Part 5: Contracts with Investment Managers
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5.1
In this Part, we report on how the Guardians established, managed, and monitored contracts with Investment Managers as at the end of 2007. For these contracts to be effective, we expected to find:
- a defined and established business operating model;
- a structured process for selecting Investment Managers;
- effective assessment and monitoring of risk associated with investment activity;
- effective performance management of Investment Managers; and
- effective monitoring of Investment Manager behaviour.
5.2
Investment fund managers generally adopt one of three business operating models:
- perform all investment operations in-house;
- outsource all investment operations to third parties; or
- adopt a hybrid business operating model combining the best of both in-house and outsourcing.
5.3
Although all investment fund managers tend to have consistent business processes, the choice between an in-house, outsourced, or hybrid business operating model will depend on the:
- specialist nature of the investment strategy and related investment mandates;
- volume of activity;
- proximity to major markets;
- access to relevant skills;
- requirements for infrastructure to process transactions;
- regulatory considerations;
- organisational maturity and experience; and
- business strategy and investor objectives.
Our findings
5.4
At this stage, the Guardians have generally chosen outsourcing as their preferred operating model for their business purposes. This has been necessary given the international investment focus of the Fund and the Strategic Asset Allocation objectives to establish investment mandates that outperform benchmark returns for the asset class.
5.5
Delivering returns in excess of the benchmark are referred to by the Guardians as “alpha” returns. Alpha returns are achieved by constructing investment mandates that expose the Fund to growth elements that have been identified within an asset class through:
- weighting the portfolio towards emerging markets;
- identifying entities likely to list within a predefined period; or
- focusing on investments with particular management principles and beliefs.
5.6
In many instances, specialist investment management skills are required to achieve the objective of the investment mandate. This is particularly relevant for growth asset classes.
5.7
The focus on delivering alpha returns has meant that the Guardians have deliberately chosen an outsourcing business operating model with all major risks managed through service level agreements and investment mandates. One clear and widely accepted advantage of outsourcing is that operational risks are typically lower.
5.8
At the time of our performance audit, the Fund had 44 investment mandates covering a number of different global capital markets. Most investment mandates require the Investment Manager to transact in multiple markets and jurisdictions. Figure 7 shows the spread of the Fund's global network of Investment Managers.
Figure 7
Number and value of investment mandates, by Investment Manager location
| Location of Investment Manager |
Number of investment mandates |
Funds under management (as at 31 October 2007 NZD) |
|---|---|---|
| New Zealand | 12 | 3,242,501,326 |
| United States | 24 | 6,124,250,847 |
| United Kingdom | 3 | 258,421,259 |
| Hong Kong | 1 | 3,866,988 |
| Australia | 4 | 4,062,626,349 |
| Total | 44 | 13,691,666,769 |
Appropriateness of outsourcing as the business operating model
5.9
Outsourcing means that all aspects of investment management and related transaction processing, accounting, custodial, and investment mandate compliance are performed by third parties. As a result, the Guardians have developed extensive external provider management processes.
5.10
While the Guardians have identified a clear purpose and need for outsourcing, they are considering whether this will be the most appropriate business operating model in the future. In our view, the Guardians need to continuously assess the appropriateness of their business operating model. Key considerations for any business operating model the Guardians adopt include:
- parts of the Fund's portfolio can be classified as long-term passive positions. The largely buy-and-hold strategy applying to these parts of the Fund's portfolio may not require specialist skills of external providers;
- the hedging strategy is largely a passive strategy and does not require high levels of technical expertise;
- the Act prevents the Fund from holding a controlling interest in any entity. This increases the volume of transactions because smaller parcels of shares are held in a larger number of entities. This volume may provide an opportunity for some asset classes to be traded by an in-house team where the Fund has critical mass;
- the maturing nature of the Guardians' internal control environment suggests that operational risks associated with in-house management of some investment activities could be adequately managed. This was not a consideration at the outset of the Fund when operations were not formalised and management was focused on establishing the Strategic Asset Allocation and related processes;
- over time, the economics of in-house and outsourced investment management may change; and
- by continuing to outsource trade transaction processing, asset valuation, fund accounting, and custodial services, the Guardians can maintain segregation of duties for their transaction operations.
