The industry seems to be moving inexorably towards consolidation but Mark Hodgson believes smaller schemes can have significant advantages
The pensions industry is under huge pressure and the direction taken from here will affect millions of scheme members throughout the UK. Following the Financial Conduct Authority's (FCA's) referral of the investment consultant industry to the Competition and Markets Authority (CMA), the size of pension schemes has come under scrutiny. The CMA has suggested it might recommend the creation of larger pension trusts to help smaller schemes alleviate costs, and the Pensions and Lifetime Savings Association (PLSA) has even recommended the creation of superfunds. Both of these appear to miss the bigger picture.
First, the general direction of travel seems to be towards asset pooling. The hope is that this will protect smaller schemes from market fluctuations and, presumably, from funding deficits. The logic follows that these superfunds would have a wider universe of investment opportunities and, therefore, more opportunity to outperform. Our experience has been the polar opposite, with size limiting the opportunity set and, in fact, being a drag on performance.
Larger schemes can only access funds with enough capacity to accommodate their larger mandate. This means the allocation has to be to larger funds. However, to take, for example, hedge fund allocations, Preqin data indicates there are only 770 hedge funds worldwide that manage over $1bn (£750m). Therefore, a huge majority of fund managers - ranging from hedge funds and private equity funds to real estate and debt funds - are off the radar of the larger schemes. Considering that many of the best funds close once they reach their preferred capacity, the universe of good, large funds is limited. Of course there will be many below average fund managers in the larger majority but the job of an adviser is to identify those that represent the best guardian of their clients' assets and not just take the populist approach.
To compound the issue, research from the Cass Business School has demonstrated that these larger funds are not, in fact, better insulated from market fluctuations. On average, a $200m hedge fund has outperformed a $1bn hedge fund by 61 basis points per year and outperformed a $5bn hedge fund by over 120 basis points per year. The more money you're managing, the more difficult it becomes to outperform. Portfolio construction must lead from analysis of manager quality and it cannot be governed by fund size. For example, our multi-asset fund, which invests in a diversified portfolio including many smaller funds, has produced returns three times greater than its peer group, while assuming the same level of risks.
Second, while the PLSA's DB Taskforce has reiterated calls for smaller schemes to merge into 'superfunds', the FCA has called for a review of investment consultants because of the dominance of the largest players. On the one hand, industry bodies are praising economies of scale while, on the other hand, the regulator is encouraging trustees to exercise caution when relying on enormous institutions.
As advisers specialising in sub-£500m pension schemes, we recognise the pain and confusion facing their trustees. Is bigger better? Does asset pooling lead to cost cutting? Or does asset pooling lead to a decline in performance? In the recent past cost seems to have been preferred over value, a trend that looks likely to continue. Yet the issue is that smaller schemes and their trustees are continually overlooked and are being herded towards saving money rather than delivering performance.
For smaller schemes, consultants play an essential role and should be looking at all the opportunities that are available. Take for example, our smallest client - it has access to a number of illiquid private equity, debt, and property funds with commitments of less than £0.5m to each fund. There has been no compromise on diligence or governance to invest in these funds and the scheme (and its members) is in a very strong position. This has been achieved largely because of its small size, not despite it.
The danger with the advice that is arising in the last few weeks is that the pensions industry ends up with a handful of superfunds with very low fees, generating market returns at a time when most believe that market returns will be subdued. By their very nature, smaller schemes should be using their size to their advantage - an advantage that should not be given up.
Mark Hodgson is managing director of Gatemore Capital Management
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