The investment strategy of the UK-based life assurer responsible for some £40 bn worth of assets
David Rough and his colleagues at London-based Legal & General Investment Management hit the headlines earlier this year when they publicly voiced their opposition to UK-based Farnell Electronics' proposed 'merger' with the much larger US-based Premier Industrial Corporation. The merger was just too expensive and favoured US shareholders over UK ones, explained Rough, director group investments. Legal & General decided it should come out in the media and show support for Standard Life's opposition to the deal.
The newly-created Premier Farnell is testimony to the fact that LGIM's public stance did not carry the day in this instance. But it did help put similar concerns of a significant number of other shareholders on the table. When an institution which owns around 2 per cent of the UK equity market sticks its neck out, people tend to take notice. All the more so when that institution is a significant passive investor and doesn't normally crave the limelight.The investment management operation was originally established to manage funds on behalf of its parent company, Legal & General Group plc. Today its London office manages around 21.5 bn on behalf of the life fund and 14.5 bn for external clients. There's a further 4 bn located in a small number of foreign offices most of which is sourced from locally-based insurance operations. In the UK the current investment split is 17 bn in UK equities; 10 bn in UK fixed-income; 6 bn in overseas equities; and just under 3 bn in property.
LGIM's big story is indexed funds. Around 45 per cent of the assets are managed on an indexed basis and that side of the business has been growing significantly in recent times. Rough points to gains of 1.5-2 bn in new corporate pensions business each year over the last three or four years. 'A lot of it is a reaction to the lack of consistency of some of the active managers who have been very successful at managing relatively small amounts of money,' he says. 'They've then been given a quadrupling of the size of funds under management and it's all blown up. Then the consultants get worried and annoyed; and the trustees get even more worried and annoyed and they want a safe and secure pair of hands, which consensus and indexation give them.'
Peter Knapton, managing director, securities, notes that indexation is also a considerably cheaper and extremely efficient way of managing money. 'But it isn't without costs,' he hurriedly adds.
The passive side of the business is split into international and UK sections with the latter further divided into equities and bonds. Individuals are responsible for the management of individual portfolios against stated benchmarks which can vary according to the asset allocation process being used. Knapton notes that sometimes a consensus allocation is called for, sometimes a judgemental allocation.
'That then is drilled down through individual portfolios into, let's say, the FT-SE Index and one manager would be responsible for matching that,' says Knapton. 'Someone else might have an international portfolio against the MSCI World Index. We have different benchmarks in the same way that the active business has different benchmarks for different clients.'
Does this mean that those managing the indexed funds are not interested in the companies their investments are locked into? Yes and no. Knapton acknowledges that the primary task is to replicate the index - sentiment does not come into it. Nor does meeting managements and getting their perspective on where businesses are going.
But there's some overlap with the active side's corporate governance stance here. Rough says that if the active side was not there to coordinate the corporate governance position then it would probably be necessary to set up some form of separate unit. 'With indexation you haven't got the option of selling out of a company if you're not happy with the way it's going,' he notes. 'In terms of overlay, corporate governance is the single entity currently under the active side which the index side has to rely on. Even though we can't sell stocks, that doesn't mean we can't try to influence management to improve the performance.'
The corporate governance role is coordinated by the active side because those fund managers/analysts have more direct contact with brokers and regularly meet with managements. 'What I wouldn't want to see is the index people diverting time and effort into meeting some of the 600 companies they own in the UK,' adds Rough. That role is left to the active side which, at the last count, met with some 900 companies in a year at one-on-ones, presentations, lunches, dinners and the like.
Before deciding which managements are going to be visited or invited in to strut their stuff in front of the active team, there are three decision-making processes applied: asset allocation, sector analysis and stock selection. Knapton defines asset allocation as determining whether they should be overweight in US equities, underweight in UK bonds and so on and then apportioning funds into the individual markets.
The asset allocation committee meets once a week - more regularly than many other houses but Knapton believes that this makes implementation of its decisions easier. The team consists of Knapton; John Monkton, who looks after bonds; Vanessa James, UK equities; Mike Payne, international equities; David Shaw, director of strategy; and Chris Robinson, director of the corporate pensions business.
'We try to put asset allocation decisions into a framework so that we know what we need to discuss,' explains Knapton. He uses the example of looking at the growth of individual economies and the liquidity that's available. 'If an economy is growing rapidly but industrial production is growing even faster, then clearly all the capital being created is going to go into funding additional production,' he says. 'At some point that will be bad news for financial assets. We look for surplus liquidity in an economy to find its way into financial assets. We then try to assess if it's going to be inflated away, priced out of the picture, or exported. We look at all countries in the same way.'
The committee then turns its attention to bonds and reviews whether markets are fair value, looks at the technical indicators and uses its proprietary model for the valuation of bonds. 'We pull bonds into the picture to decide whether we think that they are expensive or inexpensive and then we begin to build out the valuation of equities,' says Knapton. 'Are they cheap or dear relative to bonds? Are they cheap or dear relative to their own history? Are the technical indicators favourable or unfavourable?'
