Introduction to Integrated Total Fund Management: Part 1
Over the next seven weeks, each Thursday we will bring you a new installment. Below, Part 1 where Mihail introduces integrated Total Fund Management (synopsis) and we embedded a clip with a more detailed discussion at the end of the post:
TFM is the unwritten chapter in your favorite portfolio management textbook. A simple experiment to find this topic in 150 million textbooks, including seminal books by William Bernstein, David Swensen, Bob Litterman, Grinold and Kahn, has nothing TFM or total portfolio management. No matter how hard one searches, there are no textbooks or blueprints on how to do this. Most recently, there has been a notable shift in some of the largest Canadian pension funds, such as CPP Investments, OTPP, OMERS, and PSP Investments, in creating dedicated TFM functions.
This shift's main reason is to address the size, scale, and efficiency challenges these organizations face. The steps toward establishing the TFM function have been: (i) a dedicated senior executive leadership; (ii) a stated primary objective of their strategic plan documents; (iii) board of directors and CEO support; (iv) a top-down and cross-asset focus; (v) short- and medium-term capital and risk allocation; (vi) other total portfolio activities such as liquidity, leverage, currency, and balance sheet management. Following an analysis of the latest annual reports, this dedication is particularly notable at PSP Investments and CPP Investments, with most other funds also starting to expand this investment function.The organizational maturity curve that many of these funds are now experiencing is the main reason for the shift toward TFM. Following the expansive build-up phase of laying the investment engine's foundation based on strategic asset allocation and the investment groups, the initial economies of scale may now be reaching a plateau. While the funds have built strong and robust organizations, ironically, exactly when the organizations are at their best, they face their biggest challenges, and the organizational curve flattens. Unfortunately, significant size and scale come with overlaps in functions and activities, different centers of gravity, communication challenges ("hearing but not listening"), lack of proximity, and sometimes lack of clear vision. Culture becomes a problem. Many things are self-centered and focused on keeping importance, keeping the function and the benefits that come with it, internal politics, and inertness. Additional reasons are the increased external scrutiny, oversight, regulation, reputational issues, social license to operate. In some instances, even one might argue that there is no external challenge to renew because the clients are generally captive.
At this point, TFM becomes increasingly important because the critical role of TFM is to restructure the investment function to optimize scale. It is about pursuing second-order efficiencies and bring back the economies of scale and make these funds as efficient as they once were. The presentation further introduces the concept of economies of scope or the ability to do one thing, which allows up process (do many things and eventually, do them cheaper), economies of scope are a top-down process to bring second-order efficiencies. As a simple hypothetical case study, imagine that one of the funds has a sizable New Zealand real estate portfolio. There is a decision (for whatever argumentation), to hedge the NZD. Simultaneously, the fund is trying to ramp-up its natural resources portfolio by aggregating family dairy farms and land (an arduous process, by the way). Both perspectives are bottom-up. The TFM top-down perspective would be that dairy prices primarily drive the NZD (at the medium-term horizon, and interest rates short-term). Therefore, hedging the real estate portfolio is, in a way, offsetting the desire to gain exposure in the natural resources portfolio. The economies of scope, in this case, is that TFM allows for this holistic perspective to avoid the cost of currency hedging as well as the potentially unmanageable (and potentially, not even acknowledged) economic exposure due to the offset. These second-order effects might have been missed because of "not seeing the forest from the trees"). The broader benefits include better risk management, better performance attribution, better decision making, and communication of strategy and performance. To add another adage, "what is measured, is managed." The positive impact and feedback loop on the other functions is the economies of scope effect (the ability to do one thing, which allows us to do many different things better and more efficiently). This case study illustrates the power of the economies of scope extends further the economies of scale curve. TFM, as well as culture and communication, are vital instruments to renew the organization and extend its efficiency curve. This is the reason why we also witness an increased focus on culture and communication. To bring back the analogy, while everything is functioning in a very optimal manner within the asset classes and the operations, and the engine itself runs very optimally, it is not the engine that becomes a problem. It is the car itself. At this point, its success in serving its clients' ultimate purpose is no longer critically dependent on the engine. Although one wants to make sure that the engine never stalls, it is now critically reliant on whoever drives the car or whether they have a good navigation map and a clear plan of how quickly and safely arrive at the final destination. In summary, the goal of TFM is to extend the organizational curve and renew the economies of scale by shifting the focus to economies of scope, which help to extend the economies of scale. It also needs to address the size, overlap, complexity and weakening structural issues. The Total Fund mindset also needs to strengthen the alignment between investment and operations to become entrepreneurial and built-for-purpose. Finally, this cannot be achieved without the help of culture and communication efforts. If the organizational developments themselves are not enough, there are additional reasons why TFM becomes critically important. We will talk more specifically about these impacts later in the series, but it is important to note a few key points. In many cases, the maturity of