Written By: Magnus Spence
Magnus Spence at FidesIQ discusses the frequent mismatch between what asset managers are saying and doing and how to rectify it
I was recently asked a question by my daughter as she struggled with an economics degree essay that included her having to have a view on “What is the most important quality needed in business?” I toyed with various rather hi-fallutin’ suggested responses but in the end I offered a more prosaic one: “Doing what you say you will do”. Yes, delivery surely is the key to a successful business. Well, my daughter agreed and built her essay around this, and I waited nervously to hear how it was marked. More on that in a minute.
But what, you may well ask, have theories about business qualities got to do with the focus of this edition – secure income assets used by Local Government Pension Schemes (LGPSs)? Well, in secure income assets (and to be honest in pretty much every other asset class too) there is significant evidence of the opposite of “Doing what you say you will do”. What we are seeing could be described as: “Saying what you will do, and then not making it at all clear whether you have done it.”
This alternative approach where there is a possible mismatch between saying and doing, is prevalent across UK pensions. And it has significant disadvantages for investors, and I hope that by writing this article LGPS fiduciaries will in future be more alert to it and the benefits of trying to change it.
We have selected two examples of how this mismatch can arise from within the world of secure income: long income property and asset-backed securities. We could have used plenty of other strategies: these are not the only ones suffering this problem. First we look at the what asset managers say these strategies will do, and then later we look at whether they do it.
Long income property fund
We have come across many of these long income property funds, and a typical description by the asset manager of what they aim to do will be:
- To provide a steady and reliable income stream with a strong correlation to rises in inflation
- To provide returns which are less volatile than traditional property investments
The first of these objectives is particularly important during the current economic environment and I am sure that the attraction of investing in assets whose performance has a strong correlation to inflation will feature heavily in other articles in this issue.
The second – volatility-related – objective is also important, particularly if there are already real estate assets within your portfolio which you do not want to dispose of at the moment but you are also seeking not to increase the concentration risk within your portfolio.
Our second illustration is a strategy that is in favour at the moment and certainly provides many benefits to LGPS investors: asset-backed securities. We understand why investors would be drawn to one or more of the four objectives these assets are said to deliver:
- Attractive risk-adjusted returns compared to investment grade bonds
- Protection from movements in interest rates
- Exposure to risks not typically found in traditional portfolios
- Downside protection in uncertain economic environments.
The importance of objectives to decision making
We haven’t invented what we call these “strategic objectives” for our two examples, they are visible in publicly available marketing materials and in presentations made to LGPS fiduciaries. These well-articulated objectives are taken very seriously by LGPS fiduciaries when they make decisions to invest, and quite rightly. It is the pros and cons of these strategic objectives, and how their inclusion in your portfolio will improve the portfolio’s chances of meeting its overall objective – no matter what the economic conditions to come – that you will spend most time discussing with your fellow fiduciaries and your advisers as you come to a decision about investment.
The mismatch between what they say and do
So much for “What you say you will do”. Now let’s get to the “doing” bit. This is where our problem emerges. In both our examples, long income property and asset-backed securities, we (and you as fiduciaries) have no idea whether these strategies are doing what they said they would do, because their asset managers don’t tell us.
For a long income property fund investment, the way that performance is measured and reported by a typical asset manager is how the market value of the assets are moving over time. Hey! Increasing market values may be desirable, but that’s not the primary objective! The two promised objectives were shown earlier – to provide income streams that are in line with inflation and to provide lower volatility than traditional property assets.
You can see the mismatch I am talking about here: what was promised was one thing (well two actually), while what is being delivered in the form of performance measurement is increased market values – something completely different.
These funds may be doing what they said they would do originally, but the asset managers make it impossible for investors to know this in the way they communicate performance.
This same mismatch occurs in our asset-backed securities example. The way that performance is measured and reported by a typical asset manager here is based on one measure only – against a cash benchmark. Again – whoah! Beating returns on cash is not the objective that was promised! You will remember there were four of these attractive objectives, none of which are being delivered in the performance as it is being measured, or if they are, and just as in our first example, the asset manager makes it impossible for investors to know this.
How to address the mismatch
It may be that asset managers are failing to meet their promised (but unmeasured) objectives, but are instead meeting the different objective that they do measure themselves against. Clearly LGPS fiduciaries should be on high alert to spot this, and should ask their advisers to help them call this out.
But of course, there is also the possibility that asset managers are indeed delivering all the multiple benefits they had promised, but are then failing to communicate this success to their clients. If true, this is a doubly perplexing mismatch and it clearly needs fixing. Luckily there is an extraordinarily easy way of doing this: asset managers should provide performance measures which actually synchronise with each of their original promises, so that it is clearly visible that they are doing what they originally said they would do. And consultants and advisers can encourage this critical change by insisting that this is the case in future.
The investment and governance implications of the “Strategic Gap”
Why is it important to measure performance against the original objectives? We have been identifying this mismatch across the whole investment universe in UK pensions, and at FidesIQ we have given it a name: we call it the “Strategic Gap” in performance measurement. This gap is not a minor oversight, it has major investment return and governance implications.
There are four main benefits of measuring performance in accordance with the original objectives.
1. Learning from past lessons. Fund fiduciaries, whether those who made the original decision or those that come after them, are able to use the lessons from previous investments – whether they met their strategic objectives or not and what factors influenced that performance – to make better investment decisions in the future.
2. Improved dialogue with advisers. Fund fiduciaries can use the information provided by the results of this measurement to have a much richer dialogue with their investment adviser. This dialogue will centre on existing investments – whether they are doing what they are supposed to or whether they should be tweaked in some way as a result of emerging market conditions (because let’s face it, no advisers can predict future market conditions when they give their initial advice) – and can also be used to inform future investment decisions.
3. Focus on relevant areas of portfolio. Fiduciaries can focus their attention on the area of the portfolio that is having the most impact on portfolio returns, not simply on the area where performance against a stated benchmark – which may have no relevance to the strategic objectives of the decision – is most stark.
4. Engagement with all stakeholders. Most importantly perhaps, this form of reporting enables those who have perhaps a limited knowledge of investments and very little time to develop that knowledge – something that can be true of some members of pensions committees and pensions boards – to really understand the simple objectives of the different elements of the fund portfolio and to see, very clearly, how those objectives are being met.
So, we have shown the many benefits of a world where investment suppliers pay attention to what my daughter argued in her essay is one of the most important principles in business: “Do what you say you will do”, and give relevant measures to prove this over time. Well, I’m relieved to tell you that official support for the importance of this quality came in the form of a strong essay mark for my daughter from her economics tutor, so it must be true. In the future we may occasionally still see examples of asset managers reluctant to give evidence that they have delivered what they originally promised, whether it is in secure income assets, or in assets across the rest of the portfolio. But those LGPS fiduciaries who agree with my daughter and her economics tutor on what matters in business, are well placed to start making this practice a thing of the past.