Pooling has focused minds on cutting investment costs but there is more to generating value than bargain prices up front, reports Charlotte Moore
Controlling investment costs was a key driver of the government’s policy to pool local authority funds. Yet while economies of scale can help schemes reduce investment expenses, there are other ways pooling can create more value for members.
Defining value for a pension scheme is not straightforward. The results of a particular investment strategy will not be known for many years. In the face of uncertainty, it is tempting to use cost as a proxy for value.
That pressure can be particularly acute on the Local Government Pension Scheme (LGPS). Getting investment strategy wrong could at worst oblige local authorities to make additional contributions, potentially resulting in the council cutting services when pressures are already intense.
Local authorities should resist this urge. Rather than race to the bottom, they should think about how pooling could help them improve value for taxpayers and scheme members.
It helps to remember cost is not an indicator of future performance. Fiona Miller, chief operating officer at Border to Coast Pensions Partnership, says: “Our objective is to generate long-term risk-adjusted returns, net of fees. Losing performance is a much bigger risk for us than gaining any fee savings.”
Likewise, Sam Gervaise-Jones, head of client consulting at investment consultancy bfinance, says: “Over time the pools will be judged on their results, not their cost control.”
Focusing on long-term risk-adjusted returns could mean some smaller authorities will see their costs increasing. “Pooling will give smaller funds access to a wider universe of investments, which may well be more expensive,” Mr Gervaise-Jones says.
This gives smaller funds greater access to alternative asset classes but also allows them to create more value from this more expensive asset. Ms Miller says: “Not only can we can reduce cost by using our scale but we can also invest more efficiently by investing directly or using co-investors.”
Our objective is to generate long-term risk-adjusted returns, net of fees. Losing performance is a much bigger risk for us than gaining any fee savings
Build the right structure
Creating value in alternatives does not happen overnight. “If you want to be an investor the market wants to deal with, then you need to have not only scale but also the structure and governance,” Ms Miller says.
For example, infrastructure funds have plenty of sources of capital, which means they can afford to be more selective. According to Ms Miller: “The funds are paying more attention to whether their prospective partners have the necessary governance and decision-making capabilities.”
They want an investor that has a governance structure that allows them to commit to working with particular individuals, matching their pace and making swift decisions.
To invest effectively in the infrastructure market, the pool needs to ensure it has designated the authority to act on investment decisions to specific individuals. It is also vital to get the structure of the fund correct.
Ms Miller says: “We don’t believe a closed-end fund structure will work as it won’t be possible to roll it over each year. The legal documentation also needs to ensure the partner fund’s assets will be protected.”
Tax is an important consideration for investment into alternatives. Ms Miller says: “This asset class is affected by a whole range of different taxes and all these need to be taken into account.”
The tax structure of the overall fund is also important. “If you are managing £40bn, the pool needs the right operating model to give it long-term efficiency,” Ms Miller says.
For example, Border to Coast recognised it needed to have an authorised contractual scheme in place to maximise the tax efficiencies of the pool.
Ms Miller says: “Without this there would not be sufficient tax transparency and significant tax leakage.”
Focus on relationships
Creating value, however, is not just about rational investment and tax decisions. Ms Miller says: “A focus on long-term value is also about paying attention to softer factors.”
A pool can recognise it has to spend up front to save over the longer term.
For example, Border to Coast realised it needed to create the right working environment to attract and retain staff. It decided to locate all the pool’s staff in one office that was easy for existing employees to transfer to. It also had to have access to a major trainline and be located in a vibrant financial services market.
If you want to be an investor the market wants to deal with, then you need to have not only scale but also the structure and governance
Ms Miller says: “While this decision initially slowed us down, we are now finding it is helping us to recruit the right staff.”
One of the aims of this central office location is to create a centre of professionalism. “Our aim is to provide the environment for growth and development which would enable us to train our staff across a range of different asset classes,” Ms Miller says.
Border to Coast’s plan for a central office location is a good example of how pooling can help local authorities create better long-term results for members and sponsors.
Richard Tomlinson, head of investment strategy at Local Pensions Partnership (LLP), says: “The ultimate aim of a professionally run pool is to ensure sponsor contributions are affordable in the future.”
Achieving that target means building teams and organisations that can identify strategies that will create genuine value. Mr Tomlinson says: “Choosing a strategy which is cheap to implement but does not meet those long-term investment goals is a false economy.” Similarly, an expensive strategy might not be worth the fees.
For a pool to act as a responsible fiduciary manager, it needs to have a clear view of its long-term targets. “Then the pool must identify the critical drivers of achieving those goals,” Mr Tomlinson says.