the pension plans leads to increased sensitivity to negative outcomes. The main reason for this is that these plans often have not cash outflows, and this, combined with market downturns, can lead to a significant risk of contribution increases. Thus, short term losses may need contribution adjustments to amortize. As such, it becomes increasingly important to manage the short and medium-term returns better and avoid adverse outcomes in a lower expected return environment going forward. Being efficient matters even more because cost becomes an increasing part of the overall return. Or, in other words, a "penny saved is a penny earned." We have also witnessed an extraordinary environment of significant structural changes, disruption pandemic, ESG, and various policies and regulations. Thus, selectivity would be an essential aspect of portfolio management; just buying beta might not be enough anymore. Finally, it might also be a question of the survival of the pension model itself. With the increased competition and commoditization of strategies and low cost, sometimes even zero cost for some strategies, it becomes increasingly important for the pension fund managers to remain relevant.Alright, We Need TFM. But Don't We Already Have Asset Allocation?Even if one is already convinced that TFM is indeed needed, the nagging question remains: "Don't we already have Asset Allocation ("AA")?" In many funds, there is this "Cain and Abel" type of relationship between AA and TFM. TFM is often mistaken, with AA, and AA teams often assume the TFM responsibilities. TFM is sometimes also carried by public markets. Not to mention the infighting that often happens. It all boils down to the clarity of mandate and what exactly is the objective. Because it is possible that while right on a standalone basis for the AA or public markets, the same decisions might not be right for TFM, be it because of different time horizons or more structural and performance measurement issues. This notion would become very clear in (the dramatic) Episode 2, where you will learn about something nobody told you about long-term investing. Having a dedicated mandate, as part of a strategic plan priority, a senior executive being directly responsible for this function, and with the power to act are essential prerequisites to implement TFM or having a greater chance of being implemented. That said, TFM requires multi-disciplinary skills and things from public markets, Treasury, AA, risk management. Let us go one step further and try to differentiate between AA and TFM. AA is the investment policy view of the pension fund portfolio and focuses on: (i) what assets to own in view of growth, inflation, among others); (ii) what are the long-term expected returns for these assets; (iii) the current yield or cash flow and frequency for timely liability payments; and (iv) having liquidity in bad times. The policy portfolio and the additional investment policies (liquidity policy, leverage policy, currency hedging policy, among others) capture this AA view.
TFM is the asset management view of the same investment policy view. It is about: (i) the current pricing and short- and medium-term expected returns for the assets; (ii) when to own them (the beta management); (iii) how to hold them (efficient implementation, including rebalancing, balance sheet management or the interplay between liquidity and leverage); and finally, (iv) additional skill to improve outcomes, which is related to active management activities, which could also be implemented within the TFM mandate.How to Own the Assets: The Role of TFM for Efficient and Effective Implementation of the Total PortfolioThe total portfolio represents an optimal combination and an optimal flow of capital between four fundamental elements (pillars): (i) public markets; (i) liquidity; (iii) private markets; (iv) liabilities. In its role, TFM needs to support the optimality of the four pillars (local optimality) and the optimal flow of capital between them.
Also, TFM needs to complement the total portfolio toward the primary objective, whichever way it is articulated (global optimality). Examples of such primary objectives could be a 5-year risk-adjusted return, contribution rate volatility, liquidity level, and level of inflation protection. Liquidity is what allows investing in private assets and is the link between public and private investments. TFM needs to ensure an optimal flow of capital between them. The private asset portfolio optimality should be based on the investment belief of why one invests in these asset classes. If the belief is that there is some exotic beta or a proverbial illiquidity premium, just investing in anything that has the name of a private asset should bring these premiums (the "throwing darts" analogy comes right in). This notion is similar to the analogy with the equity risk premium versus bonds; equities earn more than bonds over the long term. In many cases, the benefit of private assets comes from the ability to create economic value added in the underlying assets (and maybe some mark-to-market quasi-diversification benefit from a reporting perspective, to be completely transparent). As such, the objective would be to maximize the economic value-added. Therefore, an optimal private portfolio should be built based on other inputs, such as cash flows and business risks, permanent capital impairment, the quality of partners, the network strength, the ability to source transactions, and the expertise to manage businesses. It is a "quantamental" exercise, not a typical asset allocation portfolio construction (an exciting topic on its own). Regardless of how the optimal private portfolio looks, it has an inherent residual beta exposure (capital structure, sectors, geography, among others) that are not managed and should not be managed by the private asset classes. These residual betas need to be managed by TFM, considering what there is already in the public markets portfolio and the global optimality primary objective. While liquidity was flowing from the public to private markets, the beta now loops back and flows to public markets. The public markets portfolio would probably have a more traditional risk/return objective function when constructing an optimal portfolio. But again, it depends on what goes into this portfolio and what is the investment belief about this portfolio.
