An emphasis on diversified investment strategies over the past few years could help guide the UK pension industry through the current volatile financial climate. Gill Wadsworth reports
The financial services industry has experienced dark times over the past year. Not for the first time, involvement in murky investment practices has backfired, leaving participants nursing serious burns and creating a global economic downturn.
However, in the UK, asset managers operating in the institutional space have had a somewhat less arduous task trying to pick a path through the debris of the latest market collapse.
A greater focus on diversified investment strategies since 2000 has better prepared fund managers for extreme market volatility, and there is a general belief that the vast majority of the UK's investment houses can ride out the latest storm.
However, operating in the UK is far from trouble free and the recent economic environment has placed investment practices under the spotlight. There is an increased scrutiny of performance and service levels, and given the trend to diversification, clients expect managers to be able to deliver across an increasing number of disciplines. Add to this the highly competitive environment and the likelihood of consolidation, the operating environment for today's asset managers looks particularly testing.
Among the numerous investment strategies that were created out of a need for better risk management, liability-driven investment (LDI) has been the greatest preoccupation for the UK asset management community.
Trumpeted as the ultimate strategy for managing the UK's beleaguered defined benefit (DB) pension schemes, fund managers have been touring the nation spending time and money training trustees on the merits of better matching assets to liabilities and derisking their portfolios. The emphasis is firmly on risk management and on constructing an investment strategy that better reflects each scheme's unique funding position.
In 2007, just £70bn (€88bn) of the estimated £1.6trn in UK pension fund assets were believed to be run on an LDI basis, but after a lengthy education phase, pension trustees' initial tentative interest in LDI is starting to manifest in tangible mandates. According to research from Fitch Ratings, 41% of pension funds will move to the strategy in the next three years, representing billions of pounds in new mandates. For those fund managers able to demonstrate sound capability in fixed income and derivatives, this should deliver a bumper crop of new business.
Legal & General Investment Management (LGIM), which claims to have the largest LDI team in the UK, is gradually seeing an influx of mandates generated on the back of the firm's matching capabilities.
Mike Craston, managing director for LGIM's corporate pensions division, says: "The whole LDI phenomenon took a while to gain traction; some of these solutions can be quite complicated and it has taken time for trustees to do the necessary diligence to get up to speed with taking risk off the table." He adds: "We are seeing increased interest in the derisking area and more pension funds are moving from talking about LDI to actually implementing solutions."
Insight Investment was able to capitalise on the move to derisking strategies after it restructured its investment platform in 2003 to focus on derivatives and fixed income. It has since secured some high-profile pension fund appointments including an active fixed income mandate with Aggregate Industries earlier this year. Much of its growth has been driven by its performance in fixed income - Insight's UK fixed interest plus fund has returned 5.4% annualised over the 10 years to 31 June 2008, placing it third out of 29 funds in the Mellon Analytical Securities Caps pooled pension fund rankings - but it has also built a solid reputation in derivatives. It recently bolstered its position with the hire of Schroders' derivatives specialist Richard Lloyd as head of structured solutions. Insight now runs £36.5bn in liability matching mandates, the lion's share of which is for clients in the UK.
Other fund managers have been anxious to shore up their derivatives expertise in a bid to prove their worth in asset/liability management. In August, F&C Asset Management hired former Citibank derivatives specialist Jeron Wilbrink to provide "key technical knowledge" to its asset liability management team.
BGI, which was one of the first asset managers to proclaim the benefits of LDI, claims it is also gaining from the growth in derisking strategies. Tarik Ben-Saud, head of liability solutions at BGI, says liability hedging has been "a key driver of assets and new mandates" this year, adding: "We have seen our client base increase from 20 to 100 clients in 24 months across the broad spectrum of UK pension funds."
Current market conditions continue to provide the right environment for managers with demonstrable hedging capabilities. According to Mercer, the average FTSE350 funding position is at 90%, down from 103% in March, suggesting that many pension funds have failed to take advantage of derisking opportunities. The consultant renewed calls for trustees and sponsoring employers to consider inflation and interest rate hedging products.
"Employers should consult with trustees about the investment products available to mitigate the downside risks that equities and inflation impose on their scheme, and therefore on their balance sheet," says Deborah Cooper, principal at Mercer.
