Delegation is a fundamental obstacle to the alignment of asset-owner and asset-manager goals. However, Sebastien Pouget, professor of finance at the University of Toulouse, believes a combination of customised performance benchmarks and a dual short and long-term fee incentive can help overcome the problems of the principal/agent relationship.

Pouget, who spoke at the recent United Nations-backed Principles for Responsible Investment Academic Conference in Canada, discussed whether aligning the interests of asset owners and asset managers is actually possible.

He believes the motivation shouldn’t be a problem in meeting long-term expectations, as the investors and the assets in which they want to invest both have.

Asset owners, with long-duration liabilities, should be long term and the companies they invest have projects and assets that are also the long term.

“It’s tricky when between the companies and investors you have asset managers who report on quarterly a basis, are evaluated on a yearly basis and after a few years face the risk of being fired,” he says.

Correcting short sight

This “long fight against short sight” has been well documented academically, most recently by the Kay Review, and the industry itself has also tried to come up with solutions, such as the CFA’s report, Breaking the short-term cycle.

One proposal has been to lengthen mandates in terms of management and compensation, but Pouget believes that’s largely futile – there is still an end date that alters behaviour.

“Asset owners face a trade-off between compensating asset managers in the long run, once investment outcomes are known, and offering bonuses based on a short-run performance, so that asset managers do not have to wait too long,” he says. “These different horizons are of a profound nature. There is a long chain of delegation in this industry, so it’s the nature of the relationship in the entire industry that’s at stake.

“Asset owners don’t want to give the keys to the car to a manager for 20 years, it’s a question of talent (or is it trust) that you want to allow yourself room to replace that manager in case they’re not up to it. This is very fundamental, even if you have funds management inhouse, you still need to think about pay, performance and time lines.”

There has been much economic theory studying this delegation and Pouget’s theoretical solution is for asset managers to be paid in the short and long term, and critically for their performance to be measured against a benchmark specifically constructed to be skewed against the long term.

“You can design a performance benchmark that is appropriate. This might mean overweighting assets that are sensitive to long-term issues such as value assets, resource and development-intensive assets, and ESG. Smooth out the short-term asset-price movements.”

In this way, Pouget says short-term incentives can be useful for promoting long-term goals.

“If the manager has overweighted an industry where there’s a bubble, then you won’t compensate them in the short term because you know in the long term the bubble will burst, so there is no long and short-term alignment.

Liquid enough?

“Short-term incentives are effective to promote long-term goals when the market is liquid enough, so for large caps and mature industries, and when there is a good coordination between long-term investors and subsequent speculators,” he says, noting that short termism is more prevalent when long-term information acquisition is more costly, and more difficult to monitor, for example, in intangible items and ESG issues.

“You can satisfy them in the short term and satisfy you in the long term. But crucial for this mechanism is to know what the level of efficiency in the market is. For example, if you have information of the long-term prospect of a company, then you can pay more of their fee now because it’s priced in the long term anyway,” he says.

He does say that rewarding managers only in the long-term may be detrimental to both asset owners and market efficiency.

Ironically, he says that in the absence of long-term incentives, asset owners may refrain from collecting long-term information, which is short-termism.

Determining market efficiency

A mix of short and long-term compensation may be optimal. If financial markets are perfectly efficient, prices reflect long-term information and short-term incentives are effective.

“Conceptual analysis tells you that you can use short-term bonuses only if the efficiency of the market is good. So as an asset owner, you should do work on the current level of efficiency.”

The big question, then, for asset owners becomes how you determine the level of efficiency of the market.

Pouget says the level of liquidity of market can be a determinant of efficiency, but also that asset owners should use resources similar to traders and invest in research such as microstructure theory, which looks at how specific trading mechanisms affect the price-formation process.

“By studying the behaviour of asset prices, you can determine whether there is asymmetric information or whether there’s information that the market doesn’t know,” he says. “Asset owners could invest in more inhouse research to better monitor managers.

“I am a professor and as an academic you have to be humble. Maybe if it’s not done in practice, there’s a reason why there are limitations.”

 

Pouget’s paper, Fund managers’ contracts and financial markets’ short-termism, can be accessed here.

