Asset Management: Interviews—
David G Morgan

David G Morgan, chief executive of the Coal Pension Trustee Service, is interviewed by Dr Shanta Acharya.

SA: As a major user of investment management services, how have recent developments in the industry – globalisation, technology, demographics, legislation etc. – affected you?

DM: Our trustees task us to be a lean machine focussed on implementation and governance. Internally, we have a small number of people who have professional experience of investments, and as a result we rely heavily on external sources and advisers. Legislation often can be heavy handed and can easily end up limiting investment opportunities unintentionally. The difficulties of investing in collective vehicles such as private equity were a simple example.

Technology – that is the use of technology to aid our role – is a challenge, but it does provide opportunities for electronic linkages to external houses such as our custodian. Technology as in TMT stocks of course hurt us as our major UK and US mandates are closet indexers. Globalisation is clearly a factor as we seek to understand the investment processes at our managers as they react to and take advantage of globalisation for stock pricing, research and trading.

SA: Has the rise in mergers or takeovers in the industry affected your decision to change managers? Do you think you’ve benefited or otherwise from such a trend?

DM: No, we’ve been insulated from all that. Goldman Sachs Asset Management (GSAM) bought the right to exclusive management of some 80 percent of our assets for six years. We do have a small-cap mandate with Edinburgh Fund Managers and watched the Hermes bid with interest – and we continue to watch the future of the company.

We haven’t changed our fund managers in 6 years. The only appointments we have made in that period have been a cash manager (Rothschild) and private equity managers where our clients (the two Coal Schemes) have relied heavily on external advisers. One uses Cambridge Associates, the other Watson Wyatt.

SA: What percentage of your funds if any is managed passively? How do you allocate risk within your portfolio? What is your current asset allocation – i.e. bonds, equities including indexation, real estate, alternative investment strategies such as private equity and hedge funds?

DM: None of our funds are managed passively in theory. The GSAM mandate has been managed to a trustee outperformance target of ½ percent per annum (with suitable underperformance guidance) around a trustee specific composite weighted benchmark. Within that, GSAM set their own benchmark risk tolerances some of which retained the closet index approach whilst others used a high enough risk budget to allow less constrained active management.

If I had to predict a change that will be made, it would be that Trustees will take much more direct control over where their risks are taken. The risk budget will be tightly trustee-controlled. Currently, one of our schemes has weightings and benchmarks as set out below. The other scheme differs in basis points only, for historical reasons.

Asset Allocation: Weightings and Benchmark
Asset Class Weighting Benchmark Equity
UK 30.87 FTSE 350 ex IT
UK mid and small cap 2.69 FTSE 250 & FTSE small cap ex IT (weighted by market cap)
UK small cap 1.44 FTSE small cap
US 10.92 S&P 500
Europe 10.93 FTSE Europe ex UK
Japan 5.26 MSCI Japan
Developed Asia 3.44 MSCI All Country Asia Pacific Free ex Japan (developed countries)
Emerging 4.45 MSCI emerging markets
Others    
Fixed interest- Gilts 6 JP Morgan GWBI (UK)
Fixed interest - Corporate 1.5 Merrill Lynch Corporate bond index
Index linked – UK gov 6.75 FTSE A index linked all stocks
Index linked – US gov 0.75 Lehman Bros over 5 years US TIPS
Property 10 IPD Life & Pensions £300m-£2bn
Private equity 5 FTSE All Share
Total 100  

SA: As you have a relatively high exposure to private equity, your track record is quite unique among pension funds. Could you elaborate on how and why you chose such an investment strategy? How have your investments in that asset class performed? What sort of issues need to be addressed by private equity managers to enable other plan sponsors to widen their exposure to the asset class?

DM: The Schemes got into private equity (PE) in the late 1970s and investigated various avenues. They were involved in a range of opportunities including sponsoring some films – I believe the film ‘Gandhi’ was one. The thrust gradually got more focussed until we span off our in-house private equity team in 1995. Who better to do an MBO? The firm, Cinven, is now the premier European MBO (Management Buy-Out) expert. At its peak, private equity was around 5 percent of the assets and it fell back in the 1990s to around 1½ percent last year as the funds we had invested in raised money at a rate faster than we were prepared for.

About three years ago – before Myners – the scheme decided that it wanted to broaden its PE approach and diversify by stage and geography, principally in US and Europe including the UK. We aim to have 5 percent invested again but as always with this asset class, it will take some 5 years or so before we get there. The asset class for us meets its target outperformance of the FTSE All Share by 5 percent per annum over a rolling 5-year period before fees.

