Investment Solutions: Very real problems
Complexity in regulation, heightened demand for efficient liability management, market volatility and the sheer breadth of investment opportunities have created demand for a different type of relationship between asset managers and pension funds, writes Liam Kennedy. How are they meeting this demand? And, with a new generation of ‘modular’ or bespoke fiduciary management mandates, are the boundaries between fiduciary management and ‘solutions’ breaking down?
Successive crises have laid to rest the notion either that pension fund risk management relates solely to the asset portfolio or that trustees’ and sponsor’s objectives can be efficiently met on the basis of infrequent meetings and a patchy decision-making process.
The last decade has seen growing recognition of the need for better liability risk management, and for decision-making structures that can take a dynamic approach to hedging requirements, while simultaneously taking account of increasing complexity of regulation, asset considerations and, not least, the overall objectives of the pension fund.
Investment banks were among the first to position themselves as ‘solutions providers’, and most of the major banks have created – and frequently disbanded, or reorganised – dedicated teams for the servicing of pension fund clients. Some of these teams, including the individuals who later went on to create the London-based consultancy Redington, were among the first to implement interest rate swaps for institutional clients in the early years of the last decade.
A few disparagingly viewed these teams as a thinly-disguised sales force designed to drive over-the-counter derivatives business; others were less interested in who was doing the selling if the advice and the outcome were satisfactory.
While many pension fund managers are happy to deal with the right provider on a transactional basis, the flaw in the investment-bank-as-pension-adviser model was the transactional basis of the business: after a swap was arranged, the advisory team did not have a vested interest in the pension fund, or insurance company, meeting its objective.
For some, particularly in continental Europe where investment consultants do not have the market penetration they enjoy in the UK, there seemed to be a gap in the chain of command in investment oversight, with no external party to oversee the execution of the overall strategy and to ensure the fulfillment of funds’ long-term aims. “Hedging interest rates and inflation were an early recognition that you do need to look at things in the round,” says Raymond Haines, head of European strategy and research for the investment solutions group of State Street Global Advisors (SSGA).
Perhaps it was no coincidence that, around the time the first interest swaps were implemented for institutional investors, a few individuals in the Netherlands decided to push back against the prevailing investment orthodoxy of the time, which favoured best-of-breed appointments in a value chain that was largely fragmented. In 2002, Haitse Hoos, then CIO at the insurer VGZ and working with Anton van Nunen, appointed Goldman Sachs Asset Management (GSAM) to manage €1bn in assets that had been run on a segregated basis by three domestic or regional managers and GSAM itself.
Hans Kestens, a board member of VGZ, was quoted in IPE at the time: “Although good and solid asset management is essential for our organisation, we do not have the expertise to cope with the changing complexity of international financial markets.”
Since then, a rise of fiduciary management has taken place in parallel with the emergence of consultants and asset managers competing not only for full-service, integral fiduciary business but also for problem-solving assignments that often involve an execution element, or delegation of specific tasks on a basis that falls short of full fiduciary management. These could include risk overlay or LDI components, or design and build for a bespoke portfolio of diversified alternative assets, with specialisations usually dependent on the background of the provider.
Speaking on an analysts conference call in April 2013, Larry Fink, chairman and CEO of BlackRock, noted the growth in his firm’s solutions business: “We’re having more dialogues with more large clients than ever before on the solution fiduciary-type of businesses,” he said.
Other large managers see the same trend. “We are increasingly seeing some of the largest funds around the world asking us to undertake specific projects, ranging from views on private equity to inflation hedging to thinking about factor-based asset allocation and how they would apply it to their portfolio,” says Haines at SSGA.
This articulates a clear change that has been taking place in the investment management industry, particularly since the fallout from the financial crisis in 2008-09. The emergence of opportunities in a wide range of asset classes in 2009, including corporate credit and convertibles, led some pension funds to adapt their governance models and provider relationships to improve decision-making processes and exploit market opportunities.
This period also reinforced the need for an integral view of asset and liability management, and for new asset management business models based on addressing clients’ broader requirements not just managing one or more asset components. Haines describes this as “like a consulting discussion”.
Not a few institutional investors, and pension funds in particular, are looking for someone to listen to and understand their problems, to deploy quantitative risk and modelling capabilities in defining a solution, to implement this solution in practice and, in some cases, to have a vested interest in the outcome. This requires a mix of quantitative and qualitative skills, but in many cases places asset allocation skills at centre stage. It also challenges asset managers’ traditional business models, where these have been focused on asset gathering and fee generation.
Asset managers must be under no illusions as to the capabilities resources needed. Spence Johnson, the London-based consultancy, cites performance, transparency, efficient and effective client servicing, track record, a balance between innovation and simplicity, and effective distribution.
Nigel Birch, director at Spence Johnson, singles out two other areas for particular attention – scale and alignment of interests. “To provide bespoke investment solutions the operational robustness, diversity of skill set and expertise, systems, intensive client servicing and investment clout all require tremendous economies of scale to be efficient,” says Birch.
“Being able to demonstrate a true alignment of interests with clients is perhaps the most critical success factor and a challenge that exists on many levels. Not only must providers’ businesses be free of conflicts, their solution must be aligned with clients’ interests, as must the investment component, the advice component, the fee and incentive structures, and the oversight, monitoring and reporting piece.”
Amin Rajan, CEO of CREATE-Research identifies two obstacles: “Most asset managers are not close enough to their clients to have a good understanding of their needs, liabilities and risk tolerances,” he says. “Nor do they have the capabilities to assemble multiplicity of component assets to deliver the solutions.”
