The complete solution?
Extraordinary events in recent history have created extraordinary levels of volatility, highlighting the rationale behind the mantra ‘don’t put all your eggs in one basket’. Terrorist events, war and natural disasters have shared explosive headline space with high-profile corporate governance and fraud cases, accounting scandals and news of pension fund deficits. While each of these have impacted to a degree on the global financial markets, the latter issue of pension fund deficits is likely to have the most far reaching and long-lasting effect on investors, causing widespread concern.
Outside the realms of natural and unforeseen disasters, the majority of these issues were borne of a lack of transparency. In a bid to address this and restore confidence, increased levels of legislation and directives have been introduced that place greater responsibilities on pension funds around the globe. Taking the lead, the Sarbanes-Oxley Act has had, and will continue to have, a significant impact on corporate governance considerations and therefore the regulatory structures imposed upon pension funds both in the US and in Europe. There is a likelihood of this becoming more complicated as local regulatory developments follow the suit of international standards.
Paul Myners identified that “the historical trend among UK companies was to view pensions as primarily a human resources issue”. However, various international accounting standards such as FRS17 and its ilk have also been affected by Sarbanes-Oxley, placing pension issues firmly back in the laps of those in corporate finance, with pension fund surpluses or deficits stated clearly in the balance sheet and therefore impacting on overall corporate health.
With the growing list of demands requiring more and more of pension trustees’ and administrators’ time, the task of managing pension funds has never been more onerous; therefore the proposal of a ‘one-stop-shop’ solution to pension fund issues has perhaps never been more appealing. Yet rather than heralding a return to the typical single manager balanced fund of old, following several highly-publicised cases of mismanaged pension fund assets, the trend has been toward splitting out assets, spreading risk across both asset types and providers.
As trustees are forced to focus on the more strategic aspects of pensions’ management – getting the rules and asset allocation right and attempting to match liabilities – for many this implementation process of selecting underlying managers becomes a step too far. For others the decision to outsource this part of the process has been made on the basis that it is the least controllable and – effectively – the least important aspect of pension fund management. In both cases, management have realised the significant amounts of time and skill required to evaluate the universe of investment possibilities – a universe that continues to grow prolifically.
In a liability driven world, without the likelihood of a return to late 1980s-style double-digit inflation and interest rates, the need to identify other means of generating sufficient returns to meet debt obligations has increased. Leading the charge in the new wave of options are alternative products, which appear to be lining up as the new panacea of modern pension fund ills. The debate is no longer about whether these products have a place in pension fund investing; it is over how best the new array of increasingly complex financial offerings, instruments and structures can be combined to meet the goals of each respective pensions client.
However, with a growing number of concepts and instruments to protect against downside risk such as liability-led benchmarking, risk budgeting strategies, hedging and derivatives to name a few, the onus is on investors to understand the potential pitfalls and intricacies of an increasingly complex web of offerings. Manager of managers has been recognised as a solution to bridge this gap. Complexity is not a new concept for manager of manager companies; investing in traditional asset classes (now often perceived as commonplace) such as emerging market equities and debt, are also complex, demanding in-depth knowledge. Managers of managers are also pioneering new investment approaches that incorporate traditional and alternative products to generate smoother returns while simulating less volatile asset classes in aggregate.
Developing ‘multi-manager’ type capabilities has become a trend, giving testament to the suitability of this approach for pension fund investing. Several very large pension fund companies, traditional asset management houses and consultant companies have moved to establish their own offerings, in a bid to emulate ‘one-stop-shops’, however due to the capital outlay and expertise required this is not an option for everyone.
The pros and cons and the true segregation of business interests achieved by erecting ‘Chinese walls’ is moot, although the potential overlap created by acting as both adviser and executor encourages greater scrutiny given the potential for conflicts of interest. In this context the benefits of employing an external manager of managers approach are at least two fold; trustees are able to maintain greater objectivity over performance and have the ability to fire non-performing managers mitigating some of the potential governance issues. Secondly, the pension company’s capital may be better employed by developing and enhancing core competencies including techniques relating to liability-matching, pricing longevity risk and meeting the ever-growing legislative and pension reporting requirements.
A manager of managers specialist plays a key role as integrator; creating optimal investment portfolios to suit the ultimate objective of each individual pension fund drawing on the most appropriate investment techniques and products available in the market. In addition to accepting accountability to deliver on the investment objectives, successful manager of managers providers have diligently built up capabilities to advise on pension fund investments, having identified the need to truly understand their client’s needs and objectives, not just pay them lip service.
This is highlighted by the advancing portfolio construction techniques employed by manager of managers, using matrices to create portfolios capable of generating performance in line with investor’s objectives and varying degrees of risk tolerance. Such approaches require greater skill than equally-weighting assets across a prescribed, often too large, number of underlying funds; depleting alpha through over-diversification. Ultimately, portfolios should be constructed using managers with different return patterns, not
merely compared by capitalisation or style biases but by alpha
sources and the exploitation of various market phenomena. Unlike the once narrowly defined entities of mere ‘manager selectors’, more advanced manager of managers specialists have continued to evolve; building multi-faceted investment and portfolio construction capabilities that take this into account.
More client-focused companies have also invested heavily in studies specific to understanding the obstacles faced by pension funds. They have built sophisticated modeling tools that enable scenario analysis in constructing pension investment portfolios accounting for objectives and liabilities. While these have been used more widely in the US, as the market there is more mature, transferring these capabilities should enable suitable models to be built to cater to the fast-changing European market.
Innovative, active and customised approaches to managing pension fund investments are likely to make the most headway in this new investment environment. The expertise required to meet pension fund objectives in a liability driven world are available and manager of managers can provide the right balance of advice and accountability to pension funds that are looking for a comprehensive and broadly-diversified investment solution. Working in partnership and capitalising on core competencies, the likelihood of developing a sustainable and individual solution to pension fund issues is greatly improved. While we may fancy ourselves as living in extraordinary times, ironically the ordinary mantras about eggs and baskets invariably return to keep us grounded.
1 Institutional Investment in the United Kingdom: A Review, Paul Myners, published March 2001. Available at http://www.hm-treasury.gov.uk/media/2F9/02/31.pdf