Targeting the middle market
Quantitative and qualitative evidence demonstrates that given time a manager’s performance will come around, as will currently unpopular markets, sectors and styles. Unfortunately time is a luxury that plan sponsors of European defined contribution (DC) pension schemes can ill afford. An unexpected downturn in performance against the benchmark will lead to an immediate lack of confidence on the part of scheme members and could trigger a mass exit.
What plan sponsors require, therefore, is an active asset management structure that reduces short-term volatility against the benchmark without a significant increase in costs and without any additional administration on their part.
Multi-manager structures, particularly where they employ active manager selection and combine different investment styles, arguably represent the solution to the problems posed by the traditional single balanced manager approach used by the small to medium sized scheme. Under the sophisticated multi-manager structure described, the provider constructs the portfolio, assumes full responsibility for the tactical asset allocation and implements the strategy by identifying the top managers on a best of breed/best in class basis. Plan sponsors can rest assured that from day one the provider monitors portfolio risk, rebalances asset allocation and carries out performance attribution analysis. When necessary the provider replaces managers with a swift implementation procedure.
So how does this compare with the traditional structure? Historically, plan sponsors dissatisfied with the performance of their fund have found the decision to change the manager is fraught with difficulties. This is partly because the traditional structure is reactionary in nature and partly because the options for the replacement of the manager offer no real long-term solutions.
There are several important issues to consider here – all of which are addressed by the more sophisticated multi-manager structure.
First, by the time the plan sponsor accepts there is a problem with the incumbent manager, considerable damage has already been done. Where a management structure is retained beyond its natural term it will be necessary to rebalance the portfolio, which has inevitably suffered from style drift. The multi-manager structure operates on a proactive basis by identifying problems, nipping style drift in the bud and replacing the manager before the performance begins to suffer.
Second, the problem of poor performance in traditional structures is compounded by the additional loss of returns associated with an inefficient transition to the new management structure. European pension funds are only just beginning to recognise the fact that not all underperformance is caused by poor investment management. Implementation ‘leakage’ can occur where plan sponsors expose the scheme to inappropriate style bias, take too long to replace a poor performing manager, and mis-manage the transition process. These losses cannot themselves be repaired with better asset management.
With professional transition management these charges can be reduced significantly and performance maintained and professionally monitored throughout the transition period. Transition management is a robust product in its own right and forms a vital component of multi-manager structures.
Third, experience demonstrates that where a fund relies on a single balanced manager, there is a very strong likelihood plan sponsors will replace the manager whose performance is just about to improve, and hire the manager whose performance is poised to plummet. As the performance measurer, The WM Company, observed: “Real pain will set in for those funds which appoint a manager at the top of his cycle and remove a manager who then turns performance around.”
Through performance attribution, which requires the careful monitoring of each manager’s buy and sell patterns, the multi manager provider can identify a change in the manager’s expertise and competence. Long before a change in the underlying manager’s abilities is permitted to drag down the performance of the fund, the multi manager provider steps in and implements a replacement.
For this reason, a professional multi manager provider will apply the same detailed monitoring techniques not only to the incumbent managers but also to a range shadow managers. The provider agrees terms in advance with the shadow managers and can bring them on board as soon as a problem is identified. This avoids unnecessary delays and ensures the smooth continuation of the fund’s overall performance.
To summarise, the application of the more sophisticated multi manager asset management structures can help funds achieve:
q Portfolio construction and tactical asset allocation
q Portfolio risk monitoring to provide a level of risk that is fully understood and accepted by the plan sponsors and is commensurate with the scheme’s statement of investment principles.
q Enhanced portfolio transparency.
q A reduction in short term volatility.
q A reduction in the time plan sponsors have to spend on asset management issues.
q Swift implementation of changes in the asset management structure.
There are additional arguments in favour of the clear processes used by the multi manager provider. Regulators responsible for international pension funds – such as the Luxembourg initiative adopted in its Pension Funds Act 1999, which came into law in January 2000, will require providers to demonstrate a high level of security. Regulatory scrutiny of the new SEPCAVs (open ended pensions investment funds) and ASSEPs (pension investment associations) will focus, among other features, on the investment management structures adopted for these plans, and their suitability as a robust long-term investment medium.
Arguably, good investment governance requires plan sponsors to be able to demonstrate that they understand the level of risk to which they expose their fund. They should also have in place an effective investment monitoring process that is proactive in replacing managers whose performance techniques are failing even where the returns themselves continue to look acceptable in the short term.
In practice plan sponsors increasingly are concerned about their personal liability for investment performance. While continental Europe has a tradition of defined benefit (DB) state and occupational schemes, the new private schemes emerging in key markets such as France and Italy, are almost without exception DC.
Under a DC scheme there is no pooling of investment risk as there is with a defined benefit scheme where risk is shared between different categories of members and between members and the employer. To put it rather bluntly, with DC, what you see is what you get and if members don’t like what they see, plan sponsors wonder just how far they themselves can be held responsible. In the US, where defined contribution accounts for about 50% of the pensions market, DC pension scheme members have taken trustees to court over poor performance.
In conclusion, it can be argued that the sophisticated multi manager structure provides the potential for robust long-term performance while simultaneously managing the risks of short-term volatility. For plan sponsors anxious to satisfy their regulators and scheme members that they have taken every possible step to discharge their duty to manage investment risk, these asset management structures will prove far more satisfactory than the traditional balanced managers.
Sohail Jaffer is managing director of Premium Select Lux, based in Luxembourg
Further information: The Financial Times report ‘Competitive Multi-Manager structures’ provides a clear overview of the major players in the UK market and their strategies. Contact Informa Publishing +44 (0) 1206 772 113, email email@example.com or visit the website at www.informafinance.com