Archive for June, 2011

Power to the Institutional Investor’s Edge

Ashby Monk

I was having a conversation with one of my new Stanford colleagues last week about the organizational design challenges facing SWF sponsors. Specifically, I was making a point about the difficulty of structuring a public organization that could be agile enough to successfully navigate the volatile world of global finance. This individual had one thing to say: “You have to read Power to the Edge.” So I did. I downloaded it (for free), and read it on a recent flight. I haven’t plowed through 300 pages that fast since the last Harry Potter book (for real).

Some background: Power to the Edge is a 2003 book about organizing the military by the military for the military. So it’s maybe a tad more militaristic a read than you (or I) are used to. However, I promise you, it has some broad implications for the design and governance of all organizations, including SWFs. Here’s a little teaser to pique your interest:

“One can view the history of mankind as a journey of empowerment, conspicuously marked at critical junctures by the synergic combination of a particular technological advance and an innovative social adaptation that together eliminate a debilitating constraint. The result is a leap to a new isoquant of productivity. This book explores a leap now in progress, one that will transform not only the U.S. military but all human interactions and collaborative endeavors. Power to the edge is a result of technological advances that will, in the coming decade, eliminate the constraint of bandwidth, free us from the need to know a lot in order to share a lot, unfetter us from the requirement to be synchronous in time and space, and remove the last remaining technical barriers to information sharing and collaboration.”

Cool stuff, right? I know. Basically it’s a book about how technological advances are allowing organizations to redirect flows of information, thereby allowing them to better respond to volatile operating environments. In other words, Power to the Edge is a book about creating agile organizations for the modern era. And why does agility matter? Because it is the touchstone of success in modern organizations (and the authors of the book cite a bunch of research proving the importance of agility in modern firms’ performance).

In short, agility is crucial for success in the modern era, which creates some serious problems for organizations from the industrial age that typically rely on hierarchies and bureaucracies for managing decision-making:

“Industrial Age organizations are, by their very nature, anything but agile. Agile organizations must be able to meet unexpected challenges, to accomplish tasks in new ways, and to learn to accomplish new tasks. Agile organizations cannot be stymied when confronted by uncertainty or fall apart when some of their capabilities are interrupted or degraded. This lack of agility stems directly from an Industrial Age belief in optimization and centralized planning…

…An organization that does not promote the widespread sharing of information will not have well informed individuals and organizational entities. An organization that develops an approach to command and control that takes full advantage of the information available will be at a competitive advantage. Industrial Age organizations create fixed seams through which information is lost. They create seams that prevent information from being brought to bear. And they create seams that prevent them from integrating effects. These organizations will survive only as long as it takes for others in their competitive space to take advantage of Information Age concepts and technologies. This will not be long…

And given that this book was written in 2003 (before the likes of Twitter and Facebook), this “time” is probably now. So, this begs the question, what are the components of agile organizations?

“The key dimensions of agility:

  1. Robustness: the ability to maintain effectiveness across a range of tasks, situations, and conditions;
  2. Resilience: the ability to recover from or adjust to misfortune, damage, or a destabilizing perturbation in the environment;
  3. Responsiveness: the ability to react to a change in the environment in a timely manner;
  4. Flexibility: the ability to employ multiple ways to succeed and the capacity to move seamlessly between them;
  5. Innovation: the ability to do new things and the ability to do old things in new ways; and
  6. Adaptation: the ability to change work processes and the ability to change the organization.”

One of the interesting take-aways from this book was the notion that today’s successful organizations will no longer be able to rely on a single “genius” to make sense of the entire marketplace. That’s the old hierarchical world whereby a single person can drive an organization’s direction (i.e., central planning). Today, the market is simply too complicated. A successful organization will have to tap into collective knowledge and collaborate more and more in order to ensure that decision-makers are integrating all the risks and variables into their plans.

In my view, all of this has some clear parallels to institutional investors, especially those that are increasingly bringing assets in house. With increasing financial market volatility, there is enormous value in reliable information. I’ve spoken to many executives in the past few years about the challenges of managing information flows and getting the information into the hand of the people that need it most. Anyway, I think this chart really sums up the new organizational paradigm for the “Information Age” — institutional investors should take note.

