Philippe Desfossés, RAFP: sustainable investment requires changing investor market expectations

Those who think that the current crisis is simply a rough patch and that things will quickly return to “normal”, with companies generating 15% ROE, for example (as the most “authoritative” experts were announcing only recently) are making a big mistake. That would be a return to the “abnormal”. In fact, how could we possibly have thought that capital could continue to generate ever-higher, sustained returns (the term “sustained” being the operative word here) without something happening? What does this insistence on returns on capital being maintained over 50 years lead to? The book Fault Lines by Raghuram Rajan is worth reading on this subject. Rajan clearly shows how and why many countries, solely through debt, were able to mask the stagnation – or even the decline – in real income that accompanied the heightened concentration of this same income and wealth in favour of an ever-smaller number of households. Is such growth in debt sustainable? Similarly, how could we have believed that a country could continue to pay real interest rates on its debt in excess of real GDP growth over a long period while at the same time continuing to record primary deficits?
Before they formulate requests vis-à-vis asset managers, investors – and notably institutional investors – must first challenge the behaviour and manner in which these asset managers determine their asset allocations. This challenge first requires a transparent review of the deficiencies of the asset managers’ governance. An investor invests in order to meet a commitment,and the nature of that commitment is what should guide the investment decision. For a pension fund, the promise is relatively straightforward: the key is to guarantee that the fund will, at all times, be able to pay the last pension owed to the last beneficiary. At the other end of the spectrum, a money market fund promises to guarantee that the investor will, at all times, be able to recuperate his investment without any loss of capital. The recent crisis showed that the price of liquidity had not been properly appraised. That was largely due to the widely shared conviction that everything that trades on a market can be sold on this same market at all times. Investors need to go back to the origin of the risk they are taking, and assessing this risk involves answering two questions:

• What is the nature of the promise that I am carrying as a liability?

• Do the assets in which I am investing reasonably enable me to satisfy this promise?

Investors are also suffering from a form of schizophrenia. Even as they rightly criticise the short-term mentality of the markets, they are themselves guilty of the same behaviour. For example, while active “benchmarked” investing may seem appealing, fund directors are quick to ask why one should retain a fund manager who deviates from the benchmark (on the down side, of course), when this discrepancy might have a “good
explanation”. Moreover, how can one assess equities management performance over just a few quarters, let alone months. While indices weighted by capitalisation promote pro-cyclicality, investors continue to see this result as representative of the market. For a long-term investor (such as RAFP), the very long-term liability commitments and, where applicable, positive net cash flows (in the case of RAFP more than €1.5 billion annually over the next 15 years) should encourage the adoption of contrarian behaviour. That involves going against the trend, and requires directors to accept that one needs to be on the buy side during market downturns. Should a long-term investor who began investing in equities when the CAC was at 6000 not seize the opportunity presented by an entry point at 2800 – 3000? As strange as it may seem, they generally do exactly the opposite, and one finds long-term investors behaving like trend followers and thereby accentuating up and down trends.
The last point that investors need to consider is their role in risk analysis. Here again, one finds the negative consequences of benchmarked management. For sovereign debt, we invested for the most part in euro zone country securities based on the weightings of the Ibox index, although the rating agencies were issuing warnings that we did not really want to hear on the peripheral countries, and the SRI rating of some provided a more realistic assessment of their risk. We should recall that, in the spring of 2008, “financials” made up nearly 27% of the MSCI EMU. While it may be difficult to admit, such a weighting should have raised questions. How could this sector be weighted so heavily if one looked at its contribution to GDP and earnings and, in particular, if one considered its capacity to maintain “its intermediation” and the associated cost?
Lastly, we can cite the example of “structured” products. One need not spend too much time on this point, other than to cite one particularly well-informed authority on thematter, namely Lloyd Blankfein. “In January 2008, there were 12 triple A rated companies in the world. At the same time, there were 64,000 structured finance instruments, like CDO tranches, rated triple A. It is easy to blame the rating agencies for their credit judgements. But the blame is not theirs alone. Every financial institution that participated in the process has to accept part of the responsibility”. Even as investors need to reconsider their own attitudes in recent years, the role of fund managers also merits close scrutiny. Asset management is an activity for which economies of scale give the largest funds an advantage. One way to achieve these economies is through product standardisation, which drives the trend towards a one-size-fits-all approach. Many fund managers make their pitch to clients along the lines of “I have the product that you need”, without always knowing which matching asset/liability strategy to use. Investors should also pay much closer attention to the risk of conflicts of interest inherent in large funds. Here again, without going into all the details, we can note how dynamic money market funds served as receptacles for risky assets. Or even more tellingly, consider the case of one very large US fund manager encouraging gullible investors to buy products even as another department of this same manager was helping one of the largest hedge funds to short the same products. Fund managers are still all too ready to present the performances of some of their funds or products in an incomplete or inappropriate manner. As an aside, we should note that the graveyard effect introduces systematic bias in most performance indicators, since the worst performing funds or products fall off the radar. More troublesome is the fact that we are often on the receiving end of unsuitable presentations. As a very long-term investor, RAFP manages its bond portfolio through a buy-and-hold approach. How could we be interested by double digit return since they can only be achieved through the realisation of capital gains?

