“Determined to maintain its position as an innovative asset manager, APG Asset Management has earmarked 2% of its assets under management for investment-related innovation. Anyone in the APG organisation who comes up with a good idea in the investment field can apply for funding and support to put it into practice…In setting up the innovation structure, APG Asset Management wanted to make the best possible use of the company’s resources. That meant deploying APG Asset Management’s 450 investment specialists and other experts in related fields (unlike many other pension investors, APG Asset Management has a wealth of in-house knowledge and expertise).”

I have to say, 2% of AUM is a lot of money! In APG’s case, it’s something in the range of $7.5 billion! This thus begs the question: What’s APG trying to achieve with this creative policy?

1. APG wants to stay ahead of other asset managers by seeking out new investment areas and products.
2. APG wants to motivate staff; the innovation project offers unique opportunities for staff to take on extra challenges and develop personally.

So the Innovation program is about, well, innovation. But it’s also clearly about talent retention. Think of it this way: The innovation policy offers a mechanism to satisfy the needs of highly talented and motivated individuals (by giving them a creative outlet). And, if all goes to plan, it will also lead to some very profitable products for APG in the future.

If all this is sounding sort of familiar, it’s because APG isn’t alone in using ‘innovation’ as a way of retaining talented staff. The most frequently cited example of this strategy is the “20% time” policy at Google. Indeed, engineers at Google are encouraged to take 20% of their time to work on something that they are personally interested in that is company related. The hope for Google is that it will retain some talented engineers all the while getting some interesting products out of it. And, significantly, 20% time has been wildly successful, resulting in GMail and Google News among many other products. Also, in terms of talent attraction and retention, Google routinely ranks first (!) in terms of being an “ideal employer”.

In short, APG is in good company with this type of Innovation policy. It will help the fund hold on to talented staff for longer. And, perhaps more importantly, it may result in some wildly successful innovations.

“But you’ve got to ask yourself: why a London firefighter, a London teacher, a local OPP officer, a local MTC employee and a nurse at St. Joseph’s Hospital might all be served by different pension plan managers with seemingly different strategies and risk tolerance levels? That can’t be the most efficient way to manage scarce financial resources in wild stock and credit markets, particularly when the same taxpayer winds up funding the shortfall if things don’t go as hoped. Which has been the case for at least the past three years…Each fund also has its own approach to public market management, as well. Some do most of it in-house, while others farm out the stock and bond picking to external managers. Invariably, these costs all wind up coming out of the pockets of the employer and employee in the form of the fund’s own unique investment management expenses and pension admin expenses, which amounted to $959 million in 2010…Just think: five different actuaries; five different audits; five different custodians; five different IT departments managing multiple offices…”

It’s an interesting point that definitely merits consideration. That being said, $959 million of costs on $320 billion of assets (which is the total AUM for the five funds) still only represents around 30 basis points, which is quite cheap (especially when you consider all the exotic assets that these funds are into). As you can imagine, then, the blog post above provoked quite a bit of debate in Ontario, including this letter from HOOPP CEO John Crocker, who argued that:

“Our view is that bigger for the sake of bigger alone, isn’t necessarily better. There are risks – for workers, retirees and taxpayers – when consolidating hundreds of billions of dollars of assets into one “mega fund”. In Quebec, the Caisse de Depot et Placement houses all the pension fund investments for public sector plans – yet in 2008, that “mega fund” lost more money than the five separate Ontario plans combined…Moreover, our CIO Jim Keohane notes that once a fund grows beyond $75 billion in assets the real risk is diseconomies of scale – costs can actually start to go up.”

In short, this back and forth has revived the persistent question of whether an enormous and powerful fund is better than one that is small to medium size and dynamic. Personally, I can see both sides of this argument.

I thought we could consider Norway for a moment. The NBIM, which has close to $570 billion in AUM, will have all the economies of scale that a mega Ontario fund (that McQueen is lobbying for) could ever hope to have…and probably all the problems that go with it.

