The Value Chain in Investing

Shifting the food chain to a value chain

TWO AMERICAN anthropologists – William O’Barr and John Conley – released a scathing study of pension fund governance in 1992 that provided valuable insights into the process of pension fund investing. Summing up their impressions, they suggested in their preface: “After reading our book you’ll feel a bit like the airline passenger who peeked into the cockpit at 30 000 feet and found there was no-one in there.”

They found that three factors seemed to prevail: ● The structure of most funds was primarily a function of historical accident.

• Governance debates focused on responsibility shifting and blame deflection – most specifically with their fund managers.
•  Boards appeared to place a priority on strong personal relationships with investment managers and consultants.

In these days of cost-control fanaticism and media attention on financial service industry costs it’s little wonder that the spotlight has now been turned to the consulting industry and its role in the so-called pension fund “food chain” of costs. Last year an industry publication reported that more than half of larger sized funds in the US had made the decision to go it alone without their consultants – a direct reflection of the perception they had of the quality of advice they saw available. In SA the asset consulting industry is fighting for its survival as trustees become increasingly reluctant to pay anything but bargain basement fees and competitors from a broad array of sources – administrators, custodians, multimanagers and even asset managers, encroach upon their turf with the promise to provide the same resource as a no-cost add on.

But while trustees may be right to question the “food chain”, addressing the balance between cost and benefit of “goods or services received” at each stage in the investment process demands a considerably more rigorous assessment as to what each input has on the long-term outcome of pension fund investing. Here are some economic truths:

• The cost of a service should have some relationship to its potential to add value.
• Value add is also a function of the cost required to provide it.
• The greater the accountability taken by a service provider, the higher the fee obtained.
•  Along with the axiom that “what gets measured gets managed” is the axiom that “what gets charged for gets valued”. The natural corollary here is that if something’s given for next to nothing that’s what it’s worth.

Let’s put into that context the chart that sets out the cost distributions in the pension fund food chain in sample countries worldwide. We believe that there are three “frame of reference” shifts emerging that throw into question the current convention of cost distributions:

• Current cost distributions may be a function of historical conventions that no longer have relevance.
• Our understanding of the primary drivers of long-term performance outcomes has shifted.
• The willingness of other participants in the service chain to assume “accountability” will impact.

What does have the greatest effect on long-term performance outcomes?

Traditionally, investment managers were the agent in the value chain that took on the greatest portion of risk of accountability for outcome. As such, it’s probably been logical that investment managers should take the lion’s share of the fees in the food chain. But now, the weight of opinion has shifted to the view that it’s the strategic asset allocation of a fund and the risk parameters that its trustees have set out in the investment policy document that typically have the greatest effect. But we’d like to assiduously avoid any debate as to whether the Brinson, Beebower study (commonly cited in support of that view) is misunderstood and misquoted or the questions in it incorrectly specified. Even sceptics of the “asset allocation as primary performance driver” – such as Bill Jahnke and Mark Kritzman – concede that while asset allocation does not have to be the primary performance driver it typically becomes so the minute the trustees establish a strategic asset allocation and mandate as risk constraint to that asset allocation.

Dictate to an investment manager that they must manage to a 5% tracking error to that strategic asset mix benchmark and it’s little wonder that studies such as Brinson and Beebower’s would conclude that on average 91,5% of the variability in performance in a fund could be explained by that initial asset allocation. But debate aside, what has emerged as our newly appreciated “reality” about pension fund investing is the following:

• All investment portfolios have an asset allocation, whether planned or not.
• Regulators here and internationally are suggesting that pension funds need to be far more prescriptive in terms of setting investment policy, going so far as to suggest that trustees have direct responsibility for setting their fund’s strategic asset mix and risk parameters.
• Additionally, once trustees employ more than one manager for their funds, how those strategic parameters are set and, most importantly, maintained over time will typically have a greater bearing on the fund’s final outcome than the contribution of the underlying managers.
• So asset allocation as a performance driver is likely to become an increasingly important determinant of portfolio performance.

If setting the structure of the fund is so critical to the outcome, with individual manager contributions becoming significantly diffused at the aggregate fund level, then surely we must ask the question whether the “food chain” as currently set out is still defensible.

Should consultants be given another chance?

One thing is apparent. There’s becoming an increasing discontinuity between the food chain described above in the Watson Wyatt study and the value chain in a fund’s actual experience. The issue is not so much whether trustees are paying their service providers too much but rather whether those payments are an equitable reflection of where accountability for the final outcome should lie. We suggest that a major mind shift is needed. Let’s start with the provocative suggestion that consultants, or any other service provider whose input impacts performance, must be held just as accountable as asset managers. Real outcomes say they must by necessity. But investors are right to question the quality of the advice they’re receiving. And thus begins the vicious circle. For consultants to provide any value in the space they occupy they need to be able to significantly expand on their research capabilities and service offerings.

Keith Ambachtsheer has estimated that for pension funds to provide quality inputs, they need US$1m/year (R6,5m) in research funding to develop an internal capability. That significant investment would cover everything from the analytical tools required to ferret out optimal strategies for different asset classes and manager skill, risk models to determine optimal blends of managers, transaction cost models to assess potential impacts on cash flows, performance attribution and analysis models to aggregate and disaggregate performance contributions and an administration platform to enable full aggregation of all transactions. Not many funds are prepared to spend that kind of money to develop that capability internally. Not many consultants spend it either. Clearly investors seeking these services need to turn to entities that are committed to adequately funding these resources. But here’s the brutal reality: as long as funds don’t pay for the critical service of structuring their solutions properly consultants simply won’t have the wherewithal to develop the necessary resource. With meaningful structuring inputs and on-going implementation skills lacking all around, is it any wonder that trustees are bemoaning the outcomes they experience in their funds? And where does the onus fall? To the only agent prepared to accept accountability – the fund manager – that we’ve already established has a limited effect on the aggregate outcome.

What’s the answer?

In contrast to the Watson Wyatt food chain we believe the value chain approach provides a much more effective framework for trustees to work with. Instead of allocating costs across the industry participants as conventionally set out above, think rather of allocating costs across the services required to get the job done properly. This model allows the trustees to pay critical attention to what it is they do need (and what they don’t) as well as giving them a more effective framework to evaluate the true value of those services.

 Fundamentally, the value or allocation should be derived from the following four-tiered assessment:

• What contribution does each service ultimately make to long-term performance?
• Conversely, how much value-add is gained by cost savings provided by the specific service?
• What does it cost for the service provider to deliver that competency?
• How much accountability is the service provider prepared to take in ensuring that the fund meets its long-term objectives?

The greater the magnitude of contribution along that four-point framework the greater the allocation should be. In the table we have created an idealised picture of how we believe the value chain of services could work. Note that the allocation is reflected as a percentage of the overall costs.

The value chain: a hypothetical model

Participants in the chain are seen as continuous (but not irreplaceable) partners in the process and governance procedures would reflect that partnership dynamic. As mentioned earlier, there are an increasing number of entrants to the market who can provide these services that reside outside the traditional Watson Wyatt model. The governance process would also ensure that effective value measurement was applied to every participant in the process.

Conclusion

Clearly, a shift to the value chain model would demand a new mode of participation from trustees. Trustees must now shift their focus to providing a more rigorous assessment of the service providers in the value chain – not just their fund managers. Just how well resourced are the different candidates for consideration? How can trustees balance the dual requirements of ensuring that the different service components are well integrated and efficiently managed while avoiding potential conflicts of interest in the value chain? The time has come for trustees to assess what really counts in the bigger scheme – and reward it.