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Marathon ClubGuidance Note for Long-Term Investing

Spring 2007


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The Marathon Club is a direct follow-up project to the competition run by USS Ltd andHewitt entitled 'Managing pension funds as if the long-term really did matter'. The Club iscomprised of approximately 20 members, ranging from institutional fund trustees, senior executives or senior specialists, representing combined fund assets of approximately170bn.

The overall aim of the Club is to stimulate pension funds, endowments and other institutional investors and their agents to be more long- term in their thinking and actions,

place a greater emphasis on being responsible and active owners and increasingknowledge about how their investment strategy and process can improve the long termfinancial and qualitative buying power of fund beneficiaries.

The content and guidance encapsulated in this document is a result of a broad anddetailed industry consultation and the Club would like to extend its thanks to all thosemarket participants who contributed to its creation. In particular the Club would like tothank Yusuf Samad and Giustino Palazzetti of Hewitt for their considerable contributionin organising this note; Peter Dunscombe, Reg Hinkley, Roger Emerson, Stephen Mooreand Peter Scales for actively contributing their thoughts and their time to the preparationof this Guidance Note and Sandy Nairn of Edinburgh Global Partners for providing someuseful ideas on manager monitoring.

For more information on the Clubs activities, or to enquire about how to becomeinvolved, go to: www.marathonclub.co.uk


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Marathon ClubGuidance Note for Long-Term Investing

Foreword

The Marathon Club was formed to stimulate institutional funds to be more long term in theirthinking and actions, and to place a greater emphasis on being responsible and active owners.

A fundamental issue arising from earlier research and discussions between Club members is how best to overcome the apparent barriers to long term investing, particularly in an environmentwhere funds face deficits and funding problems.

The Marathon Club has received a wide range of responses to the consultation paper it issued in

March 2006. This dialogue has greatly assisted us in developing the guidance contained in thisdocument. This is not put forward as a simple solution to the problem nor as a common approachfor all funds. However, it is clear that a successful approach to long term investing rests primarilyon the mindset of trustees and their beliefs, and on how the investment process is structured,implemented and managed. There is also a heavy responsibility placed on those who advise fundsand on those who manage the investments to deliver long term investing.

The Marathon Club plans to research in more depth some of the components expressed in thisguidance. In the meantime, I hope you find this document helpful in developing your investmentapproach and strategy.

Peter Scales, ChairmanMarathon Club

Spring 2007


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Contents

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Introduction 4

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How should the objectives for return and risk be framed and expressed? 14

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How should managers be remunerated to align their behaviour with long term objectives? 20

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Governance, Leadership and the role of Internal Executives and Advisers 25

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Trustees can allocate capital to businesses within the economy at differentstages of their life cycle - introduction, expansion, maturity, revival or decline. In each stage, businesses offer various forms of participation in their economic growth in which trustees can participate, as exemplified below.

Venture capital investment in companies at early stages of their formation;

Equity and fixed income investment in companies during their growth andmaturity phases;

High yield fixed income investment, typically in the late maturity phase;

Distressed debt and private equity in companies that are in decline or recovery.

There is a strong rationale for a disciplined long-term approach to investmentacross a wide range of asset classes, in recognition of the long-term nature of funds obligations.

Decline

laviveRnoisnapxE

Introduction

Venture Capital

EquityE quity and Fixed High Yield Distressed

Investment and corporate life cycle

Private equity Debt

Maturing


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Components of long term mandate

In contrast to some observers of the investment industry, the Marathon Clubdoes not believe that merely extending the formal term of investmentmanagement contracts will lead to a long-term approach.

The components of a long-term approach highlighted in the definition

proposed by the Marathon Club have to be embedded within the philosophyand process of the investment management organisation. Crucially, for suchan approach to be successful and not abandoned mid-course, trustees must

buy into the beliefs that underpin this definition.

Central to a long-term approach are the trustees own investment beliefs.Trustees should endeavour to articulate their beliefs before venturing intolong-term investing. Furthermore, the leadership and governance of thetrustee or investment board has an important influence in forming,implementing and sustaining these beliefs. Implementation is achievedthrough setting clear investment objectives , ensuring appropriate managerselection and alignment of financial interests and through managing thelong-term relationship .