Let’s start with pros: The NBIM is remarkably cost efficient; total cost of management in 2010 was 11 basis points of AUM. This is very low but perhaps reflects the fund’s focus on indexing and its lack of exposure to illiquid markets as much as the benefits from size. The NBIM, for its part, explains these low costs as a result of the fact that the fund makes “less use of external managers than its peer group.” Indeed, the NBIM believes (and has found) that the cost of internal management is lower than the cost of external management and, moreover, that the NBIM’s internal management costs are lowe r than its peers. So in short, NBIM has the scale to do things that a smaller fund might not, which is a real positive.

Now let’s consider the cons: The sheer size of the fund means that a small error or event can have significant financial consequences for the country. This is why the NBIM is so focused on internal compliance and controls and has a keen focus on countermeasures to prevent fraud or ‘unwanted events’. While laudable (and necessary), this can lead to institutional sclerosis that prevents innovation or dynamism (i.e. too many rules). But, to give the NBIM credit here, what choice do they have? You can’t manage $570 billion without rigorous and heavy-duty systems to ensure that all operational risks are well managed. But, again, these systems impose a real cost on the fund in terms of innovation, in my view. For example, the NBIM is only now (after decades of operations) moving into real estate and has no other real assets to speak of. My personal opinion is that a long-term investor should be investing in infrastructure, timberland, agriculture, and real estate. But the size of NBIM makes any of these allocations very slow in coming (if they ever come).

In short, there are arguments that go both ways. I can see how being too large can constrain innovation and lead to conservatism. Moreover, being large can drive funds away from some interesting deals; I happen to know some large funds that miss out on fantastic deals that are “too small to move their return needle” because, given that internal resources (i.e. fixed costs) necessary to source and vet don’t change much by deal size, these funds focus on the large deals even though the small deals offer considerable upside. But I can also see that being large can bring considerable benefits. Large funds have the ability to manage assets in house, make direct investments in real assets, and impose a sort of monopsonistic leverage in their negotiations with potential asset managers, all of which offer considerable return potential.

And, so, I think the ultimate decision as to whether a sponsor should ‘go big’ or ‘go dynamic’ depends on the local economic and political geography of the sponsoring authority. In other words, it may make sense for Norway and Japan to have single large funds, while it may also make sense for Ontario and Sweden to have a handful of smaller funds. There’s really no one-size-fits-all solution.

This post originally appeared on the Oxford SWF Project.

• New York says it wants its pensions to finance bridges.
• The UK wants its pensions to build roads and railways.
• And China, for its part, doesn’t want to miss out on all the infrastructure goodies that will undoubtedly be privatized over the coming few years.

So perhaps we’ll finally see the massive wave of privatization of infrastructure assets that some have been expecting? No doubt the pension funds would be quite keen on this, as they like the asset class (for a variety of reasons). Indeed, all the people rattling on about ‘win-win‘ situations with respect to infrastructure needs and pensions’ interest in infrastructure…are right!

But, sadly, that doesn’t mean investors will jump at any of these new opportunities to invest in infrastructure. Why? Because the problem isn’t the appetite these funds have for the asset — the problem is a lack of viable and effective ways to access the asset class. Put simply, there is no easy mechanism (for now) that allows long-term investors to invest in infrastructure in a fully aligned and cost-effective way. It simply do esn’t exist.

Even the new Osborne plan in the UK seems a but murky on the issue of access; the news articles I saw simply said that the country would try to unlock pension assets for infrastructure in the same way the Canadians have done. For real? So does that mean we can expect the UK to help their pension funds develop large in-house teams with high levels of expertise (and high salaries) in order to make direct investments? Because if this isn’t the plan, then the UK’s not really doing what the Canadians did.

Anyway, whatever the case, this is a step in the right direction. But ultimately this discussion will have to be redirected towards the mechanisms to facilitate “easy and direct access”. Stay tuned.

This post originally appeared on the Oxford SWF Project.

Given that I’m also coming off a week in Malaysia — which is the global hub of Islamic finance — I can’t help but reflect on some of the lessons that this niche market may offer the mainstream. Why? Because there are some really innovative things happening these days in Islamic finance. (And for those of you that think Islamic finance is not worth paying attention to, consider this: Goldman Sachs, in October, registered a $2 billion Islamic bond program → pay attention.)

