The global financial crisis has shown institutional investors the hard way that textbook theory on portfolio and risk management doesn’t work very well.
As a result, pension funds, sovereign wealth funds and other investors are rethinking how they measure risk, are rediscovering the benefits of long-term investment, and are changing their relationship with external managers.
So argues Ashby Monk, a pensions-focused research director at Stanford University as well as an advisor to Alberta Investment Management Corporation, which is responsible for multiple pension funds from that Canadian province.
What’s more, many of Monk’s academic views are actually being put into practice by institutional investors, including the likes of South Korea’s National Pension Service and Malaysia’s KWAP, as well as by investors in North America.
Monk, in a presentation recently to the Asian arm of the Pacific Pensions Institute, argues that diversification failed investors in 2008, and that investors didn’t understand their true risk exposure.
The old concept of asset allocation involving investment in equities/fixed income/alternative investments is out of date. Instead, some pension funds are reorganising their risk buckets by putting a far greater emphasis on private equity, advancing into emerging markets, or into concentrated portfolios of public securities.
In Asia, the likes of Malaysia’s KWAP, the civil servants’ pension fund, has done exactly that, by exploring overseas markets. It is now beginning to build an alternatives exposure, says Khairul Azwa Kamalul Bahrin, director and head of risk management and compliance.
Moreover, relying on quantitative data isn’t sufficient. It’s hard to know how much historical data is required to make a sensible analysis. Monk says investors need to do more hands-on due diligence.
As they adjust their asset allocation, they need either to go into the field more regularly (relying less on external managers or consultants for due diligence) or develop partnerships in distant markets. North American investors such as Calpers and British Columbia Investment Management have expressed their intention to do that.
When it comes to time horizons, Monk says, “Institutional investors have given up a comparative advantage,” noting that they are long-term in theory but no longer in practice. Peer risk, the desire to escape volatility and sometimes regulation has shrunk institutions’ holding periods.
This is changing, however, as many pension funds move more into illiquid investments, including private equity, infrastructure, timberland and real estate. These exposures provide long-term cashflows and protection against inflation.
To make this work, however, requires huge changes in how many funds operate. Governance is probably the hardest thing to get right. Decisions can’t constantly be second-guessed by trustees or higher-ups. Aligning manager interests is always difficult, especially so in areas like private equity. But those funds that get it right can focus more on big-picture trends and capitalise on them (think climate change, demographics or infrastructure needs) rather than get bogged down in day-to-day market volatility.
Finally, Monk argues that more investors are in-sourcing mandates in order to save on fees. At the most progressive end, he says some institutions such as the Netherlands’ APG are even seeding their own external managers, in a sort of incubation model.
He claims that in-sourcing last year saved the Alberta Investment Management Corporation as much as $50 million in fees, and that Calpers has made even bigger savings by renegotiating with its hedge-fund managers over base management fees, which may need to be high for small players and start-ups but are not justified for big ones.
Finally, Monk says institutions should do more co-investing, although he acknowledges that this is hard in practice. There have been one-off instances, but few institutions have the fortitude or understanding to develop meaningful relationships that can survive arcane legal problems as well as the ability to say ‘no’ to inappropriate deals.
Nonetheless, he says investors can do better at leveraging local knowledge in overseas markets. Pooling capital provides scale, access to bigger deals, and diversification of risk. “Trust and mutual respect are better than signing an MOU,” Monk says.
Many funds say they are in-sourcing more. For example, Singapore’s Central Provident Fund used to outsource 100% of its assets, but is bringing many of these in-house, says Don Yeo, deputy to the CEO.
“I like in-sourcing,” adds Terry McCredden, CEO at Australia’s UniSuper, who says this has saved a lot on fees. In the case of core Australian equities and fixed income, he says UniSuper’s performance has been as good as or better than most outside firms.
UniSuper still uses external managers for tilts in its portfolio, for strategic asset-allocation reasons, and to create specific mandates tailored to the fund’s liabilities. To do more by itself, moreover, requires superior operations, systems and risk resources, as well as the ability to recruit seasoned market players.
The trick is to have good governance that assures veteran portfolio managers and risk officers that their decisions are not going to be second-guessed by trustees.
Many pension funds find this last hurdle a difficult one. Lee Kyungjik, head of global equities at Korea’s NPS, says governance is a challenge. He notes that the National Assembly is considering a law that would enable NPS to spin out its investment management team into a separate entity that could be managed along private-sector lines. But there is little momentum in parliament, he says.
This is a challenge in the United States, too. Jim Sherwin, director of public equities at the Employees Retirement System of Texas, says it’s difficult to have a strong, autonomous CIO when there are multiple stakeholders on the board of trustees that need to be included in many decisions.
But this hasn’t stopped the Texas fund from forging deeper relationships and seeking co-investment deals for its private equity portfolio. Sherwin says his fund has successfully used a sub-advisory model for its external managers.
Some fund houses don’t want to participate along those lines, as it denies them full discretion, but such relationships become very deep. Over the long run, managers will benefit, because the pension fund is likely to retain external partners even in years of poor performance.
Monk’s views are increasingly becoming mainstream, then, although not every suggestion fits each institutional investor. But the painful experience of 2008 is pushing pension funds and other long-term investors to refocus on the internal governance they need to behave like real-money accounts, capable of taking suitable risks over the long haul.