Denmark has blitzed the pension-system competition, being awarded the first Mercer Global Pension Index A grading. In the process, it has relegated the Dutch and Australian systems to second and third places, respectively, after four years.

Mercer senior partner and report author, David Knox, says the reasons for awarding Denmark the top grade were clear.

More than 80 per cent of the working-age population is covered by the nation’s pension system, the contribution rate is 12 per cent and assets put aside for the system are 150 per cent of GDP.

In addition, Knox says the Danes have relatively few funds so they can reap the cost benefits of economies of scale through administration and also through participating in large-scale investment deals.

The Danish darling

While the Mercer index rates countries on their systems – not the individual funds within the country – it is worth pointing out that the $98.4-billion Danish ATP fund is widely recognised as one of the best funds in the world.

It has a mission of matching assets and liabilities, and is managed in two distinct portfolios: hedging and investment or return-seeking. It’s the hedging portfolio, which hedges as closely as possible the interest-rate exposure of the fund’s pension liabilities, that allows the fund to sustainably pay its beneficiaries. See article here.

Lars Rohde, chief executive of the fund for 14 years, has been appointed the new governor of the country’s central bank. Replacing him at ATP remains a challenge for the board.

Raising the Netherlands

While it moved to second place, the Dutch system improved its rating from 78.9 to 79.9 this year, with improvements in both the adequacy and sustainability ratings. The Dutch system is in the middle of major reform discussions, with a likely move away from its current defined-benefit structure to a “defined-ambition” one. See article here.

Equities for Australia

The Australian system improved its score slightly from 75 to 75.7, primarily because assets as a percentage of GDP improved and, with the slated guaranteed contribution increase of 9 to 12 per cent, Knox says he expects the Australian score to gradually improve.

However, he said that regulatory reform, particularly as it applies to the provision of an income stream, will be needed in order to improve the rating further.

From an asset-allocation point of view, the main point of difference was the allocation to equities. Both Denmark and the Netherlands have less than 20 per cent in equities across the system. Australia has one of the highest allocations to equities of the OECD countries, with more than 45 per cent.

Annual additions

Each year since inception, the index has been tweaked slightly. This year an integrity question was added. Using the World Bank’s worldwide governance indicators, a “governance of governments” was measured.

“We want people to trust the long-term pension systems, and that means they have to trust the government to not change the system,” Knox says.

The global coverage has also expanded every year with the number of systems covered growing from 11 to 18 in the past four years.

Denmark and Korea were added this year, and last year it was Poland and India.

The index is calculated by assigning values to adequacy, sustainability and integrity. About half of the index questions are sourced from international groups, such as the IMF and the OECD, while the other half are sourced through Mercer.

It is produced by Mercer and the Australian Centre for Financial Studies and funded by the Victorian State Government.

The full report can be accessed below.

Mercer pension index 2012

 

For many years Japan has been an insurance-market behemoth and Japan Post Insurance Company is one of the giants with $1.13 trillion.

But the industry has not been immune to change. Between 1997 and 2001 seven life insurance companies became insolvent, and there is a question mark over whether it was a low interest-rate environment that caused this fallout.

Given that history and the current low interest-rate environment, investment risk manager at Japan Post Insurance Company Ryujiro Miki, who will speak at the Conexus Financial Fiduciary Investors Symposium, says it is worth exploring the potential effects on the insurance industry.

 

Mixed messages

The economic statistics in Japan are grim: the official government bond rate is 0.8 per cent, having peaked at about 8 per cent in 1980. Similarly, the Nikkei peaked at ¥39,000 in the 1990s and now it’s at ¥8000.

However, the bond market in Japan is unique in that 92 per cent of the nation’s debt is domestically owned. Furthermore, the Japanese government owns 40 per cent of the banking system directly, and about half of government bonds are held by government-owned institutions.

“Japan owns the bond market, external debt is very tiny; we are self sufficient,” Miki says.

“Since the peak of interest rates the Japanese industry has been trying to get rid of excess capacity so inflation has not been an issue but deflation has been… The debt-to-GDP ratio is 200 per cent – much worse than Greece – but the net-debt position is half that.”

