Looking to find a fund that will beat the market during tough times? Catherine Lafferty explains how.
One of the central relationships in the balletic performance of a pension scheme is that between a fund’s chief investment officer and its external asset managers. Their carefully choreographed investment dance should, all going according to plan, produce a performance of rare beauty.
Surrey Pension Fund is currently conducting a review of its asset managers. It testifies to the importance of the relationship that a review is not to be executed at a rushed pace.
According to Neil Mason, head of pensions at Surrey Pension Fund, the object of the review is for the scheme to establish all the metrics that fit into the fund’s overall risk analysis.
Risk and how much to take, has always been at the heart of investment decision making. Yet the concept itself has evolved over time.
“Whereas before we looked at currency risk and political risk, now we are more holistic and will also look at ESG risk,” Mason says. “We are also looking to see that the risks are consistent with the return profile of the scheme.”
Risk is justified by return and is the basis on which asset managers are ultimately assessed. However, different pensions take different approaches to the question of the best way to measure asset manager performance.
While Surrey Pension Fund sets a performance target for asset managers, who must meet the fund’s discount rate, the Centrica Pension Fund has what its chief investment officer, Chetan Ghosh, describes as a “differentiated approach” to targets. The fund eschews setting targets and benchmarks for its asset managers to meet.
“We uncover managers who have their own process that they will not change for any client; it’s up to us to buy into that process through thick and thin,” Ghosh says.
“We will find our own ways of tracking whether that manager has done well over time but do not set them targets. A massive problem in the investment management community is when people unduly constrain their managers to overly focus on an index or outperformance target without actually focusing on best cumulative return outcomes,” he adds.
Surrey Pension Fund sets each of its asset managers their own discrete targets. Mason agrees that there are limits to the utility of benchmarks but believes they can assist individual managers if they are given targets against which they can be measured.
Given their importance in pension funds, it is unsurprising that the selection of asset managers is a carefully conducted operation.
Centrica, which has the luxury of a well-resourced in-house investment team that is not shared by many of the 5,500 UK DB pension schemes, has a well-developed selection process. To begin with it makes it as widely known as possible what it is looking for by using such channels as the press, thereby allowing potential candidates to approach it, rather than the other way around. It typically spends two to three years getting to know a manager through meetings and only then is the candidate put to its investment committee.
According to Ghosh, Centrica does not have a tick-box approach to asset manager selection but rather considers whether the individual managers can deliver it a competitive advantage. “It’s a clear example where we might think differently; if some one hasn’t out thought the rest of the market why not just go passive,” he asks rhetorically.
Playing the long game
The questions posed in the selection process can be as generic as asking about the investment process. But the problem is not a scarcity of clever individuals at asset managers but the opposite: a superabundance of them, all working with the same information in the public domain. How then to distinguish between them?
“We have fundamentally come to the opinion that choosing a manager on the back of a short presentation who has been shortlisted without any reference to what you’re looking for on a principals basis does not work and that is the process used by the majority of pension schemes typically,” Ghosh says.
The Nationwide Pension Fund appoints asset managers following a long process of review and due diligence with input from its investment consultant. Among the topics it considers are investment philosophy, culture and strategy, past performance, fee structure, individual track record and portfolio management process. Also examined are exit strategies together with what lessons have been learned from previous investments, ESG policy, risk management policy and mitigation and information and cyber security measures.
Trevor Castledine, who recently joined bfinance as senior director, private markets, was formerly deputy chief investment officer and private credit investment director at Local Pensions Partnership (LPP) and before that deputy investment officer at Lancashire County Pension Fund, says that his role was setting investment strategy and appointing asset managers to help execute that strategy.
The two local authority pension schemes had clear ideas about what they wanted to invest in.
“We always went out to the market. You need to do a very deep and wide search and see all the different offerings,” Castledine says. “It is also important that it is known that we are looking at a wide range of asset managers, they then compete and we pick the best price.”
He stresses the importance of a manager meeting the pension fund’s needs in terms of risk/reward and geography.
“We were making sure we could build the portfolio we wanted rather than take the portfolio someone offered to us, but it was always my investment decision at the end of the day,” he adds.