The committee's weekly assessment is put into a matrix system to produce a score for each market indicating an optimistic or pessimistic outlook. Knapton stresses that those scores do not set the asset allocation in stone: 'We can go through periods of having a high score for a market but think it is wise to be less enthusiastic.'
But on a broad basis the scores determine where funds are invested and decisions are implemented in portfolios straight away - trading conditions permitting. Derivatives can be used in realising those asset allocation decisions when the move is seen as being relatively short-term. Positions are then backed up with stocks when there is more confidence in such a switch.
Once the top-down decisions are in the bag each week, it is up to the divisional teams to allot the available funds to individual stocks. Knapton uses the eleven strong UK equities team to illustrate the process. The fund manager/analyst role is combined throughout the business and in UK equities the responsibilities are split into one group of three people following consumer goods and financials; one of four covering capital goods; and a team of three devoted to smaller caps.
The UK team meets every morning to review news, views and snippets of information and, in the light of that, to determine which sectors and stocks they favour. 'To be frank, it tends to be driven more from the stock level than from deciding to be overweight in, say, building materials,' says Knapton. 'They do have less regular strategy meetings where they would look at the sectors rather than just going through individual stocks. In those sector meetings they would see if they've drifted too far out of line because they were too enthusiastic. But that won't necessarily override stock selection.'
In-house research is supplemented with broker reports across the board. Knapton believes that the UK's FT-SE 100 companies are followed by too many analysts, which has led to a good deal of replication in the research received by Legal & General's teams. Conversely, the smaller companies - to which the UK equity team dedicates a disproportionate level of time - are often under-researched.
That does not necessarily imply that there is difficulty in obtaining information, though. 'We're not dealing in the very small companies where nobody other than the house broker will follow them,' Knapton says. 'Often the companies we're following will have three or four brokers looking at them who can give us some form of sensible appraisal - not just because they're connected with the company or receiving a fee from it.'
Does that mean that he distrusts information from house brokers and always seeks to back it up from another broking source? 'I didn't mean to imply that,' he replies. 'I think it's always a good idea but we don't go out of our way to make that a rule.'
Given the hectic schedule of meetings with managements, it is hardly surprising that Knapton prefers companies to visit LGIM's offices, rather than have his staff go out to presentations and conferences. Holding meetings in their own office also gives the portfolio managers the chance to dictate the course of meetings and elicit the information peculiar to their needs. Larger presentations do not afford that opportunity and can stray away from the areas they are interested in. It is a question of time management. 'We feel that if companies come to see us we can learn a lot more about them,' says Knapton. 'It means we can structure questions in a way we would like.'
The reliance on regular meetings with management helps ensure that LGIM is able to run an informed and comprehensive voting programme. Knapton says that the firm always tries to vote its holdings - and succeeds in around 90 per cent of cases. The other 10 per cent are mostly accounted for by small foreign holdings, where the mechanics of voting can make it commercially unviable.
'But we try not to sit on the fence and say we don't know,' says Knapton. 'We try not to abstain, although sometimes that's the wisest thing to do.' The bulk of these votes will go with management but it is by no means a guaranteed tick in the box. Voting intentions are usually only revealed in high profile cases, such as Premier.
That being said, LGIM kept its voting intentions a well-guarded secret during Granada's bid for Forte at the beginning of the year - despite being constantly pestered by the media to reveal all.
'Forte was doing a lot of things that it had been asked to do for a long time,' explains Knapton. 'It was all working to shareholders' advantage, even if Forte had remained an independent company. We listened and modified our thoughts by having both sides come in and make presentations to us. Had we gone out and said we're definitely voting one way or another, we'd have had quite a different attitude to those conversations.'
So what prompts LGIM to vote against management? 'If we thought voting for something was going to give a disproportionate share of rewards to one individual or one group of individuals and that reward was very large,' says Knapton 'we would vote against it. And we have done so.'
But, as illustrated by the Forte case, LGIM is not in the game to publicly pressurise managements by declaring the intention to vote against them. Much more can be achieved by discrete discussions behind closed doors. At times that involves the firm becoming privy to inside information, so the company concerned will have to be put on the stop list. No problem. That allows for a sharing of ideas between shareholders and management which Knapton believes is healthy and part of the role of institutional investors. It might not be corporate governance Calpers' style, but it is geared towards the same end.
'A lot of changes have taken place in the UK - some that you wouldn't necessarily think about - where institutional pressure has been brought to bear and changes have been made,' comments Knapton. 'One area where we do begin to have problems results from our not being, or wanting to be, operators of businesses. We mustn't stray down that avenue of being shadow directors. We don't want to be; we have no intention to be; and we don't know enough about it. We have to tread a careful path.'