The Chancellor has announced plans to pool the assets of UK Local Government Pension Schemes with the stated goal of “delivering significantly reduced costs while maintaining overall investment performance.” Whilst this should be encouraged in principle, we at TT worry that it is cost that is being primarily targeted and not value.
As any consumer knows, cost is only one side of a decision to buy a good or service. Quality is the other metric, which together create value. If cost were the only consideration then BMW and Marks & Spencer would have failed as businesses a long time ago! The notion of quality is highly subjective in most consumer goods, but in financial services it is far more objective. Investment performance is easily measurable and, when compared with cost provides a straightforward calculation of value.
To remind readers, the aim of the Chancellor’s plans is to amalgamate the 89 separate local government authorities (plus the Environment Agency) into six wealth funds, each with at least £25 billion of assets. The goal is to achieve “substantial savings in investment fees” while “maintaining overall investment performance.” It also encourages local authorities to invest in local infrastructure and the consultation document notes that “only a very small proportion” is currently invested there. This is a topic that we will not cover in this paper, although we would hope that this is done only if clear investment benefits are expected to accrue to pensioners. Local authorities will submit their initial proposals by February 19th 2016, with a transfer of assets into the new pools from April 2018.
We are not against the Local Government Pension Review. On the contrary, any proposal to improve returns for pensioners should be encouraged. Our concern is that politics is being played in an important economic decision. It is politically appealing to be able to claim the headline “Government saves pensioners £xx million” and already commentators have quoted numbers that could be saved by going passive. This is unhelpful and highly misleading. Costs alone should not be of relevance to the pensioner. Net returns are all that he or she should be interested in.
The danger is that if saving tens of basis points has the effect of costing hundreds of basis points in returns, then value has been destroyed. In a society with an ageing population where pension provision is a ticking time bomb, such a result would be catastrophic for today’s working population.
Of course, costs are a legitimate part of the equation and there are no doubt examples of some local authorities that are paying excessive fees and receiving sub-market performance. In such instances, switching to passive management may be a solution – immediately improving both cost and return. However, it would not necessarily be the best solution. In pooling resources, basic economics tells us that cost saving synergies should be available, both in direct administration and in investment management. Some investment projects such as infrastructure require scale in order to be viable. But in some asset classes, diseconomies of scale are also evident. High quality investors in more volatile or illiquid asset classes, for example, will often limit the size of their pool in order to optimise returns. There are many examples where extremely large asset managers have underperformed significantly due to diseconomies of scale and illiquidity.
In our view the consultation on this issue has been handled badly. Neither asset managers nor Local Government Administrators seem to have any certainty regarding the proposal. The danger is that in the quest to cut costs, all assets are pooled, to the detriment of many. It may be that some asset classes can legitimately be run more efficiently on a smaller scale, and some should remain active due to consistently superior performance over the index.
At TT, our performance team has looked at a number of asset classes to try to guide readers as to which are particularly vulnerable to diseconomies of scale. US equities are a highly efficient asset class, for example, and are notoriously difficult for active managers to outperform once fees have been netted off. Unless specifically focused in stock number or investment style, this market would seem suitable as a target for cheap passive investment.
Conversely, UK equities are demonstrably attractive for active management. The UK index is inefficient in its make-up, with the top 10 stocks constituting over 30% of the benchmark, and the volatile Materials and Energy sectors accounting for over 14% of it as at the end of 2015. If we compare the performance of the index in 2015 against active funds, it would rank in the 76th percentile, with the median active fund outperforming by 4.5% – well worth paying a higher fee for. Over a five year period, the index would drop to the 90th percentile against an active peer group!
Comparing US and UK active managers’ returns over the last 10 years, we can see that the US demonstrates a classic normal distribution around the mean, with active managers generating negligible returns over and above the index. In stark contrast, the UK shows a notable skew to the right-hand side of the chart. In other words, the median manager has consistently outperformed the index.
10-year relative returns in US and UK equities
Source: eVestment, as at 31/12/15
According to our analysis, the UK appears to be one market in which Local Government Pension Schemes should most definitely engage in active management. Indeed, in TT’s recent experience, alpha generation has been so strong that the UK market is increasingly being targeted by international managers looking to hedge out market risk and benefit from the strong relative returns generated.
Taking the UK as a case study, and incorporating the extra fees incurred for active management, we considered the effect of active versus passive performance, net of all costs. If we assume a conservative 60 basis point extra annual fee* for active management, over a five year period, an investor with a £50,000 pension pot would be £10,758 worse off if they had invested in a tracker instead of buying the median active UK equity fund. If they had chosen wisely – as of course one would hope the local authority investment teams would – and picked a top quartile fund, their pension would have grown to be worth £85,823 net of costs versus a tracker at £66,279. That is a huge difference of £19,544 – or 39% outperformance. Even if investors made a poor choice, a 75th percentile UK active equity manager would still have outperformed a passive fund over this period net of all fees. These numbers show the differential over 5 years, but pension savings have a much longer horizon, which would compound the catastrophic effect of making the wrong choice when purely guided by costs.
Net return of active versus passive investment in UK equities
Source: eVestment, as at 31/12/15
*80 bp fee assumed for active managers, and 20 bp for passive.
We also looked at less liquid asset classes to assess whether diseconomies of scale were evident. In Asia, where volatility has been heightened in recent years, it is notable that smaller managers (which we define as those managing less than $1bn in the asset class) have outperformed larger managers over both 1 and 3 years by in excess of 200 basis points per annum.Data also supports outperformance by smaller, more nimble managers in Emerging Markets more broadly over recent years. This is perhaps unsurprising given the huge volatility in the component parts of the Emerging Market universe. For example, Hungary was the best performing Emerging Market in 2015 in US dollar terms, with a gain of 33.9%, whereas Greece lost 62% of its value in dollar terms. Wide divergences such as these present active managers with an excellent opportunity to generate significant alpha for investors.
Return in US$ of MSCI Emerging Market countries
Source: Bloomberg. Indices 31/12/2014 – 31/12/2015.
There is a great danger that a sledgehammer is being used to crack a nut in the Local Government Pension Review. Better value should be the metric sought. This is easily measured and, as such, both the Local Government Administrators and the underlying fund managers should be held accountable under strict criteria. Selectivity is key in order to choose between which asset classes should be run passively and which provide good value to investors through active management. Similarly, the pooling of all assets is not an efficient blanket solution. More volatile and less liquid asset classes should continue to benefit from being run by specialist managers. As a result, current guidelines will save costs but, in some cases, will destroy value for pensioners. That would be a disastrous outcome for today’s public sector workers.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).