Sustainability focus underlines NEST’s growing importance as a UK institutional investor

NEST, the UK’s £36bn (€42bn) defined contribution (DC) master trust, has this week awarded Lombard Odier Investment Managers (LOIM) a thematic equities mandate.

The strategy is intended to benefit from system changes arising from the moves towards sustainability.

It encompasses key themes such as climate change mitigation and adaptation, natural capital and social issues. As chief investment officer Elizabeth Fernando explains: “If you’re investing for 60 years you need to be thinking about the companies who are still going to be there delivering the returns that you need to pay those pensions over that time.”

The objective is to invest in companies who have business models that are sustainable, and operating in ways that are consistent with government policy.

This mandate is estimated to reach a size of £5bn by 2030 and illustrates the growing influence of NEST in the UK institutional investment market. It is expected to grow to £100bn by the end of this decade to become one of the UK’s largest pension schemes.

As such, its investment strategy has important repercussions not only for its beneficiaries but also for the UK economy as a whole, given that NEST is a signatory to the Mansion House Compact to invest at least 5% in unlisted assets and infrastructure.

Overall asset allocation is undertaken by NEST’s own small investment team headed by Fernando, but the actual management of all assets is outsourced to a roster of 20 investment management firms.

Relative attractiveness of asset classes

NEST members can choose from among six investment strategies but over 98% of the contributions are directed towards a suite of retirement-date funds, which gradually shift the asset allocation towards less risky assets as an individual approaches retirement.

Unlike many such funds, the asset allocation is not a simple equities-versus-Gilts decision as NEST’s investment team also takes into account the relative attractiveness of different asset classes over time.

As a result, when quantitative easing led to Gilts having artificially ultra-low yields, with index linked Gilts offering negative real returns, NEST had little exposure as it had instead moved to corporate credit offering higher yields. This, says Fernando, left members well positioned during the 2022 Gilt market collapse.

Other funds offered by NEST include high and low-risk options, a retirement fund, an ethical fund and also a Shariah strategy. The return profiles of the funds have generally been as expected over the last five years, with the 2040 retirement date fund having annualised returns of 8.0%, the higher risk fund showing 8.6% per annum and the lower-growth fund returning 1.4% per annum. The glaring exception has been the Shariah Fund which has shown a staggering 16.7%.

The explanation, says Fernando, is that given all the exclusions imposed by Shariah compliance, the fund was heavily overweight tech stocks and so benefitted from the huge outperformance of the US major tech stocks.

Liz Fernando at NEST

Liz Fernando at NEST

That also has a downside: “It isn’t obvious that someone who has chosen to follow in Islamic faith should be forced into the highest risk portfolio that we offer,” says Fernando, adding that now the fund has sufficient scale, the CIO raises the possibility of a creating a more diversified portfolio that better caters to the needs of people who choose to invest in it.

Mansion House Compact

NEST’s position as a pension scheme representing a third of the UK workforce gives it arguably a responsibility beyond just ensuring the largest pension pot it can for its members.

“Because of our membership, we have a real interest in a high-performing UK economy creating lots of good, well-paying jobs and so I think we should be supporting businesses who will deliver those aims,” says Fernando.

But she is completely indifferent as to whether those companies are headquartered in the US or the UK, and whether they’re listed or private – provided they are able to generate the required returns for their members.

Yet around a fifth of the overall portfolio and 40% of the private market allocation is in the UK.

As NEST already has good exposure to infrastructure and renewables, becoming a signatory to the Mansion House Compact to allocate a minimum of 5% of funds to unlisted equities by 2030 was not an issue – although as Fernando pointed out, the compact did not specify the assets had to be in the UK.

NEST is also not currently willing to invest in venture capital, which Fernando sees as offering too high a risk of a permanent impairment of capital than the growth stage of private equity, which has been the focus so far.

For NEST’s asset allocation team, the key issues relate to both long-term valuations and shorter term fundamentals. Gilts were not an attractive long-term investment at 1% yields, but are worthwhile at 5%. The US, not surprisingly, does tend to dominate their analysis.

“A lot of the research we do and the thinking we do is about what’s the Federal Reserve going to do as the trajectory for interest rates is a really interesting question for the next 18 months or so,” she explains.

As Fernando points out, in 2023 the consensus was that the world was going into recession, which that did not happen. Getting it always right may be unrealistic but what Fernando worries about is letting people down: “Making a bad decision is going to mean that someone ends up with a less good outcome and a less good retirement than they could have had.”

For NEST’s 12 million or so members, that may be a comforting thought.

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