Pension fund respondents to this month’s IPE Off the Record poll on investment solutions were relatively cautious when asked what asset managers needed to do to become a ‘trusted partner’ to institutional investors.
“They can provide valuable viewpoints and specialist knowledge about markets,” said a Danish pension fund. “Some asset managers also have almost independent asset allocation teams, which provide good advice. But the end decisions about asset allocation and manager selection must always be taken by someone whose salary is paid solely by the client/pension fund.” A UK fund saw the need for a clear separation between asset management and advisory services.
Fee structures must be free from conflicts if asset managers do make asset allocation decisions, the Danish pension fund went on to say, to avoid the obvious conflict of interest if there is a temptation to allocate to higher-fee equity products over fixed income strategies.
Some believe it is easier for asset managers to add an element of advisory work to their business than it is for consultants to add execution elements to theirs. For their part, asset managers say they are aware of the challenges.
“There is an array of investment challenges that clients bring to the table,” says Richard Urwin, head of investments for fiduciary mandates at BlackRock’s solutions unit. “Even though it is possible to group these together, at least part of what each client is trying to achieve is idiosyncratic so we have to be very flexible in understanding what clients are trying to do so we deliver success on their terms rather than on our terms. What we try not to do is draw hard and fast lines.”
BlackRock structures its solutions relationships around what Urwin terms a “focus group”, typically without a single client relationship manager but rather with a number of senior people who aim to collectively manage the relationship.
There is less talk of full service fiduciary management than there was three or four years ago, and there has been at least one notable mishap. For Vervoer, an early adopter of fiduciary management, dissatisfaction with the implementation process of the fiduciary, GSAM, led to a lawsuit, which is ongoing. As we note elsewhere in this report, there has also been a fundamental shift in thinking about fiduciary management, particularly in the Netherlands, but also elsewhere.
Managers are keen to emphasise their flexibility; although they use the fiduciary management label for recognition and convenience, they have no particular affection for it.
“The term fiduciary management is a misnomer,” believes Patrick Disney, managing director of SEI’s European institutional group. “We will work with different models around whatever level of delegation the client requires.
Richard Urwin at BlackRock agrees: “The term fiduciary management is becoming very fuzzy because it can mean very different things in very different contexts,” he says. “We’re not tied into one particular model.”
Other managers are waiting in the wings, or are at least officially not in the market. “Fiduciary management is something that we have the skillset to do, but have elected not to in EMEA,” adds Haines, noting that SSGA undertakes delegated CIO work in the US.
“Partly because this part of the world is intermediated to a great extent so it would be a crowded place to be.” AXA Investment Managers offers fiduciary management outside the UK but not in the UK market itself.
Of the largest 50 global asset management groups, nine, including Allianz Global Investors, M&G, Legal & General Investment Management and AXA Investment Managers have an insurer as a parent; in the Netherlands, APG and PGGM work for their parent pension funds and other external entities on a full-service basis.
Although an internal client may help asset managers hone their problem solving capabilities and solutions infrastructure, it is not straightforward for them to replicate this for other institutions. The internal client may distract an organisation from properly servicing the needs of external entities, or raise suspicions that it will always get preferential treatment in trade execution.
In early 2012, AXA Investment Managers announced the appointment of Laurent Seyer from Lyxor to run its investment solutions operation, which Seyer soon retitled multi-asset-class solutions.
“I would say the cultural challenge is probably the trickiest,” says Seyer of the process of creating a solutions unit. “We are a large group and a global company with a significant business with our parent company. Operations are always a challenge but I do believe that for a global company like ours the biggest challenge is the cultural one.
“We have a very strong derivatives team, but the challenge is to have the right people on the ground who are smart enough to utilise the skills within the organisation. I’m an asset manager, I know the pieces I can bring and I know I will sometimes have to partner with competitors, with consultants and with the scheme. It has to be a partnership.”
Are solutions groups just a repackaging of old capabilities? Are they a rediscovery of a better form of interaction between asset managers and pension funds? Or are they a fundamentally new way for asset managers to interact with clients? Arguably they are a combination of the three.
“What asset managers can bring is the asset allocation capacity, access to expertise and the fiduciary aspect that we manage third-party money,” believes Seyer.
Inevitably, solutions units will be judged by their shareholders on the revenue they generate. But the revenue generation potential for solutions is not as easy to forecast as in other areas of asset management, particularly where consultancy skills are in demand but there is no hourly billing, and where there is no certainty, of winning business for the execution of a particular service. But successful asset management solutions providers will have to live with this; pension funds will certainly see through asset managers where a ‘trusted partner’ culture is not embedded in the organisation, or solutions teams are thinly disguised asset gatherers.
Urwin points to longevity of relationships as a metric of success: “I think there is something a bit different about the solutions business,” he says. “It’s more about partnership, and partnerships that last a long time are good ones, so some element of longevity in these relationships demonstrates across a whole market cycle that clients have found it advantageous to work with us. It’s a loose definition of success and it’s not the only one but it’s a good one.”
Fluidity is certain in this market, and it is notable that SEI and Frank Russell started off as consultants but later moved away from this model towards implementation, as multi-managers and as delegated CIOs or fiduciary managers.
Others may adapt their business models, and many consultants, asset managers and large pension funds will converge on similar business models, involving elements of advice and implementation, with highly customised success criteria and remuneration structures.
Where smaller providers cannot compete in terms of scale for the resources and computational systems necessary, they may collaborate on a formal or informal basis.
The perfect storm of low interest rates, underfunding, volatile markets and regulatory complexity will not abate for some time. Demand for solutions to real problems is certain to continue.