One of the biggest problems for a lot of pension funds is that overall control over their investments has traditionally been in the hands of amateurs.
The day to day investment management may often be in the hands of professionals but the asset allocation is usually decided by the controlling board or trustees. This body is often made up of people who would not claim any great investment knowledge. The irony is that performance is mostly dependent on such big picture decisions rather than the day to day management.
Traditionally the answer to this problem was simply for a pension fund to give its money to a balanced manager but often it did not perform. Let’s face it, it is difficult for one organisation to be good at everything, so funds started appointing a number of balanced managers which didn’t really help. Sometimes it merely served to provide index performance. Occasionally it magnified performance which was okay when it was good but if you appointed a number of growth oriented managers at a time of value then it merely served to depress performance faster than might otherwise have occurred.
Of course a number of funds did appoint the same sort of managers in the early 1990s and were surprised in the mid-1990s when they all failed at the same time. But there again, as has so often been said investment management is one of those few purchases that tends to be made at exactly the wrong time. Either when the market is at its most expensive or by appointing managers just as they are about to underperform. Why – because we hire managers after they have had a number of years of good performance. Funds should be more willing to appoint good managers after they have underperformed. Every-one underperforms from time to time, why should funds not appoint managers at the end of their underperformance cycle rather than the start?
After funds realised that balanced management often didn’t deliver, they started appointing specialist managers, usually again at the wrong time, but progress was being made except that it left the asset allocation decisions in the hands of the trustees. Trustees were themselves advised by their actuaries and other investment advisers but tactical asset allocation often took a back seat whilst the trustees concentrated on strategy. Or rather more often they didn’t!
For a while, for good and then for bad, all that appeared to matter was how much money was invested in equities, other decisions appeared to be secondary. But can we say that now? After three years of a bear equity market, investment strategy matters even more and funds require a lot more help than ever before.
Naturally there are many asset management structures available. Last month I briefly looked at fiduciary management and it is clear that such a service might be capable of offering many advantages for the smaller and particularly mid-sized asset owner whether pension fund or insurance company. But what can fiduciary management offer?
According to Bob Litterman, managing director of quantitative resources at leading provider Goldman Sachs, “asset allocation skill is probably one of the single most important aspects of fiduciary management”. However it doesn’t stop there: “Other aspects include optimal strategic benchmark determination, risk budgeting and external manager selection and risk monitoring capabilities”. Quite a comprehensive service!
But does fiduciary management offer more than the alternative routes? Obviously no single strategy will work for everyone and even fiduciary management does not work in isolation. Litterman believes that “fiduciary management works best for a pension fund if used in conjunction with an external liability modelling consultant”. I can certainly see the logic of this. Whilst the more traditional asset liability studies are seen as discredited in some circles, funds still need to understand their liability profile. For too many funds the asset assumptions used in ALM were merely a reflection of recent experience and yet we all know that past experience is a poor guide to future performance.
The problem of a fund of funds route is that strategic asset allocation, risk appetite assessment and even tactical asset allocation may not be properly handled. Many manager of managers structures may also be too simplistic, hence the rise of something more tailored – fiduciary management.
However you decide to manage money, one of the key decisions is whether it should be done actively or passively. As they charge higher fees an active manager really has to convince funds that they can do better than passive management and convince trustees of that statement.
But picking the best active managers is a real skill. It is interesting to see that Watson Wyatt have now followed the example set by Mercers last year and published the results of their manager recommendations. Fiduciary managers don’t just publish league tables, they have to stand by their actual results.
Perhaps, one of the most appropriate indicators might be alignment of interest. Many managers argue that remuneration by performance fee ensures alignment of interest of manager with client. The key issue is to ensure that it doesn’t promote unnecessary risk taking. Time will tell.