Strategy to the fore as pooling rings the changes

Written By: Matthew Craig LAPF Investments

Matthew Craig looks at a range of different issues that pension funds could consider before making any significant changes to their investment strategies

Developing the right investment strategy and executing it efficiently is the best route to investment success. But this is easier said than done, given the myriad challenges that investors face.

For local authority pension funds, the question of investment strategy has come under renewed focus with the pension fund pooling reforms, which have the goal of creating larger asset pools, capable of using a wider range of investment in a more efficient manner than the current system allows. In particular, larger funds, with £20 billion or more in assets, should be able to get better deals and more direct exposure to assets such as real estate, infrastructure or other alternative assets. And in equities and bonds, they should be able to use their size to drive down costs, such as manager fees, while having more clout with company boards on issues they are concerned about.

So will the new local authority asset pools have very different investment strategies to those currently in use among the Local Government Pension Scheme (LGPS) members? Views vary on this, with some believing that the healthy, well-funded plans may not need to change strategy, while others believe that there is potential for significant changes. PAAMCO global head of research, Lisa Fridman, commented: “We believe LGPS pools are looking to build more diversified portfolios and use scale to consolidate and increase alternatives’ allocations. With the greater focus on managing costs, investors are also looking for lower fee solutions, such as alternative risk premia.”

While Fridman’s comments make sense, it might take longer for things to change on the ground. For example, the Wales Pension Partnership is the combined asset pool for eight Welsh local authority funds. Anthony Parnell, treasury & pension investments manager, at Carmarthenshire County Council, explained: “The Wales Pension Partnership has appointed an operator for the investment platform. The operator will select managers for the subfunds on the platform, to meet the needs of the eight Welsh fund members. The operator will also have responsibility for investment consulting services including due diligence on new managers appointed.”

Parnell added: “Each of the eight Welsh funds will have their own investment strategy and strategic asset allocation. That will be fed through to the investment platform by each fund. The operator will have discussions on the funds’ expectations for their investment strategies, so each fund has input into the range of subfunds on offer and the process that the operator has for appointing managers.”

At the present time, Parnell pointed out, the majority of LGPS funds are going through an investment strategy review after their last valuation, as at the end of March 2017. Parnell added: “Following the recent valuations, I don’t think there will be major changes at the eight Welsh funds, as they are all fairly well-funded. The government has said it wants to see more investment in infrastructure. Each of the Welsh funds is looking at infrastructure allocation and a strategy for investing in it, although placing money is further down the road. For the new platforms, the first assets to be used will be equities and bonds and the funds are likely to be looking for income generation strategies, partly due to the changing cash flow at LGPS funds. It is becoming tighter year on year, with the membership profile changing and becoming older.”

These comments give a strong indication, that investment strategy changes at the LGPS are likely to be evolutionary, not revolutionary. Local Government Association head of pensions, Jeff Houston, said that the official policy is for investment strategy and allocation decisions to continue to be taken at local level. “The purpose of the asset pools is to implement the strategies of member funds. It is the pools’ responsibility to have a range of sub-funds or vehicles, so the underlying fund can say ‘I want to have x% in global equities’, with the pool selecting the manager and doing rebalancing,” commented Houston. He added that the rise of asset pools could be a concern for investment committees at underlying funds. “They feel that they are doing a good job and feel they are losing control. It is really important to say that they have the most important role, which is asset allocation decision-making. Everything I’ve read says that 70% of investment returns comes from asset allocation decisions.”

So while the larger pools will, arguably, bring some new investment opportunities, investment strategies will still be decided by individual funds within the pools. Within this approach, both Parnell and Houston can see more use of alternatives and infrastructure in the future, following pooling. Parnell commented: “There will also be a bigger opportunity to use alternatives through pooling assets. Once the operator has a range of sub-funds, we can expect to see the potential for more use and rationalisation of alternatives.” And Houston added: “What should change is that pools should provide investment opportunities which the smaller underlying funds do not currently have. The best example is direct infrastructure. The only route for smaller funds might be through a fund-of-funds, which is horribly expensive, so they don’t invest. In future, the pools could create a vehicle to invest directly in infrastructure, enabling smaller underlying funds to have direct access.”

Larger asset pools should also be in a stronger position than smaller funds to implement environmental, social and governance (ESG) policies. Parnell shares this view: “ESG is also going to have to be factored into the strategy, as the eight funds are serious about ESG and it will be easier to do this at pool level, as having more assets gives economies of scale.” There are many ways that the new pools will be able to implement ESG into their investments, from screening out unacceptable investments, to engaging with companies in order to influence their policies. In this area, the main difference is likely to be that existing ESG policies can be applied in a more uniform basis, and perhaps to a greater extent, through larger asset pools.

For alternatives, the larger asset pools are likely to take a variety of approaches. PAAMCO’s Fridman expects to see larger asset pools moving away from off-the-shelf products, to the use of more customised products, or working with alternatives providers as strategic partners: “Typically, we see the decision on direct investments vs. fund-of-funds allocations being driven by the availability of the in-house resources and expertise for a particular area. In general, as larger asset pools are growing their internal teams, the focus is on selecting partners who could not only make discretionary allocations for a particular area, but also help the investor develop a direct investment program. Knowledge sharing and infrastructure support (e.g. managed account platform services, risk management aggregation) are usually important aspects of such partnerships.”

At this particular time, local authority pension funds could be part of a wider trend among institutional investors to increase their use of private market assets and alternatives, to diversify and protect against corrections in equities and the impact of rising interest rates on fixed income assets. Fridman commented: “We believe that diversified portfolios of hedge funds targeting low sensitivity to equities and fixed income should limit downside if there is a fall in equity markets. Evaluation of the portfolio’s liquidity profile as well as scenario analysis for various types of market stresses are important elements of risk management when considering a potential market crash.” Looking for returns to close funding gaps could be another factor. Fridman said: “We see funds which are not fully funded seeking alternatives which would deliver alpha and help decrease the deficit.”

In conclusion, it can be seen that there are many influences on how pension funds decide on an investment strategy. For LGPS members, moving to a new structure with fewer, larger asset pools should bring new opportunities. But it does not necessarily mean overnight changes; decision-makers will need to ensure new strategies are suitable and can be implemented satisfactorily. While some may see a greater use of infrastructure, perhaps with more direct investment, as an acid test of the new reforms, the pension funds themselves will look at a range of issues before making any significant changes to their investment strategies.