Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.
Back in early December, Aliya Ram of the FT reported, Danish pension fund halves outsourced money:
Denmark’s biggest pension fund has halved the amount of money it outsources to external asset managers over the past two years, arguing that increased scrutiny of costs and transparency has made hiring them untenable.
ATP, which manages DKr806bn (£91bn) for 5m Danish pensioners, used to allocate more than a third of its DKr101bn (£11.4bn) investment assets to external fund managers.
However, Kasper Lorenzen, the chief investment officer, told FTfm that this has halved to 19 per cent since December 2014, a loss of DKr19.3bn (£2.2bn) for the industry.
“Some of these more traditional, old-school mandates, where you hire some asset manager, and then they track a benchmark and try to outperform by 14 basis points . . . we kind of tried to get rid of that,” Mr Lorenzen said.
He added that after the financial crisis investors wanted cheaper options. “I think the main thing is that there is more focus on costs. I think there is more transparency. There are really low-cost implementation vehicles [out] there.”
ATP joins a growing group of asset owners that have pulled money from active managers in favour of cheaper, passively managed funds, or more complicated investments in infrastructure, financial derivatives and property.
The California State Teachers’ Retirement System, the third-largest pension plan in the US, told FTfm in October that it plans to pull around $20bn from its external fund managers. It has already shifted $13bn of its assets in-house over the past year.
Alaska Permanent Fund, which manages $55bn, said this summer that it will retrieve up to half its assets from external managers, while AP2, the Swedish pension scheme, dropped mandates from external managers earlier this year. AP2 has moved more than $6bn from asset managers to internal investment staff over the past three years.
Railpen, the £25bn UK pension scheme, also said last year it had achieved £50m of annual cost savings by cutting the number of external equity managers it worked with from 17 to two, and managing more money internally.
The active industry has come under pressure for failing investors with poor returns and high fees in an era of low interest rates where returns are more difficult to come by.
Last month the UK regulator sharply criticised the industry for charging high fees and generating significant profits despite failing to beat benchmarks.
There is nothing new or surprising about ATP’s decision to significantly cut its traditional external managers. There is a crisis in active management that has roiled the industry and many large institutional investors are bringing assets in-house, especially in the more traditional mandates where they can significantly cut costs and gain the same or better performance.
And it’s not just large pensions that are cutting external managers. Attracta Mooney of the FT reports, CIO of £12bn pension pot threatens to cull external managers:
Chris Rule, the man charged with investing £12bn on behalf of more than 232,000 current and former local authority workers in England, begins his meeting with the Financial Times earlier this month by apologising.
Standing in his office in Southwark in the south of London, he explains the air-conditioning is on the blink. It is a crisp, cold January evening, but Mr Rule’s small office, located in a building that also houses London Fire Brigade’s headquarters, is sweltering. It has been all day.
The building managers are on the case, he says, but for now the only way to cool down is to resort to shirt sleeves and big glasses of cold water.
Mr Rule seems unperturbed, if a little hot. It is hard to imagine that many chief investment officers across London would so easily shrug off such an uncomfortable office environment. But the father of three has other things on his mind, namely the radical overhaul happening across the UK’s local authority pension funds.
In 2015 George Osborne, the chancellor at the time, called on the 89 local authority retirement funds across England and Wales to create six supersized pension pots or “British wealth funds”.
The plan was that these funds would work together to reduce running costs and invest more in infrastructure. Since then, proposals for the formation of eight local authority partnerships have been put forward to the government for approval.
Mr Rule is the chief investment officer of one of these pools: the Local Pensions Partnership, or LPP, which was set up to oversee the combined assets of the London Pensions Fund Authority and the Lancashire County Pension Fund. The two pension schemes’ plans for a partnership predates Mr Osborne’s proposals, but his demands cemented their efforts.
Mr Rule says: “People [across local authorities] have done a lot of heavy lifting over the past 12 months and got the sector massively further forward than many stakeholders or commentators would have believed was possible in that space of time.”
Last month, LPP received the seal of approval from the government, when Marcus Jones, the UK minister for local government, signed off its plans. But the minister flagged some concerns, not least the size of the fund. LPP is short by almost half the £25bn figure Mr Osborne indicated he wanted the pooled funds to manage.
“It is no secret that the minister would like us to be that magic £25bn [in assets]. But it is important to realise that we are up and running; we are live today,” Mr Rule says.
LPP, which began operating in April 2016, is one of the few local authority partnerships that is already functioning. It has also received regulatory approval from the UK’s financial watchdog, unlike the majority of the other local authority pots.
