The United Kingdom’s £2 billion ($2.6 billion) Church of England Pension Board, CEPB, is slashing its equity portfolio and investing much more in private markets. The significant change in strategy at the defined benefit, final salary scheme for church clergy, a sister fund to the larger £8 billion ($11.1 billion) Church Commissioners which manages the church’s endowment assets, comes as the fund seeks better returns and less volatility.

It is also a strategy emboldened by youth: CEPB is 15 years away from peak benefit payment and is forecast to double its AUM over the next 10 years.

The fund is also supported by a strong commitment to keep the scheme open by the church, in contrast to most other UK DB scheme sponsors.

“We are pretty much all the things that don’t really exist nowadays,” says CIO Pierre Jameson who joined 11 years ago when the CIO role was created, and the fund only had $1 billion AUM. “It makes us quite unusual.”

CEPB’s 85 per cent allocation to return seeking assets (the remaining 15 per cent is in liability matching gilts and corporate bond allocations managed by BlackRock and Insight Investments) is currently divided with two thirds in public equity and one third in private markets to infrastructure, hedge funds, real estate and private debt. Now Jameson plans to cut the public equity allocation to around 35 per cent of the growth portfolio and plough the proceeds into infrastructure, private debt and private equity.

This will amount to doubling the allocations to infrastructure and private debt to 20 per cent and 8 per cent respectively and building a private equity allocation from scratch to account for 7 per cent of AUM over the next 10 years. Here CEPB is on the cusp of making its inaugural fund of funds investment.

“We have found our managers, but it’s not public knowledge yet,” he says.

Jameson expects cash yields of 5-7 per cent annually in infrastructure and the “same again” from the upside from management of the businesses giving an IRR of around 15 per cent. In private debt he is looking for yields of 6-8 per cent depending on where the fund is invested in the capital stack; in private equity he is targeting returns at the high end of public equity – around 8 per cent a year.

In contrast, volatility can cost the fund dearly and escaping from its swing is the other reason, alongside better forecast returns, for reducing equity. UK pension schemes must mark to market, and the private investments to which they mark are much less volatile than public equity, he explains.

“Private assets are valued according to cash flows and realistic expectations for underlying business. They are not pushed here and there by market sentiment.”

Although public equity may, over the long term, return 6-7 per cent a year that comes with 18 – 20 per cent volatility. The fund has tried to navigate volatility by allocating to defensive equity strategies which typically include low beta names like utilities and telecoms and negatively correlated stocks. But Jameson notes there “is only so much we can do as it is all publicly traded.” He estimates these defensive allocations reduced volatility from 18 to about 12 per cent which “helped,” but is nothing like the calm of private markets. In another challenge, UK pension schemes triannual review process makes navigating volatility even more important. “Where markets end up at the triannual date can give a random outcome. We will suffer less from this with a larger allocation to private markets and stop that volatility running through into contributions the sponsors have to make.”

Fee burden

The decision to invest more in private markets, where investment is in third party funds, will increase the fee burden but Jameson is confident the returns and loss of volatility will make it worth it.

“Private market assets are expensive to have managed. If you go in with a mindset to give up a third of your gross return you won’t be disappointed; this is a good rule of thumb,” he says. CEPB’s consultant, Mercer, provides it with an annual review of what other pension funds pay in fees.

“We are in the ballpark,” he says.

Jameson is also heartened by recent sharp falls in active equity fees – the remaining equity allocation will shift from a passive/active split to wholly active strategies. The rules of supply and demand usually dictate that investor demand for strategies or particular asset classes gives the asset managers that supply them the opportunity to raise fees.

However, the fall in fees for quantitative equity strategies (like passive but still classed as active mandates nonetheless) bucks the trend since it’s come just as more investors pile in.

“Fees have come down precisely because of the increasing popularity of these kinds of styles of management,” says Jameson who estimates the fund is now paying two thirds of what it was in its quantitative allocation. “These managers have a fixed cost base so they can take on new assets on an incremental basis that is attractive. It’s like a sausage-making machine: once the machine costs are covered, making additional sausages is cheap.” 

