The pension and funds management industry needs to redefine performance to an absolute return measure, according to The Influential Investor: How Investor Behaviour is Redefining Performance, a paper that is the result of 12 months of research with more than 3000 investors and investment providers across 68 countries.

The report, which sought to uncover the forces that will shape the investment management industry over the next decade, found that while relative performance based on peer groups or indices may serve the provider, the investor’s view of value is more complex and reflects their own personal blend of alpha seeking, beta generation, downside protection, as well as liability and income management.

“In the future, the investor will be the benchmark,” says Suzanne Duncan, global head of research at State Street Centre for Applied Research and co-author of the report.

The Influential Investor states that performance is the most highly rated factor by investors but it is simultaneously the number-one weakness when rating managers.

“Our research finds that the value proposition must evolve to one that defines performance as personal, a new definition of performance in absolute returns,” Duncan says, “but we are yet to see an academic framework that defines performance as personal.”

Personal, in three parts

State Street has developed a framework for this new definition that is made up of three components:

  • an alpha-seeking component, which will only be paid for if it is reached;
  • income management, which will be different for each investor and requires the income stream to be managed and protected in the context of the aims; and
  • liability management, which Duncan says has begun with liability-driven investing but hasn’t gone far enough.

“Investors need to understand current and future cash flows and manage to that,” she says.

The State Street research shows that investors are too busy looking at what their peers are doing and not defining performance as personal to what their own needs are.

“There is so much pressure, so investors are looking at what their peers are doing, but they need to look at their own needs and the needs of their beneficiaries, and manage that. It is an exciting period because there is awareness of the issues and the need for outcome-oriented investing and there can be experimentation around that.”

Industry direction

The impact of this shift will be massive, the industry will need a keen understanding of the role of local intelligence in decision-making systems, the report says.

It will need to streamline the delivery model at both industry and organisational levels to eliminate complexity and bring strategic priorities in line with what investors want most: personal performance.

And it will need to define a formula for sustainable returns to account for investors’ unique performance goals, to align fees with value delivered and to be fully transparent so the investor can appreciate that value.

“Under the new definition of performance, the investor is the benchmark,” she says. “This will have a profound change and impact. The system itself is in the way. There is too much of everything – funds, service providers, fees – the delivery model will be rationalised.

“Everyone has to agree with what we mean by success; there are different expected outcomes by different participants. If there is a precise definition of what performance means then there is a level of commitment. Investors need to measure success on their own income and balance sheet, not some other.”

The research also identified that the investment management industry is very different to other industries in the number of layers and level of participants or players.

“There are too many levels of decision-making in the governance structure. We looked at the added value across each layer, and there is not enough value to have that level of intermediation,” she says.

 How retail and institutional investors behave

Behind these headline findings, State Street examined the behaviour of retail and institutional investors, concluding that investors are not acting in their own best interests.

For example, while retail investors say they will invest more aggressively, they are moving more towards conservatism that is demonstrated by a 30-per-cent average allocation to cash.

Similarly, institutional investors are not acting in their own best interests and are becoming more aggressive due to what they see as artificially high expectations.

For institutional investors, the ultimate allocation in terms of growth is alternatives, but they also cite that their greatest risk is their inability to deal with the risks of these assets.

“There is a divergence of goals by institutional investors: they are looking at alternatives and they also believe they’re not prepared to handle the risks associated with their actions,” Duncan says. “There is nothing wrong with alternatives or risk per se. But there is herding and convergence into alternatives, and they believe that they’re taking on risks and there is a knowledge gap in that. There is not the evidence they have the governance structure or investment knowledge.”

She says investors are also becoming increasingly aware of the system’s instability.

“There is a very low level of trust in markets and in regulators.”

The future investment management business model
1 The value proposition – a new definition of performance
2 Delivery method – must be rationalised
3 Profit formula – or how to measure success  – will be sustainable returns
unique to an individual organisation regardless of others.

 

 

 

 

 

To access the full report, click The Influential Investor.

 

The Spanish Social Security Reserve Fund is set to be depleted by another €7 billion ($9.05 billion) before the end of 2012, according to IESE Business School pension expert, Javier Diaz Gimenez.

The $90-billion fund has already been asked by the government for $3.8 billion, which is likely to go towards a raise in state pensions this month.

Diaz Gimenez says “there is no question” that Spanish social security system will run into a multi-billion deficit in December at the latest, when pensioners draw an extra Christmas payment.

“That has to come out of the fund,” he adds.

Diaz Gimenez also says that ballooning unemployment in Spain and sharply worsening demographics make the outlook bleak for the Social Security Reserve Fund. Without deep reform of the social security system, it could be forced to make a number of asset sales in the years ahead, he reckons.

Patriotic fund

The fund has almost doubled its holdings of Spanish government bonds since 2008 in what many believe to be an effort to compensate for weakened demand for government debt issues.

Spanish sovereign paper totaled a shade under 90 per cent of the fund’s asset holdings in 2011.

