cisi.org

Frontline fund governance for the new pension paradigm

Welcome: George Littlejohn MCSI, Senior Advisor, CISI

Presentation: Jon Beckett, Chartered MCSI, Scottish Widows/Lloyd’s Banking Group

Discussion: Dr. Con Keating, Head of Research, BrightonRock Group

Concluding remarks: Alderman Professor Michael Mainelli Chartered FCSI, Executive Chairman, Z/Yen Group, and Fellow, Gresham College

22 January 2014

Frontline Fund Governance for the new Pension ParadigmJon ‘JB’ Beckett, Chartered MCSI

Prepared for CISI and Z/Yen

www.longfinance.net

The ‘Gatekeeper’: protecting customers

Source: CSR

• Change: What do we fear?• What can insurers and DC schemes do?• What can we do as gatekeepers?• Are Market Standards the answer?

Approx 25 mins.

Change: What do we fear?“The world as we have created it is a process of our thinking. Itcannot be changed without changing our thinking.” A. Einstein

• Baby Boomers: “almost 75% of retail assets in the world will be held by retirees or near retirees [within 5 years]” 1

• Pensions Gap: “future generations will have a crisis on their hands that will make the recent banking crisis look like a tea party.” 2

• The [not so] New Normal: “both firms and consumers are likely to continue to misjudge the risks associated with higher returns.” 3

We fear the growing pension deficit between needs and assets

1 ‘Investing in a Debt-Fuelled World’ Create Research, 20132 Douglas Ferrans, Mansions House address, IMA, 06.06.133 FCA Risk Outlook 2013

We fear that regulation may make wealth management a nil sum game..

• Gradual demise of trust-based schemes, Auto-Enrolment, Work & Pensions Select Committee, TPR ‘6 Principles’ for good governance, RDR and FCA thematic reviews

OFT quote: “Overall we have found that competition alone cannot be relied upon to drive value for money for all savers inthe DC workplace pension market.” OFT, September 2013

We fear inflation and the inability to find sustainable excess returns

• Cash: Sickly base rates, thanks Mr Bernanke and Mr King!

• Gilts: A crazy world when ‘good’ means negative real yields to maturity

• High Yield: Increasing influx of ‘hot money’ may threaten rise of defaults

• Equity: Here we go again.. Rising equities are seemingly still fair value?

• Mixed Asset: Fund managers adding risk and complexity to their portfolios

• Property: Solid foundations or sinking sand; liquidity remains a concern?

• Gold and Metals: Anybody’s guess Mr Soros

• Softs: We’ve got to eat; if you have the stomach for it

• Oil: Dirty work for the brave; #frackit

• Derivatives/Hedge: The unicorn, plus basis risk

Madoff.. A Poster Boy for Taleb’s Turkey?

• Ponzi: In November 2008 Neue Privat Bank marketed that the Fairfield Sentry USD 3x Leveraged had ‘92% positive months’, why? because Madoff was generating them out of the 16th floor of his office!

• Precipice: When the scheme inevitably collapsed it led to investor losses estimated at least $50bn and Madoff jailed for 150 years!

• Probity: E.g. JPM ignored risk officer’s red flags over the $76bn ‘703’ account and will now settle c.$2bn with SEC. JPM is not alone!

Arch Cru.. Surprises on the downside

• Funds marketed as lower risk were found to hold higher risk assets

• Credit Crunch brought into sharp focus the concepts of liquidity and leverage

• FOS deemed that advice given had been unsuitable even when the adviser had relied on the literature (and governance) of the distributor (in this case Capita)

• Drew attention to the fragility of using sector classifications as a proxy for risk; we have seen a subsequent reform of ABI and IMA sector classifications

• Arch Cru collapse lead to a rise in FSCS levies for advisor firms and large compensation scheme created by Capita, HSBC, BNY Mellon

The IFA response: “The losses incurred were not foreseeable. The investment and specialist portfolios had 94.87% and 92.31% respectively over a three year period. A 50% decline in one month was not foreseeable" FOS final decision Feb 2012

What can we do as gatekeepers?‘Wealth managers must be able to select the best products for their clients, without bias either from rebate arrangements or towards in-house products.’ Principle 5, newcityinitiative.org

Spreadsheet Governance?

• Relying on past performance and risk metrics as a proxy of ‘good’

• Affirmative action through fund closure remains a rare (left-tailed) event

• Use of meaningless and sometimes misleading risk ratings

• Pooling creates aggregated realities: not attune to client investment horizons

Devolved Governance?

• Post RDR: growth in distributor-influenced and vertically integrated frameworks

• In some we found dysfunction in key asset allocation and oversight processes

• Increased scope for conflict of interest between advisory and investment roles

• Opaque ownership structures between proposer, distributor, DFM and owner(s)

• Mandates are often written to allow a degree of investment freedom

• Many insurers lack sufficient investment capability when designing mandates

• Insurers may hard code in unexpected risk (E.g. SmartBETA)

• Myopic focus on monitoring mandate breaches (no foul; no harm)

• Some insurers still face conflicts of interest with incumbent fund managers

Mandate Governance?

