Nobel Prize winner, Robert Merton, has thrown down the gauntlet. He claims that by focusing on a retirement income goal he can beat any competitor that is managing a 70:30 portfolio that has wealth accumulation as the goal. Do you dare take him on?

The defined contribution pension management industry has it wrong, according to Professor Robert Merton.

“There is so much competition over getting alpha, but everyone has access to the same hedge funds. Give up! That’s not what is important,” Merton says.

Instead the focus should be on goals-based investing, he says. And the right goal for most people is an inflation-protected income at retirement, not wealth accumulation. It’s something Merton talks about with a passion that has supported a 45-year career researching risk and lifecycle investing.

Conventional retirement fund investments focus on wealth accumulation and measure risk as volatility of the portfolio, he says. In this context success looks like maximising the size of each individual’s account balance.

Instead, Merton proposes a new generation defined contribution plan – called Managed DC – which puts retirement income squarely in focus as both the investment goal and as the measure of success. Risk then becomes falling short of achieving the income you need. Managing retirement funds in such a way will provide a much higher degree of certainty of actually succeeding, he argues.

“The secret sauce of Managed DC is that if you are willing to agree on a goal, say for example $58,000 per year protected against inflation in retirement, and my competitors and I start with the same Sharpe ratio, but I use dynamic strategies based on the goal versus a 70:30 portfolio, then I promise you I’ll beat them,” he says. “Focusing on the goal is like having 20 per cent more assets.”

Merton, who has spent his entire career writing and researching lifecycle investing first publishing in 1969. These days he is the School of Management Distinguished Professor of Finance at the MIT Sloan School of Management. He is also the University Professor Emeritus at Harvard University,

In his opinion the retirement management industry should change its language, and techniques, to focus on income, and to look at earnings for spending and lifestyle.

“For people outside the financial services industry that is normal, but for the entire history of defined contribution the language is about portfolio returns, not income.”

Most lifecycle products use age as the only trigger for investment allocation differences, but Merton argues income is an essential piece of information.

“Adding income a big step up from age alone,” he says. “For example, a 34-year old woman earning $168,000 is very different to a 34-year old man earning $56,000. Age doesn’t tell you nearly enough to make a sensible asset allocation.

With target date funds the investment mix is such that as you get older you get more conservative because of age alone. That’s wrong. Actually the prime drivers of fund asset allocation are the risk composition of total retirement assets. That includes future contributions and how close you are to fully funding the income goal.”

In this way Merton argues that what drives the asset mix is not age, but the amount of remaining human capital and the funding ratio.

“Although they are correlated why go on a correlation? Go to the primary drivers including income and account balance., Those give you all the answers.”

He believes that defaulted defined contribution funds can get that income information from the administrator, and that getting that information is really important.

Merton who co-founded Long-Term Capital Management, is currently resident scientist at Dimensional Fund Advisors, where he is developing this next-generation, integrated pension-management solution system that addresses the deficiencies associated with traditional defined benefit and defined contribution plans.

He says the motivation for the Managed DC concept came out of the 2000-02 crisis when worldwide stock markets fell and interest rates fell at the same time, an experience repeated in the global financial crisis of 2008-09.

“Traditional DC was not well set up to serve as the core retirement product,” he says, adding in the US defined contribution was originally a supplement to the Employee Retirement Income Security Act (ERISA) as a footnote for higher paid executives motivated by tax.

As corporate funds were struggling with their offering, Merton saw an opportunity.

“What would a CFO rather hear from a manager – a 17 per cent return alongside a 10 per cent fall in the funding ratio, or a 3 per cent return alongside a rise in the funding ratio? The CEO wants to hear that they don’t have to contribute. The funding ratio looks at the income.” Traditionally defined contribution plans only looks at one side of the balance sheet, the asset side. In contrast Merton’s Managed DC borrows some of the elements of defined benefit schemes and takes into account the liabilities side in asset allocation.

To put his ideas into action, Merton chose Dimensional, an independent, transparent firm founded on financial science, something dear to his heart. (Merton received the Alfred Nobel Memorial Prize in Economic Sciences in 1997 for a new method to determine the value of derivatives.)

