Following the leaders
American pension funds can be rightly hailed as global trendsetters, but European institutions can also learn from their mistakes.
Bigger, better, whizzier – that’s the image of America through European eyes, and the pension investment world is no different. US plan sponsors are perceived to have more resources to play with, a larger pool of investment talent to draw on,and to have developed a far more sophisticated approach to managing their funds than their European counterparts. All this may be true, and in many ways European funds do have a lot of catching up to do. But the US system also has its downside. At its worst, it has bred excesses in the form of overcomplex manager structures and the single-minded pursuit of performance. Also, European investors should remember that the US system has evolved to suit the US stock and bond markets. Certain elements of it – such as ‘style’ investing – will not work quite so well across the Atlantic.
US pension funds have the edge over European funds in one major regard. Their investment decision-making processes are more incisive, and also more informed. This is partly because pension investment is regarded as more of a ‘key’ company activity in the US. The typical plan sponsor of a large US plan usually delegates authority to an investment head who can then draw on other resources.This gives the fund the flexibility and confidence to try out new asset classes, and to move swiftly when necessary to shift assets around, or to hire and fire managers.
By contrast, the trustee governance structure common in the UK is cumbersome. It relies on a consensus approach that hampers quick, forward-thinking decisions and so carries an opportunity cost. The financial costs of this structure are difficult to quantify but often significant. The committee-based structures favoured in continental Europe have the same effect. We believe that pension funds should increase their ‘governance budget’ – the time and resources spent running the fund – or at least use it more efficiently. One way they could do this is by following the US example and hiring an investment professional to take responsibility for the assets.
A move in this direction – to quicker and better decision-making and a more professional focus – would also encourage more use of specialist managers. Investing with a spread of managers of different types helps boost returns and reduce risk, and this has been a feature of the US pension market now for about 25 years. There are several reasons why the US market evolved in this way – and these reasons are key to understanding why US funds behave so differently from those in Europe.
In the US, consultants tend to operate independently from actuaries. This has led to a return-based culture that is very different from the liability-driven approach that developed throughout Europe. In response, ‘boutique’ managers started splitting off from the staid banks and insurance companies that managed most US pension assets in the 1970s, and offering superior returns.
Another reason why US funds turned to specialists, very simply, is that the US market is huge, and therefore easy to slice and dice into subsets that can be used to diversify investments. Various academic studies helped ‘sell’ this approach to investing. The result is that now more than 80% of mandates in the US go to specialist managers.
In continental Europe, by contrast, pension portfolios have been based on bonds for greater safety in matching liabilities and guaranteed rates of return. Even UK funds – whose equity bias was designed partly to beat inflation – have investment policies rooted in their liability structures. But a more complex investment world is now encouraging the use of specialist managers in Europe. According to Greenwich Research, for the first time specialist mandates outweighed balanced mandates in the UK last year. This shift is due to trustees recognising that changing their manager line-ups can help boost returns.
Two specialist areas in particular are catching the eye of European funds, following the US lead. Corporate bond investing has attracted billions in pension assets in the past year, thanks to ballooning issuance and attractive yields, and a dwindling supply of gilts. Trustees are realising that they are paying over the odds for government bonds, and can safely substitute AAA-rated corporates.
European funds are also now paying more attention to alternative assets in the shape of private equity and hedge funds, which because their returns are not correlated with mainstream asset classes. A big caveat is that alternatives need expert monitoring, so only big, sophisticated funds will have the rescues to invest directly. A better option for trustees may be to outsource the hard work and invest in a fund of funds.
But there are some areas in which US pension funds are decidedly not at the cutting edge, orthey follow practices that will not catch on in Europe – or indeed should be actively avoided.
US funds have never embraced international investing with any great enthusiasm compared with European funds far greater appetite. Though this varies from one country to another, the average European allocation to non-domestic equities is in the range of 15% to 25% compared with some 10% to 15% for US funds. Instead of going overseas, US funds diversify within their own huge home market. One way they do this is by ‘style’ investing, handing out mandates to ‘value’, ‘growth’, or ‘small cap’ managers who can add value in their own corner of the market So far, ‘style’ investing has failed to get a grip in Europe, mainly because the European markets lack the wide range of opportunities available in the US (which is why European funds diversify by investing outside their home markets). Also, the massive underperformance of ‘value’ compared with ‘growth’ in the past two years has highlighted the problems of pigeonholing managers in this way. In fact, some US funds are beginning to go back to ‘core’ mandates, many others are managing their style exposures more carefully.
Meanwhile, European funds would do well to avoid some of the worst excesses bred by the US approach. One is overkill. Specialisation adds value, but many US funds have gone too far. They have complicated their investment strategies and manager structures to an extent that goes beyond the original goal of diversification, and makes the funds at best difficult to manage and at worst a very expensive index tracking fund. However, the past few years have seen a backlash against complexity in the US, with a number of big funds trimming back manager numbers and simplifying structures.
The single-minded pursuit of short-term performance is another pitfall that European funds should sidestep. There has been a shift of perspective away from the long-term approach that should underpin pension investments, with manager line-ups being changed as a result of ‘flavour-of-the-month’ considerations.
To sum up, European pension funds should continue to pay attention to what is happening across the Atlantic, but be selective as to where they follow the lead of their US counterparts.
Roger Urwin is global practice leader at Watson Wyatt Investment Consulting