LGA casts doubt over pure passive LGPS

The Local Government Association has added its voice to the growing list of organisations warning the government not to impose a wholesale requirement for passive management of funds within the Local Government Pension Scheme.
Ministers, announcing a consultation on the matter in May, said that using common or collective investment vehicles (CIVs) and moving to passive investment of listed assets could save the scheme more than £660m a year in management fees and other costs.
However, in its response, seen by Room151, the LGA called for a more sophisticated approach.
It said: “The LGA does not believe there is a good case for across the board imposition of pure passive management.
“However it does consider that there is a place for enhanced passive and/or targeted increases in pure passive and would therefore support a ‘comply or explain’ approach but with the backing of some form of regulatory conditions for permitting continued use of unlimited active management.”
The LGA said that a similar reduction in fees to those outlined by the government could be achieved by councils managing mandates in house, rather than by hiring external managers.
It said: “This would reduce the current £310 million in active fees quoted…by some £248 million, an amount equal to that saved by moving to passive mandates.”
It added that internally managed funds could be expected to outperform the market benchmark.
This was partially explained by a lower turnover of stocks within portfolios which are managed internally compared to externally.
The LGA said: “This also demonstrates the long-term approach to managing the portfolio, which makes a substantial contribution to performance.”
Moreover, the consultation response raised questions about the government’s claimed savings from a wholesale move to passive, which also showed no drop in performance of investments.
The LGA said: “…although performance was on par with the index over five years if this policy had been implemented three years ago total LGPS return would have been 1.2% lower over that period.”
Passive management could also make it more expensive for councils to implement ethical investment policies, according to the response.
It said: “Following an index would present a risk that the LGPS will end up owning politically toxic assets with the resulting reputational damage.
“It is possible to use tracker funds which aim to match an index while selectively excluding or including stocks for ESG reasons – however the greater the degree of sophistication the greater the cost and the closer we get to active management.”
In addition, the LGA said that a lack of clarity on the meaning of passive management could make it difficult for the government to regulate and police an enforced move.
It said: “Passive management could be defined as anything from a predetermined strategy that does not use stock picking or timing, to matching a portfolio to an index, to picking stocks then leaving them alone for a long time or as the opposite of active.”
On proposals relating to CIVs, the LGA said that although the model could provide benefits, other arrangements could prove equally if not more beneficial.
Instead, co-investment agreements agreed on a project-by-project basis, could “provide the scale of capital needed for direct investment without the need for overarching and potentially complex governance structures”.
The LGA also said that councils could delegate investment powers to another authority with an in-house team, enabling joint mandates without the need to create a CIV structure.
It also pooh-poohed a suggestion in the consultation for the creation of a single CIV for alternative investments.
“A straightforward idea but the sheer range of asset classes would question if one body could have the capacity, expertise, experience and resource to provide the required level of service and performance,” the response said.
“The LGA does not consider that a single passive CIV and a single alternatives CIV are a sensible outcome,” it added.
“ LGA believes that it is for Government to set the objectives of collective investment, if necessary in regulation, and for the sector to then determine the style and scope of such arrangements.”
In its response to the consultation, pension adviser Hymans Robertson said that too many CIVs could risk diluting benefits of scale, while too few could result in some “diseconomies of scale and a lack of choice for some asset types”.
It also rejected the idea of a wholesale move to passive investments, saying that the idea ignores the potential to access governance benefits which could lead to greater gains and introduces “risks of naïve index-tracking” against market capitalisation benchmarks, which it said were vulnerable to bubbles.
“We do not like 100% of anything,” it concluded.