Relationshipwith

Manager

FinancialAlignment

ManagerSelections

Objectives

Leadership&

Governance

TrusteesInvestment

Beliefs


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We consider that the following beliefs are a prerequisite to long-terminvesting:

Equities will outperform bonds in the long term

Participation in economic growth is a major source of long term

equity returnIlliquidity and volatility are short term risks which offer sources of additional compensation to the long-term investor

Fundamental, research oriented, buy-and-hold investing is superior toother investment styles in the long term.

Appendix A gives an example of the belief set which might formulated bytrustees to guide their investment policy.


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Club believes that the best approach is a more in-depth review at the time of manager selection, with ongoing monitoring concentrated more on themanagers investment process and portfolio construction. These issues aredealt with more fully in the sections on Manager Selection and Relationship.Questions around how performance against the benchmark is related tocompensation are discussed in the section on Alignment


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A good marriage is at least 80 percent good luck in finding the right person at the right time. The rest

is trust.

Nanette Newman

Trust, but verify.

Ronald Reagan

ManagerSelection Introduction

Having set a mandate, the most important decision trustees make is selectionof the manager. Choosing the right partner is critical to the success of a long-term relationship. Those with experience of a long-term investment approachstress that significant time and resources need to be committed to themanager selection process.

The Marathon Club believes that, under conventional mandates, trustees andmanagers often do not spend enough time together prior to appointment. Thebeauty parade format has, in many cases, been too short and superficial,and trustees only really get to know managers, if at all, much later. A muchhigher mutual understanding of the beliefs of each party must be reached atthe very outset to see if there is a fit.

We recognise that the available time and resources of the trustees themselveswill often be limited. In addition, not all trustees will have the level of expertise required for in-depth review of a potential investment manager. Itis therefore imperative that trustees make best use of the time and resourceswhich are available. As the Myners Report mentions, it is good practice for trustee boards to have an investment panel to which all or a significant partof the selection process can be delegated. In addition, there will almostalways be some level of in-house expertise on which the trustees can draw,whether staff dedicated to the fund itself or finance or treasury staff of thescheme sponsor. Finally, there are independent investment advisoryresources available from large firms and an increasing number of specialist

boutiques.

Process steps

A robust selection process requires clarity in setting out the steps in it,assigning responsibilities for each step, the criteria for decision making, and(where responsibilities have been delegated) reporting decisions and thereasons for them. We believe that a robust selection process should placeemphasis on the establishment of mandate parameters and the criteria for manager selection, in the light of the trustees formulations of beliefs andobjectives, so that the candidates short-listed do indeed have the attributesneeded for long term investment in line with those beliefs and objectives.


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The Marathon Club recognises that its recommendations will likely requireconsiderably more time and resource to be devoted to the selection processthan trustees might currently take, but we believe that to be a good long-terminvestment.

Duration of contract

It is important that the trustees and the manager take time to agree at theoutset what events would be used to review the contract. These are likely toinclude concerns about key people, ownership or process changes, regardlessof what the results are. In other words, if the initial conditions that wereconsidered essential for entering into a long-term relationship change, thenthe contract is reviewed.

Documenting the reasons, expectations and monitoring processes will serve

to remind both parties of the beliefs and objectives.Although the duration of the contract is not necessarily synonymous withlong-term investment, the Marathon Club recognises that there may beextended periods of under-performance against market indices. Trustees willneed to consider this as they consider long-term mandates.

J.M. Keynes said:

An investor is aiming, or should be aiming primarily at long period results, and should be solely judged by these. The fact of holding shareswhich have fallen in a general decline of the market proves nothing and

should not be a subject of reproach. It should certainly not be an argument for unloading when the market is least able to support such action.

At a minimum, trustees should accept that they may only obtain an objectiveappraisal of performance if they consider a full business cycle as the term of the appointment. Within this timescale trustees should consider what signalsshould be used for the early identification of potential problems.


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One feature that has been used to discourage trustees change of managersfor reasons solely to do with short-term performance is a sliding scaleredemption charge. The redemption fees progressively reduce over the termof the mandate and may be fully withdrawn after some specified period.However, exemptions to the sliding scale redemption fees need to be built inand to include trigger events for review of the mandate which are non-

performance related.


