10 October 2020
Authors: Matthew Roberts and Chris Gower
Whilst there are some prominent exceptions, in recent years we have observed that much of the growth being experienced in DC defaults (including Master Trusts as well as Corporate schemes) has been invested in passive/index tracking investments.1
Based on our conversations with those directly involved, and our own reading of the topic, this is due to some combination of:
- The 75bps charge cap; though maybe some are leaving room for future investments in higher cost investments such as private markets;
- Fear of buying a poor non-passive solution (“Why take the risk?”), which is possibly a consequence of prior poor experiences;
- A view that the ‘cost-minimiser’ model best meets the requirements of members in the long run;
- Very tough price competition amongst the newly approved Master Trusts; and
- Focus on the broader experience – for example customer service, the digital interface/member experience, the administrative burden a pension can have on a company or at the level of the trustees.
Some of these points are understandable, but we are not convinced they are all valid. We address each point in this paper, other than point E), which is an important part of any DC pension provision.
We also explore the following questions. From a pure investment standpoint over the long term, is passive the best approach? Is the cost-minimiser model equivalent to ‘profit maximisation’? If more time were spent on these challenges around the metaphorical DC coffee table, would the approaches be more varied and different to what they are today? Finally, why think about this now?
An Impartial Implementation approach – what is the best solution, net of all costs?
Our aim is to find the best possible implementation route for the asset class we are researching whether this be:
- Passive/Index tracking or active
- Internally or externally managed
- An existing fund vehicle or a new fund launch
We have an all-encompassing approach for each investment decision which reflects a recognition that there is inherent uncertainty in markets and that there is a whole world of investment opportunities out there. We feel it a duty to consider as many of them as possible and to remain open to possibilities in the future investment time horizon. We are forward-looking, on a net of fees basis, rather than being too focused on the returns generated in a prior period.
There are very few things that we tend to refer to as “factual” in investing and we will try to keep to that mindset in this article. We often find a good starting point for a discussion around implementation routes begins with ‘Do we have a genuine justification for not investing passively in this area’?
Why passive isn’t always the right choice; and what more can be done in DC Default design?
For today, we thought we would share some of the reasons why we have chosen not to invest passively in a good number of the asset classes in our opportunity set. It is also worth bearing in mind that we have chosen to remain passive in some as we could not identify a better option; to reiterate, we are not myopically focused on investing in active strategies either!
1) Fees and Costs – Active management is more justifiable today than in the past
It is undeniable that, in recent years, there has been meaningful downward pressure on active management fees.2 This is due to a variety of factors including consolidation (and hence greater bargaining power) amongst the asset owner community.
Being first mover on new fund launches, and for us this typically means those who already have an established track record, can lead to even bigger reductions in fees. We have experienced several situations where the active managers all-in costs (i.e. the OCF or equivalent) are lower than the lowest-cost passive equivalent we can find. In these cases, this is a pretty big swing factor in favour of active management. The “fear of buying a poor non-passive solution” referred to earlier appears to have blinded market participants to the potential benefits of allocating to established capabilities coming to market for the first time.
Whilst these examples may be the exception rather than the rule, there is always an appropriate balance to be found in price setting for active management in the long run. More importantly, we are not suggesting that a lower fee active offering should be automatically selected since there may be incentive issues to investigate. The very fact these situations exist leads to the curious possibility that active may be the preferred choice even in an asset class deemed to be efficient.
Notably, we have also encountered, on a number of occasions, instances of poor implementation within passive vehicles; this might be a result of higher than expected transaction costs, excessive index rebalancing costs or the quality of market access.
So, the costs of active management have reduced in many cases. Many schemes have headroom within the charge cap to take advantage of innovative thinking and in some cases, they may not even need to use it.
2) Asset class availability – Building a portfolio with greater breadth
It is not possible to invest in some asset classes passively or through index-tracking funds. Many of the private market disciplines come to mind when thinking of this and whilst the Exchange Traded Fund (ETF) industry continues to innovate, it is possible to gain access to unique investments in the private market arena which have the potential to improve diversification and investment results.
It may be that the 80/20 rule is used to justify not exploring these types of investments – ‘our portfolio will do a good enough job and the extra work won’t outweigh the potential gain’ or it may be that it is just too ‘administratively problematic’. Either way, is it possible that this is the very reason why there are excess returns to be had by going the extra mile?
Asset class access is one of the key reasons why we feel much of the rhetoric on fee levels in DC is naïve; apples are often compared with oranges. Put very simply, the cost of accessing different asset classes is different and this makes sense given that the cost of production can be very different. This is not the same question as ‘do I want exposure at this price?’
Consequently, for example, it would be wrong to dismiss one Master Trust over another if the first was making a genuine attempt to access different asset classes and their costs were, therefore, a bit higher. A focus on “Cost-minimisation” over-simplifies the issue.
3) Manager diversification – How do you get breadth whilst minimising single manager risk?