SWFs Managing Executive Succession

Ashby Monk 

Executive turnover and succession tend to be quite serious events for all large companies, but they take on added significance in the context of a sovereign fund. Why? Sovereign funds oftentimes underwrite a state’s financial stability and social welfare. In times of crisis, the fund is called upon to cushion the state from the external forces that threaten autonomy. Indeed, these funds are more than just special purpose investment vehicles; many are buffers against the unfettered forces of global capitalism. As such, when a C-level executive (Ceo, Cio, Cro, Coo, Cto, etc) departs, this can result in a change in the fund’s performance (either for good or bad). Put simply, SWFs have to get succession right.

Significantly, many SWFs around the world have been facing some serious executive successions as of late. Consider these examples:

  • The Government of Singapore Investment Corporation is losing Deputy Chairman and Executive Director Dr. Tony Tan to retirement.
  • The Alaska Permanent Fund is losing CIO Jeff Scott to the private sector.
  • Singapore’s Temasek may be losing CEO Ho Ching to retirement sometime this summer (though rumors of her departure have been around for years…and she’s still there).
  • China’s National Social Security Fund is losing Vice Chairman Li Keping this summer (to the China Investment Corporation).
  • The Future Fund is losing Chairman David Murray this year to retirement (after losing General Manager Paul Costello last year).
  • Samruk-Kazyna lost its CEO Kairat Kelimbetov to the Ministry of Finance.
  • The China Investment Corporation’s will soon lose COO Zhang Hongli to retirement.
  • The Abu Dhabi Investment Authority faced a very difficult and sudden succession after Sheikh Ahmed bin Zayed al Nahyan died in a unfortunate glider accident.

All this is to say that there are plenty of C-level transitions taking place. And, given that a new executive tends to break organizational momentum (which can be a good or bad thing depending on the circumstances), the big question is how SWFs can best manage these transitions so that financial performance meets expectations. To answer this question, I thought I’d snoop around the “succession literature” and share some insights.

A paper by Wei Shen and Albert A. Cannella Jr. stood out to me among the 60+ I quickly found on the topic (thank you, Google Scholar) as offering some really good insights for SWFs. This paper offers a detailed examination on the performance consequences of the types of successors the organizations choose and, specifically, how these new individuals drive the performance of an organization. Indeed, the paper may offer SWF Boards some insights into how they might think about these sorts of transitions. Here’s some blurbage:

“Successor origin both reflects succession context and has significant implications for subsequent firm performance…”

“…[in addition to outside successors] there are two distinct types of insider successors: those appointed following their predecessors’ dismissals  and those  appointed following their  predecessors’  ordinary retirements. We labeled these two types of inside successors contenders  and followers,  respectively.”

“…we examined three types of CEO successors. These three types of successors — contenders, followers, and outsiders — differ importantly with respect their ability to manage change, their firm-specific knowledge, and the risk of adverse selection they pose.”

And so what did they find? Well it’s rather interesting. First, if things are going well and you want things to continue going well after an executive’s retirement, then you should hire an internal ‘follower’ (i.e., a protégé). That’s pretty straightforward, as the institutional knowledge in these funds can be priceless (which would trump an outsider), and the dedication to continuity would be desirable (which would trump a contender who thinks they may “know a better way”).

However, if performance has been poor and you want to change things up, then the decision is not really between an insider and an outsider but is more accurately labeled as a decision between an outsider and an inside contender, as both will be looking to restructure the way things are done to improve performance. Interestingly, the findings of this article seem to favor the contender over the outsider, as the former has the institutional knowledge required to manage some continuity, while also having the ability to inject new talent into the management team. Because an outsider is already a disruption, any additional changes to the management could potentially be too destabilizing for the organization (which favors choosing a contender).

