If pension funds are reluctant to spend money, it is understandable. Across Europe, most pension schemes are facing cost cutting pressures. At the same time, they have to find new funds to focus on matching assets to liabilities, hire alternative managers, and deal with regulation, among other things. It means that often, particularly for smaller pension plans, value added services come lower down on the priority list.
“A lot of pension funds are spending an awful lot of time thinking about costs and the lowest fees that they can. But I think it’s important to remember that value is really a two sided proposition. One is price, the other is the quality of things that you are buying,” argues Barry Sagraves, chief executive of Northern Trust Global Investments.
And there are some value added services that pension funds should at least be considering, whether they decide to use them or not. Industry participants say that pension funds sometimes overlook the most obvious ways to add basis points.
One example is commission recapture. At its basic level, commission recapture helps any asset owner to reduce the costs of administrating that fund by targeting the commission that’s used and generated to execute trades on their behalf, explains Jo Sellers, vice president for commission recapture at the Bank of New York. Last year, the Bank of New York bought New York-based commission recapture specialist Lynch, Jones, & Ryan from Instinet Group for up to $159m (e124m). It is one of the few providers in the marketplace.
Commission recapture first evolved in the US, where soft commissions were common practise and criticised for their lack of transparency. Natalie Pilcher, director of implementation services at Russell Investment Group in the UK, says the firm first implemented commission recapture in 1969, and brought it to the UK in 1985. “The commission recapture provider will provide a correspondent broker list of top tier global brokers. They will have agreed with the commission recapture provider that any commission will be eligible for a part rebate,” she explains.
At a portfolio level, a pension fund can claw back 2-3 basis points of the total portfolio value. But pension funds aren’t particularly impressed. “We have been doing it for about three years now. We find it strange that it’s even possible to do. We hope that over time it will disappear, so that every fund manager will be able to negotiate the best price for whatever it is he is buying. But until then, getting some of it back is at least better than nothing,” says Paul van Gent, fund manager at the E19bn Dutch metals industry fund PME.
As unbundling of soft commissions becomes a major issue on both sides of the Atlantic, Pilcher believes the prominence of commission recapture will cease. “Ultimately, you could see the disappearance of commission recapture programmes, but at the moment, commission rates don’t seem to be crumbling.”
Others say the service should be used alongside unbundling. Jeremy Welch, who joined The Bank of New York from the LJR acquisition, argues that unbundling will show pension funds where there money is being spent, but it won’t actually give them money back. “If you do a commission recapture trade for a fund and they get a certain amount back, they are actually better off. It should be used in parallel with unbundling.”
He also points out that if a fund is using research of a broker, it must reward them. For her part, Sellers says it is important for clients to realise that not every trade is worthy of research commission. “If you were buying a million Vodafone shares, which didn’t take any research to buy and was a straightforward purchase, then that should be done at the execution price. Commission recapture separates the costs of the execution from the research,” she says. She also points out that recapture happens post trade, so that it should not have any effect on the investment manager or their strategy to affect best execution.
Increasingly, pension funds are waking up to the benefits of transition management and providers are scrambling over themselves to offer services to clients. “Transition management is entering a whole new phase of maturity and credibility. There are more and more people providing it. We see significant advantages of being involved in it. A transition manager can negotiate better brokerage fees for changing around the portfolio and reducing costs,” says NTGI’s Sagraves.
Still, as industry participants, particularly custodians, flock to the market to take advantage of demand, there are some concerns about the process of management. “In a transition, there is a significant amount of trading. When you do a transition you can trade as much as a pension fund does in a whole year, and often brokers are making additional money in undisclosed ways,” says Sam Lunqvist, head of transition management for EMEA at Russell Investment Group.