“We must ensure that when we face issues that give rise to potential conflicts of interest, we are able to think independently and put our clients’ interests first.”Douglas Ferrans”, IMA, Mansions House June 2013

From the Frontline: issues

• Fund managers sacking sub-advisors then managing assets themselves

• Conflicts of interest arising from sub-advised agreements and AMC sharing

• ‘Letterbox’ fund managers springing up with no demonstrate add-value

• People turnover and restructuring arising from increased M&A activity

• Building assets book but not re-investing in processes and controls

• Portfolio dilution, pseudo trackers, high cash, high churn portfolios

• ‘Zombie portfolios’ where portfolio activity has halted after a manager change

• Soft-launches encourage outperformance by keeping initial fund size small

• Marketed soft-closures: a means to accelerate sales flows into a fund

Putting our house in order.. Early days

• Address committee membership

• Delegation of decisions creates a shrinking pool of decision-makers

• Lack of recognised relevant qualifications

• No agreed best practice for the Due Diligence Questionnaire

• Not enough communication along the value chain and with customers

• Beginnings of a reality check on ‘star manager’ obsession

• Growing focus on conflicts of interest between distributors and fund managers

• Advent of first investment trustee qualification in Ireland

• Work ongoing by New City Initiative, Association of Professional Fund Investors and Chartered Institute for Securities and Investments (‘CISI’)

Frontline

Con Keating London, February 2014

Con.Keating@BrightonRockGroup.co.uk

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0 10 20 30 40 50 60 70 80 90 100 110 120

Valu

e Two Funds

A B

Translate and Rescale

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Many problems in finance reduce to comparison of distributions

Affine transformation - Translate

Translate and Rescale

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Over this common support, you can integrate out the differences between portfolio and market.

And the economics around that are entirely redundant

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This shows that the CAPM is just a distribution comparison

Why is this relevant?

The absence of liquidity in MPT causes it to fail badly as we move from short-term speculation to long-term investment.

Revisiting Fund A & B

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Statistic A B Minimum -10.49 -8.23 Maximum 11.10 6.74 1st Quartile -0.24 -1.73 Median 1.24 0.19 3rd Quartile 3.40 2.20 Mean 1.47 0.04 Variance (n-1) 10.33 9.14 Standard deviation (n-1) 3.21 3.02 Skewness (Pearson) -0.13 -0.39 Kurtosis (Pearson) 1.16 0.04

But neither fund shows any autocorrelation

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1 11 21 31 41 51 61 71 81 91 101 111

A-B

A-B

The samples are statistically different from one another in both mean and variance

These are in fact random draws from the same (normal) distribution

A is highly unlikely –only 2.6% more positive B - 77.4% would be better

• The minimum length of time to distinguish signal from noise • If we assume normality in return, we can estimate these:

• Only with high return, low volatility strategies are market prices informative. Everywhere else, we are working with noise.

Volatility 0.05

Volatility 0.1

Volatility 0.15

Volatility 0.2

0.1

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100

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0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1Average Return

Year

s (Lo

g)

Minimum Time to Distinguish

Market prices – Information and Noise

Governance - Trust • We cannot rebuild trust – all we can do is improve our trustworthiness

» Competence » Reliability » Honesty

• Transparency and Disclosure are important in this, but as important is good Communication

• We parse data using models to extract information • Guarantees and Collateral do not enhance trust – they are rivalrous

substitutes • Institutional corruption ... refers to institutionally supported behaviour

that, while not necessarily unlawful, erodes public trust and undermines a company’s legitimate processes, core values, and capacity to achieve espoused goals.

• Institutional corruption in business typically entails gaming society’s laws and regulations, tolerating conflicts of interest, and persistently violating accepted norms of fairness, among other things. ...”

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Regulation

• Principles-based regulation is based upon trust that it alone cannot create, though it can facilitate its development.

• Without trust, Principles Based Regulation will never be operationalised; it will exist only in the text of the rule books, not in the way they are implemented.

• Coercion is a substitute for trust and in implementation could easily be asymmetric and destructive of mutual trust between fund manager and investor.

• While it ensures compliance within the specific context covered (under threat of explicit sanction), it also increases the likelihood of perfidious behaviour elsewhere.

• Information exchange and interpretation might then no longer be free and open. It would also be costly in terms of compliance and enforcement and reduce economic efficiency.

• In soft form, however, legislation can provide the governance framework that allows for the enforcement of agreements over rights that are commonly shared, but permits relations of trust to do the heavy lifting. This reduces the other, non-enforcement costs of legislation by allowing private monitoring and information collection and generation.

• We should also not forget that for the signals generated by someone wishing to demonstrate their trustworthiness must themselves be costly if they are to be credible

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Reputation

• It used to be said that: “You can only sell your reputation once” • But that does not consider whether it is worth selling your reputation

anyway • If the gain is large enough, it is rational to do just that • And if there are limited alternatives, say four or five dominant participants • Loss of clients will be offset by gains of disgruntled clients from others • These are problems of competition • And it is well known that many financial markets do not exhibit the

standard properties of competitive markets • The problem is not one of treating customers fairly but of putting

customers first, • In a world which is highly uncertain and little is known with certainty. • Choice under uncertainty requires flexibility and occasionally generosity

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