Mixed signals on the road ahead
UK pension funds “have had more thrown at them in the last 18 months than in the last 18 years!” is how one fund manager describes the turbulent UK pensions scene since the turn of the century.
The lull in UK pension fund activity over the past 10 months is understandable, given their maturing status in a falling investment market, the Merrill Lynch/Unilever court case, the introduction of FRS17 accounting standards, 11 September and the much-trumpeted Myners report, which gives UK schemes until next year to meet proposals to improve the UK industry or face legislation.
Add to the mix increasing talk of a mid-2003 UK referendum on the euro and it’s not hard to see why schemes have more than enough to keep them occupied.
For the UK asset management community, the knock-on task has been to read the tea leaves correctly and work out where best to position their businesses to take advantage of the fall-out.
The significant effect of UK plan maturity thus far has been the shift towards increased bond investment. While the 100% bond transition by the Boots pension fund last year is seen by most managers as an extreme scheme-specific case, most acknowledge it as the thick end of a wedge of money set to move away from equities (see page 33).
Des Macintyre, managing director of the pension strategies group at Deutsche Asset Management in London, which manages £64bn (e100bn) in UK institutional assets, explains what he sees as one of the major impacts of the maturing pensions market.
“Many defined benefit pension funds are not only liquefying their assets to pay out to new retirees, but also closing their schemes to new entrants. Both diminish their asset base and ability to generate returns.
“A lot of companies are sitting on their hands and waiting to see what will happen, but as FRS17 starts to show the impact of this on company cash flow, then analysts and credit rating firms will start to take a view on the company’s credit rating. There have been firms whose dividend policy has been impacted by this, and in terms of M&A activity this is a time-bomb that people have to be very sensitive to.”
Nigel Taylor, managing director at UBS Global Asset Management (formerly Phillips & Drew) with £26bn in UK institutional client money, offers his scenario for the months ahead: “Post-11 September, a lot of UK funds were facing some awkward solvency issues and battened down the hatches to take a long hard look at important strategic issues. Since the fourth quarter of last year, the number of RFPs and mandates up for grabs has been significantly down.
“We expect the result to be an increase into UK bonds – both sovereign and credit – and a better split in equity allocations between UK and ex-UK assets. Our best guess is that there will be a lot of mandates coming out in the last quarter of this year and the first quarter of next year.”
Such predictions of a fixed-income shift have encouraged a number of houses to sharpen up their bond divisions and hit the marketing trail.
Many predict that a lack of UK gilts will push pension funds into greater corporate debt exposure and further towards opportunistic bond briefs and emerging market debt – with alpha generators being used as a substitute for equity.
Another effect of the search for increased returns, say managers, is that the huge flows into pure indexation products over the past five years – reaching around 30% of the market cap – may have passed their peak as schemes look to sweat their core assets a little more in the current market environment.
Andrew Fraser, manager, global consultants, at Henderson Investors, with £23.4bn in UK assets, describes the shift from pure passive to enhanced indexation products as clients looking for “more bang for their buck” – capturing the product’s implantation from the US. As a result, Fraser says Henderson began marketing its own enhanced index product last year.
Kanesh Lakani, marketing director at State Street Global Advisors, with £24bn in UK institutional assets, agrees that where clients are comfortable with the principle of indexing, they are now seeking consistent added value in all market environments.
“The enhanced product has risk characteristics similar to that of the index but aims for 75–100 basis points in added value. Some investors buying supposedly low-risk core strategies have had underperformance in the past through issues such as non-control of style and capitalisation bias etc. Now they want to limit the downside.”
Similarly, Miles O’ Connor, managing director of UK institutional business at Barclays Global Investors (BGI), with £128bn in UK institutional assets, concedes that while over 60% of UK pension schemes have used indexation within their fund structure, it seems that the tail of the trend to passive could be in sight – although he notes that the passive business is “stable” and not losing assets.
O’Connor questions, however, the oft-quoted lack of viability in the passive business: “The fees may be low, but the question is profitability. If you have the right pricing structure, pooling of assets and a range of added services such as stock lending and custody, then there is no reason why you cannot be profitable.”
BGI, nonetheless, has leveraged its passive bulk to develop a strong active quant business and, like many other firms, now touts its strength in investment product diversity as a factor for future success.
The tail-off in indexation mandates within the current market conditions would appear, then, to play well for active managers.
Yet widespread criticism from pension funds over performance, alongside accusations of benchmark-hugging against active managers bidding to retain business, have forced many houses to think again.
Throw in the switch amongst pension funds from peer group comparison to scheme-specific benchmarks, and active managers are having to deal a new hand of higher performance/ higher risk products to meet fresh performance demands.