He believes that most transition manager models have conflicts of interests, pointing out that it is hard to measure transitions. Most parties now use implementation shortfall, he says, and no matter how you calculate it, you come up with a single number. “Within that, you have all the costs, the commissions, the taxes, etc. It is relatively easy for some providers to hide some of these undisclosed revenues,” he says. Lunqvist believes that 70% of pension funds are now using managers, and points to the obvious benefits. Managing transitions can help lower costs. A transition manager will also see all of the moving parts as a co-ordinator, and make sure everything is co-ordinated but as little as possible is traded. A good transition manager should also be able to lower risks, both on the investment side and the operational side. In the past, where a fund sat on cash for a few interim days, managers now buy and sell on an intra-day basis. “And a good transition manager minimises the operational side as well. These can be very complicated. I’ve done trades where there are 30 parties involved. If you have someone in the middle, the operational risk will be significantly minimised.”
He warns pension funds to take care when choosing a manager. “There are 25 parties out there hanging their shingles out saying they do management. But we don’t think they are all credible. There is a relatively low barrier to entry.” Instead, pension funds should look at the pros and cons of hiring an investment manager, custodian, or consultant to handle the process.
Pension funds say the cost of not hiring a manager can be high. “Doing a transition without one could cost you 50 basis points more, but in the worst case it could be more than 1%,” says PME’s von Gent. And he says, though standardisation is still lacking, and is more of an art than a science, he believes managers are fairly transparent. “Standardisation may be still lacking, but it is developing in the sense that there are good checklists to run through. In cases where you have illiquid assets and multiple managers, you need a good reason not to use a transition manager,” he says.
The majority of pension funds are not lending out their stock, and custodians and agents say it is about time that this changes. “Securities lending is a dependable source of alpha, and one of the most predictable a pension fund can find,” argues Chris Jaynes, managing director of eSecLending, the global securities lending manager which was formed in 2000 and has auctioned over 725 portfolios totally more than $750bn in US equity, international equity, and fixed income assets.
Unlike traditional programmes, eSecLending auctions off securities, forcing borrowers to compete for assets in a blind auction where there is no known market rate. It also runs individual client programmes, rather than creating a larger lending pool. “We believe that pooling assets together disadvantages the largest lenders. We set up individual customised programmes for each of our clients to maximise their returns according to their risk tolerances,” says Jaynes.
Pension funds thinking about lending out their stocks have much to consider. For one thing, it is important to get the paper work right. “If someone goes into stock lending they should always use standard documentation,” says Joe Seet, founder of Sigma Partnership, the UK firm which helps hedge fund start ups. For his part, Jaynes points out that the largest amount of work that any fund does is in the approval and due diligence process.
Pension funds are divided about the benefits. “We are not doing any stock lending. We’ve looked at this area a couple of times, but there are some tax issues that need to be resolved,” says Claus Joergensen, head of equities at PKA, the Danish administrator of eight pension funds. Seet points out that pension funds have to be careful of the VAT classification of the fee that they receive.
PME, which does lend out its stocks, says it makes sure not to lend out 100% of any of its securities, largely because voting rights are transferred to the borrower. “We don’t lend out the entirety of any of our holdings, so we can let our voice be heard at shareholder meetings,” says van Gent. Though securities can be recalled, he wants the industry to do more about the issue. “I’m hoping that the industry will look to solve the issue of voting rights going forward.” PME is currently reviewing the whole area of how hedge funds use voting rights, but says it is not often that there is a conflict between the borrower and the lender over voting.
Still, industry participants point out that securities lending can fill pension funds pockets nicely. “Real returns are anything from 1 basis point to 50 basis points. In fact, I’ve seen up to 100,” says Michael Hunt, director of operations at Russell Investment Group. “If you are a UK pension fund and have UK assets, there’s not really a huge demand for borrowing UK stock. Other asset classes, like global real estate funds, are particularly interesting to the borrowers,” he states.
Many small pension funds argue that their size prohibits them from lending, but Jaynes dismisses the argument. “The basis point return that smaller pension funds see is often not as large as the bigger funds, which may have a different asset allocation that is more attractive from a securities lending point of view. However, many smaller pension funds have been successfully lending their assets for many years,” he says.
Seet points out that the hedge fund industry floats on the stock it borrows. “Pension funds want to invest in hedge funds, but without securities lending, there would be no hedge fund industry,” he insists.