Playing the long game

Marathon runners know that tackling 26 miles and three hundred and eighty-five yards requires thorough pre-race preparation.

In investment terms, pension funds are distance athletes. They are less concerned with short-term sprints than the stamina needed for healthy long-term returns to meet liabilities. Institutional investors can run off short-term performance gasps in pursuit of better, more holistic, returns over time. Broad economic factors that threaten their goal of meeting long-term pension commitments can, however, be critical.

The recent long-term investment guidelines issued by the Marathon Club, a collegiate of UK pension funds representing £170bn (€249bn) in assets, say they aim to realign pension funds with this long-term reality.

The club, created as a result of the 2003 long-term mandate competition organised by Hewitt, the investment consultant, and the UK Universities Superannuation Scheme, said the guidelines were a reaction to short-term thinking in institutional investment decisions. Pension funds, the club said, were increasingly demonstrating a dangerous sprint mentality by demanding quarterly investment results from asset managers and regularly terminating contracts in the event of a poor run of returns. As a result, asset managers had been tacitly encouraged to invest in strategies with short-term prospects to clear these three-month hurdles. The club raised concerns that this approach had become detrimental to the long-term developments of the wider economy and the promotion of a healthy, responsible corporate sector.

Other barriers to long-term investment, it said, included excessive attention to index-based mandates and a preference to sell rather than engage with companies for long-term change. As a result, the report said, trustees spent excess time on volatility and liquidity concerns, both factors of short-term investment. Instead, they should be more attentive to issues of company failure or weakness of covenants, it argued.

The Marathon Club said pension funds should define what investments were valuable for economic sustainability. Investment research should look at all risks and retain a “focused discipline of seeking positive returns over the long-term business cycle”.

The club pointed to the internationally respected Myners Report on institutional investment in 2001, which concluded that pension funds were “influential in defining the capital marketplace and ultimately the shape of the broader economy”.

The guidelines seek to give practical advice to fund trustees and management on how to make such long-term investment thinking and active ownership part of the daily work of running a pension fund. Significantly, they say that funds should recognise that despite radically different levels of assets under management, varied solvency requirements and risk profiles, their common investment rationale is the time horizon of liabilities.

This, it said, was instrumental in determining the best choice of long-term assets balanced with appropriate risk levels. A measured, durable investment approach, it said, implied less potential downside risk for investments than short-term asset decisions. Starting from a priority of long-term asset allocation, the club said pension fund boards should publish an internal manifesto on its investment beliefs. UK pension funds will recognise the approach from their legally required statement of investment principles (SIP), which some have criticised as a socially responsible box-ticking exercise.

The difference, said the Marathon Club, would be that the statement of investment beliefs should act as a consultation document, unlike the legal requirement of the UK SIP. It said the statement should be open-ended and encourage, not inhibit, thinking.

With this in mind, the Marathon Club suggests trustees trigger a series of internal debates, including off-site days, in order to draw up the manifesto.

An example debate, it said, should be whether trustees believe a fundamental, research-orientated buy and hold investment strategy is superior to other approaches over the long-term. The Marathon Club said pension funds had a choice over whether they accumulated capital through short-term trading or allocated it to successful and growing businesses. Another cornerstone of the internal document should be the treatment of governance issues within investee companies and the fund’s attitude to social and environmental risks. This was important, the club said, because of consensus that management or mismanagement of issues such as reputation, corporate governance, the environment and human capital management, played a significant role in long-term value creation or destruction.

The second major step for pension funds is to determine what a long-term mandate contract should look like and how it should be assessed.

Performance of investment managers, the club said, remained key, but needed to be overseen regularly by a specialist investment panel within the pension fund. Discussion would take place with fund managers about the reasons for any lag. Reaction to short-term underperformance should be remedial rather than terminal to promote performance over economic cycles - generally considered to be five to seven years. Potential for asset managers to get ‘lazy’ with longer mandates could be avoided by robust assessment.

Such developments, said the club, would require new methods for measuring fund managers.

One interesting suggestion is the interim appraisal of long-term mandates based on realised returns using the entry and exit prices of shares. This would avoid short-term performance measurement that can be impacted by market noise. In addition, it would clearly test a fund manager’s ability to add value. Unrealised investments could be approximated by calculating the internal rate of return (IRR): a theoretical look at what investments would be worth based on quarterly or year-end stock prices.

The setting of new absolute risk objectives, the club said, would also be key. Funds might, for example, demand that their fund manager not lose any more in a given year than a percentage of the fund.

In turn, trustees should question whether tracking error - the difference between asset manager performance and a benchmark index - was really any value to a long-term mandate.

Measures, such as value at risk - the probability of loss for a fund manager - could be more useful for checking managers’ stock selection convictions. Other risk factors to prioritise, it said, were the minimum and maximum number of stocks held by a manager, the maximum stake in any one stock, portfolio turnover and gearing levels.

Taking a longer-term time horizon, the club said, would also enable pension funds to include investments with longer risk profiles. To this end, the club said consultant influence would be decisive in advising pension funds’ specialist investment panels.

With regards to manager selection, the Marathon Club said the traditional beauty parade had served pension funds badly. Asset managers were often badly known by the fund and there was little mutual understanding of investment objectives.

Instead, asset managers should be selected after proving they have a long-term investment approach embedded within the company. This would require detailed engagement by investors, including regular, well prepared site visits.

Investors should also be aware of exactly what they are paying for: How original is the investment approach of the house? Does it have portfolios that differ significantly from the index? What are its levels of stock turnover? What is its capacity to successfully hold views contrary to the market? How consistent is it? What is its attitude to fundamental research and capital maintenance? Furthermore, how are clients informed about the loss of key staff or changes in investment process or ownership?

In another key proposal, the Marathon Club said it strongly supported co-investment by fund managers in order to align client interest; adopting what has become a norm in asset classes such as private equity.

On the crucial issue of manager fees, the club said funds might look to introduce a base fee to cover fund manager costs alongside a performance related element on the basis of pre-agreed targets. Further performance could be progressively rewarded using a series of hurdles subject to a ceiling to dampen excessive risk taking. Pension funds limbering up for their long-term investment tasks should take a close look at the Marathon Club training guideline.

Hugh Wheelan is the editor of Responsible Investor (www.responsible-investor.com), the on-line newswire and magazine for institutional investors dedicated to environmental, social, and governance issues