In this month’s Off The Record we look at the issue of investment and independence. How much value do European pension fund managers and administrators place on the independence of their investment managers – and how much are they are prepared to pay for this?
The question arises because many investment management companies are part of larger banking and financial services groups that were created in the 1980s and 1990s to provide ‘one stop shops’ for financial services. The logic for bundling financial services in this way was that it would provide a wider range of expertise and greater resources to institutional clients.
However, combining financial services under one roof can produce conflicts of interest, as the recent behaviour of some the large US investment banks has shown. The New York Attorney General, Eliot Spitzer, has alleged that their investment advice was tainted by conflicts of interest, and that analysts were being less than truthful in their public pronouncements on stocks of companies for which their banks did investment banking business.
The offending banks have now agreed to put in place reforms that will insulate securities research analysts from undue influence from its investment banking division, and will change the way analysts are compensated.
The affair has highlighted the importance of independent investment research. Paul Myners, the author of a UK Treasury report on institutional investment, has argued that investment managers must invest more in developing their own proprietary research rather than relying on “sell side” research from brokers.
The affair has also put a question mark over the whole dilema concerning investment management firm’s independence. Are investment management companies that do not belong to a banking group more likely to do a better job managing a pension scheme’s plans than companies that do? Or are there advantages in having an investment management operation which can call on the resources of a bulge bracket bank?
The problem of a conflict or misalignment of interest is not an academic one. It can cost institutional investors money. Tim Hodgson, investment research specialist of pension consultants Watson Wyatt suggests there is a general problem of misalignment of interest between the principal (that is the pension fund or other investor) and the agents (the consultants, investments managers, and securities brokers). Principals are linked to agents by a food chain in a value adding processes. The more distant the principal is from the action the lower their return is likely to be.
How worried are pension funds about misalignments or conflicts of interest? We wanted your opinion. Our survey shows that a minority of pension fund managers and administrators doubt whether there is a problem – certainly not enough to worry them. However, they admit this attitude may change. One UK pension fund manager says candidly: “We have not been conscious of the conflicts of interest to which you refer and we have not given some of these issues much consideration,” but adds – generously – “your questionnaire will perhaps act as a trigger for us to do so”.
However, most of the pension fund managers who responded to our questions agree that there is at least a potential problem. A large majority (88%) agree with the suggestion that investment management companies that are owned by an investment bank are likely to face any conflicts of interest in their management of a pension fund’s portfolio.
If this is the case, should pension funds rate independence more highly when choosing an investment manager? Indeed, should it be one of the criteria for selection, along with investmenent performance? An overwhelming majority of respondents (94%) agree that independence should be a criterion.
However, there is far less certainty about the value of independence; for instance, whether independence equals better service. Only a slight majority (53%) think that an independent investment management company is likely to give better service to a pension fund than an investment management house belonging to a banking group.
Indeed, a rather larger majority (56%) feel that an investment management company that is the satellite of a large banking group is likely to offer advantages to a pension fund that are unavailable to an independent manager.
These advantages are identified as greater resources and economies of scale. Banks are perceived to have deep pockets. One UK pension fund manager suggests that the chief advantage of having a banking parent is “the ability to subsidise the asset management business for the wider relationship – and bail out the business if anything goes wrong”.
Better IT services are also seen as an advantage of using an investment manager belonging to a banking group. One manager of a Swiss pension fund suggests pension funds will get “possibly more accurate information in some cases”. Others suggest better administration, advice on tactical and strategic issues, and the use of analysts.
There is also a feeling that membership of a large financial services group gives an investment manager access to a wider financial world. The manager of a Dutch pension fund suggests there is “a trade off between independence and synergy”. Tied investment managers benefit from “the external effect”, he says, whereby “bigger groups are more likely to be more involved in the financial world at large”.
So what virtues does independence bring with it? One of them may be closer contact with the client. Investment managers are currently competing with each other on how close they can bring the client to the investment process. If pension fund managers want to talk about the management of their portfolios, they are put through to the portfolio manager rather than the marketing manager.
Independent asset managers might be expected to be rather better at this than tied managers. However, opinion among our respondents is evenly divided on this. Only marginally more (53%) think that independent investment managers are likely give a more personal service in terms of access to the portfolio manager.
If independence is not rated especially highly, what about independent research? “Sell-side” research from brokers has earned itself a bad name recently. Today it is perceived as little more than promotional material for a bank’s corporate finance department. So should investment managers use “sell-side” research produced by their parent group? Here, there is fairly strong agreement, with 69% of respondents saying that investment managers should sup sell-side research with a long spoon.
Myners has argued that investment managers should develop their own in-house, proprietary research rather than use outside broker research. There is general support for this, with 71% of respondents agreeing that managers should do their own research.
Furthermore, our respondents are prepared to pay more for this research. Three in four (76%) say they would pay higher fees to investment management companies that produced their own research. However, there are some provisos. “It would depend on our belief in their ability to add value,” one UK pension fund manager warns.
Generally, sound research is seen as part of the job of an investment manager. “We certainly support fund managers carrying out as much research as practicable,” the administrator of a UK pension fund says. “We also think it is very important to analyse broker and other costs and ensure that the manager is providing value for money.”
The suggestion has been floated in the US that the only way that pension funds can avoid suspect research and misalignments of interest is to choose investment management companies that work exclusively for pension funds. However, this idea attracts little support, with 71% opposed – some quite strongly. “We think it would be an unnecessary constraint to be confined to managers who only work for pensions schemes,” one pension fund manager comments.