The investment world has changed in seemingly contradictory ways – more opportunities to add value, easier ways to default to market returns. The relationship between pension funds and their asset managers needs to be reset with new rules of the games, to reflect these changes.
Pensions are a bellwether for the health of a long-term investing mind set. And where the majority of liabilities do not fall due for decades, pension schemes should be the ultimate form of patient capital.
Today’s investment universe offers golden opportunities to reinforce such an approach but other trends have created challenges.
Historically, there were natural straitjackets for pension fund investing. Using simple building blocks, an investment portfolio designed around an equity-bond mix was perfectly understandable.
It aligned neatly with the academic idea of a “market portfolio” of risky assets diluted by defensive assets. The monochrome 60/40 portfolio became the generic basis for investing.
While equity broadly remains equity whatever its flavour, it is arguably the debt universe that has caused the greater disturbance to the old model, particularly in terms of understanding its place in the overall portfolio.
For many years it crudely equated to ‘defensive’; today investors can choose a variety of leverage points and therefore access a broadening array of cash flow generative assets with more equity-like returns.
The simplistic portfolio has therefore gone, and with it the old taxonomy of asset classes.
New asset classes, more acceptable illiquidity, asset owners taking more direct ownership with less intermediation all offer the potential for better outcomes, but also accumulated governance challenges. This is in part because there has also been a contrasting flow in the direction of accepting what you are given as active management has given way to passive investing. The world’s largest pension funds have had to deal with the negative effects of size.
While there are certainly more resources available for larger investors to be active, there are also constraints, especially given the growing concentration of listed market weights in fewer names.
Size leads to owning the market – by default you become a passive investor. Smaller pension funds too are feeling the lure of passive – as simplicity and costs have moved to the forefront of thinking. This contradictory blend of trends has led to the governance setting framework becoming strained.
Schemes are faced with a pressing need for governance frameworks that can make sense of the combination of new and old investment styles and opportunities.
Traditional strategic asset allocation benchmark setting feels unresponsive in this context. With investment opportunities becoming ever more granular, the simple ranking of returns from equity to risk-free into linear betas looks somewhat out of date; with passive investing taking on more of a core role, the modelling of alpha also becomes challenged.
In governance terms, historically, mandates handed out to asset managers were tightly restricted. The asset owner would give a specific mix of assets as a benchmark strategic asset allocation, with the manager formally monitored with respect to their benchmark –relative performance.