Roger Urwin advocates a greater focus on governance and internal investment resources for pension funds

Strong governance is hugely important in institutional investment, but it is a very difficult area to get right with only the most conscientious and gifted succeeding in all areas. Among this number are some prominent institutional investment funds that made the right sort of strides with their governance arrangements and have successfully shown the world that very good performance can come from those strides.

For a long time governance has been seen simply as a constraint. Funds have learned to simply get by without being adequately resourced. However, the investment
world has now changed irrevocably and the last ten years has added more complexity than any period in history. Greater regulation, product proliferation and much competition for effective investment strategy and products have complicated the sorts of decisions that funds have to face. Funds face some critical issues: how much risk, what types of risk, what types of return: absolute or relative; what types of strategy: mainstream or alternatives, beta or alpha. But stepping back, the institutional fund must first get its mind around a higher level question: how much time and resource should be committed to governance and how this effort should be organised.

According to our research, only a minority of funds worldwide have investment strategies and governance arrangements that are aligned. The research shows that the more common misalignment is for funds to be over ambitious in their investment structures, introducing too much complexity for their governance to cope with.

As a simple step, consider a trio of governance arrangements, and let's set out investment arrangements that are aligned and can be implemented with confidence. How can governance be assessed in this way? We use the concept of a governance ‘budget', which we see as a combination of time, expertise and organisational effectiveness of the decision-makers. Funds can be grouped into three categories by the size of their governance budget.

1. Limited governance budget

Cost minimiser: compatible with the lowest governance resources, is a set of arrangements that manage down all costs and focus on easily available investment returns. Being the least sophisticated investment strategy it would have only bonds and equities and use mainly passive managers.

2. Mid-range governance budget

Diversity seeker: with greater governance available, the fund can pursue more value creation opportunities. The focus would be mainly on improving market exposure diversity outside equities and bonds. Generally these arrangements would again not contain large exposures to active management, simply because alpha is the hardest part of the investment spectrum to create value from.

3. Advanced governance budget

Diversity and skill exploiter: with strong governance, the arrangements would major on diversification but also include a significant amount of risk in active manager structures. There is greater emphasis on identifying manager skill opportunities including ones where the market return and the active manager return are difficult to separate as is the case with many absolute return products.

We acknowledge that in practice funds may not find it easy to position themselves this way. Most have taken their different investment strategy routes by reference to a peer group mentality that has established one institutional norm, rather than by reference to governance budgets. This needs to change and indeed there are some positive signs that this is occurring.

One of these is the growing body of research showing a clear link between superior performance and strong governance, particularly among larger funds. It is perhaps not surprising that the best-governed funds tend to perform better than averagely-governed funds. While quantitative data on the precise size of the ‘bad-good governance gap' is relatively scarce, in the Ambachtsheer Letter of June 2006, Ambachtsheer uses estimates from his data-base research that the gap has been worth 1-2% of additional return pa.1

We have also recently undertaken our own research (in combination with Oxford University) into actual practice at top funds around the world. The research, entitled ‘Best-practice investment management: lessons for asset owners',2 involved case studies on 10 funds across the world that were cherry-picked for their exceptional reputation and strong sustained performance. The ten comprise six pension funds, two endowments and two sovereign funds, located in North America (five funds), Europe (three funds) and Asia-Pacific (two funds). They are all large in terms of assets, ranging from around $5bn to well over $50bn (€3.4bn-€33.7bn).

The study identified five main areas of critical significance to institutional funds where these funds excel, namely: risk management; time-horizon focus on the long term; innovative capabilities; clarity of mission and effective management of external fund managers and other agents. However, even these funds with exceptionally strong governance capabilities find it difficult to overcome certain constraints. The research shows the most common constraints are inherited regulations and systems of control and the competing claims of multiple stakeholders. In addition, it shows there is an unpreparedness in the industry to consider in-house resources as anything other than highly visible ‘costs' whereas external spending on managers and transactions costs tend to be seen as ‘performance benefits'. This has always seemed like an extreme case of tortured logic.

The central finding of the research was to isolate 12 best-practice factors as indicative of future success in meeting institutional goals. Six of these are assessed as being within the reach of most institutional funds: mission clarity; effective focusing of time; investment committee leadership; strong beliefs; risk budgeting framework and fit-for-purpose manager line-up.

Six further global best-practice factors were isolated in the research and described in the research as requiring significant resources including an executive team, usually with a chief investment officer (CIO). The research suggests that these exceptional attributes are not easy for most funds to achieve. They are as follows: highly competent investment executive; high level board competencies; supportive compensation; real-time decision making; exploit competitive advantage and learning organisation.

In terms of structure, leading funds tend to split the key functions between a board, which governs, and an executive, which implements and manages. The board also appoints and supervises the investment CEO/CIO. In terms of people, the CEO/CIO will tend to have a very high degree of investment expertise, and be supported by strong researchers. Process-wise, leading funds are extremely skilled at maximising any sustainable comparative advantage that they have over competing funds, and tend to have impressively efficient decision-making structures.

These 10 funds seem like the pin-ups of institutional investment and have all made the move up from being seen as ‘good' in their field to something close to ‘great' by committing passion and excellence to their mission through their governance structure. They are testaments to what can be achieved and I personally would love to see more funds make the commitment to have a CIO.

To sum up, I believe that investment success and value creation are driven by the quality of the decision-making involved and that there should be a stronger link between governance and investment strategy. The potential to destroy value through unsuitable strategies can be reduced if funds are honest about their governance capabilities in the first instance. And if they can start to treat governance as a variable, not a constraint, things could look brighter for their considerable numbers of stakeholders.

1See How Much is Good Governance Worth?, The Ambachtsheer Letter, June 2006. For additional evidence in this area see Improving Pension Fund Performance, Keith Ambachtsheer, Ronald Capelle, Tom Scheibelhut, Financial Analysts Journal, November/December 1998

2Urwin/Clark: November 2007. The academic paper can be found at
Urwin/Clark: November 2007. The academic paper can be found at See How Much is Good Governance Worth?, The Ambachtsheer Letter, June 2006. For additional evidence in this area see Improving Pension Fund Performance, Keith Ambachtsheer, Ronald Capelle, Tom Scheibelhut, Financial Analysts Journal, November/December 1998Urwin/Clark: November 2007. The academic paper can be found at

Roger Urwin is the global head of investment consulting at Watson Wyatt