External managers still make sense

All over Europe, pension funds are handing over the running of their assets to third-party managers. Outsourcing has become a buzz word as regulatory reform, a clampdown on costs and risk, and a greater awareness of best market practice lead pension funds into new asset classes with new managers and new investment structures.
In short, there is a growing trend among European pension funds to use outside expertise to help get the best out of assets. This, in turn, frees up fiduciaries to focus on their core responsibilities.
Among the biggest catalysts for the outsourcing trend has been a relaxation of protective legislation in Europe. At the root of this easing is a gradual breakdown in state provision, which has accelerated over the past five years or so. If the state will
no longer provide, it follows that other pension purveyors will have to fill the gap.

As a result, different types of investment management firms – increasingly foreign as well as domestic – are now offering their products and services in markets that were previously closed or difficult to access. The new European Pension Funds Directive should encourage this trend.
Northern Europe is proving to be particularly fertile territory for these managers. In the Netherlands and Switzerland, thanks to a relaxation of the rules, pension funds may now manage third-party assets. A number of the bigger funds have set themselves up under different trading names to that of their original sponsor to manage and administer other pension funds’ money.
To compete successfully in the new environment, these providers need a full complement of best-in-class managers across the entire range of asset classes. Instead of building this capability in-house, they are turning to external managers and also to investment consultants to help with manager selection.
In Germany, externally managed pension funds frequently used the Spezialfonds vehicles, having to arrange these with KAGs, owned by a separate depot bank providing custody and administration. This has discouraged multiple manager structures as institutional investors often had Spezialfonds with a number of different KAGs. But the master KAG structures are now encouraging pension funds to consolidate their activities and use more complex manager structures.
New markets have also opened up as a result of the trend to defined contribution where, again, a wide variety of investment options is essential. In Italy and Sweden, for example, the rise of life-cycle funds has increased opportunities for external managers. Meanwhile, Spain is poised to ease its ban on pension funds having more than one manager. The net result is that Europe’s pension markets now look far more accessible.

Picking a winner
Along with outsourcing has come a move away from multi-asset mandates and into specialist mandates. These types of mandates – from corporate bonds to venture capital to hedge funds – are increasingly popular as the pressure to perform is leading European pension funds into new asset classes. Some funds are
even looking to outsource their asset allocation to funds of funds, multi-management vehicles, or external advisers.
As Europe’s pension funds increasingly turn for help to external investment managers, they face the problem of picking those that are most likely to outperform in future. How is it possible to identify tomorrow’s winners?
It may surprise most people that past performance rates relatively low on Watson Wyatt’s list of factors that go into identifying good managers. Instead, we focus on three ingredients that we believe are vital for a manager’s future success – business management, people, and investment process. Of these three, by far the most important differentiating factor for a manager is the quality of its people.
People are so important because investment management firms are operating in increasingly tough conditions. It is hard for them to maintain a stable business environment because of the frequent changes of ownership of investment firms. At the same time, it is tough to sustain a competitive advantage by having superior investment processes. This means that managers’ key strength must lie in top-quality people.
Studies have shown that an active manager’s past performance is not, by itself, a guide to future returns. Investment firms are constantly changing in response to markets and their own staffing requirements, and these changes affect their ability to deliver good numbers.

In other words, although we think that investment managers do exhibit skill, we believe that skill is very difficult to sustain. So we look at performance numbers more with an eye to understanding how and why managers achieved their track record. Was it skill or was it luck? Can the manager be expected to repeat the performance in future?
In our experience, the real drivers behind consistently good numbers are the so-called soft factors of business, people and process. By thoroughly researching these key ingredients, pension funds can ensure that what they buy today from their managers is what they will receive tomorrow.

A sensible solution
Managing multiple relationships inevitably has its problems – leading some observers to look for signs that outsourcing is failing, and that the trend is reversing. The example usually cited is of one of the big Dutch industry-wide schemes, which has started to invest directly in hedge funds, as well as investing via funds of hedge funds.
In fact this is less a backlash against outsourcing than the continued evolution of a 20-year trend, which started when pension funds invested mainly in state bonds, and many were run by the corporate treasurer. To access new asset classes they used external managers until they were confident enough to bring management in-house.
This raises the question of whether outsourcing can really deliver on its promises over the long term. For all but the most sophisticated European pension funds, the answer has to be yes. In-house performance has (with some exceptions) generally been poor, so while appointing external managers who deliver higher returns may not turn out to be cheaper, in most cases is certainly not more expensive.
The clearest case for outsourcing is that it permits pension fund fiduciaries to focus on their core competencies. It has to make more sense for fiduciaries to spend their limited time on their members’ best interests rather than becoming enmeshed in the day-to-day running of increasingly complex investment activities.
Above all, the pension fund is clearly a non-core activity for the sponsoring employer. With corporations becoming increasingly aware of their pension fund liabilities, and urgently in need of reducing costs and risk on their own account, it seems likely that outsourcing is here to stay.
Nick Watts is Watson Wyatt’s European head of investment consulting

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