What's Your Prior?

Finding Diamonds in the Rough

July 07, 2020 Damian Handzy Season 1 Episode 3
What's Your Prior?
Finding Diamonds in the Rough
Chapters
What's Your Prior?
Finding Diamonds in the Rough
Jul 07, 2020 Season 1 Episode 3
Damian Handzy

Pension Funds have to be very careful in picking fund managers - they often invest for the long haul and compounding returns are great if the returns are good, but the lost opportunity is painful if money is left on the table every year. Sweden's AP1, which manages 366B SEK (39B USD), has developed a robust and mature approach to selecting the best managers and I sat down with Majdi Chammas, Head of Equities at their External Partnership and Innovation team, to dig into what matters to them and why.

Mentioned in the show:

Show Notes Transcript

Pension Funds have to be very careful in picking fund managers - they often invest for the long haul and compounding returns are great if the returns are good, but the lost opportunity is painful if money is left on the table every year. Sweden's AP1, which manages 366B SEK (39B USD), has developed a robust and mature approach to selecting the best managers and I sat down with Majdi Chammas, Head of Equities at their External Partnership and Innovation team, to dig into what matters to them and why.

Mentioned in the show:

Damian Handzy:

There are just over 4,000 public companies in the US, down from a high of about twice that back in '96, but there are about 8,000 mutual funds in this country. Now, globally, there are over 600,000 public companies you and I can invest in, and there are about 120,000 different funds. Now, all the challenges associated with choosing which stocks to invest in, they're just magnified when you expand the universe to include funds. So this is something that a pension fund does all the time. They have to pick managers who are then responsible for growing the assets so that eventually retirees can safely enjoy their well-deserved golden years. I think it's worth reminding ourselves that investment management isn't just about rich people getting richer. This is about teachers, firefighters, public servants, and a host of other people potentially having a secure retirement, or not. So how do the most sophisticated pension funds choose where to invest their money? A typical pension fund has somewhere between 20 and 50 managers. Those are chosen out of thousands who are vying to get their investments. Now, how do pension funds choose those investment managers so they can deliver those retirement benefits years and often decades later? I've been advising pension funds around the world on investment and risk management for about 20 years, and I can tell you I've seen the good, the bad and the very, very ugly, but in this episode, we look at a pension fund whose approach is about as mature and evolved as any I've ever seen. Most importantly, this pension fund actively keeps evolving and improving by continuously asking itself and its investment managers, what they can do better.

Introduction:

Hello and welcome to What's Your Prior? The podcast for the adaptable investor with your host Damian Handzy.

Damian Handzy:

Hi, and welcome to this episode about picking the best fund managers. Now, first AP Fondant also known as AP1. They manage part of the capital in Sweden's national income pension system. The fund has assets of about 366 billion Swedish Krona. That's about 39 billion US dollars, and they boast having delivered a real return of 6.9% over the past 10 years. They invest in a global portfolio of equities bonds, real estate, infrastructure, private equity, and even hedge funds. Now my guest today is Majdi Chammas, who's the head of equities at the external partnership and innovation team within AP1. Majdi describes the investment philosophy at AP1 as "looking for managers where people and talent cultivated in the right culture, employing a structured process that incorporates principles of ESG naturally deliver performance." Now, AP1 runs what Majdi calls a barbell approach: on one extreme there's passive and systematic investments, and at the other end, there's active concentrated managers. He says that concentrated portfolios through active management can provide much more value for money than less active managers. And AP1 typically achieves a profit to cost ratio of five to one. So Majdi says that many asset allocators like pension funds, they take shortcuts by screening the universe of managers for metrics that they want to see in the portfolio. Now at AP1, they do things a little bit differently, and they spend a lot of time examining candidate managers because they expect to invest with them for a long time. He says that they divide the candidate managers into three buckets: firms which clearly qualify, not all of whom may get an allocation, but they qualifie. Bucket number two: firms who clearly don't qualify. And then there's the group that takes a lot of work,:the gray zone in between. So Majdi, I'd like to start by digging into what it takes to get an allocation from AP1. Let's start with how you identify those firms that clearly don't qualify for an investment. I mean, if I have a fund and I want to convince you to invest with me, what are some of the most obvious attributes that if I had them, I would immediately be disqualified from your consideration?