Anyway, as you are no doubt aware, Islamic finance imposes some pretty serious constraints on its denizens. For example, there’s a ban on excessive speculation. There’s a ban on leverage. There’s a ban on selling things you don’t own. There’s a ban on charging interest. There’s a ban on investing in firms that rely on interest revenue or that carry a lot of debt. There’s the requirement that income must be derived as profits from shared business risk. And so on. On the surface, then, you’d expect Islamic finance to be severely constrained. And, you’d be right. But I’d argue that these constraints may offer opportunities for mainstream finance.

In the world of intellectual property, the workarounds that people come up with to avoid infringing a patent are sometimes more sophisticated and valuable than the originally patented concept. So, my thinking goes, perhaps the constraints imposed on Islamic financiers will lead to creative innovations and products that ultimately improve finance generally. Why? Because the constraints listed above actually sound reasonable. And, moreover, since Islamic finance is firmly rooted in capitalism (i.e., the profit motive and private ownership remain firmly intact), these constraints (and their workarounds) are compatible with non-Islamic finance as well.

Now, I’m not saying all investors should avoid pork products or sell their alcohol stocks. I’m also not arguing for a return to “simple finance”. (Note: There are, today, Islamic hedge funds, Islamic derivatives traders and even Islamic mechanisms to sell short; see “Arboon Method”). I am saying, however, that I think Islamic finance offers insights into how finance can be better grounded within the “real economy”, from which it has grown increasingly disconnected. For example, in nominal terms financial markets are four times as big as real markets. Why? Is it for the benefit of industry? Or is the size of finance for the benefit of finance? Because every transaction has to have an asset earmarked with it, the Islamic financial sector cannot distance itself too far from the real sector. Perhaps that’s something worth exploring in the mainstream.

In sum, institutional investors have given up on MPT and are searching around for P-MPT principles because they want to really understand the assets they own and the risks they are exposed to. It seems to me that certain aspects of Islamic finance would greatly improve the visibility of assets and risks through a deconstruction of financial products and services that ultimately roots them in the real economy. And it’s in this regard that I think Islamic finance can be useful to P-MPT.

This post originally appeared on the Oxford SWF Project.

On cue: My Oxford colleague Gordon Clark has just published a paper that really adds to our understanding of the institutional constraints to long-term investment strategies within pension funds. The paper is entitled “Fiduciary Duty, Statute, and Pension Fund Governance: The Search for a Shared Conception of Sustainable Investment.” Here are some blurbs to whet your appetite:

“Fiduciary duty is the golden rule ‘regulating’ the relationship between trustees and beneficiaries. In principle, it regulates behaviour by pre-empting those actions that would harm the interests of beneficiaries while promoting duties of care consistent with the interests of those that stand to gain from well-intentioned and responsible decision-making. But, in many respects, fiduciary duty is a chimera: it looks to convention rather than forward to innovation in investment management. As such, governance policies and practice must provide the instruments that simple recipes of fiduciary duty are ill-equipped to provide. In this paper, I argue that the design and governance of investment management institutions is, actually, more important than honouring the principle fiduciary duty which, in the context of Anglo-American statute, is increasingly empty.”

And if that didn’t raise your eyebrows, try this:

“In so many ways, fiduciary duty has been so denuded by government regulation that what is left is a rhetorical gesture on behalf of those that stand to benefit by the status quo. At best, fiduciary duty remains as a case specific mechanism for restitution in circumstances where government policy, regulation, and its guarantee institutions are either not relevant or unable to deal with the issue. At worst, fiduciary duty remains as a trump card for those that would wish to protect their own interests in the face of obvious demands for profound change in the nature of investment practice.”

Note to the Long Term Investor Council of the World Economic Forum: Gordon can be found here.

This post originally appeared on the Oxford SWF Project.

