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Institutional Investment Mandates ANCHORS for LONG-TERM PERFORMANCE SECOND EDITION APRIL 2020

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Institutional Investment Mandates ANCHORS for LONG-TERM PERFORMANCE SECOND EDITION APRIL 2020 REPORT Institutional Investment Mandates ANCHORS FOR LONG-TERM PERFORMANCE SECOND EDITION APRIL 2020 FCLTGlobal is dedicated to rebalancing investment and business decision-making towards the long-term objectives of funding economic growth and creating future savings. FCLTGlobal is a not-for-profit dedicated to can increase innovation, and create value. developing practical tools and approaches that FCLTGlobal was founded in 2016 by BlackRock, encourage long-term behaviors in business and Canada Pension Plan Investment Board, The Dow investment decision-making. It takes an active Chemical Company, McKinsey & Company, and and market-based approach to achieve its goals. Tata Sons out of the Focusing Capital on the Long By conducting research and convening business Term initiative. Its membership encompasses asset leaders, FCLTGlobal develops tools and generates owners, asset managers and corporations from awareness of ways in which a longer-term focus around the world. MEMBERS Table of Contents TABLE OF CONTENTS 4 Executive Summary 5 Institutional Investment Mandates: Anchors for Long-Term Performance 6 Top Ten List for Long-Term Mandates 7 Model for Long-Term Contract Provisions 9 Exploratory Provisions 10 Examples of Long-Term Mandates 11 Ontario Teachers' Pension Plan 12 Kempen Capital Management 13 MFS Investment Management 14 Adjusting Performance Reporting 15 Conclusion 16 Long-Term Model for Institutional Investment Mandates: Contract Provisions 17 Long-Term Model for Institutional Investment Mandates: Key Performance Indicators 19 Acknowledgments 19 Sources This document benefited from the insight and advice of FCLTGlobal’s Members and other experts. We are grateful for all the input we have received, but the final document is our own and the views expressed do not necessarily represent the views of FCLTGlobal’s Members or others. The information in this article is true and accurate to the best of FCLTGlobal’s knowledge. All recommendations are made without guarantee on the part of FCLTGlobal. Reliance upon information in this material is at the sole discretion of the reader; FCLTGlobal disclaims any liability in connection with the use of this article. Institutional Investment Mandates: Anchors for Long-term Performance | 3 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 • Is the focus on leading or lagging indicators of that institutional investor partnerships fulfill long- performance? Disclosure of changes in the firm term objectives are the investment management or team, shifts in the investment process, and contracts between asset owners and asset results measured by key performance indicators managers, the “mandates.” The terms and conditions (KPIs) may provide an owner with more insight embodied in these mandates constitute a mutual into future performance than current or past mechanism to align the asset managers’ behaviors performance does. with the asset owners’ objectives. These contracts define the relationships between asset owners and • Do the mandate terms reward long-term investing asset managers and play a crucial role in ensuring and mitigate the common “buy-high, sell-low” the success of these relationships over time. pattern of chasing performance? It is tempting to invest in managers after strong performance and Shaping mandates with provisions specifically terminate them after poor performance, leading oriented towards long-term goals can help build owners to chase rather than capture strong stable, lasting investment partnerships and, if returns. Contracts that renew on a long-term designed properly, improve long-term performance. calendar and place explicit caps on manager asset capacity can support a process driven by long-term Here are a few questions for institutional investors to factors instead of short-term performance. ask as they negotiate a mandate: This paper provides a starting point for contract • Do the incentives built into the mandate support negotiations between asset owners and asset a long-term relationship? For example, fees that managers, helping them define mandate terms decline with the longevity of the partnership that build trust, ensure alignment, and advance rather than with the assets under management the owners’ long-term investment goals. 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. 4 | Institutional Investment Mandates: Anchors for Long-term Performance Institutional Investment Mandates: Anchors for Long-Term Performance The relationship between asset owners and asset with short-term relationship impediments and who managers presents a classic time-horizon mismatch. also admit that nothing is happening in response. The owner has a specific set of investment objectives that correspond to its stakeholders, Translating long-term intentions and objectives liabilities, return goals, and risk tolerance. The into investment management mandates involves manager has a different set of stakeholders; the rethinking the primary provisions applicable to goals and internal incentives facing its portfolio public equity investment strategies and the key managers and business leaders are likely to differ performance indicators (KPIs) used to evaluate substantially from those of the asset owners whose asset managers. Quarterly performance is an easy capital it manages. Therein lies the challenge: how measuring stick to use, but it is unlikely to provide to ensure ongoing alignment of incentives and much information about underlying capabilities goals between two distinct institutions, often over a or future prospects over the duration of an long period of time. Nearly a thousand investment investment mandate. The reasons that an owner professionals surveyed by State Street’s Center chooses to invest with a manager can lead to the for Applied Research affirmed this challenge: “77 development of KPIs that may be monitored and percent of asset owners said they were concerned discussed throughout the relationship, leading to a that short-term incentives were not being aligned deeper understanding of the managers’ strengths with long term objectives… More than half of and weaknesses, and improving the likelihood of asset managers (57%) said the same.” Institutional successful investment outcomes. Investors who investors’ best tool in accomplishing this difficult responded to State Street’s survey pointed to “short- goal is the investment mandate, the contract that termism” as the industry’s top-ranked problem, and governs these relationships and lays out the specific asset owners—principals or clients—particularly terms and parameters of their relationships. expressed this belief. While each investor will undoubtedly use different contract provisions and FCLTGlobal’s long-term model for institutional KPIs to fit their individual goals, and shorter-term investment mandates responds to this challenge provisions may be completely appropriate for by providing a menu of ideas to help anchor these shorter-term investment allocations, starting with a mandates to the long term. The asset owners and long-term mindset is more likely to lead to a mutually asset managers involved in the Focusing Capital beneficial, long-term relationship. 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 Institutional Investment Mandates: Anchors for Long-term Performance | 5 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 6 REPORTING Do the fees and fee structures reward a long-term Do the tables and commentary highlight long-term
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