Archive for March, 2011

Investment Tip: Do Less

Ashby Monk

This morning some smart folks directed me to a fun little research report by Michael Mauboussin of Legg Mason that really resonated. The report’s entitled “Why Doing Less Can Leave You With More.” That sounds nice, right? Whatever Mauboussin is selling, I’m buying.

All kidding aside, the report highlights some behavioral problems with investment decision-making that do not add value to portfolios. Basically, the report makes the case for long-term investing. And it does it in a fun way. For example, the report kicks off with a nice anecdote:

“Robert Kirby, one of the founders of Capital Guardian Trust, told a story of a couple he worked with as an investment counselor for about a decade through the mid-1950s. Since wealth preservation was the primary objective of the client, Kirby followed his firm’s guidelines and bought and sold investments to make sure that the portfolio was sensible and well-positioned. Kirby worked primarily with the husband on a portfolio in the wife’s name.

After the husband died suddenly, the wife called to say that she had inherited his estate and was adding his investment portfolio to hers. Kirby reviewed the man’s portfolio and was amused and shocked. He was amused to see that the man had piggybacked the firm’s buy recommendations to his wife. The man purchased about $5,000 of each stock, tossed the certificates into a safe deposit box, and simply ignored the investments. Kirby called it the “coffee can portfolio” because it reminded him of a time when it was common for someone to place his valuables in a coffee can and stick it under his mattress. Since it incurred no transaction or administrative costs, the can’s value hinged solely on what the owner placed in it.

Kirby was shocked when he saw the value of the man’s portfolio, which greatly exceeded that of his wife’s. It was an odd mix, to be sure. There were a number of holdings that had sunk to $2,000, several large positions that exceeded $100,000, and one stock with a value in excess of $800,000. That jumbo position was the result of a small commitment to a company called Haloid Photographic, which later changed its name to Xerox.

The lesson that Kirby took from the episode was not that an investor should buy stocks hoping to find the next Haloid (or Google or Apple). Rather, it was that a portfolio created by acting on only half of the firm’s recommendations and with negligible costs handily outperformed the portfolio to which Kirby fully attended. Buying undervalued stocks and doing nothing did better than attempting to navigate the market’s ups and downs. Warren Buffett expressed a similar point when he said, “Lethargy bordering on sloth remains the cornerstone of our investment style.”

Most of us are taught from a young age that effort leads to results. But if you take effort to mean activity, the lesson doesn’t apply for long-term investors. The message here is simple: investors often make changes to their portfolios—with the best of intentions—that do not add value. This is as true for sophisticated institutions as it is for the unsophisticated individual. Doing less can leave you with more.”

In case you’re a visual learner, here’s the problem with short termism:

Risky Business but with Attractive Returns

Ashby Monk

Long time readers of this blog may have been doing a bit of head scratching lately over my sudden predilection to write about infrastructure investments. Well, I think the following headline from this morning’s IPE explains my interest and motivation pretty nicely: “Sovereign wealth funds flock to infrastructure.” In short, SWFs are increasingly keen on this asset class, which means I am too.

Accordingly, I thought I’d offer a quick primer; tell you what sort of returns and risks SWFs are exposing themselves to with infrastructure. In order to make my job easier, however, I’m just going to crib from Georg Inderst. He has a new paper entitled “Infrastructure as an asset class.” It offers a useful framework for understanding all of the considerations of a commercial infrastructure investment.

First, here are the things that separate infrastructure assets from other assets:

  • High barriers to entry;
  • Economies of scale (e.g., high fixed, low variable costs);
  • Inelastic demand for services (giving pricing power);
  • Low operating cost and high target operating margins; and
  • Long duration (e.g., concessions of 25 years, leases of 99 years).

Second, here is the value proposition:

  • Attractive returns;
  • Low sensitivity to swings in the economy and markets;
  • Low correlation of returns with other asset classes;
  • Long-term, stable and predictable cash flows;
  • Good inflation hedge;
  • Low default rates; and
  • Socially responsible investing.

