The investment philosophy and process is framed with reference to the investing institution’s skills, resources and processes.
The choice of whether to use an internal investment function or select an external investment manager is one of the most fundamental and important decisions that the social security institution will make. In order to make the appropriate decision on whether to use an external manager and, if so, for what proportion of total investments, the institution will need to assess the resources it has within the organization and whether, with these resources, it is able to manage appropriately part or all of the assets of the reserve fund. This decision is a global, top-level decision reflecting a fundamental choice about whether investments are most efficiently implemented and managed internally or externally.
If the investing institution decides in principle to manage assets internally, it may still evaluate on a case-by-case basis whether a specific investment or investment class is most effectively made and managed internally or externally considering the capabilities available within the investing institution. As such, this decision is an implementation decision and should be considered during portfolio construction.
Therefore, investing institutions need to be aware of their competitive advantages and disadvantages and adapt their decision-making accordingly. They should be aware of areas where they have little or no expertise or governance capacity and seek to adjust their strategy accordingly. This process enables the investing institution to establish a governance budget.
The amount of resources an organization can devote to the governance process is limited. This amount of resources that can be devoted to the process is known as the governance budget. The governance budget of a fund refers to the amount of expertise, financial resources, time available (both internal and external) and operational effectiveness required to operate the fund. It is the capacity to create value derived from the skills, resources and processes employed in an organization’s value chain.
The size of the governance budget will affect the expected governance performance. A certain size of governance budget should be matched with a certain investment style and strategy. In situations with limited governance budgets, resources must be allocated appropriately to different tasks within the governance process and the investment process must be managed skilfully. There are ways to adapt the governance budget over time, with implications for likely investment performance and pay-offs.
More generally, the resources devoted to the governance budget and, therefore, its size is also a strategic choice framed according to the investing institution’s ambitions in relation to long-term investment objectives. Industry best practice suggests that investing institutions should be deliberate about their chosen governance procedures and practices, treating governance as an investment in realizing their objectives. Here, a balance is normally struck between short-term cost efficiency and long-term performance (even if it is sometimes difficult calibrating the value created by effective governance). Lower governance budgets are consistent with less complicated or sophisticated investment arrangements. Higher governance budgets are characterized by a large volume of assets under management and/or organizational resources including time, commitment and real-time investing. This supports the ability to use more complex investment arrangements.