Widening the net
Unpasteurised cheeses are becoming ever more popular in the UK on account of their more complex flavour – a flavour which becomes still more complex as the cheese matures. The sophistication of tastes is presenting new challenges - and thereby opportunities - to many a UK cheese manufacturer. Especially the more mainstream ones.
Such is the UK pension market. As many of the UK’s pension funds have closed their defined benefit (DB) schemes to new members, so new challenges have emerged for asset managers and consultants alike, namely to manage the existing DB liability which accounts for by far the largest portion of overall pension assets.
But while the market becomes more tangy some managers have become distinctly crumbly.
“The major task for trustees is that schemes are maturing so needs are going to change,” says Andrew Kirton, head of Mercer’s UK investment consulting practice based in London. “There is a move to liability driven investing (LDI) with more interest in sophisticated bond products that match the fund’s cash-flow characteristics more closely.”
Not only are DB funds maturing, but there are also many that are still in deficit. “The bigger the deficit the less bonds can be used to bridge it,” says Andrew Dyson, head of institutional business at the London office of Merrill Lynch IM. “Traditionally investors issued mandates requiring benchmark plus 0.5-1% using traditional sterling bonds. These days funds are seeking returns of 2-3% above the benchmark. A lot of mandates are stretching bond management too far; other techniques like combinng higher return assets with swaps should be considered.”
So how is the market placed to meet the new challenges and opportunities? Arno Kitts is director of institutional business at Henderson Global Investors in London. “UK players are well placed to match cash flows given their experience with insurance clients,” he says.
Helen McGill, head of product at Aegon in Edinburgh notes: “LDI is not a new concept, as pension schemes have been choosing their assets to match their liability profiles for years. The products we’re seeing today are just approaching it from a different angle, taking advantage of the opportunities in the derivative market to make the connection more transparent.”
The challenge for UK managers is that there are various forms of LDI. The traditional form is full matching of liabilities, which focuses on interest rate risk. But as the industry woke up to the costliness of a pure-bond interest strategy aimed at eliminating interest rate risk, it realised the importance of addressing other forms of risk such as wage inflation and longevity. As a result new ‘broad’ forms of LDI emerged, designed to address these additional risks. “Clients want return so they are looking more widely at bond assets, for example global corporate bonds, emerging market bonds and CDOs,” says Anthony Ashton, investment consultant at Hewitt’s London office. “This is not the traditional home of UK asset managers which specialise in gilts and following interest rates.”
Rick Lacaille is CIO at State Street Global Advisors in London: “LDI is more than alpha generation,” he says. “It is about financial engineering - understanding the assets and liabilities - using inflation-linked securities, derivatives as well as asset allocation overlay. Looking for these skills among narrowly focused UK houses is not easy.”
US managers on the other hand, are known for their breadth of expertise in fixed income products. But they have not prioritised the UK market, as Donald Hay, director of institutional business development at Edinburgh-based Martin Currie Investment Management explains: “For a long time US players missed out because they saw the UK market as a low-margin investment grade market,” he says. “But as people wake up to liability-driven investing, US bond managers have been coming up with sophisticated bond products.”
But US managers have not drawn on their home market for inspiration, as Lacaille explains: “US fixed income managers have been successful because of their alpha skills, not their financial engineering abilities. So financial engineering has not been imported – it has been grown in Europe.”
There is still some way to go in terms of take-up of the more complex form of LDI. “Many trustees and their advisers are some way from taking the plunge into this pool,” says Stephen Acheson, head of UK business at Edinburgh-based Standard Life Investments. “However there is some interest in straight cashflow matching and mandates are being awarded. Moving firmly into the LDI space will require trustees to take a genuinely longer-term investment perspective when awarding LDI mandates of say five to 10 years. This will require a big leap of faith.”
Lacaille quantifies the slow start of the complex LDI option: “I would be surprised if it was worth more than £10bn (e15bn) out of the total £600bn UK pension fund assets. Only the larger players that have plenty of resources have really taken LDI seriously.”
Size of investor makes a difference in terms a the transition of a pension fund to LDI. “Some larger funds are putting their toe in the water,” says Nigel Taylor, head of institutional business at UBS in London: “They have specialised structures with five or six managers, and in order to move to LDI they will have to narrow down to around two managers; obviously this cannot be done immediately. On the other hand many of the medium sized £100-200m funds have converted to LDI fully. They might have had two managers to start with so it would have been easier for them to convert. Smaller funds may find it difficult to allocate the resource needed to consider this option.”
For many pension funds the prospect of a move to LDI is daunting indeed. “A tricky but persistent obstacle to LDI is the feeling that funds have that they are getting into another market and that there will be a timing mistake,” Lacaille explains.
This is not helped by the fact that at present the UK has lowest real yield of any long-term bond market, despite it not being obvious that the UK represents the lowest risk. “So with real yields at 1.6% pension funds are reluctant,” Lacaille continues. “The consensus on the long-term strategy for pension funds is contradicted by the strong tactical view in the UK, namely can they afford it given that if they buy at that yield costs will be higher.”