5.11
The Guardians' review of the current business operating model may not necessarily lead towards an in-house or hybrid model. Ultimately, the Guardians need to use a business operating model that is practical and relevant to their business objectives.
5.12
In our experience, fund managers in New Zealand and Australia tend to adopt a hybrid business operating model, rather than outsourcing all activities or doing everything in-house. It is also more efficient to engage Investment Managers for international investment mandates because of New Zealand's distance from global capital markets. Conversely, domestic outsourcing tends to be more costly relative to larger international markets. In our view, the Guardians need to ensure that they identify the comparative advantage of any business operating model that they adopt.
| Recommendation 11 |
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| We recommend that the Guardians of New Zealand Superannuation review their business operating model periodically to ensure that all aspects of their business (including whether operations are outsourced or done in-house) enable the objectives of the Fund to be met effectively and efficiently. |
Process for selecting Investment Managers
5.13
Investment Manager selection is governed by the Investment Manager Selection Policy (June 2007). The policy's objective is to establish:
... the process and criteria by which recommendations will be made to the Board of the Guardians of New Zealand Superannuation (Board) for the appointment of external investment managers.
5.14
Initially, the Guardians' primary objective was to establish investment mandates and appoint Investment Managers. This was necessary so that funds received could be invested in accordance with the Strategic Asset Allocation. In the first years of the Fund, several new Investment Managers were appointed. As the Fund has matured, this activity has reduced as the focus moves from appointing Investment Managers to managing and monitoring Investment Managers.
Investment Manager due diligence
5.15
The Guardians apply a detailed due diligence process before appointing an Investment Manager. Once the Guardians have established a need to appoint a new Investment Manager, a Request for Information questionnaire is sent to prospective Investment Managers. In our view, the questionnaire is suitably detailed when supported by appropriate validation procedures and analysis. This includes review of supporting documents, interviews, and site visits. We saw all three elements when we examined in detail the appointment process for one Investment Manager.
5.16
The Board retains authority to approve Investment Manager appointments, the benchmarks against which Investment Manager performance is assessed, and the fees to be paid to Investment Managers. The implementation of the Investment Manager appointment process has been delegated to management.
5.17
When it receives the Investment Manager's response to the Request for Information, management assesses the information and, if satisfied, does a more detailed evaluation including:
- referee checking by Guardians' staff or by a qualified third party (where required);
- face-to-face due diligence performed at the Investment Manager's premises;
- a comprehensive analysis of the Investment Manager's investment strategy; and
- accounting, taxation, legal, and financial due diligence.
5.18
The completion of each of the above steps generally occurs but is not mandatory under the Investment Manager Selection Policy. This ensures that the process remains appropriately flexible, and relies on the Board's review and approval process to explain why certain steps have or have not been performed.
5.19
Once appointed, Investment Managers are monitored to ensure that they continue to meet the standards required by the Guardians. In our view, these procedures are sound by industry standards and, in all instances, they meet or exceed benchmark requirements applied by a selected regulator.1
Assigning a conviction rating
5.20
In addition to the requirements set out in the Investment Manager Selection Policy, the Guardians assign all prospective Investment Managers a “conviction rating”. The conviction rating reflects the confidence that the Guardians have in the Investment Manager to achieve its investment mandate.
5.21
The conviction rating is an overall score based on the different assessment elements included in the Investment Manager Selection Policy. Different weightings are given to different scoring elements, depending on the relative importance placed by the Guardians and whether the investment mandate relates to private or public markets. Investment Managers must achieve a certain conviction rating score before they are appointed. The Guardians regularly review the conviction rating of each of their appointed Investment Managers.