Majdi Chammas:

We have our philosophy, which is, you know, talented people cultivated in the right structure and a strong culture philosophy process considering ESG. They want to achieve superior performance. And if you don't tick all those boxes, at least, you know, have a good standard in them, then you are disqualified for any of those reasons.

Damian Handzy:

Okay. So I actually have to tick all of those boxes for you to consider me. It's not just that I have to be strong in one or two or three.

Majdi Chammas:

Absolutely.

Damian Handzy:

Okay. Well, that's quite the high hurdle, but let's take the other extreme. Can you quickly and easily identify managers who pass your initial test and make the short list?

Majdi Chammas:

I wish it was an easy one because it is not. In only cases where being very quickly adding somebody on the short list is when they clearly demonstrate that they do something different from everybody else, because active management in a way, and it's a relative game and you want to beat the market. And we believe strongly that if you want to beat the market, you have to deviate from the market. So if somebody has a very unique niche strategy that is completely different from anybody else and show demonstrate some of those other attributes too , they could be clearly included. Yes. For example, let's say in emerging markets, when we choose to have one of our managers, TOBAM, which is a quant manager based in France, back in 2011, they were included because they do something that's so different from anybody else because they are the anti benchmarks . So they go against the benchmark, whatever the benchmark is doing, they are doing something else. They're deviating way from the benchmark. And that is a unique way of managing the portfolio even among Quant managers. So that for us is a very clear inclusion into a short list.

Damian Handzy:

So one of the things that struck me about your, your list of things that you look for is a performance is kind of at the end, almost as an afterthought. I mean, there's, there's culture, there's people, there's process, there's ESG. Now everyone chases returns to some degree, but you don't seem to put performance as, as kind of a "must have." So how does performance bake into your , uh, into your evaluation of a manager?

Majdi Chammas:

The performance is not to take it to something that's not important. It is important, but it is an explanation of, or a confirmation of your process and philosophy and the way you manage the portfolio. So it should, like a DNA of an individual, that when you look at the performance, you should be able to understand that this is actually the same manager that I'm looking at. This is the managers' performance. They behave exactly the way that I would anticipate in different market regimes and that you should be able to see in your performance.

Damian Handzy:

Alright . So in our conversations, you've mentioned that the culture at the asset management firm really matters to AP1. Now culture can be healthy and rewarding. It can also be toxic and it can be anything in between those two. So what are some of the cultural attributes you look for in a manager and what are some of the red flags you've come across from a culture perspective?

Majdi Chammas:

I think it's a culture is I believe one of the toughest things to assess in a way, because as you mentioned, some cultures are toxic and if you can see, identify those, then you clearly, it's very easy one to adjust , exclude. But what you really need to understand is cultures . We have to find a way to work together. That's what culture is all about, what fits our sort of way of working. That is the best culture for us. And when we assess the managers, we try to understand, have they found a culture that we believe will actually make them superior? So let's take a culture like Bridgewater. I think Bridgewater is one of the managers in the world that has a very, very unique culture that I could also, you know, it's very tough for others to adapt the same kind of culture. I don't know if you're familiar with them Bridgewater. They have a very strong culture of honest feedback, constantly giving feedback to each other, and they record all their meetings and the decision making, et cetera, et cetera. And that is a culture that they have found to be a very good way for them to work. Saying that that could be adopted by all other managers? I don't think so. But for us, it's about understanding is this manager, do they have the culture that fits for them? And if you don't have a culture that is open for debate for challenging, for new ideas to come through that I believe is a very tough for firms, especially in the investment management. We try to see, you know, how do portfolio managers, CIOs, CEOs, how they behave together with their analysts, other people within the firm. Is it an open culture? Is the culture promoting ideas, promoting challenging the senior PMs or not?

