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Putting fund manager selection into perspective Back  
Tom Murphy advises pension fund trustees to have a sound, well thought-out investment strategy that will achieve the fund's objectives before addressing the issue of who should manage it.
Many trustees in Ireland have become disillusioned with what might be described as the ‘investment merry-go-round’. This arises when a pension plan moves from one manager, who has consistently underperformed, to another only to find that, despite a very thorough selection process, the new manager’s performance also starts to head south over the following years.

To improve their chances of success, a growing number of trustees have begun to adopt a framework within which all aspects of the investment decision making process can be considered and where the ‘beauty parade’ is simply one part of a bigger process. This helps them to make their investment decisions in a logical and considered manner and to see the ‘wood from the trees’ when considering which manager to hire.

Many trustees have found it useful to take a step back and put the manager selection process in perspective. The aim is to provide trustees with a process within which hard decisions can be made while at the same time seeking to strengthen the trustees armoury when it comes to ‘managing’ their delegates (including investment managers) effectively.

As a starting point, it’s useful to consider the role of trustees as guardians of the plans’ assets. trustees are somewhat like the management of a company insofar as managing the assets of a pension plan is quite similar to managing any business process. While the trustees normally delegate the day-to-day investment decision making, they retain overall responsibility for making strategic decisions; defining the framework, including responsibilities, within which each party should work and finally, they also retain the responsibility for monitoring each party’s performance.

Investment objectives
In keeping with most management roles, the first question trustees should ask themselves is why or for what purpose are they investing assets in the first place. In other words, what are the trustees’ objectives?

The over-riding objective for most trustees is to ensure that all benefit payments will be met as and when they become due. Other, typical objectives include: to maintain solvency at all times; to maximise returns and to reduce the contribution rates.

By identifying and crucially, by prioritising their objectives, trustees can begin to lay down the bedrock upon which all subsequent investment related decisions will be based.

It is important to note that, in almost all situations, the objectives identified by the trustees are conflicting. Consider, for example, the objective to maximise returns. If the trustees believe that equities will out-perform other asset classes over the long-term then there is an argument that the investment strategy should be 100 per cent equities. However, if another objective is to ensure that the plan remains solvent, this will usually require some element of bond or cash exposure.

Investment strategy
The next stage in the process is for the trustees to set a long-term investment strategy or in other words where the assets should be invested.

At the highest level, long-term investment strategy boils down to the overall equity / bond mix that the trustees adopt. A pension plans’ long-term investment strategy is the single most important aspect of its investment profile and is, therefore, the most important of the investment responsibilities maintained by trustees. This statement is supported by the results of a US study which concluded that the long-term strategy adopted by a pension plan explains 94 per cent of the actual returns achieved. In other words, short-term tactical asset allocation bets and stock selection decisions made by the investment manager attributed to just 6 per cent of the actual returns.

To date, the majority of Irish trustees have delegated long-term strategy decisions to the market ‘conventional wisdom’ by telling their manager that they are to be measured against the performance of an ‘average’ fund. This means, the trustees have implicitly decided that their own pension plan is not that different from the ‘average’ and therefore a strategy based on the average asset allocation in the Irish market is reasonable. While this may be a perfectly valid approach for some funds it is important for trustees to understand that the responsibility for strategy still lies with them.

As a result of a growing awareness of this issue there is a trend, which is gathering momentum, for trustees to be more involved in explicitly setting long-term strategy. This, again, brings us back to their role as overall ‘managers’ of the pension plan. By setting long-term strategy, trustees are simply playing the role of a board of management who have decided the broad objectives of the firm and have set out how these might be best achieved. In other words, by setting long-term investment strategy, trustees are not taking over the investment manager’s function - to outperform a particular target. Instead, they are simply defining what that target should be, based on their objectives, their specific risk / reward preferences, and the plans’ unique liability profile - these pieces of information are not readily available to the investment manager.

Manager structure
The next question to be tackled is how this mix of assets should be managed. By this question, we are not asking ‘who’ should manage the assets but rather what type of manager and how many managers may be appropriate.

Because to-date most Irish trustees don’t adopt an explicit investment strategy, typically their manager structure tends to involve one or more investment managers managing a mixed bag of different assets on a discretionary basis. This is known as balanced management.

At the opposite end of the scale is specialist management, which focuses on particular assets classes, such as global equities or Euroland bonds. The following analogy has proved useful in explaining the differences between the two approaches. Suppose you employ a handy man. He re-wire’s the kitchen, he fixes your wooden gate and he landscapes the garden all to a satisfactory standard. You could, however, have employed three specialists; an electrician, a carpenter and a landscape gardener. The latter approach may have been slightly more expensive but some would argue that the end product is better.

In recent times, there has been a trend towards specialist management. There are a number of drivers for this including, the increased size of pension funds, multi-national involvement (balanced management is virtually unknown in the US) and also the fact that overseas managers, who tend to be specialists, have become much more active in the Irish market.

The type and the number of managers employed should, again, reflect the trustees’ objectives and their risk tolerances. For example, if the trustees are particularly risk averse, they may invest a relatively high percentage of the assets on a passive basis. Alternatively if the trustees are less risk averse and the financial health of the plan is particularly good, they may look for a more aggressive management style.

In practice trustees who reach this stage usually end up with a combination of balanced and specialist management as they dip their toes into these relatively new waters.

Manager selection
I would suggest that it is only at this stage that trustees should tackle the issue of who should manage the plans’ assets.

Unfortunately there is no crystal ball when it comes to manager selection. However, by completing the above steps, trustees should be more familiar with the dynamics of their pension plan and they should also know the role and the type of manager who would best fit their needs. Being aware of these issues should at least allow the trustees to put the manager selection process in perspective.

Of course, the final stage in the process is that of monitoring the managers’ performance and also monitoring the long-term strategy that the trustees have adopted. The long-term strategy should also be revised periodically (maybe every three years) to ensure that it is still suitable given the plan’s financial position and the trustees’ risk appetite, which may change over time.

Tom Murphy is a partner in Mercer, where he works in the investment practice advising pension fund trustees on all elements of the investment decision making process.

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