Institutional Investment Mandates: Anchors for Long-term Performance

Matthew Leatherman is a Director, Sarah Keohane Williamson is CEO, and Victoria Tellez is a Research Associate at FCLTGlobal. This post is based on their FCLTGlobal report. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here) and Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here).

Executive Summary

Asset owners—the cornerstones of the investment ecosystem—often have very long-term investment goals, such as funding liabilities, building an endowment for perpetuity, or providing for subsequent generations. For some of these asset owners, especially pension and retirement funds, these goals reflect the long-term needs of individual plan members who rely on these institutions to safeguard and build the savings which they will need down the road. Ensuring assets are managed in line with these long-term horizons is critical to achieving these goals. This presents a challenge, however, because assets are often managed by asset managers, distinct from the asset owners, and managers may have different time horizons, incentives, and goals.

Among the most important elements in ensuring that institutional investor partnerships fulfill long-term objectives are the investment management contracts between asset owners and asset managers, the “mandates.” The terms and conditions embodied in these mandates constitute a mutual mechanism to align the asset managers’ behaviors with the asset owners’ objectives. These contracts define the relationships between asset owners and asset managers and play a crucial role in ensuring the success of these relationships over time.

Shaping mandates with provisions specifically oriented towards long-term goals can help build stable, lasting investment partnerships and, if designed properly, improve long-term performance.

Here are a few questions for institutional investors to ask as they negotiate a mandate:

  • Do the incentives built into the mandate support a long-term relationship? For example, fees that decline with the longevity of the partnership rather than with the assets under management may provide owners incentives to be more patient through periods of underperformance.
  • Do the ongoing communications concentrate undue attention on short-term results? Simple changes—such as emphasizing long-term returns in performance reports, highlighting annual (or multi-year) instead of quarterly performance, and defining a rebalancing policy—may counteract the impulse to overreact to short-term events.
  • Is the focus on leading or lagging indicators of performance? Disclosure of changes in the firm or team, shifts in the investment process, and results measured by key performance indicators (KPIs) may provide an owner with more insight into future performance than current or past performance does.
  • Do the mandate terms reward long-term investing and mitigate the common “buy-high, sell-low” pattern of chasing performance? It is tempting to invest in managers after strong performance and terminate them after poor performance, leading owners to chase rather than capture strong returns. Contracts that renew on a long-term calendar and place explicit caps on manager asset capacity can support a process driven by long-term factors instead of short-term performance.

This post provides a starting point for contract negotiations between asset owners and asset managers, helping them define mandate terms that build trust, ensure alignment, and advance the owners’ long-term investment goals.

Institutional Investment Mandates: Anchors for Long-Term Performance

The relationship between asset owners and asset managers presents a classic time-horizon mismatch. The owner has a specific set of investment objectives that correspond to its stakeholders, liabilities, return goals and risk tolerance. The manager has a different set of stakeholders; the goals and internal incentives facing its portfolio managers and business leaders are likely to differ substantially from those of the asset owners whose capital it manages. Therein lies the challenge: how to ensure ongoing alignment of incentives and goals between two distinct institutions, often over a long period of time. Nearly a thousand investment professionals surveyed by State Street’s Center for Applied Research affirmed this challenge: “77 percent of asset owners said they were concerned that short-term incentives were not being aligned with long term objectives… More than half of asset managers (57%) said the same.”Institutional investors’ best tool in accomplishing this difficult goal is the  investment mandate, the contract that governs these relationships and lays out the specific terms and parameters of their relationships.

FCLTGlobal’s long-term model for institutional investment mandates responds to this challenge by providing a menu of ideas to help anchor these mandates to the long term. The asset owners and asset managers involved in the Focusing Capital on the Long Term initiative wrote in the Long-Term Portfolio Guide that the investment management contract is “a mutual mechanism to align the asset managers’ behaviors with the objectives of the asset owner, not simply a legal contract.”

