An investment opportunity may look enticing but don't bite off more than you can chew, says Steven Grahame

The quality of fiduciary decision making, or governance determines how the risk budget is deployed and whether this creates or destroys value. The notion of ‘best practice investment' should be closely tied to the governance capabilities of each fund/pension scheme. This implies that there is no single best practice model that is appropriate for all investors.

All too often, we see investment solutions proposed that are technically efficient but which are beyond the governance capabilities of the fiduciaries. The results are inevitably lower than expected.

Not surprisingly, the best-governed funds tend to perform better than averagely-governed funds. While quantitative data on the precise size of the ‘bad-good governance gap' is relatively scarce, in the Ambachtsheer Letter of June 2006, Ambachtsheer estimates that the gap has been worth 1-2% of additional return per annum.

However, what distinguishes a high, or strong, level of governance from a low, or weak, one? We use the concept of a governance ‘budget', which we see as a combination of time, expertise and organisational effectiveness.

We have recently undertaken research with Oxford University into actual practice at some of the world's top funds. We believe that we have detected certain common practices among these funds, practices that are worth noting and which will be available in a fuller report in due course. More precisely, the research has revealed that governance can be segregated into 12 best practice factors, grouped by structure, people and process.

In terms of structure, leading funds tend to split the key functions between a board, which governs, and an executive, which implements and manages. The board also appoints and supervises the investment CEO/CIO. In terms of people, the CEO/CIO will tend to have a very high degree of investment expertise, and be supported by strong researchers. Process-wise, leading funds are extremely skilled at maximising any sustainable comparative advantage that they have over competing funds, and tend to have impressively efficient decision-making structures.

We view governance as central to successful investing. Skimping on governance is likely to result in lower-than-expected performance, and an inability to manage the conflicts of interest that abound in the investment industry.
Some investors will see merit in improving their governance arrangements by increasing the time they spend on investment issues, adding expertise, and rethinking their organisational structures.

However, it is unrealistic to suppose that all pension funds can better their arrangements to such an extent that they become high governance funds.
We suggest that there are three primary ‘control levers' for an investment fund to consider using in various degrees depending on their governance; these are shown in the box (right).

Because governance resources differ, we have identified three different investment models (see figure 3) which correspond with funds' different levels of governance (see figure 1). Each one will have an ‘ideal' investment solution (figure 2).

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. This model is compatible with the lowest governance resources. Diversity seeker. The diversity seeker has sufficient governance resources to pursue some value creation opportunities. The focus would be mainly on improving beta diversity, with limited active management. Diversity and skill exploiter. The third model has significant diversity and a high proportion of active risk. There is greater emphasis on identifying alpha opportunities, and as a result, this model requires very strong governance.

We think that these three models give a glimpse of how the three ‘control levers' (LDI, cheap beta, and reliable alpha) can be better used, given funds' different governance budgets. We believe that current practice is overly ambitious in terms of trying to identify successful active managers. Few funds have sufficient governance in place to fully exploit manager skill effectively.

Funds should also be mindful of their governance capability when seeking greater exposure to diversity assets, although we believe that the governance hurdle for successful diversity approaches is somewhat lower than the hurdle associated with successfully hiring and firing active managers. To sum up, many funds aspire to a model that is simply too complex for their resources.
Provided that governance is up to the job, we see three big investment opportunities becoming available:

Wider diversity of betas and benchmarks. The trend of diversifying away from equity risk appears well established. Going forward, we see opportunities for some investors with higher governance to do better with different betas;  Optimised risk allocations. With the use of leverage and ‘porting' (or moving around the different components of return within the portfolio), risk allocations can be more flexible, and less tied to capital. If we want, we can have more exposure to the alphas than the underlying capital would suggest, and there is also more scope to separate the alpha and beta decisions.  More long-term investment. Short-termism has come to be seen as a ‘bad thing' because it introduces unnecessary costs. New opportunities to do more and better long-term investment are requiring fiduciaries to make longer-term decisions, and creating demand for long-term products. Among these, we see continued growth in long-term absolute return investing, and in real estate and infrastructure opportunities through globalisation.

Provided the investment managers demonstrate greater investment thinking and innovation, we believe there are some significant investment opportunities available:

Global opportunity set portfolios. For example, investment manager allocating to markets and real estate types especially for the purpose of capturing and mixing superior beta and income;  Capturing structural mispricing. Allocating capital to investment ideas that are likely to deliver superior investment returns whether they are debt, equity, derivatives, unlisted funds or real estate investment trusts;  Participating investor. The investor allocates capital on conviction of the deal or investment proposal in conjunction with a fund manager, syndicate or club arrangement.

Figure 3 demonstrates how different governance levels may directly impact on the quality of the overall investment decision making, and ultimately the funds and investment managers who are selected to manage a scheme's assets. The separation of prospective returns is much more reliant on skill and ability to adapt dynamically to change. At the same time, we believe that future mandates will need to:

Increase the transparency of the return drivers. For example, many hedge funds get a large portion of their returns from diversified traditional betas but they charge alpha-type fees to investors;  Be more explicit about time frames. While long-term investing tends to be more appropriate for pension funds there may be nothing wrong with a short time horizon if it is appropriate for the mandate and the investor is clear on the process that would be consistent with such an approach;  Ensure that benchmark constraints are consistent with the level of fund governance. If a fund can apply a high level of governance to the investment process it may well make sense to allow active managers more freedom to apply their skill, assuming that such funds are able to maintain cheap beta and reliable alpha within such a framework. Conversely, lower governance funds may be wise to avoid overly loose benchmark constraints and adopt wider index diversity instead;  Charge a fairer fee for the value added. We believe that both traditional relative return and absolute return mandates charge inappropriate fees for beta.

All of this could have implications for investment organisations. Growth is typically easier in new areas, and this is already leading to a convergence of organisation types. More particularly, for traditional real estate investment managers they are very much competing with private equity and investment banks for idea execution and implementation, which will very much challenge the traditional buy/hold strategies of some of the largest open-ended funds.

Alongside these changes, we suggest that the next five years may well see significant growth in the use of LDI, diverse benchmarks and leverage, and a decline in traditional low-risk long-only (IPD relative return) mandates.

One further big opportunity available to pension funds and other institutional investors is to recognise the direct link between governance and performance. This recognition should lead to a strengthening of internal governance, with funds spending more time on strategic issues and less on investment products.

A more integrated approach to pension fund management is the way forward.

Three primary control levers

Effective LDI: Liability-driven investment refers to the reduction of unrewarded liability-related risks, typically using bonds and swaps;  Cheap beta: This refers to packaged market exposures with the stock-specific risk taken out. By ‘cheap' we mean ensuring that a fund does not overpay for the market component of return;  Reliable alpha: This refers to pure skill returns. No single skill source produces consistently positive returns, so alpha must be made more ‘reliable' by diversifying across a broad line-up of managers.

Steven Grahame is senior investment consultant at Watson Wyatt