Q&A: Jason Fletcher of LGPS Central on understanding investment management costs

Jason Fletcher

Jason Fletcher, chief investment officer at LGPS Central talks to Room151 about full cost transparency and why pools can’t accurately measure their impact unless they establish the true picture of where they start from.

Room151: Depending on which numbers you believe, the LGPS may have spent somewhere in the region of £1bn on investment management fees in 2017. Is that a reasonable amount for the total sum of LGPS assets under management?

Jason Fletcher: Until we get full cost transparency, we won’t know. As a broad guess, I suspect that number is about right but we need to find out what the exact number is. If it is £1bn then I think that is too much, to put it bluntly, and we can get a better deal without damaging investment returns. Obviously, every penny that we can save in costs gets added to our investment returns.

R151: What would be a good deal?

JF: Again, until we have full cost transparency, we don’t know. Clearly we have to manage these costs down but in order to do that we need to know exactly what the costs are before we can take a clear view on what a good deal would be. 
That said, we should be looking at taking big chunks out of that amount; it’s too much and if you compare it with private sector firms who are running institutional money, then it could and should be much lower.

R151: In terms of transparency, you’ve overhauled the way you look at costs. Can you tell us about that?

JF: Before my time here, David Kane (WMPF CFO) and other people were instrumental in working with CIPFA, the SAB and the IMA on getting fuller cost transparency. That initially involved designing templates to ensure that we stopped looking solely at the accounted cost of investment and included performance fees and other things which are fundamental to understanding overall costs. That started in 2013 and we saw a big jump in cost, on that basis, rising above £80m for the West Midlands Pension Fund. That was a big shock but it was critical to show what we were really paying for investments, rather than simply what we were being invoiced.

Since then West Midlands has managed a 5% per annum reduction in absolute costs, which I think is quite an achievement. You have to remember, over that period we have seen assets under management go up a lot because markets have done well. Measured as a basis point fee of asset management costs have fallen even faster. To have brought absolute costs down when the assets have been performing well (WMPF has outperformed its customised benchmark post the change in cost measurement) has made a significant difference to the West Midlands fund.

As soon as you actually know what your costs are you can start to manage them properly and I think this process has demonstrated that.

R151: Where have you been able to save on costs? How were you able to negotiate those down and are other LGPS funds paying those costs when they shouldn’t be?

JF: Other LGPS funds may be reducing investment costs, I don’t know.

I think the fundmental point is you can’t negotiate unless you know what the price is. You have to have a starting point to negotiate from. Up until now it has been benchmarked and only against the management fee. People have found it very hard to combine performance fees, here and there, and to add custody fees, or not, and everyone is measuring on a different basis. Once you can clearly breakdown the costs, then you can start questioning what is fair and what isn’t. It is vital that you have full transparency to ensure you have a correct starting base for costs.

The other issue is with this convention of basis points of cost: what reason is there for that?  We should be talking about costs in pounds.

If you are running an equity portfolio and the market doubles, you are paying your fund manager twice as much the following year. Are they doing any more work? What is the justification for that doubling? Have they out-performed the benchmark? Not necessarily.

It is just that the market has gone up and I think that is also true of performance fees; performance fees are getting paid because you have a misaligned benchmark.

The whole of the funded occupational scheme sector (LGPS and Private Company DB and DC plans) are equally in the dark on cost transparency. This isn’t an LGPS issue — it’s an issue for all pension fund and institutional investors.

R151: Does the SAB template provide this full transparency?

JF: It gets very close to it and I would argue it’s pretty much there for liquid assets. For alternative assets, it is going to be much more difficult.

At West Midlands we have a template for alternative investments because there are a lot more costs which are not necessarily as transparent and we are doing our utmost to try and find out what they are. We are doing that on our own at the moment but there are other templates being built: the FCA working group and others are putting some good work into that. The important thing is that while they don’t all have to be exactly the same, they do need to head in the same direction because in the end we are going to use them for cost comparison.

We welcome the FCA’s action in this area to force asset managers to disclose their full costs and charges so that we can all benefit from full cost  transparency.

R151: What are you trying to achieve with the template?

JF: One of the ways we are trying to evaluate full cost is in firstly, agreeing that the true cost is the difference between the gross return and the net return. From that starting point we can find an accounting basis for the numbers and we are at the beginning of that process.

That, to me, is the most reasonable way and a similar process to the one we went through in liquid markets, with things like unbundling of research from commission. There are lots of costs which are bundled in the private equity and alternatives world and they are more difficult to calculate, but it can be done, provided you know what you’re looking for.

R151: What justifications do you come up against on the other side of the table from firms who would rather not disclose anything that sits between the net and gross costs?

JF: Well, the first thing to ask is why do you not want to disclose this? If someone refuses, then we will ask why? We should be even more concerned if the answer is they don’t know what those costs are themselves. In any other world people are expected to be open and transparent with their customers. We are leaving huge amounts of money with mangers so they have a customer responsibility (fiduciary duty) and we are taking a hard line.

