In the second in a series, Amin Rajan and Neeraj Sahai discuss the causes and consequences of globalisation for pension funds

By the end of the 1990s, the cumulative assets held abroad by asset managers were around 20%. Now that figure has shot up to 50%. The quantum leap this decade has been largely driven by pension funds, according to a new research study.*

In hindsight, the 2000-03 equity crash was a defining moment for them.

It marked a decisive shift from relative returns to absolute returns that are not correlated with market movements. Five mutually reinforcing factors have stimulated pension funds' interest in cross-border investments in this decade (click on figure 1 below to view full graphics).

Not surprisingly, the search for alpha has been at the top of the list. The new generation of absolute return mandates from their clients has forced asset managers to look outside their domestic markets to deliver good consistent returns. This is because their domestic markets - like, for example, the US, UK, the Netherlands and Switzerland - have proved too deep and liquid to offer large scale alpha opportunities for dominant domestic players.

In contrast, the emerging economies in Asia, Europe and Latin America have proved rich fishing grounds, thanks to high and sustained growth in their economies, which are fast emerging as major players on the global scene.

However, given the sums of money involved, pension funds have been keen to ensure that the absolute return strategies adopted by their asset managers are scaleable within sound governance structures that meet all fiduciary requirements. This has encouraged asset managers to not only increase the geographical coverage of their mainstream strategies; but also to create centres of excellence in various locations using local talent to generate high conviction ideas and execute them.

Those medium and small pension funds that, as yet, do not have the in-house investment expertise or governance capability have relied on asset managers to offer all-inclusive global mandates. They enable pension funds to focus on what they are really good at. Too often, pension funds' resources have been too thinly spread across a range of activities, countries and asset classes; exposing them to the ‘key person' risk. Such manadates have increasingly bundled key activities like strategic asset allocation, manager selection, tactical asset allocation, performance attribution and back office processing.

The economic take-off in Central and Eastern Europe, Asia and Latin America has also increasingly featured in the regular asset-liability modeling done by pension funds around the world. In the process, they have had to rely a lot on their asset managers with strong presence in these and other jurisdictions for credible market intelligence. Some managers have done it by engaging their asset managers in the strategic asset allocation process.

Others have done it as part of a strategic alliance which involves co-investing. Those large pension funds with in-house investment expertise have formed strategic partnerships with asset managers under which they have collaborated on a range of activities that go beyond strategic allocation and involve research, investment and risk management.

As a result of these factors, pension funds have hitherto provided powerful tailwinds behind the globalisation of fund businesses.

The scorecard so far

It is therefore not surprising that they have also reaped numerous benefits so far (figure 2 graphic, above).

Around 60% of pension funds participating in the study's survey report that they have had a much better alignment of interests with their fund managers. In practice it has meant having good investment returns and high quality service.

For sure, capitalising on new opportunities has not been easy. But by venturing into virgin territories, it has enabled asset managers to restore trust which many of them had lost in the aftermath of the bear market losses.

Asset managers have done this by turning the spotlight on three factors:

Credibility: they have been able to establish a good track record of success by delivering what it says on the tin. They have matched deeds with words. They have stress-tested many products before putting them on the market; Synchronicity: they have achieved a higher alignment of interests with their pension fund clients, which has been akin to a partnership in a three-legged race, where the runners in each pair rely on the other's co-operation to win; Stability: they have ensured continuity in investment culture, investment processes and investment talent across the world. This has raised that the probability of replicating the past successes in the future. Globalisation has been an outstanding phenomenon for managers and their clients alike. It is set to grow as asset managers continue the search for new clients and investment opportunities.

Liberalisation of pensions in Europe and Asia, backed by the emergence of new investors around the world, will drive the next wave. But success will accrue to those asset managers who are able to develop business models which drive down the cost income-ratio as the business expands. As we saw in our previous article (IPE November 2007), operating leverage is vital for creating a win-win between managers and their clients.

But that is not the only challenge. Managers also have to improve the basics of their business. The recent sub prime turmoil in the US has yet again turned the spotlight on risk budgets. Pension funds have lost out significantly by going into strategies that invest long-term by borrowing short-term. Hence, they want their managers to improve their tools to minimise four kinds of risks which have lately come to the fore: liquidity, market, financial and operational.

The new generation of structured products - like CDOs, CLOs, and SIVs - are now widely viewed as financial monsters. Like Frankenstein, they are easier to create than control. As a result, our study envisages flight to quality and simplicity: quality, to minimise the risk; simplicity, to understand its dimensions. With their widely recognised seal of good housekeeping, global asset managers are better placed to capitalise on the current shifts in client behaviours than domestic players.

*Globalisation of Funds: Challenges and Opportunities Available free from

Prof. Rajan is CEO of CREATE-Research and Neeraj Sahai is global head of securities and fund services at Citi.