Richard Jones is chief executive of Stoneport Pensions.
Nobel Prize winner Harry Markowitz, one of the grandfathers of modern portfolio theory, is often attributed with the expression “diversification is the only free lunch in investing”. This expression is designed to illustrate a key tenet of modern portfolio theory, that diversification in your return seeking assets will enhance the return you can achieve for each unit of risk (or indeed you can get the same return at a lower level of risk).
UK defined benefit (DB) pension schemes typically have had limited diversification in their return-seeking assets but, since the introduction of the Pension Protection Fund and its regular update on the industry through the Purple Book, we can see a dramatic shift in how schemes aim to generate their excess returns.
As shown in the table below, in 2009, public equities dominated the return-seeking portfolios of schemes, with UK equities particularly prominent at 39% of return seeking assets, despite making up only around 5% of the global market capitalisation of stock-markets.
|UK public equities||39%||8%|
|Overseas public equities||47%||44%|
|Total return seeking||100%||100%|
By 2020 we can see that schemes in aggregate have sold down their UK public equities dramatically. This money has not been reinvested in global public equities but, in aggregate, moved to diversify assets with unquoted and private equity holdings increasing by 5%, and hedge funds going from a minor player to providing a fifth of all return seeking assets across the industry. Property investments have also increased their weight in return seeking portfolios.
Such widely diversified strategies can present significant governance issues. Large schemes can work with their investment consultants to walk through the complex issues of allocation between the various asset classes and select the best-in-class managers for each component of the strategy.
Smaller schemes have found this level of oversight and governance of their investment strategy to be somewhat impractical. Thus, many schemes that bought into diversification and had faith in their investment consultant, decided to delegate the implementation of a diversified strategy to their investment consultant through fiduciary management.
Fiduciary management is something of a compromise at a governance level, allowing the trustees to focus on the overall package of risk and return rather than the individual components of the strategy.
Moreover, if the fiduciary manager selects all the underlying managers, some of the benefits of diversification can be lost. The recent CMA findings on fiduciary management have introduced some further governance requirements for trustees wishing to delegate the individual asset allocation and manager selection choices to a third party, with competitive tendering now required on a regular basis.
Current options for ensuring trustee oversight of the individual asset allocation choices and manager selections before they happen, rather than reviewing the performance implications of these choices in a rear-view mirror, are extremely limited for smaller schemes. Diversification is good; but oversight of a diversified strategy is hard for all but the largest schemes.