All asset owners should strengthen their investment governance frameworks as their portfolios grow, to manage the associated risks and ensure those precious economies of scale are realised.
This principle is particularly important for superannuation funds, because of their fiduciary obligations to members and the closely regulated nature of the industry.
The intersection of scale and governance.
Why even pursue scale, with all its inherent risks? Why indeed particularly in a resource-finite world. however the plain fact is that the pursuit of growth, particularly within investment markets, is a constant. The examples are many, including:
- GDP, a measure of period-on-period economic growth
- investment growth, so dear to our industry hearts and constantly sought
- enterprise growth, a key measure of organisational and business success
- And then there is growth in superannuation member retirement balances – striving to maximise that growth is no less a fiduciary duty, hence a legal obligation of RSE trustees.
The pursuit of growth is almost certainly a constant in our worlds, however organisational risk is with equal certainty, not! Except to the extent that risk (essentially of a governance nature) is constantly changing, and this is particularly so as a financial institution progresses (hopefully upwards) along the scale continuum.
Scale can be achieved incrementally or in step changes. Fund mergers require successfully navigating key challenges and a sharp focus on the end game, being portfolio and member outcomes. For those already at the larger end of the (domestic) continuum, the governance challenges may be different (such as efficiently deploying capital) but no less critical to strategic outcomes.
So, whether you are big and getting bigger, or about to swim in an even bigger pond, good governance demands the strategic focus be on the future, because of the risks associated with progressing along the scale continuum.
The nature of a continuum
Before describing the risk features and the governance responses necessary to mitigate them, it is worth considering the nature of a continuum. I consider this is relevant in both understanding these risks and framing a response.
A simple definition of continuum is a continuous sequence in which adjacent elements are not perceptibly different from each other, although the extremes are quite distinct.
In this context the continuous sequence can be considered analogous to an investment horizon as a portfolio grows. The adjacent elements can be compared to any data points along that horizon, at which time changes in risks may not be readily apparent, for example, to the trustee board or to individual directors. However, at the extremes of the continuum, the differences (in risk) are likely to be significant. The result is that the governance stakes are considerably higher as you travel further up the scale curve, where benefits, but also downside risks, are heightened.
Having a strategic focus on the future enables governing authorities to periodically consider in advance how will we be positioned when we get there. Hence investment governance must evolve incrementally along the growth continuum, even when associated risks are not perceptibly changing or different.
Economies of scale do not just happen… and can quickly evaporate
To capture scale benefits and mitigate associated risks requires deliberate planning, clear fit-for-purpose frameworks, and an evolutionary approach to the upgrade of capabilities, portfolio structure and governance strategies that optimize total portfolio outcomes.
The changing complexity of scale is multi-dimensional and represents an ongoing governance challenge for boards, trustee directors and investment management. Examples include:
- Portfolio diversification and associated investment management complexity, involving, for example, offshore operations and direct private market investments
- Human resources and related governance frameworks regarding delegations, risk culture, remuneration and internal controls
- Workplace culture: how to maintain workplace standards and those key success factors as the workforce expands along the continuum
- Skills mix and asymmetry of information and understanding between the board and internal teams which is critical in ensuring good investment risk management
The governance challenge is to be well positioned for that changing risk profile as the organization grows – reputation risk is a key downside if this challenge is not anticipated, actively addressed, and monitored.
Scale-related risks often precede scale benefits
There are many examples of leading indicators of risk:
- Deviations from the fund’s strategic asset allocation
- Capacity constraints within the portfolio
- Expanding internal teams while maintaining culture
- Reaching technological limits in administration systems as cash flow and members increase
- Greater public and regulatory scrutiny
- Achieving lower investment and administration fees while capital expenditure and fixed costs grow
- Expanding the trustee office or investment operations offshore
The challenge is to oversee this growth momentum while ensuring the structural integrity of governance systems. This requires bringing forward necessary decisions to mitigate emerging and future risks, including on the appropriate framework to cater for growth, ensuring the skill mix and sophistication levels across board, committee and management approval authorities are fit-for-purpose and systems are in place to monitor, assess and maintain organizational culture and other aspects of competitive positioning.
This governance response cannot be passive or reactive. As scale milestones are anticipated and or achieved, reviews and structural upgrades mitigate associated risks and improve the firm’s ability to capture scale benefits, being the ultimate growth dividend.
Economies of scale do not just happen as an asset owner proceeds along the scale continuum and can instead evaporate under the weight of often leading risks. To capture the growth dividend requires pro-active governance management across the organisation, including at the board and portfolio levels. This includes monitoring and critical review at key scale milestones. To capture scale benefits, mitigate associated risks and optimize total portfolio outcomes requires deliberate planning, adjustments to ensure fit-for-purpose frameworks and an evolutionary approach to the upgrade of capabilities, portfolio structure and governance strategies.
Brett Lazarides is Frontier’s head of investment governance.