The best-practice investing model could either involve how you do it or what you do. In reality a successful model is about both, and how they line up. The rest of this article seeks to find the patterns that will make certain models successful. The secret is that there is no single answer; the best model depends very heavily on context.
In seeking answers to the question posed in the title, it seems important to list the characteristics that make asset owners distinctive types of organisations. First, they are very pure people businesses; they must be centred on effective governance, generate creative ideas and have streamlined processes. All three disciplines – governance, ideas and process – require talent.
Secondly these institutions work in not-for-profit forms in the long term, so avoiding the shorter-term ‘creative destruction’ of the for-profit sector; they also have remarkably long time horizons in their missions; and are blessed with permanent capital with limited competition in gathering assets.
Thirdly, asset owners rely on a complex chain of external providers, notably asset managers (I’ll call it the ‘value chain’ from here).
It’s these characteristics that speak loudly to the best-practice question. This can explain how the ‘endowment model’ came to be a pin-up of its time and why it needs adaption in future.
The launch pad to the model was the exceptional investment thinking embodied in David Swensen’s ‘Pioneering Portfolio Management’. It recognised the importance of good governance. It showed understanding of other investors’ limited recognition of the new field of private markets. It captured the rich early seams of the illiquidity premium. It worked the fertile areas in its value chain and did so with a talented investment team that had its specialisations but managed to integrate well with the external investment industry, particularly the private market sector.
Subsequently, however, in many places private markets have become over-crowded, making thinner pickings for illiquid assets. The investment thesis burns less bright as a result, but it has not been extinguished. Taking advantage of long time horizons and differentiating yourself from the traditional index-centric asset class investment strategies has still got an attractive pattern to it. Crucially though, this investing model needs to be supported by an organisational model with an uncompromising reliance on investment talent – both internal and external. As Yale have observed themselves in their most recent annual report, “while alpha is not dead, opportunities to access it may not be available to all investors”.
So where else should investors look for investment model inspiration? A global search might well throw up the Canadian and Norwegian models; also there are notable examples in the Netherlands, UK and Australia.
But, before we look into these we should parse the finer distinctions between the different approaches. Earlier in this series, we discussed the overarching issues that we believe will shape the investment industry in the coming years (see “Challenges facing the world’s biggest funds”).
These are about differences in risk philosophy on private and public markets, the shape and philosophy in the value chain and the organisational design as regards integration or separation.
The managed risk route to higher performance
The risk budget can take on two areas of high conviction. The biggest opportunity is in how large the move away from bulk beta to produce high diversity is (that can be both in public and private markets), and there is also how long the decision-making time horizon is in both design and implementation.
As many investors seek better returns, reduced concentration on (equity and bond) bulk betas is a natural move. In public markets the obvious move is to commitments in alpha. But there are also opportunities in factor investing, other smart betas and liquid alternatives.
Investors can also go further with the esoteric and exotic: think of reinsurance, volatility investing and alternative credit. While asset allocation as practiced a decade ago was making allocations to maybe eight or 10 asset classes, some now see allocation to around five buckets (grouping into risk premia, for example equities, credit, duration, real assets, skill) but as many as 25 allocation classes.
A distinctively different strand of this is the private markets area where there has been a rise in the popularity of real estate, infrastructure and private equity. These investments are symptoms of a more competitive pursuit of excess returns. Of course the endowment model is associated with 50 per cent or more in private market assets; the more common version of this among the pension funds and sovereign funds is a 20 – 30 per cent allocation.
A longer time horizon sits well with these ideas. Thematic opportunities around trends and discontinuities such as emerging wealth, ESG, resource degradation and scarcity, and demography can offer longer-term investment theses for further effective departures from the norm.
The organisational design route to high performance
The current organisational design debate pits integration against specialisation, and internal structure against external. These simple tags mask many subtle differences. The most significant issue concerns the specialisation drift of big funds. Specialisation carries a competitive edge and specialist teams may capture better alpha from their domain excellence.
But highly diverse strategies lose something in specialised silos, as tightly benchmarked asset class teams will forgo some opportunities in the merging mandates, horizontal themes and total portfolio areas. The approach adds together a series of bite-sized pieces. There will be overlaps and inefficiencies as these are pieced together.
Increasingly favoured is the integrated model where the whole portfolio is considered as one. This involves balancing factors, exposures, risks, correlations and thematic thinking over an entire fund; a significant, but logical, shift in approach. Every idea is tested in its risk return impact to the portfolio. The team can come together to compete with their ideas. This is not about filling buckets and managing tracking error – both concepts that have drawbacks in the specialist teams approach. This ‘one portfolio’ approach offers a unique oversight into true risk exposures, whilst also allowing investors to have impact with thematic positions. So it works well with the philosophy of multiple lenses to risk.
In the internal against external debate, there is no substitute for strong internal capabilities. This is particularly the case when it comes to private markets. The extent of external management is a value chain decision but a strong external model can never be complemented successfully by a weak internal model. The model fund has to be uncompromisingly tough on the value chain. It can look to drive out any cost excesses and value-add blemishes from the value chain by considering embedded costs alongside explicit costs, and ensure that they achieve value propositions in all situations.
In many cases this analysis may lead funds towards the conclusion of increasing internal management. Funds by and large on my calculations spend too much on external strategies that border on hope. Hope is not a strategy.
Investment rigour and alignment
We now come full circle to the two must-haves in the model: rigour and alignment. Rigour combines deeply-held beliefs, coherent investment processes and diligent execution. The governance binding these elements is critical.
Board governance often undermines strong executive management. The alignment connects the competitive position of the fund, the intellectual rigour to the positions taken, and the organisational design and value chain.
We have good examples of this alignment in the frequently quoted Norwegian and Canadian models. Each is a joined-up mix of features. The Norwegian model is based around strong cost-controlled governance, a select internally-oriented team and narrow breadth in active management. The Canadian model is based around strong value-driven governance, specialist internally-oriented teams and wide breadth in active management.
The third model (the one with no name, I’d try ‘Australian model’ after Future Fund) is the one based on strong long-term governance, integrated internal and external team, and wide breadth in active management. Wellcome Trust is another exemplar here.
We should also debate one other dimension – the sustainable investing model. The concept of sustainability in investment is concerned with strategies that are designed to be effective in the short and long term, recognising the complex linkages between short and long term while balancing the financial and non-financial factors. ESG lies at the prosaic end of sustainability; the more meaningful end is broader, being keyed into a long-term sustainable mission.
One of the best examples here is the Dutch pension fund PFZW (managed by PGGM). Their philosophy is to take some ‘responsibility for contributing tangibly to a sustainable world’ while assuming ‘a sustainable world is a necessary condition for generating adequate returns over long investment horizons’.
That is basically an articulation of the ‘universal owner’ model that a large asset owner with a long horizon and globally diverse investment ownership should contribute to the economic and sustainable well-being of society because it is ultimately in their financial and non-financial interests to do so. Asset owners of course will find themselves in unique circumstances, particularly those born of constraints from scale, politics, governance and culture. There are unique objectives, history and resources to factor in.
It seems questionable then to posit a series of ‘investment models’ (let alone just one) as a way to position investors to compete for the returns they require. None of the above models is fit for exact imitation but all create clusters of attributes worthy of study. The model needs to be one that matches compelling perceptiveness and depth in thinking and understanding, while taking control of the value chain with depth and quality at both ends – internal and external. The model is both what you do and how you do it.
By Roger Urwin, global head of investment content at Towers Watson
Roger Urwin