Written By: David Rae
David Rae of Russell Investments examines different structural approaches that may be taken by LGPS pools and outlines the potential benefit of an “open architecture” approach
The LGPS pools will be amongst the largest institutional investors in the UK and indeed the globe. This scale will provide the opportunity to reduce running costs and increase value for money. On the other side of the balance sheet, the pools are in a position to be at the forefront of investment innovation and create solutions that deliver higher investment returns and better risk management.
For many pools, today’s focus is understandably on the establishment phase, ensuring solid foundations are laid. This includes setting up the necessary governance and investment structures, and the transition of the existing assets. There are many critical paths to ensure the immediate success of pooling within the required timeframe. The six-month window to complete FCA Authorisation, ACS establishment, fund launches, custody and ultimately to transition the assets is very compressed.
Across the board, no one is underestimating the sheer volume of work that needs to be completed in a very short space of time. Each pool’s approach varies dramatically across a suite of different factors. The current portfolio management resources and team structure influence the preference for internal and external management of the assets. Culture and risk tolerance have influenced the asset allocation and investment approach of each fund differently. Significant investment is under way, ensuring high calibre executive committees, internal investment teams, and investment systems are in place.
Ultimately, the success of every pool will be judged on the long-term delivery of strong net-of-fee returns. Given this, pools are crucially working to balance these immediate demands relative to the best long-term opportunities to generate return and manage risk across their portfolios.
The immediate investment priorities
For very valid reasons, the first changes will focus on streamlining existing mandates, and establishing core funds. For many of the pools as they come together, there are overlapping and/or competing mandates, where rationalisation is possible. The initial consolidation exercise is a highly complex project that has the potential to reap great benefits. At the same time however, some of the biggest investment risks surround the restructuring and transition of the assets. A poorly executed transition could result in significant transaction costs and immediate performance loss. This will involve one of the most concentrated periods of trading in the portfolio’s life.
Whether the assets are managed by internal or external teams, there needs to be a very clear project plan that identifies significant risks, and documents how to manage these risks, ahead of time. For example, there may be a change in the regional market exposure, which could best be managed through futures alongside the stock level transactions. It will be crucial for pools to utilise expert transition planning help, whilst being mindful not to leak information to the market ahead of trading.
As the transition begins, it will be critical to monitor in real time the portfolio positions and risk exposures and ensure they remain in line with the pre-transition estimates and plan. After each phase of the transition, in-depth reporting needs to be considered to assess the effectiveness of the transition and to incorporate progress into the planning for the next phase of the transition.
The longer-term opportunities
The structure and processes of the pools will evolve over the years following launch, with each even relatively minor improvement having a material impact when compounded through the life of each fund.
Some key differentiators between pools will include whether pools opt to maximise an internal asset management, or take an “open architecture” management approach, utilising multiple asset managers. Furthermore, the degree of discretion they are able and willing to take over their funds’ aggregate investment allocation. At one end of the spectrum, a pool may hire an array of single manager funds and require their clients to choose. Alternatively, a pool may grow towards a structure that allows them to have full visibility of a fund’s aggregate investment exposures, and manage the investment risks inherent across the aggregate portfolio. These are very different offerings.
The biggest opportunity in the longer term is to evolve towards a structure which enables each pool to be more in control of overall portfolio exposures and outcomes, with full transparency and unbiased inputs.
The power of an open architecture structure
Many pools are embracing an open architecture approach in the belief that no single fund manager can be the best at everything. Almost every pension fund in the world is open architecture – allocating to more than one manager in a given asset class, for diversification. Pools can benefit from an open architecture structure in a number of ways:
- Access to the full opportunity set through specialists: Employing multiple specialist managers is especially powerful in fragmented markets like the credit market, ensuring access to all parts of the intended market (i.e. corporate, personal, and sovereign borrowing), unlimited by the skillsets of individual managers.
- Capacity to succeed: Single-manager strategies are often capacity-constrained and their performance can deteriorate when they absorb too much cashflow. A sophisticated open-architecture approach is well positioned to adapt to this challenge, constantly looking for new skilled strategies with capacity. This will be an especially important consideration for the pools given the large volume of assets each will be running at full scale.
- Performance consistency: Designed and implemented successfully, a portfolio employing multiple-managers or strategies has a higher probability of outperforming a single manager approach.
- Futureproofed approach: If an issue arises with a manager, it is possible to replace that element of the portfolio, rather than the entire portfolio, reducing transaction costs. By having more than one manager, subsequent changes are not as onerous as the daunting task of a one-for-one manager change (and it can be designed to happen within the structure, as opposed to doing a repeat tender every time).
How pools can reap the potential benefits of open architecture
Managing large pools of capital using an open architecture structure is not an easy task.
- A governance structure that is fit for purpose: Any investment process is defined by the governance structure. Success requires an executive function that is empowered to make portfolio changes in response to changing market conditions and expectations. Too much delay inhibits the successful implementation of best ideas. Above and beyond this, a governance function is required to ensure that the decision-making is consistent with investment philosophy, expectations and control limits.
- More than simply hiring and firing managers: True success comes from integrating capital market insights, manager research expertise, tactical asset allocation capabilities and factor capture skills in one integrated and dynamic process. It is important to utilise best-of-breed managers to access the most attractive opportunities and use a dedicated implementation team to support adjustments through the cycle. Above and beyond manager “buy ranks”, your provider should look at the manager’s strategy and see whether it is appropriate for the current market environment, how it interacts with the overall portfolio, and whether the timing is right to invest now.
- A more extensive toolkit: When considering a view, it’s important to have a robust understanding of existing exposures, and how you want the portfolio to be positioned. An extensive toolkit of data analytics is required to help identify the potential benefits of any portfolio change – whether this be through active managers, factor based strategies, or other instruments.
- The power to implement changes: To fully embrace an open architecture approach, a platform that allows risk management and trading across every available instrument becomes a necessity, including the ability to design and build bespoke completion portfolios to help manage risk efficiently in an open architecture structure.
The future is bright
Without making light of the enormity of the immediate challenges facing the LGPS sector as a result of pooling, we firmly believe that there are some great opportunities over the long term for funds to benefit significantly from the pooling structure.
Ultimately, the pools will be accountable for the aggregate investment performance. It is imperative that the governance structure, tools and resources are in place to exploit an open architecture approach. Russell Investments’ experience in managing large portfolios in similar structures has been that the commitment to innovation has been rewarded by improved risk-adjusted returns.
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