Infrastructure

The return profile of CEPB’s infrastructure allocation is core-plus and core- plus plus, invested in manager-run strategies that favour buy-and-hold assets and buying assets, improving them over time and selling them to other investors in a private equity flavor. The portfolio has evolved in three waves from an initial investment in European funds only, to a global remit. Now, in a new development, he is looking at more industry or regionally specific investments. Typical investments include economic infrastructure around communications, transport and distribution sectors. The fund is also invested in energy infrastructure and utilities including water. Only 12 per cent of growth asset are exposed to the UK economy since CPB removed its UK bias 3-4 years ago. That has helped it step away from the current competition in UK infrastructure where Jameson observes demand from new LGPS mega funds has led to assets being overbid.

Overpaying is a key area in his manager due diligence.

“Because infrastructure assets are overbought, it’s important to make sure you’ve got managers that are not going to overpay,” he says.

Here he demands clarity from his managers on what proportion of assets they buy on a bi-lateral basis versus asset auctions, and that managers have “sound procedures” in place for asset auctions where prices get bid up. The best assets, he says, are those where the seller isn’t chasing the highest price because they have primary concerns around investment ethos, or want the asset managed in a particular way going forward. Asset auctions where an existing owner wishes to sell, and the sole objective is to get as high a price as possible, are a “recipe for overpaying,” he says.

CEPB will soon boost its internal team of five to nine with new hires fleshing out the ESG team. The fund works with 26 managers, predominantly in North America and Europe, across 28 portfolios. Jameson estimates he meets with managers twice a year. That will increase if the allocation has underperformed, there is a change in corporate structure or strategy, or if there has been a significant outflow of funds, he concludes.

Our five million members as well as our different stakeholders and Danish and international NGOs all have expectations, sometimes diverging, regarding how ATP should act responsibly.

Institutional investors are also faced with their own constant dilemmas in terms of responsible investment, including their assessments of specific companies. ATP takes this responsibility seriously and our two frameworks ’Policy of Responsibility in Investments’ and ’Policy of Active Ownership’ allow us to navigate an area characterised by diverse expectations, dilemmas and complex issues.

Responsibility in investments

To ensure management ”ownership” of responsibility across ATP’s investment process, the responsibility efforts are coordinated by a committee for responsibility. That committee is chaired by our CEO Bo Foged. Other members are the CIO and the CRO, as well as relevant investment managers.

We believe that sustainable development is the precondition for good future returns and sustainable business value creation. Therefore, it is important that the companies in which ATP invests establish long-term goals and take responsibility for the societies in which they operate. By acting responsibly, businesses maintain their legitimacy and licence to operate, which is fundamental to continued growth and development.

Investee companies’ long-term growth contributes directly to generating solid returns for the benefit of ATP’s members. At the same time, experience has shown that better investment decisions are made by integrating ESG information with knowledge of other business aspects, into the decision-making basis.

Institutional investors are faced with constant, embedded dilemmas in terms of their responsibility in investments, including in their assessments of specific companies. As an investor with a global, diversified portfolio, ATP has investments in various sectors and geographical locations. As a result, ATP’s portfolio companies are exposed to a variety of risks and opportunities associated with, say, the UN’s Sustainable Development Goals or specific themes related to human rights, labour rights, environment and climate, anti-corruption and corporate governance.

ATP may find that a portfolio company contributes positively to one goal, says SDGs, but negatively to another. For instance, companies that construct hydroelectric power plants contribute to achieving SDG 7 on stable and sustainable energy. However, hydroelectric power plants, especially in developing countries, are known to present challenges in terms of contributing to the protection of the rights of indigenous peoples and biodiversity – SDG 15.

As a long-term investor whose purpose it is to provide good pensions to its members, ATP has a strong interest in the sustainable social and environmental development of the planet and the economy. Therefore, ATP takes an active position on this type of dilemma in its efforts to integrate ESG into its investment processes and active ownership.

Our policy of responsibility in investments constitutes the overall framework for the work on responsibility across asset classes and investment processes. The policy establishes basic principles and minimum criteria for the conduct of portfolio companies. Among other things, the policy states that ATP does not invest in companies that deliberately and repeatedly violate the rules and regulations of the countries in which they operate. The policy also states that the portfolio companies must act in accordance with the standards that follow from the international conventions adopted by Denmark.

