The breaking point of scale
|
Written By: Niamh Smith |
As the government pushes LGPS funds to merge and achieve growth, does scaling up reach a point where it stops delivering additional benefits?
Over the past decade, the LGPS has undergone a significant transformation, with policymakers and industry bodies consistently encouraging funds to achieve greater scale. The rationale is clear: larger asset pools can unlock efficiencies, reduce costs and create more opportunities for investment in infrastructure and other long-term assets.
But as consolidation efforts continue, a more nuanced picture is beginning to emerge. While scale can undoubtedly bring benefits, there is growing recognition that bigger does not always mean better, and that beyond a certain point, the advantages of size may plateau or even come with new challenges.
The cost power of scale
The government’s drive to consolidate LGPS funds into fewer, larger entities is based on the belief that greater scale leads to significant cost savings. Iain Campbell, Head of LGPS Investment at Hymans Robertson, agrees that the primary advantage of scale is reduced costs.
“By numerous investors combining their assets together to invest, better fees can be negotiated with external managers or, if enough scale is achieved, internal teams can be recruited to manage the money more cheaply than paying for external management,” he says.
Chris Sier, CEO of ClearGlass, agrees that smaller funds pay higher fees than their larger counterparts. He adds that ClearGlass data shows a wide variation in pricing, with large portfolios, such as those of USS and NatWest, each managing around £80 billion, able to reduce costs for global active equity to around 40 basis points.
“The pools have done something unique. Not only have they done what we expected, which is, as the portfolios get bigger, they’re providing a fee saving, but they’ve also managed to move the scale curve. They live in a different price paradigm to the rest of the world,” he says.
In private markets especially, larger pension funds have leveraged their increased negotiating power to cut fees by an average of 15 basis points, according to Sier.
He adds that these fee reductions extend beyond global active equity to include multi-asset credit, active corporate bonds, global passive equity and every strategy ClearGlass has reviewed.
In addition, he notes that the savings apply regardless of the fund’s structure or operating model.
“It doesn’t matter if they have an authorised asset manager model, like Border to Coast, or a fiduciary manager like LPPI. It doesn’t matter if they’ve gone through the model like Access, which is where they have an operator that they’ve outsourced all their management to,” he notes.
However, John Simmonds, Principal and Head of Business Development at CEM Benchmarking, cautions that while cost savings are often seen as an obvious benefit, they can sometimes be misleading.
This is because as funds scale, the pools gain access to private investments in a way that individual funds couldn’t secure on their own. However, these investments typically come with higher fees, so instead of lowering costs, scaling up can sometimes lead to the opposite effect.
“As they tip their asset allocation towards private investments, the cost of those private investments is substantially higher than the public market alternatives that they are moving out,” he says.
“In aggregate, costs go up, but what happens in practice is they become more efficient because the pools give them access to those private assets on a more favourable basis.”
He adds that while larger pools can negotiate better fees due to their scale, the real cost savings don’t come from fees alone. Instead, they result from the ability to adopt a different approach to implementing investment strategies – something he says has two key components.
“The first is internalisation,” he says. “When you reach a certain scale, it becomes possible to stop buying from fund managers, and build a team of people who are going to go and invest those assets directly. That is typically done at a much lower cost than any external mandate.”
The second, and potentially more significant, factor is the ability to access private markets in a more efficient manner after scaling, Simmonds adds.
He explains that smaller funds typically turn to aggregators or fund providers that gather assets from multiple pension schemes before approaching a private market manager.
This structure introduces additional layers of fees, first to the aggregator, then to the underlying manager, which creates a significant cost barrier for smaller funds, he says.
“It’s not to say that you can’t overcome it through good performance, but it puts you at a significant disadvantage from those who are big enough to go to the private manager directly and play at scale in that market,” he says.
Does scale hit its limit?
The cost benefits of scaling are clear, but as consolidation advances, it’s becoming apparent that increasing size doesn’t always translate into greater advantages. In fact, scale can reach a tipping point where the benefits begin to plateau.