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analysis, as shown in Appendix C, can be the most insightful part of themonitoring process as it will help the trustees understand how the process is

being applied, the depth of research and see the output of the investment philosophy.

As already described above, trustees should agree the metrics with theinvestment manager which will be used for evaluating the portfolio at thefinal stage of the manager selection.The type of metrics agreed upon will vary according to the preferences of thetrustees and the way the investment manager is managing the money. Someexamples of the types of measures that could be relevant for monitoring longterm mandates are provided in Appendix D.

Termination of a Manager

A mandate should be terminated if, based on a review process describedabove, the trustees conclude that the portfolio does not reflect the investment

philosophy and process or that changes to the organisation or key individualsare such that the philosophy and process will not be deliverable in the future.

Trustees will generally need to be more tolerant of managers appointed for along term mandate who may encounter occasional bumps in the road(experiencing periodic performance decrements in anticipation of a major

pay-off).


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The Myners Report and other publications have all highlighted the problemscaused by trustees having limited time or experience. In these circumstances,trustees need to determine what matters should be delegated to internalexecutives or to external service providers. Delegation of investment issuesto an investment committee or a small group of trustees along with internalexecutives and independent advisers can be an effective vehicle for dealing

with the complexity of investment issues.The format of investment committee meetings can adapt to a long-termapproach by placing greater emphasis on less frequent but more in-depthreviews of investment issues, instead of the typical quarterly cycle. Theinvestment committee can still keep track of developments in the portfolioand investment trends through quarterly reports from the investment manager and the independent advisor. An effective structure would promote ongoingtraining and encourage the manager or independent advisor to notify thetrustees of any critical developments, outside of the quarterly reporting andannual review cycle.

While these may all be considered aspects of good investment process in amore traditional approach, they are fundamental to the good governance of long-term investment.

A number of commentators, including Myners, have lamented the reductionin numbers of in-house investment managers. We understand that, for thosefunds or sponsors who can sustain and manage an in-house team may beeasier to obtain alignment between the funds objectives and the managersinvestment strategy. Leaving aside the counter-arguments on conflicts of interest, many funds will simply find it impossible to attract and retaininvestment professionals of sufficient quality or will be too small to justifyan effective in-house arrangement. For them the only choice is between

different external advisers. These business realities reinforce the need for clearly stated beliefs and policies and, equally importantly, manager selection and monitoring processes which are consistent with the trusteesstated aims.


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The way forward The Marathon Club believes that trustees of endowments and pension fundsmust fundamentally re-consider the way they invest.

This paper argues that a long-term approach is ideally suited to investorswho have a long time horizon. A change of mindset is needed for investorsto think of success in investing as participation in the growth of enterpriseswithin the economy at various stages of their life-cycle. This is differentfrom the widely followed approach of perceiving success as outperformingmarket indices over short periods of time.

The Marathon Club recognises that the change in mindset needed issignificant. It cannot be achieved without the cooperation of all participantsin the investment chain trustees, investment managers and investmentadvisors. The role for each is clear:

Trustees must devote time to establish their investment beliefs andexpress their need for long-term investment in seeking advice;

Investment advisors must raise trustees awareness of a long-termapproach through advice, discussion with and training of trustees.

Investment managers must be prepared to offer investment productswith a long-term approach, which includes appropriate pricingstructures and reporting.

Some might argue that there is insufficient supply of long-term investment products. We believe that the supply will follow demand. If trustees,supported by their consultants, ask for long-term approaches to investmentand question managers on their approach, the products available willexpand. This Guidance Note should help trustees to specify their need for long-term investment and create such a demand.


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Appendix A: Investment beliefs

Underlying beliefs Practical evidence

Strength of a sponsors covenant can allow alonger term deficit recovery period, say 20

years.

Reasoned funding strategy statementLong term volatility features in risk

assessment both to funding levels andcontributions

Equities will outperform bonds and thereforeshould dictate the asset allocation.

Heavy weighting of equity type assets inrelation to bonds

Diversification across all asset classes, assettypes and management structures will reducevolatility of deficit.