Policy of active ownership

ATP’s policy of active ownership establishes the principles and processes that guide ATP’s active ownership activities. As a responsible long-term investor, ATP has an interest in being able to understand and control the overall actions of the listed companies it holds, thereby promoting the companies’ long-term value creation.

We give our active ownership activities a high priority and engage in direct dialogue with the companies we hold. Two processes are used to exercise active ownership activities: We vote at the AGMs of all of our equity investments and we are in continuous dialogue with many of the companies in which we have major holdings.

2018 special measures

In 2018, ATP increased its investments in green bonds. At year-end, ATP owned green bonds worth approximately DKK 10 billion ($1.5 billion.) Transparency is important to ATP, and our dialogue with issuers of green bonds is ongoing. Specifically, ATP wants to enhance the quality and volume of data from bond issuers to provide investors with detailed information about the projects and climate and environmental improvements financed by the bond. Ultimately, ATP wants investors to be able to follow the exact projects funded by purchasing specific green bonds as well as the purpose of these projects.

We have also carried out systematic work on climate-related financial risks. In 2018, ATP continued its work on the Task Force on Climate-related Financial Disclosures’ (TCFD) recommendations for investors. Through its active ownership activities, ATP has engaged in dialogue about sustainability and green transformation with electricity producers that rely on coal for more than 50 per cent of their electricity generation. Based on this dialogue, ATP sold its shares in a number of companies with no realistic plans for phasing out coal in the long term. Moreover, as part of its voting process, ATP also contacted 69 companies to influence them to monitor climate risks and report data on their carbon emissions.

ATP also included the TCFD recommendations in its own efforts. In 2017, for the first time, we published the carbon footprint of our equity investments and in 2018 ATP also calculated the footprint of its corporate bonds. In 2018, as part of its work on implementing the TCFD recommendations on climate-related financial risk disclosures, ATP began the process of trying to understand how scenario analyses can provide inputs and new insights for the investment processes. ATP has been focusing particularly on the UN climate panel’s RCP scenarios and the CMIP5 climate model data. ATP has applied these data to the forests owned by ATP through ATP Timberland Invest K/S.

We are also working on creating more transparency in our active ownership activities. In 2018, ATP implemented a range of transparency initiatives, including the publication of its portfolio of corporate bonds. Here we also calculated the carbon footprint of the corporate bond portfolio. Moreover, ATP publishes the names of companies with which ATP has engaged in ‘thematic engagements’. We also publish names of companies that have received voting intentions.

When we issue a voting intention it means that we want to explain to a company how our vote should be interpreted. ATP always seeks to inform the company of its intentions and motivation ahead of the general meeting if, on one or more voting items, ATP intends to vote against the board of directors and the company’s own recommendations. Finally, we also publish names of specific projects funded by ATP’s green bonds, ensuring issuers report on these projects in a transparent manner.

Ole Buhl is vice president and head of ESG at ATP.

ATP’s latest ESG report in English can be found here: https://www.atp.dk/sites/default/files/esg-rapporrt-2018_gb.pdf

For most investors recognising whether geopolitical tensions are a short term blip, or a long-term systemic shift is key to understanding how those risks inform investment decisions.

Angela Rodell, chief executive of the $60 billion Alaska Permament Fund says the challenge around geopolitical risk is determining how sustained or long-lasting any particular risk is and managing around it. 

“We want to make sure we are not overreacting to short-term noise and taking advantage where we have conviction around any particular geography,” she says. “Geopolitical risk is one risk discussed along with all the other risks an investment may have that are taken into account in making a decision,” she says.

“I think geopolitical issues have always been an important dimension to a global investment strategy and therefore you need to have views about what is happening in the world, where you want to be invested, where you do not want to be invested and how your risk profile changes as a result.”

In its geopolitical risk indicator Blackrock recently upgraded the risk around some specific risks namely global trade tensions, US-China relations, gulf tensions and European fragmentation risks.

Rodell says all of these risks will have an impact on the Alaska portfolio and have had an impact over the last couple of years.