Michael Hughes, chief investment officer at Baring Asset Management with £7.2bn in UK institutional assets, defends the active management community, but notes that predicted allocation shifts will require greater understanding by trustees and increased transparency from investment houses: “There is a world of difference between aiming for a 1% out-performance target in today’s environment, where the trend total returns are 5–6% a year, and in trying for 1% outperformance against a 10–12% bull market.
“In the environment we are now in, many people would argue that we can expect much lower returns. Looking at history there has never been a period where you have had trend rates of return of 5–7% that have been stable.
“To outperform in this environment you have to take a different set of risks than before, so in the years ahead the job for both asset managers and consultants is to educate trustees about risk and the changes in the types of risk and bring them on line in the policies that you are operating. There will also be the need for a much longer period of performance appraisal.”
Without a doubt, the post- Unilever/ Merrill world of potential litigation will sharpen minds here.
Anna Roads, director of research and product development at Fidelity Investments, managing £17bn in UK institutional funds, takes a similarly long view as to where the various elements could put the UK market five years down the road: “Firstly, is the proportion of bonds and equities going to be reversed? The most extreme view predicts a 60/40 split in favour of bonds. This would have two implications for products. There will be less money as a whole in equities and much more of this will be overseas. On top of that, investors are going to want their equity investment to work harder. What you will see is higher performance targets, higher risk mandates and potentially fewer managers.”
To date, though, UK institutions have been slow to diversify from the domestic arena, because of the size of the UK equity market and the continuation of sterling-denominated liabilities.
Yet a shift to the euro sooner rather than later is by no means improbable. And so, it seems, UK pension funds are making plans for the kinds of transitions that have seen European pension funds desert their domestic stock markets overnight.
Peter Hunt, head of UK marketing and sales at Fidelity, adds: “A lot of global mandates at the moment are being structured to include a 10% weighting to the UK – they aren’t ex- UK. I can’t help thinking that this is due to funds and their advisers testing their managers’ capacity to manage such allocations and looking ahead at a pan-European scenario.”
John Angell, head of UK equity products at Schroders, which manages £56.4bn in UK institutional funds, flags up one new product he believes is meeting this appetite for greater specialisation in the market. “We are seeing a demand for more absolute return strategies and one popular product at the moment takes positions against cash/inflation but is invested in mid-cap equities. This is not seen by clients as a straight equity product.”
The real ‘noise’, though, in specialist/absolute return products has been the hedge fund market. The big question is how much this ‘noise’ is translating into business for the smaller hedge boutiques.
Hughes at Baring remains sceptical whether some of the theoretical advantages of hedge funds can be delivered to pension schemes.
“Firstly, I think it is a genuine mistake to assume that returns from hedge funds are normally distributed and that you can do a normal mean risk analysis. In fact, the returns are heavily skewed.
“Secondly, I think that the portions being recommended to hedge funds are too low to have the sort of impact that many suggest you need to take the risk/return trade-off down the curve.
“Thirdly, you have to ask if the skill set is there. Hedge funds have come in relatively quickly. If the skill set has not developed at the same pace as the fashion there is the scope for making mistakes.”
Nonetheless, larger fund management houses are sitting up and taking notice. Morley Fund Management has made overtures in this direction with the recent appointment of former Dexia head of asset management, Phillip Manduca, to run its fledgling alternative investments arm.
Michael Le May, deputy CEO and managing director, Europe, at Morley, comments: “We believe hedge funds are here to stay, but we see this going very much down the fund of funds route. It is certainly now part of an overall fund management offering that I believe is figuring on the consultant lists in recommending managers.”
Another hedge fund bull is Macintyre at Deutsche: “In the UK pension funds are unsure at the moment and are much more likely to move down an optimisation framework looking at how to integrate hedge funds into asset allocation – whether as a stand-alone structure or part of their fixed-income and equity strategies.
“I know though that the trigger is about to be pulled and that there will be significant schemes moving into hedge funds. Increasingly, you may even have those products integrated into more mainstream offerings in fund management houses.”
The ‘if you can’t beat them, join them’ approach could define the top-tier of the UK fund management industry going forward, as the larger players strive to offer the whole product range to the market – alternatives and all.
Step back from the leading edge of pension fund strategies, however, and the reality of the UK pensions market is still a huge number of smaller schemes investing in balanced and pooled funds, or looking for a one-stop pensions solution.
There is some sense here, however, that the market may be homogenising. As Roads at Fidelity comments: “I think that the distinction between pooled and segregated funds is actually breaking down somewhat, because you’re not getting different investment strategies through pooling and many of the larger segregated clients will be investing in the pools anyway.”
Hunt adds: “We now have a central team really for client servicing, whether it’s pooled or segregated and they work more closely than they ever have before.”
