Speaking notes for a panel discussion. David Neal, Managing Director of the Future Fund, at the 7th Annual Meeting of International Forum of Sovereign Wealth Funds, Milan, Italy.
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For me, the priority in attempting to reshape the institutional investment industry is to improve the level of alignment between all the various actors in the investment value chain. The value chain is a series of principal/agent relationships, from the management of the investee companies to their Boards, Boards to investment managers, managers to funds, funds to beneficiaries, and a host of others in between these.
The principal agent risks that this chain creates structurally plague the endeavour of long term investing. These risks exist because it is so hard to design incentive systems that create true alignment over the right time horizons. With the best will in the world, incentive systems that reward actors in the chain on time horizons of 10 years or more are just not practical. We must of course pay attention to smart design of our incentive systems, and make them the best we can, but we also must recognise that misalignment will exist.
So how can the risks of a principal/agent relationship without perfectly aligned incentives be mitigated? In my view, there are two avenues.
The first is to be immersed in the monitoring function. The fuel that allows misaligned behaviour to develop and persist is the asymmetry of information and understanding between the principal and the agent. For example, if we, the institutional investors, don’t have the skills, resources, time and focus to understand the activity of our managers, their natural incentive structure will likely carry them to portfolios and trades that best meet their needs and manage their risks. Portfolios will focus on tracking error and often be over diversified to manage career risk. Imagine an investor, with, say $100bn total portfolio, that has a mandate with a property manager to find attractive European real estate. If the expectation is that that mandate be $1bn in size, it is only 1% of the total portfolio. To the institutional investor, concentration within the mandate is really not an issue. To the manager however, they are likely to avoid large single exposures, no matter how strong the value proposition, in order to hold a diversified portfolio across sectors and geographies, diluting their best ideas with a range of others to protect their interests.
To mitigate this tendency, the institutional investor needs to be constantly explaining its risk preferences, in its context, and requiring that portfolios be built accordingly. The good news is that today, more than ever, institutional investors - be they sovereign wealth funds, superannuation funds, insurance companies or family offices - have the opportunity to build and apply the resource necessary to effect this kind of change. On a global basis asset owners are professionalising. They are now a much more competitive part of the landscape for talent. That isn’t just a statement about remuneration; it’s a statement about the more sophisticated, technical and challenging investment careers that can be had at funds like ours and others, and also the real sense of purpose that comes with the long term mission.
This means institutional investors are developing both the skills and expertise required to push managers to deliver an aligned outcome. Importantly, this push comes with an implicit, or sometimes explicit, threat to the managers – align with me, or I will do it myself.
The second route to achieving better alignment in my view is culture. Ultimately culture is perhaps the most important and most powerful tool. Culture defines how and why people make decisions, and in so doing it influences at quite a deep level the extent to which you have true alignment. The right culture can enable a person or an organisation to recognise when there is a conflict between their interests and those of the client, and to “do the right thing” by the client. I am sure we all work on ensuring we have strong, coherent and aligned cultures across our organisations. We would all expect our staff to “do the right thing” if faced with their own internal conflict. The question then, is do we put the same effort into ensuring our service providers, and particularly our investment managers, have such a culture. I think the financial services industry is a long way from having the kind of truly professional ethos that we expect from our legal and medical professions. Again, with additional skill, resource and focus, I believe institutional investors can tackle this issue and exert pressure for change.
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