Alastair Ross Goobey explains how the UK’s biggest pension fund will grow its investment services on the back of the defined contribution market. Fennell Betson reports
Hermes is on the cusp of a momentous next stage in its development. As the UK’s largest pension fund, it is about to take the step of offering investment services to third parties.
Chief executive and chief investment officer Alastair Ross Goobey is nothing if not a lateral thinker, ready to challenge conventional patterns of thought, which may explain why he is sitting astride £32bn ($51.5bn) of assets.
We are now 100% owned by the BT scheme, but we still have the majority of the assets of the Post Office scheme under our investment management and administration.”
The BT pension scheme - the largest individual one in the country- had £20bn at end 1996, the PO scheme was over £11bn and the newer PO office scheme was over £1bn. The PO is a third party client, in effect.
“We have no other third party clients, but we are about to change this with our agreement with Liberty International,” he says. The background to this is what he calls an “interesting dilemma” for organisations like Hermes. “Having £32bn under management is big enough to justify being an investment management organisation on our own. But the investment management world is moving rapidly towards consolidation. Although we are probably among the top ten or so managers in the UK, we cannot afford to stand still, as in relative terms we would be in decline. The resource that is needed to service worldwide investment these days is increasing,.”
Hermes is already used to being in competition, in that both BT and the PO employ other managers for specialist remits. ” We don’t try and pretend that we are all things to all people. Managing large portfolios like these does require specialist managers for various parts.” But Hermes has overall responsibility in terms of tactical asset allocation and strategic advice.
Large portfolios like Hermes’ he likens to a layer cake. “If you start off at the bottom layer of the cake with indexed funds very low risk, with a plain vanilla flavouring. Then you can have a marzipan layer of low risk active management (LRAM) with the sort of things we are trying to do with our distinctive net zero approach. Above that you can have higher risk, with more exciting active managers, -the icing on the cake. And on top of that you can have the nuts and cherries, with things like small cap or venture portfolios.” Part of the advice Hermes gives is about the depth of these layers.
Between the three schemes, Hermes manages equities which are equal to 1.5% of the UK market. “You can take two routes to managing that sort of size of fund: Either you say ‘I want to own the best 100 performing shares in the UK stock market’ or you go for some sort of indexing.”
Hermes’ starting position is a share of the 900 companies in the index at market weightings. Each portfolio manager managing on the low risk active basis has a slice of that portfolio “What we demand from them is that they add to the stocks they like and have to match that by selling stocks they do not like. So they have no market effect - they have ‘net zero’ market exposure.”
If the manager wanted he could sell all the shares of a company in his portfolio and in the index core as well, by borrowing that stock from the core and selling the whole position. As Ross Goobey says: “There is nothing more galling for trustees than to own shares in a company that goes broke. ‘Isn’t there something that you could have done?’ Though the indexed portfolio is still deemed to own it, but we as a house do not have any shares in it. That has been a useful addition to the armoury of the net zero manager. The point we find is that because they are concentrating on 60 stocks and we can use futures as well as stocks to balance the net zero, so they do not have to have the same number of buys and sells exactly.”
“Our main active thrust is the LRAM, which has been developed over the last seven or eight years and is proving to be highly successful in delivering consistent added value.”
It has been adding over 20 basis points per annum to the index return over the last seven years. “That is pretty good considering our size.” The net zero and core approach is applied not only in the UK, but extends to US, Japan and Europe portfolios. Around 15% in the UK is managed on the net zero basis.
But Hermes knows full well that among the other 800 or so in the indexed portfolio, there will be companies in decline. Not being prepared to accept this ‘passively’, last year it employed a ‘corporate focus executive’ to try to identify companies where there were real longterm strategic worries. “He has been ferreting around in these stocks to find where we might be able to intervene before it gets too bad to try and suggest alternative strategies or to press for changes in management. The last thing we want to do is to try to run the company. What we do is to press them to explain their strategy to us. If we are not convinced by this, we will then start pressing for changes and co-ordinating with other investors around the City.”
Ross Goobey does see a corporate governance issue, where indexed managers shrug their shoulders about underperforming companies, saying: “It does not matter because we’re indexed”. “Our view is that we have a greater obligation as we’re indexed. Because we are not interested in one company succeeding and one company failing in that area, we are trying to improve the returns for all UK quoted industry and that’s what we see the whole corporate governance effort and focus to be. It is not a moral crusade at all, it is trying to improve the returns on British industry for the benefit of our clients.”
The size of the active portfolio varies between markets. “We vary the amount on whether the index beats the average manager or vice versa. For example, Japan has been very poor over the last seven years for indexed managers, because the banks have done so badly. Whereas in the US, the index has done very well against active managers who have tended not to be able to add value overall. So we vary the size of the active management layer and increase the size of the icing layer, depending on our performance as active managers and the performance of active managers as against passive managers.”
UK equities account for 52% of the portfolio, overseas equities for 23%, with property accounting for 10% and bonds and cash for the balance. Around 80% of the BT schemes assets are managed in-house while about three quarters of PO schemes’ assets are. “About 15% of the UK assets are actively managed by us and by Mercury Asset Management. We do low risk and small companies actively and Mercury do high risk active and large companies actively.” Last year was probably the best year yet for smaller UK caps.
Schroders, in Europe and Japan manage money o n the high risk active side for BT and PO. In Far East ex Japan the PO has two managers; in the US, PO has around four, including small companies, large cap active and small cap passive; while Hermes does all the active there for BT with a small cap portfolio. As the two schemes go their separate ways, increasingly the management of the schemes diverge, to some extent. In the BT scheme, Hermes is involved in manager selection , but not in the case of the PO schemes. The PO reviews on a rolling three year basis and will look at each mandate. “”We currently have 16 mandates, these will be reviewed so many per year.””
The TAA side is mostly activated through derivatives, says Ross Goobey . “It is important not to disturb the underlying portfolios, so we run quite large derivative futures positions, but always backed by cash,” he says. “The specialist managers are not asked to take TAA decisions, as these are taken centrally by us under contract. So there is no danger of us zigging while they are zagging. This is very helpful to them as they do not have the problem of floods of money coming to them, just because we have changed asset allocation. We give them a stable amount of money to manage, which we will adjust once a year if there is any real big move away from strategic asset mix or if the strategic asset mix changes.”
How has TAA added to the returns? “Well, you have to take into account currency allocations as well, as we do that at the same time. Like most UK investors, we have been too bearish of Wall Street for too long. But fortunately we made that up by getting the currencies right. we were short on the DM and the Yen through 1996 against our strategic weight. And long on the dollar and sterling. That made a big difference to the TAA plus currency allocation. Having run with the Yen while it was strong, we changed our position when it topped.” All in all, without disclosing numbers, 1996 proved to be “a pretty satisfactory year”. Property, which forms 10% of the portfolio, did very well last year. “UK property has outperformed bonds over the last three years.”
Contrasted with the huge staff that some investment management houses have, Ross Goobey takes pride in his lean burn team of 35 investment professionals: “It’s a very focused team.”
“Altogether, we have about 180 people in the City. If this is compared with the number of people they have - and we do all book-keeping for schemes and the property management, we are extraordinarily cost effective.””