Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Funds need more scrutiny on internal teams, investment models: Frontier
Without stronger oversight, reviews and challenge to investment decisions, asset consultant Frontier Advisors believes that the drive towards large internal investment teams will “lead to more risk” for super funds.
“Internal teams face a wide variety of different assessment practices,” said Paul Newfield, director of sector research at Frontier. “Some are reasonably detailed, but these tend to be the exception. Many are light touch and do not represent a detailed or thorough assessment akin to that applied to an external manager.”
The Association of Superannuation Funds of Australia estimates that around $1 trillion is “directly invested” by large super funds – though it’s not clear whether the figure differentiates between mandates and funds managed internally – while a separate Frontier analysis puts internal assets at around $700 billion, with industry funds growing faster than other sectors.
“The external managers appointed by many large asset owners are vetted by specialist investment consultants and rarely present to the investment committee or board (a review of the manager is presented instead),” Newfield said. “By way of contrast, we see examples of internal teams which are required to present to the investment committee or board on a rolling frequency basis without a third-party review.
“Asset owners should be aware this difference in governance can potentially create an internal advantage if boards, investment committee or executives are not armed with the same information to effectively question internal teams.”
But Frontier believes that the risk in investment models is potentially greater than that in investment teams, because they tend to hang around longer than the people who created them, create over-confidence in decision making, and, because of the large technical knowledge gap at the trustee and investment committee level, are hard to question.
“The governance of internal investment models is especially challenging,” Newfield said. “Almost every single investment decision today by funds, executives, investment committees and trustee boards is underpinned by a plethora of quantitative analysis… Within funds, the number of models is growing due to larger internal teams, more investable markets, the number of factors to consider in decision making, and the amount of data available.”
Frontier illustrates the dangers of relying on financial models to underpin decision making with the examples of Long-Term Capital Management, which had to be bailed out after it almost collapsed because its models underestimated the potential for extreme market movements, and the subprime mortgage crisis.
“While these situations may not have been ultimately preventable, they underline the need for better governance of and reliance on models… Ultimately, trustees need to satisfy themselves that internal capabilities stack up from not only a cost perspective but also from a return and risk perspective,” Newfield said.
Frontier advocates for funds to put their internal teams through the same rigorous assessment they’d apply to outsiders, focusing on (among other things) business management and culture, investment process, and performance, as well ensuring there are clear objectives and constraints. Models should be reviewed based on things like their complexity, frequency of use, the worst case outcomes of that use, their “uniqueness” and spread of model knowledge through the organisation.
“Internal investment teams and internal investment models have exploded in growth in recent years,” Newfield said. “While both are important to deliver value, insights and efficiency, they both have the capacity to bring material risks into a large asset owner.
“We believe both are generally underweighted across the industry in terms of how much risk focus is applied although we have seen some exemplars looking for best practice and continuing to grow their focus.