Mr Rule’s job at LPP is highly pressured, especially at a time when record-low interest rates are hurting returns and driving up liabilities for retirement schemes. LPP has been tasked with undertaking the majority of the work that the two local authority funds once did, from asset allocation to pension administration.
The 38-year-old is at pains to stress that LPP has already used its increased scale to reduce costs for its two founding funds, despite falling far short of the desired level of assets.
The partnership has a far bigger allocation to infrastructure than other local authority pools. “At the size we are, we are already getting significant discounts when we are negotiating with third-party managers,” he says.
The former Old Mutual fund manager is now focused on axing asset managers in favour of running more money internally in order to cut costs.
“Our intention is to expand our internal capability, develop new internal strategies and therefore be able to insource more of the assets. That is clearly where we get the greatest fee savings, because we can operate at a much lower cost.”
Last November, LPP launched a £5bn global equity fund, consisting of the pooled cash of the LPFA and LCPF. About 40 per cent of the assets are managed internally by LPP, while a trio of fund houses — MFS, Robeco and Magellan — run the remaining 60 per cent.
Morgan Stanley, Harris Associates and Baillie Gifford, which previously ran equities for the pension funds, were axed as a result. This move is expected to save £7.5m a year in investment management costs. The trend of cutting managers is set to continue as part of Mr Rule’s aim of running around half of LPP’s assets internally, up from a third currently.
The managers most at risk are those running equities: Mr Rule would like to manage about 80 per cent of LPP’s investments in stock markets internally.
But he adds: “I would never expect to be 100 per cent internal. There will always be areas that we want to go and get [external] expertise for.
“We are only going to allocate money internally where we believe that is better than anything we can get externally. There is no point saving £5m in costs if it costs us £30m in returns.”
If LPP manages more money itself, it needs to grow its investment team. There are 25 investment staff positions at LPP, almost double the combined size of the now-defunct investment teams at the two founding pension funds. Some of the LPP positions, however, are yet to be filled.
Mr Rule admits that convincing employees to switch from private sector asset management, where higher salaries are the norm and offices have working air con, is a difficult task.
“If they don’t care about anything apart from money, we are going to have a challenge attracting and retaining them because there is always going to be someone that will pay more than us,” he says. “We can offer people a degree of autonomy that perhaps they would not have in a traditional asset manager.”
As Mr Rule continues to extol the virtues of a career in a local authority pension fund, it starts to become clearer why he left the private sector.
“There is always a bit of a conflict with an asset management firm, and I say that having worked all my career in asset management firms. As an individual, sometimes it can cause you to question the merit of what you are doing,” he says. “We are the asset owner. It is not about how we can generate fee income and profitability for the [company]. We have a different lens we look through.”
For a young 38-year old buck, Mr. Rule has huge responsibilities but at least he gets the name of the game. When you work for an asset management firm, it’s all about gathering assets. This goes for firms working on traditional mandates (beating a stock and bond benchmark) and it also goes for elite hedge funds shafting clients on fees.
When you work for a pension, your objective is to maximize the overall return without taking undue risk and in order to achieve this objective, pensions need to cut costs wherever they can, especially in a low return/ low interest rate world.
Rule is right, pensions can’t go 100% internal but many are cutting costs significantly wherever they can. And I agree with him when he states the following: “We are only going to allocate money internally where we believe that is better than anything we can get externally. There is no point saving £5m in costs if it costs us £30m in returns.”
Go back to read an older comment of mine when Ron Mock was named Ontario Teachers’ new leader where I went over the first time we met back in 2002 when he was running Teachers’ massive external hedge fund program:
Ron started the meeting by stating: “Beta is cheap but true alpha is worth paying for.” What he meant was you can swap into any index for a few basis points and use the money for overlay alpha strategies (portable alpha strategies). His job back then was to find the very best hedge fund managers who can consistently deliver T-bills + 500 basis points in any market environment. “If we can consistently add 50 basis points of added value to overall results every year, we’re doing our job.”
He explained to me how he constructed the portfolio to generate the highest possible portfolio Sharpe ratio. Back then, his focus was mainly on market neutral funds and multi-strategy funds but they also invested in all sorts of other strategies that most pension funds were too scared to invest in (strategies that fall between private equity and public markets; that changed after the 2008 crisis). He wanted to find managers that consistently add alpha – not leveraged beta – using strategies that are unique and hard to replicate in-house.
The key message? Beta is cheap!! Why pay some asset management firm big fees especially in traditional stock and bond mandates when most of them are incapable of beating an index over a long period? The same goes for hedge funds charging alpha fees for leveraged beta? Why pay them a ton of fees when they too consistently underperform a simple stock or bond benchmark over a long period? That too is insane!
