Mettre le pouvoir entre les mains des investisseurs

When it comes to selecting and working with external asset managers, larger asset owners have a dual responsibility—says Majdi Chammas of Första AP-Fonden (AP1), one of Sweden’s four pension reserve funds with more than SEK 460 billion (USD 47 billion) in assets. “We should push the industry, not only to help our own fund,” he observes, “but to benefit other investors: smaller investors, for example, who do not have the capacity to push for change.

Majdi Chammas,
Portfolio Manager, External Partnerships and Innovation Första AP-Fonden (AP1), Sweden

Winners of ‘Swedish Fund Selection Team of the Year’ at the Nordic Fund Selection Awards for the last five consecutive years, Chammas (Portfolio Manager, External Partnerships and Innovation) and his colleague Tina Rönnholm have worked hard to press for this sort of positive change through their work with external asset managers.

He recently sat down with bfinance Investor Spotlight to shed light on some of the most important themes of their recent work. These have included:

  • The development of new ‘solutions’ strategies, which met their needs where off-the-shelf products couldn’t deliver;
  • The introduction of unconventional and innovative ‘dynamic fee’ structures, now used with all of their active equity and high yield bond managers;
  • The conviction to persist with full procurement processes for manager selection, involving the widest possible universe of participants, despite perceptions that these can be time- and resource-intensive.

In an extended interview—shared in edited form below—he also discussed how his team has responded to newer post-pandemic pressures, such as the increasingly popular perception that virtual due diligence with managers can be an adequate substitute for face-to-face reviews.

You've spoken about moving towards 'solutions' rather than 'products' when working with external managers. Tell us about that change?

As early as six or seven years ago, we were increasingly thinking that ideally we should not be looking for ‘products’; we should be looking for ‘solutions’. Every asset manager has their own portfolio; we would of course prefer to have something that fits with our own portfolio and objectives, and we felt that we had the asset base and the privilege to do something about this. We were even having discussions about this with managers. But it was a vision, not a reality at the time—which was a bit frustrating, to be honest.

The first real ‘solutions’ mandate was implemented in 2018, although we’d been working on it for a few years before that. We were looking for a replacement for our passive equity exposure because of ESG challenges. Every time that companies faced controversies and bad headlines, we would usually have exposure to them through our passive book. We took the challenge to a lot of managers that are the ‘usual suspects’ in passive investing and asked: can you take our passive book of equity business and solve the ESG issue? Many of the managers wanted to take the ‘easy’ route—have us tell them which ESG index we want to use and let them replicate it—but that’s not what we wanted. We don’t want a manager to replicate an MSCI benchmark because we don’t think MSCI has the best ESG scoring. The scores are based on lagging information, they’re reliant on company disclosures and there’s weaker coverage of emerging markets and smaller companies. A couple of managers, however, were able to offer a more sophisticated approach. A lot of it comes down to defining the problem in the right way: when we redefined what our needs were and what ‘passive exposure’ is, managers were able to propose a better solution for us. We ended up seeding new funds.

The next ‘solutions’ opportunity was in high yield bonds. Our board took the decision to divest from fossil fuels in 2020, but energy companies comprise a fifth of the high yield benchmark. At the time we had three managers (one systematic, two fundamental/discretionary). For the fundamental/discretionary mandates, we had custody and were able to exclude what was necessary; the managers got on board with it. However, we were particularly impressed with the systematic manager: we were invested in their fund and thought they’d reject this, but they actually produced a lot of analysis and presented a solution that was similar in many ways to the original (which we liked) in terms of duration, spread and other characteristics. It was also managed against the same benchmark, with a performance-related fee, which is what we wanted.

I like to think that the work we’ve done here has benefited other investors as well as ourselves. For example, it’s great to see others investing in the future core fund in emerging markets which we seeded to replace our passive exposure.

Why do you believe it is important to do a full procurement process for manager selection?

When we select managers, we firmly believe in the advantages of doing a broad procurement exercise where we receive as many responses as possible and have a very large pool of managers to select from. Many of our peers take an easier route, using a shortlist or screening on a simple quantitative basis and then doing a deeper dive on that shortlist. But we really believe that this delivers the best outcomes for us. Procurement also supports our wish to find ‘solutions’ rather than just ‘products’: we can express our needs to the market; the market can answer.

Full procurement can be a lengthy process—it can take 12 months or more for us—but we are fine with a long timeframe. We don’t want to churn managers: ideally we would find the right managers and keep them forever! Over time, we have found more ways to enhance and streamline the process, such as using service providers for certain aspects. There is always internal debate about whether public procurement is the right approach, but I like critique and discussion—it’s a positive thing.

