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Selecting delegated investment managers

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Learnings from e-commerce and beyond.
Ortec's Maurits van Joolingen shares his thoughts on ratings, reviews and choices when it comes to investment management.

Let’s face it – no one buys a product online these days if its rating is below three stars, or it has no reviews. Ratings and reviews (the five-star rating system and user reviews) are undoubtedly one of the key success factors behind the spectacular rise of e-commerce over the last decade or so. Think Amazon, think your local restaurant. Lack of reviews, lack of stars and ratings, it plants a seed of doubt.

The concept of rating has become so popular that it is difficult to imagine consumers selecting products and services without it. However, there is a catch. Although ratings and reviews do help consumers in selecting many things, their utility is limited when it comes to selecting complex products and services. For example, a simple performance indicator-like rating or a bunch of user reviews is probably not enough for selecting large and complex household goods or financial products.

Let’s now look at DB pension plans where we’ve seen a spectacular rise in delegated investment management structures, also known as Fiduciary Management or Outsourced Chief Investment Officer (OCIO). There are many different providers for this kind of service these days, all calling themselves different things which can be confusing for schemes, but what is really lacking is the information to quickly assess their performance to make reasonable comparisons.

The fundamental question therefore is – just like simple ratings and reviews are not enough to select complex products to buy, how should delegated investment managers be compared and selected if proper information or guidelines are not available?

Most likely, the reason why such information is lacking for delegated investment managers is the complexity that comes with assessing their performance. Although the overall objective of a pension plan is often explicit, there are varied degrees of disparity about outperformance of liabilities, underlying risk drivers, covenants and degrees of freedom.

Moreover, a strategic investment policy should be closely aligned with the risk appetite of the underlying stakeholders (e.g. what is the maximum acceptable level of contributions) which can differ significantly across plans. Due to these many differences associated with delegated services, it becomes complicated to define one single benchmark for the whole industry.

How to solve this dilema?

To assess the added value of delegated investors, we need to go back to the core of the brief. Usually, this is to provide an attractive risk-adjusted return compared to a passive low-cost strategy and help the pension plan achieve its ultimate objective. The added value of a delegated investment manager can then be determined by comparing their performance to such a passive low-cost strategy, often referred to as a reference portfolio - a concept that has been adopted by some large institutional investors globally.

The reference portfolio should reflect a simple investment strategy with a low-cost profile, which a pension plan can easily adopt and manage with limited resources. For Equities and Fixed Income, a wide array of exchange traded funds (ETFs) is available which provide such possibilities. It is also relatively straightforward to invest in Real Estate (REIT’s) and Commodities (also via ETFs). Combined with a strategic asset allocation that is closely aligned with the strategic objectives and risk appetite of the pension plan, the reference portfolio provides a simple, relevant and replicable benchmark for any delegated investment manager to target.

A delegated investment manager should aim to add value for the pension plan in excess of the reference portfolio and this can be done in a number of ways, such as:

·       they can access a broader range of asset classes, such as private equity or hedge funds.
·       they can hire specific portfolio managers which could outperform a sector or industry specific benchmark.

In either case, it is imperative that the risk/return profile of the actual portfolio is closely aligned with the reference portfolio for it to be a suitable benchmark. When that happens, it provides an appropriate basis to assess the performance of the delegated investment manager.

How can the concept of the reference portfolio be brought into practice?

Pension plans that are undertaking a selection exercise for a delegated investment manager should ask for a reference portfolio during the initial strategic discussions. Furthermore, pension plans that have already appointed delegated managers should ask them to define reference portfolios in line with the existing investment policies. Once defined, its returns can easily be measured as a part of standard performance reporting and included as a long-term benchmark for the manager to beat.

Overall, the reference portfolio concept can provide an interesting framework to evaluate and compare delegated investment managers. Setting up a reference portfolio requires the pension plan to also define a strategic view on interest rates and inflation hedging, as well as the degrees of freedom they are willing to provide the delegated investment manager to outperform the reference portfolio.

However, these issues have successfully been dealt with at other institutional investors and work well in the evaluation of in-house investment managers as well. The reference portfolio provides a great opportunity to increase transparency in the sector and lets trustees make better informed decisions.
Maurits van Joolingen, Lead Consultant at Ortec Finance