Now, I know the arguments for active management. We went from a big alpha bubble which deflated to a mega beta bubble where the BlackRocks, Vanguards and a whack of Robo-advisors are inflating a giant beta bubble, indiscriminately shoving billions into ETFs, and it’s all going to end badly.
Moreover, just like François Trahan of Cornerstone Macro who was in Montreal last week, I am openly bearish and you’d think in a bear market active managers will outperform all these beta chasers, but it’s not that simple. Most active managers will perform even worse in a bear market, incapable of dealing with the ravages of a brutal decline in stocks.
Having said this, there will always be a market for good active managers, whether they are traditional asset management firms or elite hedge funds or private equity funds, so whenever pension fund managers think they are better off outsourcing assets to obtain their actuarial rate-of-return target, they should do so and gladly pay the fees (as long as they are not getting the big shaft on fees).
Pension fund managers don’t mind paying fees when they get top performance and great alignment of interests, but when they don’t, they just bring assets internally and cut costs, even if that means lower returns on any given year (over the long run they are better off with this strategy).
An example of where it makes sense to outsource assets, especially in illiquid markets, is in a recent deal involving the UK’s Universities Superannuation Scheme. Dan Mccrum of the FT reports, UK universities pension plan in novel deal with Credit Suisse:
The pension plan for UK universities has snapped up most of a $3.1bn portfolio of loans to asset managers, in a collaboration with Credit Suisse which highlights the shifting roles of banks and investors in the continent’s capital markets.
The £55bn Universities Superannuation Scheme has agreed to provide debt financing to private equity and asset management groups that have raised so-called direct lending funds. These funds make loans to medium-sized businesses, displacing traditional bank lending.
It comes as Credit Suisse undertakes a reordering of its business designed to reduce activity which requires large commitments of capital, in favour of advising clients in return for regular fees.
In the first deal of its kind for a UK pension fund, the collaboration begins with the Swiss investment bank offloading most of a portfolio of loans and loan commitments made in 2014 and 2015, typically lasting five to seven years. The bank, which retains a small portion of the original lending, will manage the pool of loans and arrange new financing for USS on the same basis.
Ben Levenstein, head of private credit and special situations for USS, said the pension fund allocates a quarter of its capital to investments where it can earn a higher income than equivalent securities in public markets, which can be easily bought and sold. “We do have a tolerance for illiquid assets,” he said.
The $3.1bn of existing lending commitments to groups such as GSO Capital Partners, part of the alternative investment group Blackstone, will eventually be backed by around $6bn of lending to medium-sized businesses, in competition with commercial banks.
“Non-bank lending is a structural shift in capital markets, and the asset managers want a funding source not reliant on bank financing,’’ said Jonathan Moore, co-head of credit products in Europe, the Middle East and Africa for Credit Suisse.
Several years of very low interest rates have forced pension funds to search for unusual sources of income, at the same time as regulatory changes have caused many banks to conserve capital. Since 2013, $119bn has been raised for direct lending, by more than 200 investment funds, according to Preqin, a data provider.
The funds typically lend to businesses with earnings before interest, taxes, depreciation and amortisation of less than €50m, too small to access public debt markets. A borrower might expect to pay 600-800 basis points above interbank borrowing costs, for a five-year loan.
Asset managers boost investment returns by raising debt against the funds. The lending commitments arranged by Credit Suisse are so-called senior loans, financing half the value of the underlying portfolio at low risk. The typical cost of such funding is around 250-300 basis points over interbank borrowing costs, according to participants in the market.
While the deal may be a model for institutional investors to follow, USS is unusual among large UK pension schemes which offer defined benefits to members in retirement. USS remains open to new members and continues to make new investments as contributions flow in.
Private debt is a huge market, one which many Canadian pension funds have been pursuing aggressively through private equity partners, in-house managers or by seeding new credit funds run by people that used to work at large Canadian pensions. In this regard, I’m not sure how “novel” this deal between Credit Suisse and the UK’s Universities Superannuation Scheme really is (maybe by UK standards, certainly not by Canadian ones).
Lastly, it is worth noting that while many pensions are rightfully focusing on cutting costs and insourcing assets wherever they can, large endowments funds like the one at Harvard, are moving in the opposite direction, adopting Yale’s model which is based on outsourcing most assets to top external asset managers.
The key difference is that top US endowments have a much shorter investment horizon than big pensions and they allocate much more aggressively to illquid private equity, real estate and hedge funds. They have also perfected the outsourcing model which has served many of them well and have developed long-term, lasting relationships with top traditional and alternative asset managers.
