Full head of steam for asset managers
At first glance the British asset management industry appears to radiate an air of optimism. "The theme in the UK is an increased investment sophistication," says Arno Kitt, head of European institutional business at Henderson Global Investors. "Because of a focus on solvency and governance there is no escaping the need to get to grips with investment in a sophisticated way. Things are going in the right direction."
And consultants agree that the industry is delivering the goods and reacting to the evolving demands of pension funds. "It's fantastically responsive," says Paul Trickett, head of the European investment practice at Watson Wyatt. "Asset management is such a vastly competitive industry that players are always looking at how they can be ahead of the marketplace. There are always people out there developing new products and ideas. The willingness of pension schemes to look at risk-adjusted returns in a more sophisticated way and to look at new strategies is a positive encouragement to the asset management industry to do what it loves doing, which is develop new products and new ideas and get them out into the marketplace." So everything is fine, sophistication is the order of the day and the future looks bright. Well yes, apart from a few problems.
"The industry is facing a hell of a lot of challenges," says Peter Harrison, chief executive of independent asset management firm MPC Investors and former CIO of Deutsche Bank. "For me the first is just what is the industry. It used to be that five asset managers dominated the UK market, you could talk to five consultants and they would tell you exactly what was going on, it was all very clear. Today there are some 55 hedge funds with more than $5bn of assets, the number of consultants has shrunk and the survivors are trying to research a much bigger pool of asset management firms and a much wider number of strategies. And we are competing with investment banks. So just what constitutes asset management is changing out of all recognition."
And asset managers are trying to hit a moving target as the pensions industry tries to come to terms with a new environment. The market collapse earlier this decade shattered many of their investment orthodoxies and the introduction of a new financial reporting standard, IFRS 17, both reminded pension funds that they had liabilities as well as assets, and should alter their asset allocation accordingly, and brought home to their sponsors just what the impact of those liabilities was on the balance sheet. And asset managers have to come up with the solutions to the newly highlighted problems.
"This is the first time that this level of change has been experienced in the industry but arguably that is going to be the norm," says Stephen Millar, head of European consultant relations at T Rowe Price. "And the skill for the fund manager to be successful is to embrace that level of change and to see the opportunities it provides."
So do asset managers have that skill and are they coming up with the products pension funds want? "It's always a bit of push-pull," says Patrick Disney, head of institutional at SEI. "Asset managers will always think up products to put forward to trustees to generate business and to try to reflect the changing environment. The reason why there's a proliferation of products now is because pension funds still have a hang up about having bet everything on equities before the bear market of the early 2000s. So asset managers are rolling out a whole lot of defensive structures."
"The industry as a whole is going in two directions, which is not to say that there aren't fund managers that are doing both," says Millar. "First, there is a risk management aspect whereby unrewarded risks within pension funds are being removed and second is the seeking of alpha, and from an asset management perspective the alpha thresholds have increased substantially over the past two-to-three years in terms of the targets that that we are being set by clients and that we are setting ourselves."
"There has definitely an evolution around a greater understanding of risk allocation in pension schemes and how they can take the unrewarding risk out of the picture and how they can apply their assets, which of course they want to make sweat in the most efficient but risk-adjusted return way," says Simon Chinnery, vice-president UK institutional at JPMorgan. "And certainly here are new offerings around, whether it's in absolute funds, new balanced type of funds, total return funds." "Pension funds are much more interested in having a holistic and integrated view of how all the bits of assets relate to what they are trying to do which at the end of the day is pay pensions, says Kitt. "And risk one of the theme - risk relative to the liabilities and the risks of active management verses passive."
"For the past two or three years we have seen pension funds willing to at least consider higher risk strategies, which they never would have done on the past," notes Paul Richie, client director and business development for Aegon AM. "Previously we had problems convincing them to invest in UK credit, they thought it was too risky. Now when we mention we have global strategies, emerging market debt, high yield, they say bring it on."
Joe McDevitt, managing director, head of Europe for PIMCO, agrees: "Over the past two or three years we have seen a growing willingness among trustees to look at a wider range of instruments than they did before, both on their bond portfolios but also sectors such as mortgage backed securities, a wider range of credit opportunities, emerging market debt, high yield and then some of the derivative tools that are required to best focus the risks where the manager really wants to take them."
"The trend arising from the need to get back to a funded status is to allow fund managers more scope but also to demand more of them," says Ominder Dhillon, head of UK institutional business at Scottish Widows Investment Partnership (SWIP).
"Five years ago you might have had fixed income mandates with a standard out-performance target of 50-75bps. Now the target is 100-150 bps with an expectation that the fund manager delivers it not just through the normal bond classes in the sterling market but also have the skills to look further a-field into other bond types. And that extends across to equities where they want more out of the UK equity managers and we're seeing is an increased interest in unconstrained equity mandates. But that requires a change in the benchmark."
Kitt sees three developments in terms of investment strategy. "First there is increased diversification, with not so much money in the equity risk pot and some of it being better diversified in equities, so less in the UK. It's also going into fixed income, which typically will match the liabilities. Or second it's going to harvest the illiquidity premium. And third, we're seeing in the removal of constraints on fund managers. Clients are becoming more willing to say ‘do what you need to do to generate returns for us'." But do asset managers have the resources to meet these new demands, can they attract enough skilled staff and should they attempt to stay on top of the emerging products? "One of the big challenges for all of us is whether we have enough bandwidth to fully comprehend what's on offer and ensure that people end up with the right products for their particular plan," says Harrison. "The typical US plan might have 40% of its assets in alternatives - including real estate, private equity, hedge funds - but it's nothing like that in the UK."
