Ask most analysts in the estimated £800bn (e1,230bn) UK institutional investment management industry how they see the market today and they will tell you the same thing – it has never looked so open.
The reasons behind the loosening of the traditional collar of the asset management scene away from the large UK balanced managers are as em-blematic of a cultural shift as the headline-grabbing underperformance of recent years.
First, government intervention on pension funding issues – following the Maxwell affair and the pensions mis-selling fiasco – through initiatives to boost public confidence such as the minimum funding requirement (MFR) and the recently promoted statement of investment principles (SIP) has obliged retirement schemes to examine their investment approach closely. UK funds are also rapidly maturing – partly as a knock-on effect of the government pensions opt-out programme in the 1980s, which inadvertently pushed age ratios upward.
Although these issues may have shifted the goalposts slightly in the UK market, bad form from traditionally reliable players alongside a tactical switch by pension plans in their manager selection have really changed the name of the UK investment game.
And though there may be very few new defined benefit pension schemes appearing in the market the amount of money moving around is “colossal”, according to one fund manager.
The unmistakable recent trend in the UK pension fund market has been the shift towards indexed investment, allied with a satellite specialist ap-proach. In the past three years alone, institutional market share for the indexers has risen from around 15% to about 25%.
MFR and SIP have focused trustees’ minds on exact asset/liability needs of funds, with the move clearly away from peer group benchmarking and the notion of selecting two or three balanced managers for a scheme’s assets.
Unsurprisingly, combined with the continued bull market, these factors have swung pension funds towards the notion of safety and strong returns indexers have offered, at a time when their active counterparts have struggled to outperform and justify fees.
Significantly, with more than just a hint of bad timing, the performance problem has been particularly acute for the UK’s large balanced management houses – the ‘big four’. Their previously unassailable hold on the market has been rudely contested following a flood of lost business.
Investment strategy criticisms of the big four range from drastic underweighting of the US to overweighting in small caps, industrials and the Far East at a time when large caps and technology stocks have been fuelling the market. In the case of Phillips & Drew, its dogged pursual of a value strategy next to the soaring growth of the US economy has been questioned. And Mercury Asset Management (MAM) has attracted client complaints over dispersion that saw portfolios within the same house produce markedly different results.
Kanesh Lakani, head of marketing at State Street Global Advisors (SSGA), currently managing $20bn of UK pension money, sums up the situation: “The big four began tending to control business risk rather than investment risk and on the investment side became quasi-indexers because they were investing in every sector, which severely blunted performance.”
Charles Farquharson, chief operations officer at MAM’s UK institutional division, concedes the company did have to tighten its ship somewhat following a downturn in performance in 1997. “We have implemented changes to sharpen up our decision making processes, such as improving the linkage between research and portfolio construction, as well as tackling the dispersion around client performance - but these changes have not been unique to Mercury.”
Andy Carter, head of UK institutional equities at Gartmore, with assets of £52.4bn, agrees that the large houses were caught napping. “It has been easy talking up the passive/specialist argument in the last two to three years looking at performance, but I certainly don’t see the whole market going this way.
“There are pros and cons on either side of the debate, and for many funds a balanced approach has been perfectly appropriate. We have lost business though, which has led to root-and-branch changes. Research has been separated from portfolio construction and we have settled on an unexpected earnings growth ap-proach to investment, which is now uniform across the company. The results are already showing and in the last year performance in UK equities was the best we’d had for a long time.”
Consequently, other managers have seen a golden opportunity to exploit the misfortune of their larger rivals.
Chris Walker, director at Hill Samuel Asset Management, with £40bn institutional assets under management, comments: “There is a very real feeling these days that the fight for UK pension fund business is on. We are aggressively pursuing mandates that the big houses are losing and have already won more active money this year than in the whole of last year.
“We’re seeing more UK bond mandates and are increasingly getting short-listed for balanced briefs. We have the track record to prove model portfolios can deliver better performance and tighter returns, especially compared to houses with a lot of managers doing their own things.”
Roger Hunt, director of institutional marketing at AMP-owned Henderson Investors, with £38bn of UK institutional assets under management, adds: “I believe this kind of change is good for the market, and obviously it creates competitive op-portunities which a few years ago in the UK would have been hard to find. The one manager good at everything statement just defies logic today and I’m all for managers being selected for what they really are good at.”
Rod Hearns, executive director at Pictet Asset Management UK, set up in 1980 and running just under £1bn for 20 UK clients, says the competitive dispersion is also benefiting less established specialist managers coming into the market. “A critical influence, I feel, has been the consultants. It’s fashionable to knock them, but they have pushed specialist mandates for some time now, and are very professional in their manager research.
“We’re getting the name awareness over here that we have in Europe, and on a Europe-wide basis we can deliver on both the active and passive sides, which I think puts us in a strong future position.”
And niche players, such as Brighton-based top-down stock picker Pavilion Asset Management, say they are finding it easier to attract consultant attention. Pavilion manages around £800m for UK institutionals, but with ethical investment portfolios on the books and top decile performance for UK equities, according to WM figures. Chris Edge, chief executive at Pavilion, comments: “You have to knock hard on the door to begin with, and I do feel consultants should be talking to a wider variety of managers, but they are listening now to our arguments.”
