NEST diversifies via high-yield bonds

The United Kingdom’s National Employment Savings Trust (NEST) is preparing to introduce an active global high-yield bond fund. The new mandate will add to the existing ‘building blocks’ that underpin the scheme’s default NEST retirement date funds, and some of its alternative fund choices.

The multi-employer defined contribution fund, launched just five years ago, looks after more than £1.4 billion ($1.8 billion) on behalf of 4.1 million members and is set to grow considerably as auto-enrolment gathers pace.

“High-yield bonds can offer attractive returns in an otherwise low-yielding fixed income environment,” says chief investment officer Mark Fawcett, who has been in the role since NEST’s outset.

“Procuring a high-yield bond fund will also further diversify our members’ portfolios. By including this asset class in our building-block mandates, we will be joining the growing number of institutional investors holding high yield.”

There are nearly 50 retirement date funds in NEST’s default strategy. It accounts for the bulk of members and their assets, which are divided into three investment strategies depending on their age.

For young savers in the foundation phase, strategy is low risk, aiming for returns that match inflation and encourage saving. The growth phase, typically lasting 30 years, targets returns of inflation plus 3 per cent in a diversified strategy. The consolidation phase invests in inflation-matching assets to de-risk.

The active bond allocation marks a departure from NEST’s general preference for passive management. Its commitment to passive is based on an investment belief that indexed management, where available, is often more efficient than active management. It is also part of NEST’s need to control costs in line with its 0.3 per cent annual management charge.

High yield, and a handful of other allocations, are the exception, Fawcett explains.

“We need to believe that active managers are likely to improve the risk-adjusted returns relative to the index in any given asset class,” he says.

“Thus, we have elected to use active in credit markets where indices are less well constructed and we believe active managers can manage default risk. Hence, for investment-grade credit, emerging market debt and (in the future) high yield, we use active managers. Also, in some asset classes, such as direct real estate, passive management is clearly not an investable option.”

ESG criteria in the mix

For equity markets, NEST generally uses passive management, although Fawcett stresses that the fund does “select thoughtfully” which index to track.

For developed markets, it uses just market-cap weighted, whereas for emerging markets it tracks two alternatively constructed indices.

NEST made its first allocations to alternative indices through two emerging market equity mandates in 2014. One fund weights companies according to certain fundamentals; the other screens out stocks on the basis of certain environmental, social and governance (ESG) criteria.

NEST’s new bond mandate will have to incorporate ESG criteria, now integrated across all the retirement date entities and other fund choices.

Far-reaching ESG objectives are outlined in the pension provider’s inaugural responsible investment report, titled Working for Change, published mid last year.

“Considering [ESG] risks and opportunities, combined with being an active investor, is part of how we make the most of members’ pots,” Fawcett explains. “Integrating ESG into our investment processes is one of the means we deploy to grow members’ money over the long term.”

The report highlights four key aims.

Better risk-adjusted return: Targeting an improvement in ESG performance where there is evidence that doing so can lower the amount of risk needed in order to achieve a return.

Better functioning markets: Working to improve how markets operate and are regulated in jurisdictions where NEST invests.

Support long-term wealth creation: Encouraging the companies NEST invests in to deliver sustainable and stable performance to support good returns for members over many years.

Manage reputational risks: Protecting NEST’s reputation and increasing members’ trust by encouraging companies to act in ways members can feel confident about.

With these key aims in mind, NEST went on to identify its most important ESG risks, Fawcett explains. So far, these include how companies treat the environment, addressed through focusing on companies’ greenhouse gas emissions; how companies interact with others, tackled through a focus on conduct, culture, and staff reward; and how companies lead and organise themselves, addressed through a focus on audit and dividends that contribute to public and investor confidence and trust.

Long-term partnerships with fund managers

NEST has also built a reputation for nurturing long-term manager relationships, something Fawcett believes lies at the heart of successful investment strategy.

“Fostering long-term partnerships with our fund managers is crucial to establishing mutually beneficial commercial terms and providing for a stable framework for our asset allocation decisions. We want to avoid the destructive feedback loop of hiring managers at the top of a performance cycle and firing them at the bottom. It is precisely this behaviour that encourages investment managers to take inappropriate short-term risks and charge higher fees for short-term revenues. Of course, there is a difference between low cost and value for money – NEST’s focus is very much on the latter, subject to our fee budget.”

The fund’s internal team comprises a small but skilled group responsible for managing core aspects of the investment strategy, from asset allocation and risk management to the development of ESG and the responsible investment policy.