This month’s Off The Record was hastily rearranged to pull together your views on the recent out-of-court settlement reached between the Unilever Superannuation Fund (USF) and Merrill Lynch Investment Managers (MLIM), in one of Europe’s most high-profile financial court cases in years.
We wanted to know what you thought the implications of such a landmark case, which ended up in payment by an investment bank to its pension fund client.
To kick off, we asked whether you thought there was actually a case for pension funds to be compensated in the event of manager underperformance.
Over half felt there was, albeit with some more strongly in favour than others. Those firmly in favour of compensation qualified their comments with the proviso that this had to be in a case of serious breach of a mandate contract.
One manager noted: “In a case where the manager breaches an underperformance limit which they have freely entered into, then yes.”
Another added: “Yes, when there is a sort of guaranteed return being stipulated or in cases where specific risk controls have been set and the manager incurred losses by not adhering to these controls.”
With this in mind, we probed you on what you thought the impact of the court case would be on the pension fund/investment manager relationship. You weren’t shy in suggesting that the effects could be significant, with many managers suggesting that the relationship could become more “strained”.
A number of you fear a heavier legal framework being introduced, with several warning of an increase in legal fees jacking up the price of external fund management.
One scheme chief sees the managers running for the hills, so to speak: “Fund managers will continue to hide behind their benchmarks, small bets will become the norm and hedge funds grow rich.”
For most of you though, the real impact will be greater focus on the small print and the wording of contracts, as one fund head surmises: “Pension funds will be alert, looking at their contracts and perhaps looking to get something like it in their contract. Managers will act the opposite way.”
Nonetheless, when we asked you whether manager underperformance should be a case for litigation, not one reply advocated the intrusion of the courts on this process. Wise words indeed!
Similarly, we wondered whether there might be a case for internal litigation in the case of underperformance by in-house managers.
One manager noted that this was “extremely doubtful”, pointing out the obvious drawback: “there is a danger that you might end up suing your self”.
Stupid question, maybe? Well, no. One manager notes that if the internal investment manager is owned by the parent firm, then there could well be a need for such a case to protect pensioners’ money.
Another concludes that the possibility of action is what makes the external manager relationship so robust: “The beauty of outsourcing is that you can act in accordance with a tough contract. If an internal manager misbehaves then it is a personnel issue.”
So just how do you consider the issue of manager underperformance? What processes do you have in mind to evaluate and deal with a manager on the slide?
Some of you, it seems, have underperformance targets – bit of an oxymoron. One fund explains the criteria: “We measure the manager in relation to an underperformance target: currently to avoid underperforming the index by 3% – after fees – on a rolling 12-month basis.”
For another scheme, confidence is the key: “Depending on the contract (active or passive) we speak regularly with our managers about performance against the benchmark. It is difficult to give a specific rule, but in general we continue the mandate as long as we have the feeling that the investment process is still working and we still have confidence in the manager.”
In terms of how long you let underperformance go, there is further disparity in your approaches, with the range of time that managers are allowed to stray into the red stretching from six to 36 months.
One scheme chief explains how times have changed in this respect: “In the ‘old’ times you would let the manager do his thing over a couple of years – a market cycle. Nowadays we have more sophisticated tools to trend performance and use that as a warning flag. Then it is really up to the transparency and communication between the parties. Managers are selected after a long due diligence. If the manager acts consistently in accordance with the evaluated process and all controls are in place, but makes a misjudgement or two then this is an issue for discussion. But if the manager changes its process without communicating that to the client or the safety net is not working properly, then they have a problem.”
It is time to start looking at those contracts…
Half of our respondents say they will begin reviewing their contractual details, although a number note that such measures have already been introduced in the past few years.
One comments: “We may look at the contracts again – although we have tightened them up in the last few years. I anticipate that we may get pressure from some managers, or any new managers that we hire, to add in additional clauses in the contract.”
On average, it appears that you have formal meetings with managers on a quarterly basis, while informally you chat to them on a monthly or more frequent basis – a frequency that none of you feel the need to change.
So let’s move on to risk. How do you analyse just what kind of risks the manager is running with your portfolio?
Risk measurement systems mentioned include WM/Barra/ CAPS/Probore (Sweden) with attribution measured down to the stock level and comparisons made with key trends and ratios in the market. So little doubt that you know what you are doing. Some appear to know better than others though, with one manager claiming an insight into risk “just by looking”!
Fifty per cent say you additionally employ consultants to measure and analyse manager performance.
You also note that managers are prompted to “thoroughly” explain their style and investment process before any ink goes on the contract, with one fund manager adding: “Either we get it in detail or we stay out”.
So just what will the long-term effects of the case be? Well, one in five respondents believes the affair will start to create doubts about the role of external managers.
However, many of you counter that the court case actually strengthens the reasons for outsourcing: “Outsourcing makes it easier for you to have an effective pension fund. If you have the same problem in-house you have to handle a personnel problem and this might interfere on efficiency in hiring and firing. But it will focus minds on the need for active performance monitoring, whether in-house or outsourced,” says one fund.
Again, only a fifth of you concur, as observers have suggested, that the case will drive pension funds towards passive investment. A number of you point out that this was a case about monitoring and control, not active versus passive management.
A manager retorts: “If they do it will be a cop-out, or they do not believe that active managers can add value. With stamp duty in the UK it is obviously more difficult to beat the index, but our experience, particularly in overseas markets, is that it is worthwhile.”
Could performance-related fees be the answer? For the majority of you, the answer is a resounding no.
While it seems no similar court case has taken place in the rest of Europe, the resonance of the Unilever/Merrill case will no doubt be felt across the continent for many years to come. Let’s hope the impact will be more positive than negative for the industry.
At any rate, we’re sure that we can all leave thinking about it until the New Year. Season’s Greetings from Off the Record!