This project builds on that principle and offers a long-term model for investment contract terms, with the goal of providing a starting point for mandate negotiations that emphasize long-term provisions rather than the short-term incentives that are all too common in today’s investment contracts. Indeed, adapting mandate agreements is an important and readily-available action for the 82 percent of asset owners and managers who told State Street about their concern with short-term relationship impediments and who also admit that nothing is happening in response.

Translating long-term intentions and objectives into investment management mandates involves rethinking the primary provisions applicable to public equity investment strategies and the key performance indicators (KPIs) used to evaluate asset managers. Quarterly performance is an easy measuring stick to use, but it is unlikely to provide much information about underlying capabilities or future prospects over the duration of an investment mandate. The reasons that an owner chooses to invest with a manager can lead to the development of KPIs that may be monitored and discussed throughout the relationship, leading to a deeper understanding of the managers’ strengths and weaknesses, and improving the likelihood of successful investment outcomes. Investors who responded to State Street’s survey pointed to “short-termism” as the industry’s top-ranked problem, and asset owners—principals or clients—particularly expressed this belief. While each investor will undoubtedly use different contract provisions and KPIs to fit their individual goals, and shorter-term provisions may be completely appropriate for shorter-term investment allocations, starting with a long-term mindset is more likely to lead to a mutually beneficial, long-term relationship.

Top Ten List for Long-Term Mandates

The terms and conditions that asset managers and asset owners set for their relationship can drive long-term or short-term behavior. Based on a series of working groups with leading asset owners and asset managers from around the world, we offer this list of questions to anchor investment mandate negotiations in a long-term direction:

  1. Fees. Do the fees and fee structures reward a long-term focus? Discounts that increase with longevity may strengthen owners’ commitment and give managers more flexibility to make long-term investments.
  2. Benchmark. To what extent does benchmark-relative return capture a specific strategy’s performance? Are any other metrics as important, such as absolute return or liability matching?
  3. Contract Term. Does the contract encourage long-term commitment and protect against overreacting to short-term events? For instance, a three- to five-year contract term may set longer-term expectations than an at-will contract and still give the owner discretion to terminate, if necessary.
  4. Redemptions. Is the asset manager able to commit to the long-term strategy while maintaining the liquidity needed to meet permissible redemptions? Would allowing in-kind redemptions help to strike this balance?
  5. Manager or Strategy Capacity. Does the investment strategy have asset capacity limits? Noting capacity limits in the contract may instill discipline and mitigate the common pattern of asset gathering following strong performance.
  6. Reporting. Do the tables and commentary highlight long-term investment risks and future investment prospects? Reporting could discuss long-term returns first and primarily comment on annual or longer performance.
  7. Projections. Have the negotiations and discussions included explicit performance projections across multiple timeframes to account for the differences between short- and long- term risks? If so, how?
  8. Active Ownerships. Is part of this strategy to add value through activities beyond portfolio-specific decisions? These activities may include maintaining dialogue with portfolio companies and casting proxy votes strategically.
  9. Disclosures. Does the manager conduct business in a way that is consistent with long-term investing? Disclosing personnel or process changes may offer better leading indicators of future performance than past returns do.
  10. Evaluation. Does the contract establish a plan for how the owner will evaluate the manager? For instance, scheduling regular evaluations may enable more open communication than watch-listing during periods of underperformance.

Asset owners and managers need to ensure that the answers to these questions come together in a coherent way, so that the contract terms are complementary and supportive of long-term investing. Above all, do the terms enable the manager to commit capital according to the desired time frame of the strategy, or is there some mismatch in incentives, liquidity, or elsewhere?

Model for Long-Term Contract Provisions

In the first matrix that follows, we provide a menu of choices for key mandate provisions: fees, benchmarks, contract terms, redemption policies, asset capacity, projections, reporting requirements, expectations for active ownership, disclosures, and evaluation processes. We compare today’s common standards, which tend to reflect a short-term mindset, to a longer-term starting point for negotiations. In parallel, we offer ideas on additional exploratory provisions to incorporate into long-term contracts, as appropriate.