Depending on the fund structure and how performance measurement and benchmarking are set, public markets may or may not be responsible for the cross-asset beta management. I am just opening a bracket here that benchmarking is not a standalone exercise, but a thoughtful process rooted in the investment beliefs and portfolio implementation. But more about it some other time). In this case, TFM either manages the cross-asset beta or complements the beta to the primary objective, considering private asset residual betas and the liquidity flows and balance sheet use.
Finally, liquidity needs to meet liabilities at all times or else the pension promises will be broken.From this perspective, TFM serves two primary purposes: (i) it ensures the local optimality, allowing for each element of the total portfolio can function optimally within its requirements to be optimal; and (ii) it ensures global optimality. In other words, the sum of the parts is also optimal versus the primary objectives and outcomes that the organization targets. There is also a third purpose: value-added activities, whether these would be outright asset allocation activities or some form of alpha generation within the transmission mechanism to serve the local or the global optimality. Examples of such activities could be strategic tilting, could be rebalancing, could be balance sheet management, currency management and currency hedging, among others.TFM Decision Structure: The Role of Single Versus Multi-Client StructureAnother critical question of TFM is the single versus multi-client structure. As demonstrated in the previous section, TFM is about achieving global optimality. In a single client case, what is optimal for the total portfolio is also optimal for the client. This may not be the case in a multi-client structure, especially when clients have very different circumstances or different business models (e.g. pension versus insurance clients). The total portfolio now represents a combination of individual clients, and what is optimal for each client might be different depending on each client's circumstances. Portfolio rebalancing could provide a good illustration of this. Suppose there are two clients. One is underweight equities by 10 percent, and the other is overweight equities by 10 percent. If one thinks of the Total Fund as just pooling everything together, there will be no change. One is plus 10 percent, and the other one is minus 10 percent, both offset each other; therefore, no decision or action is necessary. However, this might be a suboptimal decision or even an outright wrong decision, because for one client, depending on its profile, the optimal decision might be "do nothing." For the other client, the optimal decision might be "rebalance all the away." Thus, a key challenge becomes how to create a joint top-down total portfolio and bottom-up client optimality. One needs to add to this the extra dimension of asset classes (remember from the previous section, they also have their optimality), so we end up with a three-dimensional problem: (i) to achieve a top-down optimal total portfolio; (ii) to preserve the bottom-up client optimal portfolio; and (iii) to allow for optimal asset class portfolio. There is also another aspect of the total portfolio in a multi-client setting where there are two total portfolio decisions: (i) "pooling assets" aspect; and (ii) "pooling decisions" aspect.
The first type of total portfolio decisions could be called "pooling assets" decisions. These decisions are taken from the perspective of the asset manager as a corporation. These decisions are not related to the clients but are related to the asset manager as a corporation because of the asset manager pools assets from many clients. Because of the "pooling" aspect, the asset manager is a recourse body to all the counterparties, banks, clearinghouses, among others. These are typically decisions regarding the efficient implementation of the portfolio, balance sheet, leverage, liquidity, contingency, concentration. These decisions are not directly related to the client, but the asset manager as a corporation. The "pooling decisions" aspect is when the asset manager has one market and view, and this view now needs to flow down to the different clients, with their different circumstances, and to the asset classes. Thus, the same market and risk view might lead to clients' individual decisions, depending on their profile. So, clients could be very similar or could be somewhat different. They could have dissimilar liability profiles, or in many cases, they could be a combination of pension and insurance clients, for that matter. It might mean individual rebalancing decisions, risk mitigation, liquidity, and leverage decisions for each client. And at the same time, the same market and risk views also impact the public and private asset classes within the organization and influence directly or indirectly, within asset class decisions. So, the way one builds the TFM structure, the way the decisions are made needs to ensure that these are jointly optimal, optimal for the asset manager, optimal for the clients and optimal for the asset classes. These impacts also need to be very clear and well understood. Again, the adage is very pertinent: "what is measured, it is managed."When to Own the Assets: Another Way to View the Same Problem of Asset AllocationWe talked so far about TFM and how to own the assets, and we also talked about this "Cain and Abel" relationship between AA and TFM. If one makes the brave step to turn the AA upside down, then we might be able to reunite these concepts that we thought, in the beginning, have this "Cain and Abel" relationship. So, let us turn the AA notion upside down.