When we are looking to tackle that long list of manager responses, we prefer to start not with quantitative screens but with a focus on people. Our philosophy is that talented people, cultivated in the right way (the right culture, a strong philosophy, a disciplined process), will deliver outperformance. Before we do any quantitative assessment, we read every single RFP and do an initial qualitative assessment covering things like company culture, philosophy, process and the way they integrate ESG. Managers that appear to be a fit with us on these aspects pass that filter and then we look at the quantitative metrics: how they’d fit in our portfolio, what sort of market conditions they deliver in, do they have a top-down or bottom-up approach, that sort of thing.

You've moved managers towards a type of performance fee structure which is rather unusual. What is it, and how have you implemented it?

We now use what we call a ‘dynamic fee’ model for our mandates. I haven’t yet seen any other examples of other investors doing this, although we have had conversations about it with our peers.

The catalyst for first developing a ‘dynamic fee’ model was a situation with a particular manager. This manager really ticked a lot of boxes that we liked—the company, the culture, the team and the process. It was also a partnership structure, which we think is really the ideal set-up. However, they were not performing: market headwinds meant that their style was out of favour for a long time. Paying quite high fees and getting low performance is a real problem for us: we’re under scrutiny as a public fund. We are happy to pay a big cheque when we know we have four or five times that multiple for ourselves, but we don’t want to be paying for promises or beta.

The problem is that, whenever you discuss going from fixed fees to performance fees, many managers—especially Americans, I’d have to say—are very hesitant to do it. As a result, the performance fees that they offer tend to be very unattractive, specifically to dissuade you from doing this. They don’t like the unpredictability: they have to pay bonuses every year to retain talent. I went back to my desk thinking: how can we solve this problem? We started to design a different type of fee structure which can address the issue of predictability for managers while also meeting our needs. We want to be aligned; we want a long-term solution that works for both sides; we believe that talented people should be compensated fairly.

A ‘dynamic fee’—as we call it—is not a pure performance fee. Instead, it’s a structure in which past performance (e.g. over the last five or three years) sets the fee for the coming 12 months. If you don’t achieve objectives, the fee goes down; if you exceed objectives, it can go up. We don’t go all the way to zero: the floor is what we’d pay for a passive solution. And if, when we look back after five years, we work out that we’ve underpaid overall then we pay up.

The specific structure varies depending on the manager and the strategy. For example, the manager may believe they can deliver 3% alpha over a five-year period, so we would work based on that understanding. As a starting point, we believe in the one-to-five principle: 20% participation for the manager is a fair split. That equation might shift a bit depending on how resource-intensive and scalable the strategy is; for a more scalable strategy, a one-to-seven approach may be more appropriate.

Once the managers understand the model, they typically like it a lot. It’s extremely transparent and gives predictability which helps them manage their businesses. Some, however, do have issues with it—especially the reconciliation period. They may not want to take the variable fee onto their books where there might effectively be a clawback years later.

Are there any notable changes which have come about as a result of the pandemic?

The pandemic, with its restrictions on travel and meeting face to face, has created an important question which is still under debate: do we need to be on-site for manager due diligence and annual review meetings? There is debate over this internally, of course. Personally I really do believe that this is better face-to-face. You cannot evaluate a manager’s culture over Zoom or Microsoft Teams.

I’m also a big believer in having two pairs of eyes in these meetings: people have different skill-sets; you can work together in meetings (e.g. ‘good cop bad cop’), and debriefing right away with a colleague who was in the same meeting can be very helpful.

The key themes highlighted by Chammas—the importance of full procurement processes, the difficulties in creating alignment on fees and the need for client-driven solutions—are issues that resonate with many institutional investors around the globe when considering and navigating external manager partnerships. Innovation is crucial and, as he highlights, large investors have an influential role to play in that process. We look forward to seeing how the AP1 team continues to evolve its approach to selecting and working with managers over the years to come.

Important Notices

This commentary is for institutional investors classified as Professional Clients as per FCA handbook rules COBS 3.5R. It does not constitute investment research, a financial promotion or a recommendation of any instrument, strategy or provider. The accuracy of information obtained from third parties has not been independently verified. Opinions not guarantees: the findings and opinions expressed herein are the intellectual property of bfinance and are subject to change; they are not intended to convey any guarantees as to the future performance of the investment products, asset classes, or capital markets discussed. The value of investments can go down as well as up.