IPE at 20: Back to 1996 - four moments in pension investing
1996: a year in focus
• Tony Dye of Phillips & Drew says the FTSE 100 is overvalued at 4,000.
• The Dutch government privatises ABP.
• Norway seeds its Petroleum Fund with €5.9bn.
• Goldman Sachs acquires CIN Management and the right to manage the UK coal scheme assets.
Fads and fashions ebb and flow, in the world of pension investment seemingly as much as any other. Balanced management is firmly out of favour. Fiduciary management is in. Yet both represent a different take on the outsourcing of investment decision-making to external parties.
The term outsourcing emerged in the late 1970s in business parlance, probably from the engineering sector as manufacturers engaged external suppliers to take on key processes or activities, particularly non-core ones. Asset managers themselves have for many years outsourced non-core activities, particularly in areas like back office and fund administration. Outsourcing investment activity is tricky for pension funds, not least because investment is a core activity, not a peripheral one.
Value in what?
Fortunes and reputations were about to be won and lost in the run-up to the stockmarket bubble and subsequent crisis in the late 1990s and early 2000s. One prominent value investor whose reputation suffered and who was then vindicated was the late Tony Dye of Phillips & Drew Fund Management (PDFM). In 1996, the year before we published our first issue, Dye argued that the UK large-cap FTSE 100 index was overvalued at 4,000 (it has dipped below this level twice since, in 2002 and 2009).
Along with the likes of Schroders, Mercury and Morgan Grenfell, PDFM dominated the UK institutional investment sector in the 1990s. Balanced management was the favoured approach, only just being supplanted by multi-specialist strategies, which the large consultancies were recommending.
By the end of the 1990s, PDFM was haemorrhaging clients and assets. Dye was right in his thinking that hype-inflated growth stocks were too expensive, but many of his clients did not share his views and pulled assets in the run-up to 2000.
Most commentators go on to say that Dye was wrong in his timing in 1996 when he argued that the FTSE 100 was overvalued, but this is not correct. What he was wrong about was the willingness of pension funds (and his employers) to share his long-term view on markets. Despite their supposed long investment horizon as open defined benefit schemes, many pension fund trustees looked anxiously at the soaring stock indices of the late 1990s and decided they wanted a piece of the action.
The denouement of the Dye saga was itself an irony of market timing. Unwilling to bear investment and reputational loss, PDFM’s parent UBS integrated the entity with its global investment management offering (the core of which was Brinson & Partners, itself an iconic value name under the renowned Gary Brinson) right on the cusp of the market crash. The pension trustees that replaced PDFM with racier growth equity managers mitigated their own career risk by adding to the career risk of Tony Dye.
Three more moments
What is now often termed the value ‘factor’ is perhaps more familiar as a style of investing, as first laid out by Graham and Dodd in the 1930s, focusing on companies with a low price-to-book ratio. And the evolution of value investing – as an active investment style, asset management model and commoditised beta investing approach – is emblematic of the past few decades.
Active, value-based stockpicking approaches now compete with smart beta ETFs and other strategies that isolate the value factor in low-cost form. This has led many to question whether active value equity managers have a long-term future, and some to observe that pension funds might have been better off holding the stock of active value managers rather than their funds.
The proliferation of investment products in recent years means pension funds have more investment opportunities at their disposal than ever before. This choice leads to growing complexity, which has in part prompted the growth in fiduciary outsourcing approaches. More broadly, the march of globalisation in commerce and trade has continued unabated until fairly recently. Pension fund portfolios mirrored the globalisation trend, with the rise of global mandates and diversification in fixed income, equities and alternatives, often outsourced to specialist managers.
Yet equity investment style choices have seemed like second order questions as demographics, market risk and regulation have driven a profound change in the way portfolios are managed. Risk management has achieved first-order status, as seen in the widespread adoption of liability-driven investment approaches focused on interest rate and inflation swaps, particularly in Scandinavia, the Netherlands and the UK. Regulation has been a key driver, as has the maturing of liability profiles.
The 1990s also saw increasing recognition of pension funds as significant pools of capital. Large actuarial surpluses, which were later to prove illusory, were a great temptation for politicians seeking sources of tax revenue (Ruud Lubbers in the Netherlands and Gordon Brown in the UK). It is hard to credit in 2017, but in the late 1990s and very early 2000s there was a vigorous debate about the ownership of pension fund surpluses in defined benefit schemes: did they belong to members in the form of enhanced benefits or to the sponsor? In the Netherlands the threat of taxation in the early 1990s was enough for employers to trim surpluses, while in the UK the removal of the dividend credit for pension funds later in the decade was in part a response to high reported pension surpluses.
The 1990s and early 2000s saw the rise and growth of new pension funds. Indeed, 1996 was the year Norway’s Petroleum Fund was first seeded with a transfer of NOK47.8bn (then the equivalent of €5.9bn) of North Sea oil revenue. Norway’s fund (now known as the Government Pension Fund Global, GPFG) has since become the one of the world’s largest sovereign funds with assets of around €850bn as of early 2017.
