Gail Moss assesses how pension fund boards and trustees can make sure their interests are in line with those of their asset managers
Alignment of interests between service providers and pension funds has always been a holy grai. Taking the recent market turbulence into account means that pension fund trustees have an even more pressing need to ensure their asset managers are working in the fund’s best interests.
Mn Services, the Dutch fiduciary manager, has seen the recent market crises as an opportunity to strengthen the governance structure of its relationship with pension fund clients by redefining responsibilities, increasing the use of in-depth reporting, and evaluating fee structures.
The company has also strengthened the governance structures between its in-house fiduciary management department and its in-house asset management function - in other words, the internally and externally managed mandates. It has also strengthened the governance structures between mandate selection and monitoring on the one hand, and internally managed mandates on the other.
The due diligence processes for selection and monitoring of external managers have been strengthened. Mn Services now places even more focus on risk management, risk reporting and downside protection, while ‘know your relation’ - deep screening of current and potential relationships - has become common practice.
The Danish pension fund PKA has also modified its relationship with asset managers in response to the financial turmoil.
“We are focusing on how managers can perform in turbulent markets and to what extent they are reacting, to market conditions,” says Claus Jørgensen, PKA’s head of equities. “We believe our managers should adapt to new market conditions, but not panic. We do not want them to totally change strategy, because we chose them for the strategies they already have. These strategies should be performing all the time, rather than just in these markets.”
This emphasis on consistency is echoed throughout the pensions community. “Trustees should have an effective strategy based on what they are trying to achieve - for instance, buyout or self-sufficiency over, say, 10-20 years,” says Andrew Birkett, group pensions manager, Babcock International Group. “There should be clear flight paths and triggers to move from growth assets to hedging assets, and triggers within hedging portfolios for buying interest rate and inflation swaps to match future cash flows.”
Birkett adds: “It’s a bit like professional golfers who make a big play about having the same pre-shot routine all the time, so when the going gets tough they can rely on using the same approach to provide stability and maintain their strategy.”
He says that, in times of turbulence, trustees, employers, investment advisers and fund managers could meet more frequently, since trustees and employers need to understand how markets are performing and expected to perform and they need their advisers and views of their managers.
“This enables trustees to take advantage of opportunities as markets are dislocated,” he says. “It will help them to move along their flight paths by seeking an opportunity, improving the funding level, then de-risking by switching some growth assets to hedging assets.”
However, assessing investment performance is a notoriously subjective task, especially in terms of the timescale over which asset managers should be judged.
While there may be a consensus that it is the long-term picture that matters, what exactly is the long term?
“I believe long term means at least 10 to 20 years,” says Piero Marchettini, managing partner, Adelaide Consulting. “However, the impact of unusual events, such as legislative changes, unpredictable market movements and the unorthodox policies of central banks, may require a much shorter-term focus by the pension fund board. This means a much more frequent assessment of asset managers’ performance, for instance, every two to three years.”
But a distinction has to be drawn between long-term performance and shorter-term monitoring, says Wouter Pelser, chief investment officer at Mn Services.
“Whereas in the past, performance was often the key indicator to evaluate a fiduciary manager, the focus today has partly shifted towards more strategic performance drivers, such as strategic advice for investment plans and strategic allocation decisions,” he says.
As an employer of managers, Mn Services also monitors all of its own managers on a quarterly basis. During these sessions, it evaluates performance within a number of other criteria. Manager performance is typically assessed over a three to five-year period. Having said that, the company judges performance based on each manager’s individual style.
“In our portfolio, each manager has its role,” says Pelser. “If a manager with a so-called downmarket protection investment style underperforms slightly in a rising market, we are not worried. But if the same manager underperforms in a bear market, we will intensify our monitoring.”
One problem is a potential mismatch between the investment horizons of the pension fund and of the asset managers. “In the past, investors generally have just looked at the long-term horizon,” says Carl-Heinrich Kehr, principal, Mercer Investment Consulting in Germany. “Our experience is that they are reluctant to fire an asset manager after a few months of poor performance. On the other hand, the fund manager has a much shorter time horizon.”
Kehr warns that investors need to understand how the asset manager is performing over the stages of a market cycle.
“I think investors should pay more attention to mid-term horizons,” he says. “They can adopt temporary strategies such as risk overlays, to get away from buy-and-hold, thereby reducing risk and providing opportunities as well.”
PKA normally changes one or two of its mandates a year, although the number has increased in the past couple of years. “If we have a manager underperforming for three to five years, we look at it from a quantitative angle, while also analysing the standard qualitative parameters such as people, process and strategy,” says Jørgensen.
“In relation to the quantitative angle, we look at the extent of the underperformance and the length of period over which the manager has underperformed. The longer this period is, and the higher the extent of the underperformance, the bigger the probability that this is a manager who doesn’t have the skills that we like to see.” PKA also performs this exercise during more normal market cycles.
Babcock’s Birkett says managers should al-ways be under review: “Wise trustees would have a substitutes’ bench in case a decision was made to reduce the length of time taken to hire and fire a manager. The old days of leaving funds with a manager for three to five years, then taking nine months to decide to sack them, are long gone.”
“Investors should focus more on the medium term, ie, three to five years,” says Michel Meert, senior investment consultant at Towers Watson. “We think that too much focus on short-term results can have a negative impact on long-term objectives. But meetings tend to be held every quarter, so trustees and institutional investors in general should be looking not only at quarterly performance, but also results for one, three and five years.”
Meert says that investors have wanted to fire their managers after short-term poor results, especially during the recent financial crisis. “On many occasions we have advised our clients not to do this,” he says. “Poor quarterly performance doesn’t necessarily mean the asset manager has become a bad manager.”