“Since 2016 we have seen huge shifts in trade tensions, increasing tension with China, the Gulf continues to be a place of conflict and Brexit along with concerns about Italy impact the performance. The challenge for us as long-term investors is to find opportunity within these arenas and generate value for taking on certain geopolitical risks,” she says.

Rodell believes there is a fundamental change taking place in the US/China relationship and recognising that helps inform investment decision making.

“Knowing what is long term systemic change and what is short term noise is important and while we don’t have any more knowledge than anyone else on that front we think there is definitely a need to watch trends and how the market responds.

“US and China relations are definitely significant, and there are trade tensions, but we think the US and China are too large to let it flounder. The global economy doesn’t allow countries to throw up borders and say they are not playing,” she says.

Having said that Rodell acknowledges that it is important to recognise the world is a different place.

“You could say you don’t want exposure, or you could say China is an important trade partner with the US and so want to invest in China. You have to distinguish between the long term shifts happening in terms of trade and then the individual noise of certain behaviours, like Trump leaving China a day early,” she says.

Alaska has exposure to China through A-shares and is looking at private market opportunities in infrastructure and technology.

“We believe that China will continue to be a place we want to have exposure to and so we need to work to find long term value in strategies that are exposed to China, and while maintaining awareness of how trade talks evolve and the relationship changes, not allow short term volatility dissuade us from that conviction.”

Rodell says there is some mild concern around the US and its attitude to foreign investment and whether there will be a response by some countries that results in barriers to US dollar investments.

“Does China still want to attract USD? This is something to watch,” she says.

Rodell believes certain political risks do create buying opportunities.

Nationalisation of assets is one political risk to avoid so some emerging and frontier markets are challenging, she says.

But in terms of a buying opportunity Brexit is creating interesting opportunities in the United Kingdom and Europe. Opportunities she views as a more tactical move.

“When the initial referendum took place and there was a vote to leave the EU, we were in a good time zone and could see the Asia market over reacting and so could take advantage of the short term noise,” she says.

“We have some tactical accounts where we can move money very quickly. We can also convene pretty quickly on investment committee level too, and are talking to our active managers and discussing opportunities with them.”

Alaska has an investment policy set by the board with percentage allocation bands around each asset class. The investment team can move within those bands. In addition its governance allows investment of up to 1 per cent of the fund in a single manager without board approval. That’s about $600 million.

“It allows us to be nimble,” she says.

This was also demonstrated during the euro crisis in 2012, where the fund took advantage of undervaluations in certain Eurozone countries, investing in real estate in Spain and Portugal.

“We try to look at these advantages and think the value outweighs the potential risks,” Rodell says.

At the end of the day perhaps geopolitical risk is something not to baulk at.

“The unexpected is what makes markets, creates spreads and allows us to generate alpha,” she says. 

Ian Silk, chief executive of the Australia’s largest pension fund, the A$130 billion ($91 billion) AustralianSuper, has thrown down a challenge for industry funds, the profit for members sector of the industry.

He said if the superannuation industry is really performing optimally for members there should not be any consistently underperforming funds.

“If those running consistently under-performing funds don’t do the right thing, APRA must,” he said.

“The real test will be whether we act in members’ interests every single time, not some or most of the time, but each and every time we make a decision, including when that might not be in the best interests of our fund, or even ourselves.

“We should welcome the extra scrutiny that comes with our current position of industry leadership.

“Each of us and our funds should make a genuine commitment to take our funds from their current position to elite performance for members.”

In focusing on delivering what members want, Silk said that funds will need to ensure they have sufficient resources, the right skill mix, the ability to invest in capabilities and to plan and act for the future.

“We have all, and I don’t think there are any exceptions, behaved in ways that will not cut it in the future,” he said.

Specifically Silk challenged those funds whose membership has been declining, or have consistently had below median performance to ask if they can do better.

“Have you really considered whether your fund’s members are best served by the status quo continuing?”

“Have you instructed your financial advisers that when they believe that one of your fund’s members would be better off in another fund, that they should tell the member that, and facilitate the transfer to the other fund? Do you vigorously pursue non-payment or under-payment of superannuation contributions on behalf of members?”