Finally, here are the many risks that need to be managed:

  • Construction risk;
  • Operational and management risk;
  • Business risk (demand, supply factors);
  • Leverage, interest rate risk;
  • Refinancing risk;
  • Legal and ownership risk;
  • Regulatory risk (fees, concessions);
  • Environmental risks;
  • Political and taxation risks; and
  • Social risks (e.g., opposition from pressure groups, corruption);
  • Concentration or cluster risk (small number of similar assets in portfolio);
  • Illiquidity risk (immature secondary market);
  • Pricing risk (valuation basis);
  • Risks related to the governance of investment vehicles (e.g., conflicts of interests, opacity); and
  • Reputation risk.

The risks will undoubtedly vary according to how the fund accesses infrastructure. The risks facing a fund investing through a listed product will be far different than the risks for a direct investor. Anyway, there you have it: SWFs & Infrastructure 101. Class dismissed.

Deep Thoughts by Knut Kjaer

Ashby Monk

I recently came across a very interesting Powerpoint presentation by Knut Kjaer, current President at GCapm and former CEO of Norges Bank Investment Management. Knut is sort of a star within the small sovereign fund world, so I’m always interested to hear what he’s saying. And, in this Powerpoint, I think he really hit the nail on the head; I found myself whispering little encouragements (“Yes!” “That’s so true!” “Yeah, no kidding!”) as I flipped through the slides. I assure you, that doesn’t happen every day. So, I decided to make Knut one of my 2011 ‘deep thinkers’. Without further ado, here are some ‘deep thoughts’ by Knut Kjaer:

“Typical institutional investors spend 80-90 percent of their time on implementation issues, building complexity, rather than on strategic and ALM issues that normally determine 80 – 90 percent of expected risk and return.”

“The ultimate long-term investor is contrarian. Building a successful investment strategy is to acknowledge the pro-cyclical human instincts and safeguard against it by setting up institutional frameworks.”

“Asset management and risk are two sides of the same coin. Asset management must be based on the underlying risk factors. Risk management should be centered along the basic strategic choices: why do we take on the risk initially and are we rewarded for the risks that we are taking?”

“A complex environment has enormous potential to generate truly confusing surprises. Reality is immensely more complex than models, with millions of weak links.”

“The financial industry is all about principal – agency dilemmas. You easily become a victim if you engage (directly or indirectly) in activities beyond your core competence and skill set.”

“Rebalancing maintains optimal utility and prevents the asset with the highest drift from eventually dominating the portfolio holdings. Thus, rebalancing ensures diversification and mitigates risk.”

And there are plenty more interesting nuggets in there. For example, I thought this chart was quite useful in thinking through the many challenges facing investment decision-makers:

City of London: We ♥ SWFs

Ashby Monk

TheCityUK (formerly IFSL) has just released its annual SWF update, which offers some useful information for the data-starved analyst in us all. As usual, it also makes its sales pitch to attract SWFs to London:

“A number of large SWFs such as the Kuwait Investment Authority, Brunei Investment Agency, Abu Dhabi Investment Authority and Temasek/General Investment Corporation of Singapore have local representative offices in London. A number of other SWFs are also looking into setting up offices in London…The UK welcomes investment by SWF in the financial sector and other industries on the basis that the UK has a regulatory, competition and national security framework that ensures that all foreign investment, whether from a SWF or not, meets the appropriate criteria. The UK Government is committed to ensuring the UK remains an open and competitive market for international investment.”

Yes, indeedy. SWFs take note: According to the City of London, the City of London is pretty much awesome.

Now on to some of the interesting data. According to this report, SWFs now have $4.2 trillion AUM, and the expectation is that this will shoot past $5 trillion in the coming year:

And here’s an interesting breakdown of SWFs’ asset allocations. Question: How is it possible that 15% of SWFs hold no public equities or that 14% hold no debt instruments? What are these funds doing? Should we even consider them SWFs if they have zero debt or equity investments?

But the most interesting chart (at least to me) is the one that shows the sudden rise in popularity of these funds. I know I’ve been talking about this for a while, but it’s still remarkable:


Profiling the Korea Investment Corporation

Ashby Monk

To date, I haven’t really been interested in writing and posting SWF profiles on this site. It’s not that I don’t see the value in sharing basic information with you on these funds, it’s that I’m quite simply too lazy to be bothered. (Or, if the person reading this is my department head or funding provider, I’m far, far too busy with other important things.) Still, once in a while, I find myself looking at documents that offer some really useful, albeit basic, information on these funds. And such was the case today for the Korea Investment Corporation.