“For innovating you need the right culture, and Dimensional has the quality people, it’s transparent and has had great success,” he says. “I want to succeed at this, I don’t like the idea of failure, I don’t plan on failing.”

The basic premise of “Managed DC” is income for life adequate for a good retirement, rather than unlimited risk taken in static wealth maximisation strategies. And the investment strategy is the dynamic management of each member’s asset allocation.

“You have to stay live, not fixed, and continuously innovate on a cost benefit basis. It is the art of the science,” he says. “Believe in better not best. It is not realistic to be perfect.”

 

 

 

Robert Merton’s work can be accessed here

 

The city of New York spent $472.5 million on asset manager fees in 2012/13. The allocation of these funds is part of the $68 billion annual budget the City Comptroller has to run the city of New York.

The bureau of asset management that oversees the $137.4 billion in pensions fits within that budget, but the money it spent on asset manager fees has increased more than the returns it generated. How it reins in those fees will be one of many challenges for the new Comptroller Scott Springer.

What would you do with a $68 billion annual budget?

For the full New York city financial report click here

The $91 billion Australian Future Fund’s approach to investing is to get even more sophisticated as it borrows ideas and techniques from other investors, including the risk management and portfolio construction techniques of multi-strategy hedge funds. David Rowley speaks to CIO David Neal.

Many will quickly tell you there is greater return to be made from smart asset allocation than from manager selection, but few investors will jump to expand on this theory the way the Future Fund does.

The journey down that path has been so rewarding it is encouraging them to take what David Neal describes as the “most exciting chance” facing his profession.

For Neal, strategic portfolio construction is typically done at too high a level. For example, he says an allocation to property that is split 60 per cent Australian and 40 per cent international is like taking a view of the world at 20,000 feet. To him, it can be done on a more granular basis.

 

Current state of play

The Future Fund’s process is to seek the most interesting risk-adjusted return opportunities available anywhere. The goal is to build a total portfolio from these best ideas. So, diversification of risk is sought across the whole portfolio rather than within an asset class.

Opportunities are often sub-sector themes – such as multi-family property or opportunistic energy-related infrastructure in the US.

Each such theme is examined for the levels of premia it delivers from equity risk, illiquidity risk, credit risk, inflation risk and real yield exposure.

This enables it to be compared like-for-like on a risk-adjusted basis with an opportunity in other sectors which are competing for the same capital.

Neal believes there is another level of analysis it can reach. He describes this process as determining the “systematic generators of value”.

For example, this would entail asking of a potential private equity investment, how much of it is a small cap bias? How much of the return comes from leverage? How much value is added from buying off-market?

“Doing that across the portfolio would be interesting to understand the risks a bit more and could lead to a further evolution in our investment philosophy,” he says. “We are not there yet, but that is part of the research we want to do. To get finer grained in understanding our portfolio’s risk exposure. The challenge of looking across all those opportunities, which are totally disparate, and making a decision on where to put the marginal dollar, is significant.

It’s a different way of constructing the portfolio and demands a quite different combination of skills and mindset for an investment team. It is one of the most exciting challenges for the asset-owner profession,” he says.

Neal contrasts this with a more broad-brush approach. “Comparing property and equities in terms of their 10 year characteristics is not the same thing as comparing that building versus that airport versus something else,” he says.

He admits that many aspects of this thinking have been informed by studying others.

He is impressed, for example, with the risk management and portfolio construction techniques of multi-strategy hedge funds.

“We have this incredible privilege of being exposed to the best investors in the world all the time,” he says. “One of the most fascinating things about my job is to get exposure to those and reflect on them, so ‘why are those people doing it that way? That is not the way we do it. See whether there is a tweak or an overhaul required in the way we do it.”

 

Professionalisation

Neal says new thinking such as this is part of the growing speed of improvement by institutional investors, a process which he likens to professionalisation. The way the very best Australian, Canadian and European funds have shared ideas over the last few years is a key contributor to this change.

