Alpha for defaults?
Are defined contribution schemes guilty of making false economies by prioritising cost over quality?
Passive investment in pensions has been steadily growing in popularity and the launch of auto-enrolment last October is accelerating the trend.
Many pension providers offer a pure passive option – and it’s not just confined to institutional investment. Standard Life, for example, has launched a range of Passive Plus Pension Funds that offer investors access to a broad range of assets, including equities, bonds and property, all through tracker funds.
Nor is it confined to the UK. California CalPERS, the second biggest US public pension fund, is considering transferring $255 billion of assets to an all-passive portfolio.
An Evercore Pan Asset white paper released in December, entitled Passive investing for pension fund trustees, pointed out that many defined contribution schemes newly set up to cater for auto-enrolment are targeting annual fees of just 0.5 per cent – nigh-on impossible to achieve with high alpha managers.
“The proportion of active global, US and European fixed income managers who have beaten their benchmarks over the past 15 years is zero,” it says. The paper points to the US experience of exchange traded funds, where they have been well used by pension funds for many years. In Europe, the market has boomed in recent years, expanding from $10.7bn of assets under management in 2002 to $313bn at the end of October 2012.
The Evercore paper found that a diversified portfolio selected purely on the grounds of lowest cost for pension schemes would comprise 58 per cent exchange traded funds, 40 per cent index-tracking funds and 2 per cent cash. The tracking difference of this portfolio in 2011 would have been a positive 0.08 per cent – in other words, it would have just beaten its respective basket of indices – and including all purchase costs would have cost only 0.1 per cent in its first year.
Figures like this, and increasing pressure to keep costs down, beg the question: will there ever be a role for high alpha managers in DC default schemes?
The worry for investors is that when an active manager underperforms a market, high fees erode capital even faster. But even the most cautious pension advisers learn from historical mistakes and, if volatility returns to stock markets this summer, passive management will bear the brunt.
“If the current economic conditions continue, investors will probably experience low growth and high volatility for a while yet,” says Charlie Crole, institutional director at Jupiter, who is a champion of active management.
“This is potentially an unattractive environment in which to be solely invested passively or via low alpha strategies. ‘Low cost’ strategies are of limited value if they deliver little return.”
Mark Jaffray, partner at Hymans, says: “Do managers truly believe passive management is better? Or is it a way to reduce the cost to the member? It is probably both, and also due to the lack of scale in funds under management that any of them currently have.”
Employers and advisers need to be confident that more costly high alpha managers can deliver returns that pay for their charges before they can comfortably recommend them for a default fund.
Ryan Taylor, senior DC investment consultant at Aon Hewitt, says it should be possible to recommend any fund as part of a default solution for a DC plan, as long as it can be clearly demonstrated that the fund will add value to the overall returns for the member.
“This ensures that a combination of the suitability of the fund, the charges and the potential returns are taken into consideration. The obvious difficulty is that you are more likely to know what the ongoing charges are likely to be in the
future, compared to the potential investment returns,” he says.
This adds to the appeal of a passive approach – in a falling market, the smaller charges are easier to stomach.
The Evercore white paper concludes that performance net of all costs is the best guide to investors “as it represents the real return that they would experience”. Using this measure, it concludes that “ETFs are predominantly the best way for us to build and manage diversified portfolios for pension fund trustees, allowing us to deliver sophisticated, dynamic strategies at two-thirds of the cost of leading off-the-shelf diversified growth funds”.
But the smart money knows there are pros and cons to both active and passive approaches. Identifying good high alpha managers is key. If it was possible to identify them beforehand with 100 per cent certainty, there would be no such debate.
“Well advised default funds, however, can load the odds in their favour and gain confidence by judging certain factors,” Crole advises.
“These can include experience, investment discipline and a history of making good strategic investment calls. Choosing a supposedly low-cost passive investment approach is also, in itself, an active decision.”
The argument seems to have polarised into support of either passive or active investment. But Nigel Aston, head of UK defined contribution at State Street Global Advisers, says this oversimplifies matters. “The answer is to work towards a middle ground, where a mix of complementary approaches gives the best balance of cost and reward,” he says. “This can be through tactical and dynamic blending of tracker components or through ‘smart beta’ techniques. The answer seems to be active plus passive, rather than choosing one or the other.”
Crole adds that within such active diversified funds, there is a place for both active and passive decisions, depending on the asset class, region, sector or opportunity.
“Good active asset allocation strategies are very difficult to replicate passively, while conventional active strategies within sovereign bond markets can arguably add only a limited degree of additional alpha. But even in relatively mature markets, such as the UK, there is scope for a good active manager to add value over time.”
Multi-asset fund managers such as David Coombs at Rathbones use this approach in running their retail funds.
Advisers say tracker investments are generally better suited to developed markets, such as Europe and the US, where information on stocks is more readily available, making it harder to beat the market. In emerging markets, funds run by managers may find it easier to find shares with unnoticed potential.
Coombs uses passive investment to hold an allocation to a certain region or sector when he cannot find a compelling active manager.
James Bateman, head of multimanager and multi-asset portfolio management at Fidelity’s Investment Solutions Group, says active management generally makes sense in the equity market.
“Because markets are less efficient and liquidity constraints could mean passive strategies can struggle to fully reflect indices, active investment strategies can add real value in these markets.”
However, he concedes that passive vehicles are the better option for investment in government bonds as it can be difficult to add value.
Taylor says there is already a move in the DC market, both trust and contract, away from an investment strategy purely comprising low cost trackers to include other types of funds, such as diversified growth and absolute return funds.
“These funds often include a combination of passive and active investment strategies and there is no reason why this could not be replicated in an equity or bond phase of a default lifestyle,” he says. “A core holding in passive funds with, say, a 10 to 20 per cent holding in actively managed funds could help minimise the impact on the overall charge while adding value through active management.”
This blended solution is the preferred approach of the Department of Work and Pensions and the Pensions Regulator. They support diversified multi-asset funds, such as Coombs’. In these funds the asset allocation decision is perhaps the most important and is an active decision which cannot be avoided. Simply plumping for passive management can lead to over exposure to certain sectors, such as mining in the FTSE 100. A high exposure to a volatile sector by default, rather than design, does not seem a logical approach to long term retirement planning.
Taylor says an essential element of a blended portfolio would be to construct the investment so that changes could be made when required, for the benefit of all members.
He acknowledges that this can be a challenge under some contract-based structures, though this is gradually changing with more ‘advised employer’ agreements enabling changes to be made to structures without member consent.
But one of the simplest ways to accommodate this is to create a series of blended funds, where each underlying fund manager could be replaced as necessary.
Taylor emphasises the consequent need to review and monitor the actively managed funds or components to ensure they deliver the value expected from them, so there are the costs of this additional governance to be taken into account too.
Aston concludes that bringing down the cost of active management would help to break down barriers to entry.
“If we can agree that most of the upside of a portfolio comes from asset allocation, it seems strange to spend so high a proportion of fees on stock picking. We should be able to get to a point where we offer consumers good value, rather than simply high cost active or low cost passive,” he says.
Crole agrees. He says that pension advisers should not have to chose between cost and performance – all that should drive investment choice is the desire for growth.
“There is some strong support for the contention that passive investing will not produce this in the current environment, over the long term,” he says.
“At the moment, the DC market is immature and growing rapidly. Attention has tended to focus on areas where comparisons can easily be made, such as ‘cost’. Investors are likely to focus increasingly on investment outcomes.
“A challenge for the industry is therefore to provide value-for-money multiasset solutions combining the best of active and passive solutions.”