By Jenne Mannion A herd mentality among institutional fund managers as well as the cosy relationship...
By Jenne Mannion
A herd mentality among institutional fund managers as well as the cosy relationship between pension consultants and major firms are among the issues being scrutinised by a Government-sponsored report.
The review of the UK institutional funds industry, led by Paul Myners chairman of Gartmore, aims to address a number of high profile issues.
The primary focus is to investigate whether there are factors distorting institutional investors' decision-making processes.
A consultation paper has followed the 2000 Budget, whereby the Government made clear its concern there may be factors encouraging institutional investors to follow industry-standard investment patterns, too often focus overwhelmingly on quoted equities and gilts and avoid investing in venture capital and other smaller companies.
Myners has already issued a consultation document highlihgting the maxi areas he intends to investigate. In addition, he has given the industry until the middle of July to add their views to this process.
In his consulatation paper, International Investment, Mybers states he is looking at whether or not the public is ill-served by the current structure of the £800bn pension industry, which accounts for 45% of equity investments in the UK.
His review is to cover defined benefit and defined contribution pensions as well as life assurance.
Myners said: " I hope to explore in depth the factors that guide institutional decision making. I have been concerned for some time that we are not making the best possible use of our capital markets.
"It is not appropriate for Government to second-guess institutions' investment decisions. However, if there are structural factors that are distorting rational decision-making, then there may be a role in helping to remove them."
Myners is investigating issues such as why fund managers operate in a herd like manner, by comparing their performance against their peers, rather than against a benchmark.
Perhaps the most high profile example of this herd instinct was seen in the 1990s when UK pension funds decided to be negative on Wall Street.
With most fund managers trying to be more negative than their peers, the level of investment in the US whittled down to a level where the average fund manager held more in the single stock of Vodafone, than in that whole US market.
This tendency to follow the peer group results from asymmetric benchmarks for fund managers.
As the report says, significant underperformance against the benchmark is likely to lead to mandate termination. Significant outperformance merely qualifies the manager to compete for new appointments with others with similar performance records.
He suggested that this asymmetry may create an incentive for fund managers to shadow their benchmark fairly closely and such a strategy would minimise the risk of underperforming it by much.
However, this also leaves open the possibility of outperforming the benchmark by a small amount by varying investment strategy.
Myners will also look at how fund managers are rewarded against performance benchmarks, and ask whether these are too conservative.
Phillips & Drew is one such company that cannot be accused of following the herd mentality. It stuck by value stocks when much of the rest of the market was following growth companies, leading to the long-term underperformance of its pension assets.
That underperformance culminated in the retirement of CEO Tony Dye earlier this year, after 17 years with the company.
This otherwise widespread reluctance to take big risks in deviating from the benchmark has resulted in the failure to invest in instruments such as corporate bonds and venture capital.
In general, fund managers don't deny acting in the so-called "herd like" manner. Rather, they say, they are merely responding to their clients' requests.
William Claxton-Smith, director, UK equities at Clerical Medical, agreed that where fund managers are seen to be acting with a herd like instinct, this is at the client's requests to outperform their peer group, particularly in the case of segregated mandates where such objectives are most common.
It is therefore important that the report goes one step further to consider what determines client preferences, according to Michael Ashbridge, head of UK sales at Flemings.
He said: "If the objective is to outperform the peer group, as opposed to achieving absolute returns, then an element of this herd instinct is inevitable.
"If the benchmark is the peer group, and the objective is to have consistent performance against that benchmark, then the fund managers will take a low level of risk relevant to their peers.
"With fund managers looking to their peers as the benchmark, they are not prepared to take the risk of investing heavily in companies like venture capital firms."
As a result of an internal project called Insight, Clerical Medical last year, moved to asset allocating against predetermined benchmarks rather than taking account of what the competition was doing at any one time for its managed unit linked and retail pension funds.
At the stock selection level, Clerical Medical moved to benchmarking against an appropriate index for the fund. Claxton-Smith said Clerical Medical now offers its clients the two distinct choices of benchmark.
Mike Webb, managing director of Invesco, agreed with Myner's statement on herd mentality and the incentive to track benchmarks, is dangerous considering the high cost of active management versus passive management.
However, he said in many cases the market may turn negative or positive en masse in certain areas, not because they are following their peers, but due to other circumstances.
He added: "When the bubble burst on Japan, most fund managers were bearish on this market. This is not because fund managers started following each oth
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