Neal says until recently the global institutional fund management industry did not face the same commercial pressures that force private sector businesses to constantly evolve and question their activities.

Low performance, he says, did not mean you went out of business, and change happened slowly.

“It feels to me that the cadence of the asset-owner industry change, especially here in Australia, has really picked up now. You are starting to see much more activity,” he says.

One mark of the need for change was the poor way funds communicated their risk tolerances to fund managers, leading to inefficient relationships and funds often not knowing what they were buying.

“You had investment managers doing their thing very close to markets – very sophisticated, very highly paid, lots of information,” he says.

“Then you had [people within] funds who were quite distant from that; they were not full time, not well paid not that sophisticated from an investment sense; so you had a marked asymmetry in the relationship.”

Neal says the Future Fund, like many other institutions, has sought to narrow the gap. This means being closely engaged with fund managers to the point that they can test, challenge and explore opportunities and drive genuine alignment of interest.

 

Management style

The Future Fund’s processes are run by a 40-strong team that sticks to tailored principles to work as one. For a fund of its size, this is quite a lean team.

The philosophy it follows is termed “one team, one portfolio” and as part of this, all new investment ideas are debated against each other regardless of asset type.

Moreover, performance remuneration is determined on the basis of performance for the fund as a whole, rather than reflecting the performance of individual asset classes.

Underneath the board the key investment decision-making body is the investment committee which includes the sector heads of each asset class together with the CIO, managing director, director of emerging markets and director of strategic risk management.

Each sector head is responsible for coming forward with their best current ideas and to say what they like and don’t like about their current portfolio.

This is also reflected in the other decision-making structures that are used to assess, filter and review opportunities and existing investments.

It is “an incredibly stimulating environment”, says Neal.

Professionals are exposed to the full breadth of opportunities beyond their own specialism – for example, those in the listed equities team find themselves on the asset review committee understanding the detail of buying a property or an infrastructure asset.

Also, if a sector head has an under-performing contributor to the overall portfolio they are encouraged to get rid of it, rather than empire building.

“Everyone came in on the basis of the contest for capital between ideas and not between people,” Neal says.

 

People management

When asked whether the process could be prone to individuals using psychological technqiues to subvert, perhaps by getting their ideas chosen over others, Neal replies “absolutely”. He uses the same word in reply when asked whether certain personality types would be better off in another organisation.

“You do not want people who are in it for themselves,” he says.

Similarly, this team-based system will not work if members only offer praise to their colleagues, perhaps as a means of gaining favour or promotion.

“It is a balance between being a real team player and sometimes telling your colleagues that they have got it wrong – and you need to tell them fast frankly and openly,” Neal says.

“The person receiving that information needs to be a team player in the sense that they say ‘thank you for telling me that – I appreciate that, I will go away and think about it some more’.”

He caveats this quickly by stating it does not always happen as sweetly as that, but it is the fund’s aspiration. And if it does not always go down well, it is better than having team members feel like they cannot be bothered to raise concerns.

Neal says that so far this approach has worked pretty well but that it requires ongoing attention and effort, and it means the organisation puts a premium on finding good cultural fit in recruitment.

A more extreme version of this approach comes from global hedge fund giant Bridgewater Associates, which has around 240 business principles in handbook written by the founder and CIO, Ray Dalio. It’s compulsory reading for all staff. (link)

Neal describes this as “an extraordinary codification of a culture and process” and the encouragement of “incredibly frank feedback all the time”, which he admits is challenging for most people, but shows the importance of clear rules of engagement if you want to get to the top.

(A 2011 New Yorker article on Bridgewater gives a good insight.)

Neal’s place in this structure is not that of a typical chief investment officer.

Indeed he suggests that the notional roles of chief risk officer and chief culture officer are more important aspects of his role at Future Fund.

“I would consider myself primarily the engineer of the process and the culture,” he says. “The team does the investing – they are the smart people going and finding great opportunities. A big part of my role is that of chief culture officer – a monitor of the rules of engagement.”