Specific mandates to asset classesAllocations to alternatives and to quotedequities with long-term expectationsMix of styles and approaches

Passive management of equities provides lowcost exposure to equities.

Use of index tracker mandates for equitieswith clear benchmark performance targets

Active managers can add value over the long-term with clearly expressed objectives.

Objectives expressed in terms of periodicout-performanceCareful manager selection process and duediligence

Different management styles can reducevolatility but can cancel out performance.

Choice of different approachesManager freedom to hedge out short-termmarket impact

Benchmarks and risk parameters constrainactive managers.

Market indices should be used to set performance targets but should not definesecurity selection.

Absence of benchmark constraints on assetallocation

No tracking errors imposedBenchmarks used only to define a

performance target

Alternatives to publicly quoted equities provide additional return, but carry additionalsolvency risk.

Portfolio performance targets set in relationto liabilities and relative to equity risk

premium

Any allocation to bonds should be for cashflow matching purposes.

Bonds allowed within multi-asset mandates No specific mandates for bondsStructured mandates for cash flow matching

Important to avoid being a forced seller inshort term markets.

Cash or liquid assets held linked directly tofund short-term cash flow requirementsClear strategy agreed for cash

Performance of active managers should beassessed to confirm that the originalinvestment process on appointment is beingdelivered.

Criteria evidenced at time of appointmentMonitoring focuses on action in relation tocriteriaInvestment decisions evaluated againststrategic criteria


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Short-term performance reviews detract fromlong-term strategy.

Manager performance reviews operateannuallyEmphasis on forward strategy rather than

past actions

Active management performance should bemonitored over annual rolling cycles. Performance targets linked to actuarialvaluations and targetsForward targets set on rolling three years

Active managers cost more money.

Fees should be aligned to the interests of theTrustees rather than the performance of themarket.

Investment management costs rise as a percentage of fund valueFee levels structured to reflect performanceFee scales combine flat fees with shares of out-performanceHigh performance increases fees rather thanmarket increases

Investment consultants are a source of expertise and research to inform trusteedecisions, which should be based onindependent advice.

Trustees use independent advisers to guideselection and mandate constructionTrustees use consultants to advise onmanager long lists and provide researchIndependent advise is used to determinemonitoring and performance evaluationProcess in place to assess trustees, advisersand consultants


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Appendix B: Attributes of a Long-Term Investment Manager

stability of ownership, financing and staffing the investment management business. This maycome from its ownership by the current generation of managers, or at least by their having avery significant minority holding

manager remuneration based on alignment of financial interests, e.g. co-investment in the samestrategy or fund

investment processes with a focus on capital maintenance and a distinctive investment philosophy, typically based on fundamentals, for researching investment opportunities

the ability to monitor and control risks from poor corporate governance and to exerciseownership rights

the ability to assess long-term risk factors from damage to environment, poor human capitalmanagement and damage to reputation

wherever possible, a track record over several business and market cycles

analysis of the track record which references the source of return to the investment process, tosupport its validity and sustainability

evidence of being able to hold a successful contrary view to the market

portfolios (often but not necessarily concentrated in a smaller number of stocks) which differ significantly from the index and sector weightings of the broader markets

low portfolio turnover (typically 10-30% per annum, rather than the 50-200% recorded amongconventional managers)

internal absolute return targets. NB: trustees need to ask themselves and their adviserswhether long-term managers who are prepared to accept targets such as RPI plus 5% per

annum or more, or whose internal benchmark is cash plus or gilts plus, are adequate in relationto their investment policy

the discipline to invest money only as opportunities arise, rather than vesting immediately intoan existing portfolio, (sometimes on a commitment/drawdown basis like private equity, or being

prepared to hold cash or bonds until sufficient real asset opportunities present themselves)

avoidance of growth in assets under management at the expense of investment performance,evidenced by a policy of closure of funds to new inflows whenever necessary


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With special thanks to Claire Maloney and the team at Capital MS&L for their helpin the formulation of this guidance note.

Printing provided by First Colour Limited


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The Marathon Club6 More London PlaceLondon SE1 2DATel: 020 7939 4363

[email protected]

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