We have heard much about the governance shortfall in pension fund investment decision making and why it arises. It results from investment decision-making becoming increasingly complex, a lack of in-house resources and/or the appropriate skills and knowledge, not enough time devoted to investment decisions, and decision making structures that do not promote efficient decision making.
Governance can be improved in three basic ways: by increasing one or both of internal and external resources.
Trustees can increase internal resources by adding expertise (through training or the appointment of individuals with the relevant knowledge), increasing the amount of time spent on investment decision making and by improving the decision making process. The latter can be achieved through the appointment of a dedicated investment executive or by the formation of an investment committee.
Trustees can increase external resources by delegating responsibility for certain investment decisions to an expert third party. This is often referred to as implemented consulting – the group of investment solutions in which organisations, often with a consulting background, take responsibility for designing and/or implementing part or all of an investment programme. Fund of funds and manager of managers are specific forms of implemented consulting (explained later in the article).
The diagram below, which we refer to as the asset planning cycle, comprises the seven basic activities that should be undertaken to achieve efficient investment decision making. The yellow arrows signify those decisions that must be taken by the trustees, while the blue arrows are those investment decisions that may be delegated. Arrows that are shaded both yellow and blue are those activities that are shared.
So what are implemented consulting, manager of managers and fund of funds? How are they similar and where do they differ?
Implemented consulting, in its broadest application, comprises elements of policy formation, manager structure and selection, and performance monitoring. Although the trustees may delegate some or all of the investment decisions labelled in the asset planning cycle as the executive function, it is very much a partnership between the trustees and the consultant. Some trustees wish to remain involved in the decision making and some wish to be completely removed. Some wish to delegate investment decisions for their whole fund and others only for an asset class (such are as alternatives which tend to be governance intensive). Implemented consulting is flexible and tailored to individual trustee needs.
In an implemented consulting arrangement, the trustees determine the high-level objectives for the pension plan (mission and governance), the amount of risk they believe is appropriate (the risk budget), and the high-level bond-equity split. Only after this can appropriate investment policy be designed. The trustees can take advice from an external consultant, but these aspects of the investment decision making must ultimately reside with the trustees under most regulatory regimes.
Often pension fund trustees do not spend enough time on these activities because this is where their investment knowledge is weakest. However, we believe that the ways in which decisions are made and monitored and the way risk is quantified is are key to a pension fund achieving its financial objectives.
Following the setting of the mission and governance and the risk budget, the next step is to spend the risk budget, or set the investment policy (strategic asset allocation). The investment policy aims to deliver the desired risk adjusted return. Decisions at this stage include, for example active versus passive split, the amount of assets that are placed outside one’s home country (both for bonds and equities), whether corporate bonds are permitted, and whether alternative assets are considered.
It is from these decisions that a benchmark portfolio is designed and the most efficient indices selected to create an investible benchmark. Manager structures can then be developed for each asset class and managers selected. A manager structure for an asset class might comprise one manager or many managers, active and passive management, core and specialist managers, and might combine different investment styles (growth, value and thematic as examples). The complexity of the manager structure will vary by client. Although the responsibility for selecting and deselecting managers is delegated to an expert, the manager has a direct relationship with the pension fund.
Manager mandates are linked to the achievement of the desired overall risk-adjusted return for the pension fund as expressed by the benchmark portfolio. Performance monitoring occurs both at the manager and at the total fund level, the latter performed by the trustees.
Implemented consulting is ideal for larger and medium size pension funds. It combines the design of an appropriate investment policy unique to that fund with the implementation of that policy. As it is a flexible service, the trustees can remain involved in the decision making or can delegate to the consultant in an outsourcing arrangement. The trustee can even elect to use the service for a part of their pension plan. The consultant has no financial relationship with the investment managers and therefore has no conflict in selecting and deselecting managers as necessary.
Manager of managers and fund
The basic philosophy behind a manager of managers (MOM) programme is that more consistent results can be achieved through the combination of multiple managers, each of whom adopts a different investment style. By combining managers with multiple styles, unintended style biases can be controlled. Each asset class has its own multi-manager structure, and it is the combination of these asset classes that allows the trustees to achieve the fund’s goals. In terms of our asset planning cycle, MOM combines manager structure with manager selection and performance monitoring.
In an MOM arrangement, the trustees delegate responsibility for manager structure and selection to an expert, often an investment consulting firm. It is the MOM provider who contracts directly with the manager and who performs the performance monitoring. An MOM programme itself does not involve the development of investment policy for a pension fund. This must be performed by the trustees or can be delegated to an investment consultant. However, many MOM providers have investment consultancy arms as well.
MOM programmes can be customised for a client’s risk and return objectives if the assets are large enough; otherwise the MOM provider has pooled funds available for smaller clients.
MOM programmes are ideal for smaller clients who otherwise would not have sufficient assets to build a fully diversified portfolio of managers in a cost-effective manner. And despite the conflicts of interest in most MOM arrangements (some pension funds believe it is difficult to receive independent advice from a firm that also offers MOM products), this is still an attractive option for smaller clients.
Fund of funds (FOF) programmes are broadly similar to MOM programmes in many ways. As with MOM arrangements, trustees remain responsible for developing the investment policy. The trustees delegate to the FOF manager, in an outsourcing arrangement, responsibility for manager structure, selection and monitoring. It is the FOF manager who contracts with each of the underlying mangers. Each asset class has a separate multi-manager fund and it is the combination of these that allows the creation of a portfolio. The main difference between MOM and FOF arrangements is that FOF have pre-determined risk and return objectives and there is no scope to augment these to suit the pension plan’s individual risk and return objectives. In fact, pooled MOM products are really FOF.
Many FOF providers are also arms of consulting firms and the conflicts outlined above exist here. Finally, like MOM arrangements, FOF do provide access to multiple managers and investment styles, allowing the creation of a diversified portfolio in a cost effective manner that otherwise would not be available to smaller pension funds.
Implemented consulting, MOM and FOF arrangements are all ways for a pension fund to increase its governance capability by alleviating some of the investment decision making that would otherwise be required by the trustees. However, the trustees remain responsible for the decisions taken by the external expert and are required to monitor the success of these decisions as if they had taken them themselves.
For larger pension funds, both implemented consulting and MOM arrangements provide the degree of customisation some funds require, while a FOF arrangement does not. Under a MOM or FOF arrangement, the trustees have less scope to remain involved in the decision making, and in fact, the investment managers are responsible contractually to the MOM or FOF provider and not the trustees. This is not the case under an implemented consulting arrangement where the trustees contract directly with the investment manager.
Janet Robovsky is senior investment consultant with Watson Wyatt in London