 

Distractions

Neal has helped create a finely tuned machine and he is grateful for the brief the Future Fund has not to manage assets in house, other than some infrastructure assets.

“Different funds have different approaches and contexts when it comes to in-house management versus an outsourced approach,” he says. “For us, we see a particular advantage in focusing on the total portfolio while bringing our investment expertise to bear through deep relationships with our external managers. It helps us avoid getting dragged in to implementation issues in a way that can be distracting and take us away from what we believe we really need to think about.”

He acknowledges the model is more expensive but it is also part of the distinctive approach to investment and provides a comparative advantage.

This is useful, for example, in an analysis of the current investment outlook, in which he says his fund is positioned neither aggressively or in defensive mode.

“We spend a lot of time making sure we have the best possible understanding of the context that markets are operating within,” he says.

Neal believes the current market, which he acknowledges has large structural imbalances caused by quantitative easing in the US, Europe and Japan, is “reasonably” supportive for asset prices.

“We are neither aggressive or very defensive. We are not afraid of investing in this environment,” he says.

Not that he is over-confident, he realises the weaknesses in the system could easily lead to markets dropping back again.

In the meantime, the fund is taking the keenest looks at the best opportunities given the environment.

“We want to be sold to by people who have great ideas. The life blood of good investing is good ideas,” he says.

 

Wall Street’s leaders are largely unrepentant for the immense harm their institutions inflicted on the U.S. economy during the financial crisis, and their outlook nd behavior have not changed in any significant way since the crisis, according to a George Washington University Law School paper.

However the lengthy and detailed paper argues there is hope.

“It remains possible that continued revelations of excessive risk-taking and other abuses on Wall Street could finally shif thte weight of public opinion against our new financial oligarchy.”

Author Aurthur Wilmarth argues that critics of Wall Street must presevere in their efforts to persuade the American people to demand fundamental reforms…. that could finally end too big to fail subsideis for megabanks and therefor break Wall Street’s seemingly invincible power.

 

To access the paper click here Why Washington keeps giving into Wall Street

 

An investment banking background brings a different perspective to the role of pension fund chief investment officer, and for the London Pension Fund Authority that means more focus on risk management, quantitative tools and processes, and implementation cost savings. Amanda White speaks with CIO Alex Gracian.

 

Alex Gracian has only been the chief investment officer of the £4.6 billion London Pension Fund Authority (LPFA) since October 2012, but in just over a year his style is infiltrating into the investment philosophy of the fund.

Gracian is a proud quant. He has a degree in theoretical physics and has managed money quantitatively at Lehman Brothers, Deutsche Bank, the TRW Pension Fund and as head of equities at Gulf Investment Management.

“Being a quant, my focus is using quant processes. A lot of fund manager selection can be about who rings the personal assistant of the CIO the most,” he says. “We want a more transparent, holistic, diversified approach.”

Gracian has now put in place a quantitative selection process for all managers, which uses quant filters to narrow the universe, and optimise the short list, a process which he says has some surprising results.

“The initial screens throw up some interesting names, and we’re calling them instead of them calling us,” he says. “We want to be at the stage where we are not having quarterly meeting reviews but instead there is more internal analysis and discussion on their funds which may lead them to be an implementer of our ideas, we want to work together with our managers.”

Gracian says the investment team, which numbers six including him, is working closely with managers, particularly in equities and the asset liability matching space.

Within equities beta is a focus and there is work being done to blend alternative indexes into one portfolio.

“Alternative indexation it is not just about alpha but about diversification, and volatility reduction. For us alpha is not the primary driver,” he says.

Within beta management, Gracian says he is a “big fan of cash equitisation” and the fund is building a futures book with about £300 million managed now.

Over time he plans to optimise that, use it for TAA implementation and as a source of cheap, ultra liquid investments.

The team is also discussing investment techniques with some of the bigger hedge funds to use their long/short skills and presence in the long-only space. It fits well with the fee philosophy at LPFA which advocates low base fees with proportionate and properly constructed performance fees.

