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RI/Environment Agency Mandate Feedback series: The practicalities of a long-term mandate

The latest in the Environment Agency Pension Fund’s ‘Mandate of the Future’ series.

RI NEEDS YOU: Get involved in changing the structure of investment management. Send your feedback directly to the Environment Agency Pension Fund as it explores the construction of genuinely long-term investment mandates!
eapf@environment-agency.gov.uk

In this second part of a novel series of articles on a conceptual new global sustainable equities mandate for the £2.2bn (€2.6bn) Environment Agency Pension Fund (EAPF), explores the practicalities of a long-term investment mandate. Developing the mandate of the future was the first in the series.

There has been much talk of long-term investment – the Kay review in the UK, an EU white paper and of course most recently Prince Charles added his voice to the debate at the NAPF conference. Faith Ward, responsible for sustainable investment at the EAPF, states: “The EAPF is of course very sympathetic to long term investing – as a pension fund our liabilities stretch over decades and the average life of our liabilities is around 20 years. Much of our work on sustainability involves consideration of long-term risks and opportunities and seeking to integrate that into investment realities. However, as we look at the practicalities of long term mandates and specifically for a listed equity portfolio, a number of issues and challenges arise.”
To start with, as member of the UK’s Local Government Pension Scheme, the EAPF is legally required to be able to terminate its mandates at short notice, and to get quarterly performance reports from managers – hardly a great start for defining a long-term manager relationship. Nonetheless, while perhaps the regulations could be reviewed, this is the framework the Fund has to work within. Interestingly, the Fund’s experience is that managers respond very differently to this framework – some managers are comfortable ignoring these short term pressures and take a genuinely long term perspective, while others seem to get obsessed by the benchmark, latest performance numbers and tracking error.

And although the Fund is willing to act as a long term investor, it still needs to ensure that it has some control and governance of managers – it is obviously stretching the definition of long term too much to assume that one can just give a manager some assets for ten yearsor more and just leave them to it: there is a limit to how much leeway an investor can give managers to underperform short term in the pursuit of long term performance.

However, if the normal current controls are inappropriate what should replace them? We look below at some options, but would welcome any other comments from the industry.

The Investment Management Agreement
Although the EAPF hopes its IMA reflects best practice, is it still potentially a source of short-term pressure? As recent legal cases have demonstrated, managers have reason to be cautious over potential negligence and breach of the IMA. Do these concerns materialise in attention on simplistic measures: ex-ante tracking errors, portfolio limits – and a short-term focus? If so, should the Fund do more to ensure the IMA explicitly emphasises the long-term measures we regard as important (e.g. failure to exercise stewardship or consider long term risks) so that they, rather than simple short-term metrics, get managers’ attention?

A manager covenant?
As a long-term investor, would it be useful if the EAPF were to detail its expectations of managers and how they anticipate they will evaluate them (and ultimately sack them)? The idea here would be to set out in a document – “a covenant” – key aspects of the relationship – it would not be legally binding, but hopefully would reassure and explain. It might start by explaining the Fund’s own goals and priorities – not least that replacing a manager is a major commitment and not undertaken lightly. When looking at performance, it could lay out more formally what performance targets mean in practice, and when a performance is unacceptable. Thus it could explain that short-term performance is only used to help understand the investment process and analysis, not as an immediate reason to terminate an appointment. And when it comes to terminating a mandate (the big worry for managers of course), the document could highlight that, while often there are multiple considerations, the key reason – typically more important even than long term performance – is concern over the investment process and investment team – for example a manager that does not follow the process or philosophy they laid out for us.

Reporting requirements
Current normal reporting requirements also, arguably, reinforce the short-term focus – with the emphasis on short-term attribution of performance and analysis of risk. The EAPF has two suggestions and would be interested to get feedback from managers on these or any other ideas. Firstly, there could be a greater focus on the narrative reporting: particularly on the stories behind the investments: why they were bought, how they are doing, the manager’s expectations of them, the outcome of any engagement etc. Secondly, quantitative reporting could focus on longer term, more stable measures – so for example it could present an aggregate report of the portfolio companies’ cash-flow, earnings, and income. In a very real sense, these are what the EAPF wants to see growing over the long term – market valuations may move around and be difficult to predict but as long as the underlying earnings and income progress over the long term the Fund should have no difficulty paying its pensions.

Another aspect of reporting that managers could improve on comes from understanding that one challenge clients face is that they generally only look at a mandate periodically. Thus it becomes easy to review each period somewhat independently – inadvertently resulting in a short-term focus. To address this it would be sensible to look at linking successive reports much more, identifying where we were, what the manager planned to do, what they actually did, and what they are now looking at would help bring a longer-term perspective to the discussion.Governance and engagement
Proper stewardship of companies is a fundamental aspect of most long-term investment approaches – and indeed a key reason they may deliver good performance. Yet governance is a difficult area to formulate and structure – it is certainly much more than voting shares. Indeed as part of a long-term mandate, does governance need to be more than the policy and structure driven governance that is the focus of much manager led stewardship today? Thus, should it focus more on business strategy, financial strategy and organisational culture – or is this overstepping the line and should such matters be left to the board?
And of course, long-term stewardship raises a series of difficult questions: How do you identify and prioritise engagement targets? How do you monitor and measure success in long term stewardship? When is it appropriate to give up and seek an exit? Should you stick with a good but overvalued stock? And then how do you capture this and convey it to your clients? And how at an aggregate level would you expect to be judged on your engagement as a whole?
The EAPF would welcome responses to any of these questions. In addition, managers who have interesting products / strategies are invited to send summary details of them to eapf@environment-agency.gov.uk , ideally by mid-November. Please indicate clearly if you consider some or all of your answers confidential, which the EAPF will respect, as they will otherwise share responses with Responsible Investor and summarise in future articles.

In the next article the EAPF will look at the key issues of fees and benchmarking