Where governance can create or destroy value
At our recent iX (Ideas Exchange) conference in Hong Kong, we conducted a survey of governance and investment arrangements. We found that 44% of the funds present had their investment strategies and governance arrangements aligned. This is fairly consistent with our more extensive research in the UK, where we found that around 40% of UK pension funds have aligned investment strategies and governance arrangements. However, this indicates that there may be scope for value creation through better alignment of investment strategy and governance arrangements.
We believe that investment success and value creation are driven by the quality of the decision-making involved. As such there should be a much stronger link between governance and what is considered to be best practice investment. Funds also need to be clear about their governance resources before embarking on a specific investment strategy, particularly those involving complex investment models with significant asset diversity and skill-based strategies, which require high governance. The potential to destroy value through unsuitable investment strategies can be significantly reduced if funds are honest with themselves about their governance capabilities in the first instance. In The Ambachtsheer Letter of June 2006, Keith Ambachtsheer estimates that the “bad-good” governance gap has been worth 1-2% of additional return per annum.
Given that governance can be hard to visualise, we have developed three broad levels of governance. These are based on the concept of a governance budget, being a product of Time x Expertise x Organisational Effectiveness. Having established their governance budget, funds are then better able to choose a suitable investment strategy, appropriate to their governance budget.
The three governance levels are (see Figure 1):
Ê Limited governance budget. This group would probably have a single board and typically focus on avoiding value destruction.
ËSome governance budget. This group probably has an investment committee and deploys most of its resources in diversified market exposure gains.
Ì Greater governance budget. This group would probably have a CIO and an investment team and be looking to add significant value from multiple sources of risk and return.
Using this approach, governance comes first and investment strategy should be chosen appropriate to the governance budget. We further propose that there are three fundamental building blocks or control levers that can be used in constructing an appropriate investment strategy. These are: effective liability hedging or liability-driven investment (LDI); cheap market exposures (beta) and reliable manager outperformance (alpha).
Investment strategies can then be categorised into one of the following three broad approaches, bearing in mind the three control levers (Figure 2):
Ê Cost minimiser. The point of running a fund in this way is to manage down all costs and to focus on easily available investment returns. Being the least sophisticated investment strategy, it would typically include only bonds and equities and use mainly passive managers. This model is compatible with the lowest governance resources.
Ë Diversity seeker. The diversity exploiter has sufficient governance resources to pursue some value creation opportunities. The focus would be mainly on improving market exposure diversity (more than 15% outside of equities and bonds), with limited active management. This would be suitable for funds with moderate governance budget.
Ì Diversity and skill exploiter. The third model has significant diversity (more than 30% in diversity assets) and runs a significant amount of risk in active manager structures. There is greater emphasis on identifying manager skill opportunities, and as a result, this model requires very strong governance.
So what happens in practice? Figure 3a shows what we might have hoped to see in our survey results in an ideal world. With perfect alignment, the funds and their investment structures should appear along the diagonal line going from bottom left to top right.
Figure 3b shows what we found in the real world at our Hong Kong conference. There is some alignment. However, 6% of funds were in the governance level 2/investment model 1 category, perhaps indicating room for value creation by exploring more diversity. Conversely, the results also indicate that around 50% of funds have an investment model that exceeds their available governance budget. They may be overstretching and may do better by either scaling down the ambition of their investment models, or by increasing their governance budget (as indicated by the arrows on the chart).
Funds should appreciate that use of the LDI control lever - risk minimisation - can be a key priority across all levels of governance. However, use of the alpha control lever - searching for manager outperformance - will not suit all funds. This control lever requires high governance to find that elusive alpha and to avoid destroying value by hiring and firing managers at the wrong time. A good analogy is a tennis game. Sometimes the best strategy may be just to keep the ball in play. This can apply to all skill levels. However, unless you have the right skills, going for the more difficult shots may simply result in blasting the ball out of court and making unforced errors.
It remains our view that different investment strategies are too often arrived at by following the status quo, rather than by reference to governance budgets. This needs to change.
Anthony Chan is senior investment consultant at Watson Wyatt Hong Kong