Manager concentration comes hand in hand with the cost-minimiser model; there is a risk of too high a proportion of assets being placed with one given asset manager. We simply can’t get comfortable with this philosophy. There are a multitude of risks that apply to every investment and many of these are not predictable in advance. Any manager can be affected. This concentration risk is one we see asked about by Trustees more and more.
Dealing with the fear of making a mistake requires a deep understanding of the issues associated with manager concentration and how best to build diversified portfolios, but, with good governance, these concerns can be overcome.
4) Non-profit maximisers – Now is the time to position to take advantage
This is an often-used reason to justify active management; if there are non-profit maximising participants, this has the potential to lead to excess return opportunities for others.
One of the reasons we raise it here is that we can’t recall a time (at least in our living memories) when there has been so much non-profit maximising activity; QE, Central Bank interventions and now we have politicians directly making capital allocation decisions. We would argue that the very decision to pursue a simple cost-minimiser DC default is in and of itself a non-profit maximising activity, or at least profit agnostic. For example, a typical DC default might choose to exclude small cap equity exposure, which raises the cost of capital for these issuers, thereby potentially contributing to an inefficiency.
Ironically, the non-profit maximiser argument has been used in many cases to justify poor performance in active strategies over recent years. We believe there is a time horizon issue here. It is hard to argue that the non-profit maximisation activity doesn’t create inefficiency, but it has persisted for long periods which may lead to agency issues, with active managers finding it difficult to maintain positioning. At this point in the development of DC default schemes in the UK, we would suggest they are well placed to work with managers in partnership on a long-term basis.
Cost minimisation is not equivalent to profit maximisation.
5) Increased Dispersion and Low bond yields – Factoring in long-term megatrends
Several longer-term macroeconomic megatrends, such as technological change and the focus on climate change, are accelerating as we live through Covid-19. We have seen an increased level of dispersion amongst individual securities, which is potentially linked to this and has the potential to lead to a wider range of outcomes for active managers going forward. In other words, if you can maintain a positive win ratio in your selections, there is potential for improved results.
Simultaneously, very low bond yields in the developed world makes for a very tricky investment case. Thus, without active strategies, growth portfolios are at risk of becoming one dimensional. The current market conditions may well create a promising environment for the diversifying properties of other asset classes and active management to come to the fore. Does the cost-minimiser model give DC savers the opportunity to benefit from these diversifying characteristics and the long-term megatrends in a sufficiently targeted way, or is the hope that passive (mainly global equity) allocations will work out okay?
What can DC defaults do to broaden the asset allocation range for DC savers?
Based on our framework, there is a strong case for active management in several key asset classes, and some DC defaults could be leaving something on the table for members by not pursuing these potential sources of competitive advantage.
Notably, some of the above points also go to answer the question ‘Why now?’. Since the world of investing is so dynamic, some of the above points might change or diminish as investors cotton on to them, though equally others may well appear in their place. We are talking about a progressive approach and we are most certainly not advocating the legacy fee model of the active management industry. Moreover, a select handful of DC investors are considering many of these issues already, so there is a very real danger of falling behind.
The questions you ask of others should be the questions you ask yourself
We thought it useful to share a small selection of key questions we ask ourselves when we are deciding on the implementation route for investments we make on behalf of our clients. These lead us in different directions, though we find they are a vital part of the decision-making process and vary significantly from asset class to asset class and from manager to manager.
Which method will…
- …do the best job of active ownership and ESG-integration? There have been huge developments in ESG across the board and this is only set to continue. We deem this to be a potential source of value creation and at a minimum a preventor of value destruction. Is tilting global equities to a climate aware benchmark enough, or should defaults be investing with strategies more focused on meeting the Paris Agreement?
- …give us the best client service? Good client service creates a better understanding of the strategy amongst the owners of the strategy. We would wager that this leads to better investor behaviour and thus, better end outcomes for members.
- …complement the rest of our portfolio the best? We feel this should be considered more deeply across many more dimensions.
To what degree is the governance conundrum the issue?
Before we end, a word on governance. The nature of markets, along with the fierce competition for excess returns, are key reasons why governance is so crucial in any active endeavour. Exploiting any or all of the above factors requires a sophisticated governance framework – we know this because we spend much of our working lives focussed on it. Perhaps, in retrospect, this is a key determinant as to why many of the DC defaults are structured the way they are?
The governance burden can be almost entirely outsourced nowadays so we don’t believe this should prevent a shift towards improved diversification and/or active management and it should help overcome the challenges, such as the fear of making a mistake, outlined in this note. We are not saying that including some active exposures will be right for everybody and of course any cost of outsourcing should be part of the cost-benefit analysis. Perhaps though, in time, given the fundamental role they play in our country’s future retirement savings, the default design and belief structure underpinning it will command more time and attention and we will see more asset owners engaging with these issues within the UK DC pensions industry. Or, maybe, it will take another sharp equity correction, followed by a far longer recovery time to recoup losses, before we see a fundamental reassessment of portfolio structure.