Top 400: Investing for the future
Changing institutional investor thinking has profound implications for asset managers. Here, eight leading figures* from six international organisations – BlackRock, Caisse de dépôt et placement du Québec, Canada Pension Plan Investment Board, GIC, New Zealand Superannuation Fund and Ontario Teachers’ Pension Plan – outline progress made on an initiative to realign institutional investment with long-term goals
Focusing Capital on the Long Term (FCLT) is an initiative co-founded by the Canada Pension Plan Investment Board and McKinsey & Co in 2013. Its intent is to help shift market dynamics and behaviour in the investment value chain from excessive short-termism towards longer-term capital investment, business practice, and value creation for all stakeholders. If the major players in the market, starting with the world’s large asset owners and managers, adopt longer-term perspectives, we can create a virtuous circle across the investment value chain.
As part of the initiative, FCLT gathered 24 experienced investment professionals from nine institutional-investment organisations controlling an aggregate of over $6trn (€5.4trn) in assets under management to develop practical ideas for how institutional investors might reorientate their portfolio strategies and management practices to emphasise long-term value creation.
The five areas below provide a framework for institutional investors to improve long-term outcomes for their portfolios, their investee companies, and ultimately for all stakeholders. Within the context of their own unique situations, we urge institutional investors to evaluate, adapt, and adopt an appropriate mix of the following ideas to enhance the long-term value they create for their beneficiaries.
Clearly articulate investment beliefs, with a focus on their portfolio consequences, to provide a foundation for a sustained long-term investment strategy.
Investment beliefs are tenets and principles based both on conviction and fact. They set the investment philosophy, provide a long-term compass to select investment strategies and help navigate short-term turbulence. Institutional investors should explicitly state their investment beliefs and provide their rationale for and portfolio consequences of holding those beliefs. Although, by definition, beliefs cannot always be substantiated with unequivocal evidence, enduring beliefs, rather than short-term reactions, should form the foundation of all investment strategies and decisions.
To articulate, or rearticulate, investment beliefs that reflect long-term orientation and intentions, institutional investors should:
• Gain the commitment of all major internal stakeholders in the formulation process to develop a set of investment beliefs that will be universally adhered to by employees, management, and the board;
• Examine and record why they hold particular beliefs and analyse their practical implications;
• Determine how their beliefs will guide their selection and evaluation of investment strategies and provide resilience during short-term turbulence;
• Consistently check to ensure long-term beliefs are being reflected in the daily investment process.
Develop a comprehensive statement of key risks, risk appetite, and risk measures appropriate to the organisation and oriented to the long-term.
Prudent management requires investors to assess both their need and tolerance for risk. Developing a risk-appetite statement (RAS) provides a mechanism to articulate the overall tone, capacity and tolerance for investment-related risks taken in pursuit of long-term strategic objectives. A RAS goes hand in hand with its investment beliefs – beliefs guide the investment strategy and the RAS addresses the material risks in executing the strategy.
A comprehensive long-term RAS has three essential components:
• Articulate the organisation’s motivation for accepting, mitigating or avoiding certain types of risks;
• Identify constraints (for example, liability requirements), specify measures (for example, likelihood and magnitude of tail losses) and set out monitoring mechanisms;
• Support long-term investment by acknowledging that there will be periods of short-term losses in the pursuit of strategic objectives and by identifying the economic and market environments in which these losses may occur.
Select and construct benchmarks focused on long-term value creation. Distinguish between assessing the strategy itself and evaluating the asset managers’ execution of it.
The investment strategy and benchmarking process should entail three sequential steps:
Institutional investors should establish benchmarks at two distinct levels:
• The strategy level, adopting a broad-based benchmark that signals the asset owner’s intended investment strategy, and is used to measure the success of the strategy itself; and
• The execution level, determining a more specific benchmark that reflects and guides expected portfolio construction and characteristics, and is used to assess how well the asset manager executes against the agreed mandate over time.
Most of the available indexes do not sufficiently incorporate long-term value-creation factors. An investable index that reflects long-term value creation factors could serve as a useful tool for asset owners and managers.
Evaluations and incentives
Evaluate internal and external asset managers with an emphasis on process, behaviour and consistency with long-term expectations. Formulate incentive compensation with a greater weight on long-term performance.
We advocate a more balanced approach to evaluation of asset managers, based on both quantitative and qualitative factors, by:
• Including the total return relative to the objectives of the asset owner over a stated period (that is, meet or beat an absolute or strategy target);
• Evaluating quantitative performance over a minimum of five-year rolling windows;
• Ensuring that performance fees or internal incentive compensation are earned only at the end of each five-year time horizon;
• Relying on qualitative evaluations specifically tailored to assess adhesion to stated investment beliefs and intended manager strategy during intervening periods. Shorter-term assessments should focus on whether portfolio management is being carried out consistent with expectations that have been mutually agreed upon ahead of time for the investment strategy, process and outcomes.
Use investment-strategy mandates not simply as a legal contract but as a mutual mechanism to align asset manager behaviour with the objectives of the asset owner.
Whether for internal or external portfolio management, asset owners should ensure mandates adhere to the following principles:
• Ensure both asset owners and managers have sufficiently aligned investment philosophies and risk tolerances;
• Be well and sufficiently defined – go beyond ‘beating benchmark x’;
• Formalise the commitment between owner and manager to execute the long-term strategy on a pre-discussed and pre-agreed basis;
• Mitigate behavioural biases of owner and manager that interfere with long-term investing;
• Provide the asset owner with an enforceable set of measures with which to assess the manager. Mandates should describe relevant quantitative parameters but also emphasise qualitative factors.
To align the interests of asset owner and manager on long-term value creation, mandates should provide clarity on the following: investment philosophy and strategy (for example, investment beliefs, risk appetite, management approach); investment processes, including observable portfolio metrics that indicate the manager is acting according to expectations; investment and risk guidelines and limits; and, terms and conditions (for example, benchmark choice, compensation structure/scheme, and other potential contractual requirements such as lockup periods, redemption restrictions, clawbacks and the need for asset managers to have ‘skin in the game’).
Institutional investors have a fiduciary duty to invest for the long-term interest of their clients/beneficiaries. Institutional investors should build a culture that rewards and encourages long-term thinking, while remaining aware of shorter-term realities and opportunities. Long-term investors can take advantage of opportunities and reap the rewards missed by short-term investors unable or unwilling to manage with a long-term perspective. Investors can create better and more sustained value by adopting strategies that harvest the fruits of long-term growth, rather than short-term market price movements. In doing so, they will benefit not only themselves but also savers, beneficiaries, capital markets and economies.
• This article is adapted from ‘Long-Term Portfolio Guide: Reorienting Portfolio Strategies and Investment Management to Focus Capital on the Long Term’, FCLT, March 2015, fclt.org. The authors are drawn from the working group members who contributed to that paper.
*Anuradha Gurung, investor lead, Focusing Capital on the Long Term initiative, Canada Pension Plan Investment Board; Colin Carlton, senior consultant, Total Portfolio Management, Canada Pension Plan Investment Board; Bryan Yeo, managing director and head of credit markets, GIC; Katie Day, head of risk for fundamental equity, Americas, BlackRock; Kong Hean Lee, senior vice-president and deputy head, total return equities, developed markets, GIC; Maxime Aucoin, vice-president, strategy, Caisse de dépôt et placement du Québec; Rishab Sethi, senior adviser, New Zealand Superannuation Fund; Wayne Kozun, senior vice-president, fixed income and alternative investments, Ontario Teachers’ Pension Plan