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Carrot or stick: the shift to passive

Earlier this year, the UK pension and asset management industries watched as the government revealed its vision for the 89 Local Government Pension Schemes (LGPS) in England and Wales.

These funded schemes, with assets of £178bn (€218bn), remain fragmented in separate funds and as separate investors. Little surprise that politicians are growing weary of perceived inefficiencies and a lack of collective investment.

The government is now consulting on the creation of two collective investment vehicles (CIVs) – one for passive listed assets and another for alternatives.

External analysis by consultancy Hymans Robertson says shifting all of the listed equities and bonds into a passive investment vehicle could save £420m, through a reduction in investment fees and transaction costs. This relates to around £85bn worth of assets being forcibly shifted away from active mandates.

The analysis also states that investment returns, on an aggregate basis, would not have been affected if the LGPS had invested passively over the past 10 years, rather than the current mix. However, it is this aggregate basis that may cause concern for many in the industry.

South Yorkshire Pension Fund – a £5.3bn investor, with around 60%, or £3.1bn, invested in equities – is one example. In its last annual report, the scheme returned 17.2% on UK equities and 17.1% on non-UK equities, both above benchmark, and all managed actively in-house.

John Hattersly, fund director, says the scheme has been active, and in-house, since the late 1970s. “We believe we can add value over time,” he says. “We do actively manage the UK and overseas equity portfolios, but in a measured way.”

He says there may be situations where passive is beneficial, but only in relation to a risk/return level the fund is comfortable with.

“If you are starting from a fully funded position, your attitude to risk is different than if you are 50% funded,” he adds. “A straightforward analysis of benchmark and returns fails to capture that.”

The issue of schemes’ belief in an active bias, and running this in-house, will be contested in the consultation. 

While South Yorkshire stresses its conviction in active management, other pension funds – notably West Yorkshire, Derbyshire, West Midlands and Greater Manchester – join it in having successfully managed investments in-house and, to an extent, at lower cost. In their eyes, wholesale – and forced – shifts run the risk of wasting valuable investment expertise, as well as jobs within the funds themselves.

The Hymans Robertson analysis does not mislead on the benefits of passive, but it states this on an aggregate basis, a flaw accepted by the authors. However, it answers questions posed to it by government.

John Wright, head of public pensions at Hymans Robertson and co-author of the report, says some funds clearly performed above average. However, some also partake in expensive active mandates with little added value.

The government consultation leaves scope for active management, and it will choose how to approach the promotion of passive management, either through carrot, or through stick.

Any potential asset shift could cause ripples elsewhere. According to Legal & General

Investment Management (LGIM), one of the largest index investors in the UK, the total make-up of active equities in the LGPS is only around £25bn, insignificant in relation to total assets.

However, the closure of £85bn worth of active mandates, currently spread between in-house teams and 50-60 external managers, would send shockwaves into the asset management world.

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