Assessing the power of pension fund consultants in determining global investment strategy
There's nothing like a poorly performing market to bring about a change of heart. When a bull market is raging, everyone is happy; people feel they are more or less on the right track. Enter the downturn, though, and everything changes. Just ask a few internet stocks.
With that in mind, perhaps the rapid rise in the use of hedge funds in the UK's institutional investor portfolios over the last year or so should really come as little surprise. Hedge funds hold out the tantalizing carrot of rising returns in falling equity markets, albeit with a bit of extra risk thrown in to boot. Still, coaxing notoriously conservative pension funds down the hedge fund route would seem to be a tough job. And you would think it might be even tougher considering that the CSFB/Tremont index of hedge funds frequently failed to beat other performance indices over the past year.
Still, a Golin Harris/Ludgate survey of institutional investors recently found that European institutions more than doubled their use of hedge funds in the past year. Some 36 percent of fund managers were putting money into hedge funds in the first part of this year compared to just 17 percent at the end of Q1 2000. Even more note their intention to invest institutional money in hedge funds in the near future.
And who does the institutions credit with being the key force behind shaping their new-found attraction to hedge funds? The aggressive marketing departments of the hedge funds themselves? Nope. Think again and look toward the shy, retiring types that you might not normally credit with directing innovative global investment strategy: pension fund consultants.
Actually, we're actuaries
Pension fund consultants hold enormous, often uncredited power over the way that funds are invested. And that power increasingly lies in the hands of a few global actuarial advisors such as Watson Wyatt, Mercer, Russell and Towers Perrin who mop up the large corporate pension fund accounts. 'It is a scale business and that is part of the problem,' says Ric van Weelden, a partner in the investment practice at Watson Wyatt. 'If you're looking at an institution with 2,000 asset managers based all over the place, you need a lot of global research and knowledge. That type of thing is hard to do for a domestically-focused consultant.'
These few firms play a huge role in determining investment strategy for a large chunk of the world's pension monies. Sure, investment managers usually hold the final say over stock selection, but by the time they bring their expertise to the table it may be too late. The pension fund consultants - or actuaries - will have already laid down much of the law in terms of balancing a portfolio between various asset classes and international weightings. The benchmarks they create govern how funds are invested.
Ask any pension fund consultant about their level of influence and they tend to point out that they do not usually get involved in stock selection at all. True - unless, of course, you note that it is difficult for investment managers to select stocks that lie outside the benchmarks the consultant has dictated. 'We'd actually like to move away from indices altogether,' says Nick Fitzpatrick, head of global investing at Bacon & Woodrow, 'because we're effectively laying down some form of stock selection.'
Think of a Venn diagram with one big circle representing all possible investments. Plonk a much smaller circle right inside it representing the investment choices that can actually be made according to the predefined benchmark. It is now easy to see that the size of the inner investing circle is largely determined by the actuarial choices made by the pension fund consultant.
Consultants tend to have long-term relationships with their pension fund trustee clients. Fitzpatrick notes that the average tenure in the UK, for example, is around 25 years. This would be unheard of in most other fields but it is easily explained by the need for pension planning over a number of years. Brendan Reville, investment director at Gissings, a much smaller UK-focused operation, admits that most pension scheme trustees just use the consultant that comes along with their employee benefits advisor.
Nice & cozy
Pension fund consultants are in a 'sandwich', snugly fitting between the trustees and the investment manager. Many pension fund trustees do not fully understand the investment world, hence their reliance on the actuarial consultants for expert advice. Yet, if the fund underperforms in the short term, the long-term nature of pension fund planning is a useful cover. Over a slightly longer period the consultant can advise that a change of investment manager might be the most sensible policy.
It is a good position to be in, but despite the few big players and long periods of appointment, the consultants insist the industry remains highly competitive - and it is likely to become even more so in a sustained bear market. 'We're increasingly helping pension funds become smarter,' says van Weelden. 'Poorly performing equity markets mean that pension funds have to become keener to explore different ways to increase returns while maintaining similar risk levels. That's where we come in. Pension fund trustees are keen to achieve investment efficiency while holding risk levels down.'
