With markets turning increasingly volatile is active management on the verge of a comeback? Decision-makers at key pension schemes share their views with Mona Dohle on how to pick the right manager and whether higher fees are a price worth paying.
October was a rough month for equity investors. As stock markets across the world plunged dramatically, institutional investors who were cautious about relying too heavily on passive vehicles might have finally felt a sense of validation – perhaps there was still a point in picking an active manager.
No doubt, the past 10 years have been challenging for active managers. Fuelled by unconventional monetary policies, stock markets have shown remarkably little volatility, making it easier for passives to show strong performance.
During the past decade, active fund managers beat their passive peers in just two of 49 investment categories, according to data provider Morningstar.
Yet despite the negative headlines, UK institutional investors have increased the share of actively managed assets in their portfolios.
Two thirds of all UK institutional mandates (66%) are now managed on an active basis, up from 61% five years ago, according to fund industry body The Investment Association.
One example is the £50bn BT Pension Scheme, which recently increased the allocation to active managers in its equity portfolio to 60% from 50%.
“We feel that as the weight of money has moved into passives over recent years, it has created more opportunities for active managers,” says Douglas Clark, head of manager selection at BT Pension Scheme. “We also think that we are at the longer end of the economic cycle and believe that active managers will be able to protect capital better if markets are correcting,” he adds.
Another scheme with faith in active managers is RPMI Railpen. The £28.5bn retirement fund for the UK railway industry has invested the bulk of its portfolio in actively managed strategies, as the scheme’s chief investment officer Richard Williams explains: “There are good reasons for passive investing if you just want super low cost exposure to the market but the market return is not good enough for us. We want to control the investments we have, not be dictated to by what others decide should be in an index.”
Tesco’s £13bn defined benefit (DB) pension scheme is also almost exclusively managed through active mandates. “We have virtually no passive vehicles in our fund,” chief investment officer Steven Daniels says. “We would only tend to use them for making tactical asset allocation decisions and where we couldn’t find an asset manager that could generate alpha beyond market return.
“It really depends on the size of the fund that you are managing but for a fund which isn’t a mega sovereign wealth fund, and depending on the size of the mandate, we think that by selecting the right manager, there is still an opportunity to outperform in the vast majority of markets” he adds.
KEEPING THE FAITH
Yet while most institutional investors, certainly on the defined benefit side, refuse to give up their faith in active, they remain divided with regards to the sectors where active managers can still deliver out-performance.
For Daniels, a broader mandate in relatively less liquid markets offers opportunities for active management, while a narrow mandate in a more liquid market, such as US large caps, could be challenging.
“But in the Tesco Pension Fund we don’t generally invest in country specific funds, we tend to allocate broader mandates, such as global equity strategies, and as a consequence of that managers have the opportunity to create additional alpha through their country or sector allocation,” he adds.
Daniels also believes that active management shouldn’t necessarily just be restricted to a growth oriented equity portfolio. “At the moment pension funds tend to see the liability side as completely separate from the growth portfolio, but it doesn’t always need to be that way.
“Any good long-term asset can provide the income to pay pensions that includes fixed income and alternatives,” he adds.
Mark Hedges, chief investment officer at the Nationwide Building Society’s £4.5bn Nationwide Pension Fund has little faith active equity managers to out-perform, but sees opportunities in less liquid, alternative markets. Only 15% of the scheme’s portfolio is invested in public equities, of which the vast majority, 80%, is in passive funds. Only emerging market mandates are currently actively managed, but even in this relatively inefficient market Hedges is disappointed with the performance of active managers.
“When we look at developed public equities, unless you go down the route of a really active investor, we see it as very difficult to really add substantive alpha and paying higher fees is making it even more difficult,” he says.
“By their very nature, alternatives require active management and we would typically be investing in a small number of companies with a clear strategy to undertake actions,” Hedges adds. “Active management in public equity doesn’t offer you that opportunity as having access to certain corporate information would often amount to insider trading.
“Private equity is often seen as a less transparent asset class but in these cases, because they are not publicly traded, they can be very transparent on what’s going on in their business,” he says.
PLAYING THE LONG GAME
One view many institutional investors have in common is that active investment is defined as pursuing a preference for managers which operate independently from the benchmark rather than making frequent portfolio adjustments. Once a manager has been selected, institutional investors tend to stick with them for several years.
For Williams, active investment means above all to have a large active share. “We want a portfolio that is quite different to the market, however we don’t want to be active with that, and we want to be long-term investors.
“We are fortunate that our stakeholders are supportive of that, we are not constantly being asked to justify performance versus market benchmark,” he says. “In practice that can still be quite tricky, index providers have captured the industry and it is a tough battle fighting back against that.”
Similarly, Clark says that choosing an active manager should always come with conviction. “For us, we typically don’t have many niche strategies,” he adds.
“Every mandate should be impactful on a scheme level. It might have taken us a bit of time to get to know them, often we won’t start as a full position but gradually increase our investment over time, we don’t tend to invest in very nichey strategies.”
The £50bn scheme then has a relatively low turnover; in general, the team conducts only one or two mandate changes a year. Remaining invested requires patience, especially in periods of underperformance, as Hedges points out. Despite the fact that the scheme’s limited active mandates on the emerging market side has delivered a disappointing performance, the team has opted to remain invested for their usual period of around five years to test the performance of the strategy in different market environments.
A lower turnover and long-term commitment necessitates a thorough screening process. While not every fund relies on quantitative databases, in most cases, multiple manager meetings will take place before investors choose to commit.
Clark says his team is likely to know a fund manager for several years before they choose to invest. “We meet them in person, in fact we would be meeting them multiple times and also see several people in their organisation to really develop an understanding of the manager and their strategy,” he says. “We would never invest in a fund without having met the manager first.”
This means that access to a fund manager and good communication throughout the investment process are a key requirement for investing.
Daniels says that what he likes to see in an asset manager is that they consider his scheme to be a client that is worth building a relationship with. “Going to a £10bn fund with a £10m investment and then being met with not enough engagement is something that is of very little interest to us that is where relationships are very important in my opinion,” he says.
Once the decision to invest has taken place, it remains important to communicate any changes in strategy. “We had a case of a manager who later told us that he hadn’t actually invested in the way they said they were going to invest because they believed that the market environment had changed,” Daniels says.
“In such a situation I would expect somebody to pick up the phone and communicate why they changed their approach,” he adds. “We might not have been the biggest investor but we still had a significant amount invested. This lack of communication meant that we wouldn’t invest with them again.”
With the onset of monetary tightening, markets have been increasingly volatile, but does this mean that the value of active managers could increase again going forward? Despite his current scepticism of active managers, Hedges is observing the changes carefully. “It is fair to say that it has been a market environment where it’s been hard to add value. Volatility is definitely giving active managers more room to out-perform so we will be open to listening to that view,” he says.
For Daniels, disproportionately high fees still remain a key problem when investing with active managers. “As an investor, you have to be certain that an active manager is going to generate significantly more than the passive equivalent,” he adds.
“An active fund might be performing at 7% and charge a 3% fee, so what you have got to ask yourself is are there easier ways to get a 4% performance without paying 3% to fund managers? Are we getting a fair share in terms of risks and returns? “We think long and hard about paying higher fees, but there isn’t always a credible passive strategy to have instead,” Daniels says.
Clark still believes, however, that there could be a growing role for active management in pension schemes “even though the trend has been very much the other way in most institutional portfolios”.
“Especially for DB schemes, both active and passive strategies have a role,” he adds.