When Hermes Pensions Management decided to seize the initiative and go into third-party provision back in 1997, it made perfect logic. The company reasoned that if the investment strategies and techniques it employed were good enough for the £40bn (e57bn) of assets it managed on behalf of the BT and Post Office schemes, then it was surely good enough for other pension funds. Stands to reason really. For Tony Watson, the newly appointed CIO of Hermes Pensions Management, the transition from internal manager to external provider was a natural move. If you have the capacity and the skills, you ought to try and leverage those skills in a controlled way in the external marketplace," he states simply.
The decision has indeed proved fruitful. Hermes' first move into the external arena resulted in a strategic link-up with South African fund manager Liberty International Pensions in 1997 targetting the DC market, where the investment management for the index-tracking and actively enhanced index funds would be run through Hermes. The combined company's indexed products have, according to Watson, seen a constant stream of interest from pension funds, with a notable £300m win coming last year from supermarket group Sainsbury's scheme.
Next in line for a Hermes partnership was US shareholder activist Lens Asset Management last year.
Out of this came the Hermes UK Focus Fund, designed to target underperforming companies with the aim of assisting improvements in shareholder returns. The fund, which Watson says has been performing "well ahead of the index", received a welcome boost in fresh investor interest recently, particularly from local authority pension funds, when Hermes hit the headlines for its part in the removal of Mirror Group CEO David Montgomery. Having rapidly transformed itself into the institution recognised as being one of the highest profile corporate governance activists in Europe, Hermes must have been rubbing its hands in glee. That kind of publicity doesn't come along every day. A US equivalent has now been added to the product line and the marketing efforts behind the UK fund have been rolled out across Europe. Maintaining and increasing the size of the fund is imperative to how effective it can be in the corporate governance market, as Watson well knows.
"One of the issues about the activist fund is if your desired exposure is not a big percentage of the company, they are not going to take as much notice of you than if you had more," he says. "So where do you get that money from? You get it from somebody else. How do you get that somebody else's money? You get it on the basis of the record and the activist proposition."
Hermes is now in the process of recruiting a marketing professional, whose main responsibility will be to tie together these two very different areas of interest, and not least to communicate them effectively to the investment consultants - the gatekeepers to the UK pensions market. The marketing strategy is still at an embryonic stage, admits Watson, so the new member of the team will be given pretty much a clean sheet in terms of where Hermes should move next, both in geographical and product terms. As Hermes is currently only a two-product manager, adding to its range of offerings may be a good place to start.
"There are plans to make plans to do that," says Watson. "We have an excellent record in index-matching and the most obvious area next to go to is Europe, to have a Europe-wide index-matched fund and we are certainly thinking very hard about how to do that."
He adds: "The marketing strategy will obviously have to be based upon where in geographical terms and where in product terms is there a happy fit between what we have done well in the past and hopefully continue to do well in the future, and the market opportunity."
While he admits that Europe is an attractive market, he notes that the regulatory barriers have proved problematic for UK managers trying to access the market in the past. For the time being the UK will remain the main focus, if for no other reason than that Hermes lacks a substantial distribution capability to take on such a task. "We haven't got 500 sales representatives and we don't have a natural, at this stage, distribution base. We have got something through Liberty obviously, but apart from that we haven't got anything and so we would have to do it ourselves." Hermes' strategy has to be one of approaching the third- party market one step at a time and to know its own limits, he believes. "What have we been good at? Well we've been very good at index-matching, we've been good at bonds, at property, at emerging markets and small companies, and cash. And there is actually a lot in there. It takes time to build consultant support, you have to build it product-by-product."
To achieve this, Hermes sees the only way forward in the UK market is to position itself as a specialist. Balanced management is definitely a no-go area.
"Strategically, you have to say that the marketplace in the UK for bog-standard balanced pension fund management is pretty well catered for, not only by the big segregated providers, the MAMs, Gartmores and Schro-ders, but also the smaller funds in-tend to use pooled funds anyway.
So it is a pretty crowded marketplace in that area."
Fees are also an issue. The remuneration from managing a portfolio on a balanced basis is, not surprisingly, less than that of the sum of its parts. "If you add a specialist UK equity mandate and a specialist overseas equity mandate, specialist bonds and property, tactical asset allocation, the aggregate of the fees is going to be higher than if you took the whole thing on board! From our point of view, we would want to offer as high value products as we can and balanced doesn't conform to that.
"The strategy is to deploy what I would call core competencies in the external marketplace, but overlapping with that it is also about trying to make sure we invest in investment management businesses which are capable of delivering returns on any funds we might feed them with, but are also capable of generating external assets. And that strategy we are working through at the moment."
Aside from the Lens and Liberty partnerships, private equity firm Granville and Argent, the property development company, also comes under the Hermes umbrella, though neither of the companies are included in managing assets for Hermes third- party products as yet. "Some of the private equity money is managed by Granville, we don't actually do that ourselves, we advise that they BT should have some money in that area." Argent is virtually 100% owned by the BT scheme but actually operates through and reports to Hermes. Watson is keen not to dismiss any possibilities for the company and, like the marketing person he will recruit, he is viewing the future with an open mind. But his main concern is that, while Hermes is adapting to an external mindset, the quest for new clients does not come at the expense of existing ones. Building a third-party capability clearly can help recruit and motivate staff, but Watson will be keeping an eye out that in the process of adjusting the focus of the company the fund managers themselves don't lose their own original focus. "Our people have to understand what an external client will be looking for and that means more of an outward focus and that involves some presentation challenges and some marketing challenges without them losing what they are actually good at or putting them in a position where they turn into marketing people as opposed to fund managers."
When it comes down to it, both BT and the Post Office could and do look elsewhere for investment provision, says Watson.
"From their point of view, it's a very good thing as it keeps us on our toes," adding, "It is very important in terms of seeking external business that we continue to deliver to the Post Office and BT so they get net overall benefits and that we do not fall into the trap of seeking high-profile external wins at the expense of the £40bn of business at home."
It works both ways. New clients coming in who invest £200m have to feel as if they will be treated in just the same way as those two existing 'jumbo' clients who have invested £40bn. "Obviously one of the challenges is equality of treatment," he says. "If you are Sainsbury's and you give us £300m and we have got so many billions under management in index funds, are you going to get the same crack of the whip as the big in-house scheme? The answer is, of course you have got to get that, otherwise it completely destroys our commercial proposition and offends all the IMRO [Investment Management Regulatory_Organisation] regulations as well, so it is not in our interest to treat them preferentially."
Sainsbury's decision to transfer that amount of money into Hermes' indexed fund would of course have been largely due to the fact that the existing client, BT, was willing to transfer £1.5bn to fund its inception. That level of faith in Hermes' ability speaks for itself."

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