Will in-house management come back into fashion?
The concept of ‘investment for the long-term’ is a theme that is currently attracting a great deal of attention. The UK-based Universities Superannuation Scheme (USS) launched a competition last year to stimulate new ideas for that approach, whilst Watson Wyatt announced 10-year mandates as a ‘radical response’ to the issues the pensions industry is facing following the TMT bubble. There is no doubt that the current structure of the pensions industry in the UK has deep-seated structural problems that give rise to behaviour by pension funds that is clearly not in the long-term interests of their members.
The Myners review raised a number of these issues and tried to encourage greater investment in areas such as private equity and a much bigger focus on asset allocation. Most UK pension funds, even with private equity investments of 5-10%, still have less in that whole asset class than they had in one stock, Vodafone, at the height of the TMT boom! The reasons for such irrational behaviour lie in the interactions between the five major players in the pension game: the trustees, the fund managers, the company, the government and finally, the external investment advisers.
Each ultimately, has a different set of objectives and acts in a rational manner to reduce its own risks, which ultimately may have little relevance to the other players. Attempts to invest for the long-term will always be faced with devising mechanisms to align the interests of the players in a way that can achieve a level of stability over long periods. This critically requires an alignment of interests between the trustees, the sponsoring company and the fund managers.
In-house management is one way that can, if structured well, provide a good solution to the competing objectives of the players for very large funds. Staff are employed by the company guaranteeing the pension promise, with a focus on investment performance to meet liabilities rather than beating arbitrary benchmarks to attract more business. They are able to place much greater emphasis on asset allocation whilst retaining the ability to outsource investment mandates to specialists when required for reasons of expertise or cost-effectiveness.
In-house fund management during recent years has often been seen as a second rate option, giving poorer performance compared to the alternative of completely outsourcing all funds to third-party fund managers. The 1990s saw the closure of a number of in-house managers in the UK, whilst the same handful of third-party fund managers were being actively promoted by the major investment consultancies. Corporate management, under pressure to stick to core activities, often saw pension fund management as something very much out of the company’s main areas of expertise. Periods of poor performance often provided the excuse to close down the in-house management and outsource to the external providers. However, it can be argued that following the short-term fashion was the wrong decision in many cases and, in the post-TMT bubble world, it appears that even the performance figures of in-house funds can stand comparison with third party managers.
Performance measurement company WM’s November 2001 research into internally-managed UK pension funds, showed that internal funds had a lower risk profile, with an average tracking error of 1.6% pa. This lower risk was converted into higher average total fund returns. Reviewing returns on a 'net of fees' basis would have further enhanced outperformance and in addition, internal funds had a significantly lower level of trading activity.
Internal fund managers have, in theory at least, the huge advantages of stability and security essential to give confidence to take decisions that may be radically different from a peer group. The best example of this was probably George Ross Gooby, the Imperial Tobacco pension fund manager during the 1950s. He took a large bet in moving into UK equities in a massive switch from the more traditional bonds, and thereby introduced the cult of the equity into institutional investments. He did this without reference to other schemes and without performance comparisons against arbitrary benchmarks.
In today’s world, such a stance would be difficult to maintain even for an in-house scheme and impossible for a third party manager. There appears to be a much greater acceptance and interest in managing investments with absolute return or liability driven benchmarks from entities such as, family offices and private client fund managers, where there is a much closer relationship between the ultimate beneficiaries of the investments and the managers than in the institutional pension fund marketplace. Endowments with their own investment departments, such as Yale, have also led the way in adopting very successful asset allocations that are radically different from the average stance based on a capitalisation weighted approach concentrating mainly on equities and bonds.
Is there a case for resurrecting in-house schemes? There is certainly a case for structures that enable fund managers to have a much closer alignment of interests with the beneficiaries and sponsors; in-house schemes would have this advantage. As the Myners report pointed out, asset allocation is a key function, but responsibility often falls between the different players. External fund managers managing only part of a portfolio are not in a position to take on asset allocation decisions; investment advisers are reluctant to take responsibility for investment decisions they could be sued for, rather than giving advice that need not be acted on, even if in practise, many trustees would prefer following that advice blindly.
Adopting an approach of in-house schemes concentrating on a core expertise and outsourcing specialist funds externally, would appear to be a good pragmatic approach. The schemes could consider a hierarchy of activities. The most important would be to focus on utilising a risk budgeting approach to asset allocation.
Developing in-house expertise in particular market segments may be appropriate, and the WM figures show that trustees need not necessarily fear underperformance relative to independent fund managers. Clearly, incorporating a wider range of asset classes would require expertise in new areas that in-house schemes may find difficult and unrealistic to acquire. Many schemes may also be too small to justify separate management and it is interesting to look at the example of the Dutch based industry schemes as a possible way forward, even for the UK.
A clear strategy, with a much wider range of asset classes, would involve outsourcing many specialist mandates, and there may also be a case for outsourcing a core index or, enhanced index portfolio, to the BGIs of the world who can manage such portfolios at very low cost. Large funds could possibly justify developing expertise in constructing portfolios of hedge funds and private equity funds, thereby avoiding the double set of costs entailed by seeking a fund of funds route.
The interesting question is whether initiatives such as the USS competition will encourage the creation of a new generation of in-house schemes; perhaps some on an industry basis or on a mutual ownership approach to cover asset allocation as well as management of core assets such as fixed interest and global equities. The factor that may mitigate against this arising is the inexorable progress of conversion from defined benefit to defined contribution pension schemes that may be the fashion that companies prefer to follow, rather than improving the effectiveness of defined benefit schemes.
But it also takes a change in mind-set by trustees. Imperial Tobacco again provides a good example. The in-house managers took a strong value stance during the TMT boom that led to significant underperformance. The trustees reacted by closing down the investment team in 1999 and outsourcing. Thus, despite achieving returns that with hindsight were in absolute terms probably attractive, the lack of trust with their own in-house team led to events that arguably left everyone worse off.