Almost every pension fund, sovereign fund and other institutional investor throughout Asia has been reassessing their risk management and asset allocation framework since the financial crisis of 2008-2009. More recently, institutions’ desire to improve their investment approach has extended to their governance framework as well, says Mahendran Nathan, Russell Investments’ CEO for Hong Kong, Taiwan, India and ASEAN. “As we engaged clients more closely over the last two years, we noticed significant gaps in the quality of advice and innovation available, especially around the finer points of planning an investment strategy and establishing a governance framework for improved long-term outcomes,” Nathan explains.
Trevor Persaud, the firm’s newly appointed practice leader for consulting and advisory services in the region, suggests that building a robust governance framework need not be a complicated exercise. “The starting point is as simple as stating and agreeing an investment objective before building an investment plan and executing it. It sounds like common sense, but in reality it doesn’t always happen that way. There has been significant volatility in the Asian markets, so investment approaches are cyclical and investors often move from one bandwagon to the next. For example, returns from style or thematic investing, value or fundamental investing, under some market conditions can look like alpha, but when those specific market conditions disappear, what next? What is the overriding objective and thus driver behind the next approach or allocation and will it pay off through the cycle?”
The questions trustees and investment committees might need to ask are fundamental. For example, what is the central criterion of any investment decision, ranging from investment strategy, universe of allowable instruments to desired portfolio structure and characteristics? If the central requirement is liquidity, all decisions must be centred around liquidity. Nathan gives an example of how this might work: Let’s say an institution requires a liquid local-currency fixed income strategy but desires more alpha than that market is likely to deliver. In this case, a portable alpha strategy may be the right answer. A modest,say 5% to 10% non-domestic allocation, will likely conform with both liquidity and alpha requirements. Furthermore, if the non-domestic allocation allows for underlying derivatives exposure, much of the liquidity, currency and even credit exposure can be hedged out . If the institution decides against any derivatives, the liquidity constraint would be key in determining the right diversifying allocation that is consistent with the overall return objective of the plan and with proper risk management.
Russell’s approach to establishing a governance framework looks elegant, but Nathan and Persaud recognize that there are practical challenges. Persaud says: “We need to decompose the thinking process and behavior of the people involved in the investment process, including investment committees, boards of trustees and investment teams. For example, some might have pre-conceived perceptions about derivatives, but is it relevant to the fund’s specific circumstances currently?” Nathan thinks that it is important to engage investment committees and trustees as well as investment teams, but how much time would they have for soul searching?
Perhaps a metric Russell devised might help institutions decide where they stand. In 2009, Russell surveyed about 200 pension funds in the UK, which resulted in a governance benchmark that institutional investors can use to compare their decision-making and governance practices with peers’. The benchmark gauges six areas: First, the fund’s structure which ranges from lean to super-resourced. Second, the accountability fog index shows whether a fund has high or low clarity on who takes ownership of each decision. Third, a delegation index which indicates to what degree the trustees have entrusted investment decisions to an investment committee, an in-house investment team or an external investment manager. Fourth, a confidence index indicates how confident respondents are in varying aspects of the fund’s decision-making. Fifth, the trustee time spent index gauges how much time trustees spend on investment matters. Sixth, the internal expertise index measures how much in-house investment expertise is available.
Russell’s survey found that large pension schemes in the UK, those with £500 million to £999 million, have a higher tendency to be less clear about who is accountable for each decision. The report suggests that when results are unfavorable, a blame game can materialize. The most ambiguous area appears to be investment decision-making. One in three respondents indicated numerous parties, such as the trustees, investment committees, the in-house team, advisor or actuary and external parties, were involved in making each investment decision, ranging from investment strategy to manager selection.
The survey also found that some trustee boards that have delegated investment work to an investment committee duplicate the committee’s work. Inadequate oversight of the investment function is another area of concern, especially for small and mid-sized pensions of £100 million to £499 million in the UK’s case. Often, pensions of this size have fewer resources for monitoring.
Given these findings, Persaud thinks that investment committees and trustee boards―which are often comprised of mostly non-investment professionals―may work more effectively if given softer, non-investment training. “The board might focus on accountability, delegation to qualified investment professionals and placing confidence in the professionals they selected. The board’s objectives need to be clear: Are they playing an executive role, delivering results, and checking on managers? If so, do they have the necessary resources to do so? Or are they playing a non-executive role with oversight and governance responsibilities?”
He observes that often, boards of trustees in this region―consistent with Russell’s observations globally ―have little clarity on their roles. “Many boards inevitably focus on immediate or topical issues such as short-term performance of managers or inflation-hedging as opposed to truly strategic long-term investment issues such as determining risk tolerance, strategic asset allocation and the right range of investment alternatives that can achieve their long-term objectives.”