In today’s investment environment, many institutional investors have shifted the focus from a sole emphasis on returns to a more holistic approach that places risk at the centre of portfolio construction decisions.
Yet, when you look at the individual mandates, they still largely follow a traditional framework where the generation of alpha takes centre stage. Entering into partnerships with asset managers might be one way to build better risk parameters into mandate contracts.
“The partnership model allows investors to establish a very different kind of mandate based on the problem that you are trying to solve rather than simply the delivery of alpha,” David Veal, Chief Investment Officer of the US$2.3 billion City of Austin Employees Retirement System (COAERS) says in an interview with [i3] Insights.
“For example, one of the big philosophical questions is: ‘Should you allow shorting as the academic literature suggests you should?’ If a manager doesn’t like a stock or an asset class, do you allow them to express that conviction and bet against it?”
Veal was appointed as CIO of COAERS in April 2016, and is also known for his time with the $126.6 billion Texas Teachers Retirement System, where he was Director of Strategic Partnerships and Research, a position he left in February 2015.
Texas Teachers’ partnership model has received much interest around the world and today more investors such as COAERS are considering ways to adapt this approach to their own investment programs.
A partnership involves much more than increased face-to-face time with asset managers, Veal says. It requires a deep understanding of how a manager operates, what it strengths and weaknesses are, and what bets it is taking in its portfolios.
Under an approach like that employed at Texas Teachers and elsewhere, each partner manages a slice of the overall portfolio that includes a wide range of asset classes. “The kind of portfolio we are talking about may contain stocks, bonds, commodities, and any other assets that are important to the fund.”
Whenever the allocations to the various slices managed by the partners differ from the overall portfolio, Veal says, it allows the fund to engage in a discussion with the manager to better understand the thinking behind the various investments.
Think of it as the tail that wags the dog. A small, multi-asset allocation with a skilled partner can inform what the rest of the portfolio is doing.
“For COAERS such an allocation would ideally mirror the investment policy statement of the fund overall,” he says. “Making them too different would limit the lessons that you could learn from what your partnership structure is doing relative to what is happening at the fund level.”
“A key benefit of this approach is that conversations with these partners can help you understand what they are doing and you can say: one partner is overweight emerging markets and perhaps another one likes treasuries. That is information you can use to decide what you will do with the other 90-95 per cent of the fund.
“Think of it as the tail that wags the dog. A small, multi-asset allocation with a skilled partner can inform what the rest of the portfolio is doing,” he says.
Veal recognizes that any foray into the partnership model at COAERS would likely take some time to reach its full potential. He got involved in the partnership model at Texas Teachers when it was already underway for some time.
In the early days of a partnership managers may not be comfortable with sharing their views openly or discussing their positions in the presence of competitors. “It is not entirely natural to sit in a room with your competitors and talk about your best investment ideas,” he says.
In addition, Veal says these types of programs can be very resource intensive and believes in the need for staff working full-time on the partnerships.
“Ultimately, a dedicated business unit is probably the best way to run such a structure. It is a very labour intensive exercise given that you manage risk parameters, performance reporting, facilitating research projects, and other functions on a daily basis.”
Given that the partnership approach is a resource-intensive activity that is done best by a dedicated team, implementation may be a challenge for smaller plans.
Indeed, resource constraints could limit the ability to gain the knowledge sharing and skill transfer that is a key attraction of the model.
“In a large organisation, a dedicated team can understand what problems the internal teams are working on and map those needs against the resources and capabilities of the partners” Veal says.
“The partnership model is something we are in the early stages of considering at my current fund, COAERS,” he says.
Because of the staffing requirements, it would difficult to imagine more than 2-3 managers for a smaller fund like COAERS.
“The numbers that we have modelled would be around 5 per cent for each single manager. Yet because of the staffing requirements, it would difficult to imagine more than 2-3 managers for a smaller fund like COAERS.”
“If you have one or two partners, each managing 4 or 5 per cent each, you can still have an ongoing dialogue with them. There are few enough that you could talk to them frequently without neglecting the rest of the allocation.
“This approach is almost like having a sliver outsourced to another CIO. However, some investors may be threatened by that and think: ‘Maybe someone will think I’m bad at my job’. I don’t think it means that at all. It means that I’m smart enough to seek out wise counsel in an effort run the fund more effectively,” he says.
Veal says there is still a long way to go before COAERS will make a decision on this. “We have had several meetings with managers to see if this approach would make sense and what it would look like for us. However, there is a lot of wood to chop. It is a big decision.”
There are other strategic and operation considerations that would also need to be addressed. “Let’s say you do hire two partners, how often should they interface with the board? Do you want them to come and visit a few times a year? Do you want them to talk to your consultant?
“This is an area where it can be tricky, because a consultant might feel like you are stepping on their toes. For smaller plans where a consultant is often influential, it can create an interesting dynamic.
“These are all questions that we hope to help the board evaluate as they think about how these pieces might fit together to create a best in class investment program,” he says.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.