Karen Shackleton: The cost conundrum of active managers

LGPS is in a better position to assess the cost of active managers, even if it remains difficult.

It is common sense to take costs into account when judging the performance success of an active manager. Yet the considerable debate around costs, in recent months, indicates that this is not as easy as it sounds.

Part of the problem is identifying all the different costs. Explicit costs are relatively easy to pin down. These include the manager’s annual fee, accountancy, administration and legal costs, custody charges and consultancy fees (if used).

Hidden costs have, in the past, been much harder to identify. These include the bid/offer spread (the frictional cost of buying and selling holdings), stamp duty, market impact, foreign exchange costs and broker commissions.

The Financial Times recently reported that these hidden costs resulted in a fourfold increase for some funds. Even for large institutional investors, these costs can have a significant impact. Railpen, for example, spent time identifying and quantifying all its hidden costs and found that total costs doubled as a result.

Finally, there are other costs, such as transition costs, performance fees or carry (in private funds), which must be taken into account.

Horizon

Concern over costs has led to greater scrutiny of the net value added by active managers. CEM Benchmarking’s recent research for the Financial Times found that active managers’ costs were absorbing 75% of the value that they were adding for their clients. It meant that, on average, they were adding just 0.16% per annum compared to a passive mandate, net of all the explicit, hidden and other costs.

A further consideration for investors is the impact of consultant advice. Through the Competition and Markets Authority (CMA), the Financial Conduct Authority has recently published the initial findings from a review of consultancy firms.

They analysed the “buy”, “hold” and “sell” recommendations of the larger consultancy houses to establish whether the “buy” list outperformed or not.

The conclusion was that “buy rated” funds did not outperform, on average, to any level of statistical significance when taking costs into account.

All this could make an LGPS investors  gloomy about active management. Yet there are some lights on the horizon that could result in better outcomes for local authority pension funds.

Lights

Going forward, MiFID II means that managers are required to be much more transparent about their hidden costs. A voluntary code of transparency for cost reporting has also been introduced by the LGPS Scheme Advisory Board and a growing number of managers are signing up to this.

The code will make the quantitative analysis of costs much easier to determine in the future, as well as facilitating more direct comparisons between managers using the common reporting standards. This, in turn, should incentivise managers to be more proactive about controlling costs.

Active equity managers who take a longer-term view often end up delivering better added value to their clients, on average, net of costs. By moving away from three-year performance assessments and quarterly scrutiny, managers should be more willing to extend their holding periods.

LGPS funds can (and should) review managers’ costs as part of their ongoing due diligence process. They should certainly put pressure on all their managers to sign up to the voluntary code of transparency.

A second light on the horizon is the recent focus on patient capital, following on from the UK government’s review in 2017.

With patient capital, the investor invests with no expectation of turning a quick profit. Instead, they are willing to forgo an immediate return in anticipation of more substantial returns over the long term.

With the emphasis on quarterly scrutiny of manager performance, it is no surprise that the average holding period of stocks has fallen rapidly over time.

On the New York Stock Exchange, it dropped from eight years in the 1960’s to less than nine months in 2016. This will have had a dramatic impact on hidden costs.

Yet investors who can afford to be patient (and the LGPS falls into this category) can seek to capture improved returns over the long-term with considerably lower hidden costs. This is already happening with increased allocations to private markets. Buy and maintain portfolios in bonds have also become more popular.

Active equity managers who take a longer-term view often end up delivering better added value to their clients, on average, net of costs. By moving away from three-year performance assessments and quarterly scrutiny, managers should be more willing to extend their holding periods.

More efficient active solutions are also growing in popularity. Strategies such as smart beta, low volatility and risk parity can be delivered at more competitive fee rates than traditional active managers. They can play an important role in an LGPS portfolio, complementing both passive and traditional active approaches.

Finally, pooling should make the LGPS feel less gloomy. The use of consultant advice can become more selective.

For example, a pool’s investment committee may decide that they still want to access consultant manager research (which generally is of a high standard), but they may decide to put less emphasis on picking managers from the buy list. They might even decide to buy in several consultants’ research for a given asset class so that they can make fully informed choices.

What will be more important to them is how a given manager’s approach complements other managers within a blended fund, and that is something that can be done internally, by the pool, or at least in partnership with a consultant.

Laurels

We cannot sit on our laurels. There is still more work to do with the most recent focus on frictional costs of trading (the bid/offer spread). Importantly, however, the direction of travel means that the LGPS can begin to make more informed decisions about the success – or otherwise – of its active managers.

Karen Shackleton is a senior advisor at MJ Hudson Allenbridge.

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