To sum up, Peter Drucker argued that the most important factor driving an organization’s success and survival is its top managers. So executive succession is a critical juncture for any organization, which means that changing a management team can be difficult and potentially dangerous. SWFs will thus want to take considerable care in selecting a successor. For a struggling SWF, it looks as though an “internal rival” may be the best executive successor to ensure performance.

Anyway, if you’re really keen on succession literature, this article has a complete review of all of the papers published between 1994-2004 on the topic (seriously). Enjoy.

Hedge Fund-of-Funds? Anybody? Anybody at All?

Ashby Monk 

In January 2009, Yale’s CIO David Swensen called the community of hedge fund-of-funds (HFoFs) “a cancer on the institutional investor world.” He also went on to say that these intermediaries…

“…facilitate the flow of ignorant capital. If an investor can’t make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There’s also more fees on top of existing fees. And the best managers don’t want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers.”

Ouch. That’s pretty bad. When the architect of the “Yale Model” and the acknowledged guru of institutional investment says you’re a cancer, you know you’ve got problems. And, as it turns out, that seems to have been the case for HFoFs these past two years.

In the past two months, two rather interesting reports have been published on the decline of  HFoFs. An aiCIO article entitled “The end of 3 and 30” was really compelling. And, yesterday, Citi published a new study entitled “The Growth and Impact of Direct Investing,” which offers survey results that show institutional investors giving up on HFoFs and making investments in hedge funds directly. Here’s a blurb from the latter:

“The shift to direct hedge fund investing has been dramatic since the global financial crisis — particularly among larger pensions and sovereign wealth funds…The roots of this shift in investment approach had begun around 2006–2007. Larger pension funds and early sovereign wealth fund investors had gained exposure to hedge funds via traditional fund-of-fund managers earlier in the decade but, for economic and diversification reasons, had opted by mid-decade to build out their own capabilities to select and manage their hedge fund portfolio. The global financial crisis and Madoff scandal accelerated the move toward direct investing, particularly as a second wave of sovereign wealth money began to enter the market.”

I’ve been writing about direct investing for a while, and, in my view, the case for in-sourcing hedge fund allocations is a strong one. (Given Swensen’s comments, it’s not like I’m going out on a limb here.) You save a ton on fees. You have more control over your assets. You have a better understanding of your fund’s exposure. In short, I’d expect the trends shown below to continue on in the same direction.

And The Award For Most Improved SWF Goes To…

Ashby Monk

Back in 2007, Ted Truman wrote a paper calling for greater transparency and accountability of sovereign funds. He then published, in 2008, a paper outlining a “blueprint” for SWF “best practices” that detailed in explicit terms what he meant by transparency and accountability. Subsequently, this blueprint — which he also used to generate a scoreboard of SWFs’ behaviors — was partly responsible for the eventual creation and adoption of the Santiago Principles.

I think it’s fair to say that Ted’s early work on the subject of SWFs was both groundbreaking and influential. But how big an impact has his work had? Well, it’s interesting you should ask, because Truman has just published a new paper (this one on Asian SWFs) that updates his scoreboard and offers a sort of “most improved” category for the community of SWFs.

Obviously, the improvements by SWFs aren’t owed to Ted’s work alone, but it is quite interesting to see the dramatic changes that have come about over the past four years. Indeed, many SWFs have made a sincere effort to alter their behavior in order to keep markets free and open for their investments. For details, see the chart below.

Sweden Launches Review of Buffer Funds

Ashby Monk

Sweden’s government will soon launch a broad review of the country’s five pension reserve funds (aka the “buffer funds”), which together have roughly $150 billion in assets under management. Here’s a blurb describing what’s up:

“The government’s “pensions group”, which includes representatives of all five of the country’s mainstream political parties, will look at the investment rules of the funds – and even whether there are enough or too many of them.”

As you may have guessed, the buffer funds exist to buffer the state’s budget from looming pension liabilities. There’s nothing too unique about that, as Canada, New Zealand, Ireland and others have similar institutions. However, what is interesting about the Swedish case is the fact that the government split up the pension money among five different funds to encourage competition and diversification. (It’s actually a really cool idea.)