Silk acknowledged that the industry fund sector is now larger than the retail sector, and the gap is growing. In addition he said the Productivity Commission explicitly, and the Royal Commission implicitly, concluded that the industry fund sector is superior to the retail sector. But he said this meant industry funds needed to step up, not be complacent.

“What does this new-found mantle of industry leadership mean, he asked. “Member and community expectations are going to be higher, regulators are going to be more aggressive, political focus will be more intense and the media scrutiny will be sharper. And all of this in the context of a more challenging investment environment,” he said. “We shouldn’t complain about greater scrutiny. When it’s applied in good faith we should accept that it comes with the responsibility of looking after the retirement savings of millions of Australians, and of becoming a more important source of capital for the domestic economy.”

The fact that industry funds emerged largely uncriticised from the Royal Commission process is “no cause for triumphalism”, he said.

“That the profit-for-member sector was not found to have committed widespread misconduct, or behaved in a way that failed to meet community expectations, should be a base level expectation of profit-for-member funds. There is no basis for complacency or hubris whatsoever.”

Silk urged the delegates to think bigger than simply whether profit for member funds were better than retail funds.

“Our challenge is more fundamental,” he said. “It’s to be the best we can be for existing members, and the many that are currently choosing to move to industry funds. This weighty responsibility means both a big difference in mindset, and ultimately our actions.”

Silk pointed to three factors that he said make it incumbent on  the industry to operate the system in the public interest and the interests of members.

“The Parliament has established a super system which involves the implementation of public policy through the outsourcing to the super industry itself, a super system that is compulsory, and a super system that receives significant tax concessions,” he said.

“Because of these factors the obligation on us to operate the system to the highest ethical and performance standards is greater than exists in most industries,” he said.

A post Royal Commission and Productivity Report environment, combined with projected lower returns for the next decade than the past decade, creates a challenging future environment for the Australian superannuation industry, he said.

“The effect of each of these new factors means a more challenging environment in the future, which will be compounded by a reduction in the positive tailwinds that have boosted the performance of many profit-for-member funds,” he said.

This, he said, will require a different and bolder mindset focused on the best interest of members.

Silk gave the keynote address on day one of CMSF, an event that is in its 29th year.

In opening the conference, chief executive of AIST, Eva Sheerlinck urged delegates to “never lose sight of the core of who we are: proud stewards of others hard-earned savings”.

In recent years Robert Hunkeler’s investment strategy at International Paper’s $14.8 billion pension fund for employees of the paper and packaging giant has grown increasingly conservative. Today the $9.1 billion defined benefit portfolio is on a de-risking glide path and matching liabilities and fixed income investment is order of the day. But that still gives Hunkeler, who has run pension strategy at the world’s biggest paper company since 1997, ample room for innovation and success.

Like the strides he’s made reducing the deficit in the last three years. The pension fund is now 90 per cent funded on an accounting basis, up from 78 per cent in 2016 and equating to a reduction of pension risk, or the volatility of the funded gap, by around two thirds.

In a multi-pronged strategy the paper giant offloaded $4 billion worth of liabilities, boosted its contributions to the pension fund and shifted more pension assets from risk allocations to long bonds.

It also increased an interest rate hedge via a derivative overlay to 75 per cent in an approach that allows the pension fund to generate a greater return than if it used physical assets to hedge its liabilities.

“It is rational to reduce interest rate risk embedded in a portfolio as best you can, and derivatives give us the advantage of being able to do that while maintaining higher allocations to risk assets,” saysHunkeler in an interview from Stamford, Connecticut, where the investment team of seven is based.

The allocation in the DB fund, divided between stocks (37 per cent) bonds (50 per cent) and alternatives (13 per cent split between hedge funds, private equity and real estate) will stay the same for now.

Only when it’s 100 per cent funded will new triggers kick-in, reducing the equity and alternatives allocations and increasing the hedging ratio again. However, despite the progress of the last three years Hunkeler doesn’t believe the pension fund will be fully funded anytime soon.

“My guess is it’ll take a while to get to a fully funded level: interest rates won’t likely rise much in the near term, returns won’t likely be large either and I don’t think we’ll make any voluntary contributions for some time to come.”