The Japan Post Group is 100-per-cent owned by government. It is made up of two gigantic institutions, both of which are the largest in the world: Japan Post Insurance, which has $0.8 trillion of US-dollar-denominated Japanese government bonds (JGB), and Japan Post Bank, which has $1.8 trillion of them.

“We hold roughly 30 per cent of JGB,” Miki says.

The Japanese government is looking to sell the stock of a number of holdings in order to recapitalise after the earthquake, most recently the airline, and Japan Post Group is on its list.

 

Lesson from the 1980s

The potential listing has great consequences for the market more widely. If it lists and diversifies its asset allocation away from domestic bonds, it could have an effect on interest rates.

Back in the 1980s interest rates were deregulating but there were also a number of structural issues that contributed to the demise of the seven insurance companies, worth about $120 billion. These included financial deregulation and globalisation, a maturation of the death-coverage market and fierce competition for private insurers to raise assumed interest rates to struggle against public insurers.

In the 1980s insurance coverage was meeting its limit, according to Miki. While interest rates were deregulating, investment-style products were becoming more popular.

“Investors wanted high-return products and insurance companies were competing against the mutual-fund industry,” he says.

But really, Miki says, it was the absence of risk management, and asset-liability modelling, that led to the failures in the 1980s, not low interest rates per se.

“Under the circumstances, there was too much rapid expansion and concentration on risky assets, but there was a lack of corporate governance, an absence of risk culture and good management,” says Miki, who at the time was in the investment-planning department at one of Japan’s private insurance companies.

One of the main lessons from that time is that asset-liability modelling is the key to hedging interest-rate risk, Miki says, but he believed enterprise risk management, or lack of it, was the real cause of the insurance companies’ demise.

“It wasn’t the bubble bursting alone, but bad management also,” he says.

At the International Centre for Pension Management’s biannual meeting in London, Jack Gray and Generation’s David Blood had a tête à tête on sustainability.

An academic at the Paul Woolley Centre for Capital Market Dysfunctionality at the University of Technology Sydney, Gray has written a paper, Misadventures of an Irresponsible Investor, that at its core suggests that there is an opportunity cost to not doing something else by spending a disproportionate amount of time on “responsible investment”.

David Blood, former chief executive of Goldman Sachs Asset Management, has built a business around sustainability at Generation Investment Management, alongside royalty of sorts – the former US vice president Al Gore and Mark Ferguson, son of Manchester United manager, Sir Alex Ferguson.

Sustainability, it seems, is working out OK for Blood, with the UK press reporting he took home more than £10 million pay in 2009 alone.

 

Blood and Gore vs Gray

Gore and Blood do have some sensible investment tenets, in my opinion, based on long-term incentives being the antidote to the short-term greed that many attribute with causing the recent crisis.

Gray, on the other hand, is confused.

Most would describe Gray as an intelligent man. And I would now add brave to that description.

To admit, in front of a peer group of leading investment minds and the largest institutional investors in the world, that you “don’t get it” takes courage.

In the closed session, delegates – mostly pension funds and some academics – were asked a simple question. Were they long green or long brown?

The audience vote showed that 30 were long green, and 20 were long brown.

 

The metamorphosis of “responsible”

While this is a blunt investment question, in reality it is not that simple. Many funds say they have dual incentives.

But Gray’s philosophy is that markets are not driven by morality and, in any case, society is not that moral as a collective. But he also admits he is confused.

“I abhor the view that companies’ motives are to only drive profits. But when it comes to pension funds, I flip over and think that is their only reason for being,” he says. “I’m confused.”

What Gray does object to is the use of the word “responsible” for what he sees as an investment analytical approach that started as the enhanced analytics initiative named by Raj Thamotheram, then at USS.

This initiative ran for four years between 2004 and 2008 with the aim of stimulating sell-side analysts to produce research that incorporates ESG issues in such a way as to enable fund managers to integrate them into their investment decisions. It was claimed a success and a stimulant for exponential growth in this research.

Somehow enhanced analytics has morphed into responsible investment or sustainability or ESG, depending on who you talk to.

 

Flowing into the mainstream

Nomenclature in this sector is a problem.

