Study on governance of investments – Focus in 2010: risk management

Issued in 2008, the survey of the “Governance of investments” represented the initial analysis of how institutional investors in Germany plan, manage and monitor their investments.

Conducted in 2010, the second study takes a new look at aspects of this subject, and thus indicates the degree of progress made over the past few years in the developing of the key structures of governance.
The new study also encompasses the measuring, reporting and management of risk, with the latter also considering the efficacy of overlay techniques in the handling of exposure. This study was carried out by Complementa Investment-Controlling AG (Complementa) and by the Bavarian Financial Center (BFC), with the former being responsible for its contents, pursuing and evaluation. BFC’s end-to-end role in the project consortium was to facilitate its implementation, to coordinate the working relationships existing among the project’s partners and advisory boards, whose members are from both the scientific and business communities, and to assure the anonymity of the participants responding.

These, in turn, were 49 institutional investors. Comprising corporates, foundations and other parties (ecclesiastical bodies), pension schemes and funds, CTAs, and prudential funds maintained by occupations, these investors handle a total volume of investment of more than €40 billion. The largest groups among them are the insurers and pension schemes, numbering 16 and 12 respectively.

The survey revealed that the upheavals experienced upon capital markets and the ensuing ramifications have caused the investors to substantially alter their investment objectives, strategies of realization and organization of holdings. The prime objective of institutional investors – with this especially applying to insurers, to the group comprised of foundations/associations/others, and to pension schemes – has become over the last two years the maintaining of the value of their investments, followed by the setting of risk in a way maximizing the yield targeted for the investment. The assumption of importance of these objectives is probably attributable to the difficulties – systemic-endemic volatility and the low rates of interest and (in many cases) of return for risk-bearing classes of investment – plaguing markets.

Best able to realize their goals during the past three years of unsettled markets were those investors – more than half of the pension schemes, insurers and prudential funds maintained by occupations undertaking such - striving to realize moderate (up to 4%) rates of return by pursuing primarily defensive allocations of assets. Ninety-four percent of all respondents have established and implemented a strategy enabling them to allocate their assets in a way facilitating the realization of their objectives.

The alterations formulated and made in these allocations primarily involve the reduction of positions held in euro-denominated governmental bonds and strategic liquidity classes of investments. We regard these alterations as constituting the institutional investors’ response to public sector indebtedness. In the case of the hedging against the euro, which is one of the world’s prime currencies, this is precautionary in nature. According to the investors polled, these classes are being replaced by an ongoing shift into the real estate, high yields, governmental bonds and stocks offered in emerging markets. In the alternative segment, commodities are the main objects of investments.

The next 12 months are forecast to see an increase in investments in the private equity and absolute return/hedge funds classes. The study shows that institutional investors in Germany continue to tend to manage their investments proactively and in-house.

To be efficacious, reporting on investments has to be properly-structured, delivered in a timely way, and informative. The latter is achieved by using indicators of performance and risk measurement that report on both the consolidated and in-depth levels. Key finding: 32% of the participants have no or only partially consolidated information on the performance and exposure to risk evinced by their holdings in their entireties. Only 41% of the respondents are capable of identifying divergences from benchmarks, and of establishing whether these have ensued from the choice of strategies or of items.

A different story in the area of reporting on risk: nearly all respondents have access to data on profits or losses. More than 60% avail themselves of forecasts of and reports on situations on markets, of risk indicators (value at risk), of reports on cumulative risk, and of management summaries. Similar situations prevail in the areas of reports on the adherence to legal stipulations, of benchmark-based comparisons, and of management summaries. Some 61% of the respondents complement the performance and risk reports prepared by expert systems by relying on Excel-based evaluations created in-house or by third parties.

To be informative, risk reports have to be comprised of both performance and risk indicators and of analyses and evaluations capable of structuring this data into controlling reports. In a change from the previous study, this one showed that most of the respondents achieve this goal by fleshing out their risk reporting to comprise interpretations of the data. The study also found that the relaying of these reports to senior managements and to executive boards (and thus their being informed) had been improved. For nearly all respondents, controlling reports serve as the trigger for the making of alterations in investments, and are accordingly intensively availed upon.

Another, countervailing finding: the average term of initial provision of risk reporting has lengthened over the past two years, with some 12% of the respondents receiving risk indicators and reports only after the 15th day of business. Most respondents (76%) employ overlays as their instruments of protection against market risks. The prime goal is managing (reducing) risks. This may be joined by maximizing earnings. However, only 46% of the participants have access to evaluations of the impact of the overlays upon performance and risk. In more than half of the cases, users of overlays have not created a procedure for dealing with an exhausting of the budget for risks. In view of the recent financial crisis, this constitutes an alarming wake-up call.

Summing it up, the improvements and extensions of reporting have joined with the expansion of the liaison with senior management and of executive boards in furthering the development of governance mechanisms. To be faulted are, however, the lack of information and the failure to provide it in a timely way. This is especially pronounced in times of crisis.

Also showing improvement are the methods employed in governance. The importance of the topics at hand has been accounted for by increasing the frequency of meetings and of management interventions. A further trend is towards increasing using such objective factors as track records when making selections of service providers. This is complemented by a greater employment of such subjective factors as preferences for persons and teams. This is accompanied by a de-emphasizing of the importance of independence of service provision. This gives rise to potential conflicts of interest.

The respondents see the ways of ensuring the positive development of investments as being the identifying of further sources of yields, of new approaches toward the strategic allocation of assets, of suitably-operating overlay instruments, and of methods of improving the reporting on risks. The defining and identification of the latter constitute the greatest challenge facing institutional investors, in their opinion, along with the ensuring that the persons charged with the management of investments have the requisite qualifications. The respondents believe that the beefing up of know-how and the employment of more powerful IT systems in all pertinent processes are the ways of improving the management of risk.