UK – Pension fund trustees should allow fund managers more freedom when picking stocks, and let them make important investment decisions, says Hewitt, Bacon & Woodrow.

Measuring fund manager performance against a traditional benchmark – a market capitalisation index - is preventing managers from doing their jobs properly Hewitt believes.

According to the consultant, “it prompts fund managers to think about risk only in terms of the extent that they deviate from the index and restricts the extent to which they can back their own judgement”.

Hewitt is proposing that trustees instead hand over decision-making to the managers, and let them pick the best stock regardless of country, sector and index weighting.

“By selecting index benchmarks, trustees strongly influence the stock selection decisions that they need to delegate to their manager. As a result, they may be taking undue risk, and not getting good value for the fees that they pay to their managers,” says Kerrin Rosenberg, investment consultant at the firm.

The National Association of Pension Funds, however, is not in complete agreement. “Trustees cannot dodge the bullet. It is their duty to make the decisions and there is plenty of advice they can receive to help them,” said a spokesman at the association.

Instead, Hewitt Bacon & Woodrow is recommending that mandates are set which allow fund managers to invest in what they believe to be the best investment opportunities, transferring the stock selection decisions to the fund manager.

Unshackling managers from an index, however, makes it difficult to judge performance - and how to award performance-related fees. But, says Rosenberg: “Getting rid of benchmarks does not mean getting rid of performance measurement and we are urging our clients to set mandates based on new ways of benchmarking success.

“These could include measures against our clients' specific liabilities such as a customised portfolio of bonds, inflation-linked or absolute returns, or comparing returns against a range of simulated portfolios.”

Hewitt is suggesting using a computer program to select 10,000 different portfolios at random, and taking the upper quartile average performance as a rough benchmark. “We’d expect decent managers to appear in the upper quartile,” says Rosenberg.

But the NAPF spokesman was concerned, saying: “There is a need for some sort of standard in order to judge the success of funds.”

Rosenberg believes this “unconstrained benchmarking” is less risky. Indices tend to be quite concentrated, and managers are therefore forced to hold perhaps more of one stock than they would ordinarily. For example, UK equity fund managers wishing to maintain a market neutral position will hold 22% of their portfolio in just three stocks - BP, Vodafone and GlaxoSmithKline - due to their significance to the overall index.

“If trustees imposed some sort of diversification criteria,” says Rosenberg, ”then you could have 50 stocks each with a 2% weighting, for example, which would be much less risky.”

Hewitt has been in talks with fund managers about similar approaches to investing – namely ‘best ideas’ products. The consultant will now be recommending more freedom and flexibility to fund managers to its pension fund clients.