In the second matrix, we rethink the KPIs that asset owners use to evaluate asset managers. Asset owners select managers for their investment and business characteristics and their fit into the overall portfolio. Choosing KPIs that reflect these priorities can give investors better leading indicators of performance than backward-looking returns do.

Long-term investors select mandate provisions and KPIs appropriate for the specific investment approach and relationship. They then ensure that these provisions are complementary and integrated into a cohesive package that provides the underpinnings of a long-term, mutually beneficial relationship.

Fees are often at the top of asset owners’ priority lists when discussing investment mandate terms. Today’s norm is for owners to pay managers a fixed percentage of assets under management (AUM), a variable performance fee, or a combination of the two.

Asset managers who use an AUM fee often offer asset owners discounts based on the size of the account. A discount based on longevity of the relationship may provide a longer-term incentive for them. An owner receives a benefit for patience and continuing commitment, while the manager benefits from the comfort of a more reliable capital base, both of which may help them capture long-term premia.

Owners and managers that prefer to use a performance fee can incorporate long-term incentives by calculating performance over a multi-year period, such as three to five years, and using a hurdle rate that compounds with time accordingly. Asset owners can also defer the performance fee to ensure that only long-term performance is rewarded. Deferring such a fee, rather than paying it and clawing it back in the case of future underperformance, lessens the possibility that the manager will become overly risk-averse during the later years of the contract.

The benchmark used to judge the success of an investment strategy understandably receives a great deal of scrutiny. We have yet to find a perfect benchmark to encourage long-term thinking. In fact, the selection of a benchmark, while important, appears secondary to many other provisions in terms of providing an incentive for long-term behavior. In other words, how the benchmark is used, and its reference time frame are more important than selecting a specific benchmark.

Another key component of a relationship is the contract term. Asset owners can usually terminate their relationships at will and without cause. While asset owners may appreciate maximum flexibility, at-will contract terms present several challenges. Owners may make shorter-term commitments to their managers than they expect their managers to make with their capital. They often “re-underwrite” relationships in response to short-term events, leading asset managers to overreact to such events.

Furthermore, when there is staff turnover due to departures or internal rotations, there may be no champion of an existing relationship, leading to mandate churn.

Setting a three- to five-year term with automatic renewals—provided that the asset manager continues to act in the best interests of the asset owner—may build the relationship with a long-term timeframe in mind, shifting the onus from reacting to short-term performance to evaluating progress towards long-term goals. These contracts may still offer wide discretion for termination, in contrast to strict lock-ups, so that asset owners can make the decision to terminate if circumstances warrant.

A manager’s opportunity to redeem in-kind (in securities instead of cash) can also affect their ability to pursue long-term opportunities. It is challenging for a manager to undertake a long-term investment strategy, such as investing in a turn-around situation, if redemptions may require shorter-term liquidity than the underlying investments provide. The owners’ ability to invest with a long-term outlook is similarly undercut if other investors in the strategy or fund can redeem prematurely. Clarifying in-kind redemption provisions and understanding their impact, if any, on the manager’s strategy can improve alignment of long-term goals.

Discipline is a critical component of long-term investment-management relationships, including the discipline to keep assets under management within the boundaries of an investment strategy’s capacity. It is tempting for managers to grow assets in high-performing strategies beyond the level at which they can expect to achieve long-term outperformance. Contracts can specify a strategy’s capacity, in absolute terms or as a percentage of investable market capitalization, to help managers maintain that discipline over time.