These capital gains merely reflect a decline in rates, and the reinvestment of the proceeds in bonds will be made on less favourable terms. So what should one expect or ask of fund managers in the current situation? Firstly, we can hope that more even-handed research will gradually become the norm. Until now, we have observed a significant overrepresentation in favour of buy-side vs sell-side recommendations. In his book Au Coeur de la Folie Financière (“At the heart of the financial madness”), Edouard Tetreau recalled how, in 2005, he naively sent his first memorandum replete with critical analyses and sell recommendations to the trading floor only to be politely told to go back to his office and not come out again until he had come up with a list of “correct” recommendations, i.e. ones containing practically only buy recommendations. At ERAFP, the best-in-class approach of our 100% SRI policy naturally steers us toward a very “even-handed”, long/short analysis. In fact, some asset managers have this type of analysis that requires the removal of a security from the portfolio in order to add another. In that respect, fund managers would be taking a large step forward if they would incorporate a best-in-class type SRI policy in their investment process. Some are tempted to do so. Few have actually taken the step. Many are content to pay polite lip service to the idea. They are making a mistake, as will become evident in the years ahead. For investors, the issue of conflicts of interest will become increasingly important. We have seen the extent to which the CDO rating activity “altered” the risk assessment capabilities of the rating agencies. As regards ERAFP, this is a point that we watch closely, and it is clear from this standpoint that pure players have an advantage. After all, how could the research department of an asset manager owned by a large bank issue a negative opinion on its bank or even cast a truly critical eye on the recently conducted stress tests, with the credibility issues of which we are all aware?For investors, remuneration structures are another point that will need to be addressed. As returns fall, fees and all other expenses weigh more heavily on performance. In that regard, it is time to question just how well suited remuneration is to the nature of the mandates. Once an investor gives an investment mandate to a fund manager, it is only logical that the cost of this management should be higher than that of fund management closely resembling benchmarked management (and even higher still compared to the cost of indexed management). It would, however, also be reasonable for a portion of this remuneration to be contingent upon the achievement of the performance targets announced in the fund manager’s prospectus. As it turns out – and this is a situation that investors accepted for a long time – one ends up paying the cost of active management only to obtain, at best, an index-level performance. One should, therefore, have a remuneration structure that more closely aligns interests with coverage of research and management costs, combined with a performance fee. Meanwhile, and this will affect fund managers, it appears likely that large-scale investors will consider the possibility of defining indices whose construction satisfies some of their own themes or convictions. In that regard, and in line with ERAFP’s critical view of indices weighted by market capitalisation, we have worked closely with EDHEC to develop an SRI Best in Class index that weighs equities by taking into account the risk factor of each security. By shifting from a weighting based on capitalisation to one based on risk, RAFP has reduced its exposure to the financial sector by seven percentage points for the corresponding investment mandate. Fund managers would do well to ask themselves why more and more investors are looking to work with index managers and researchers to define new avenues for management.
Philippe Desfossés is Director at RAFP, the French civil servants additional pension fund