Our approach rests heavily on external private equity advice and we have little in-house experience today. One client scheme uses only the fund-of-funds route (with some direct investment alongside), whilst the other has started to use managers who make direct investments. The usual route in for large investments is through limited partnership interests and the legal work is very expensive in fees and time. Other simpler vehicles need to be more extensively available if the industry is to attract smaller pension schemes. Private equity managers tend to obscure their work for reasons that are perfectly proper and desirable in looking at deal flow and investment, but they need to learn to become transparent and client friendly when dealing with investors and trying to attract money.

SA: What is your view of hedge funds? There is the issue of transparency with hedge funds as much as with private equity. How does one address the issue? There are other issues, including fees and regulation. Do you have any comments?

DM: We don’t invest in hedge funds principally for governance reasons. We have only a limited investment staff and the priorities lie elsewhere. Of course, our global tactical asset allocation mandate within the GSAM mandate is little different from one type of hedge fund so they’re not entirely new. The transparency issues that apply to private equity investing apply here as well but in spades. We’d want to be sure that there was complete openness about the risks being taken, and we’d ideally want to see those being monitored on a day-to-day basis by a manager that knows the positions daily and checks their consistency to the stated aims of the hedge fund managers. We want control of our risks.

SA: How many consultants do you use in your overall investment process? What level of value-addition do you achieve in that process and how is that monitored? Have you ever replaced a consultant; if so, could you please elaborate why?

DM: Watson Wyatt are our principal investment consultant with Nick Watts our partner. We tap into many parts of their research process for manager information, risk watching, custodial review etc and we use their asset-liability modelling (ALM) unit. Nick attends all our investment sub-committee (ISC) meetings and all our Board meetings where investments are on the agenda. ISC meetings are also attended by our plan sponsor (more strictly our plan guarantor), the DTI with David Hager of Hewitt Bacon and Woodrow Limited attending as their adviser. We also have an additional investment professional present (a different one for each scheme), and we have a property professional (Richard Barrass) present when the property mandate is under review. For private equity, we use either Watson Wyatt or Cambridge Advisers. In total, that’s around 8 experts we can tap for advice. We also involve other leading consultants such as Don Ezra of Frank Russell in our training programmes. We use other specialist consultants for issues such as stock lending.

Value addition is notoriously difficult to measure in this area not only because of the noise in any figures but also because advice is only advice, and you can only measure the effect of the decisions which may differ from the advice. We have for some years had an annual appraisal of the principal adviser, but it mainly picks up on soft issues. We’ve really only had this team for some six years and we’ve been satisfied with the performance. There have been changes but mainly for retirements.

SA: Would you prefer to see trading costs absorbed into your manager’s fees?

DM: We certainly would not want to see commission bundled. Commission is the tip of the transaction cost iceberg, and you should not address any part of transition cost on their own. We insist that the factors affecting transition costs all pull in a similar direction, and if commission costs were bundled, then the influence would be very different. Open dialogue about these costs starting from an informed basis with statistical analysis is essential for alignment. Opportunity cost and market impact are clearly for the trustees’ account – if I could agree what they were and get a manager to accept those, I’d be happier! Given that that’s unlikely, we take a very simple stance: Transaction costs are ours, but they’re managed for us by the investment manager. He should account to us for his stewardship of those costs and he should be prepared to demonstrate his skill and prowess in that area by making available to us the results of transaction cost performance measurement on our trades – ideally broken right down against the price when the portfolio manager decided on the trade. I know that’s asking too much of today’s order management systems (OMS) and transaction costs analyses (TCA) but with the rapid computerisation of OMS and web based fast reactive TCA systems such as ITG’s, it’s coming.

SA: What is your view about the issue of independence of research and what sort of changes would you like to see in the industry to improve the quality of research?

DM: There is a lack of attention to the cost of research by brokers and its’ value to managers. Much of what is produced has limited value – if any. I do believe that the long-term effect of focussing on transaction costs will be that the entire relationship between managers and brokers will come under price pressures and cost-effective practices will have to be enforced as a result. Paul Myners may not have had the right solution but he has highlighted a problem that needs to be addressed . Research will change in its availability and it will be paid for openly and transparently. Investment managers have not paid as much attention to the quality of the research they have received.

With regard to the independence of research, apart from the investment banking relationships that stand in the way, the lack of accounting robustness is also a concern. As a major shareholder, I am very concerned if there is a growing tendency going beyond inventive accounting towards aggressive accounting; as that is undoubtedly manipulating share prices. One can see that the finance managers of companies want to represent their firms in a positive light, but the independence and thoroughness of the audit profession should reflect in the accounts. Investors have lost confidence in that process. I have worries that the audit profession has not only lost its reputation, but has lost its teeth; and I am beginning to move towards a view that there should be clear separation of the audit and accountancy sides of the business so that greater professionalism is restored to auditors. Certainly there needs to be positive action to restore regulations across the Atlantic and to prevent any spread of the US culture to the UK

SA: How do you ensure that your funds are invested in a socially responsible way? What are the major corporate governance issues that concern you the most?