Rather than focusing on quarterly performance, long-term owners and managers will want performance and risk reports to draw attention to the long term. Minor changes to standard reporting templates can help reframe the discussion, such as reporting long-term returns on the left of the page and short-term returns on the right. Focusing written commentary on long-term results—rather than on events of the quarter—and being transparent about trading and operational costs can also encourage discussion of issues that drive long-term success. While it is important to comply with GIPS requirements, including extrapolating statistics from one-month data, owners and managers can agree in the mandate document to produce—and focus on—supplemental reports that highlight the actual risk data, instead of extrapolations.

In order to thrive in the long term, investors also have to survive short-term turmoil. One way to balance those competing perspectives is to include projections as part of the discussion process around a mandate. Today, up-front projections tend to be very limited, and often rote. Owners and managers may find it easier to maintain relationships for longer when they have a shared view about the expected risks and returns across different time horizons—not just at the closing date but across the full pathway of their investment.

Active ownership or engagement with investee companies is important to many long-term investors. As part of the mandate process, owners can ask managers to detail their current practices for engaging with portfolio companies and for casting proxy votes. In doing so, they can ensure these policies are long-term in nature and match their own long-term goals.

Disclosures beyond performance also can play an important role in building a long-term relationship. Asset owners identify the most important components of the manager’s investment and business operations during the due diligence process. Monitoring these factors for changes and defining relevant KPIs can deepen the long-term relationship and avoid unwanted surprises. Changes in firm ownership or the composition of the portfolio management, research, trading, and business management teams may be leading indicators of future investment performance. The mandate can provide a framework for owners and managers to commit to the operational and business KPIs to disclose.

Finally, delineating the evaluation process at the outset of the relationship can help asset owners better manage their own decision-making processes over the long term. For example, documenting and monitoring the reasons for hiring a manager beyond portfolio performance; meeting with managers routinely, rather than just in reaction to underperformance; and measuring expected transition costs before making a termination decision can all lead to better long-term decisions.

Exploratory Provisions

Our work generated several further questions for asset owners and managers that would like to explore additional ways to promote long-term thinking, including:

  • Could built-in rebalancing mechanisms counteract the typical performance-chasing cycle of fund flows?
  • Would having a manager continue to report performance to the owner for three years after termination counteract owners’ tendency to terminate managers after poor performance only to have performance rebound as it reverts to the mean?
  • Would alternate benchmarks that explicitly incorporate long-term thinking, such as the S&P Long Term Value Creation Index or the asset owner’s discount rate, be effective in encouraging long-term behavior?
  • How can asset owners and managers generate constructive dialogue on portfolio managers’ personal incentives, circumstances and succession planning?
  • Should performance reporting consider the economic indicators of companies in the portfolio in addition to financial return?
  • How can asset managers use economic projections (e.g. aggregate revenue, earnings, portfolio modeled as a business) as leading indicators for financial returns?
  • Should the asset owner define expectations of the manager’s engagement with companies as part of the mandate, and then monitor and reward such engagement?

Conclusion

Long-term asset owners and asset managers already have used these ideas to put significant assets to work in longer-term mandates that support their stated desire to focus on the long term. As more and more investors make this choice, we expect that their long-term behavior can translate across the investment value chain to influence corporations’ business and capital allocation decisions. Ultimately, a shift towards the long term across the investment value chain can help foster improved economic growth.

FCLTGlobal believes that the mandate agreement is one of the most fundamental tools for influencing long-term investment behavior. As such, we may continue to update these mandate terms as our research identifies additional opportunities for using this tool to encourage more long-term behavior.

The mandate sets parameters of the investment relationship and defines the incentives that will guide the asset owner and manager. Well-designed mandates explicitly integrate provisions that reflect long-term objectives. By incorporating long-term objectives into the initial contract itself, owners and managers can help ensure fruitful investment partnerships that both satisfy their needs and support the productive long-term allocation of capital across the investment value chain.

FCLTGlobal’s Long-term Model for Institutional Investment Mandates provides a starting point for negotiations and helps investors define mandates that are in line with their long-term goals.

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The complete report is available here.

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