Markets are increasingly volatile. Global growth prospects are bleak. Fixed income is played out. Equity markets are viewed with suspicion. Clearly, the prospects for investors seem pretty bad these days. And this raises a very important question: Where in the world (and I mean that literally) will pension and sovereign funds find the attractive investment opportunities required to have any hope of returning what they’ve promised to their stakeholders?
At a recent conference, we polled the fifty or so institutional investors in the room on this very topic. The answer? Most will be rolling out a variety of “creative” (read: very risky) investment strategies with the hopes of generating double-digit returns.
Scared? You should be.
Driven by these excessively high return objectives, many funds are being forced into strategies that they can’t possibly fully understand. And, worse yet, they’re going into these investment opportunities without the necessary resources and tools to succeed. We should thus not be surprised if they fail and cause more harm than good.
The real question then is whether there are ways to assess the suitability of a given investment strategy against the internal capabilities of an institutional investor.
It’s in this regard that I find the notion of a “governance budget” particularly useful. Just as we create “risk budgets” to help guide investment decisions, so too should we create “governance budgets” to help benchmark strategy decisions against organizational capabilities. Here’s how governance godfathers Gordon Clark and Roger Urwin describe the interplay between risk and governance in ‘budgets’:
“Essentially, institutional investors use the risk budget to inform asset allocation and the governance budget to manage the investment process. The risk budget and the governance budget ought to be synchronised such that strategic asset allocation and manager choice are subject to a level of appraisal and management commensurate with institutional capacity.”
“...risk-taking against well-defined objectives is an essential ingredient in any well- governed financial institution, and; second, the extent to which risk-taking is a deliberate and managed activity depends upon the governance budget allocated to this function within the institution. Poorly governed entities rarely take seriously risk- planning and wrongly economise on the governance budget treating it as a cost that limits net financial performance...”
The key conceptual building block of a governance budget is to view “governance” as an investment in the firm’s ability to generate returns. It’s also a finite resource in the same way that risk is viewed in finite terms. In the case of a governance budget, there are three key ingredients:
- the amount of time that a fund can apply to a given investment problem;
- the level of expertise that can be called upon;
- and the fund’s organizational effectiveness.
Governance budgets offer a way for pension and sovereign fund boards to think about how they can “add value” (or, perhaps more appropriately, not destroy value) in this challenging economic environment. The idea is to root the fund’s investment style and strategy in a clear assessment of the organization’s investment capabilities and the resources at the disposal of staff. So as more and more pension and sovereign funds start to get “creative” in their pursuit of returns, they would be well served to start with a rigorous assessment of their governance capabilities. ...Primum non nocere...
