of ESG; one of lower standards of living punctuated by greater wealth inequality; high inflation; and transport and fuel restrictions.

“ESG is a tool for enhancing returns… But one should also do what is right for the sake of doing what is right.”

David Rae, head of asset allocation for New Zealand Superfund (NZ Super), also told the crowd about how the fund had recently brought ESG management “out of the back office to the front office.”

It’s a move he says, that had some of their investment professionals “kicking and screaming” about drafting their own policies but effectively “switched on their brains” about ESG and the costs and implications of getting it wrong.

It’s an approach that’s resulted in direct changes in major listed and unlisted companies NZ Super invests in, including changing supply chain issues in 16 technology companies, a complete change of board at another, and broke up “empire building” governance in a large listed infrastructure company.

Rae says their ‘active engagement’ on ESG won’t stop there, but is looking to build power in numbers through working together with other New Zealand funds on governance issues in particular.

“We recently got people in a room and said, ‘let’s raise corporate governance issues, and lets act as a group on these… we realise that tough talk in a locker room can quickly disintegrate on the field, so it’s important to have one company that’s leading that charge,” said Rae.

 

This issue marks the 400th edition of conexust1f.flywheelstaging.com,  which looks at the strategies and views of the world’s largest asset owners. So what were the concerns and opportunities of investors six years ago, and what are they now?

 

Since its launch in 2008, the journalists at conexust1f.flywheelstaging.com have written more than 2,000 stories on the strategies and views of the world’s largest asset owners. Our edge is in our truly global coverage, and our in-depth analysis of these investors’ strategies via our Investor Profiles.

The first fund we ever profiled was ABP, back in September 2008. At that time volatility was spiking to record highs and there were major losses across equity markets. But the profile proved what is still true today, that large, patient investors acting diligently can add value over the long term despite market conditions.

Central to their ideology is the idea that a long-term investment strategy increases the potential for higher returns and enables the fund to take on more risk. It advocates diversification across and within asset classes including alternatives sources of yield, and it prudently manages risk. The same profile could be written today.

Reflective of many of the world’s pension funds, the coverage ratio of ABP, the world’s third largest pension fund, fell to 90 per cent in 2008 from 140 per cent in 2007, due to a drop in the actuarial interest rate at the end of the year to 3.6 per cent, and a return on investments for the year of -20.2 per cent. The investment strategy thus became a focus on meeting liabilities.

In other sectors, such as sovereign wealth funds, growth continued despite the investment losses.

In 2008 sovereign wealth funds collectively grew by 18 per cent, bringing the sum of assets held by the vehicles to $3.9 trillion. Today that is around $5.4 trillion.

In December 2008 CalPERS appointed its first woman chief executive, Anne Stausboll, who remains its captain today.

Later that month the president of China Investment Corporation, Gao Xiqing, warned that markets had not yet bottomed and the US dollar would resume a downward trend. He turned out to be right, with one US dollar buying £1.49 when he made his prediction, but only £1.38 a month later. It’s now around £1.68.

In January 2009, two US pension funds and one UK pension fund fund (the $15 billion New Mexico State Investment Council, the $2.1 billion Baltimore Fire and Police Retirement System, and the $6.4 billion Merseyside Pension Fund) revealed exposure to Madoff through fund-of-hedge funds.

The exposures raised serious questions about the due diligence of large pension funds, and the lack of transparency around the underlying managers in funds-of-hedge fund investments, an investigation which hasn’t dissipated today.

At this time, the effect of huge market losses were seen at asset owners of different types. Harvard Management Company began shedding 25 per cent of its workforce in February 2009, after incurring a 22 per cent loss since the beginning of that financial year.

The $59 billion New Jersey Division of Investment made several changes to its alternatives investment portfolio including a slowdown in new commitments, on the back of a belief that large institutions with high allocations to alternatives would be forced to sell portions of their portfolios in order to raise liquidity and rebalance their overall asset allocations.

Instead its focus shifted to credit-related opportunities within private equity and real estate; and the targeting of potential opportunities to purchase interests in existing alternative investment partnerships in secondary market transactions.

Similarly the then $161 billion California State Teachers’ Retirement System tweaked its allocation seeking to deploy $6 billion tactically in the debt markets, as well as the conception of a new “innovation portfolio”.

