A truly active approach to equities based on fundamental research and a disciplined investment process
The investment world has changed in seemingly contradictory ways. There are more opportunities to add value, but also easier ways to default to market returns. The relationship between pension funds and their asset managers needs to be reset with new rules of the game, to reflect these changes
Fiduciary management can be a very effective response to governance challenges in a complex world. To be done well, the ownership of all the pieces of the puzzle needs to be better and more transparently shared between pension funds and asset managers.
Pensions are a bellwether for the health of a long-term investment mind-set. In a framework where the majority of liabilities or outcomes will not fall due for decades (irrespective of whether they are part of a defined benefit, defined contribution or other system or structure), pension schemes should be the ultimate form of ‘patient’ capital.
Today’s investment universe offers golden opportunities to reinforce such an approach but headwinds have challenged the ability of pension funds to take full advantage. Ultimately, the response required is a governance one.
Historically, there were natural straitjackets for pension funds when it came to investing: they could lend (invest in debt) or own (invest in equity). Their lending was traditionally limited to governments and companies in the form of standard capital market instruments; lending to households was the preserve of banks. Ownership was historically limited to listed stocks, highly tilted to the domestic market.
With these simple building blocks, an investment portfolio designed around an equity-bond mix was perfectly logical. It aligned neatly with the academic idea of a ‘market portfolio’ of risky assets (represented by the stock market) balanced by a portfolio of risk-free or defensive assets (high-quality bonds). A portfolio comprising 60% equity and 40% bonds (a ‘60/40’ portfolio) became the generic basis for investing, providing some risk but not too much.
Subsequently, other users of capital began to access pension scheme money. Initially, similar proxy risk-assets were the most successful. These could be overseas companies via an offshore equity allocation, domestic and commercial property assets, or private equity investments via a protective fund-of-funds structure. In essence, investors attempted to swap out of one risk asset that they understood for others, tentatively dipping into areas that were less familiar.
These newer asset classes were seen as an alternative to the traditional portfolio, rather than a meaningful component of it. With time and familiarity, however, many have become mainstream holdings. For those looking for patient capital, it has become increasingly available direct from investors. This has itself changed the necessity for public market listing or bank financing (see Chart 1).
While equity broadly remains equity whatever its flavour, arguably the debt universe has caused the greater disturbance to the old model. For many years the debt allocation crudely equated to ‘defensive’ assets. Today, investors can access a broadening array of cashflow-generative assets that offer more equity-like returns.
The simplistic concept of a monochrome 60/40 portfolio has therefore gone and with it the old taxonomy of asset classes. Some alternatives have become “traditional” and therefore the range of assets that can contribute to return (while also potentially dampening volatility) has widened. This broader opportunity set, more palatable illiquidity and asset owners taking greater direct ownership with less intermediation offer the potential for better outcomes (see Chart 2). With these attractions, however, come accumulated governance challenges.
But the shift is not only about having more investment choice. At the same time as new opportunities are finding their way into pension funds, there is a contrasting move away from active management in favour of passive investing.
as new opportunities are finding their way into pension funds, there is a contrasting move away from active management in favour of passive investing.
While the perceived failure of active management is an oft-cited reason for this trend, there are other significant forces at play. The world’s largest pension funds – as well as large insurers and sovereign wealth funds – have had to deal with the negative effects of their size. There are certainly more resources available for larger investors to be active, but there can also be constraints when simply investing in public markets, especially given the growing concentration of market weight in fewer names (see Chart 3). Being large means having to own the market – so by default you become a passive investor. Meanwhile, smaller pension funds are feeling the lure of passive investing, as simplicity and cost have moved to the top of their priority list.
The resultant somewhat contradictory blend of trends – harder-to-bucket new investment opportunity sets and simplified implementation approaches – has strained the governance-setting framework. Schemes are faced with a pressing need for updated investment governance frameworks that will properly make sense of the combination of new and old investment styles and opportunities, and provide clear directions for asset managers to follow. All this is also in an environment of increasing regulation, increasing cost pressures and increasing scrutiny of the decisions and actions of trustees.
One problem for trustees has been the way in which long-term return expectations have been used to set an SAA benchmark, which has become too “set in stone”. In a world where traditional markets are likely to experience challenges ahead and asset managers cast the net wider in the quest for returns, new forms of active management have become a necessity. Yet an appropriate governance response needs to acknowledge that specific investment returns are highly uncertain and increasingly hard to group consistently, and that it is burdensome to make significant changes to SAA with every ebb and flow of the market. The granular control that trustees have exerted in the past – the static fixed-weight asset allocation populated by discrete and narrowly focused fund managers – allowed the asset owner more control but potentially resulted in opportunities being missed because the investment process is more static. For example, the manager is less able to respond in an effective and timely manner to new opportunities that might arise. This has had to give way to approaches that accommodate the evolving landscape. The return and risk expectations will still be at the core of the process - but these levers can be used in different ways.
One common approach since 2008 has been for pension funds to give their managers ‘outcome-orientated objectives’, setting a goal, such as cash + x% or inflation + y%, that is aligned with the asset owner’s specific requirements. The logic of this approach is that investors are simply delegating the investment decisions to professionals, who then have the flexibility to use all their capabilities to try and achieve the required performance. The level of trust placed in the asset manager is meaningful. And yet there is nothing, other than the end goal, that connects the asset owner to the asset manager. For many, this is too complete a delegation and does not represent a balanced fiduciary relationship.
So how can we bridge the gap, harnessing the insights and skills of the asset manager, while ensuring they are empathetic, aligned and understood by the asset owner? We believe the best relationship is one that does not pressurise asset owners to make a binary choice between micro-management and full delegation. Instead, developing the asset allocation by first establishing a reference portfolio can be a useful framework for both asset owner and asset manager alike, making both parties complicit but separately accountable to the process.
A reference portfolio translates an outcome-orientated objective into an initial and simple, specified mix of assets. It is typically a selection of passive market indices that best represents the desired risk and reward characteristics of the investor over the long term. It can be considered the ‘buy-and-hold’ portfolio that would be selected by asset owners were they to conclude they were unconvinced by active management and new asset classes’1. Such a portfolio would include the following characteristics.
This approach then allows the asset manager to create a dynamic and granular portfolio, to be assessed against this more straightforward but slower-moving comparator over longer-term investment periods. This balances the complex reality of the investment universe against the simple reality of choice of investment approaches available, and offers a helpful way to reset the asset-owner/asset-manager dynamic within the pensions industry.
While the rise of fiduciary management (see Chart 4) is a positive step in the governance process, we believe it needs to reflect the principles behind the asset-owner/asset-manager relationship to be an appropriate arrangement. Otherwise a complex investment programme loses connectivity and accountability when compared to an ever more realistic and more straightforward alternative in the form of a reference portfolio.
None of this means that the job is done. This is not a one-off reset of the 60/40 portfolio to a new framework with a systematic answer. Governance can be enhanced but can never stop. The key liberation of the approach described is to bring realignment and accountability to the pension scheme’s true long-term investment potential.
For instance, the focus could move to investment markets as they might be in five, 10 or 20 years; a different balance of geographies; ownerships across capital structures and not simply within asset-class buckets; or active ownership of assets and not funds. Ideally, pension portfolios will be created that reflect the changing nature of the world’s financing basket and maximise the opportunities available. In this way, pension providers can strive to meet their end-goal of being able to pay that last pensioner liability in 40 or 50 years’ time.
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