£5bn in hidden underperformance from alternatives in LGPS revealed

Henrik Pedersen is managing partner of Clerus who have this week published a paper on alternative investment performance in the LGPS.

Alternative assets such as hedge funds and Diversified Growth Funds (DGFs) are typically promoted by investment consultants as a vehicle to achieve equity-like returns, but with only a proportion of the risk. However, according to Local Government Pension Scheme (LGPS) annual reports and investment principles issued over the last year, an estimated £20bn of alternative assets is being benchmarked against cash-like return across LGPS.

This includes 100% of DGFs, 100% of hedge funds and 90% of infrastructure funds.This choice of benchmark is inappropriate because it seriously understates the risk of these assets and the equity-like returns being expected by pension funds.

Hiding Poor Performance
Our report released this week quantifies the performance impact on scheme benchmarks, had more appropriate equity-like benchmarks been used over the last decade.  This is important because a typical allocation to alternative assets will be accompanied by a reduction in the expected return of the scheme specific benchmark. This happens because a percentage of assets are allocated from equities, or bonds, into lower yielding cash or cash plus investments.

The reduction in benchmark performance is estimated at 0.5% per annum or £5bn in today’s money for all LGPS. This estimate excludes fees paid to advisors for manager selection and monitoring, transition costs and incentive fees paid to managers for below target returns.  The underperformance from alternative assets versus expected returns is hidden, because most LGPS only monitor and report on investment performance versus scheme specific benchmarks, but do not measure or report on the performance of asset allocation decisions (i.e. benchmark changes).

Reducing benchmark returns does not in itself lower overall fund performance. However the alternative investments recommended to LGPS over the last decade did not produce equity-like returns. Instead the combined investments produced lower net returns than equities and bonds, a result that could have been achieved by simple de-risking at a fraction of the cost.

Spotlight on Governance
This highlights a serious governance issue. The use of misleading performance metrics raises important professional and ethical questions. It also undermines basic performance assessment principles and leads to excess fees (including potential performance fees) being paid to investment managers for longer as their performance looks better than it is and cannot be assessed correctly.

We must also question why investment consultants are promoting these products as providing equity-like returns, but recommending that they are benchmarked and remunerated against cash-like benchmarks. This principle is no different to measuring an active equity manager against a cash benchmark instead of an equities index.

Unfortunately this has created an artificial situation where both schemes and consultants are able to report above benchmark performance from their manager selection and asset allocation activities even if overall performance was reduced and deficits increased.

Recommendations
Our report recommends that local authorities invest to acquire the expertise to challenge and review the advice they receive from their consultant and to improve existing performance benchmarks. The pay-back in improved governance and transparency will be fast and any costs will be far outweighed by the benefits of lower fees and better investment returns.

Link to LGPS reform
These findings place another huge question mark against the LGPS reform proposals. Why would the LGPS want to be in a position where they were paying £301m of annual fees, and 58% of total fees, to an 11.5% allocation to alternative investments expected to produce such low cash-like returns?

Photo: “Numbers And Finance” by Ken Teegardin