The drive to LDI will also influence indexation management. “We are likely to see a polarisation of managers who are paid to deliver alpha in an unconstrained way and indexation managers who deliver low cost market exposure,” explains Richard Hannam, head of global structured products group at State Street Global Advisors. “Until now, actrive managers, with performance measured relative to a benchmark, have needed to focus on both generating alpha and controlling risk relative to the benchmark. This has left managers constrained in their ability to add value and investors paying higher management fees for market exposure which could be delivered more cheaply and effectively by a passive manager.”
The drive for more return is encouraging funds to pay less attention to the benchmark. Kirton notes: “Now more pension funds are willing to take greater risk and invest in a more unconstrained way. So a lot of managers are examining their key areas of skill and deciding whether they should be in this or that field. So there is more pressure on active managers to perform.”
Kitts provides examples of the unconstrained investing: “DB schemes will move into real estate and private equity – these are obvious diversifiers in a low return environment, and in a DB context. We also think that their returns will be higher than equities.”
However, constraints remain, and one is the necessity for speed in identifying the best managers, and this has become more urgent with the growth of specialised mandates. “It is a challenge for consultants to research new names before the product closes,” says Hay. “This is why multi-managers are making inroads.”
Part of the reason for the significant move to specialised mandates is that investors have identified a need for more control. And yet balanced mandates seem to be making a comeback. “It seems that many investors have not got the skill that it takes to make the asset allocation decision,” says Alan Borrows, chief investment director at Liverpool-based Midas Capital, which specialises in balanced management.
Traditionally equities have accounted for 75-80% of pension fund investment portfolios, and of that UK equities have formed the largest part. “The problem with this is that the UK index is becoming concentrated with about 50% of the index in 10 stocks, which increases risk to uncomfortable levels,” says Ashton.
So what role should UK equities play in portfolios in the future? “UK as a subset of a pan-European portfolio makes sense,” says Lacaille. “Without it there would not be enough pharmaceutical, oil and smaller exploration companies and banks. We are seeing more pan-European mandates generally – in our UK pension business, for example. Most of our UK pension fund clients would back a UK equity exposure of 50% of total equities and I could easily see this falling to 30%. And this puts more emphasis on currency management.”
The currency risk is the sticking point. Borrows is more conservative: “The trend towards more global equities will continue but I would be surprised if the UK proportion fell much below 50% on account of currency issues,” he says.
But funds should guard against moving money into US equities. Borrows continues: “Typically the US market gives very little yield; it is not in the psyche of US companies to pay a dividend. But income is very important to funds with a growing amount of benefits in payment.”
Sometimes the comfort factor reigns supreme. Andy Frepp, director of sales and marketing at Edinburgh-based Scottish Widows Investment Partnership notes: “I agree with the theory of increasing the proportion of global equities,” he says. “But as well as the currency risk there is the psychological home country bias – irrespective of the logic. Some institutions think like this.”
Specialist equities managers are acquiring a growing proportion of the UK equities business. “The key reasons are capacity,” says Hay. “One of the understated problems is that it is very difficult to be an active UK equities manager when you are managing £10bn because you have to take such large shares in the individual companies which makes it difficult to get in and out of the market.”
However, Frepp is concerned about UK equity management capacity in general. “We are not seeing as many good UK equities houses as there has been a drain of personnel to hedge funds,” he says.
Hedge funds continue to attract interest while equities markets remain unpredictable and returns low. But uptake remains sluggish. “There is a low level of manager interest in hedge funds due to the high level of fees, low transparency and general cynicism regarding performance,” Hay notes. “But the outlook is promising as clients look for return-seeking instruments.”
The concern about performance has potential long-term implications. “There is growing interest in hedge funds but some are nervous about how sustainable a hedge fund investment will be,” says Dyson. “The question is, are the recent blips in hedge fund fortunes just blips? If clients think that hedge fund performance over the next 10 years will match that of the last 10 years they will be disappointed.”
Kirton shares the concern and asks: “Given the weight of money involved will funds of hedge funds provide the performance that they market? We wouldn’t be surprised to see moderate returns versus high pricing, so there is a good case for pricing to come down over the next two years.”
This is good news for Borrows at Midas Capital: “We do not have the resources to do the necessary due diligence on hedge funds so we use fund of funds despite the second level of charges which we believe is justified given the level of due dililgence required.”
And the problem does not lie only with funds of funds as Robert Harris, portfolio manager at London-based Majedie AM notes: “Hedge funds charge high base fees; those that can justify this are closed.”
Hedge funds’ progress in the market is also constrained by consultant capacity. “There are only a few investors in hedge funds which makes it manageable because it is easier to find five above average funds than 50 above average funds,” says Ashton.
Hay points to the problem of staff retention: “Consultants are handicapped because whenever they tried to develop a hedge fund capability their experienced funds of funds people leave”.
But things may be on the mend. “Consultants have thrown money at researching hedge funds over the last 12 - 18 months, so there is no longer a resource issue,” says Taylor.
So in this consultant-driven UK market it may be reasonable to assume that interest in hedge funds may be set to increase significantly.
