Loneliness of long distance runners
This month’s Off The Record considers the question of short-term and long-term thinking in the management of pension fund assets.
Are asset managers are taking a sufficiently long term view when managing the portfolios of pension funds ? Or are they driven by a need to perform over the short term to be sure of retaining their mandates?
There is a growing feeling among pensions fund managers that investment management is now structured in such a way that short-termism is inevitable. Peter Moon, chief investment officer of the Universities Superannuation Scheme (USS), one of the largest pension schemes in the UK, speaks for many: “It almost goes without saying that pension funds should invest for the long term. Unfortunately, the current system of investment decision-making has much stronger management mechanisms for ensuring relative outperformance over the short-term. Yet, as all runners know, you cannot hope to win a marathon by treating it as a series of sprints.”
Now USS and pension consultants Hewitt, Bacon & Woodrow are organising a competition for asset managers to encourage them to devise a truly long term solution to the management of pension fund assets.
The idea has won qualified approval from the European Asset Management Association (EAMA) the body that represents European asset managers. Klaus Mössle, president of EAMA, says that he accepts that many pension fund mandates may have been awarded to asset managers “without adequate regard to the asset liability matching requirements of pension funds”. He admits that asset managers must accept some blame for not raising their voices loudly about this and insisting that their mandate reflect a sensible overall investment strategy of their pension fund client.
However, he thinks that asset managers should not have to bear all the blame for “short termism”, since it is up to pension plan sponsors, advised by their consultants, to decide on the risk-return profile of the overall investment strategy.
Perhaps the buck does not stop there. Perhaps the supervisors and regulators should be included, particularly those that insist on pension funds selling equities in a falling market? Perhaps credit analysts are also to blame, since their downgrades can encourage companies to take short-term action to remove long-term pension liabilities from their balance sheets?
Moon says the whole investment industry needs new thinking. But what will this mean for pension funds? A move out of equities into bonds? A move out of asset management companies altogether and back into banks and insurers? We wanted your views on where you think the problems lie and what you think should be done about them.
There is no doubt from the response to our questionnaire that short-termism is seen a problem. A large majority of the fund managers and administrators who responded (77%) agree that fund managers in general are too focused on short term performance. This is not seen as a problem confined to fund managers. Almost as many managers (73%) feel that the overall investment decision-making system has become more short-term.
It is also clear that asset managers are not the only culprits. We asked who was most to blame for short-termism – asset manager, consultants, pension fund managers, pension fund boards and trustees – or all of them. Blame is evenly spread across the various disciplines, with exactly half (the respondents 50%) saying that all were to blame. Some managers single out individual culprits of their own, notably the financial supervisory authorities. Others spread the blame more widely and include the market system as a whole.
One solution to short-termism, often proposed in the past, is that asset managers should be awarded mandates of longer duration than the typical three years. This idea gets mixed support, with exactly half of the respondents (50%) in favour of longer mandate durations.
However, the feeling is that they should not be substantially longer. Most (81%) are prepared to extend asset managers’ tenure by only two years to five years. A far smaller proportion (19%) are prepared to countenance 10 year mandates. And perhaps it should come as no surprise that nobody is prepared to trust part of their portfolio to an asset manager for 20 years.
Perhaps pension funds would be more prepared to award longer mandates if they were able to reserve the right to terminate them if asset managers failed to do what they were supposed to do. One UK fund manager suggests the compromise of “a longer duration but with the opportunity for a break clause to be operated if the underperformance limit has been breached”. Another suggests longer mandates would be acceptable so long as they were cancellable.
The advantage of longer mandates is that they would enable asset managers to show pension funds what they could do over the longer term. This would stand them in good stead when the time for re-selecting managers came. “It would switch the emphasis to good long term performance to seek to retain the business rather than focus on shorter time periods,” says one manager.
Few of those who approve of longer mandates are worried that they would give asset managers too long a leash. Clearly, respondents feel that it is up to pension fund managers and their investment committees to ensure that asset managers do not stray from their brief. We asked whether longer mandates would give asset manager too much freedom. Two thirds (64%) think not. “Not if one defines adequate controls on the management agreement,” says the manager of an Italian pension fund. “Not if the investment committee manages them properly,” says a UK pension fund manager.
Turning from asset managers to asset classes, the proposition that fixed income is the only appropriate match for long term liabilities gets short shrift from respondents. A small minority (10%) agree with this, suggesting even more strongly that the move out of equities by the Boots pension fund was a one-off event rather than the beginning of an asset allocation trend.
The word “only’ worries some, however: fixed income is an appropriate match for pension fund liabilities, but it is not the only one, one manager says. Another rightly insists that the whether or not fixed income is an appropriate match will depend largely on the circumstance of the fund. “Fixed income is appropriate only insofar as the liability portfolio is nominal and stronger, so that the net cash inflow in the asset portfolio is zero,” the manager of a Dutch pension fund points out.
If pension funds are prepared to take risks over the longer term, what risks should they take? Should asset managers consider alternative investments such as hedge funds as a match for long-term liabilities? Most of the managers in our survey (70%) see no reason why not. However, the minority feel that hedge fund are essentially short term instruments.
One way of ensuring that asset managers are fully aligned with the objectives of the pension funds that hire them is to bring them in-house; in other words, to have an internal asset management operation. This idea gains little support, however, with a small minority (17%) favouring such an arrangement.
The objection is that in-house management may be too costly for smaller pension funds. “Depending on the size of the fund in-house management may be more expensive than an outsourcing arrangement ,” says one manager. “Smaller funds may not have sufficient resources to manage their investments internally, especially in an increasingly complex investmenent environment.”
A more radical solution to dissatisfaction with asset managers’ short-termism is to get rid of asset managers altogether and to give the business to banks and insurance companies. This suggestion provokes a collective shudder among our respondents. Only a mischievous minority (3%) think that the financial services behemoths would do a better job than asset managers. For the rest, it is clearly a case of “better the devil you know…”