By Lauren Juliff
The reform objectives of the LGPS: to reduce fund deficits, improve investment returns and deliver value for money, appear to have been discarded in favour of simply making cost savings in areas which could lead to sub-optimal results.
Rather than removing active management, the LGPS should enhance governance standards by ensuring scrutiny of potentially value-destructive ‘closet indexers’ and full understanding of the impacts of collaboration and economies of scale, which don’t always apply to investment management and could also have a detrimental effect to client returns.
Good governance vital
Governance should be the most important consideration in this consultation but it has been pushed aside in favour of short-term cost savings. It is vital that scheme governors have the ability to select and monitor strong active managers, which requires them to have the necessary skills to understand a manager’s ability to generate long-term alpha and avoid closet indexers; those running an ‘active’ fund and charging a commensurately higher fee but in reality offering an investment strategy that effectively clones an index. These fund managers benefit at the expense of their clients who are arguably misled as to what the fund offers. However, employing true, good quality active management provides the opportunity to outperform the market, net of fees. This is an area for potential cost saving leading to real value for money, rather than cost saving at the expense of improved investment returns.
Active need
Schemes should have the choice of whether to invest actively or passively in each asset class. There are clear benefits to investing actively in certain markets, including listed equities. Emerging markets, in particular, which offer the long-term returns required to meet funding deficits, are best navigated by high quality active managers. They are often illiquid and can be difficult and expensive to access and replicate by passive investors; ETFs seldom meet their objective of delivering a market return.
Evidence demonstrates that true active management, when properly defined and understood, delivers superior long-run returns. One of its best indicators is active share, which measures the proportion of a portfolio that is invested differently from its benchmark. Its creators, Yale academics Antti Petajisto and Martijn Cremers, found that the most active stock pickers have persistently added value for investors, beating their benchmarks by an average 1.3% a year net of fees and expenses. In contrast, closet indexers – those with an active share between 20% and 60% – consistently underperformed. A recent study by SCM Private also found that 72% of UK funds with a high active share outperformed by an average 1.6% each year after costs.
By extension, if 50% of the LGPS £178bn assets were managed in true active mandates and delivered similar alpha, it would potentially lead to annual gains (net of fees) of £1.4bn a year, more than twice the proposed £660m savings from a removal of active management.
Bigger isn’t better
Although collective pooling of assets may be beneficial, for example to lower administration costs through shared services – a good example of this is the LGSS managed by Cambridgeshire and Northamptonshire – bigger isn’t necessarily better when it comes to investment management. Scale can limit a fund’s ability to access attractive investment opportunities and the history of asset management shows one clear and consistent failure – as funds grow too large so performance deteriorates resulting in reduced benefits to investors.
In conclusion, the current proposals for reform are misdirected and do not address the bigger issue that the LGPS should be sustainable and affordable in the long-run. Indeed, their full implementation would likely make the problems they are seeking to address worse and ultimately lead to an increase in the tax burden for individuals as the scheme will not have the flexibility or tools to meet future pension obligations.
Lauren Juliff is part of the UK institutional team at SKAGEN Funds
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