The challenge of maintaining a skill base has also contributed to the fragmentation of the market. “There are more opportunities for boutiques as pension funds cast the net more widely to find managers,” explains Ashton. “While there is still some brand value in the big firms this has diminished; historically these providers had problems of performance and staff retention, and this has shaken investor confidence. So now investors are looking more widely and trying new names. This trend continues.”
Acheson sheds further light: “There has been a bit of a shake-up over the last ten years or so. Many of the major houses, eg Merrill Lynch, Gartmore, Deutsche and Schroders all had problems at one point or another over the period and this created opportunities for new players.”
The demand for performance has been instrumental, as Gillie Tomlinson of Artemis points out: “Against a backdrop of underperforming balanced houses, the continuing move to specialisation and the increased demand for high performance mandates, there is now the appetite for proven active (and outperforming) asset managers.”
Boutiques are keen to highlight the fact that equity participation gives them a key advantage in the area of staff retention. James de Uphaugh, Majedie AM’s managing director, refers to the “run of the mill musical chairs of the larger players”.
Borrows shares the optimism: “Seven or eight years ago it would have been impossible for a boutique to get onto a consultant list without a three-year track record. Now they just have to prove investment process.”
Consultants vary in terms of their receptiveness to boutiques. “The smaller consultants are very happy to deal with us,” Borrows continues. “But some of the larger consultancies are less willing to give the smaller operators a chance. They have the resources but there is a a reputational issue: they are less ready to take the risk.”
There are drawbacks to the boutique model, as Taylor explains. “If a boutique loses a couple of people it is finished.”
He adds: “Furthermore they don’t have the resources to withstand difficult market conditions. When the market is doing well boutiques become popular but when there is nervousness in the market as there was regarding the war in Iraq, people will look at managers’ credit ratings and ask how well resourced they are.”
As the low return environment persists so the debate about fees intensifies. “Managers have been risk averse and have hugged the benchmark but have charged active fees,” says Kirton. “If they do this for much longer they will lose the business anyway.”
Performance-related fees also have their limitations for managers, especially given the increasing use of fixed income products in client portfolios. “Behind the new fixed income there is a lot of risk for us due to the expenditure on technology,” says Lacaille. “We need a higher base fee as a reward for the intellectual content.”
More clients are looking for performance-related fees on bonds but because fees are low relative to equity mandates it is difficult to generate more fees through performance. Louise Kay, head of UK institutional business at Aegon in Edinburgh notes: “New clients are asking for it – there is an element of fashion here.”
She adds: “Clients are increasingly asking for performance fees – this is defensive positioning.”
Meanwhile Hewitt’s Ashton takes a very different line: “The move to specialised mandates has enabled managers to ramp up fees by moving clients on to higher value added products.”
But performance fees bring risks for managers, as Acheson points out: “If too much business is run on a performance fee basis cash flows can become too volatile for comfort. So from a stability of earnings perspective it is not good to have too much business on performance-related terms.”
In spite of the fact that the growth in the use of performance fees is partly trustee-driven, in practice the learning curve for trustees is steep. “Trustees simply think that they will have to pay more for a given level of performance,” says Hay. “They don’t think of the value of this. They underestimate how hard it is to generate alpha and underestimate the risk of not generating alpha. Trustees look too much at the best performing managers and asset classes even though we know that historical performance is not an indicator of the future.”
Trustees’ frustration is part of the reason for a steady increase in the use of performance-related fees. But as with any new concept in this industry, it is, in the main, the larger funds that have the resources to deal with it. “Our client base would not be receptive to performance fees – they are suspicious of the complexity,” says Borrows. “Predominantly it consists of funds of between £2-20m, so they tend to be fairly conservative and are unlikely to step outside the box.”
The capacity of trustees to manage funds efficiently remains an issue. “The pace at which regulations develop requires a lot of expertise,” says Kitts. “But we do get frustrated from time to time by the lack of engagement of some pension funds. More engagement would be good for everyone.”
Clearly trustee knowledge places limitations on market efficiency. “Trustees are educated in terms of trends but to sell business in to them is an issue,” says Ashton. “Repeatedly it is the good communicators who win, rather than those that have the best offering.”
Lacaille agrees but sounds a note of optimism. “It is changing in that there is more involvement from the management of the sponsoring companies. They have been more effective educators of trustees than the orthodox framework of consultant training. FRS17 is driving this.”
But with the trustees on a steep learning curve can we really expect them to be on top of every new product? “Trustees get a bad rap,” says Taylor. “If managers are coming up with new products and capabilities it is their job to communicate.”
He adds: “Some consultants are frustrated but we have not had this problem. We had to work very hard on ways to communicate on subjects like derivatives where the perception is that they are risky but the reality is that they control risk.”
Taylor refers to a recent investment conference held by the National Association of Pension Funds where fund managers and consultants were criticised for using too much jargon. “We could expect them to do a better job,” he says.
But it’s not just a problem of jargon, as Lacaille explains: “I can feel sympathy for trustees who have had several versions of the truth over the past 20 years. For example, they hear that there is no link between equities and inflation, and no link between equities and liabilities. This also undermines confidence in the professional advice.”
Which just about takes the biscuit. Little wonder that trustees are feeling cheesed off.