DM: One of our schemes, the Mineworkers’ scheme, was the one that got the Megarry judgement between Scargill and Cowan in the mid 1980s over South African investments. So, we’ve been active in this arena for a long time and for a long time we were a long way ahead of the game. Others are now catching up but we’re still ahead of most trustees. We still believe our task is to look after the best financial interests of our members, so we’re not here to trail blaze for the sake of it. It is our responsibility as shareholders to maximise the financial value of our investments. If that can be achieved via greater activism, then it has value; and from a social point of view, it has some control mechanisms that are very useful.

Management is there to handle corporate social responsibility – that’s an integral part of management – and as shareholders we should only get into oversight issues when management is getting that wrong. The investment manager is charged with handling all oversight issues – and SRI issues are essentially investment oversight issues, not structural governance issues. Of course, we do expect our manager to be accountable for this part of his work but it’s his role to manage. We do have a corporate governance policy which expresses our views to managers.

Governance of the structure of the board is a different matter where we do have stronger views and where we tend to want to lead our managers where the mandate and management style allow. Structural governance is not about investment issues; it is about alignment of interest and control and operational structures. Alignment of interest is where we are most focussed – remuneration issues where we welcome the new DTI initiative and the Higgs review on the role of the non-executive director. But above all, we must remember that the board is principally there to drive the company forward and in most companies, control structures are secondary. So of them all alignment and remuneration issues are critical.

Remuneration does appear to have got out of control and not to be achieving its purpose. There has to be a balance between risk and reward and the extent of remuneration seems to be getting too high in total. So, from that point of view I do believe very strongly that management are more accountable to shareholders, and welcome what the DTI have done. I have worries about the extent to which we focus on share price performance as the key financial element of remuneration schemes, as that can lead to share price manipulation as we have witnessed in the case of various companies in the US.

SA: According to the Myner’s report, a majority of pension fund trustees in the UK are ill equipped to deal with complicated financial issues, as they lack both qualifications and training in that area. Do you think such a state of affairs may have damaged the future of defined benefit schemes, or was it dying a natural death anyway as a result of an assortment of external factors?

DM: Pendulums have a habit of swinging back over time; and in time, companies will remember that a defined benefit scheme is the cheapest way to deliver a given amount of pension income to workers. You can follow an optimal investment strategy and you don’t have to overprovide for some employees and underprovide for others (assuming you actually want to be right on average).

Of course, if you mark a pension fund to market without smoothing mechanisms, you will find volatility. But for a going concern with an ongoing pension fund, that volatility is irrelevant to the business operation. To bring the volatility into the balance sheet is just plain stupid and I hope that analysts will see through it. Of course, it does become relevant when a business is going bust, but this should be balance sheet note information for ongoing businesses. As a user of accounts, I welcome the suspension of FRS17 and hope it will be replaced by something that provides useful consistent information without distorting corporate reporting. I served for 3 years in the 1990s on the International Accounting Standards Board (IASB) committee that looked at this and got deeply involved; I’m firmly convinced that the accounting profession has gone overboard on this one.

I certainly don’t think it was lack of trustee skills that killed it off. More a combination of the transition to low inflation, the difficulty of producing corporate profits in that environment, the threat of the injection of volatility into corporates’ accounts (for some companies), the search for cost cutting in others and the drive in all businesses to eliminate unnecessary risk – a factor that is not always aligned with shareholder interests. There will have been different reasons in corporates with different pressure points and different opportunity sets.

SA: Do you have a wish list of changes you would like to see in the asset management industry that, in your opinion, will enable you to do a better job?

DM: Such a wish list would include:

  1. More transparency all-round, especially in the private equity industry but also in marketable security transactions.
  2. No stamp duty on shares and property
  3. No further legislative constraints on our ability to maximise shareholder value and no statutory obligation to activism.
  4. Most of us now manage our schemes with an elegant framework derived in the 1970s and improved over the next 30 years. The framework uses asset liability modelling to create a pattern of asset classes that allow us then to set index benchmarks around which the asset manager can manage the assets controlling risk and the trustees with their consultants can have confidence in that they have controlled and can measure their delegate, the investment manager.

Everybody now plays the same game to a high degree of sophistication. I’d like to see alternative frameworks developed so that we were not all chasing the same holy grail.

Shanta Acharya started her investment management career with Morgan Stanley Asset Management in London after an academic career at Oxford and Harvard. She was subsequently a fund manager with Swiss Bank Corporation Portfolio Management International and Baring Asset Management. She also served as a Client Servicing Manager at the Bank of Ireland Asset Management. Her most recent publication is Asset Management: Equities Demystified (Wiley, UK; 2002).