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.

 

 

Investors increasingly embrace “smart beta” investing, by which we mean passively following an index in which stock weights are not proportional to their market capitalizations, but based on some alternative weighting scheme. Examples include fundamentally-weighted indices and minimum-volatility indices. In this whitepaper we first take a critical look at the pros and cons of smart beta investing in general. After this we successively discuss the most popular types of smart indices that have been introduced in recent years. Read more about ‘smart beta’ investing.

The $26 billion Australian super fund, Sunsuper, is investing in an increasing amount of exclusive unlisted asset deals. Chief investment officer David Hartley says the difficulties of banks in Europe in particular have led the fund down the path of increasing the amount of debt investments in its unlisted exposure. Much of this has been in distressed debt.

There is a view that a mid-sized fund has optimal economies of scale and stealth in manoeuvre and the ability of anything larger to outperform is dulled. But it is hard to believe that is the case when listening to David Hartley enthuse on the opportunities coming the way of a $26 billion fund. Indeed, Sunsuper might be said to act like a bank or at least a private equity firm in its ownership of unlisted assets, such as the recent majority takeover of the Adelaide based Discovery Holiday Parks.

The advent of Basel II and III has meant private equity, infrastructure and property developers often do not get access to the same readiness of capital from banks. This leaves opportunities for large institutional investors to partner with them. Such deals deepen existing business relationships, not least because it helps managers avoid having to partner with competitors.

Hartley describes the leverage Sunsuper gets. “For some of those deals we help get off the ground you can get a zero fee. [Managers] would prefer to give that opportunity to their good clients, if it means they can do the deal rather than share with another private equity firm. We had one co-investment where we put $15m in and within two months we got back $45m.”

Given such windfalls, it is easy to see why Hartley foresees creating more co-investment relationships, but he is at pains to point out that all are measured on the basis of their relative attractiveness to a listed asset.

“When we look at an unlisted asset, ‘we say what are we replacing?’, ‘what would we have the money in if we weren’t in it?’.”

As well as these opportunities there are more conventional long term private equity deals. In February, Sunsuper announced it had become the 98 per cent owner of Discovery Holiday Parks, a company with 30 sites in Australia.

Here, Sunsuper had initially been a partner with private equity firm Allegro, taking just 28 per cent of the shares. Once the company’s debt issues were sorted out, Allegro and the other investors sold their shares to Sunsuper, while management bought the remaining 2 per cent.

Sunsuper has known the management team at Discovery for quite a while and Hartley says they are appreciative of having a long term institutional investor behind them.

Here, responsibilities extend to hiring an executive search firm to find independent non-executive directors to oversee the management  and to liaise with Sunsuper. Under the governance policy of the Sunsuper, its staff cannot sit on the board of an investee company.

In place of banks

Hartley says the difficulties of banks in Europe in particular have led the fund down the path of increasing the amount of debt investments in its unlisted exposure over the last couple of years. Much of this has been in distressed debt (secondary loans), which has provided an impressive 16.7 per cent return per annum since 2004. Here, established relationships with firms such as Oaktree and Loan Star, who are specialists at assessing the security behind bank loans, has been key.

These managers take over bank loans that are viewed as being at risk of default. They make an assessment of the worth of the company to whom the loan has been made and then make an offer to the bank of less than the nominal value of the debt. This is done on the basis that the bank is often willing to realise a loss in return for the certainty of receiving cash they can then recycle. The fund manager then goes to the borrower and offers to walk away from the debt, if the company can pay back a percentage of the debt that reflects the company’s worth.

Hartley is wary of new managers in this space. “You are better off sticking with those who know what they are doing and are very practised at it. Many people who are sticking up their hands right now are not going to cut it.”

Hartley forsees further involvement in the co-investment space, not least because it is a way of stripping out some of the fund manager profits from its overall fee budget.

In common with other big funds, he is aware that the bigger they get, the bigger the profit that fund managers can make from increased funds under management. Or as he puts it, “it does not cost twice-as-much money to manage twice-as-much money”. Funds such as AustralianSuper, REST and Unisuper have taken some management in-house, but Hartley thinks partnerships with managers will provemore profitable in the long-term.

“Setting up an internal team is one way for us to harvest the benefits of scale, but it is good to focus your team on where the most value can be extracted. “Smart partnering” and getting co-investment opportunities is probably a better long term route.”

One of the smart wins from co-investment is the way it educates internal teams on how deals are constructed, allowing them to ask smarter questions of their other managers. If the deal is offered to them on an exclusive basis, they are also given greater time to assess it. Another advantage is greater transparency from more detailed due diligence.