But although there is still a perceptible aversion to hedge funds among UK trustees, they pose a threat to fund managers. "There is a huge threat not so much from hedge funds per se but there's a huge drain of talent going to those houses that have got the ability to offer equity participation to managers," says Harrison. "Many fund managers when they reach the age of, say, 40 are frustrated by the bureaucracy and aggravation of working in a big company and want to go and ply their trade as a smaller firm, in a boutique environment, and participate in the equity value they create. We see this every day and as a result the industry is going to fragment even further."
And asset managers are having to come to terms with another market shift. The IFRS 17 requirement that a pension fund surplus, or more usually deficit, be recognised on the sponsor's balance sheet had led the sponsor to both take an interest in the trustees' asset management decisions and try to influence them. The problem is that a pension fund's interests might urge the trustees to follow an investment course that the sponsor might find has an impact on its balance sheet and could even affect its share price. "Volatility on the balance sheet is a big issue for corporates, particularly when there's a big pension fund," says Anthony Ashton, an associate at Hewitt. "And while trustees may see risk as an issue, they don't see balance sheet volatility as an issue."
"There is the potential for a conflict given that the views of the corporate are about best use of capital a may not deem it to be tying more capital up into the pension fund because of pressure from IFRS 17," says Chinnery. "But that is not something that can't be resolved, it's just that it's become more essential to the debate. There's always been some tension between the corporate and the trustees."
But this time it's being formalised, notes Ashton. "Traditionally actuaries and investment consultants have advised the trustees and those trustees have included corporate executives," he says. "Consequently, the sponsor view was implicit in the trustee discussions. But over the past 12 months we have seen discussions between sponsors and trustees taking place outside the trustee forum and some schemes have even kicked corporate executives off the trustee body due to conflicts of interest. As a result companies have started appointing their own advisers to have a formal process whereby they influence the trustees' decision making, particularly in the investment area."
And this complicates the picture for asset managers.
"Typically the recommendation from a consultant would be to move more into the bond market to reduce risks," says Richie. "But the sponsors are reluctant to do this because they are reluctant to give up the opportunity to close the gap through equity returns. So what they want is higher returns but no increase in risk, that's the Holy Grail."
"Now when we meet clients we have to be very aware of the strength of the employer's covenant with regard to the pension fund and be able to discuss with either the pension fund or the finance director because the fund manager not only has to market to the pensions manager but has to make the case of what it can do for the pension fund to the parties concerned," says Millar. "That has resulted in a number of asset managers employing either actuaries from the investment consulting world, where they have been involved with the sponsors, or recruiting direct sales people with an investment banking background, where they have been involved in marketing to the finance director, the treasurer the CEO of companies."
"Investment banks traditionally have good relationships and a lot of influence with the corporates," says Ashton. "So if the finance director has a pension problem he is very open to proposals from investment banks and many of them have seen the opportunities and are going proactively to finance directors and a few, but a minority, are trying to incorporate pensions into a broader approach."
And this represents a further challenge to asset managers. "Many investment banks have set up pensions units but essentially they are transactional based not relationship based," says Disney. "They are giving advice of a sort that will lead to a transaction whereas the existing model, which is very entrenched in the UK, is one of relationship-based advice, that is through consultants."
"Investment banks are muscling in, especially on the LDI side," says Richie. "Whether it's right for the individual schemes is another matter but they are definitely taking up business and this is a good period for them. But the term LDI covers such a wide area and a wide ranger of strategies it means all things to all people. Investment banks now say ‘we do all that' and they certainly do some of it but it is not a panacea for some of the problems the pension schemes have."
"LDI is an area of opportunity and challenge," says Dhillon. "But it's early days, everybody is piling into this market - investment banks, investment consultants offering the full service and then asset managers. But I am less worried about investment banks because while very large schemes may feel comfortable dealing directly with them there's a whole swathe in the middle that want both the comfort of best execution and would want to enter through a pooled arrangement."
Jerome Booth, head of research at Ashmore Investment Management, is a liability management sceptic. "The problem is that nobody actually assesses liabilities particularly well," he says. "So-called liability-driven investing is a function of actuarial tables and the particular profile of the members, so every pension fund will have a completely different liability structure. And these are real time changing liabilities. So to have a chance of managing that accurately you are going to have to reassess the liability structure every month. And nobody does that, they do it once a year."
"It used to be tri-annual, now if you're lucky maybe it's once a year," concedes Chinnery. "We take the view that LDI is a risk-monitoring framework rather than being a simple investment product and it is a pretty inexact science - we can't know about factors such as mortality, for example." So should fund managers respond too these changing demands and the emergence of new products by attempting to cover the water front or specialising in a few key areas? "It's a binary call," says Olivier Lebleu, managing director of MFS UK. "You can either try to define yourself as a company with the intellectual an organisational firepower to adapt to the changes in conditions every time they happen, or as a firm with a limited but precise core competency that you offer to the marketplace irrespective of what the change in beliefs represents. We've opted for the second choice, to stick to what we do best and define our core competency in a limited and precise manner."
Millar agrees: "You've got to identify at where your skills lie and how that fits in to the context of the problems that pension funds have," he says. "You have to decide what you can offer pension funds to either take risk that they are not being rewarded for off the table or provide the alpha to fill the deficit, and show you can provide it on a consistent basis. The mistake that some fund managers could mistake is that they will try to be all things to all men, try to cover every asset class and claim to be a one-stop-shop."