If the customer asks questions about costs they should be told what those costs are and if they are not fully transparent then that is a problem and something should be done about it.

R151: Would you not hire a manager who couldn’t demonstrate full cost transparency?

JF: We are moving in that direction, yes. I will be looking to put in on our RFPs [requests for proposal] so things like not filling in the template, I don’t think is acceptable, and I would bring it right up front in the RFP (asking them to fill in the template as part of the due diligence process) when you are going to procure a manager. There is going to be a lot of procurement across the pooling sector and together we can insist on this and take back control of the process. If the £1bn is correct that is an awful lot of money which is not currently being properly accounted for.

R151: How do you think fund managers are adapting to the initiative?

JF: It was the same on bundling research in the listed world, I would expect the people who move to being fully transparent early on, will benefit from that. The ones who are very late to change will not do as well. There are some alternative managers who are very transparent and there are some that just aren’t.

If a manager doesn’t want to be transparent then I would ask, ‘Well, do you know what your costs are?’

If you’ve got someone managing your money, and they’re not managing their costs, that’s quite an interesting issue. Whether the manager is withholding information, or they don’t know what the true cost is? Both are very bad outcomes.

R151: Will you be looking to beat external management costs with your in-house management?

JF: Where things are managed internally, of course cost transparency is going to exactly match what we expect from external managers. Again, how could we possibly make a decision between whether we use an external or internal manager unless we’ve got a true picture of the cost? Obviously with the internal mandates, we have all the data at our disposal.

We’re managing money for nine different pension funds so we in turn need to do provide full cost transparency back to them.

R151: What in particular are you finding in bundled costs that you didn’t expect to find?

JF: There are areas in alternatives where we’ve brainstormed to see how many categories of cost we can think of and we went beyond a piece of A4 and are still going. To be fair, alternative investment can be a very complex and expensive process. That’s fine, provided the costs are transparent and the returns after costs are worth it, on a risk-adjusted basis.

The funniest anomaly to me is when you get rebates, which I often see in some alternative structures. You suddenly see a rebate and you think, ‘what’s that?’
Why did we get a rebate? Why were we paying it in the first place? How long have we been paying it for and was it reasonable that we paid it historically?
Obviously, we’d rather get the rebate than not, but at the point when someone says you’ve been rebated 50% of X, you want to know if the other 50% was a reasonable cost.

R151: Do you think the cost of managing your passive equities should be fixed?

JF: I think it should be fixed and it will be for internally managed passive equities, but crucially it should not relate to the market AUM. Passive manager remuneration needs to reflect the fact that people are employed to work on matching the indices and so on but their pay should relate to wage inflation rather than the performance of the assets under management.

Passive fees have come down a lot in recent years not just because of fee transparency but also because there has been a lot of competition.

R151: Do passive fees have further to go?

JF: Yes. Passive management is an area where we’re not fully uncovering costs yet. There are a number of things in passive investing which make full cost transparency difficult. One of those is stock lending. If, for argument’s sake, you pay 5 basis points as your cost for managing passive equity, what happens if the manager is making a 5 basis point gain from lending your stock out? Technically, we could argue the reward for generating stock lending fees should be offset against the investment management costs, and the fee should be zero. It’s important not to compare one passive manager that is doing stock lending and with one which isn’t.

R151: As we move towards April 2018, are the signs so far that pooling is going well?

JF: First of all, we have to make sure our starting point or base is correct. How do you know how much you’re going to save if you don’t know how much you’re paying in the first place? And we will be judged on savings to a large extent. It’s almost as though when people look back and say was pooling a really a good idea, we’ve got to be very clear about what our starting point was and what our true costs were to measure whether it’s has been a success. To that end, I don’t think the clock should start from April next year. The clock should’ve started three years ago, when the idea took off. Pooling has already generated cost savings for LGPS Central despite the go live date being April next year.

R151: So, there’s some work to be done going back over the historic costs?

JF: Absolutely, and that’s something that we will be doing soon, because the different partner funds within LGPS Central will have different ways of measuring costs. I think the pools need to get together to make sure we develop a fair basis for comparison. We need to clean up the past and stop comparing apples with oranges on historic costs. We want to be very clear what our starting point is and what our true costs were in recent years otherwise we simply can’t measure whether pooling has worked or not. I think it’s absolute critical to the whole pooling arrangement — if we are publicly saying we’re looking at £250m in savings over 16 years then we have to know what cost base we’re measuring against.

R151: How are you collating the data?

JF: We’re using an external provider to help us gather the information. There are nine different partner funds, all with slightly different ways of measuring costs, and we need to go back to the underlying fund managers with our new templates and find out what the real costs have been.

R151: Are you expecting all doors to be open when you’re asking for that historical data?

JF: It’s a good test. I think the external managers to their credit have moved a long way especially in the liquid world. They’ve accepted cost is an issue and I think we have moved on hugely. MiFID II rules being implemented will unveil what is very close to a true number in the cost of liquid assets.
We’ll see what response we get but hopefully in the back of managers’ minds they’ll look at us as potential clients of the future and it’s in their interests as well as ours to collaborate.