Sier notes that in Sweden, pension schemes underwent a procurement process that consolidated their assets into a single large fund, similar to an LGPS pool, significantly reducing the number of funds available to pension savers.
He explains that, unlike UK pools which typically manage between £20 billion and £50 billion in assets, the Swedish pool was significantly larger at £180 billion under management.
However, when ClearGlass compared unit pricing data between the Swedish and UK pools, Sier notes that the Swedish pool did not achieve greater cost savings despite its much larger size.
“Sweden has pot portfolios twice the size of LGPS pools, but even they don’t get any more savings that have been squeezed out of the LGPS,” he says.
“There comes a point when the costs bottom out. In this case, the Swedish Fund Procurement Agency appears to operate in the same paradigm as the local authorities, i.e. better than the private sector, but it doesn’t do any better than the LGPS pools.”
He suggests this is likely because beyond a certain point, managers cannot profitably lower their fees further, so they choose not to reduce them anymore.
In contrast, Simmonds argues that CEM Benchmark’s data shows “no evidence of diseconomies of scale across their database,” suggesting that benefits continue to accumulate as funds grow.
However, he acknowledges that the data becomes sparse at the very largest scale of around the £500 billion mark, since only a handful of funds operate at this level. With just four or five data points, it’s challenging to draw definitive conclusions.
Although the data on whether funds eventually reach a point where scaling offers no further benefits remains inconclusive, Simmonds emphasises that there is a clear threshold where scale begins to deliver significant advantages.
“You can get some much smaller funds that are doing things very effectively, but the rule of thumb is to get to a fund managing £50 billion with 500,000 members,” he says, “It can make the decisions that very large funds make.”
The trade-offs of growth
Though it is clear that scaling delivers a cost saving benefit, albeit up to a point, the impact of scale on performance is much less clear and “unarguably” more important, according to William Bourne, Founder of Linchpin Advisory.
He cites that the New Zealand Superannuation Fund outperforms most, if not all, of its peer group, despite only having £37 billion assets under management.
One reason, he says, is that while internalising management reduces costs, funds need to put good governance in place and offer competitive pay. He adds this is especially important in private markets, where the range of outcomes is wider and performance-based compensation is standard.
“Look at the Swedish experience, where following the Northvolt collapse, the government there has commissioned a review of how the big state pension funds invested in it. Getting this right will be a big challenge for the pools,” he notes.
In addition, Campbell also warns that funds should be prepared for potential downsides that can come with increased scale.
“Increased scale can be a double-edged sword, with no single number or range that is optimal for all. Whilst some clear benefits can be achieved, there are drawbacks to having a larger pot of assets to manage,” he says.
For example, one downside is a reduced ability to influence the range of investment options available, Campbell says. He notes that some of the savings come from cutting down the number of choices available, which means investors have to accept fewer options. So, there’s a clear trade-off between saving money and having less choice.
“Where these are simply preferences that can’t be met, this doesn’t matter too much, but where they are key investment issues or beliefs, scale becomes a real challenge to achieving underlying investor outcomes,” he says.
He adds that another key drawback can be a reduced ability to invest in smaller, more niche strategies, which is an area in which LGPS funds have been particularly successful.
“LGPS funds have been successful in supporting these types of strategies, particularly in private markets, often with a ‘local’ or ‘impact’ focus,” he says.
“However, if you are managing a private markets programme with tens of billions to invest, it becomes far more difficult to invest in these types of solutions.”
It becomes more difficult as funds need to justify the work to invest a few million in a niche strategy when they could instead use that time to commit hundreds of millions to larger, more traditional mandates, according to Campbell.
While it is possible for larger investors to still invest in these more niche strategies, he notes that they will need to employ more resources to do so, increasing costs.
This is particularly important now given the government’s push for LGPS funds to invest locally, where many of the opportunities will be small and unique, he adds.
The government’s push for bigger funds promises cost savings through greater bargaining power and bringing investment management in-house. But scaling isn’t a magic bullet. There’s a tipping point where those benefits level off. Beyond that, funds will also need to navigate potential new challenges that come with growing larger.
More Related Content...
|
|
|