The remaining 10 per cent is a combination of French ($3.9 billion), German ($2.6 billion) and Dutch (€1.6 billion, $2.1 billion) sovereign bonds.

“This was a neat way for the government at the time to cover its financing needs but it has created an accounting fiction at the reserve fund,” explains Diaz Gimenez. “If you buy your own debt, you effectively have nothing, so the government has filled a giant piggy bank with IOUs it has signed itself. There was obviously a hope that a financing bridge could be built, but it hasn’t turned out as planned.”

Diaz Gimenez continued to criticise the strategy of the fund, which was established in 2000 to support Spanish social security commitments by investing budgetary surpluses.

“In reality,” he says, “it has just continued the total domestic exposure you have in an unfunded pay-as-you-go system anyway.”

Diversifying abroad or investing in domestic corporate debt or equity would have placed the fund on firmer foundations, according to Diaz Gimenez.

Sopping up bonds

The fund is managed by a committee of senior civil servants and politicians, headed by the Secretary of State for Social Security.

On a pure investment basis, the fund’s mainly long-term government bond focus has been a success.

The fund has earned average annual returns of 4.14 per cent following its inception in 2000.

Critics warn, however, that this strategy is now set to backfire for the fund’s sponsor government.

A sale of bonds to dissolve a section of the fund could flood secondary markets, dampen demand for newly auctioned debt and raise yields at a critical time for the Spanish government.

The fund also stands to lose out from sales in the secondary market due to low prices for government debt, Diaz Gimenez believes.

The fund purchased $14.6 billion of Spanish government bonds in 2011 on both primary and secondary markets with a full spread of maturities.

Any need for the fund to deplete its holdings would also likely reduce its future potential to soak up government debt issues.

Looking for the best deal

Carmela Armesto Gonzalez-Roson, who sits on the Social Security Reserve Fund’s management committee, refutes suggestions that the fund has invested poorly.

She says that the management committee’s decisions are taken with an advisory committee and “always takes decisions in the best market conditions”.

The fund is obliged to ensure all assets are of “maximum credit quality”, Gonzalez-Roson explains.

Octavio Granado, who was Secretary of State for Social Security until the end of 2011, has defended the recent strategy of filling the fund with debt from Madrid by arguing it is looking to profit from the higher yields on offer.

The $3.8 billion that the Spanish government has requested from the fund will be financed from coupon returns and asset appreciation. The fund has amassed over $18 billion in coupon returns since its inception.

Moving with business cycles, procyclical stocks have been found to yield higher average returns than countercyclical stocks. William Goetzmann and Akiko and Masahiro Watanabe use 50 years of real GDP growth expectations from economists’ surveys to determine forecasted economic states in order to avoid the effects of econometric forecasting model error. The scholars created a priced risk measure by loading the expected real GDP growth rate and from this have discovered the procyclicality premium. Welcome to a snappy new term. Read on to find out how it works.

121109_Procyclical stocks earn higher returns

Despite the constant pull on Railpen chief executive Chris Hitchen’s expertise in other directions, most recently helping to run NEST, the UK government’s new low-cost pension scheme, he is resolute that his primary task is ensuring Railpen, inhouse manager of the £19-billion ($30.4 billion) pension scheme for Britain’s rail industry, successfully delivers on its monthly pension obligations. In a policy shaped by innovative investment ideas and a willingness to diversify, it’s a challenge he relishes.

The Railway Pension Scheme is an umbrella fund for the entire rail sector. Some 170 different rail-related companies – from large train operators to small engineering specialists – as well as pensioners of the former state-run British Rail that was privatised 17 years ago give their pension pots to Railpen to manage. Although the liabilities from the diverse contributors are separate, the assets are pooled into different funds, each with particular risk profiles, like a unit trust. The employers decide how and where to allocate their funds in the different pools Railpen operates with a clear delineation between liability-matching and return-seeking assets.

The scheme, one of the UK’s biggest, is a defined-benefit fund open to new members. Although many defined-benefit funds are closing as employers collapse under the weight of these more generous schemes, Railpen is still attracting enough members to make it work. New, young employees paying into the scheme give Hitchen’s team a long-term horizon and more punch and flexibility in its investment strategy. “Many funds are closing down their risk and investing in government bonds and LDIs. We are not taking unnecessary risk but we still want returns,” says Hitchen, who joined Railpen in 1998 as investment director.

Bold strokes in the growth pool

Of all Railpen’s pooled funds, its bold strategy is best encapsulated in the flagship $9.6-billion Growth Pooled Fund, introduced in 2010 and targeting 5 per cent above the Retail Price Index (RPI) in liquid, return-seeking assets.

