Should fiduciaries manage assets?

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Anton van Nunen explores the changing role of the fiduciary manager. Should they manage pension assets themselves despite the potential conflict of interest?

To put it bluntly, yes, the fiduciary, after showing his competence, should be allowed to manage assets. Pension funds are grown-ups who can circumvent possible pitfalls in this field.

Fiduciary management has gained a prominent position in the Dutch pension world. Several independent parties indicate that about 75% of Dutch pension assets are now managed on a fiduciary basis.

However, one of the fields in which the Dutch regulator is critical is actual asset management. The criticism is based on the stance that the fiduciary manager, because of his expertise in financial markets, his advisory role in portfolio construction and his risk management role, cannot play a dominant role asset management. I agree completely. If all these elements were carried out by one party, the whole structure could be defined as the opposite of fiduciary management.

The concept of fiduciary management emerged as a logical answer to the different ways in which pension funds carried out their asset management through the years.
In recent years, a top-down approach with room for different asset classes and the strongly increasing number of (sometimes quasi) scientific studies on diversification possibilities increased the universe of asset categories available to pension funds. There was also an increase in the number of specialised asset management companies with good track records. Pension funds used this greater set of assets and these managers who claimed to excel.

However, lopsided growth soon became evident between the expertise of the principal and that of the agent. Even more important was the drawback that nobody seemed to carry responsibility for the overall portfolio. Managers and consultants were responsible for their part of the work, implying that those with expertise did not carry overall responsibility and those who did were not equipped with sufficient expertise.

Fiduciary management tries to put an end to this situation, in which too many people play their own role and nobody carries ultimate responsibility. Expertise and responsibility are united:

• The ALM specialist maps the liabilities;
• The fiduciary manager validates the outcome, receives the board's desired risk profile and constructs a strategic investment portfolio which clearly shows the risks in the overall balance of assets and liabilities;
• The fund chooses the desired portfolio, after which the fiduciary manager brings together a set of sub-portfolios (with managers), which consumes the specified risk budget efficiently;
• Again here, the fund and the fund only takes the decisions (see further);
• Monitoring and reporting complete the core duties of the fiduciary manager.

Actual management of pension money was, is and stays the most important duty of the fiduciary manager. That is a difficult area in which the fund has to take decisions in many fields, having to lean heavily on the fiduciary's advice.

The issue is clear. The client must get the best managers within the defined framework. A fiduciary manager has more expertise than the client, which is the reason why a specialist is hired in the first place. The customer normally has vague ideas about the universe and long list and relies on the fiduciary having good data material and the right method to select, but that does not mean he should not oversee.

Contrary to many advisers and some fiduciary managers themselves, I believe that the fiduciary should be allowed to propose himself as a potential manager. This conviction is based on a notion that will not be denied by anyone: the client is entitled to get the best managers available. Many fiduciary suppliers have a background in investing and good track records. It would be counterproductive if these managers were excluded from selection up front merely based on pedigree. If data indicates that results are sufficiently good, a fiduciary client would be unfairly treated if this party were not selected.

Exclusion arises from conflicts of interest. It is evident that asset management brings in more money than advice and the general feeling is that fiduciaries therefore want to emphasise this activity. This is not to be disregarded, although this is not in line with the fiduciary bearing of the assignment. Of course, confidence is also hurt when the result of manager selection is biased by this consideration. Pension funds, therefore, should be on guard here. That is not to say that they should be protected from themselves, which is the case when regulators exclude asset management by fiduciaries. Pension funds are grown-ups who should be able to manage conflicts of interest, when they are aware that these can occur. Exclusion up front is too easy a solution. It avoids possible mistakes, but at a price. That price is an invisible, hardly traceable lowering of future returns.

A better solution is rules between principal and fiduciary. To begin with, a clause can be arranged setting the scene. The client chooses one of the possibilities with respect to internal management:

• It is excluded (not to be recommended in my eyes);
• It is excluded, unless... ;
• It is possible, provided that…. ;
• It is possible up to a certain percentage of total assets; or
• Advice in this is without limits.

The great advantage of such a clause is that it is clear from the outset that conflicts of interest can occur, which makes it improbable that undesired situations will occur. The rest of the process is relatively simple. When introducing managers, the fiduciary shows that his alternatives are best in class with respect to investment results, costs or a combination of the two. Normal practice is that only in a limited number of cases an internal manager at the fiduciary's office will prove to be the best. The opposite is hard to imagine.

It is possible that in a specific situation a relatively large part of the portfolio is rightly put forward for management by the fiduciary manager. For instance, a pension fund wants to hedge a large part of liabilities without any risk by an index bond portfolio, which can be offered by any manager. This is a plain vanilla affair: when the fiduciary can offer this sub-portfolio in a cost-effective way, there is no objection to it.

The situation becomes a problem when the fiduciary manager proposes himself as the major asset manager in a highly diversified multi-asset portfolio. This situation hints at an inadequate selection process, at arrogance or at a structure that is not in the client's interest. A fiduciary house, however large, cannot have the best product in, say, 80% of the cases in tens of sub-portfolios. This is impossible by definition by merely looking at the size of the universe, even when the fiduciary is a large party and has an efficient factory at its disposal. It is almost certain that the fiduciary's business case is not aligned with the customer's interest.

It cannot be stressed enough that the principal always takes the decisions with respect to asset mix and hiring managers. It is advisable to have this formalised, for instance by signing asset management agreements. The fund listens to the fiduciary's advice, makes a judgment in co-ordination with the investment committee and possibly external advisers and ratifies the recommendation with or without amendments. The board is in control by the formal competences and the available expertise in assessing the proposals.

The second reason why asset management by fiduciaries is under discussion is the regulator's opinion. The regulator frequently indicates that the fiduciary in his advisory duty already plays a major role in pension funds. Delegating asset management as well would make funds too dependent. These worries should, of course, be shared by everybody involved, but they do not necessarily lead to the same conclusion. The simple fact is that hiring specialists always implies a degree of dependence. It is a logical consequence of outsourcing. One should be on guard not to let this dependence grow too large.

However, excluding asset management by the fiduciary is the wrong answer to the right concern. It is throwing away the baby with the bathwater, because asset management is exactly the activity that the pension fund has at its disposal to reach its objective. Most fiduciary managers do have expertise in this field, having a pedigree in asset management. Managing money is in their genes and excluding them is counterproductive. But that does not mean the funds should not be on guard. Financial institutions after all are not known for their altruistic attitude. There is only one adequate reaction to looming dependence and that is mobilising sufficient internal countervailing power. When complexity in asset management increases, expanding the investment committee or hiring external specialists is the best way to unite the two positions.