I had seen the news this morning that the KIC was partnering with ADIA to do some joint investments, and it inspired me to use my lunch break (I’m just so busy it was the only time I had) to read a paper on the KIC that’s been on my desk for months. As it happens, the paper had some useful charts that I thought I’d share:

1) In case you had any doubts as to the complexity associated with designing and governing a sovereign fund, the following chart should extinguish them. And, relative to others I’ve seen, this isn’t even that complex. Behold:

2) Between 2008 and 2009, the KIC dramatically altered its portfolio allocations. This move towards a more sophisticated approach coincides with the arrival of CIO Scott Kalb. It looks like they added three new asset classes in one year. Is that right?

3) In case you’ve noticed, I’ve been going on and on and on about the in-source vs. outsource debate. In all sincerity, my focus on this topic is NOT due to some secret agenda I have to get sovereigns to outsource or in-source; it’s because the funds have decided this is a huge issue for them. And, as you’ll see below, the KIC is aggressively moving assets in-house. In other words, managers, don’t shoot the messenger! (Note to self: I owe the managers a coherent post highlighting the pitfalls of internal management. This was an attempt, but I acknowledge it was a bit too disjointed.)

Have Your Cash and Spend It Too?

Ashby Monk

I saw an interesting headline this morning:

“Australia should use the riches garnered from its resource-rich economy to counter its infrastructure backlog instead of establishing a sovereign wealth fund.”

The author’s point was that building infrastructure today would be a better mechanism for intergenerational wealth transfers than setting the money aside in a sovereign fund. And, leaving aside the issue of Dutch Disease, it’s actually a valid point that merits consideration.

Recall that Robert Solow argued in his seminal paper that intergenerational equity is based on transmitting generalized productive capacity, whether in the form of mineral deposits, capital equipment, or technological know-how, to future generations. In other words, if the present generation exploits the natural resources of the country, inter-generational equity necessitates a commensurate standard of living and productive capacity for the future generations to come. This can be via savings in a sovereign fund or it can be through infrastructure improvements or whatever else translates into sustained economic and social improvements.

The issue, however, is that for many countries, resource riches are associated with lower economic and social indicators; the wealth is simply wasted or worse. The term ‘resource curse’ does a nice job of describing the problem.

So, when I read the headline above, I thought to myself, ‘It’s a good point. But why do infrastructure and SWF have to be mutually exclusive? Why can’t the money go into a sovereign fund with a broad mandate to invest in domestic infrastructure?’ Granted, a SWF could not fill all infrastructure needs, since a SWF would only choose to invest in commercial ventures (public goods would obviously not be an attractive investment and the government would need to handle those). But a SWF could invest in certain infrastructure projects while simultaneously preserving and possibly building wealth for future generations. In fact, a properly structured sovereign fund with a clearly defined mandate and good governance could also help to ensure the money isn’t wasted on bridges to nowhere.

I guess what I’m wondering is whether there is a way for Australia (and others) to have their cash (in a SWF) and spend it too (on infrastructure investments). It’d be a big ask, but I think it’s possible. You’d simply need a highly sophisticated SWF with the ability to make commercial investments in infrastructure assets (even if there’s nothing simple about designing such a fund).

‘Insourcers’ Score One Against ‘Outsourcers’

Ashby Monk

The debate among institutional investors over whether to in-source asset management to internal teams or to outsource to external fund managers continues. And the in-sourcers may have just scored a game changer against the outsourcers. To build up your anticipation a little bit on this one, how about some background first? Here’s my take on this debate from a few weeks ago:

“I don’t personally have strong views either way. On the one hand, I can understand why a sophisticated institutional investor, such as the CPPIB, might like to bring assets in house to save on asset management fees, avoid agency issues and better align the interests of portfolio managers with the organization. On the other hand, I can also see the potential pitfalls of trying to run a sophisticated asset management operation in-house and, equally, I have genuine respect for those funds that focus their governance budget on becoming a highly sophisticated, outsourced institutional investor, e.g. the Future Fund.”

In general, the Canadians and the Australians represent the two extremes. The CPPIB has upwards of 87 percent of its assets managed in-house, while the Future Fund appears to be legally required to use external investment managers. As Paul Costello’s “Report from the General Manager” in the Future Fund’s 2009/2010 annual report explains:

“The legislation governing the Future Fund requires the use of external investment managers. While this is likely to result in higher portfolio management costs compared to organisations which elect to manage a proportion of their assets internally, it has the important advantage of keeping the focus firmly on the optimal design of the overall investment program rather than the challenge of building and supporting internal asset management teams.”

