Friday, July 25, 2008

Pension Governance: Focus on Alignment of Interests

When I was responsible for analyzing and monitoring hedge fund managers, I would always start by looking at a few basic things like how they are aligning their interests with the interests of the pension fund. Does Mr. or Mrs. XYZ Hedge Fund Manager have skin in the game? If they are not investing in their own fund then why should I invest pension money with them?

Another thing that I would look at is the number of people on the sales staff relative to the number of people on their investment staff. Hedge funds typically charge a 2% management fee and a 20% performance fee. Those that primarily focus on marketing will garner a lot of assets under management in a short period of time. This typically happens after a period of strong performance. Most of these large hedge funds then go on cruise control and forget about the performance fee because they are content collecting 2% on a billion or more dollars (they basically become large asset gatherers).

The main point is that when it comes to investment management, you have to ask yourself how are fund managers and pension fund managers aligning their interests with those of their stakeholders? You will read things like "our bonus scheme is based on a four year rolling return period" but I will tell you right away, that isn't good enough.

When it comes to alignment of interests, the devil is in the details. You need to drill down and conduct a rigorous performance attribution to make sure that the performance of the pension fund manager is measured relative to an appropriate benchmark. If it isn't, then chances are that you are compensating that manager for taking on more risk or for the 'beta' of that investment activity.

Let me give you some brief examples of bogus benchmarks below:

Example #1: Bogus Real Estate benchmarks: In a previous post on Alternative Investments and Bogus Benchmarks, I discussed how for the most part, real estate benchmarks do not reflect the 'beta' of the investments or the risks that are taken by the real estate pension fund managers.

One benchmark that pension funds use is some spread over CPI inflation. The rationale is that real estate is an "inflation-sensitive" asset class and you want to use some spread over inflation as your benchmark. The spreads typically are 400 to 600 basis points (4% to 6%) over the annual inflation rate.

There is nothing wrong with this benchmark if your pension fund's real estate portfolio is primarily made up of core real estate AAA properties. The problem is that many pension funds invest in value added or opportunistic real estate holdings, taking on more risk to beat their benchmark. (You can read more about real estate investments by clicking on this TIAA-CREFF Asset Management paper).

Example #2: Bogus Private Equity benchmarks: Another asset class that typically has easy performance benchmarks is private equity. You can read more about private equity's benchmark blues by clicking here.

Once again, many pension funds use some arbitrary figure based on inflation, but if your pension fund manager is primarily investing in top-quartile buyout funds, then make sure that his or her benchmark accurately reflects this. The key is that you need to understand the composition of the private equity portfolio. Are they primarily investing in large buyout funds or are the returns coming from direct investments and co-investments?

Example #3: Bogus Infrastructure benchmarks: Infrastructure investments also need benchmarks that accurately reflect the 'beta' of the asset class as well as the underlying risks. You can read more about infrastructure index wars in this Pensions & Investments article.

Example #4: Bogus Hedge Fund benchmarks: Many pension funds invest in hedge funds or undertake internal absolute return strategies. Whether they they invest in external hedge fund managers or internal absolute return strategies, make sure you understand the risks of each and every strategy and make sure that the benchmarks used to evaluate these internal or external absolute return managers reflects the risks and the 'beta' of the strategy.

These activities need to be carefully monitored because I can guarantee you that most pension funds do not have a clue about how to properly benchmark these hedge fund strategies. For example, if your pension fund manager is using some spread over T-bills (typically 500 to 700 basis points) and primarily investing in asset based lending hedge funds or other exotic strategies with lock-ups of two to four years, then that benchmark is not reflecting the risk/return profile of those strategies. (Read more about asset based lending here and here).

Some pension funds use commercial indexes like the HFR indexes to gauge the performance of their hedge fund portfolios. Here again, the devil is in the details. For example, if your hedge fund portfolio is made up primarily of top quartile hedge funds that are closed to new investors, then a more appropriate index is the HFR non-investable index.

All these examples highlight the need to drill down into each and every investment activity but to do this, pension funds need to be more transparent by clearly stating who is responsible for these investments and how their benchmark accurately reflect the 'beta' or risks of the investments that make up their portfolio.

As a rule of thumb, if your pension fund manager is easily beating his or her benchmark every year, then you've got a serious benchmark issue which also means that you are overcompensating your pension fund managers for 'beta' or taking undue risks.

The solution to all these benchmark issues is easy: pension fund managers need to be more transparent about each and every investment activity that governs their overall composite benchmark. I would suggest that they follow the lead from Ohio PERS and provide detailed policies on all activities (OPERS' investment policies are not perfect but they are a step in the right direction). Moreover, stakeholders need to know who is responsible for each investment activity and how risk is being managed to hedge against any significant losses.

When it comes to alignment of interests, stakeholders are better served by pension fund managers that continually bolster their governance process by providing as much transparency as possible on the risks and returns of each investment activity.

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