In Ireland and France, governments seeded national funds with the proceeds of UMTS licence sales in the early 2000s but these funds have fared less well. Ireland’s government drew down on its fund, now the Ireland Strategic Investment Fund (ISIF), in the aftermath of the financial crisis. ISIF now manages €8.1bn, most of which is invested in key areas such as domestic infrastructure, SME finance, technology and life sciences, with a dual mandate to support the Irish economy as well as making returns for the taxpayer. In France, FRR’s inflows were cut from 2010 and the government plans to draw down on the €36bn fund until 2024 to support the state pension system.
Debt silo to Dutch powerhouse
Our year in focus, 1996, also saw the privatisation of ABP, the vast Dutch government pension scheme. This meant it evolved from government agency to fully-fledged standalone foundation with the same freedom to invest as any Dutch private sector fund. ABP and the Norwegian Petroleum Fund have taken different organisational trajectories but a key thread running through their investment operations has been decisions about whether to build internal resources or to outsource.
Before 1996, ABP was essentially a captive buyer of Dutch government debt, with fixed income totalling some 90% of the portfolio and most of the rest in equities, half local. But ABP’s journey from government debt silo attached to a giant pension scheme to fully-fledged investment powerhouse has involved one of the most fundamental decisions in pension investment management – whether to build internal investment capability or to buy it in.
This remains a key question for pension organisations, large and small, to this day, including Norway’s GPFG. The Norwegian fund has increased its internal investment capabilities over recent years, with external managers now running about 6%. It remains overwhelmingly exposed to equity market risk, with an overall equity allocation of 62.5%.
By the time of an early IPE interview in 1998, ABP was, like hundreds of other pension funds, on the cusp of large-scale asset diversification prompted by the launch of the European single currency the following year. ABP then held about 20% in equities, up from 8% before privatisation. Jean Frijns, ABP’s CEO, told IPE’s founding editor Fennell Betson that the approach would be to manage European and US equities in-house, for instance, with Asia-Pacific and emerging markets strategies outsourced to specialists. Recast as a pension delivery organisation in 2008 under the APG name, it now acts as a standalone fiduciary management and pension servicing company with the ABP scheme as its largest shareholder and client.
As a sizeable institutional investor with an international profile, APG now competes with sovereign wealth funds and sophisticated pension funds across the board for talent and scarce yield-focused investment opportunities in areas like private markets. More recently it has increased internal management to around 70% of equity assets (as reported by APG in 2015).
Goldman Sachs’ 1996 acquisition of CIN Management, which ran the two British Coal pension schemes, meant it took on the right to run 80% of the schemes’ assets for six years. (Cinven, another arm of the former British Coal, has become an established private equity house while CIN Property Management was sold to La Salle, also in 1996.)
Yet, when the contracts expired, the schemes adopted a more orthodox outsourcing route, informed by the core-satellite approach, as advised by Watson Wyatt, Coal Pension Trustees’ then CEO David Morgan told IPE in 2004. This was combined with active governance through an investment risk committee and some delegation to the management arm, but only in areas like stock lending, commission recapture, transaction costs and corporate governance. Barclays Global Investors (since merged with BlackRock) ran a third of the assets in passive equity and bond mandates following the reshuffle while Goldman Sachs retained a low-risk bond mandate.
Since then, the schemes have edged back towards their old model, having increased internal resources with the creation of a new entity called Coal Pension Trustees Investment Services, which was authorised by the then Financial Services Authority in 2011 to provide investment advice and management services to the coal schemes. New staff were subsequently hired to boost investment resources in areas like asset allocation and portfolio construction, but with investment management still outsourced to external managers. Would the coal schemes have been better off following a different trajectory, building up in-house resources from the start? Perhaps, but they would have been swimming against the tide, given the widespread faith in fully outsourced pension investment models in the late 1990s and 2000s.
Tony Dye’s call on the FTSE, the seeding of Norway’s Petroleum Fund, ABP’s privatisation and Goldman Sachs’ purchase of CIN Management all took place within the same 12 months and all reflect different models of pension and investment management. The travails of Dye’s PDFM coincided with the demise of balanced management. The other three entities have had to make mission-critical decisions about outsourcing since the year in question.
In common with other pension funds that outsourced much or all of their investment function in the 1990s or 2000s, including some of the early proponents of fiduciary management in the Netherlands, entities like the UK coal schemes have since sought a balanced median between the extremes of full outsourcing and extensive in-house management.
Building up internal resources, particularly in en vogue areas like private markets, is a slow and expensive game – Canada Pension Plan awarded its former CEO Mark Wiseman direct compensation of C$4.5m (€3.2m) in the fiscal year 2016, only to see him depart for BlackRock. Private markets and infrastructure portfolios take years to build and can result in heavily concentrated direct portfolios.
Dye’s value-management approach ironically embodies many of the characteristics of patient capitalism that are fashionable these days, even if value-equity styles can underperform for years, as they have done recently. Many investment organisations and their professionals still share Dye’s dilemma – that taking a long-term view and outperforming over longer time horizons can be useless if your stakeholders or clients do not share that long-term view.
Just as with many others in real-life business situations, institutional investment professionals and pension trustees are still prone to focus on the short term at inopportune points, while a seemingly opportune long-term strategy can easily prove itself to have been inopportune over time.
Liam Kennedy is editor of Investment & Pensions Europe