Our Journey to Long-Term Mandates

Mark MansleyAlthough we consider ourselves to be a long-term investor—indeed it is our first investment principle—Professor John Kay’s “Review of UK Equity Markets and Long-Term Decision Making” in 2012 prompted us to consider whether the mandates we had with our managers really were reflective of that. And, we also questioned if we were effectively supporting our managers in taking a long-term view of investments and stewardship at companies.

Regulations mean our mandates are terminable at will and we require brief monthly and full quarterly reporting. This is not exactly the best starting point. In spite of this, our focus is very much on long-term performance—we are looking out 15 years and beyond in our asset/liability modelling, for example. In our search for returns we are reasonably tolerant of tracking error, and therefore accept the risk of short-term underperformance. A key practical consideration is that changing managers is a time-consuming exercise we undertake with great reluctance, and we would rather work with managers to address problems.

Discussions with managers revealed that they were much more aware of the terms of their contract than the broader reality of our approach. Managers were typically very sensitive to language, often over-interpreting requests as implicit criticism. As a result, they often felt under short-term pressure, and were perhaps not always able to take the long-term view.

We considered how to address this mismatch by revisiting our contracts with managers and other documentation, and identified three key areas for action:

• An updated investment management agreement (IMA)

• A new manager covenant

• Revised communication and reporting

Our new IMA is based on the International Corporate Governance Network’s model mandate and other initiatives, but seeks to go a little further in key areas. Fiduciary duty is deconstructed into its key components, notably a requirement to act in our best interest.

To protect managers, we introduced a modest notice period for the first time (one month—the most we are allowed under local government pension regulations). We have placed greater importance on key-man risks and the need for orderly transitions of personnel. We have also requested greater transparency on pay and incentives structures, although this is an area that will take a while to change.

The covenant represents the core of the new approach. This lays out our expectations of managers—and what they should expect of us. It is not legally binding, but intended to give greater clarity to the practical workings of our relationship, documenting explicitly some of the unwritten assumptions that otherwise can lead to misunderstanding. It emphasises the need for communication. It directly addresses the key issue of why we might terminate the mandate, emphasising that ‘style drift’ or team instability are of greater concern to us than short-term underperformance.

It requires us to provide feedback to the manager and to keep them informed of broader changes in the pension fund. It also includes a clear commitment to try to work with managers to repair mandates rather than simply terminate them. This is something we have done with two managers in recent years: changing the benchmark with one, and ensuring the other stayed focused on its core strengths.

Reporting has also been reconsidered. Rather than some monthly reporting and extensive quarterly reporting, we are moving to ad-hoc, quarterly and annual reporting. Ad-hoc reporting is primarily intended to cover significant events, such as team changes. Quarterly reporting remains but has been somewhat simplified and focused. Increased emphasis has been given to detailed annual reports. The context of reporting has been reconsidered, with greater attention on a narrative reporting, particularly on changes; greater disclosure of underlying metrics at companies (sales, cash flows, profits, etc.), so we can understand more how the businesses are really doing; and rather less emphasis on endless attribution analysis to dissect what the market is focused on.

Our commitment to responsible investing means we expect to see disclosure of long-term environmental, social, and governance metrics such as carbon emissions, voting records, and an evaluation of governance and strategy at companies—all of which are relevant to long-term understanding.

Although we are still rolling out our new IMAs and it is early in these new relationships, the response from our managers has been very positive. We are confident these changes will help fulfil our goal of being a successful and responsible long-term investor.

Mark Mansley is CIO of the Environment Agency Pension Fund.