In Safe Hands

Institutional investment has evolved from working with a balanced manager as the sole provider of investment management to employing a whole range of asset managers trying to grasp the benefits of diversification. The first concept did not deliver on expertise and diversification. One manager cannot be the best in all relevant asset classes. At a later stage, modern portfolio theory stressed diversification, another shortcoming of the balanced manager, and advised a number of specialists, each responsible for a part of the portfolio.

But this concept also failed to deliver on responsibility. Specialists only focused on their part, while those who were responsible for the overall picture were no experts. They had to call for the help of consultants, who had only limited purview too. This created an ineffective organisation without overall risk management and without a fundament for good strategic decision making.

Fiduciary management employs specialist managers and brings responsibility of the overall portfolio into one hand. It brings comprehensive risk management, oversees strategic decision making, and organises effective governance. These characteristics are delivered when the fiduciary properly provides five functions:

• advising the board/trustees of the plan sponsor
• constructing an efficient investment portfolio
• selecting asset managers
• monitoring those managers
• reporting on the investment process.

The fiduciary should offer expertise and a commitment to the overall management of the plan, including asset-liability studies and balancing risk and return considerations, and should diversify as much as is efficient. The board, in general having limited knowledge of and experience in investments, should use an ALM study to take responsibility for a neutrally defined risk budget, stated in terms it is familiar with, such as a maximum probability of having a certain amount of underfunding. The fiduciary can use this verdict to translate it into investment terms, guiding the choice of asset classes, their benchmarks and the level of active policy.

After the board has outlined the broad issues associated with investing, it can formulate the investment approach as a top down construction of assets among a set of asset classes, with sub-allocations within some of them and possibly supplemented by active and dynamic management. The fiduciary achieves an optimal degree of diversification and he manages portfolio risks in combination with liabilities, using state-of-the-art models for dealing with correlations which vary over time.

The fiduciary brings a holistic approach, so that the plan sponsor can still see his or her target within the complex calculations and decide on which asset classes to use and to what degree. These strategic decisions cannot be delegated and they determine to a large extent the outcome of the investment process. This is a very important exercise as, with the introduction of IFRS and of more stringent funding regulations, pension funds tend to match assets and liabilities. Obedience to the regulator is increasingly preferred to the prospect of generating higher returns. Adequate calculations can combine high aspirations and acceptable risk, serving the well-being of pensioners instead of easing the mind of the fund’s decision makers.

Special treatment

Once the strategy is in place, the fiduciary proposes specialised managers to actually invest. He or she should know all the relevant managers and use the necessary data to select them and combine them efficiently in sub-portfolios, thus raising the information ratio. With this input, the fund should have a diversification not attainable before (lack of information, too expensive, no proper risk management of the overall portfolio) and the prediction that selected managers have the skill to produce excess returns.

These revenues of diversification, together with the lower fees the fiduciary is able to achieve on behalf of the client, should improve the long-term revenue picture of the fund.

Once the board has approved the portfolio and contracted the managers, the fiduciary monitors the portfolio by measuring risk and return at the level of the managers, the sub-portfolios and the overall portfolio. To ensure that measuring leads to good interpretation, adequate benchmarks are needed.

It is the fiduciary’s task to advise on benchmarks which enable the fund to understand the results acquired. Do the absolute returns contribute to the set of specified goals and do both absolute and relative returns indicate that risks have been rewarded and the fund does not lag peers?

Transparent reporting on the basis of custodian’s data is a prerequisite for good control of the board, enabling the plan sponsor to evaluate the achievements in terms of return and risk and how these results relate to benchmarks, peers and, especially, the goals of the fund. The fiduciary provides management information, comprised to a volume that invites management to read it, and more in-depth information for specialists to understand all the intricacies of the results. The format of reporting should be according to the wishes of the plan sponsor and, of course, should also comply with regulations.

The detailed alternatives in construction, active and passive policy, overlay procedures, hedging currencies and liabilities, etc. often based on complicated calculations, may require the plan sponsor to receive some training. Moreover, the board is often surrounded by people and organisations chasing their own agendas. Employees want secure assets but higher benefits, the sponsor wants low risk but low contributions, investment managers claim to generate high returns and low risk and advisors claim to have solutions for all kinds of problems. A fiduciary can educate the relevant executives so that they can make the right decisions on all these issues.

Some critics advocate that fiduciary management resembles existing models such as multi-management and implemented consulting. However, looking at the breadth of tasks of the fiduciary, it is obvious that fiduciary management is more than multi-management, which only has one corresponding characteristic and not even the most important one. The construction of an efficient portfolio, in the sense of producing maximum returns given the risk budget, is far more important and multi-management is not part of that structure.

Implemented consulting can approach the fiduciary concept quite closely, if offered in a different way than it is now. The consultant should be embedded in the fund, instead of advising on a limited number of days per year and he or she should have proven skills in translating the ALM outcome into investment terms, portfolio construction, manager selection and the interpretation of portfolio results. It is a valid question whether the consultant will be able to deliver those fiduciary services, as in the past they did not. Did they change because of losing market share? Is it a trustworthy offer? Are they really independent?

Fiduciary management, therefore, is a management model as such and not some purified form of an existing model.