One theme that seemed to come up in a lot of conversations was the global search for returns by US pension fund managers that are trying hard to meet lofty return expectations — 7.5 to 8.5 percent in some cases. As someone said to me, “Where on earth do we find the returns we need? Seriously, Ashby, where? I’m all ears.” And so there is a growing community of under-resourced pension fund managers scouring the world for markets and industries in search of these mythical returns.

The irony in all of this is that these return expectations are high because the pension beneficiaries want to preserve their benefits, and governments want to keep their contributions low. So the burden falls on the pension funds’ investment teams to make up the difference. In other words, sponsors ask these (under-resourced) funds to generate returns that exceed the long-term return on equities! That’s right: in the 20th century global equities returned 5.8% and bonds 1.2% (or thereabouts) in real terms. So we’re asking pension funds to develop a diversified portfolio and beat long-run equity returns by more than 200 basis points. Sorry, team, that sounds crazy to me. What gives?

In short, the sponsors are asking pension funds to deliver unrealistic financial returns over the long run in order to generate short-term political returns. By using an unrealistic return expectation, the pain of paying for the pension promises can be kicked down the road to future generations. Anyway, I find all this really frustrating. But enough of that depressing stuff. Enjoy your weekend!

This post originally appeared on the Oxford SWF Project.

Indeed, a growing number of institutional investors, and in particular sovereign funds, are seeking out talented, young asset managers — generally in the hedge fund space but there are other examples in infrastructure and private equity as well — with the purpose of seeding them with startup capital. The idea is to spot a rising star and extract concessions before the young star’s bargaining power becomes too strong. There are many new examples of this in both the public and private sectors, but I’ll give you one example to make it all a bit more tangible: APG’s IMQubator. APG’s seeding vehicle describes its raison d’être as follows: “IMQubator’s mission is to realize high absolute returns at low costs for our investors by investing in new and innovative investment managers.”

By setting up ‘arms length’ funds, institutional investors can try to get the benefit of superstar talent without having to actually locate those individuals within the walls of the organization. People that would never work for a pension or sovereign fund actually end up working for a pension or sovereign fund. And these individuals are outside the organization, which means they: 1) are totally free of political interference; 2) can be paid market rates; 3) can be located in financial centers; 4) can be easily fired if they underperform; and 5) do not spoil the culture of the public organization with their egomaniacal ways.

It’s really quite an interesting development: you’ve got large (oftentimes bureaucratic and public) institutional investors that are, in effect, launching new companies. Last I checked, this is a very hard thing to do, and I’m not sure I’d look to public pensions for brilliance in the area of venture capital. Anyway, the fact that these public funds are willing to incur these risks should give you some sense for how frustrated they all are with the current norms in the asset management community. Watch this space!

You really have to admit, this is an elegant solution to an intractable problem. I envision a group of sovereign funds or pension funds coming together in an alliance in much the same way airlines have done through OneWorld or Star Alliance; they’d compete in some areas but agree to collaborate in areas where there is mutual benefit. In the case of the airlines, the partners focus on different geographic territories, so it makes sense to collaborate instead of trying to build an organization that can cover the whole planet. So they code-share and link rewards travel, which gives their local operations a global reach. Why can’t institutional investors collaborate in a similar manner? Why doesn’t the IFSWF in effect become the Star Alliance of sovereign funds? The Sovereign Alliance!

Anyway, this is why it’s so much fun being an academic: I get to write stuff that makes absolute sense intuitively but, in practice, is probably impossible to implement. The truth is this: It’s really, really hard for institutional investors to collaborate. It’s all about finding like-minded individuals within like-minded institutions that are willing to accept “No” 10-20 times to co-investment opportunities before they hear a single “Yes”. It’s about developing relationships, trust, and all of those things that are extremely hard to formalize and institutionalize in legally binding ‘Alliances’.

In fact, some funds and people are trying desperately to formalize and institutionalize collaboration right now, and I can guarantee you that all those individuals will tell you the same thing: It’s really hard. And when you add lawyers into the mix, collaboration moves somewhere between really hard and impossible.

Nonetheless, I remain absolutely and utterly convinced of the logic of collaboration. And I also think it’s worth the effort to find ways to work together. Here’s hoping that a new ‘Sovereign Alliance’ or ‘OneWealthFund’ will be ‘deal-sharing’ in the coming decade.