Interestingly 2009 marked the first time the largest 20 pension funds globally, underperformed (by 2 per cent) the rest of the Towers Watson top 300 universe.

In 2010 Sweden’s first four buffer funds, with combined assets of $83 billion excluded 10 companies from their investment universe for violating international law; PGGM sought alpha by internally managing illiquid assets and OMERS launched its co-investment entity, OMERS Strategic Investments.

Risk became a focus with funds all over the world, including UniSuper in Australia and PSP in Canada and looking at new and comprehensive risk management systems.

Funds also took risk off the table with equities allocations decreasing and alternatives on the rise – CalSTRS, New Zealand Super and ABP were among those looking for “opportunities amongst the wreckage”, while the Australian Future Fund began its love-affair with debt.

In 2011 fiduciary capitalism emerged and investors were engaged in the role they could play in the future and stability of the financial and broader economic and social environments. What had they learnt from the crisis was that the future was uncertain and they wanted to play their part in making it more sustainable.

Alpha, beta, and alternative beta emerged as the subject du jour in 2010 and fund’s continued to invest in alternatives. For their part, the Canadians continued their infrastructure and property shopping spree.

The defined benefit/defined contribution design debate hotted up, with most defined benefit funds on the defensive, and the Dutch introduced the complex, but fair, concept of defined ambition.

Water emerged as a theme, with Canadian and European funds the first to realise we are running out of the world’s most precious resource. One of the world’s largest investors, the $576 billion sovereign wealth fund of Norway made water one of its six investment focus areas. How the world will feed China is perhaps the most pressing thematic for 2014.

Investors all over the world changed their approach to asset allocation in 2010 and 2011 and began allocating according to underlying risk factors rather than asset buckets.

In December 2010 CalPERS introduced two hedging portfolios as part of this process, and in its analysis found the portfolio has a 90 per cent exposure to equity risk

The two enduring themes of 2011 were ESG integration and underfunding. Tail risking strategies entered the investor vernacular in a big way, and hot topics for investors were rebalancing criteria, bond allocations and insourcing investments.

The world’s largest fund, the Government Pension Investment Fund, Japan, substantially increased its allocation to international equities, moving more than $31.8 billion of assets into offshore equities in the year to June 2011.

Collectively, investors globally woke up to long-term investing and collaboration towards the end of 2011. They also continued to review their strategic asset allocation with greater regularity and looked at tactical and event-driven investments more often.

Texas Teacher’s strategic partnership program started baring fruit, and other investors started following suit, marking a change in the nature of asset owner/asset manager relationships to one of collaboration and intellectual property exchange.

That same year European funds started slashing equities in the wake of the Eurozone crisis, and reducing fees and finding, the increasing elusive, alpha continued to be a focus

The Kay Review in 2012 renewed British investors focus on long-term investment horizons and the obstacles inherent in the financial system.

Distressed debt was all the rage, and while there was a lot of talk about green bonds not a lot of action. Currencies were unpredictable and emerging markets went in and out of favour.

Many funds started looking at their decision making processes, costs and staffing in house and governance reforms became the norm. In the UK and Australia consolidation of pension funds continued, while on the investment side stranded assets became a consideration.

As volatility continued and investors became hungry for alpha, risk parity and smart beta entered the fray in full force in 2013 and there’s no sign of their retreat. The only marketing jargon that could even come close to pushing smart beta off its mantle would be “big data”.

At the end of 2013 the average global asset allocation of the seven largest pension markets in the world was 52 per cent equities, 28 per cent bonds, 1 per cent cash and 18 per cent other assets.

For the past six months interest rates and the prospect of positive correlations between stocks and bonds is the potential nightmare keeping investors awake at night.

So what will investors be talking about for the next six months?

My predictions are liquidity; proxies for alternatives, particularly private equity; dynamic asset allocation and of course rising interest rates.

 

 

We look forward to the next 2,000 stories about, and for, asset owners.

 

For any editorial enquiries please contact amanda.white@top1000funds.com

 

Implementing the asset allocation changes of a very large portfolio, particularly in private markets, is a conundrum CalPERS is dealing with as it moves its asset allocation and decides how to fill new private market allocations.

