Global Investment Review

Global Investment Review

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Getting started on the Global path

To date, very few multinational pension funds have adopted a truly global approach towards investment. Isn’t it time they did?

Global mergers and acquisitions now seem to be almost a daily occurrence. A tremendous amount of time and resource goes into structuring these deals, and once they have been completed every effort is made to rationalise the various businesses and unite them in a common purpose. Relatively little effort, however, is applied to the pension fund investments, despite the value of the assets often being a significant proportion of the value of the corporate balance sheet and the contributions being a significant proportion of total expense.

The investment arrangements of multinational companies are often inconsistent and inefficient. For example, as the table shows, the risk taken by a multinational company in its German plans is typically much lower than in its UK or US plans. As well as giving very different risk profiles because of the allocation to equities, these differences in investment strategy have resulted in very different costs of benefit provision in different countries.

So, why don't multinationals operate a consistent investment strategy for all of their plans? The most commonly given answers include the lack of efficient pooling vehicles, differences in local investment restrictions and uncertainty over the legal control of the pension fund assets. None of these responses is unreasonable, but they need not stop multinational companies from making significant improvements to their pension plans.

We find two further obstacles to moving towards a global approach – differences in governance practice and the lack of a common investment language. Governance can be defined as the skills and experience of those people making decisions, the processes they use to reach those decisions and the information they employ to help them do this. The investment language is the set of definitions and tools that are used to determine the investment arrangements. The language must be consistent across all countries and it must be equitable, that is, not based on the approach of any single country. We have suggested some common investment language in the areas of asset allocation and manager structure overleaf.

The Globally Diversified Policy

In terms of asset allocation strategy, most plan fiduciaries think that the split between domestic bond and equity markets has the largest effect on risk. They therefore consider this decision first. Their next decision focuses on the split between domestic and foreign equities. The belief that domestic bonds form the best proxy for the current ‘cost’ of pension provision and, therefore, the lowest risk investment for a pension fund, is quite reasonable. However, the assumption that domestic equities in some way provide a link with pension liabilities is an example of ‘home bias’.

One bold statement that holds true for most countries is that domestic equities provide no better link to domestic pension liabilities than global equities. In today’s global equity markets it is no longer tenable to behave as if one’s domestic market is somehow special and will offer higher returns for lower risk than foreign markets. Holding a significant proportion of assets in domestic equities results in concentration and specific risk, which is unlikely to be rewarded. For a multinational, the problem of home bias is compounded by the fact that each country thinks its equity market is special in relation to its liabilities and views the world as its own market plus ‘the rest’. This approach clearly lacks a common language.

So, we would advocate the first asset allocation decision any pension fund makes is to determine their appetite for risk in terms of the split between domestic bonds and global equities.

Before one hears cries of “but that’s not true in my country” and “local legislation won’t allow high foreign equity allocations,” it should be noted that once a financially sound, globally consistent, decision is made in terms of the division between domestic bonds and global equities, then at the next stage domestic equities can be added back to comply with legislation or to provide local decision makers with a degree of comfort.

To summarise, the globally diversified policy overturns the traditional decision process to produce a more efficient, globally consistent framework that starts with domestic bonds, adds global equities to provide additional returns and finally adds domestic equities only in order to comply with local legislation. By removing the concept of ‘other markets’ and classifying assets in global terms we provide a common language for multinational decision makers.

Achieving consistency of manager returns

The idea of multinationals having preferred providers of investment management services has been around for a while. The purpose is to achieve consistency, cost savings and, hopefully, to identify the best providers by applying greater resources centrally. In practice only the most integrated of multinationals have achieved this, not because the principles are flawed, but rather because the management structure at each plan level is not the same – there is no common language. For example, a specialist US equity manager would not fit easily into many Australian pension plan investment structures, which typically employ global equity managers rather than regional specialists.

If multinationals wish to design a single structure that can be applied by each country they cannot use language that is specific to any one country. They also need to recognise that investment decisions are often based on non-financial factors such as comfort and familiarity, as well as financial factors such as relevant experience and resources. Any structure that does not allow local fiduciaries to retain sufficient control to make them comfortable with their fiduciary risk is almost certainly doomed to failure.

So what is the solution? We need to define manager structures according to some simple, globally consistent measures. We believe these measures should be risk, return, cost and fiduciary comfort level. We use these measures to develop three layers, each of which is distinct and understandable on a global basis.

1 Passive Core

index-tracking managers giving low cost solutions, with low monitoring burden and good economies of scale for a multinational.

2 Active Core

low risk active managers with strong brand names (good comfort levels) in local markets. Unlikely to produce high levels of excess returns after fees.

3 Active Satellite

high risk managers likely to produce good returns after fees. Provide limited comfort for local fiduciaries and impose a significant monitoring burden.

The various asset classes can then be allocated to these layers as indicated in the box below.

A GLOBAL MODEL
	Passive Core	Active Core	Active Satellite
Domestic bonds
Domestic equities
Global equities
Global bonds

Under this model local fiduciaries would have significant discretion over the selection of Active Core managers for domestic assets. These managers would provide the necessary comfort level to the structure and would fit in with local operating practices, for example, splitting managers by capitalisation and style in the US, and using a local bank in Japan. A global fiduciary group would exercise greater influence over the selection of the riskier Active Satellite managers who manage the global equity and global bond assets, and the passive core manager.

Because we now have a common language we have categories of managers for whom multinationals can identify preferred providers (passive core all asset classes, active satellite global equities and global bonds). This structure also allows local fiduciaries to exert control over the active core managers who invest the pure domestic portion of the assets, and the overall asset allocation by adjusting the passive core weightings to the different asset classes.

We all continue to strive for the ideal pooling vehicle, which will let multinational companies build efficient manager structures that can often be used cheaply by plans in many countries. But we suggest that as much as 90% of the gains can be obtained from adopting a common investment language and moving to a consistent approach to asset allocation and manager structure – something that can be done now, without waiting for governments worldwide to agree on the legal status of pooling vehicles.