Watson Wyatt urges pension fund rethink

Watson Wyatt is calling for Hong Kong's pension funds industry to focus more on fund governance if it is to get out of the trap of obsessing over short-term returns at the cost of long-term asset performance.

On Wednesday it held its annual seminar measuring investment performance and delivered a highly ambitious presentation calling for fundamental changes in the way institutions manage their assets.

"It was an extremely comprehensive presentation," says Mark Konyn, CEO at Allianz Dresdner Asset Management. "They were showing their expertise."

The consultancy argues that pension funds suffer from a short-term outlook that is increasingly costly, and as a result are insufficiently diversified in their investments. Watson called for 10-year absolute-return mandates and multi-asset class portfolios, a radical departure requiring a new series of beliefs about investing.

Conwell Tam, principal investment consultant, said short horizons, fear of losing assets and overconfidence lead to high costs in trading, in 'playing it safe' and in poor governance. Pension funds tend to spend far too much time on details such as manager selection and not on the big picture, and should spend more energy on risk budgeting.

This entailed moving away from the current fashion of using benchmarks, which are easy to model and measure fund managers against, but end up tying managers' hands and encouraging short-term trades to beat it - which often is at odds with the client's long-term objective.

Tam encourages the industry to consider absolute return mandates instead, without market benchmarks but using targets linked to inflation or liabilities. This would improve diversification by allowing fund managers to use more tools to beat targets. It would also mean the trustees and consultants would have less control over portfolios, and would dent the demand for asset specialists in favour of generalists. In turn, such a loose arrangement can only be fairly judged after a longer timeframe, and Tam calls for pension funds to introduce 10-year mandates - a move that would impact how fees are charged, and how pension funds govern themselves.

Fund managers in the audience generally applaud this idea, but are sceptical it will be implemented in Hong Kong. "We have a very long way before we see 10-year mandates," says Vincent Duhamel, regional CEO at State Street Global Advisors.

Adam's Konyn agrees on the utility of linking asset allocation to investment objectives, but adds, "The reality is that pension funds in Hong Kong are transitioning to member's choice and defined contribution, which puts responsibility with individuals. The industry will have to remain true to its promises that are defined by our benchmarks."

He also challenges the notion of absolute return as a long-term mandate. "It's a short-term strategy of capital preservation. It doesn't mean the manager has a free hand to do what he likes."

Fund managers agree, however, that the industry is moving toward this line of thinking, if in fits and starts.

"We're seeing performance fees for hedge funds and enhanced index mandates," says Duhamel, "so some pieces of the business are changing."

Nicholas Sauvage, associate director of marketing at Credit Agricole Asset Management, highlighted the fact that once again, Watson Wyatt named CA-AM the best performer in Hong Kong's pension space. "That is because we pursue absolute returns and don't closely follow benchmarks," he says. (Fidelity Investments and JF Asset Management were also recognized for good performance.)

Watson Wyatt's Tam says a return to balanced mandates doesn't mean just vanilla government bonds and big-cap equities, but a real mix of asset classes and the use of derivatives or warrants to improve efficiency. As a result, fee practices must change. Today fees are based on assets under management, which is simple, but doesn't reflect manager skill and encourages asset gathering rather than top-notch portfolio management. She calls instead for using a base fee that would cover a manager's overhead, plus bonuses based on performance and added value - although she acknowledges there will have to be a debate about how to exactly work this out.

"I've not seen that formula for fees before," says Elisabeth Scott, executive director and head of institutional business at Schroder Investment Management. She adds the current fee system is transparent and easy to calculate. "Developing new ways of charging fees will take time and require a long-term commitment from the client... Certainly outside of Hong Kong there are more creative approaches to asset allocation for balanced funds." She sited the example of the UK's Universities Superannuation Scheme's contest for a long-term investment mandate won by Henderson Global Investors (with Schroders a finalist). "But we like the idea of a more dynamic asset allocation, and we'd all like to see the industry move ahead. Pension funds are changing their emphasis from median performance to trying to meet their liabilities."

Duhamel welcomes the notion of giving fund managers more tools, but believes conservative pension plans are unlikely to loosen the reins soon. "Derivatives sound great in theory but it will take forever to get trustees to allow it."

Underpinning any transition is fund governance, which starts with pension plans reviewing their belief about how much risk to take, and how, says Naomi Denning, regional head of investment consulting at Watson Wyatt. Asset allocation decisions are the most important result.

Denning also highlights the importance of pension funds becoming more active in corporate governance, behaving as owners and exercising voting rights. And she says plans must become more involved in controlling not just fund managers, but other agents, such as custodians, trustees, administrators and investment consultants. She outlined at some depth how plans can better use their time monitoring managers by focusing on their overall strategy, not nitpicking performance numbers.

This won plaudits from fund management executives who say their views on corporate governance have so far fallen on deaf ears. "I was very happy to see them highlight governance," says Duhamel.