However, the funds don’t end up being very different. Because they are so transparent, they can, for the most part, align operations and copy one another’s successful investment policies. In addition, the investment rules prevent some variation as well — not to mention preventing the kinds of investment policies that one might expect to go with a long-term approach (i.e., illiquids).

So, I think a review is probably a good idea. It was probably time to do one anyway; the funds have been operating for a decade now, which means there are probably plenty of lessons learned that could be applied.

The main focus of the review appears to be two-fold:

  1. To determine whether the funds should have less restrictive investment rules. As it stands, the buffer funds are prohibited from investing more than 5% of their money in unlisted assets. This means they are under-weighting private equity, infrastructure, real estate, and so on. And they can’t invest in commodities full stop.
  2. To examine whether Sweden needs five buffer funds for one pension system: AP1, AP2, AP3, AP4, and AP6. As you might imagine, one of the objectives of the review is to see whether some consolidation is warranted.

My take: The review should remove the restrictions on investments in unlisted assets and on investments in commodities and let the funds take a truly long-term investment approach. And I also think that some consolidation is probably necessary in order to benefit from economies of scale. It seems that bigger is better for institutional investors these days; why not leverage that competitive advantage? Anyway, for some additional thoughts on how to reform Sweden’s pension system, read this interesting paper.

Top Ten Tweets

Ashby Monk

Here they are: Your top news items from the past week’s @sovereignfund Twitter feed:

  1. GIC’s Tony Tan leaving to run for President. It’s actually almost the same job; i.e., protecting Singapore’s reserves
  2. It’s judgement day for PE funds, as CalPERS tells all.
  3. Russia Direct Investment Fund winning some high-level support. Advisory board to include various big shots.
  4. Korea’s $270 billion National Pension Service is opening its first overseas office. And the winner is…New York.
  5. And the next country to consider a new sovereign wealth fund is…Poland! (They got shale gas.)
  6. Very interesting to see 11 family offices team up / pool resources to make direct investments in clean tech and energy.
  7. SEC investigating ExxonMobil’s ties to the Libyan Investment Authority.
  8. Temasek’s Ho Ching isn’t going anywhere; has told staff internally that she plans to stay on at Temasek.
  9. Mubadala launches joint venture with 1 Malaysia Development for $4 Billion aluminium plant.
  10. Qatar Investment Authority looking to bring 100 people from London to Doha.

Guest blog: Asset Allocation for Geoengineering?

Adam Dixon

I feel compelled to write about long-term investment strategies after reading Ashby’s blog from last Friday about positioning SWFs’ portfolios for the looming effects of climate change. Specifically, I thought I’d offer SWFs and long-term investors a potential scenario that needs to be on their radar: geoengineering! That’s right, technologies that attack the problem but not the cause are no longer in the realm of science fiction (i.e., reducing solar radiation without reducing CO2).

I don’t claim to be an expert on the subject, but those that are have assured me that the costs of particular geoengineering technologies, such as putting sulphur aerosols in the atmosphere, is not prohibitively expensive. In fact, the costs are actually so low that an individual country could do it, or even a wealthy individual.

For the last six months or so I’ve been working on a project with two climate modellers and another social science colleague of mine at the University of Bristol, School of Geographical Sciences in looking at the relationship between climate and economic growth to understand potential country preferences for different geoengineering scenarios.

There is one serious caveat: The ethical and political implications of this are huge. The risk of changing the global distribution of heat and precipitation are high (notwithstanding other environmental damage like acid rain). So while geoengineering can provide a means of reducing global mean temperature, the consequences of doing so for some (or all of us) may be catastrophic. This suggests that efforts to do so will be highly politically contentious (and probably should be).

Yet, if other efforts to reduce atmospheric CO2 fail and global mean temperatures increase to dangerous levels, geoengineering could find sufficient support. If geoengineering solutions were employed prior to climate change becoming a major threat to human and economic wellbeing (i.e. within the next 50 years or so) this would have implications for a long-term asset allocation that expects inevitable climate change.

Long story short: if you’re in the business of scenario planning and risk planning, you might want to put geoengineering in the mix.


About

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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