Despite the focus on the deficit the fund still has meaningful equity exposure. The allocation is broken up into US and non-US sectors, the latter comprising an international developed markets allocation and an emerging markets allocation.

The active approach spans the DB and DC funds to the extent Hunkeler only runs one index strategy in the pension fund’s entire equity allocation – a passive portfolio tracking the S&P500 in the DC fund. In the US, allocations are divided by market cap with investments split between large, mid and small cap companies with each bucket divided again between allocations to growth, value and core styles. Another layer of diversification comes from different strategies that span highly quantitative to highly fundamental.

Portable alpha

Portable alpha used to comprise another seam to the equity portfolio, introduced 15 years ago in a flagship strategy for a corporate fund.

“We looked at the excess return we needed from our large cap portfolio to be successful at the total plan level,” he recalls. “US large cap is one of the more difficult markets to outperform and it made sense to port a high alpha product like hedge funds into that area via an S&P index overlay.” The success of the overlay strategy in generating sought-after additional returns led Hunkeler to apply it to other parts of the portfolio next.

Namely the fixed income portfolio – which he describes as the second most difficult place to add value after equities – where he began by splitting the allocation between the S&P500 and the Barclays Aggregate Bond Index. Next, as the fund’s allocation shifted from the Barclays index to more conservative long bonds, Hunkeler began porting over the alpha to long treasuries and has now “completely transitioned” the entire portable alpha strategy on top of the long bond portfolio.

“As we’ve reduced our equity exposure, we’ve gradually transitioned our portable alpha strategy so that it’s now on top of a long treasury overlay. Thus, over the last 15 years it’s shifted from one end of the capital markets to the other,” he says.

The profitability of the strategy has endured the transition.

“Over the last 15 years our portable alpha program has added roughly 180 basis points a year over its benchmark, net of fees, making it one of our best performing portfolios.”

Portable alpha is also a more interesting seam to an investment strategy that has grown progressively more conservative as the pension fund focuses on the fixed income world.An aspect of the job that Hunkeler misses when he reflects on his tenure at the fund.

“Looking at strategies that could generate high returns and high alpha was fun,” he says.

The overlay is managed by NISA Investment Advisors and the alpha generating hedge fund portfolio comprises five to six funds split between fund of funds managers and direct investments. Managers include Blackstone, which has a long-standing relationship with the fund dating from International Paper investing in one of its first ever hedge fund products in the early 1990s. That formative relationship later led to Blackstone designing one of the portfolios in its portable alpha program.

“They liked the idea and developed a hedge fund for it,” he says.

Today, ensuring the hedge fund strategies don’t correlate is a challenge but Hunkeler observes that the correlation of the hedge fund portfolio is much lower to fixed income asset classes than it is to equity asset classes.

“It is working even better now that it’s tied to a long-duration treasury derivative as opposed to the S&P500.”

He also attributes the success of the strategy to not deviating from a core belief that hedge funds are market neutral.

“We are not looking for equity substitutes. We are looking for a portfolio that delivers fairly consistent, lower returns compared to what many other investors seek from their hedge fund allocation.”

Nor does he invest the full notional value of the portfolio in hedge funds to give headroom when the market swings.

“We only invest 90 per cent of the notional value so in periods when a beta of 0.1 goes to 0.6 we are not penalised as badly as we would be if we maintained it at full notional value.”

DC focus

As the need to shoot the lights out on the DB side fades Hunkeler is increasingly turning his expertise and energy into developing International Paper’s fast-growing $5.7 billion savings, or DC plan in a transition phase at the fund.

“We are doing exciting stuff on the DC side. The transition from the DB world to the 401(K) world is allowing us to bring all the learnings and skill from the DB world over to the DC side.”

That transition has involved “white labelling” many of the DB pension portfolios, making them available to savings plan participants in a process begun in 2002.

“Our savings plan core options are essentially the same portfolios we use in our pension fund; they are investing side-by-side,” he explains.

In a bid to complete the process he is now exploring adding most of the risk-based investment options in the DB fund to the savings plan although savings plan participants won’t get access to portable alpha and hedge funds “for now.”

