There was a time when performance drove manager selection. But that was more than a decade ago, when most pension plans held a mix of bonds and equities, perhaps some real estate and very little else. Then it all blew up. What worked in the 1990s probably doesn’t work now.
Certainly, traditional assets have not quite lived up to their promise. Equities have experienced two black swan events in the past decade, where markets have touched protracted bottoms not seen since the 1930s. In turn, central banks have reduced interest rates to historic lows—in part to encourage investors to purchase risky assets.
That has created a double whammy for plan sponsors. Risk in traditional equities has not been rewarded. Indeed, bonds have outperformed stocks over the past decade. From a simple diversification perspective, that’s not a bad thing—unless you sponsor a pension plan with liabilities that are calculated off today’s interest rates. That swells future return and/or contribution rates—an unpleasant prospect.
Searching for alpha
As a result, plan sponsors and their asset managers are becoming more granular. Instead of looking at the highlights, or the executive summary, sponsors are delving into deeper detail. They want to know about the people behind the investments, how decisions are made—and not just investment decisions but business decisions—and whether off-the-shelf products can be stretched or squeezed so that they are not just pieces in the policy portfolio but address a plan’s funding and liability constraints.
It’s something Roger Renaud, president of Standard Life Investments (No. 12 on the Top 40 Money Managers list), has been observing for some time. Increasingly, plan sponsors want differentiated sources of alpha, be it real estate, infrastructure, private equity or hedge funds.
“Whereas before it would have been just equities and bonds and maybe cash, people are now going in a much more granular way in terms of seeking other sources of alpha,” he says. “It means more global, more alternative and possibly less-liquid investments.”
Of course, managers of Canada’s largest plans—Ontario Teachers’ Pension Plan, Canada Pension Plan Investment Board, OMERS, AIMCo and the Healthcare of Ontario Pension Plan—have been doing this for some time. They have taken asset management in-house and have carefully calculated their investment horizons. Even so, despite above-average returns, the plans are not all fully funded.
For mid-size plans, the push into illiquid investments has to be done carefully to suit pension commitments. Thus, the pursuit of alpha is accompanied by something else: products that will help plans reduce return volatility. Institutional investors have turned to liability-driven investing, and some have de-risked their plans with investments whose maturity matches the structure of their obligations.
Says Renaud, “They’re looking at new ideas and ways to handle the volatility but also the risk aspect. Accessing these newer types of products—whether they’re absolute return, whether it’s illiquid like real estate, or more global—is becoming more and more important.
“The risk part, which is really to do with the liability-driven investment side, is coming up with solutions. For example, on the liability-driven side, we see a lot of clients changing the way they manage their bond sides but also adding absolute return strategies and real estate as part of a liability-driven strategy.”
But the risk part goes beyond this. Plan sponsors and their consultants increasingly confront money managers demanding to know more about the people, the process and, lately, the products.
That doesn’t mean the traditional questions go away, argues Anik Paquet, vice-president, institutional investments, with Invesco (No. 38). Recalling her own experience in the investment process on behalf of plan sponsors, she says, “I would ask if that process is differentiated and repeatable. If one of the researchers or portfolio managers leaves, is the investment process sustainable? Volatility of benchmark relative returns can arise from internal reasons because of a key person’s departure, for example, or a manager’s overall business model.”
So now there’s an add-on to the traditional risk and return analytics. It’s not just about products. After all, in a low-return environment, it’s very hard for asset managers to differentiate themselves by outperformance. The quality and stability of the asset manager loom large.
“You can ask how managers are incentivized,” adds Paquet. “Are their interests aligned with those of the clients? When it comes to implementation of these ideas, do you have the ability to implement effectively to gain alpha? For example, you can ask, ‘Do you have enough resources into dealing systems or, given current levels of asset under management, is capacity going to be a problem?’”
And that is important to plan sponsors. “The things that we really need to get a grasp on are mainly people-oriented and team-oriented things. That’s the toughest thing, to figure out how a team is working together and whether what they’re doing makes them stand out,” says Julie Cays, chief investment officer of CAAT Pension Plan. “Do they have an edge in terms of what they’re doing, and can they beat the market?
“It really is all around the people and their talents. So most of our work has to do with really trying to dig into the organization, how they manage, compensate and keep the talent, how they keep the people motivated,” says Cays.
But it can be hard to get inside an organization, especially for mid-size plans, says Bruce Curwood, director, investment strategy, with Russell Investments Canada (No. 34).
“That takes quite awhile. We have 100 research analysts around the world and their full-time function is to meet with managers, not as a group, but meet on each specific product. If the manager has 10 products and we’re interested in five of them, we’ll meet with them on those five products.”
While Russell has analyzed prospective managers “10 ways to Sunday,” that can be a forbidding process for mid-size plans.
“It’s really hard for mid-size plans,” Curwood says. “The larger funds have the capability of doing due diligence because they have a number of staff. But when you get to mid-size plans, they are usually down to one to three staff members. So, usually, they’re doing it in conjunction with a consultant to do that type of vetting.”
Asking for more
A lot of this due diligence is still strictly formal: quantitative measures about performance and risk, drawdowns and active value-add. But increasingly, asset managers are being asked for more: not an off-the-rack investment product that stands out from others, but a total investment solution.
“Too many managers skip this step and propose investment strategies based solely on return potential and some vague notion of diversification, without being clear what they are trying to diversify against,” says Damon Williams, president of Phillips, Hager & North (No. 3).
And that gives rise to a certain irony in the pension business. Performance for what? Performance for whom?
“Asset management is a very simple business,” says Williams. “But I think that that’s only one side of it in terms of what clients should expect their money manager to do and how they should expect their money manager to add value. On the service side, I don’t think many plan sponsors expect enough from asset managers.”
Renaud agrees. “The reality is that a client will select us for a product. Often the investment policy is quite restrictive. It might not allow us to do all the things we actually could do. So it is very important that we have a dialogue with our clients and just say, ‘Actually, the product you have was well suited for the time you bought it.’” Times change. So do liabilities.
But as new considerations arise—considerations apart from sheer performance—the dialogue can become more demanding, with the plan sponsor in control. For Williams, that means under- standing the sponsor’s liquidity constraints, its concerns around funding liabilities or solvency liabilities and its ability—not just its willingness—to take risk.
Renaud finds the same thing. “Had you bought a balanced fund, 50/50, 10 years ago, you could ask, ‘What is it that I need now versus what I bought? How is my solution evolving over time?’ That’s why dialogue is quite important. I don’t think plan sponsors should be shy in trying, not just to get the performance from the manager but to actually get what’s working with your other clients, what you see out there, what trends you are seeing, what other products you have.”
On the one hand, asset managers know they need to do more. On the other, plan sponsors need to ask for more. Says Cays: “What I’d like to see is what they see as best about their firm—not putting their spin on but putting their character on what they report.” And that means service.
Scot Blythe is a freelance writer based in Toronto. firstname.lastname@example.org