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Joseph Mariathasan: Should trustees resurrect in-house managers?

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The current issues over the value of investment consultants raised by the UK’s Financial Conduct Authority may shed a spotlight on one area where they do play a role, albeit not always without controversy.

Manager selection seems to be a major use of a pension fund trustee’s time, but perhaps not enough is spent on a more important issue, asset allocation. The problem that still exists in the current institutional arrangements for fund management is that institutional pension schemes find it difficult and perhaps almost impossible to obtain objective asset allocation advice that is not geared to selling a specific range of products from a fund manager.

Few fund managers have the expertise to move away from individual product silos to give asset allocation advice, and fewer still have found a way to make money from giving independent advice. The business model that works is to sell in-house multiple strategy funds in the guise of asset allocation, but this can hardly be regarded as objective and necessarily in the best interests of a pension scheme. Investment consultants, in contrast, may be independent, but they lack the market knowledge to undertake market-driven asset allocation decisions.

To undertake asset allocation objectively requires a very high level of skills and experience. Typically this rules out investment boards, whose function is policy, governance and oversight.

It arguably also rules out investment consultants, whose typical skill set has a theoretical bent, and whose market insights tend to be derivative, gleaned from investment managers.

Some fund managers may possess the skills, but lack the objectivity or the incentive structures to recommend best of breed third party managers.  The problem that arises is that the mismatches between involvement and responsibilities on the one hand, and skills, experience and resources on the other, end up damaging the wealth of the fund’s beneficiaries.

A key issue for long-term asset allocation decision-making is another mis-match, that between agents and principals. All of the principal players in the asset allocation decision-making pathway – investment managers, investment consultants and trustees – are agents acting for principals, who are the ultimate beneficiaries. As a result, they are all exposed to forms of career risk that result in a mis-alignment of interests with beneficiaries, the most dramatic instance being horizon mismatch. Whilst a pension scheme may have a time horizon of 30 years or longer, no agents have horizons even half as long. This gives rise to shorter-term risks of large relative underperformance, which all institutions have to grapple with.

Internal fund managers have, in theory at least, the huge advantages of stability and security, essential to give confidence to take decisions that may be radically different from a peer group.

The best example of this was probably George Ross Gooby, the Imperial Tobacco pension fund manager during the 1950s. He took a large bet in moving into UK equities in a massive switch from the more traditional bonds and thereby introduced the cult of the equity into institutional investments. He did this without reference to other schemes and without performance comparisons against arbitrary benchmarks. In today’s world, such a stance would be difficult to maintain even for an in-house scheme and impossible for a third party manager.

Is there a case for resurrecting in-house managed pension schemes? There is certainly a case for structures that enable fund managers to have a much closer alignment of interests with the beneficiaries and sponsors, and in-house managers would have this advantage. But this also relies on maintaining a long term trust between sponsor and internal managers. Indeed, in the case of Imperial Tobacco, the in-house managers took a strong value stance during the boom of the technology, media and telecommunications industries, which led to significant underperformance.

The trustees reacted by closing down the investment team in 1999 and outsourcing. Thus despite achieving returns that in absolute terms were probably attractive with hindsight, the lack of trust with their own in-house team led to events that left arguably everyone no better off.

External fund managers managing only part of a portfolio are not in a position to take on asset allocation decisions. Investment advisers are reluctant to take responsibility for investment decisions they could be sued for, rather than giving advice that need not be acted on, even if in practice, many trustees would prefer following that advice blindly.

Adopting an approach of in-house schemes concentrating on a core expertise and outsourcing specialist funds externally would appear to be a good pragmatic approach. The pension schemes could consider a hierarchy of activities. The most important would be to focus on utilising a risk budgeting approach to asset allocation. Developing in-house expertise in particular market segments may be appropriate. 

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