The UK investment consultancy market remains the domain of the larger entities, but boutiques are holding their own. Companies such as Hymans Robertson enjoy a niche among UK local authorities.
Danny Vassiliades, senior consultant at consulting actuary Punter Southall and Co, comments: “It would be difficult to break the hold of the large groups at the top end, but we are successfully winning new business from lower and mid-range funds, offering the same services but with greater scope for attention on scheme administration and more personal servicing of clients.”
However, the indexers in the UK have had the most to shout about in recent years. Barclays Global In-vestors (BGI), with UK assets under management of just over £20bn active and £67bn passive, picked up a further £15.3bn of indexed money in 1998. And SSGA attributes much of its 50% asset increase for the year to indexed briefs.
However, BGI says it is also increasingly looking to attract active business via its quant with rationale and attribution products. Lindsay Tomlinson, chief executive, Europe, explains: “Obviously we have enjoyed considerable passive success, with the core/ satellite investment strategy becoming more prevalent in an increasingly risk-conscious UK pension fund market. But the market is still substantially in the hands of balanced managers, and we believe they will have to prune back their business in the light of re-cent troubles, so we see scope for picking up more active mandates here.”
Much has also been made in the UK of the debate about the so-called passive ‘ceiling’ effect, at which index investment is purported to render markets inefficient, leaving outperformance opportunities for active managers. Tomlinson responds: “I believe we could see 60% levels with little of the mooted effects. And the fact is that the overall UK securities market is only around 10% indexed at the moment with 22% of institutional assets tracking indices – so there is scaremongering around. In the US the figure is over the mythical 30% rate and still rising without problems.”
However, the consultants are attracting criticism from some larger houses, which see the specialist route as part of a consultant business boon.
Carter at Gartmore comments: “In my opinion traditional balanced management is not favourable for the consultants and, in the light of bad performance and a shift towards a US-style specialist approach by the market, they have seen the opportunity to switch manager recommendations.
Other UK managers believe there is an issue here concerning the consultants - which they say created the ‘big four’ in the first place - no longer wanting the risk of being linked to just four managers. The core/satellite approach with fund-specific benchmarks, which seems to be the trend at present, may also lead to comparison problems, making it difficult to tell whether you’ve had good advice or not, they point out.
MAM’s Farquharson says he has also seen no empirical evidence that core/ satellite investment will outperform a combination of balanced managers and other available product areas. In the US the proliferation of specialist managers for funds is now coming back the other way. The switching is costly and the monitoring is costly so there are also disadvantages to having a range of managers.
The cultural trend in the UK to-wards core/satellite has also crystal-lised the arguments on both sides of the active/passive debate, and the time certainly seems right to try and win the battle of investment minds.
Active managers are hitting back, preying on suggestions of US overvaluation and the feeling that sooner or later the bear will be back – but also with a sense that the long-term argument for active management needs reiterating.
In a recent research paper Phillips & Drew argues the large-cap effect recognised as the stock market driver of recent times is increasingly damaging market efficiency. Noting that the top 50 US companies are trading at premiums of 33% to the next 450 firms, it argues that to justify such valuations these companies would have to grow their earnings at an “implausible” 4% a year above the next group. The “extraordinary overvaluation” of these large caps may have an enormous impact on UK pension funds, the paper says, should valuations begin to unravel.
With much of the flow into index funds coming from institutional in-vestors seeking to avoid underperformance of active manager universes, the outperformance of passive funds, it notes, has turned into a “self-fulfilling prophecy”.
“As index funds outperform they win new business from those active managers underweight in big index stocks. Reinvestment into these companies extends index funds’ out-performance further and encourages more new business,” the paper argues.
The endgame of such a spiral may be a bursting of the large-cap bubble, which will lead to very poor returns by the index and shackle them to the very same vice that was previously their virtue, it concludes.
Hill Samuel’s Walker points out that clients of index trackers should bear in mind that they will not receive the actual index return, because manager charges, duplication errors and costs still have to be hived off. He also concurs on the problem of index distortion as a result of the passive boom, asking what the effect on the underlying business will be. The recently announced inquiry into index changes would have massive implications for index funds, he says. “There are over a dozen stocks where the proposed changes could wipe more than £1bn of their market capitalisation. Index funds will be forced to adjust.”
However, some active houses suggest today’s market environment requires a reevaluation of active management altogether.
One new fund manager on the UK institutional block, Orbitex, believes that active management needs re-claiming from the consensus ap-proach if it is to prove its worth. Robin Geffen, chief investment officer, ex-plains: “Many people consider active management to be anything that is not passive or indexed these days, and a lot of pension fund trustees are a bit disillusioned as a result of the performance they have had through so-called ‘active’ management.
“Our view is that an active manager must add value through asset allocation and stock selection and to date too many managers have used the CAPS median from the previous quarter as their asset allocation starting point, which is a like driving looking in the rear-view mirror. Active managers, in my view, have been holding far too many stocks, particularly those replicating the index to a large extent, so they become quasi-trackers operating on a near-consensus basis.
