Paul Waters, Head of Institutional, UK and the Netherlands and David Kneale, Head of UK Equities at Mirabaud Asset Management.
Undoubtedly, the pooling of investments into a smaller number of larger entities will deliver several benefits; using scarce resources more effectively and generating cost savings and efficiencies from the economies of scale. However, pooled entities may also consider a broader range of investment issues to deliver the best outcomes for members, sponsors and their regions.
Beware of the rush for passive strategies
After almost a decade of “free” money and substantial quantitative easing, much of the risk of companies failing has been removed. The reward for high quality or value orientated active managers has been slim, despite those being two of the categories with the best long-term success. Conversely, the reward for allocating capital into equity markets at the lowest possible cost has been considerable and this has helped to fuel the growth in passive strategies.
What if the next decade is not like the previous one? What if interest rates rise closer towards long run averages and governments start to reduce their unprecedented levels of debt, what if volatility increases, what if markets continue to be influenced by significant macro or political events? These more challenging times will highlight the fundamental risks contained in benchmarks, but it may be too late by then. Active managers who focus on high quality, cash generative businesses with strong balance sheets are more likely to demonstrate their value in these more challenging conditions, as has always been the case in the past. Investment managers with a genuine mandate to invest actively are the only ones with any ability to avoid the next dotcom bubble, Enron scandal or banking crisis.
Bigger does not always mean better
Not all asset classes and investment strategies scale well. Active high conviction management, small/mid-cap equities and discrete country/regional strategies are all impacted by liquidity constraints and may have to compromise on high conviction ideas. There are economies of scale but they soon become dis-economies, reducing the ability to add excess return.
In addition to considerations around capacity, there is a risk that previously diversified investment strategies become highly concentrated across the LGPS pools. Furthermore, pooled strategies may be drawn towards the most liquid areas of the market, such as the large-cap equities of global companies, many of which are too large to grow above average growth rates.
Doing your bit for UK plc?
As very large, long term asset owners, the LGPS pools ought to consider factors beyond short-term investment returns. How active do the LGPS pools want to be with issues such as environmental impact and social responsibility? Do they want to encourage increased investment either locally or nationally? It can often be difficult to get your voice heard in a large cap global equity mandate. We are not simply talking about ensuring governance best practice, remuneration policy structure and environmental disclosures, but what really matters to investors: business strategy and the allocation of capital. This requires an in-depth knowledge of companies and a genuine long-term investment approach. Short-termism has resulted in too many corporate decisions being taken to flatter the next set of quarterly results.
Too rarely do we see passive investors engaging with management teams to challenge their strategies, withholding support from rights issues, removing management teams or voting with their feet and selling out of businesses whose strategies appear weak. Pushing executives to maximise the potential of companies they own is the most important role of shareholders; and one that is almost completely ignored by many.
We think the LGPS is in a unique position to satisfy their formal responsibilities and obligations, invest responsibly and encourage British businesses to be more successful, particularly at a time when many UK listed equities are attractively priced against their global counterparts.