Masters of reinvention
Both equity markets and balanced managers took a battering during 2000 and the year to date. Disappointed institutional investors are consequently looking elsewhere for that elusive alpha and, as they review mandates, so the managers in turn reinvent themselves. If it’s not balanced managers portraying themselves as specialists in everything, it’s the highly successful indexers stressing that they are no longer just passive managers but offer active management as well.
This reinvention is intended to meet greater demand for specialist managers and for the ever increasing popularity of core-satellite. For the passive managers it also boosts the bottom line. In addition, the UK has nurtured risk budgeting and information ratios (IRs), and witnessed institutions considering hedge fund and private equity investment. Then there is the well-documented report by Gartmore chairman Paul Myners with its many recommendations, including the controversial issue of commission reform and the abolition of the minimum funding requirement.
Consultant William M Mercer estimates the number of specialist mandates in the UK has grown 31% in the past two years, as opposed to 3% in continental Europe, and the number of mandates changing hands has consequently increased. A couple of years ago it wasn’t unfeasible for a £1bn (e1.6bn) fund to have just one or two managers whereas today, although not unheard-of, this is relatively rare.
Bill Baker, a London-based director with Schroder Investment Management, which has E211bn in assets, admits that the heyday of the balanced manager is over but that it retains its appeal. “We maintain there will be a market for the £150m–200m funds who don’t want an overly complicated fund structure and this will always be there for balanced managers in the future.” Even so, the number of funds in the WM Discretionary Pension Fund Universe has fallen from 700 to 500 in the past two years.
And this is why the large balanced managers are trying, in varying degrees, to present themselves as masters of all trades. Both Patrick Disney, SEI’s managing director, and Alan Brown, CIO at State Street Global Advisors, in London, agree it will be interesting to see how the larger managers adapt. “It’s going to be tough for them as long as you have a very influential consultant community out there who are basically going to run the asset liability study, suggest a target asset mix and then suggest a way to implement it. These days, consultants are more and more advocating the use of specialists and unless that changes it might be difficult for the balanced managers,” says Brown.
Fixed income investment has naturally taken up some of the slack but according to Peter Dencik, head of institutional marketing at Singer & Friedlander Investment Management, the UK and continental European equity specialist with £3bn (E5bn) in assets under management, the government bonds have been overlooked as investors opt for corporates and high yields. “We’ve also seen a move from government bonds and triple and double A bonds into high yield bonds,” he says. According to Baker at Schroders, there’s more to it than this and there has been a change in the mindset and the approach to fixed income investing. “The notion that you should just invest in T-bonds has gone,” he says. As an illustration, in 2000, fixed and index-linked gilt issuance was around £3bn, while non-government bond issuance was nearer £40bn.
Charles Farquharson, head of the institutional client division at Merrill Lynch Investment Managers, says there is diversification out of UK equities to overseas. “The answer to ‘what is domestic’ at the moment still appears to be the UK as we are not part of the single currency. To the extent that people are trying to diversify away from the UK market and away from sterling they’re currently going straight to a global portfolio rather than going pan-European first,” he says.
There has also been a proliferation of strategic benchmarks. “What you’re seeing is funds moving to fund specific benchmarks and this generally leads to less money being invested in UK equities,” says Baker. One consequence of this is that weighting to the US market has increased. In addition, Michael Hughes, CIO at ING Group’s Baring Asset Management, which manages E13.3bn in the UK, notes that investors are also paying closer attention to the constituents of some indices in order to take account of the free float re-ratings and this has typically favoured UK equities at the expense of French and German telecoms.
As with most setbacks, someone gains. One such area is that of the multi-manager or manager of manager strategy. Although still in its infancy the market is dominated by Frank Russell, Northern Trust and SEI and their popularity is again, in part, due to balanced managers’ unpopularity. Jon Bailie, managing director of institutional investment services at Frank Russell, says that there has been a growing acceptance of the multi-manager concept and equally important is the acceptance by consultants, which were initially concerned it spelt competition (see page 30).