5.22
If the Investment Manager's conviction rating drops below a certain level, the Guardians have provisions in their contract to review and terminate the mandate with the Investment Manager. This may include active monitoring of the Investment Manager, stopping further allocation of funds, or ending the relationship with the Investment Manager. We reviewed one instance where the Guardians ended a relationship with an Investment Manager. In our view, the steps taken by the Guardians in that instance reinforced the strength of their rating and monitoring process.
5.23
The Investment Manager Selection Policy covers the whole due diligence process. In our view, while the Guardians need to retain some flexibility to determine detailed conviction rating procedures depending on circumstances and investment mandate, some important aspects of the due diligence process could be better documented. Improvements could include linking the Guardians' qualifying criteria for selecting Investment Managers to the conviction rating process, and documenting how elements assessed through the conviction rating process are set or changed. The Investment Manager Selection Policy could also document how to apply ratings and weightings to conviction rating assessment elements, and who can approve these.
| Recommendation 12 |
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| We recommend that the Guardians of New Zealand Superannuation link their Investment Manager Selection Policy with their process for conducting due diligence over Investment Manager appointments. This includes linking qualifying criteria to the policy, documenting how ratings and weightings are applied, and documenting how assessment elements are set, changed, and approved. |
Anti-money laundering measures
5.24
An emerging issue faced by all investors, fund managers, and financial service providers is the growing requirement to understand risks in relation to anti-money laundering. In our experience, there is no best practice guide for meeting these obligations. The Guardians use practices that are common within the financial services sector, such as checking the due diligence procedures used by Investment Managers when they invest money on behalf of the Fund.
5.25
Other probity considerations, commonly referred to as business intelligence checks, include asking:
- Who are the people involved with the Investment Manager?
- How does the Investment Manager understand the background of companies they typically invest with?
- Does the Investment Manager have any reputation or a policy in relation to ethical investment?
- What sort of association does the Investment Manager have with politics?
- What sort of relationships does the Investment Manager have with other companies?
- Does the Investment Manager or its staff have any criminal convictions?
- Are regular litigation checks performed?
5.26
Generally, financial institutions ask these questions over and above regular financial due diligence performed on the income statement and balance sheet. Increasingly, this type of analysis and business intelligence checking is consistent with information processes required to complete anti-money laundering requirements. We reviewed the Guardians' process for anti-money laundering and noted that most of the checks listed above are incorporated in the Investment Manager Selection Policy and related processes.
5.27
The Guardians have rigorous due diligence procedures in place for selecting Investment Managers. However, these procedures could be improved by clearly relating them back to anti-money laundering requirements. For example, the information collected through the Guardians' Request for Information could specifically focus on how the prospective Investment Manager manages anti-money laundering.
5.28
We identified additional processes the Guardians could put in place depending on the asset class being invested in. For example, they could check the United States of America's State Department list for banned companies or people.
| Recommendation 13 |
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| We recommend that the Guardians of New Zealand Superannuation amend their Investment Manager Selection Policy to include an assessment of the anti-money laundering management philosophies of prospective Investment Managers, and that this assessment becomes part of the ongoing assessment process for Investment Managers. |
External advice for selecting Investment Managers
5.29
The Guardians do not always obtain external advice when appointing Investment Managers. Generally, the Guardians use external advice only when the Investment Manager is to be appointed for a specialist purpose or in a specialised asset class of the Fund's Strategic Asset Allocation. When they have sought external advice, the Guardians have used industry specialists, their existing investment advisory network, and peer network groups. For example, the Guardians appointed a recognised specialist to source and evaluate New Zealand Private Equity Investment Managers. The Guardians manage such appointments under the Adviser Selection and Appointment Policy.
Assessment and monitoring of risk associated with investment activity
5.30
The Guardians manage the risk associated with outsourcing investment activity to Investment Managers through the contracting and investment mandate process. They use rigorous processes in determining the investment strategy applied by each Investment Manager, and establish investment mandates that constrain Investment Managers with respect to:
- maximum exposures to any one listed security relative to the portfolio (that is, concentration);
- maximum exposures to any one listed security relative to that issuer's total capital (that is, controlling interests);
- maximum exposure to any one unlisted security;
- maximum exposure to collective unlisted equity;
- limits on the number of securities held (where applicable to the market);
- limits on derivative contract exposures;
- limits on related parties' transactions; and
- minimum credit rating (where money market securities can be held).
