Linda Selman on active investment, CIVs and LGPS governance

At the beginning of May, DCLG released a report by pensions adviser Hymans Robertson into the future structure of the Local Government Pension Scheme. Linda Selman, head of local government investment at Hymans gives Room151 her take on the forthcoming consultation.

Room151: Is fair to assume that the idea of fund mergers dead?

Linda Selman: It is certainly not on the immediate agenda – that is quite clear in the wording of the consultation. There was pretty reasonable consistency in the call for evidence.  Most people think CIVs have the potential to deliver the scale of benefits required without the disruption of a full merger. Whichever way you look at it, mergers would take longer and potentially face legal hurdles.

Room151: Do you have a view on how many CIVs would be optimal?

LS: What we did was deliver to the scope the DCLG set us. We were asked to examine three scenarios – five to 10 merged funds, 5 to 10 CIVs with the 89 funds remaining, and one CIV.  All the analysis we did was around those options. We were not asked to express an opinion of what was the best.
Certainly there are areas where there are benefits of scale by having fewer CIVs. One of the areas we think that might be particularly true is in alternatives.  Maybe 10 per cent of total assets are going in to those at the moment, so you would probably need to limit this to one fund to get the benefits of scale and good diversification. You can see the numbers we produced in the report – as you increase the number of collectives then the discounted value of savings reduces. It is not a huge change but it makes a difference.

Room151: Can London’s regional CIV sit alongside any of the proposals you were asked to examine?

LS: There is still quite a lot of detail to be agreed.  Clearly London has made a huge amount of progress in terms of collaboration and agreeing the Authorised Contractual Scheme model. That is extremely helpful in setting the way forward. There is still an opportunity to input in to the number of CIVs and the asset classes that might be represented in them. We are encouraging people to put submissions in to the current consultation.

Room151:  Isn’t the proposal to limit investment in actively managed funds every asset allocator’s worst nightmare, in that it removes a useful tool they currently have at their disposal?

LS: There is plenty of scope to put forward views on whether the compulsion to move to passive investments is sensible. The numbers we were asked to examine looked at the extreme scenario of going fully into passive assets. We wouldn’t necessarily advocate that. It depends on a number of factors, including your governance budget and how strongly you believe in active management. We are intending to do more work on what the appropriate balance between active and passive management might be.
If you take it to the extreme and look at all investment managers it is impossible for them in aggregate to outperform the market.  If you have a large enough group of managers they are going to look very much like the market performance. We are very conscious that the LGPS community can point to strong performance by some pension funds in active management. It would be useful if, through the consultation, they could identify what they believe are the key factors in their success. We think there is a role for some active management but this needs to be focused in the right places.

Room151:  If one believes in fee reductions and passive management, would synthetic exposure be a cost effective solution worth considering?

LS: By synthetic exposure I assume you mean using futures or other derivative based methods of obtaining exposure to listed assets.  This approach could deliver a return similar to that of physical passive investment and could be a cost-effective means of investment.  Issues that would have to be taken into account, not least compliance with the investment regulations. Another factor is the limitations on the market exposures that could be gained – using derivatives could restrict you to large cap equity exposure so that you will not capture the full return of some of the markets that physical exposure could achieve. The final issue would be the lack of voting rights. It is worth noting that the big passive investment managers choose to replicate the indices using physical stock.

Room151:  How do you think large national funds would be governed, given that many local authority members might want to retain a degree of control over the investments made by CIVs?

LS: Governance is absolutely crucial to this. The CIVs need to be run by boards and have adequately resourced executive functions. They need to have the highest standards of governance and compliance. The CIV would still leave councils with the strategic decision of how much they put into each asset class. In terms of the choices within the CIV it is important to get the balance right. Too much choice means you don’t get the economies of scale right. Too little, and committee members might feel that they do not have enough flexibility on the implementation of their strategy.