While the multi-manager concept was touted as the one-stop-shop solution for smaller funds, many question whether it has set the market alight. Patrick Disney, managing director at SEI Investments, which has pulled in approximately £250m in institutional assets after 18 months of marketing, is adamant that the message is being heard: “Three years ago pension funds would not have even thought about multi-manager, but now more are prepared to listen. In the UK institutional market, which is pretty hard to get into, I think we have managed to win business fairly quickly. The consultants are getting into it and realise that the implementation is good.”
He cites the recent RFP by Wiltshire County Council, looking solely for multi-managers, as a sign that things are moving in this direction.
Certainly, the shift by consultants towards so-called ‘implemented’ consulting solutions, as well as the proliferation of multi-manager firms in the UK market, suggest sufficient pools of business going forward.
Another area in the UK pensions market where the brouhaha has yet to translate into big business for fund managers has been the defined contribution/stakeholder market.
Few investment managers, despite extravagant claims over the past few years, appear to have found the access codes to a market where brand recognition keeps the large life companies in the driving seat.
Question marks remain, however, over life insurance investment capabilities. As a result, investment managers are now hoping to play a longer game.
As younger, less risk-averse investors join the stakeholder market, asset managers see their future role in providing more lucrative retail funds to ‘open-architecture’ life company/fund management structures.
Amid the flux in the UK pensions industry then, one of the overarching questions is what shape the UK fund management industry will take in the next few years.
Around five years ago, Goldman Sachs made its ‘hourglass’ prediction that a few giant investment houses would have the capacity to dominate pensions markets, with medium-sized players squeezed and specialist firms/hedge funds feeding off the floating niche business.
When the report came out, large financial groups were looking at fund management as their ‘nirvana’ in terms of revenue. The change of tack has been breathtaking. Come the market downturn and it hasn’t taken long for some to see asset management as a bit of a liability.
The Myners report, with its exposé of soft commissions and transaction costs, has pushed many houses to beef up in-house research teams – adding to the cost base.
Similarly, increasing governance expenses, as well as burgeoning staff retention costs to avoid the brain-drain that has plagued some firms in the past 12 months, have meant that asset management is not for the faint-hearted parent.
Consequently, the new mantra for fund managers is not so much size as ‘specialisation’ or ‘competitive advantage’.
Disney at SEI comments on how he sees the fallout of this business re-evaluation. “A few years back the fund management industry was based on groups wanting to be all things to all men. This is no longer the case. Today there seems to be no reason why mid-sized fund management companies cannot, for example, set themselves up as distributors only.
“The Goldman Sachs report came out in an era where asset managers were asking themselves how they could ‘do’ asset management. Now they are asking themselves ‘what’ they should be doing. Specialists are coming out of the woodwork across the board as the market follows the US model and people in the industry look to exploit their entrepreneurial spirit.”
Some managers, however, question whether specialisation will markedly remould the UK fund management scene.
David Hughson, deputy chief executive of Royal London Asset Management (RLAM) – an amalgamation of four asset management firms – is putting in place the changes that the firm hopes will bed it back down in the market. He says the firm’s product range will be in the traditional defensive sectors of fixed-income, property and cash management.
“Our heritage from the life sector means that we are no flash Harrys and we come over as fairly lean and mean in our cost structure.
“How many managers have actually shut down business completely in the last five years? I believe that the crumbs that the large players leave behind in this market will still be tasty morsels for the smaller players.”
Angell at Schroders captures the new ‘paradigm’: “As a business we are not explicitly chasing assets under management. Our focus must be to manage existing portfolios as well as possible and perform for our clients. That will, I’m sure, attract business, but our aim is not to be a trillion-dollar manager – it’s about performance and profit.”
Hughes at Baring adds: “For many houses the last few years have been very challenging. The result of that is that they will have to examine where their competitive advantage lies.
“An equally important issue is business diversification. We have our fund administration business, which is a source of far less volatile revenue.
“You need this because I don’t think that we are going to see the kinds of profits over the next five to 10 years that the industry demands.”
Where profits are called into question it surely follows that remedial action will have to follow for some houses – be that buying, selling or merging.
Peter Arthur, managing director for retail and institutional business at Friends Ivory & Sime (FIS), managing some £70bn in UK institutional money after its recent acquisition of with Royal & Sun Alliance Asset Management, believes the upshot will be that there are just too many players in the market to be able to stay profitable.
“I would say that if you are trying to be a serious player in this market then anything south off $100bn under management would make it difficult to compete.
“I wouldn’t be surprised at a quarter to a third reduction in the number of players in the market.”
The scramble then for that ‘competitive advantage’ in the UK fund management market-place is under way. It looks as if the next 18 months could be as much of a watershed for fund managers as the past 18 months have been for pension funds.