As defined contribution schemes become more widespread, the scheme provider's role as hirer and firer of the pension fund's manager is changing
The defined contribution scheme provider's role as hirer and firer of the asset managers is changing as DC schemes become the norm rather than the exception. The role will clearly vary according to the trustees' requirements, which, in turn, will dictate how the responsibility for performance is shared between the provider, trustees and scheme members.
At its most basic, a DC scheme with external managers can leave the entire choice to the scheme members. All the provider does is to offer a link and, although it is in everyone's interests that these managers remain competitive, the provider takes no responsibility for the outcome.
This approach follows the original blueprint for DC schemes and plans, which, among other features, were clearly intended to switch the burden for investment performance from the employer to the scheme member.
Today, a more enlightened approach is called for where the responsibility is shared, even though the provider and employer do not bear the consequences of poor performance through the underwriting of a target pension benefit.
So how can DC providers maintain optimal performance? Probably the most sophisticated system for deselection is that used by the manager of managers and multi-managers. These phrases have become interchangeable but basically mean the additional tier of expert managers that hire and fire the sub-managers.
While the expense of this additional tier of management may be prohibitive for stakeholder schemes, there is no reason why providers should not consider adopting the most obvious triggers for deselection.
The key feature to consider is the proactive monitoring process that allows the multi-manager to spot a potential problem before it irreparably damages performance. A recent survey published in Investment and Pensions Europe1 asked a number of multi-managers which factors precipitate a change. In all cases, the companies stressed that a team of shadow or alternative managers are screened and ready to step in at a moment's notice, thus avoiding loss of performance through delays and poor transition management.
Aon Investment Company cites key structural or organisational change as a trigger for manager review. Other triggers include 'an indication that long-term performance is compromised' and where 'the manager no longer adheres to the appropriate risk budgeted quantitative matrix'. In its reasons for firing a manager, Escher UK includes 'non-adherence to brief/style/risk profile; weakness in processes; loss of key staff; a significant breach of investment guidelines or a major regulatory issue'.
An old hand at multi-manager, Frank Russell, says: 'The vast majority of changes for manager-specific reasons result from either organisational instability or a change in process.'
Russell learns about these situations from three sources: its equity portfolio management team, its manager research analysts and directly from the manager. This last point is interesting: clearly, the more up-front the manager is about any change in personnel, for example, the more in control it appears and the less likely it is to be fired. The last thing any manager should do is hide problems. With these multi-manager operations on their case nothing remains secret for long.
GAM is particularly well known at the top end of the retail market. Its success has been based, among other factors, on a careful blending of investment style and proactive hiring and firing. The company says it changes managers if it believes their style is not suited to current market conditions. It hopes to fire sub-managers on expectation of poor performance, rather than after the event.
Another stalwart in the multi-manager market is Northern Trust, which has a reputation for firing managers when they are outperforming as a result of style drift (see below). Northern Trust lists five key triggers for change:
• Major staff defections.
• Changes in structure ' for example the splitting up of a successful group.
• Changes in investment style.
• Growth followed by inattention to principals.
• Inadequate response to market changes.
• Departure of the chosen manager.
Stamford follows a similar process and includes 'rapid growth in assets undermanagement' ' a trigger for review also employed by Watson Wyatt in specialist appointments under structured alpha. Research by Watson Wyatt suggests that sizeable client gains on the back of good performance can lead to skill dilution. Academic studies in the US indicate that the maximum total for a manager should be about $1bn. Where they have sufficient influence, consultants and multi-managers that adopt this approach for their specialist mandates may only hire managers prepared to limit funds under management.
Last but not least, Irish Life International highlights the importance of continual research of new managers. A change may occur therefore, because 'the fit with other managers is no longer optimal' and where 'a better alternative arises through ongoing research'.
Style management is central to the effective implementation of manager of managers' structures and requires an expert on the job on a permanent basis. This is also likely to render it prohibitively expensive for the low-cost DC schemes, but, again, it may be possible for those responsible for stakeholder manager selection to adopt some of these principles.
In this respect, it is important to appreciate that multi-style structures are not a fancy bell or whistle bolted on to add outperformance but a stabilising mechanism employed for risk management purposes. The management of style risk by the provider leaves the asset managers to deal with the job they are best equipped to handle, namely stock-specific risk. As with any multi-manager portfolio, it is important to distinguish between style bias at the manager level and the combined fund level. Multi-style portfolios require the adviser to analyse the style of different investment managers and combine them in such a way that the aggregate is more broadly diversified across investment styles than any of the component parts in isolation.
Therefore, while individual managers are likely to peak at different times during the market cycle ' depending on whether growth or value is in fashion, for example ' the combination of managers smoothes this overall volatility by reducing the impact of stock-specific risk and market volatility on the fund.
There is clearly no point in buying in a multi-style structure unless the provider can demonstrate its ability to manage style drift. Style drift is where a style-specific manager deviates from his or her area of expertise in order to improve the potential for short-term gains. A good example of this is where certain UK growth managers in the past have drifted towards value stocks to boost performance.
The problem with style drift is that it throws out of balance a multi-style, multi-manager structure and also exposes the fund to the risk that the managers in question may drift into areas where their lack of knowledge will result in poor stock selection and hence long-term loss of performance.
Equally important, style drift upsets the portfolio structure and asset allocation, which multi-style managers believe is critical to successful investment management. Style drift management aims to nip in the bud this deviation from the agreed mandate by tracking the buys and sells of the managers appointed.
One of the challenges for providers from the more style-specific US market is to find an appropriate way to measure European managers, many of which are less driven by precise styles. Indeed, some managers are wary of being seen to have a significant bias towards any particular style, in the belief that a flexible or growth at a reasonable price philosophy allows them to be all things to all people.
This approach, widely adopted by the insurance companies in the past, is woolly and anachronistic in today's competitive markets. The insurance companies that wish to survive as asset managers in the DC pensions market must have a formal, quantifiable investment philosophy and process and should be prepared to stand by this. The rest should stick to administration and delegate the asset management to the experts.
1 IPE Multi-Management Report, September 2001. Tel: 020 7261 0666 www.ipeonline.com
Key structual or organisation change is a typical trigger for pension fund manager review.
The last thing any manager should do is hide problems.
A broad combination of managers can help smooth market volatility.
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