5.31
This approach is consistent with industry-wide practices to manage risks associated with outsourcing investment activity to Investment Managers.
Investment mandate compliance
5.32
The Custodian monitors compliance with the financial risk parameters agreed with Investment Managers each day. The Investment Management Agreements between the Guardians and the Investment Managers set out minimum reporting requirements. These requirements cover reporting to the Custodian and to the Guardians.
5.33
The Investment Managers report their transactions to the Custodian each day. Once the Custodian has processed the transactions in its investment management systems, it generates and reviews investment mandate compliance reports. If there is a passive (or minor) breach2, the Custodian notifies the Investment Manager of the breach and asks the Investment Manager to resolve it. The Custodian notifies the Guardians immediately if there is an active breach, such as investing outside the investment mandate.
5.34
Under the rules of the service level agreement, the Custodian must rate and report breaches of investment mandates by the Investment Manager to the Guardians. The Custodian reports passive breaches to the Guardians only if the breaches are not resolved by the Investment Manager in a timely manner.
5.35
We have reviewed the processes applied by the Guardians and are satisfied that major risks relating to investment mandate compliance are being managed through:
- the processes agreed in the service level agreement with the Custodian;
- secondary controls applied by the Guardians;
- checking the Custodian's compliance against its investment mandate with the Guardians; and
- pre-trade clearance checks performed by the Investment Managers that include measures of investment mandate compliance.
5.36
We consider that the approach taken by the Guardians is pragmatic given the global reach of their Custodian. This allows timely resolution of investment mandate breaches with the predominantly global group of Investment Managers.
Monitoring and managing the performance of Investment Managers
5.37
The Guardians monitor the performance of Investment Managers through the Investment Manager Monitoring Policy and through the Custodian's investment mandate compliance process.
5.38
The Guardians set clear investment performance benchmarks for all Investment Managers. Each benchmark is directly related to the overarching Strategic Asset Allocation for the Fund. The relationship between the Investment Manager benchmarks and the Strategic Asset Allocation are communicated and discussed between the Board and management. This occurs annually and was last done in August 2007.
5.39
The Guardians have developed a detailed framework for overseeing and controlling Investment Managers, which includes:
- overseeing transactions through the investment mandate compliance process, performed primarily by the Custodian and overviewed by the Guardians; and
- applying the Guardians' conviction rating and performance assessment process.
5.40
In our view, both of these processes provide a strong basis for the Guardians to gain assurance over transactions and the general performance of the Investment Managers.
Investment management fees
5.41
The Guardians apply a range of remuneration practices to Investment Managers, including performance fees and fees linked to the size of funds managed. Performance fees are used in different ways, depending on the nature of the investment mandate and the markets within which investing is to occur.
5.42
The Fund's public market investment mandates have benchmarks, and the performance of Investment Managers is easily assessed based on relevant indices. The ability to benchmark public market performance means that the Guardians can separate the performance of the market from the performance of the Investment Manager for these investment mandates.
5.43
Private markets generally cannot be benchmarked to any reliable index. The net risk adjusted return tends to be the base measure, making it difficult to separate market and manager performance. Overall, the Guardians tend to apply performance incentive fees to active investment mandates, as opposed to passive investment mandates.
5.44
To earn performance fees, an Investment Manager must outperform a benchmark. Typically, this will be a market-neutral benchmark reflecting the performance of the basket of securities held within a market for a predefined period. In many cases, performance fees are paid out over a prolonged period and are pegged to the ongoing ability of the Investment Manager to generate and maintain investment returns. Where excess returns are strong, performance fees will be paid. Where excess returns are inadequate, performance fees will not be paid.