Strength in numbers
The number of asset managers employed by pension schemes varies. Centrica has between 10 to 12 asset managers, while Castledine says that at LPP there were originally around 20, who were then reduced to around 15.
“The direction of travel was to consolidate while considering the transaction costs, but the use of multiple managers enabled us to hire the best manager in each strategy and in each jurisdiction,” he adds. “We could have just appointed a multiasset credit manager but while I have the utmost respect for them it’s difficult to see them as best in every class.”
Meanwhile Nationwide’s Pension Fund currently has around 50 asset managers with different ones leading different strategies, most of whom are operating in private markets. Each one has their own strategy often based around jurisdiction and are very much specialists, Hedges says.
“We had the means to write investment commitments in the hundreds of millions of pounds; that certainly gets you into the VIP lounge,” he adds.
At LPP, which had a proactive, rather than reactive approach to asset allocation, in some cases portfolios were built internally. Two or three managers would be selected in each class, with the exception of opportunistic credit, which is a more eclectic class and would have five or six managers.
Above and beyond
As highly-trained specialists, asset managers are themselves assets to a pension fund. Thus Centrica views them as its eyes and ears on the markets. Chetan Ghosh stresses the necessity of asset managers having a long-term investment vision and being alert to any potential pitfalls that could lose a fund capital permanently.
For the majority of pension schemes, asset managers are the hands-on implementers of allocations to a particular asset class. But the Centrica Pension Fund wants more from its asset managers, says Chetan Ghosh. “In terms of how we interact with them, we are seeking a bit more than go and implement that for us and do nothing else. We use them as a material source of intellectual capital in relation to what’s going on in the markets.”
That the intricate footwork of the institutional investment dance requires highly-trained professionals is a matter of consensus in the industry. Most pension funds do not have the resources or skill sets to invest directly, so asset managers are vital.
While Ghosh says he finds asset managers a fundamentally important part of the investment food chain there is a problem in that there are too many of them and they are hamstrung by what advisers tell them they are and are not allowed to do. Centrica has low turnover of asset managers, who Ghosh says tend to be retained for an average period of in excess of five years.
“I think part of the reason for that is we are buying an investment process not trying to mould someone into what we want them to be,” he adds. “So if they have periods of underperforming a market index and it’s consistent with what we would expect that manager to do in that environment we would be much more tolerant.”
The degree of oversight and autonomy exercised over asset managers differs from pension scheme to pension scheme.
The X factor
Neil Mason characterises Surrey Pension Scheme’s relationships with its asset managers as “open-ended” and says he understands that returns are driven more by asset allocation than stock selection.
The Nationwide Pension Fund, however, tilts responsibility towards the asset managers.
“Typically responsibility lies with the asset manager as you are buying into a fund unless it is a segregated mandate whereby you can specify constraints that limit the fund managers ability to invest in only proscribed instruments, securities, equities that meet the terms you set,” Hedges says.
While the Royal Mail Pension Fund gives its asset managers total autonomy and the Nationwide Pension Fund has a similar approach, Centrica tends to split responsibility for investment decisions between in-house and external teams. Although the selection of securities is the task of its asset managers, much of the asset class positioning is driven by its in-house team.
The division of responsibility in Centrica is illustrated by means of the theoretical example of a manager who invests in high yields. Day-to-day they will select the securities and might marginally favour high yield to the extent that the allocation moves from 50/50 to 70/30. If, however, the fund believes one asset class isn’t going to do nearly as well as another then accordingly that money should be moved. It understands the manager is unlikely to move as much money as it wants and Centrica’s in-house team will supersede the asset managers and make physical allocations accordingly.
Yet for all this, could pension funds conceivably not use asset managers at all? The consensus is that they could not. The carefully choreographed dance between investors and asset managers will remain at the heart of pension funds for some time to come.
“I don’t think it’s realistic to say I’m going to ignore managers and just buy passive options; you don’t have passive options in property, in private debt sub-investment grade lending or any of the long income-type strategies being used by UK pension schemes,” Ghosh says. “You could argue a theoretical case, yes but I don’t think realistically it’s workable.”