 

In February this year the $283 billion CalPERS investment committee approved a new strategic asset allocation which will see the private equity allocation reduce from 14 to 12 per cent.

The fund’s current private equity allocation is 10.9 per cent, and Baggessen said in his presentation to the committee, this meant the exposure was underweight even the reduced target allocation, so more capital would need to be added even to reach 12 per cent even though that represents a decrease in the strategic asset allocation.

“This creates one of the more problematic asset classes with regards to targets,” he said.

Due, in part to competition to purchase assets, private markets have high valuations and CalPERS, and its consultants Wilshire and PCA, believe it doesn’t make sense to fill an asset allocation bucket just to meet a long term goal, especially in the most illiquid and expensive asset classes.

So where does that leave them?

 

Private equity pacing model

Baggessen and his team have suggested a private equity pacing model.

They recommend using an interim weight of 10 per cent this year, and increasing that target by 1 per cent each year, with a corresponding decrease in the global equity target, moving to the 12 per cent target by 2015-16.

Private market proxies are also a consideration, and Baggessen said that achieving the target weight to assets possessing the capital market assumptions of private equity may require some alternatives, such as private market proxies, and the team is currently assessing those.

But the fund’s consultant Michael Schlachter, managing director and principal at Wilshire Associates, doesn’t agree with the proposal.

“Sometimes a simple solution is best,” he said at the investment committee meeting.

“Rebalancing from A to B is best practice, you don’t go from A to B via W,” he said referring to the proposal to move the private equity allocation from 14 to 12 per cent via 10 per cent.

Similarly Allan Emkin from Pension Consulting Alliance said the board, and staff, of CalPERS needed to use common sense.

“The run up in equity markets that increased the market value of the portfolio is good news. But it doesn’t mean it’s an opportunity to put more money in private markets,” he said. “It doesn’t mean a higher allocation to illiquid asset classes that are overpriced. It’s time to use common sense. Real estate and private equity are not cheap, it makes more sense to take a deep breath and go slow.”

Some members of the investment committee were concerned that the overall CalPERS’ portfolio was still exposed to the same risks as it was in 2008, with John Chiang asking “what do we do in advance so we don’t go along for the ride if market falls?”

Baggessen said there were no investments the fund could invest in that supported the fund’s discount rate and return target of 7.5 per cent.

“There’s no place to hide from that,” he said. “What we can shift is on the margin but there is not a panacea. We can’t hedge or remove that tail risk because of the size of the portfolio, even if we were smaller it’s not clear we’d pay the cost for the hedge and if a counter party could take it on.”

Baggessen said tail risk hedging would expose the fund to other types of risk such, as leverage.

 

Size constraints

The actual allocation of private equity at the moment is around 10.9 per cent, which represents around $6 billion capital to be allocated this year.

It’s a commitment the CalPERS investment team agrees is potentially executable given the market conditions and the size of the portfolio. A 14 per cent allocation, would require capital allocations of $8 or $9 billion, depending on the year, and be much more difficult to execute.

The relativity of the fund’s private equity allocation within the industry is an important perspective. A $6 billion capital commitment represents about 2 per cent of the total private equity market. By contrast, CalPERS’s ownership of publicly traded equity, at a 47 per cent allocation of the total portfolio, represents about 0.47 per cent of the FTSE All World total capitalisation.

CalPERS’ activity within the market can thus not only impact its own ability to buy and sell, but it can impact the overall market.

Senior investment officer for asset allocation and risk management, Eric Baggessen, said this impact is even more rarefied when the fund is trying to concentrate allocations in the top performing managers.

“This is a big footprint,” he said, emphasising it as an example of the constraint of the size of the portfolio. “We are too large to accommodate any allocation to any market segment.”

One of the discussions at the investment committee was the impact of size. Board member, Priya Mathur, suggested the allocation to private markets should not be driven by CalPERS’ portfolio size but the size of the market and its capacity.

“The upper limit can’t be based on our own portfolio size,” she said. “We need to build that into how we do asset allocation.”

 

CalPERS strategic asset allocation

Asset class New target    Current actual
global equity 47% 53.7%
private equity 12 10.9
global fixed income 19 15.3
real estate 11 8.5
infrastructure and forestland 3 1.3
inflation sensitive 6 3.3
liquidity 2 4.7
ARS 0 2.2