However, asset managers must continue to innovate in this area if they are to move on from the basic liability matching strategies that remain based on generic models and assumptions. Ratings agency Fitch says in its report: "The asset management industry faces challenges in its ability to deliver customised solutions beyond generic derivative products, to minimise mismatches of fund liabilities in a cost efficient way."
Derisking is, however, only one element of portfolio management. The need to plug funding gaps and to keep up with rising longevity, means clients and investment consultants have increasingly high expectations from their fund managers when it comes to sources of return.
"If you have a large chunk of assets going to LDI you want the remaining assets to do more for you," says Diane Miller, also a principal at Mercer. "The focus is on the higher return type products." Perhaps, counterintuitively, this search for alpha has seen a growth in business for index managers. As pension funds recognise the need to spend their risk budgets wisely, it has gradually become apparent that some investors are paying active management fees for what amounted to closet indexation. Consequently, there has been a widespread separation of alpha and beta sources, in some cases leading investors to move assets from ‘active' managers over to pure passive mandates.
Ben-Saud says the firm has been steadily increasing passive assets under management. LGIM's Craston adds: "The core index business continues to do well and doesn't appear to have been impacted by volatility in markets. There continues to be a number of active managers whose performance hasn't been good and for some trustees they would prefer a larger part of their core portfolio in indexation. That has helped our business."
The proliferation of absolute return products has also reflected the need to deliver return within a clear risk framework. Hewitt Associates reported that 35% of its manager selections in 2007 were based on these kinds of strategies, while fund managers see absolute return as key to delivering outperformance irrespective of market conditions.
"Bearing in mind what's going on in the market right now, absolute return funds are only going to increase in terms of people's expectations and demands for those products," says Julian Lyne, F&C Asset Management's head of global consultant relations.
But whether fund managers possess the requisite skills to deliver on their absolute return targets remains unclear. S&P has reported that few absolute return fixed income funds have managed to outperform LIBOR and while much of this is attributable to market conditions, it adds: "Absolute return funds continued to show a wide dispersion of results in the past 12 months. Part of this is due to the investment universes, processes and risk limits they use but there was also variation within the same type of funds, reflecting individual managers' decisions."
However, managers claim this patchy performance is not driving clients away, but it is forcing them to be more discerning. Andrew Dyson, head of institutional business at BlackRock which has returned LIBOR plus 5% from its UK Absolute Alpha fund since inception, says: "Clients are not moving away from absolute return. They are sifting through the managers based on who is actually delivering a product that is genuinely absolute return and who isn't. Client appetite for absolute returns isn't any less, if anything it's more."
On the back of such appetite fund managers are set to launch products and increase absolute return innovation. However, S&P warns: "Some [absolute return funds] may use processes that have not been seen before in regulated funds. Thus there will be an increased likelihood of ‘misbuying'."
Coinciding with the explosion in absolute return has been the advent of diversified growth funds (DGFs). Offering a single point of access to a number of asset classes, DGFs have been multi-asset managers' saviour in an increasingly specialised market place. Faced with growing competition from boutique investment houses, large players claim they can deliver diversified portfolios to clients anxious to save their limited governance budgets. Rather than attempting juggle numerous specialist managers across a variety of complex asset classes, DGFs present investors with a relatively straightforward one-stop shop.
But given the persistent question marks over traditional managers' abilities in non-core asset classes, particularly alternatives, providers have been forced to include external funds in their DGFs. "It's going to be an incredibly rare organisation that could claim that any given time that they are the top quartile or above median in all of these asset classes," says Miles O'Connor, head of institutional business at Schroders which has amassed £1.4bn (€1.8bn) in AUM in its diversified growth fund in the two years since inception. "In our vehicle we use other fund managers' products which is an honest acceptance that there are going to be times, styles and asset classes where we do not have a product that runs according to the client's requirement or that has the performance that would warrant inclusion in the portfolio. In those instances we are very comfortable with holding external fund managers."
With so many fund managers jumping on the DGF bandwagon in the past year, the space is becoming crowded and it is hard to differentiate between the products on offer. Each fund manager claims to deliver something different, but with limited track records on which to compare the funds, it will be some years before clients are able separate the wheat from the chaff.