Not only will it give savers more investment options and a chance for better returns. It will also increase manager diversity. The DC fund currently offers a three-tiered investment structure where in tier one, employees can choose from three well diversified portfolios of stocks, bonds and real estate, ranging from conservative to aggressive. These portfolios are managed by a single manager; mindful of single manager risk, white labelling the DB fund will increase manager diversification.

“We plan to allow the savings plan participants to benefit from the same value-added performance that we’ve generated on the DB side.”

Hunkeler outsources all asset management to around 75 managers that together run around 160 separate portfolios. But consultancy Rocaton, also in Connecticut, helps with every aspect of strategy from asset allocation, LDI, manager searches and performance evaluation and is his first port of call. “Rocaton acts like an extension of our internal staff,” he says. “Managers always try to come to us; we always redirect them to Rocaton.”

Hunkeler also attributes much of the fund’s success and advantage to a governance structure that has delegated control over every important investment decision. It’s led to his conviction that governance by committee, where often in-expert members must approve every aspect of strategy and manager selection, is highly damaging.

“Investment management decisions should be left to those living and breathing them on a day to day basis; to not do so can lead to misalignment. It’s easy to see how committees move to conservative and safe decisions that rarely lead to outstanding performance,” he concludes.

Pension funds pay performance fees for active investment strategies and alternative asset classes such as hedge funds and private equity, the idea is that performance fees incentivise asset managers to outperform a benchmark.

A new study by Dirk Broeders, David Rijsbergen and Arco van Oord, from De Nederlandsche Bank, relates performance fees to investment performance. The study, Does it pay to pay performance fees, finds no statistical evidence that returns of pension funds that pay performance fees to asset managers for active investing are significantly higher or lower than the returns of pension funds that do not pay performance fees. This is true for most asset classes and robust if we correct for risk. We also document that large and more specialized pension funds pay less performance fees for a given level of excess return in alternative asset classes such as hedge funds and private equity.

The paper finds that large and specialised pension funds are able to realise more profitable mandates with asset managers. This is possibly the result of better negotiation power due to their large scale or high level of expertise.

 

Pension funds pay high performance fees for private equity and hedge funds

In 2017, 218 Dutch pension funds together paid EUR2 billion in performance fees to asset managers. To put this in perspective, these pension funds paid EUR 30 billion in retirement benefits in the same year.

The present value of performance fees represents the transfer of a significant fraction of the pension fund’s wealth from beneficiaries to asset managers. Performance fees vary across asset classes, with high fees typically being paid for private equity and hedge funds.

Between 2012 and 2017, pension funds paid on average 76 basis points per year of the assets under management (AUM) in performance fees for private equity. The pension funds in the 90thpercentile, however, pay more than 235 basis points in performance fees for private equity.

For hedge funds the mean performance fee is 83 basis points of AUM, and top 10 per cent of pension funds pay 176 basis points or more.

To put this in perspective, the mean performance fee across time and pension funds for equities is 2 basis points and for fixed income it is as low as 0.5 basis point. The researchers also document net excess returns. The mean net excess return for private equity is 76 basis points, while the mean net excess return for hedge funds is -45 basis points. The mean net excess return for equities is 37 basis points and for fixed income it is 20 basis points. Net excess returns are defined as total returns less all investment costs (including performance fees) and benchmark returns. The benchmark returns are self-reported by the pension funds.

Size and specialisation matter

Our study shows that large and specialised pension funds, on average, pay more performance fees.They also find, however, that large pension funds pay less performance fees for the same level of excess return for hedge funds.

Pension funds specialising in private equity enjoy the same benefit, because these pension funds pay a smaller proportion of the excess returns in private equity to asset managers. So it seems that large and specialised pension funds are able to negotiate better terms with asset managers than smaller and less specialised pension funds. This may be because their size or expertise gives them more negotiating power. Large pension funds might also be more interesting for asset managers to have as clients because of reputational reasons.

Performance fees are less relevant for net returns

Active asset management is an important mechanism for price discovery in financial markets. Performance fees by construction are only paid if the asset manager delivers outperformance.

We compared the group of pension funds that pay performance fees, with the group that do not pay performance fees. We find that the net returns of the first group are not significantly different from the second group. This applies to most asset classes.

For access to the full paper click here