ideas Exchange Conference - Australia 2010
Get Smart: Investment Solutions for a Complex World

Key Takeaways (PDF)

1. Now more than ever before, investment complexity reigns supreme as we face a fragile and highly uncertain global economic environment. This year’s conference focused on thinking outside the box to discover and discuss a number of investment solutions to prepare investors for the future.
2. As part of a table discussion exercise, Towers Watson put forward a list of eight important challenges which long-term investors will need to successfully overcome in order to generate successful return outcomes going forward. Delegates were asked to discuss and then rank these issues by order of importance. The top issue as voted upon by delegates was striking an appropriate balance between a long-term strategic asset allocation and the ability to respond dynamically to a rapidly evolving investment environment. Allocating capital according to risk drivers and improving risk management practices were the next most important issues. The complete results are illustrated in Figure 01 in the PDF (NB. the size of the bubbles in the chart denote the frequency of responses).
3. Our panel discussion delved more deeply into some of the key challenges discussed by delegates. In particular, the worsening state of major developed country sovereign debt and deficit levels was cited as a key risk for investors going forward. The importance of carefully considering how this situation may play out and positioning investments to benefit from such a scenario(s) is critical for long-term investors.
4. The “Investment Industry Road Map”—broadly grouped into macro views, asset allocation and investment theory and practice—is clearly going through a state of change, which will result in new winners and losers amongst the investment industry (see Figure 02 in the PDF).
5. With over 60% of Australian super fund assets currently being held for members above the age 50, it is critical for super funds to review and revamp the post-retirement investment products they offer to their members. However, building the perfect retirement income product is very difficult in practice. While no current products tick all the boxes, there are some interesting innovations and ideas being developed in the market, particularly around areas such as staggered lifetime annuity purchases over time.
6. Also on the subject of post-retirement solutions, another key decision funds need to make once they have assessed the options available to them is whether to use a “white-labelling” approach (that is, purchasing an existing solution from an external provider but placing your brand on it), or to build your own unique product. White-labelling is easier and imparts no capital requirements upon the super fund. However, building your own offers full control over product design and may be more cost effective. A survey of fund representatives in the room showed a strong preference for the build your own approach, with most funds expecting to get started over the next 12 months.
7. We discussed using structured products to alter funds’ risk/return profiles, noting that careful analysis and understanding of how varying combinations of derivative instruments work and how they are priced relative to market expectations is critical. Our analysis showed that:
   • Purely from a financial perspective, a static approach to using options doesn’t look attractive
   • The fees embedded in structured products most likely exceed a “fair” cost for the transferring of risk
   • The perceived benefits are greater than the actual benefits, on average
   • There may be value in option strategies if investors place greater value on certain outcomes than the “average” investor
   • Overcoming the implementation challenges of using options is not easy.
8. Delegates were strongly in support of using Dynamic Strategic Asset Allocation (DSAA) to adapt investment strategy in response to changing market conditions, with its purpose principally a risk management focus. We suggested that success requires the right framework, access to good idea generation and evaluation and a disciplined, real time decision making process (see Figure 03 in the PDF).
9. We identified the following four critical success factors for institutional investors to follow when investing in alternative assets:
   • Linking strategy to investors’ objectives
   • Achieving real diversity
   • Being clever, not complex with implementation
   • Reducing the fee drag.
10. In an effort to reduce fee drag, ensure the right incentives are in place and ensure performance fees are only paid for true value-added, we put forward an alternative private equity fee model (see Figure 04 in the PDF):
    1. Firstly, a “budgeted base fee” more closely linked to a manager’s cost of running the business—approximately 1% of assets under management. Only directors fees should be allowed to be charged to underlying companies and these should be paid directly to the fund (or at least until 100% of the management fee is offset).
    2. Secondly, we proposed a two-tiered performance fee:
       • The first tier is actually not linked to returns at all but an annual fee is linked to staff retention and the achievement of key milestones for underlying portfolio companies e.g. achieving targeted earnings growth.
       • The second tier is a more conventional returns-based performance fee, albeit we see this as being set at just 10%, payable above a genuine hurdle linked to a margin above listed equities upon the wind-up of a fund and linked to staff retention and long term incentives.