“You get really good insight into how managers are approaching these things. There is a knowledge transfer that is permanent,” he says.

Risk return

Hartley defends the nature of these deals from anyone who might think they pose a higher risk. He cites the greater transparency on the accounts and the business, such as the interest rates paid on their loans, the internal modelling of cash flows, insights into customer bases and knowledge of transactions as all giving a better indication of an asset’s true value than one listed an exchange.

“Who is to say that that modelling is any worse than the last traded price on a listed stock? Arguably I would say a good valuer has got a better idea of the price,” he says.

Sensitive to the notion that the value of unlisted assets is murkier than a listed asset, he questions whether an investor could sell $500m of BHP Billiton shares at the last traded price in a single sale. While the last traded price of an unlisted asset is a reasonable estimate of fair value, so is an independent valuation. When unlisted assets have been sold, Sunsuper “almost invariably” achieved an uplift on the valuation, he says.

Sunsuper at a glance

Returns to June 2013 (% pa) –
Balanced Option
1 year    15.9
3 years    8.0
5 years    4.1
10 years    7.1
Members June 2013 1,038,000
Assets June 2013 $23,926m
Proportion of assets in super default  73%
Net contribution flows 2012/13   $1,649m

The correlation between stocks and bonds in a rising interest rate environment can turn positive. So given the likelihood of a rate rise, what should asset allocation look like if investors are forward looking?

 

One of the growing trends in asset and risk allocations is to adopt a forward-looking view driven by macroeconomics, rather than a backward-driven view generated by historical statistics.

This is particularly important in the context of a likely rise in interest rates, something a backward-looking view would not incorporate, and the impact that would have on the stock:bond correlation.

Executive vice president and global head of client analytics at Pimco Sebastien Page, says the macroeconomic factors should be a consideration for investors in their asset allocation decision-making, and in the current environment there is a potential change in the stock:bond correlation that could have a significant impact on asset allocation.

“There has been a declining interest rates environment for 20 years and asset class returns and volatilities reflect that. Forward looking, given yields and P:E ratios, likely returns are different and interest rates increases will mean a different asset allocation,” he says. “It is clear in a high interest rate environment there is very different diversification between stocks and bonds, the correlation can turn positive.”

This has implications for how investors hedge risks and for the role of bonds.

A quantitative research piece Page co-authored with four other Pimco colleagues, The Stock-Bond Correlation, shows that from 1927 to 2012 the correlation between the S&P500 and long-term Treasuries has changed sign 29 times, ranging from -93 per cent to +86 per cent.

The paper states that while many factors influence the stock-bond correlation, analysis reveals the importance of four key macroeconomic factors: real interest rates, inflation, unemployment and growth.

The authors say that stocks and bonds have the same sign sensitivity to the real (inflation-adjusted) policy rate and to inflation, while their sensitivity to growth and unemployment have opposite signs. So depending on which factors dominate, the correlation can be positive or negative.

“If growth concerns, such as unemployment or GDP drive volatility, then the correlation can be expected to be more negative,” Page says. “If surprises in interest rates and inflation dominate volatility then you can get a positive stock:bond correlation. Bonds are not hedging as well as they used to.”

“Investors don’t always pay attention to this but it plays a huge part in, for example, risk parity volatility,” he says.

At the same time the stock:bond correlation could be changing, an allocation to alternatives may not be the saviour for portfolio diversification and risk hedging.

In a recent FAJ paper, “Asset allocation: risk models for alternative investments”, Page and his co-authors join a growing academic literature which finds there is no longer a “free lunch” in using alternatives.

The paper runs through analysis of an alternative risk framework to mean-variance optimisation and shows alternatives are exposed to many of the same risk factors that drive stock and bond returns.

“Our paper shows reflecting true mark to market risk would result in lower allocations to alternatives,” he says.

Page recently presented at the CFA Institute annual conference on asset and risk allocation trends, and while the concepts are not new, they are worth noting, because of the momentum with which they are trending.

He says first, rather than relying on a backward-driven view generated by historical statistics, investors should formulate a forward-looking view driven by macroeconomics.

Second, investors should focus on risk factor–based diversification in addition to asset class–based diversification.

Third, investors must recognise the dynamic nature of markets and make asset allocation decisions on a cyclical and secular basis rather than a calendar-year basis.

Finally, risk should not be defined solely as volatility; investors should seek to explicitly measure and manage tail-risk exposures.