The master trust is leading the way on DC investment, getting into illiquid assets and challenging asset managers to do more. CIO Mark Fawcett tells Stephanie Baxter about its evolution
NEST has been on quite a journey since it was first set up by government in 2011 to facilitate auto-enrolment. Servicing seven million members, it is now the UK's biggest defined contribution (DC) scheme and its £4.1bn of assets are set to double over the next 12 months.
At the same time, it has grown into a more sophisticated investor and is putting pressure on asset managers to develop DC-friendly versions of investments that have been commonly used in defined benefit (DB) schemes for years.
Mark Fawcett, who has been chief investment officer at the master trust since the very start, explains the rationale behind the evolution of its investment strategy to one that has diversified over time. Back then, the typical default fund in the market was 100% equities with a strong home bias.
While NEST has aimed to be diversified from the beginning, it initially had access to a broad range of asset classes through a multi-asset fund, whereas now it accesses each asset class individually.
He says: "There have been two motivations for the evolution: one to increase diversification of the portfolio so we're not focused on a narrow range of asset classes, equities in particular. Secondly, to manage the long-term risks that our members face."
For example, last year NEST launched a climate-aware fund, co-designed with UBS, to align members' investments with the 2015 Paris agreement.
In 2016 it started investing in emerging market bonds, which now account for 4.2% of the growth phase. "The fund has done very well, albeit a bit more volatile in the past few months, but our timing was pretty good," says Fawcett.
Then, this year, it started investing in commodities for the first time with an environmental, social and governance (ESG) overlay, to act as a diversifier to equities and protect against inflation (comprising 6.4% of the growth phase). It is now seeking a private credit manager in another first for the master trust.
"Looking forward, we are investing for our members for the long term and we want to take advantage of the opportunities that a long-term investment horizon gives you," says Fawcett. "For example, that gives us a lot of appetite for illiquid investments, because we have money for 30, 40, 50 years for many of our members, and we should be paid a premium for holding those illiquid investments. For example, loans to corporates, infrastructure debt and real estate debt. The challenge around that is often fee levels, which is why we've challenged the private credit managers to come up with innovative approaches to deliver at low cost."
How have asset managers reacted to the challenge?
Fawcett says reaction has been mixed but encouraging in the sense there are enough managers who realise the future of pension saving is DC and want to be part of that, and NEST is expecting very "vibrant competition" during the private credit tender.
"But at the same time, a number of managers just don't want any part of this - it doesn't suit their business model or they're not prepared to work with us both from the fee perspective and operationally to deliver. They're very much stuck in the old model - that's fine, it's their choice. What I would say is that our illiquidity appetite is probably greater than the vast majority of DB schemes probably looking to go to buyout in 15 years, whereas we've got a 30- to 40-year investment horizon. So it makes sense for managers of private illiquid assets to think about the future and how they can work with the DC industry."
Going forward, the master trust is looking with interest at infrastructure equity as well as debt; however, these tend to be more expensive so the challenge is delivering them at low enough cost. Meanwhile, private equity and venture capital have even more fee challenges than infrastructure.
But Fawcett points out that as big DC schemes in Australia, for example, have invested in these areas, "we should look at their model".
In another first, NEST has this year started investing through a segregated structure for commodities, having previously relied solely on pooled structures. This is a big move for the master trust, signalling its growth into a more sophisticated investor. Will it look to do this for other investments?
"We can do - it's a question of finding the best operational model in terms of making sure we can get the exposures we want and do the ESG integration we want. Sometimes that will be in a pooled structure, sometimes segregated. Going forward, I'm sure we'll use more segregated mandates as it allows us to customise more, but there's sometimes a cost associated with that and we're here to deliver a low cost, high-quality fund to our members.
"The bigger we get, the cost difference between a pooled and segregated fund will become smaller and smaller. In three to four years there will probably be other considerations."
The master trust's internal investment team has grown steadily over the years to 20 people.
"As we have more assets, as some become more complex, such as private markets, we're thinking about co-investing alongside some of the managers and getting into illiquid assets. We'll need to make sure we have the expertise in-house to do that."
The asset allocation and manager selection are done internally, while the fund management is outsourced and will continue to be for the foreseeable future.
The narrative at the moment is that it is a very difficult investment environment, what with shifts in monetary policy, Brexit and the recent uptick in volatility.
A lot of assets are fairly well valued, says Fawcett, and it is always hard to say if they are extremely overvalued and make some brave call that the equity markets have peaked and it should sell all of its equities.
"That isn't what we see as our role; we need to make sure there's enough growth in the portfolio so members can benefit from global growth and rising markets without taking excessive risk.
"If markets fall, you can't protect everyone from a fall in fund values but you can certainly moderate it and ensure you're sufficiently diversified so it's a smoother ride."
At the same time NEST has a lot of lower risk assets across the portfolios, which will allow it to take advantage of any good value it sees in equities, for example, if they fall further. It has a lot of investment-grade credit, some of which is shorter duration so close to cash - under five years to maturity. These tend to be less volatile assets and ones that NEST could sell if it wanted to increase risk assets such as equities, emerging market debt or high-yield bonds, for example.
One of the current challenges for DC pension schemes is assessing value for money, with increasing scrutiny of transaction costs which are not included in the 75 basis points charge cap.
However, Fawcett says NEST does not have a challenge getting information from managers because it lays out at procurement what it wants.
"We minimise transaction costs in a number of ways - one is we have a lot of index funds, which aren't buying and selling all the time. When we want to reduce weighting in a particular asset class, we don't have to sell in the market, we just rebalance using our cashflows."
For example, from the start of 2016, NEST reduced its target weighting in UK property - which is currently around 6-7%. The master trust has not sold any property at all; it has just let the weighting drift down as the assets have grown.
By thinking about the operational structure and managing cashflows, you can avoid transaction costs, which in illiquid assets, for example, can be very high, says Fawcett.
While NEST has been disclosing its explicit transaction costs for a number of years, the implicit costs are harder to calculate.
"It's really important for a long-term investor to find fund managers that aren't turning over a portfolio six times per year, because that just generates a lot of transaction costs. Then we talk to managers about what they pay in commission, how they manage order flow, and the capacity of that individual asset class and the impact on the markets. There's a lot of colour to a conversation with our managers which we do on a regular basis but particularly at the point of procurement, because hiring the manager or not and their investment style are the most important decisions."
So what does NEST look for in external asset managers?
"First, their investment philosophy has to be coherent and very clear how they add value, how they manage risk, and how they integrate ESG. A lot of managers have now signed up to the UN Principles for Responsible Investment - one gets the feeling with some it's just a tick-box exercise and the ESG risk management isn't fully integrated. In our due diligence on managers we really kick the tyres on that along with other issues."
NEST is also looking for managers to have some cultural alignment with it. This is difficult given asset managers are all for-profit one way or another while, by contrast, the master trust is not-for-profit.
"But we're looking for managers that care about the same outcomes as we do, and that's part of the fee negotiation; we want to get very good value prices because we're helping improve pension outcomes for a large part of the UK population, many of whom are low earners. So finding a manager who that resonates with is pretty important to us.
"We'll need to keep evolving in investment to have a competitive product and it's really important for our members that we deliver good outcomes over a long term."
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