And page 38 of the annual report goes on to say:

“The governing legislation requires the use of external investment managers and this is consistent with the Board’s preference to operate a modestly sized organisation with internal resources concentrated on the key issue of determining the most efficient allocation of risk across investment markets. This is complemented by a focus on selecting the most appropriate investment partners and closely monitoring their provision of services as well as tightly managing operational risks.”

They make a good point. And it is perhaps why some have criticized the CPPIB on its aggressive move in-house. Anyway, all this is to say that the Australian Future Fund would be about as improbable a direct investor as one could find anywhere.

So now, finally, the scoop.

The Future Fund has, in the past few months, begun making… [pause for dramatic effect] …direct investments. It has invested directly in UK’s Southern Water, Australia Pacific Airports, and Gatwick Airport. And in case you don’t think these qualify as direct investments, here’s Martin Arnold in the FT about the Gatwick investment:

“The move is one of the first times that the Future Fund has made a big direct investment in a company, rather than indirectly through a private equity fund.”

This is kind of a big deal, as the champion of outsourcing is now managing some of its money in-house. For today’s match, it’s Team in-sourcing: 1, Team outsourcing: 0.

As it turns out, the Future Fund has a bit more freedom than the excerpts from the annual report above suggest. For example, the formal investment policy of the fund says:

“Roles will be undertaken internally where the Board forms the view external suppliers cannot meet the organisation’s specific needs. The quality and cost of an outsourced service are the benchmarks against which these opportunities to build internal capacity will be judged…The Act provides that, in the normal course of business, the Board must not invest fund assets unless it does so through an investment manager engaged by the Board.”

There is clearly enough wiggle room in there for the Future Fund to deploy some of its assets directly. Also, the 09/10 annual report says,

“…we’re prepared to invest through pooled funds, co-investments, separate accounts and individual investments, depending on the merits of each in the particular circumstances.”

So there you have it: The Future Fund is now a direct investor. I have three initial reactions:

1) The direct investments made by the Future Fund fit in with the Fund’s evolving investment strategy. Indeed, the Future Fund’s long-term expectation is to move towards an asset allocation with 25 percent in ‘tangible assets’. The Fund’s last quarterly update showed that the allocation was (in December) only 9.8 percent, so the Future Fund clearly has a long way to go.  We may be seeing quite a few more investments of this nature in the coming months and years.

2) These direct investments were all in infrastructure assets. Of all the asset classes out there, I’m of the view that infrastructure makes the most sense for in-sourcing. I’ve said it before:

“…a SWF investing in a private asset manager that, in turn, invests in infrastructure just seems off to me. Feel free to disabuse me of this position, but won’t the SWF be giving up its main competitive advantages by doing this (i.e. scale and time horizon)? … I feel as though SWFs have a certain strategic advantage in infrastructure investing, but, in order to leverage this, they really need to be investing directly. In turn, this requires upgrading the organization for a complex and risky endeavor. In my view, it’ll be worth it over the long-term…”

Now, I don’t mean to imply that all funds should in-source infrastructure. Let’s be clear, there are some solid arguments against in-sourcing. For example, I recently had a conversation with a third party infrastructure manager with an IRR of 22% over the past 10 years, who told me that for every one deal he did, he had to expend resources doing due diligence on 20. Can public funds expend this level of resources on “nothing”? I’m personally inclined to see this as just a search cost and part of doing business. But, I acknowledge, it would take some serious buy-in at all levels of public funds to do this and get away with it. In short, in-sourcing is only for a select few that have the talent, governance and legitimacy to do these sorts of internal programs correctly.

But if you can do it correctly…and that’s a big if…it makes sense to do it directly. Infrastructure is a natural asset class for direct investing. It’s a way of sidestepping the principal-agent and time inconsistency problems associated with third party mandates in long-term assets (I’ve referred to this as ‘the chain of fools’).

3) In my view, the Future Fund has made a wise move here. No doubt they will continue to work with third party fund managers in infrastructure, but the occasional direct investment will do them some real benefit in the long term.


This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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