Some fund managers are attempting to differentiate themselves through capability in alternatives. Recognising that pension funds see these asset classes as increasingly important to their portfolios - the National Association of Pension Funds reported that 17% of UK pension plans were investing in hedge funds in 2007, a 9% rise since 2005 - asset managers are keen to demonstrate their skills.
There has been a growth in the number of traditional managers offering bundled alternative products. Capitalising on trustees' limited governance budgets, these funds take responsibility for asset allocations within a suite of alternatives.
Richard Lockwood, head of UK business at Morgan Stanley Investment Management, says: "We don't see the standard diversified growth funds as truly diversified because of the equity component. We offer diversified alternatives and we run all the funds in-house."
For other fund managers, bolstering their position in the alternatives space has meant acquiring boutiques and bringing hedge fund teams under their umbrella. BlackRock acquired alternatives boutique Quellos last year, while Morley (now Aviva Investors) bought a majority stake in ORN Capital Partners in 2006. Resolution Asset Management has a long-term relationship with Cartesian Capital Partners to shore up its place in the alternatives market, and has recently used this expertise to launch a suite of 130/30 funds.
Miller says: "Managers are bringing hedge funds under their umbrellas. They come in as a whole team and are joining to get the economies of scale. The acquirer does need to give a lot of thought to how it is set up but if they do that properly it can work well."
In spite of the moves into specialist management by multi-asset houses, boutiques still account for 13% of the UK's assets under management and of the top 100 UK fund managers, 15 are specialist houses (see figure 1). The survival of boutiques in the UK market hinges on their ability to outstrip multi-asset houses leaving them in a potentially vulnerable position. However, figures from Mellon Analytical Solutions' CAPS pooled pension fund rankings, show that specialists are more than holding their own (see figure 2).
Neptune Fund Management - the top performer for both balanced pooled funds and global equities over the five years to 31 June 2008, returning 14.6% and 25.1% respectively - attributes its outperformance to process rather than its players. However, the investment process is overseen by star fund manager and Neptune founder Robin Geffen, who ensures his equity managers feed from a central bank of research.
"Our performance is about the process," confirms Alistair Wilson, head of Neptune's institutional business. "There is a 17-strong investment team built very carefully by Robin over time. There is a team attitude; the fund managers sit together regularly discussing research to reach a consensus."
Wilson admits that the trend to diversified growth funds has had an impact on business but adds: "Trustees still like to be able to pick their own fund managers across the board and think they can do a better job than picking a single fund management house."
Much of the focus for change in the UK asset management industry has centred on DB schemes, yet the future for the retirement planning sector undoubtedly lies in DC.
Three-quarters of FTSE100 DB plans are now closed to new members and an estimated £1trn of pension assets will shift to DC over the coming decade. Consequently, asset managers without a bundled DC product need to rethink their position in the market sooner rather than later.
Fitch ratings says: "The shift to DC will favour asset managers that are already active players, offering mutual funds and other services targeted to individuals."
Diversified growth funds offer some opportunity for fund managers wishing to get on DC platforms. "Diversified growth funds offer exposure to a wide range of asset classes without huge demands on the individual," adds Mercer's Miller. "They lend themselves well to DC clients and are better than the traditional alternatives that we've had."
Lyne says the F&C is looking at ways of getting its diversified growth fund onto DC platforms: "We are not a bundled DC player so we need to understand what the DC market wants from an investment standpoint and deliver appropriately." Schroders is also looking to use its DGF as a DC product and believes it can capitalise on its existing relationships with more than 570 UK pension funds to gain footholds in the DC market.
While this relatively fast-paced change has been something of an upheaval for UK asset managers, it has accelerated innovation and improved strategic thinking.
The products on offer in 2008 are significantly more sophisticated than as recently as three years ago and although this means more time spent on client education, it should also lead to more efficient portfolio management.
A continued focus on easing the pressure on pension funds' governance budgets and the need for simplicity should be complemented with a desire to deliver products and strategies that do more to solve funding difficulties.
The recent economic turmoil has served as a timely reminder of the fragile nature of the global markets and should spur UK providers on towards creating better strategies that work for more clients.