Lessons in how not to do it
One of the most interesting reports to emerge in Ireland following on from the reserve fund announcement by the government appeared in December 2000.
Commissioned by the Irish Association of Pension Funds (IAPF), the report by consultancy Shane F Whelan & Co focused on the possible investment strategies that the NPRF might adopt, bearing in mind the fiduciary responsibility of the independent commission overseeing the assets – namely optimal returns subject to prudent risk management.
The report began by outlining the importance of the task ahead for the commissioners in selecting the fund’s investment managers.
“By 2025, and assuming the fund is then 42% of GNP, an additional 1% of return in that year would amount to a tidy IR£250m (E357m) in today’s terms. Since a 1% variation in any one year is commonplace between investment managers with the same investment brief, the role of those charged with selecting investment managers for the fund, the commissioners, is financially significant.”
For the IAPF, the significance in producing the report lay in the long-term investment objectives of the commissioners, which they noted mirrored those of pension fund trustees.
“The key financial decision facing the commissioners is how to interpret the general investment objective and put it into a workable format by prescribing a mix of equities (domestic and foreign), bonds, cash, and other investments, deemed suitable as a long-term asset class.”
One aspect where the report congratulated the Irish government was in its hands-off approach to the fund’s investment strategy.
Highlighting the lessons learnt from reserve funds in around 50 countries worldwide, the report noted that “politically motivated” investment had often lead to “dismal and at times disastrous” returns.
“The lessons from the international experience are overwhelmingly of the form of what not to do and, in the drafting of the current bill for the Irish fund, it is clear that these lessons were foremost in the minds of the drafters.”
Quoting the Iglesias and Palacios survey of 2000, a study of similar schemes around the globe, the Whelan & Co report noted that, on average, such government funds tended to be skewed in their investment towards government bonds (averaging 75% from a sample of 34 national funds), housing bonds (14%) and directly held property (8%). Incredibly, equities, it pointed out, accounted for just 3% – with Japan being the highest at 19% – while foreign assets represented a similarly measly portion.
Referring to the survey, the Whelan study noted: “These findings are consistent across countries of all types, but returns are especially dismal in countries with poor governance. The experience suggests that the rationale for prefunding has been seriously undermined by the public management of pension reserves.”
To prompt the Irish government away from this type of interference, the Whelan & Co report referenced the investment board of the Canada Pension Plan as an example where appointments were kept at arm’s-length from the government and the board was made up of experienced professionals used to maximising investment returns.
Furthermore, one of the main findings of the report was that the fund should shun domestic investment in favour of allocations to overseas securities.
At the time of publication, the report also recommended that the NPRF should initially buy foreign bonds rather than equities due to the extreme valuation ranges of global equity markets.
Again, drawing attention to the experiences of other countries with similar funds, which had mainly invested in government bonds and rarely abroad, the report noted that these had sometimes resulted in returns even lower than those on bank deposit rates.
With the NPRF subject to only one restriction – investment in Irish government bonds – the report went on to argue that the best idea for the fund would be to select investments that minimised the effects of any shock to Ireland’s economy.
As a result, it recommended that allocation to sectors over-weighted in the Irish market should be ‘de-emphasised’ in the reserve fund’s asset allocation, while diversity into industries in which Ireland is deficient, such as oil exploration and refining, should be encouraged.
On the back of high equity prices higher, the survey also recommended that the commission adjust the ratio of exposure to shares down to about 50%, even if its long term benchmark range might be between 50–80%.
It continued, though, by saying that the benchmark rate should also be reached as quickly as possible.
Regarding currency, the report also advised that the fund should be able to selectively employ hedging techniques.
Up to this point, the report could well have been the blueprint for the commission’s eventual strategy.
One area where views differed slightly, however, was the realm of ethical investment.
The consultant argued that the fund should not necessarily favour investment returns over moral responsibility, noting that “commissioners_should not seek out profit opportunities in areas abhorrent to Irish sentiment”.
However, even here the report shied away from laying down any proscriptive terms: “We prefer to see the commissioners use their discretion.”
To end, the report wished the commissioners well, signing off with a quote from John Maynard Keynes, outlining the challenge ahead: “Finally, it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness: and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”