John Harrison: The future of active management in the LGPS
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We are less than 12 months from the official implementation date for LGPS asset pooling. Time will tell whether all the pools will be ready by the deadline, especially given it falls in the middle of an Easter weekend. However, it seems likely all the pools will be fully operational at some point in 2018. Only thereafter will the full implications of pooling for fund managers become apparent.
In the meantime, we can only speculate about future trends, particularly regarding external active management in the LGPS. In practice, much may well depend on the time scales with which administering authorities seek to achieve cost reductions.
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It is well known that LGPS funds have retained a much higher exposure to equities than most other UK pension funds. The LGPS is still open to new members and has stabilisation mechanisms in place to dampen contribution rate volatility. LGPS funds have therefore focused more on long-term return generation and less on stable funding levels. The end result is an average exposure to listed equities in excess of 60%, with a significant proportion in actively managed mandates with external fund managers.
Looking forward this seems likely to change materially. The sector’s sensitivity to funding risk is rising, with an increasing number of employers without tax raising powers. If LGPS funds start to put more emphasis on stability of funding levels and less on return generation it is reasonable to expect a reduction in listed equities in favour of alternatives (especially infrastructure) and liability alignment through bonds and real assets. However, in the short term we may see just as important a change in the balance between active and passive mandates.
The rationale for creating asset pools is two-fold. First, the pools will have much greater buying power, which should enable them to negotiate lower fees. Second, the pools will have better resourced investment teams, which should over time enable more of the sector’s assets to be managed internally and broaden the range of asset types used.
At the pool level, there is scope to reduce management fees by consolidating existing mandates into fewer, larger blocks. However, this may not be straightforward because there is a tension between cost savings (offering fewer sub-funds) and flexibility for participating authorities (offering more sub-funds). Given the very different compositions of the various pools, it seems inevitable that there will be a wide divergence of approaches to the number and types of sub-funds offered.
In the longer term, the pools may be able to go much further. In listed equities and bonds the use of low cost internally managed capabilities may broaden, particularly within pools which already have participants with internal management. The bigger prize, however, may well be in alternatives, where the cost, knowledge and access advantages of scale are greatest. Having skilled internal teams able to identify opportunities early could deliver significant benefits to the sector.
At the administering authority level, there is also scope to reduce costs quickly by switching to products with lower fees. This is especially true in listed equities where actively managed capabilities typically charge fees many times higher than passively managed capabilities in the same markets. This logic could also apply in listed bonds, although a general distrust of today’s very low nominal yields has caused many LGPS funds to be wary of passive bond products.
It may take several years for the newly created pools to build the full range of skills needed to exploit new opportunities in alternatives. In the meantime, potential fee savings from consolidating existing mandates may not be enough to offset the additional costs of establishing and running the pools. The overall costs of managing LGPS assets may therefore rise before they can fall.
The challenge for the sector will be to avoid reacting too quickly to the pressure to reduce costs. Administering authorities will remain responsible for asset allocation, which will encompass the choice of the sub-funds they use. If they decide they need immediate fee reductions, they will be tempted to switch active mandates in listed equities into products with lower fees, such as passive and smart beta.
Against this background, actively managed equity mandates could come under intense pressure both from passive management in the short-term and from reductions in equity allocations and wider use of internally managed capabilities in the long-term. Some fund managers no doubt will have sufficiently strong relationships or track records to withstand the pressure, but many will be vulnerable.
While external active management of listed equities within the LGPS seems likely to decline, LGPS funds will still need active management, particularly in terms of asset allocation decisions. What is unclear is the extent to which this will be provided internally by the pools or externally by fund managers and/or advisors.
John Harrison is an independent adviser to Surrey Pension Fund.