Strategies for today’s straitened times include paring down the equity exposure in the growth pool over the last year. “We had 70 per cent in equities, now this is about 30 per cent. We’ve done this not because we know equities are going to do badly but more because we are worried that they might,” he says. The cut in stock-market exposure hit managers BlackRock, which saw its mandate drop from $4.8 billion to $3.8 billion, Pimco, Martin Currie and London hedge fund manager TT International. Railpen oversees asset allocation but has used external managers since 1987 and now has 80-odd, managed by an inhouse team of eight. The switch out of equities has pushed investment towards the other asset classes in the growth pool, including short-dated bonds and non-government bonds, property, commodities, private equity and emerging market debt. “The growth pool is invested for the long term, not to pay next week’s pension,” he says.

Hitchen is pragmatic about the enduring euro crisis. Where needed, the different pooled funds hedge their currency exposure and all are light on peripheral euro countries. The scheme has never had a particularly high allocation to European government risk anyway. “It’s difficult to say what will happen if and when the euro breaks-up – perhaps we should be overweight in German manufacturing,” he says laughingly, although it’s clear he’s not really joking. Last year the largest equity holdings within the growth pool and global equities pool included heavyweight manufacturing groups Samsung Electronics, British American Tobacco, Microsoft and GlaxoSmithKline.

Equities abroad

Another strategy is to push into emerging markets, where the scheme is modestly overweight, focused on greater China particularly, although he wants exposure to the “fantastic economic potential” of some African countries like Nigeria, too. Here, investment is limited to equities rather than resource or infrastructure plays. In China private equity investment via the Private Equity Pooled Fund, which returned 13.9 per cent last year, is Hitchen’s preferred route to market rather than direct equity investment. Access to the benchmark Shanghai Composite Index for shares listed in China, known as A shares, is restricted to foreign investors due to Beijing’s tight control over both its currency and the flow of money across its boarders. China’s stock market is also dominated by retail investors adding to market volatility and risk, he says. “With private equity there is more of a feeling that you are getting to the real economy,” he says. It’s a theme he raises again when explaining Railpen’s shift out of UK equities to a globalised equity portfolio. “UK equities account for 20 per cent of our stock portfolio; 10 years ago that would have been two thirds. Many large UK companies no longer exist. The FTSE isn’t a bellwether for UK PLC.”

PIP, CPI, RPI and the members

That’s not to say Railpen doesn’t see opportunity in the UK. It is one of six founding investors in the government’s Pension Infrastructure Platform (PIP), which will launch as a fund in January 2013, targeting $3.2 billion worth of projects. The Property Pooled Fund has around $3.2 billion invested in UK property, managed by Orchard Street. Here the emphasis isn’t on London, where he thinks returns are still “doubtful” because of oversupply, pointing out that “commercial rents are still lower than what they were 25 years ago”. Instead his focus is in regional property, in places like Cambridge’s Silicon Fen, where a technology cluster spun out of the university has kept the city insulated from the ravages of the recession.

Hitchen is wary of deficit-tackling government policy like the recent pegging of public sector-pension increases to the Consumer Price Index (CPI) rather than RPI. On average CPI inflation is roughly 0.5 per cent to 0.75 per cent below RPI inflation. He admits the reduction in the rate of increase makes his job easier but he is “acutely aware” of the impact on those pensioners who worked on the national railway and who “must now expect less than what they’ve had in the past.” He’s similarly circumspect of the raft of new regulation flowing out of the European Union that he believes will affect the way pension schemes and employers think about investment. A new caution will “tilt the playing field” towards low-risk strategies and “the appalling value” of government bonds.

It’s hardly surprising he’s using all his expertise and influence within the industry to campaign against any changes that would hurt his members. They are his first priority.

Endowments and foundations in the United States are more concerned with the US political and fiscal gridlock than the uncertainty caused by the European debt crisis, according to a survey of non-profit organisations by Mercer Hammond.

Partner at Mercer Hammond, Russ LaMore, says the US situation dominated the global macroeconomic concerns of these investors, followed by the European debt crisis and slowing growth in China.

The survey found that the investors had an “ambivalent” attitude to investment in Europe. On the one hand they thought equity valuations in Europe were too attractive to ignore, but they also wanted their global equity managers to tactically reduce their exposure to the euro, either through asset allocation or the use of currency hedging.

LaMore says the biggest investment risk cited by the fiduciaries was an over-reaction to short-termism.

“Short-termism as a fear was readily identified by respondents,” he says. “The good news is if they are conscious of it then they can address it. Good governing bodies and good governing documents will ensure events are viewed in terms of the statement of investment policy, and not what happened this morning.”

With regard to investment risk, the organisations responded that the biggest concern was fear of losing money, with market volatility ranked second.

These investors typically have large allocations to growth assets, LaMore says, and achieving the targets of their spending rates plus inflation was a big challenge given interest-rate levels.

This paper suggests a new specification for leverage aversion, which may better capture the unique risks of leverage. The authors also introduce mean-variance-leverage efficient frontiers, comparing them with conventional mean-variance efficient frontiers. They conclude that leverage aversion can have a large impact on portfolio choice.

Leverage aversion, efficient frontiers and the efficient region