Even the latest biennial sustainable and responsible-investments research by the European Forum for Sustainable Investment (EUROSIF) concedes that the judgment of whether something is SRI is “very much coloured by the cultural and historical diversity of Europe”.

At this stage, the report says, there is no consensus on whether a unified definition of SRI exists within Europe, regardless of whether that definition focuses on the processes used, societal outcomes sought or the depth and quality of ESG analysis applied.

It’s a challenge for investors to understand the various product offerings, and for service providers it may mean national distribution is required depending on country preferences.

The sustainability-driven Generation has a concentrated low-turnover portfolio, focusing on long-term advantages.

There is an argument that this type of investment doesn’t need a label, but should be just part of good analysis.

Gray says infrastructure managers, for example, have always taken social and environmental factors into account.

“The Economist reported recently that we may have reached our “peak car” use. Infrastructure investors would take that into account when they are valuing a toll road. Property guys have also always done it.”

Personally, I believe in sustainability. But I don’t believe in marketing.

Taking into consideration themes such as water and other resource scarcity (a big theme of Gray’s former employer, Jeremy Grantham), growing and ageing populations, peak car use, climate change, good management practices, governance and decision making should not be viewed as ESG screens, tilts, implementation, overlays or philosophy.

These are the practices that investors should expect from funds managers. It is simply taking into account the future in assessing the price of assets now.

In the United Kingdom there are around 1.5 million employers, and it is estimated more than half of them do not offer a pension to their employees.

The pension system in the UK is fragmented. There are more than 10,000 mostly defined-benefit plans and, unless you are a government employee or in the high-income bracket, there is very limited coverage.

Auto-enrolment, the opt-out defined-contribution system designed to fill this gap, was introduced in the UK on October 1.

The government-funded pension fund, NEST, is one of the funds on offer under the new regime, and conexust1f.flywheelstaging.com had an interview scheduled with the chair of the fund, Lawrence Churchill on that day – the first day of the rest of the fund’s life.

 

Starting from scratch

Churchill and his staff have spent the past two years preparing the fund for this date. They have the infrastructure, including appointed investment managers and more than 250 staff, in place to start managing pension money.

“A lot has been happening in the past two years, NEST has changed the basis of competition and it’s been beyond my expectation,” Churchill says. “We are a low-cost option and we’ve used simple language, trying to get all the technical jargon out of the way, and it’s landed incredibly well.”

While October 1 was the first day of compulsion, the fund has taken on some “volunteers” with 200 companies and about 2000 employees, and about £1 million of assets already running through the fund.

“We’ve learnt a lot and it has been a reasonable test of our infrastructure,” he says.

Auto-enrolment will be phased in, reaching 8 per cent in 2017, with contributions split 3 per cent from the employer, 4 per cent from the employee, and a 1 per cent tax relief on net pay.

NEST has two main competitors: the People’s Pension, which is an established UK operator traditionally focused on the building industry; and Danish fund ATP’s offering, Now.

“It will be terribly interesting to see how this plays out,” Churchill says.

 

Industrial-strength governance

The fund is aimed at low-income workers and does have some constraints for growth, in particular it can’t take contributions of more than £4400 per person a year.

Churchill says one of the fund’s strengths is its focus on good governance.

“We’ve put a lot of effort into good governance and become slightly famous for good governance,” he says. 

“We have taken advantage of starting from scratch and we want industrial-strength governance. Our trustee structure is like a FTSE 100 company – we have committees at the board level and delegations to the executive.”

The chief investment officer of Railpen, Chris Hitchen (pictured right), chairs the NEST investment committee, which is responsible for setting high-level strategy including strategic asset allocation, risk budgets and responsible investment.

The implementation of that, within parameters, is given to the executive, which includes 15 internal investment staff, who manage a risk-driven asset allocation with 12 different risk indicators, and a different risk allocation at each phase of retirement.

The internal team has a monthly asset-allocation meeting and reports back to the investment committee on a quarterly basis.

The fund has taken a largely outsourced model – both investments and administration are outsourced – and it doesn’t have a licence.

The assets are held 100 per cent in regulated markets and 100 per cent in liquid markets. The largest mandate is with UBS and the other managers are State Street Global Advisors, Blackrock, F&C Investments, HSBC and RLAM.

