Home > News > 2005 > July 2005 > Styles of Investment Management for Pension Schemes
Styles of Investment Management for Pension Schemes
Background
A review of investment strategy for a pension scheme (or indeed a charitable fund or other institutional investor) can be broken down into various stages. The first and most important stage is to set broad strategic asset allocation parameters which are appropriate to the liability profile of the scheme, risk tolerance of the trustees and employer, etc.
After strategic asset allocation, the next stage is usually a review of the style of the investment manager. Historically, trustees have often only considered appointing an "active" manager or, as a lower risk alternative, a "passive" manager. Recent years have seen the emergence of two further distinct approaches to active investment management, known as the "manager-of-managers" approach and the "absolute return" approach.
This note compares these four broad styles of investment management and considers the responsibilities each one places on the trustees. (For further information follow the links specifically on the manager-of-managers and absolute return approaches.)
Active Management
A traditional active management approach involves an investment manager trying to perform better than a benchmark of the relevant market index (or a benchmark of other active managers, although this approach is becoming less common). The investment manager attempts to achieve this by picking the best performing stocks and shares within each asset class. This requires the manager to use his skill and judgement in order to select the appropriate stocks to hold and to avoid.
In practice there is a wide range of active approaches available, for both segregated and pooled funds, to suit both single asset and multi asset mandates. For example, within the universe of UK equity funds there is a wide range of performance targets and associated risk criteria. These range from the "high alpha" funds, which might target returns of 3% per annum above the market benchmark, to enhanced index-tracking funds, which might aim for only 0.5% per annum out performance whilst maintaining a much lower level of risk relative to the benchmark.
Traditional active management is often categorised into various sub-styles, with some managers using combinations or variations of these sub-styles such as "growth", "value", "momentum", "quantitative", etc. There are also different approaches to the research process undertaken to find stocks that fit the house style, such as "top down", "bottom-up", etc.
Passive Management
An index-tracking or "passive" investment fund is one where the objective of the fund is to track as closely as possible the movements of a particular market index. This is done by utilising sophisticated techniques to replicate (either in full or partially) the constituent stocks of the underlying index. Very little judgement is required on the part of the investment manager.
Passive management represents a lower risk approach to investment management. Although the scheme will still be subject to the market risk inherent in the market index that the fund has chosen to track, investment manager risk is effectively reduced to zero. This makes the selection of an investment manager considerably easier for trustees.
As a result of the fact that very little judgement is required on the part of the investment manager their fees tend to be much lower than the equivalent funds for an active manager. In addition, the monitoring requirements on a passive manager are much more straightforward and should therefore occupy less of the trustees' time (and therefore the costs of monitoring the manager are reduced). Further, it is likely to be necessary to change investment managers less frequently than under an active manager approach and thus avoid incurring the costs that are associated with such a switch.
Manager-of-managers
This is an extension of the traditional active manager approach. In the UK it has a small, but growing, market share, although it has been more established in a number of other markets, for example North America and South Africa, for some time. There are two key differences between the manager-of-managers and traditional active management approaches:
A further advantage of this approach is that it enables schemes, particularly smaller schemes, improved access to a wider range of fund managers. Under the traditional active manager approach a small scheme would usually appoint a single manager for all geographical regions and across all asset classes. Under the manager-of-managers approach the scheme gains access to specialist managers in each geographical region and asset class in a relatively cost efficient manner.
The ongoing monitoring of a manager-of-managers should be more straightforward than monitoring active managers directly. In addition, the manager-of-managers approach ties in well with the Myners' Principles, which recommend that the appointment of investment managers should be separated from the asset allocation decision and is only undertaken by those with sufficient skills and expertise.
An additional layer of management is involved in a manager-of-managers fund and this tends to be reflected in a fee towards the upper range charged by traditional active managers. Therefore, as with a single active manager, the fund's performance after fees should be considered.
Absolute return
This approach shares many characteristics with the traditional active management approach described above. However, instead of measuring the performance of an equity or multi asset fund against an equity market or peer group benchmark, the performance target will be set against a cash or bond benchmark. The rationale for such an approach is that it more closely aligns the investment benchmark with a pension scheme's liabilities. The value of a scheme's liabilities is generally sensitive to changes in the bond market. By setting the scheme's investment strategy in this way the funding position of the scheme may be more stable over the short term.
In order to produce returns of, say, 3% above a bond benchmark (which currently equates to an absolute return of approximately 8% per annum), the investment manager would need to be given considerable freedom over the investment portfolio. They would want to be free to invest in a variety of asset classes and financial instruments (possibly including derivatives, although restrictions will generally be put in place regarding using these for speculative purposes).
The selection of an absolute return manager requires a greater degree of due diligence on behalf of the trustees, who will need to be clear that they have a full understanding of the process and approach adopted by the manager. The risk budget is being allocated in a different way and trustees will need to ensure the manager has sufficient risk controls in place. The trustees will need to closely monitor this to ensure they are being adhered to. This is a relatively new area of investment management for pension schemes and, as a result, terms and conditions will require special attention.
Summary
The table below compares the main functions of each type of manager described above.
Barnett Waddingham's view
The new approaches to active management have arisen partly due to concerns regarding the effectiveness of the traditional active management approach. However, these new approaches all face additional challenges. Passive management represents a cost effective method of gaining access to market returns and places less of a burden on trustees and will therefore be of continued interest to some schemes.
As with all investment decisions, the appropriate solution will vary from scheme to scheme and should be considered as part of a full investment review of the scheme after taking appropriate advice.
Glossary of terms
High alpha:
Alpha represents the additional return a manager is expected to achieve over and above the market return.
Momentum:
A momentum manager will invest in stocks that have recently provided superior returns.
Quantitative:
A quantitative manager will make use of complex computer-generated models when selecting which stocks to invest in.
Top down:
An assessment is made of the overall economic environment rather than individual stocks when constructing the portfolio ("bottom up" managers operate in the reverse manner).
Value stock:
A stock that the manager believes is priced cheaply by the market and will deliver a superior return when the market re-prices the stock.
For specific advice on pension investment issues please speak to your usual contact at Barnett Waddingham LLP.
Barnett Waddingham LLP, July 2005.