In the 2012/13 financial year the investment costs of the total fund went down from 0.65 per cent to 0.55 per cent; and of that 0.17 per cent was spent on performance fees.

 

Global trend

The appointment of Gracian to CIO is part of a global trend where investment banking and investment management professionals are moving in to the pension investment world.

In the UK the new chief investment officer of the Pension Protection Fund, Barry Kenneth, was managing director at Morgan Stanley for eight years. In Australia the investment teams of funds such as UniSuper and First State Super are now headed by ex-investment management professionals, and in North America some of the high-profile examples are Britt Harris the CIO of Texas Teachers Retirement System formerly of Bridgewater, and CPPIB’s chief investment strategist Don Raymond formerly of Goldman Sachs. Virtually all employees at PGGM and APG in the Netherlands have spent time on the sell side.

“An investment banking background brings certain skills, like the minutiae of foreign exchange,” Gracian says, emphasising a focus on implementation costs is one of the benefits that background can bring.

“A lot of people focus on cost savings in pooling assets, but there is often too much emphasis on that, there are other important things.”

Hiring more experienced people – that can make the most of expensive systems and can understand option pricing, swaptions, or the stochastic-ness of options – is a focus for Gracian who says risk management, and liability modelling is a necessity for the fund. He wants a young, “edgy” team and will begin slowly hiring more staff.

“You can get an external provider but that is only good if the board and the non-executive can understand them,” he says.

As part of LPFA’s development, it has undergone significant restructuring at the board level since Edmund Truell joined as chair of the board and the investment committee in January this year.

Gracian says that an early decision between himself and Truell was to “no longer go through the consultant route”.

The board, which has had half of the trustees change in 2013, now has some specific pension and investment skill among its members.

“The board has a lot more experience and there is clear delegation which means decisions can be made a lot more quickly,” he says.

Together with an experienced executive team, this means LPFA is well-positioned to take advantage of some of the investments Gracian believes are real opportunities, such as secondaries and the distressed market.

Gracian is a “big fan” of R-language (he also has a Masters of Science in Information Technology) and is taking big strides in asset-liability modelling including introducing real-time analysis.

He believes liabilities valuations are conservative, and on a risk-free basis the liabilities of LPFA are more like £8 billion, against assets of £4.5 billion.

He wants to focus on liabilities, and says “the liability profile is more important than size per se for asset allocation”.

Inflation has been highlighted as one of the biggest risks facing the fund, with the potential to effect the funding arrangements and LPFA’s liabilities, and a hedging strategy is underway to manage this risk.

The fund will have its triennial valuation in 2014, but Gracian says at the strategic level the asset allocation will be similar to what it is now with about 40-50 per cent in equities.

What will change are the vehicles the fund chooses to invest in, with a wider scope for alternative debt such as aircraft leasing and pharmaceutical royalties.

He also says the fund has a bigger appetite for things like development risk.

Over time the fund will increase its illiquid allocations in property, private equity and infrastructure moving away from fund of funds to single funds, co-investments and the secondary market. The team will use its quantitative skills and processes to do some more factor-risk modelling in the illiquid space.

 

 

The LPFA’s 2012/2013 annual report can be accessed here

 

 

As pension funds act more like asset managers, with internal investment responsibilities, they should focus on the competitive advantages to be gained from data and analytics.

 

The healthcare industry has seen a 20 per cent decrease in patient mortality by analysing streaming patient data. The Telco industry has seen a 92 per cent increase in processing time by analysing network and call data. These are two powerful examples used by IBM to demonstrate the return on equity of investing in big data technology.

For many investment managers and asset owners, data remains an untapped resource.

According to Virginia Rometty, chief executive of IBM in an article in The Economist, data constitutes a vast new natural resource, which promises to be for the 21st century what steam power was for the 18th, electricity for the 19th and hydrocarbons for the 20th.

She says that in 2014 a new model of firm will emerge, called the “smarter enterprise”.

“These firms will do the things that organisations have always done: make decisions, create value and deliver value. But they will do them in new ways. Smarter enterprises will make decisions by capturing data and applying predictive analytics, rather than just relying on past experience.”