Challenging times
Van Weelden admits that the industry faces a lot of challenges, particularly in Europe where it is being forced to play catch up with the US. For example, the US tends towards more competition and has more expertise at the pension fund trustee level. Those sorts of changes are slowly being felt in Europe. The UK is still reeling from the impact of this year's Myners Report, which proposes radical changes to the nature of trustees and the way that pension funds are managed.
He points out that a recognition by European governments of demographic change and what it means for pension provision is also forcing more markets down the private pension road. That, in turn, forces consultants to be more on their toes as they chase down the newly opened up business.
Similarly, the effects of the introduction of the euro are still being felt. That's a tangle the actuaries are still being called in to sort out, sometimes just by prompting funds to look elsewhere as the pool of European government debt has dwindled.
The rest of the problem relates to being a small fish in a much bigger currency pond. 'A lot of European pension funds were previously happy with a domestic manager relationship,' says van Weelden. 'Suddenly, they found themselves as a small corner of effectively a much bigger market.'
The true internationalization of pension fund portfolios has only really taken off over the past couple of years, according to some pension fund consultants. Until then, the US market remained largely domestically focused and the European market did not become truly global in its outlook until the euro began to take effect. Indeed pension funds have tended towards more of a pronounced local bias than other funds due to their higher aversion to risk.
The local bias is obviously still there but most consultants report a rapid rise in the need for global investment over the last two years - and predict even faster expansion in the near future. 'We want the managers we choose to think globally,' says Fitzpatrick. 'The barriers to cross-border trades are decreasing and we're trying to ride the crest of that wave.' Interestingly, he notes that the major market that is worst represented in their recommendations at the moment is Japan. 'Because Japan hasn't yet entered the world, it's still a local market with fewer multinational companies in the index than any other major market.'
Whatever the power of pension consultants in laying down these guidelines and determining overall investment strategy, their message to IROs is loud, clear and consistent: Don't come knocking on our door, we don't pick stocks. There is, however, an argument for corporate interest groups and, indeed, investor relations societies to forge stronger links with actuarial consultants - particularly with a view to corporate governance issues. There might even be an opportunity to widen the benchmarks. After all, if hedge funds can somehow make themselves appealing to pension funds then smaller-cap investments would seem to be in with a good chance. It's simply a matter of balancing risk with reward.
Funds of funds
Like many other aspects of the financial services industry, pension fund consultants are having to face up to a rapidly changing environment. And it is not just caused by falling markets; everyone's beginning to tread on everyone else's turf. Many consultants have begun moving down the more lucrative route of offering their own investment products to boot. Some suggest there might be a conflict of interest in consultants offering their own investment products. 'It's not necessarily a conflict of interest,' says Richard Davies, managing director of Fulcrum Research, 'more, perhaps, a sullying of the relationship between trustee and independent advisor.'
Some consultants have seized the opportunity with gusto. US-based Frank Russell - or Russell as it prefers to be known nowadays - is probably the best-known exponent of the art with its multi-manager investing products, or funds of funds. Others have dipped their toes in the water too. 'I like to say that we're a money manager,' says George Russell, chairman of Frank Russell. 'We don't buy and sell stocks but we research money managers and we manage managers. We utilize the knowledge that we have accumulated in manager research to help [clients] select managers and change managers. And then we have a fund business where we manage the managers in funds all around the world.'
This is radical stuff for the pension fund industry, particularly in Europe, where it has traditionally been more conservative than the US when it comes to experimenting with new approaches. However global firms also find it a difficult pill to swallow. 'We would see it as a potential conflict of interest,' says Ric van Weelden, a partner in the investment practice at Watson Wyatt. 'But we're helping funds get more involved in the management of their assets and we could get more involved in taking on more responsibility in managing the assets themselves.' So why are pension fund consultants going down the funds of funds route? 'Margins on consulting are pretty small,' explains van Weelden, suggesting the profits might only be a tenth of those possible in investment management.