Asset manager selection and review likely to be more robust

Posted On Thursday, 27 November 2003 02:00 Published by
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There is little doubt that extremely challenging market conditions are dramatically changing the way South African trustees think about investments.

Investment - There is little doubt that extremely challenging market conditions are dramatically changing the way South African trustees think about investments. Internationally, leading consultants have also evolved in their thinking.

Watson Wyatt is now calling for 10-year mandates, where investment managers would be required to achieve inflation plus 7 percent or 8 percent per annum. According to Roger Urwin, the head of investment practice at Watson Wyatt, long term mandates would replace index-based benchmarks that foster short-term investment attitudes.

"We want to start setting [managers] free ... to seek returns over the long-term," Urwin has said. In two separate recent polls, Watson Wyatt and Investment & Pensions Europe found that more than half the respondents are willing to give out mandates that run for at least five years (versus the current norm of three).

South African trustees of defined-benefit schemes will easily relate to the concept of a 10-year "inflation plus" mandate.

In the search for a cure for "short-termism", another leading international consulting house, Hewitt Bacon & Woodrow, recently supported a competition seeking ideas on how investments could be managed on a 20-year view. According to Nick Fitzpatrick, the head of global investment consulting practice at the firm, investment products today are no longer addressing the needs of many clients.

The UK government-backed Myners Report concluded that the shift to specialist mandates has meant that asset allocation was overlooked, with "dire consequences".

Andy Green, the head of investment strategy at Mercers, has indicated that trustees are now increasingly asking their fund managers for their views on medium-term asset allocation.

"Trustees want information from different sources."

In South Africa, there is a clear trend back towards more freedom for the investment manager. Unlike in the UK and the US, balanced mandates are still the preferred route for most local trustees.

Since the shift to defined contribution schemes, the retirement industry has seen investment horizons shorten and portfolios become much more peer focused. It has become quite common for investment managers to report back to trustees as often as four times a year. The measure of success is no longer inflation-beating returns over 10 years.

Instead, managers are required to outperform the peer group over three years, almost regardless of whether the peer group is behaving sensibly.

We're seeing some of the old defined-benefit thinking coming back. For a large number of retirement funds using balanced mandates, inflation-beating returns are again becoming an explicit requirement.

There is the recognition that three-year mandates are not conducive to good long-term thinking. So, instead of quarterly report backs and three-year manager reviews against the peer group median, some trustees are contemplating annual reportbacks and five-year mandates, specifically driven by the objective to beat inflation. They recognise that five years is too long to wait to fire a manager who is underperforming hopelessly. Qualitative manager review methods are being developed.

Trustees are going back to the four Ps (people, philosophy, process and performance). The peer group median performance will remain relevant over shorter periods like three years. But past performance alone is not sufficient to reach a view on future performance. Qualitative issues such as business strength, team stability, consistent philosophy, repeatable process and clarity of investment strategy are gaining prominence. On the issue of consistent philosophy, growth managers who opportunistically invest in value shares might have their appointment reviewed, regardless of how good the performance might be.

In addition to making manager selection and manager review significantly more robust, trustees are revisiting the number of managers that they need to appoint. Given the amount of work that will go into selecting and monitoring investment managers, having one manager might be enough. It would certainly be better than the status quo: having three or four managers all delivering average or near-average performance.

For South Africa's multimanagers and the "mega funds" (the dozen or so retirement funds that each have more than R5 billion in assets), specialist mandates are here to stay 

Specialisation took off locally during the second half of the nineties, with large retirement funds and multimanagers effectively separating asset allocation from manager selection. Thereafter, the fund and its advisers set a strategic asset allocation (also called a benchmark), appointed specialist managers for each asset class and then rebalanced the asset allocation back to benchmark on a regular basis.

However, the bear market has highlighted the risks inherent in static asset allocation.

Today, the mega funds and multimanagers are seeking counsel from investment managers, regarding medium term, "dynamic" asset allocation - which sits somewhere between strategic allocation (long-term, 20-year view) and tactical allocation (short-term, three-month view).

The mega funds and multimanagers, like the smaller funds, are moving to give more investment freedom.

Unlike for the smaller funds, more investment freedom for the investment managers will not necessarily mean a return to balanced mandates. When they first moved to specialist mandates, many funds and multimanagers adopted a core-and-satellite structure. The core portion is usually an index portfolio to give pure market performance at very low fees.

The satellites are more reliant on manager skill, having high market-beating objectives and performance-based fees.

More investment freedom for the investment managers could manifest in a move to absolute return satellites, where the requirement is to outperform inflation without exposing the investor to unnecessary volatility. The absolute return mandates could come in three different forms.

The first form is a multi-asset portfolio, free to invest in any and all asset classes.

Originally, these portfolios concentrated on particular forms of stockpicking, but later versions have tried to benefit from asset allocation and the introduction of inflation-linked bonds.

The second form relates to freeing managers from what is sometimes referred to as the "long-only constraint". By allowing some satellite managers to "short" the market, trustees will be able to set a cash or inflation benchmark. "Short" strategies are sometimes used to protect regular portfolios, but are probably more well known within the context of hedge funds.

Internationally, investment in hedge funds by institutional investors continues to accelerate, partly based on the view that hedge funds attract the best talent. In South Africa, regulation is moving in a direction that will make it possible for trustees to give money to hedge funds.

However, even for the most sophisticated trustees, investment in hedge funds will probably occur via funds of hedge funds, because of the need to diversify, for detailed due diligence and for access to exclusive capacity.

The third form of absolute return mandates could be for investment in less liquid markets, for example, private equity and infrastructure. It is widely acknowledged that both private equity and infrastructure offer the prospect of superior returns over a long time horizon - 10 years and more.

However, given that these asset classes are illiquid and the markets are probably not yet fully developed in South Africa, any exposure should be built up slowly over a period of years.

The bear market will continue to change significantly the way retirement funds are invested. The most important changes will be the ones that remain when the bulls return. The sustainable changes will include a return to balanced, "full discretion", multi-asset portfolios. Measurement against the peer group will no longer be sufficient to help trustees make good decisions.

Trustees are moving away from manager reviews based on short-term performance.

In both balanced structures and specialist structures, investment managers will soon experience greater freedom to make money for members, which necessarily requires inflation as the target, combined with a long time horizon.

This does not mean that trustees and members will have to remain aboard a sinking ship for five years. It will mean that manager selection and review will become far more robust and forward looking in nature.


Thabo Khojane is the director of Investec Asset Management

Publisher: Business Report
Source: Business Report

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