Passive managers are also receiving a large chunk of funds leaving balanced managers. According to the 2001 Mercers European Fund Manager Guide, the £520bn (E854bn) manager Barclays Global Investors maintained its top position in terms of European pension assets under management with $115bn. As a measure of the popularity of passive management and the success of BGI, the corresponding figure was $53bn in 1996. Legal & General provides the bulk of BGI’s competition in the UK and, in the same guide, it is the fourth largest manager with $92bn European pension fund assets.
“We’ve seen an explosion in indexing in the UK in the past four years,” says Miles O’Connor, head of UK business development at BGI, which added £6bn in new mandates last year. “When we went into finals two years ago we had to present the case for indexation against active. Now it is extremely rare for us to have to be called in to defend the case for indexation,” he says.
According to O’Connor, the UK environment has changed radically. Changes are due to disappointing returns from balanced managers, changes to the actual structures of UK pension funds and the changing role of consultants. One of the main drivers behind this is Roger Urwin and his team at Watson Wyatt promoting risk budgeting. Says O’Connor: “Watson Wyatt have pretty much pioneered this. It the past it has been reward driven and everything has focused on outperformance whereas Watson Wyatt have concentrated on risk budgeting and net IRs.”
Technically speaking net IRs are excess return divided by residual risk. Or in other words, in any field in which it is difficult or risky to outperform, it makes more sense to index this and spend the ‘risk budget’ in areas that are likely to achieve outperformance. For O’Connor the likes of JP Morgan and Merrill Lynch setting up an enhanced indexed range of funds along with many others not normally associated with passive investing is testimony to a realisation that consultants Mercers and Watson Wyatt are recommending passive and enhanced passive management.
But for State Street’s Alan Brown, passive investing and indexing differ and the former is now more attractive. Hence the potentially perplexing slogan “time to stop indexing, time to go passive”. The idea behind this is that indexing, in the narrowest sense, mimics a benchmark religiously in order to minimise tracking error. Doing so can at times appear folly and Brown gives Dimension Data as a example. Trading at around £5, it rose to £10 on entrance to the FTSE100 index only to fall back to its pre-inclusion level a couple of days later. Minimal tracking error in this instance came at a whopping price.
So passive, or enhanced passive management, is a looser variant on indexing. “We think that enhanced management will get a lot more attention here. People have done the basics of indexing their assets and now they are looking for a little bit more,” says Brown, adding that enhanced is a source of good IRs. While the passive managers continue to grow, they continue to highlight what active products they offer.
As the larger balanced mangers try to convince others they are super specialist, so the genuine specialists, the likes of Marathon, the $10bn manager focusing on investment risk as a means of adding value, and Liontrust, a UK equity specialist, watch the funds come through the door. Liontrust for example has been selected by SEI for its multi-management product and has secured a number of UK pension fund mandates in the last year. Despite starting in 1995, assets under management are £1.6bn at the latest count and Nigel Legge, the joint CEO says they are now on the lists of a number of consultants.
Alternative investment specialists, be they hedge funds of private equity firms are also receiving more enquiries, if not yet funds, from UK institutions. Says Disney at SEI: “You’re highly unlikely to get to get the kind of returns from the capital markets in the past, or at least the equity markets, so you have to think of a different approach to long only.”
Private equity investment remains a relatively small sector and the larger pension funds tend to be the only group investing in this category. As for hedge funds, one UK manager described investing in them as “rather like sex at university – everyone talks about it but you’re not sure who’s actually doing it”. Yet a number of Casanovas have emerged, among them Anglo-Swedish AstraZeneca which has invested £70m (E116m) in hedge funds. The Cable & Wireless and British Airways pension funds both invest in hedge funds and Unilever is has said it is to make an investment. Although widely reported to have allocated funds, UK supermarket Sainsburys has only gone as far as saying that, following the Myners report, it would consider alternative investments.
The timidity with which pension funds and trustees are approaching hedge funds is seen by some managers as justified. “Like most things there’s a limit to the degree of skill available in the market place so the fact that it’s got ‘hedge fund’ attached to it does not mean it is an absolute winner,” says Hughes.