Damian Handzy:

In one of our conversations, Majdi told me, and I think I'm quoting him directly here. He said, "it's not the good times that define who we are. It's the bad times that do that." And he went on to tell me a story about two different management teams that worked for the same company, but managed different funds. And AP1 has invested in both of those investment funds. Now one of the managers showed his true colors during the recent COVID crisis. The topic was about how companies should use any cash that they might have on hand, as we all went through the COVID downturn. Now, one of those investment managers specifically said that companies should hold onto any cash because they're going to need it to manage their business through the crisis. The other manager said almost the opposite. Well, not almost, he didn't say the opposite. He said, companies should return the cash to investors because it's actually the shareholder's money. Now Majdi said that both of these managers have the same announced approach and process, but they interpreted their roles in very different ways. And the second manager short-sightedness could jeopardize the company survival, and clearly it's at odds with what a longterm investor should be thinking. So AP1 actually went to pull their investment from that second manager and Majdi made it clear to me that this was not the manager's only offense. They didn't just pull the money for this, but it certainly was the manager's last defense with AP1 money. From there, our conversation turned to the topic that often evokes a lot of passion by almost everyone who enters into it: ESG investing. Now, for those not yet familiar with the term, and believe it or not, I rarely encounter people who are just hearing it for the first time. It stands for Environmental, Social, and Governance, and it's meant to encapsulate many of the investment principles that Majdi has been describing in this podcast episode. Now, AP1 takes what I think is nuanced approach to ESG investing. They expect their managers to have a holistic approach to ESG, and they have to do it across all aspects of their business and how they look at each company they invest in, through an ESG lens. So AP1, they don't want ESG to be some separate thing from the investment management process, because each investment must be for longterm benefit. As a global investor in all parts of the world, they're not willing to take shortcuts in one place because it's gonna end up hurting them in another place. So I asked MAjdi about a very recent announcement by the U S government. The government said essentially that retirement plans fiduciaries have one and only one overriding responsibility: generating the highest possible returns for the retirees. Any other consideration that detracts from that return priority can be considered a breach of fiduciary responsibility. And they specifically called out ESG as one of the investment approaches that if the returns aren't really high enough, it can be considered a distraction and therefore inappropriate. And I asked him , how do you respond to that?

Majdi Chammas:

Yeah, that could keep me going off for about maybe an hour or two or three, I don't know because that's very interesting. Number one, I just want to clearly say that we have the same priorities the government has said, you know, the first priority for the AP funds is to generate higher returns for the pensionnaires of Sweden. So we don't disagree with that one. But we think one way of doing that is by considering ESG. So ESG is just actually helping us achieve our higher returns because in this statement, by the U S government, in that case, they are assuming that ESG is a detractor of returns. We don't think so. Let's say you have a company that is very energy intensive. So they have to use a lot of energy in their production. And you have two companies. One of them is doing this in a proper way, and they are trying to household with the energy usage in their systems while the other one is just, you know, going for let's do it. It's cheap. Let's just use as much energy as possible. Who do you think we're prosper in the long run? I believe that the one who's using less energy will do so because even they are doing the same kind of work, but they're using less energy and they should prosper. So we don't disagree with that, you know, returns are important, but we believe that we can do it in a sustainable way.

Damian Handzy:

So after all these descriptions of AP1's rather thoughtful way of making investment decisions, I asked Majdi under what circumstances would he change his mind that they're not doing things the right way? What evidence would it take for him to decide that AP one should change how they're doing things? And I didn't warn him that this question was coming, and I gotta tell you, I simply loved his answer.

Majdi Chammas:

I would like to say that we do that every day and constantly, and should do it everyday and constantly. I mean, one of the biggest rewards I get sometimes is when you get challenged, when somebody tell you, you know, why you do it this way, why don't you look at it this way? You should always be humble and try to sort of learn new stuff. And I would like to be challenged every day , if possible,.

Damian Handzy:

Majdi then added one final sentiment that I think beautifully summarizes everything that he told us today:

Majdi Chammas:

We try to operate the same way we would like our managers to operate.