This is the second in a series of five articles, written by John Morris and Nick Malaczynski, on international investment by pension funds.
Pension fund trustees who choose to diversify their fund's assets by investing overseas need to engage in a multi-step process to determine the best way to invest the funds overseas.
To fulfil their obligation to "act with due care and diligence", trustees need to do much more than simply select an overseas asset manager.
Few South African pension funds have begun to invest overseas. In some cases, these pension funds have simply given their overseas assets to a manager and are hoping that the manager knows what he is doing.
In most cases, this haphazard manager selection will end up costing the members of the pension fund dearly.
Here are four rules to help pension fund trustees avoid hiring the wrong overseas manager:
* Do not hire a manager merely because you know the company or recognise its name.
Pension fund trustees may be inclined to put their fund's overseas assets with a local asset manager because they know and are comfortable with the company. But even familiar names from overseas are no guarantee of asset management success.
One local merchant bank entered into an international asset management relationship with a London investment bank.
The Wall Street Journal recently ran an article describing the London bank as "ticking like a time bomb", and listed a range of problems, including embarrassments to its asset management business and the resignation of its chairman.
Some of the best-known international names have been involved in some of the most notorious scandals of recent years.
A recognisable name is no guarantee of a sensible investment style.
* Do not hire a manager simply on past performance.
Aside from the usual problems regarding the reliability of performance data, pension fund trustees need to understand how the claimed performance was achieved, and whether it was achieved with an investment style which is compatible with the needs of the pension fund.
Was the performance achieved using derivatives or leverage which would create a level of risk unacceptable for a pension fund?
Particularly in the United States, a manager's style, rather than his stock -picking skills, may be responsible for good past performance.
What will happen when that investment style falls out of favour?
The overseas fund management industry is constantly changing. Was the past performance achieved by the current fund management team, or by people who have since left the firm?
There is a library of empirical data demonstrating that good past performance is no precursor to good future performance. If your pension fund trustees are relying only on past performance, or a consultant which merely makes recommendations based on past performance, they are not fulfilling their obligation of due care and diligence to you or your pension fund.
* Do not hire a manager simply because he is offering the pension fund an asset swap.
Unless the pension fund has had significant net cash inflow during 1995 and 1996, the only way it can transfer meaningful amounts overseas is to engage in an asset swap with an overseas institution prepared to invest in South Africa.
Some of these overseas managers will only participate in an asset swap if they are given the South African pension fund's overseas assets to manage.
A rule of thumb is that the top international asset managers get plenty of business without having to resort to asset swaps to get it. A manager insisting on the management of the asset swap proceeds is probably not the best manager for you.
* Do not hire a manager who is selling the same international investment product to every pension fund in South Africa.
Many South African institutions which are trying to get into the international asset management business are guilty of this.
Using asset swaps, they have cobbled together an international investment product which they are selling to every pension fund which will listen.
Every pension fund is different. The trustees of each pension fund need to analyse their own fund, develop their own appropriate international investment strategy, and hire specialist overseas managers who will carry out that strategy.
Pension fund trustees who simply invest in a product from a local insurance company are not fulfilling their duties.
In next week's article, we will describe the process which will enable pension fund trustees to select the best overseas asset managers for their pension fund.
* John Morris and Nick Malaczynski are the managing director and chief institutional consultant of TriStar International Consulting Limited, a company which provides international investment consulting services to South African pension funds. They wish to acknowledge that they appropriated some of the ideas in this article from Anne Cabot-Alletzhauser, an executive director of Time Life Insurance Limited.