“We believe you should hold 50 stocks and actively differentiate be-tween markets. If you’re charging active fees you have to be adding value which means outperforming indices as well as peers.
“We feel so strongly about the issue that we are offering performance-related fees for our segregated portfolios, and maybe this is the one way that the whole active question can really be resolved.”
SSGA’s Lakhani, though, feels the argument has yet to be won by either side: “The premise at the moment is that it is a bad time for indexing be-cause of high market valuations, but on the flip side we have seen no conclusive evidence that active managers can do better in bear markets. One of the main arguments for active management is the assumption that it can time market turning points, peaks and troughs.
“In reality, though, it is re-definition time for active asset management. Stock selection and asset allocation decisions are the issues, and managers must stick by them to justify their fees.”
Steve Wiltshire, director of research at consultant Frank Russell, believes the current competition has certainly focused managers on core business strategies and methodology. “Perhaps some of the larger managers felt they didn’t need to reinvent themselves when business was safe. But everybody knows what the game is now and the big players are seriously seeking to win back lost mandates.
“Overall, investment techniques are taking on a US hue, with earnings revised equity strategies and advanced quant techniques coming to the fore. Greater focus is going on risk control, partly due to the pensions environment and partly because of buy-ins by US houses, such as the Merrill Lynch/Mercury union.”
Wiltshire says there is high-profile anecdotal evidence that pension funds are buying into the specialist approach, but says he is not seeing this so strongly yet in documented buying patterns by funds. “I believe this will come through spectacularly at some point. At present 70% of all assets are still balanced, but I believe this could fall to around 50%, although I don’t see it going any lower than that in the next 10 years.”
Significantly though, he says he is seeing less manager selection solely on past performance and name recognition: “It just wasn’t healthy previously, because the ability of managers to outperform in the future in terms of retaining investment teams and company stimulation factors were not getting sufficient priority. Spurious due diligence on behalf of pension funds was having a real economic impact in fund value loss that ultimately affected the beneficiaries.”
The shift of investment focus to process and not past performance has certainly rallied the cries of the US managers in the market. Anna Roads, director at Fidelity Institutional Asset Management which manages money for 58 UK funds with just under £10bn in assets, says: “Two thirds of the assets are managed in balanced funds, but a third is now run on a specialist basis, and the market is definitely going this way. We feel this de-mands that a manager has fundamentally sound research capabilities and our rigorous bottom-up stock selection is low risk and comprehensive with no growth or value preference. Size helps, and our pan-European/ global equity research is very thorough, which appeals to consultants when recommending managers for mandates these days.”
Similarly, Capital International, which manages $11bn in the UK, be-lieves its consolidated bottom-up value with growth characteristics portfolios, with normal holdings of around 150 stocks and the emphasis on team investment decisions, are attracting good business from larger pension funds on the specialist trail.
“We have set out our investment stall and as a business are content to grow organically,” says James Stewart, senior vice president, director of marketing, at the company. “I think funds are starting to appreciate that as active managers we may underperform from time to time over short-term intervals whilst continuing to outperform in the long term, but that this is the nature of active management.”
And Ian Martin, principal at Morgan Stanley, which has focused its sights firmly on the top bracket of UK institutional business in the past year, believes the issues of size and truly global investment reach are now beginning to define the market. “I wouldn’t be surprised if further down the line we have only around 10 global managers and a raft of niche players defining the asset management industry. In terms of the shape of the UK pension fund industry, I think you’re looking at funds with five or six specialist managers in a US style as be-coming the norm.”
The advent of DC in the UK is obviously territory the US managers know well, although most UK managers purport to having future strategies in place with an eye to administration tie-ups for distribution down the line.
“Obviously as the top US provider,” comments Roads at Fidelity, “we have complete products in place and we have looked carefully at how these should be adapted to the UK market. Market growth has been slightly slower than predicted and the extent of DC is still very much in new schemes. Certainly, there is little retirement philosophy change in established UK plans, but the future dynamics are promising.”
Amidst the furore of investment progress, though, many managers concede that future client relationship and servicing could be the most important issue of all.
Bernard Cazenove, deputy chairman at traditional UK house Cazenove Fund Managers, running around £3bn in UK pension fund assets, says: “It has become one of the prime differentiators between managers. Constant communication with clients and quality relationship management is a fundamental of value added, and we feel this is what has enabled us to hold on to some clients for over 20 years.”
Clearly the future is up for grabs in the UK asset management market, but with many of the variables for success constantly changing.
Suggestions have been made that property could make a comeback as an asset class should it be securitised conveniently for UK pension fund investment. And cash, the often forgotten asset class, has looked interesting for outperformance, with mandates cropping up as a result.
Should the consultants begin to shift from thought to action in money management, à la Frank Russell, the flavour of the UK scene could change again.
And if there’s a lesson to be learned from the UK investment management game, it’s that with a future growth prize of almost £1trn in assets up for grabs, no-one can afford to take their eye off the ball.