That requires a team with the experience to differentiate between headline and total fees. Mr Tomlinson says: “The costs associated with a fund might not be fully disclosed, so the pool needs staff members who know where to look.”
Achieving long-term value requires more than forensic accountancy skills. Avoiding hubris is vital.
Mr Tomlinson says: “An experienced and professional investor realises this is a 51:49 business.” In other words, many great investors will still only have, at best, a 51:49 win ratio.
It is impossible to pick a manager and expect them to outperform consistently. “The pool needs to ensure it avoids that mistake,” Mr Tomlinson says. This is achieved by carrying out the due diligence to understand the investment in detail, along with its fee structure.
It is also vital to understand what factors will drive investment performance as well as what cause it to suffer. The pool needs to understand what levels of risk it can and cannot tolerate. Mr Tomlinson says: “That will help it to identify the red flags which indicate an investment is no longer working and should be ditched.”
Pools must have the discipline to apply these rules to all investments. “There’s a tendency to forget about small positions in the portfolio because they think the size means its impact will be contained,” Mr Tomlinson says.
The ultimate aim of a professionally run pool is to ensure sponsor contributions are affordable in the future. Choosing a strategy which is cheap to implement but does not meet those long-term investment goals is a false economy
He adds that it is always these small positions that no-one has thought about that will be guaranteed to go wrong.
However, it is important to avoid knee-jerk reactions to short-term lapses in performance. “For example, it does not make sense to fire a manager because they perform badly for a month,” Mr Tomlinson says.
Avoid behavioural bias
To create long-term value, a pool must ensure it does not succumb to behavioural biases which can scupper success. It is too easy to become swayed by an investment story. The ability to avoid things such as loss aversion and doubling down marks the professionals from the amateurs.
Investors that deliver good long-term performance avoid these behavioural traps. Mr Tomlinson says: “They achieve these goals by having a clear view on their objectives and building the necessary processes to achieve those targets.” And they have the discipline to stick to them, he adds.
Each manager and team will develop a system that works for them. “I make sure I have a clear rationale for wanting to pay a fee to manager and for why I want to take on the risk of a particular investment,” Mr Tomlinson says.
As the LGPS is responsible for managing huge pools of capital, these types of processes will become standard. There will have to be governance, process and accountability. “But it’s still important to develop your own long-term goals and systems to ensure the pool can create long-term value,” Mr Tomlinson says.
Ability to customise
Not only will pooling impose a greater focus on long-term goals and processes, it also allows the LGPS to customise investments. Being able to be more specific is another way pools can create long-term value.
Smaller local authority funds had no option to access investments via a pooled or co-mingled fund along with other institutional investors.
Using these structures limits the ability of the local authority to find the perfect investment solution, as it would have to select from a range of off-the-shelf options. It also limits their ability to shape the fund as they are one of a range of investors.
As members of a larger pool, the smaller authorities now have the option to access investments via a segregated account. Nick Samuels, head of manager research at Redington, says: “Greater financial heft makes the asset managers more open to tailoring the investment to the specific requirements of the pool.”
Those adjustments could, for example, include integrating environmental, social and governance (ESG)factors into the investment process. Mr Samuels says: “It could also include a specific tracking error or an adjustment to the alpha the manager is targeting.”
Greater scale helps a pool to get a better deal when it comes to transitioning assets from one strategy to another.
A collective pool of capital can also be deployed quickly into an attractive opportunity
Mr Samuels says: “The managers put a lot of effort into their proposals because of the size of the trades involved.” They provide the scheme with much more information than they would provide to a small local authority.
This greater detail is also available for any new mandate.
“Managers are keen to win large institutional mandates, so they will go the extra mile and provide whatever information is required in the request for pitches,” Mr Samuels says.
That enables the pool to make a better choice. “When the pool is deciding to select its manager, it has a much richer data source so it can make a more informed decision,” Mr Samuels says.
Quicker reaction times
Not only can pools customise their relationship with managers but partner funds can now access more niche or new strategies. Being a first mover has an advantage.
Ajeet Manjrekar, co-head of River and Mercantile Solutions, says: “The first investors often get access at a lower fee and at a better price.”
The pool has the resources to spend the time needed looking for the more specialist opportunities as well as the expertise to understand the risk-reward profile of these investments.
This greater governance capability also allows the partner funds to be nimbler than they would have been as individual schemes. Mr Manjrekar says: “A collective pool of capital can also be deployed quickly into an attractive opportunity.”
A fast reaction time can be equally helpful when the risks outweigh the rewards of an investment strategy.
“When market conditions change, investments can be quickly changed to minimise the damage on the overall performance,” Mr Manjrekar says.
This creates value because even the smallest partner fund can benefit from moving into a new strategy at the right price for the right fee – and equally to cut that investment when needed.