This new way of thinking of data, as a resource, is very relevant to the  investment management industry which not only has a high volume of data but relies on data for decision making. But according to a survey by State Street there is a real divide in the industry between the data leaders and the data laggards.

The study conducted by the Economist Intelligence Unit, and commissioned by State Street, “Leader or Laggard? – How Data Drives Competitive Advantage in the Investment Community”, surveyed 400 firms and looked at the strategies leading asset managers and asset owners are using to gain a competitive advantage from data.

The survey found that the vast majority of respondents saw data and analytics as a strategic priority (91 per cent), and yet only a small proportion (29 per cent) strongly agreed that they are already gaining a competitive advantage from their data now.

For those that are not, they are missing out. There is a lot for room for investors to use the analytics and interpretation of data, to identify investment opportunities and risks. The State Street report says data analytics can help with managing risk across multi-asset portfolios, enabling smarter and faster investment decisions and learning how to master regulatory complexity.

The importance of data analytics is highlighted by head of State Street Global Exchange Research and Advisory, Jessica Donohue, who says insight into portfolio data allows investors to leverage the “high ticket items” like asset allocation.

“Insight into the portfolio allows you to do things like tilt the portfolio for better return but less exposure, and it allows you to do factor analysis, manager assessment and look at things like manager strategy overlap,” she says.

“The theme of the last four years is it is all about risk, risk, risk, where previously it was all about alpha, alpha, alpha. But they are two sides of the same coin.”

This theme has also played out in the functions of investment firms, where risk was seen as middle to back office function but now it has front office implications.

The State Street report highlights one of the challenges of data, is its sheer volume (the others being velocity and variety), reporting that global IP traffic is projected to reach 554 billion gigabytes per month by the end of 2016. This is more than 110 times all of the information estimated to have been created by human beings from the dawn of civilisation until 2003.

Similarly IBM’s Rometty quotes that by 2020 there will be 5,200 gigabytes of data for every human on the planet by 2020. (To put this into perspective, one gigabyte is the equivalent of about 20,000 reasonably-sized word documents.)

For this industry its worth noting that financial data mirrors the general growth in data, and further, that the infrastructure investors use has not kept up with that growth.

A recent report from experts at the US Treasury’s Office of Financial Research says: “Financial market data volumes are growing exponentially. One should thus expect traditional data management technologies to fail, and they have.”

In particular back offices have not kept up with developments in either their own front offices or other industries.

The good news is the survey shows that investors are addressing this issue, and Donohue says that 86 per cent of respondents have increased their investment in data and analytics infrastructure in the past three years.

“We are in a cost cutting mode across the industry, but it is one of the areas people are spending money,” she says.

In addition to investment in technology, Donohue also highlights the interpretative skills as a barrier in the industry to embracing data as an advantage.

Particularly she says there needs to be continued innovation and specialisation in data analytics and then the visualisation of that data and analysis.

“This will be a powerful tool when it can be put in the hands of the C-suite, and it helps the chief investment officer, or chief risk offer see things in the portfolio and drill down,” she says.

“Having accurate data, and your own portfolio data at hand, is a big deal. “Big data” is a buzz word but there is a sense that your own data is your asset, it’s a tool you want to use. The next step is asking how you can do that and the realisation you should be able to do that.”

State Street Global Exchange is a new division of State Street and Donohue says it is a statement of how important data and analytics play in the role of our clients. It combines capabilities in research and advisory, portfolio performance and risk analytics, electronic trading and clearing, information and data management, along with new innovations to help asset owners and managers gain new insights and execute investment decisions efficiently.

 

The State Street report highlights five steps necessary to becoming a data leader

1. Improving risk tools with multi-asset class capabilities

2. Developing better tools to manage regulation in multiple jurisdictions

3. Improving the ability to manage and extract insight from multiple data sources

4. Optimising electronic trading platforms

5. Developing a scalable data architecture that will grow with your business

Source: “Leader or Laggard? – How Data Drives Competitive Advantage in the Investment Community”,