The usual AA process includes defining asset classes (also depends on the capability to execute or desire internally to venture into the activity), expected returns, risk and other parameters and assumptions. Then, applying some stochastic modelling and optimization, arrive at asset mixes (investment policy), which correspond to the funding policy's objectives and requirements. Trustees and boards then select the asset mix that best serves the funding policy. All this process has one very "religious" element – the long-term expected returns, which may or may not materialize. Even more so, as mentioned earlier, in a world of disruptions, pandemic and structural changes). The pension plans' increased sensitivity to negative outcomes, which was also briefly discussed earlier, matters a lot. What if one can translate, via the ALM process, the funding policy into a set of key desired outcomes, such as level of wealth, inflation protection, contribution risk and liquidity. Then, these outcomes become de facto the policy portfolio. Instead of an asset-class policy portfolio, one has an outcome-oriented policy portfolio. Outcomes would be more stable and could have deviation bands around them to maintain the pension promise. At this point, the organization can hold any asset mix at any time, as long as the desired outcomes and allowed variation are respected. This portfolio would be a more optimal total portfolio because it now manages the path of returns (because it considers the short- and medium-term outcomes.
This is the place to stop to keep the suspense. But it should be said straight that there is something that is not well understood, or maybe understood but not well communicated about the virtue of long-term investing. Let us challenge this notion in Episode 2.
To summarize the key takeaways from this Episode 1:
- TFM is needed to extend the efficiency curve and address organizational development, client maturity, and external environment challenges.
- TFM enables the functioning of the total portfolio and its four fundamental elements efficiently and effectively.
- TFM manages the asset mix betas dynamically, and at any point in time, not just at the end of the horizon, to achieve desired outcomes.
So why is this fundamental? It would become apparent in the dramatic Episode 2 next week…
This is a phenomenal introduction to a topic that receives little to no attention.
Mihail Garchev and I worked side by side years ago at PSP Investments. Pierre Malo, our boss back then, used to call us his "two research pit bulls" and we worked like donkeys to produce excellent research.
Before joining PSP, he was working as a landscaper but had excellent financial background as he worked in banking in Bulgaria. He literally came to this country with a few suitcases and is an example of why we need more smart immigrants like him.
After I left PSP, Mihail continued on a solid path, progressively gaining more responsibilities and he ended up at BCI where he single handedly built a TFM system from scratch, incorporating data from each department.
To be fair, he got some help along the way from Samir Ben Tekaya, VP and Head of Risk at BCI, and a couple of others who he speaks very highly about but that's it, there was nothing at BCI before Mihail Garchev got there.
Mihail's departure from BCI leaves a huge black hole. Not sure what they were thinking, don't really care, but let me be crystal clear about this, BCI will never find another Mihail Garchev and there's nobody there that comes close to his experience and intimate knowledge of Total Fund Portfolio Pension Management.
Again, that’s me, Leo Kolivakis, talking, not Mihail Garchev who is humble and stressed he left BCI and PSP on "very good terms".
Anyway, let me focus very briefly on the introduction above.
It is lengthy but packed with phenomenal insights. Think about this series and what we are presenting here as generating the foundations for the Canadian Model 2.0.
Lamoureux, Bertram, Denison, Wiseman, Leech, De Bever, Machin, Keohane and others were all part of building the Canadian model but now a Greek and Bulgarian Canadian are going to show you how we can take it to another level because let's face it, the Canadian model is stale and crusty and needs to be revamped.
This series is all about pushing the envelope on Total Portfolio Management as it impacts pensions on so many levels.
In short, TFM is about integrating a holistic approach that moves well beyond asset allocation decisions to build on what Mihail aptly calls economies of scope.
Below, I embedded the short introductory clip to Total Fund Portfolio Management and Part 1 of the series going over the material above in a lot more detail.
Take the time to watch this and other clips to come every Thursday, there's simply nothing like this available anywhere and on behalf of everyone reading this comment, let me thank Mihail Garchev for the incredible work he has done putting this series together. It truly is outstanding and can only come from someone like him who has the experience and knowledge to share great insights on this topic.