5.45
The Guardians do not have a policy covering the setting, changing, and approving of Investment Manager fees. Historically, this has been managed by the Guardians when agreeing individual investment mandates. This approach was appropriate as the Guardians developed their investment mandate scope and fee payment method. However, as the number of Investment Managers has stabilised, the Guardians need to formalise their broader fee policy.
| Recommendation 14 |
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| We recommend that the Guardians of New Zealand Superannuation establish a policy on fees for Investment Managers that sets out the types of performance fees available and criteria for awarding a performance fee. |
Cost effectiveness
5.46
In November 2005, the Guardians engaged Cost Effective Management Inc (CEM) to benchmark the costs of the Fund to peer organisations and funds. This review highlighted that the Fund's cost was 44.3 basis points3 while similar-sized funds operated at 31.3 basis points. The 13.0 basis point differential was explained by CEM as follows:
- costs associated with additional strategic advice, amounting to 2.9 basis points;
- costs associated with having more active investment mandates with Investment Managers, amounting to 2.2 basis points;
- higher relative Custodian costs amounting to 5.7 basis points; and
- other factors, amounting to 2.2 basis points.
5.47
Causes of the cost differential could be the growth focus of the Fund, the stage of the Fund's development, or compliance costs associated with the Fund's governing legislation. The Guardians have since addressed those areas within their control, such as the cost of Custodial services.
5.48
The fee structure for Investment Managers is an integral component of the conviction rating philosophy (see paragraphs 5.20-5.23) and the Strategic Asset Allocation strategy to maximise long-term risk-adjusted returns. The Guardians' approach needs to be considered in conjunction with their longer-term investment strategy. In the CEM benchmark review, the Fund outperformed its peer funds by 4.5%. The first four years of the Fund coincided with strong global markets and a period in which Investment Managers have outperformed their benchmarks. This, in turn, has meant that some Investment Managers achieved performance fees.
5.49
It is extremely difficult to determine the cost effectiveness of the services being provided by Investment Managers. The objectives of the Fund are to maximise returns net of fees. Investment mandates with performance hurdles focus on generating superior returns for the Fund, which means there is limited value in assessing cost effectiveness on the basis of simply minimising fees.
5.50
The performance of the Fund in its first four years has meant that Investment Manager fees for funds under management are relatively high compared to a number of industry benchmarks.4 The Fund's relative isolation from the majority of its major markets, combined with its growth focus, makes direct comparisons with peer funds difficult. The performance fee approach ensures that the interests of the Fund and its Investment Managers are aligned.
Access to information
5.51
Investment funds that outsource a large proportion of their investment activity face a risk that they will not retain necessary intellectual property relating to investment decision-making. While the Guardians have not formalised how they manage this risk, the operational structure creates a high degree of interdependence between the Strategic Asset Allocation developed by the Guardians and the individual investment mandates managed by the Investment Managers. Further, the Guardians have initiated a knowledge management project to collect some of this information.
5.52
In our view, the Guardians maintain a full understanding of the relationship and effect of specific investment mandates to the forecast performance of the Fund's Strategic Asset Allocation. Funds that outsource investment management tend to address this issue in several ways. In certain circumstances, a fund may choose to rely entirely on the Investment Manager, arguing that the fund has limited capacity to develop or question investment strategy. In other circumstances, the fund may choose to co-develop the strategy and constantly oversee the execution of that strategy. This latter method is more consistent with the approach of the Guardians. It is costly because more resources are required to effectively monitor the activity. However, it is also a lower risk option. We agree with this approach, given the significance of the Fund to the Crown balance sheet.
5.53
In addition, when appointing Investment Managers, the Guardians place considerable emphasis on the ability of their Investment Managers to share intellectual property and engage with the Guardians. In our review of correspondence between the Guardians and their Investment Managers, it was clear that there is a high degree of engagement between the two parties. There were numerous examples where the Guardians used their Investment Manager network to gain access to experts and specialist advice.
