Rotman ICPM / Netspar / Maastricht University Discussion Forum – October 2007 Investment Beliefs Kees Koedijk, University of Tilburg Alfred Slager, PGGM Investments / RSM Erasmus University

Page 2Investment Beliefs What makes an investor great? Investment management –Investment managers need an investment process in sync with theory (Damodaran 2007) –Upward potential for good governed pension funds (Ambachtsheer 2007), best governed pension funds focus on coherence, process and people (Roger and Urwin 2007) Strategic management: –Identifying core competences, aligning organization Common thread: focused investment beliefs

Page 3Investment Beliefs Focus on investment beliefs Why not? –Companies have to articulate their unique selling proposition for their client(s) –Especially in financial markets where different visions co-exist If not –It becomes difficult for trustees to evaluate new developments, and whether to embed them in their own strategies –More likely to “join the herd”, increasing costs and opportunity costs along the way

Page 4Investment Beliefs Vanguard ''consistently outperforming the financial markets is extremely difficult''.

Page 5Investment Beliefs Research set up Our paper investigates –What investment beliefs are out there –How do investment beliefs of pension funds and asset managers differ –Can we say something about their link to performance Data collection –Web site, (annual) report, presentations collections –Focus on largest asset managers and pension funds –Scope: publicly reported beliefs (the explicit ones)

Page 6Investment Beliefs Theory behind investment belief Observes behavior in the financial marketplace; Frames why the organization deals with this in a sophisticated way. Theoretical basis behind the investment belief. What is it about that mechanism Is it a structural, repeatable phenomenon Describes how the investment belief can be exploited. Organization to successfully exploit the investment strategy. Links the exploitation of the investment beliefs to performance measures. EXAMPLE OverreactionMispricing with information dissemmination Sell with negative, buy with positive earnings announcement Trading strategy with short term horizon. Good versus bad news announcements have to be identified. Investment Belief Theory Investment Strategy Organization

Page 7Investment Beliefs New Zealand Superannuation Fund “exploit the premium available to investors who do not require liquidity. Our long investment horizon, combined with […] no outflows, means we are extremely well positioned to capture this premium.”

Page 8Investment Beliefs From beliefs to philosophy Investment philosophy … = Coherent set of beliefs

Page 9Investment Beliefs Sample: 23 pension funds and 17 asset managers North America PensionfdAssetmng 711 Europe PensionfdAssetmng 910 New Zealand, Australia PensionfdAssetmng 30

Page 10Investment Beliefs 4 groups of investment beliefs Financial Markets beliefs Risk premium Risk diversification (In)efficiencies in financial markets, Asset pricing Horizon Risk premium Risk diversification (In)efficiencies in financial markets, Asset pricing Horizon Investment process beliefs Impact, focus on management decisions Risk management Investment management style Costs Impact, focus on management decisions Risk management Investment management style Costs Sustainability and Governance Sustainability and Corporate Governance in asset pricing Role in investment process Sustainability and Corporate Governance in asset pricing Role in investment process Organizational beliefs Teams, role of investment managers Out vs. insourcing Experience Teams, role of investment managers Out vs. insourcing Experience

Page 11Investment Beliefs PGGM capitalize on our strength as a long-term investor. […] We can select investments which generate a high return in the long term, even though they may suffer short term losses.”

Page 12Investment Beliefs PensionDanmark According to PensionDanmark, “the best investment results are most likely to be achieved with a relatively small and focused investment team combined with a high degree of outsourcing to external managers.”

Page 13Investment Beliefs OTPP “managing investment risk is just as important as generating returns. Maintaining a well-diversified portfolio is the cornerstone of the Fund's risk management program.”

Page 14Investment Beliefs ABN Amro Expects over the longer term to see ”the majority of value added come from stock selection as this normally represents a more stable and consistent source of out- performance.”

Page 15Investment Beliefs Some beliefs are more equal…

Page 16Investment Beliefs Differences in pension funds and asset managers Pension fund Asset manager Risk diversification Risk premiums Responsible Investments Goals Inefficiencies Active management Teams and staff Focus Impact Risk man.

Page 17Investment Beliefs Relationships between beliefs Weak relationships expected and found: suggests sensible thought-out processes Some relationships show up, suggesting 1.Organizations which hold beliefs about where their added value is, tend to apply it in the investment process. 2.The impact of lower costs becomes more visible with a longer time horizon. 3.Beliefs about risk diversification and inefficiencies are in some cases passed on to the external managers that pension funds select. 4.On the other hand, pension funds with beliefs about in- and outsourcing are more focused on the organizations goals and pension liabilities. 5.Some organizations consider risk premia in a broader setting

Page 18Investment Beliefs Forging a link Risk diversification Return-risk ratio Asset diversification Horizon3, 5, 8 years periods Investment Management Style Alpha Information ratio CostsExpense ratio Performance measures Performance measures

Page 19Investment Beliefs Descriptives… Pension funds create alphaAre well diversified

Page 20Investment Beliefs … Pension funds create high return/risk and report lower costs

Page 21Investment Beliefs Links exist Between several investment beliefs and structural performance measures. –Organization with investment beliefs on risk diversification also show better return-risk performance measures, but also lower costs. Focus pays off. –Funds that hold a clear view on how risk management is organized, usually in combination with a view on the management style, realize higher alpha and return/risk ratio’s than funds that do not hold such views.

Page 22Investment Beliefs Some caveats Small sample, yet the broadest so far Performance measures are relatively crude, managers might have other performance measures in mind We’ve collected the explicit reported ones, what about the non-reported implicit ones? Every pension fund holds them per definition.

Page 23Investment Beliefs Summarizing Investment beliefs: still relatively unexplored? –Developing a set of investment beliefs makes sense from a strategic perspective: an organization has to identify where and how it does add value to the investment process. Structure emerges –Beliefs about the financial markets, investment process, organization, and sustainability and corporate governance.

Page 24Investment Beliefs Pension funds and asset managers differ –A pension fund focuses on risk diversification, getting its beta right. –An asset manager stresses the role of risk management and argues for a particular investment style. Asset managers emphasize the quality of their organization. Promising link between beliefs and performance –An organization with investment beliefs on risk diversification shows better return-risk performance, but also lower costs. –Funds that hold a clear view on how risk management is organized, usually in combination with a view on the management style, realize higher alpha and return/risk ratio’s than funds that do not hold such views. –Investment beliefs framework helps focus investment strategy, governance and results