I was down in Santa Barbara yesterday at a pension fund retreat giving a talk on the “Innovations in Institutional Investment.” Basically I was asked to provide the attendees, mostly pension fund trustees, some insight into what their peers around the world were doing that is somewhat innovative and worth noting. Here are a few of the key themes I talked about:
* New Institutional Investors: I started by describing the rapid rise of SWFs and, more to the point, I described why I felt these organizations could potentially be groundbreaking for the broader community of institutional investors. As I see it, every time a government launches a new SWF, it has a blank canvas upon which to design an optimal investment organization. As such, the new SWF sponsors have the opportunity to revisit the foundational assumptions of the investment industry. SWFs may be a much-needed catalyst for innovation in institutional investing generally.
* Renewed Focus on Fees and Costs: Fees and costs tend to be overlooked by institutional investors. Why? Because most investors have better things to do than worry too much about how many extra basis points they’re paying to Wall Street. It’s asset allocation, risk management, and manager selection that tend to dominate decision-making (and based on their impact on overall returns, that’s probably right). But this means that “cost management” tends to be an afterthought, which isn’t ideal. There’s a lot that can get buried in the fee line that can take away from returns. Indeed, the opaque nature of financial products makes it easy for wily financiers to hide costs and fees. So it’s not all the surprising that I’ve seen a growing number of investors hiring specialist cost consultants or bringing in-house cost specialists. I think that’s a great development, as cost and fee savings offers the only risk-free return in this business.
* Insourcing Asset Management: This isn’t all that new to most folks, but even I have been surprised by the number of institutional investors that have taken the plunge and are now managing some proportion of their assets in house. This is related to the fee and cost issue above, but it’s also bigger than that; it’s about trying to find better alignment of interest through labor contracts instead of service contracts to outside firms. In short, the institutional investment community, which is often characterized by broadly diversified and outsourced organizations, is becoming much more involved in the day-to-day asset management of their portfolios.
* Peer-to-Peer Collaboration: Insourcing asset management is very, very hard. This is because that the economies of scale on Wall Street (and the financial services sector generally) are extremely difficult to replace with anything a pension fund could do in-house. You just can’t expect to bring all of the specialized know-how sitting in a financial center’s private industry out to a SWF or pension on the frontiers of finance. As such, these direct-investors are looking to replace the scale economies of Wall Street with the “network effects” of peer-to-peer collaboration. It’s also a way to try out creative things without making long-term internal or external commitments through a contract.
* From LPs to GPs: Some institutional investors are now accepting (or are considering accepting) asset management mandates from peer funds. That’s right, the pension funds that worked so hard to disintermediate third-party asset managers are themselves becoming third-party asset managers. This shift stems from the fact that certain pension funds or sovereign funds have spent considerably to build up sophisticated investment teams that seek to maximize returns over the long term. So, why not defray the cost of that investment by bringing a few peers along for the ride? After all, one pension giving another pension money would seem to get pretty close to a full alignment of interests (time horizon, liabilities, etc.). Moreover, the not-for-profit status of many of these organizations would seem to help minimize agency problems and excessive fees.
* Seeding New Managers: I can think of five public pension funds, four sovereign funds, three endowments and a big group of family offices that are all seeding new managers right now. The objective of seeding a new asset manager is to maximize the alignment of interests and minimize fees between the asset owners and the asset managers. This is achieved by extracting concessions from the new asset manager upon launch of the vehicle. A seeded vehicle offers the institutions that seed it an opportunity to participate in the vehicle’s ownership and/or revenue, which offers additional return opportunities. I’m a big fan of this activity, which I call the venture capital of asset management. If any pensions or sovereigns are doing this in a big way, please do reach out to me.
* Post-Modern Portfolio Theory: When it comes to the world of finance, I admit to being rather disappointed with the many tools and models that purport to help investors achieve their long-term investment goals. Phooey. In the wake of the Asian financial crisis, the Long-Term Capital debacle, the Internet bubble and bust, the “perfect storm,” the global financial and sub-prime crisis, the European debt crisis, and whatever is about to hit China and the emerging markets, I’d be more than understanding if you suddenly threw all your old finance textbooks out a window. Encouragingly, some investors are already operating in a “post-modern portfolio theory” world. But what does the Post-MPT world look like? As the traditional models fall out of favor, investment beliefs are becoming increasingly important. Assets are becoming the ultimate layer of of analysis instead of products. Concentrated portfolios are becoming an objective, as folks start to see that diversification is not, as the entire world including the Nobel committees seem to think, an entirely free lunch (e.g., what’s the cost of not actually understanding the companies you own? Because there is one).
* Moving Closer to the Action: Some institutional investors have decided to launch satellite offices in major international financial centers and/or regional commercial centers at home and abroad. In effect, these funds are expanding geographically, moving their organizations into the markets they find appealing, rather than waiting for intermediaries to come to them, reflecting a broader trend towards the professionalization of pension and sovereign fund investment organizations.
* Venture Capital: After a decade of running away from the misaligned and asymmetric relationships on offer here in Silicon Valley, some would-be LPs are beginning to dip a toe back into the venture asset class (...just as the bubble is set to pop...). Still, it’s not all that surprising that there’s a renewed interest, as the time horizon to a company going public has been pushed out from roughly 5 years to 9 years; the teams that were once “small cap” investors would, today, be growth capital private equity investors. Moreover, some institutional investors are trying to get creative with how they approach the asset class generally.
Anyway, that’s just a partial list of the innovations I see in the space today. I have to admit, that’s a lot for all of us to work on in the years ahead!