 

Encourage saving

From an investment point of view, there are many particular characteristics of the fund. For one, it is largely indexed, with the average fee being 50 basis points.

“What we’re doing as an aggregator is bringing wholesale costs down to a retail market,” Churchill says.

And for young members the default fund is unusually defensive.

The philosophy behind this, Churchill says, is that it is better to encourage saving per se, than to tempt people to opt-out because they have had a bad or volatile investing experience.

The fund’s chief investment officer, Mark Fawcett (pictured right), says the amount of risk taken when you have a small amount of money is less important than actually continuing to save.

“When you are very young, you have a small amount of money to invest. If you take a lot or a small amount of risk it is irrelevant because the amount of money is small. When you are 30 to 50 years old, it is more important,” he says.

NEST has done extensive research and has found that young people in particular are adverse to volatility and losing money, and a reaction to that could be to opt-out of the fund all together.

“You have to keep saving to create a pension,” Fawcett says.

 

Long-term relationships

Risk management and diversification are the drivers of investment management for NEST, and the fund “believes” there is better value in passive management.

“It is better to use resources on asset allocation,” Fawcett says.

More than half of mandates awarded are passively managed.

In addition, the fund is looking to have long-term relationships with its service providers, including its investment managers, demonstrated by mandates being open ended.

“We went into it saying if you do what you say you’re going to do then you’ll be around,” he says. “We want to keep managers focused so we don’t believe in artificial horizons – even 10-year mandates are artificial time horizons. If two years from the end of their term they are underperforming, then they will take more risk.”

While it is not on the immediate horizon, Fawcett says it is possible assets will be managed in house.

It is a requirement that the fund uses a consultant for manager searches, and both Aon Hewitt and Mercer have been used so far.

Fawcett says the other unique aspect of the fund is that the default fund is a series of target-date funds, one for every year of retirement, and there is dynamic management within the target-date funds.

The target is on expected retirement date, and risk is managed according to annuity prices, not the size of the pot. Something other defined-contribution funds could learn.

“We are trying to philosophically see our way through conversion risks,” Churchill says. “We focus on retirement income.”

He says the fund is looking to broaden its range of retirement-income offerings and will work with providers to add products such as low-cost, advice-lite drawdown products.

 

In an interview with conexust1f.flywheelstaging.com, John Kay, economist and author of the UK government-commissioned enquiry into long termism and the UK equity markets, has said it is “fanciful to imagine large number of trustees will have the skills and knowledge to have long-term relationships with corporates”.

Kay says the key players in the UK equity chain are funds managers, and while 20 years ago the role of pension and insurance companies would have been emphasised, that is not so today.

 

Embrace the complexity of ownership

 

In Kay’s review, the emphasis was on funds managers, who he says have a critical role in the buy-and-sell decisions of shares as well as voting.

He says semantics around the word “owner” are not particularly helpful and get in the way of the discussion.

“There are different characteristics of ownership,” he says, adding that funds managers need to see themselves more as owners in order to alter their behaviour.

The recent so-called Shareholder Spring, when many institutional investors and funds managers voted down executive-pay issues, was a step in the right direction, according to Kay.

However, he says, in the long run he would like to see more engagement.

“Corporate governance has become about stopping people doing bad things. The Shareholder Spring was prompted by the excesses of executive pay, but I’d like to see more focus on things like concentrated portfolios that are differentiated from each other.

“There is a high degree of closet indexation and pre-occupation with tracking error. I’d like to see a a different structure in funds management.”

 

The culture of singular excess

The number of intermediaries and the cost of intermediation in the UK market is excessive, he says.

One of the findings he emphasised was a move to reduce the role of transactions and trading, and move to a relationship-based culture.

“This is a philosophical shift that will take place over a long time. But I’d like institutions to feel more comfortable giving long-term mandates, for example.”

Kay believes one of the more important recommendations from his review is to form an institutional investors’ forum in the UK to facilitate collective action.

“There needs to be an emphasis on fiduciary duty to encourage asset managers to change their actions. This could be through giving asset owners the ability to give long-term mandates that are more absolute-return focused.”

The next step in the reform process is for the government to respond to the review. This is expected to happen in November.