Yet another major problem exists for the institutional investor keen on investing in hedge funds. “Pension fund money brings with it the need for more and better disclosure, more clarity of process and more consultant scrutiny which some hedge fund managers might not welcome,” says Farquharson. And here is the rub – many hedge funds do not want pension fund money – they already have enough and are anyway unwilling to meet what they consider unreasonable disclosure and reporting requirements. The E175bn US pension fund CalPers, for example, announced it was investing $11bn in hedge funds but has since revised the figure to $1bn after it tested the market.
Despite the attributes of hedge funds, there are those senior investment managers who remain resolutely opposed to them. According to the 2000 Ludgate hedge fund survey, one CIO, when asked whether his group invested in hedge funds, replied: “No we don’t. It is completely obvious that hedge funds do not work. We are not a casino.”
The past 18 months have been a revelation in terms of benchmarks in terms of the number available and which to follow. In the UK equity markets FTSE dominates while MSCI holds sway in Europe. 2000 also revealed the extent to which indices can inadvertently introduce sector bias. The MSCI US and S&P500 indices are both meant to represent the US economy but the former’s tech bias opposed to the latter’s utilities bias has led to wildly different performance. Where there has been most change is on the fixed income side and the surge into corporate bonds.
Here there has yet to emerge a clear preferred fixed income index provider. Merrill Lynch, Salomons, Lehmans and Barclays Capital, for example, have their own series of corporate bond indices but one of the most interesting developments is that of iBoxx. Deutsche Börse and seven investment banks – ABN Amro, Barclays Capital, BNP Paribas, Deutsche Bank, Dresdner Kleinwort Wasserstein, Morgan Stanley and UBS Warburg – are launching a series of real time indices for the UK and European bond markets.
The consortium has already launched the iBoxx £ Gilt indices, which effectively mirror the UK gilt market for sterling denominated government bonds. To complete the series, sub-indices for sterling-denominated non-gilt government bonds, state-guaranteed bonds, collateralised and corporate bonds are to be launched soon. What is appealing to investors is that the indices are based on real time bond prices supplied by the seven investment banks.
Then there is the Myners report and its controversial coverage of soft commissions and transaction costs. Brokerage fees on fund managers’ trades are at present passed on to the pension fund. Myners has since recommended that the brokerage fees be included in the fund managers’ fee, a move that has come up against significant opposition.
The Fund Managers Association, the group representing the interests of UK-based institutional fund managers, has criticised Myners for failing to consult them adequately and, as with most UK fund managers, Schroder’s Baker has his reservations. “The cost of dealing is not just in the commission you pay, it is also in the spreads. Driving everyone to deal net is not necessarily cheaper nor more transparent,” he says.
And according to Merrill Lynch’s Farquharson, there are two issues at stake. One is soft commissions and the second is transaction costs – and the first has incorrectly been given greater coverage. In practice, the large investment banks do not make a killing out of soft commissions, rather it is in corporate finance and underwriting fees. “My favoured outcome would be that soft commission would be outlawed if someone can define it tightly enough. This would then enable legitimate transaction commission to be paid and I think that this is in the interest of the client,” he says.
Then there is the issue of how the UK market believes it will change the fee structure on its own. Says Bailie at Frank Russell: “Nobody else in the world has gone down this route. It’d be a bit anomalous if we were to do this as a relatively small pensions market and a relatively small equity market.”
Whatever the outcome of this particular issue the Myners report was pretty well-received and the decision to scrap the MFR caused little surprise. Abolishing MFR has added to the effect of the new accounting standard FRS 17 in speeding the move to corporate bonds. Following the MFR’s introduction, the long end of the yield curve fell by almost a third in 1998. The market recently priced in the belief that MRF would be abolished but the spread between 10 year and 30 year Gilt yields has narrowed since the report was published.
Myners has also drawn attention to investment in private equity and more exotic classes and this comes back to some managers reinventing themselves as specialists. According to State Street’s Brown, the fund management industry in the UK will polarise in the next five to 10 years. A few trillion-dollar managers will offer every service known, boutiques will flourish and those in between will be left flailing.
Whether this will affect the alternatives open to pension funds or for that matter any other institutional investor remains to be seen. As one senior manager says: “You should never underestimate the capacity this industry has for inventing new ways of doing exactly the same thing.”