5.54
There were also several examples where the Guardians used their exposure to best practices through their Investment Managers to develop good practice processes. For example, several assessment measures were identified by the management team in consultation with external experts during development of the Guardians' Investment Manager Selection Policy. The assessment measures are included in the policy, but are not mandatory, reflecting the different circumstances in which Investment Managers can be selected and appointed.
5.55
In relation to Private Markets, the Guardians face greater challenges to access reliable information. This is an industry-wide phenomenon arising because most information comes directly from the Investment Manager and cannot always be easily validated through independent sources.
5.56
The nature of Private Markets assets has meant that there is reduced disclosure for this type of investment. These investments are not subject to regulated disclosure requirements. Underlying assets are not publicly accountable and principal sponsors tend to protect their intellectual property. The Guardians have formalised their approach to managing this risk by:
- increasing due diligence checks of Investment Managers whenever investing in Private Markets;
- increasing the requirements for ongoing monitoring of Private Markets investments;
- establishing a dedicated governance committee at the Board level to oversee Private Markets investments until internal management control frameworks are prepared; and
- committing to establish in-house Private Markets capabilities, focusing on risk areas such as due diligence over Private Markets investment structure, and ongoing monitoring and testing of these investments.
5.57
In our view, the Guardians' initiatives represent a reasonable approach to Private Markets risk management. However, these initiatives will become more important to the Guardians as the Fund acquires more Private Markets assets. The risk is partially mitigated by diversification within this sector. This increases the Fund's exposure to the asset class, allowing benchmarking within its portfolio as well as providing a basis for determining appropriate disclosure by the Investment Manager. The greater the Fund's exposure to Private Markets, the greater the exposure of the Guardians to unreliable information about its investments.
5.58
The best approach for the Guardians to mitigate this risk is the approach they have taken - to continue to build their understanding of the sector and develop minimum operating requirements for their Investment Managers.
Monitoring the behaviour of Investment Managers
5.59
Investment fund managers that outsource a large proportion of investment activity face a risk that an Investment Manager might behave in a negligent or inappropriate way. The inherent risk associated with this exposure is no different to risks faced by active in-house trading functions.
5.60
The Guardians mitigate these risks by:
- performing upfront due diligence when selecting an Investment Manager;
- carrying out ongoing investment mandate compliance and overseeing processes;
- requiring daily reporting of transaction activity by Investment Managers to the Custodian; and
- getting the Custodian to perform operational risk management.
5.61
To a degree, some types of inappropriate behaviour are less likely to be detected when outsourcing. These include trades that attract inappropriate commissions, trading behaviour commonly referred to as market manipulation, and trading out of market rates or excessive deal commissions. However, the risks are partially managed by aligning the objectives of the Investment Manager with the Fund through the use of performance fees.
5.62
In our view, the Guardians' measures to protect the Fund from negligent and inappropriate behaviour by Investment Managers are appropriate and consistent with global practices applied to outsourcing relationships.
Our conclusions
5.63
The Guardians have adopted an outsourcing business operating model for investment management. This has been an appropriate approach, given the growth focus of their investment strategy.
5.64
The Guardians have developed a process for selecting Investment Managers and assessing their performance.
5.65
The Guardians manage risks related to gaining and maintaining intellectual property for the Fund's investments, and take an active approach to understanding and challenging the value of Investment Managers.
5.66
As the Fund grows, the Guardians have opportunities to standardise the fee structure for Investment Managers, reassess the ongoing appropriateness of the business operating model, and build in-house knowledge and expertise.
5.67
In our view, the Guardians have taken a reasonable approach to assessing the current business operating model.
1: We have compared the Guardians' selection process with the requirements of the Australian Prudential Regulatory Authority.
2: A passive breach is one caused by circumstances beyond the Investment Manager's immediate control - for example, market price movements.
3: A basis point is a unit that is equal to 1/100th of 1% and is commonly used to denote the change in a financial instrument, the difference (spread) between two interest rates, or the measure of performance or relative cost against the funds under management.
4: From CEM research done for the Guardians.
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