“Take for example, our approach to climate change. We believe that an integrated approach to climate change risk will help investment managers in all asset classes to identify potential risks and opportunities and thus improve long-term performance. Investments are not to be selected or rejected solely on the basis of climate change risk factors. Rather, climate change risk factors are taken into consideration to the extent that they have a material impact on the financial return of an investment. For example, in conducting due diligence on a potential acquisition, we would consider the fact that well- managed companies may have a process in place to identify and analyze future challenges and opportunities associated with climate change if it is deemed to be a material investment risk. A clear and straightforward statement regarding the implications for competitiveness that addresses issues such as access to resources, the timeframe that applies to the risk, and the company’s plan for meeting any strategic challenges posed by climate risk is encouraged.”

In other words, it’s all about developing a risk-based culture that thinks creatively about these issues — assessing present and future risks to a certain investment strategy or acquisition. Anyway, interesting stuff. Kudos to OTPP.

This post originally appeared on the Oxford SWF Project

This paper serves as a remarkable analogy for the current governance constraints facing pension and sovereign funds. Just as many institutional investors around the world are accountable to lay boards, so too are many project teams overseeing large scale projects. Indeed, the themes and issues applied by the authors to ’steering committees’ (SCs) can easily be applied to the Boards of Directors, Investment Committees, and Trustees and Guardians of pensions and sovereigns.

As such, the paper (unwittingly) describes the challenges facing institutional investment in the modern and complex era of global finance (and even offers some ideas for resolving them). Here are some of the most interesting blurbs from an investment perspective:

“This study addresses the dilemmas and challenges facing steering committees or other supervising bodies of large and strategically important initiatives. They ultimately bear responsibility, but they are not in a position that allows them to understand all the details of what is going on. They do not have the time, they are distant from the actual work processes, and, after all, executives cannot be experts on everything.”

“The added difficulty comes from organizational distance: hidden information, multiple areas of expertise, non-aligned interests, and other changing circumstances. Some projects fail not because of project management itself, but because of failure of the supervisors to provide the necessary senior leadership and governance to the project.”

“SCs are often formed based on political decisions, including people “who are important” on desirable projects (or those who are irrelevant on undesirable ones), rather than people who really have a role to play, (either because they own resources or the benefits and risks associated with the project).”

“Keeping the SC to a manageable size is therefore important. “You try to staff the SC to have people who possess the power and the capability to get things done, and who have a shared interest. Typically, a SC should have 6-8 people on it.”

“The SC needs to clarify and agree on project goals…Goal agreement is easy to characterize in principle: The SC needs to agree on a set of goals that can be translated into targets for the team. However, coming to an agreement about “clear, operational goals” is hard to do.”

“In an ideal world, the SC should be in the position to choose the [project team]; articulate the domain expertise required for successful execution, and ensure that this expertise is represented on the PT. In practice, however, the SC is often put together after the project team has already been put in place. Nevertheless, the SC should still to the best of their ability define and articulate the required expertise for the project and check whether the PT suffers from severe gaps.”

“Because of the complexity and specialized expertise involved in complex strategic projects, a tight oversight (ensuring a vetting of all important decisions) is simply not feasible for the SC. Substantial delegation is unavoidable.

“Misalignment can become catastrophic, and moreover, it may be so subtle that it is hard to recognize at first. Thus, the abdication that we have described in the section above is a real risk that can arise without the SC realizing it.”

“No matter how carefully you have planned, it is not a question of whether but only a question of when the plan will have to be modified. The key question is then whether the deviation was due to a mistake that can be corrected, an unavoidable deviation that is minor and can be made up for, or a reason for actually modifying the plan?”

Fascinating. This has given me the inspiration to really dig through the project management and governance literature. There’s a lot to learn. Anyway, the charts below offer some thoughts on 1) the constraints and challenges of good project governance and 2) how to overcome these challenges (click on image to enlarge).

This post originally appeared on the Oxford SWF Project.