From time to time the pension fund industry re-visits the question of whether the best route to achieving the optimal result is to invest in a balanced fund or opt for a series of specialist mandates. In recent years, trustees appear to have adopted the view that balanced funds offer a better solution, as indicated by the shift in the industry away from specialist mandates. But will this prove to be the right decision over time?
The primary argument in favour of balanced mandates centres on the fact that the manager has the full flexibility to decide which asset class to invest in and to change his asset allocation when necessary. As the manager is close to the markets, he will know when to adjust his asset allocation, or so the argument goes. When establishing their overall strategic asset allocation, trustees will often allow for a certain amount of fluctuation within certain parameters. With asset allocation being one of the main drivers of returns, actively fluctuating a fund’s asset allocation within this ‘risk budget’ is crucial. Yet some managers do not really change their asset allocation so trustees pay for the fee for this skill, but are not getting what they’re paying for. It also comes down to whom trustees allocate tactical asset allocation decisions. If this stays within the realm of the board of trustees, in consultation with their advisers, then trustees should ask whether the fees they’re paying for a balanced mandate are compensated for by the benefit their fund is receiving.
The other argument in favour of balanced funds is that they appear to offer trustees a simpler solution. Trustees are understandably attracted by the fact that decision making appears to be less complex, even as diversification across asset classes is being achieved. Furthermore, balanced mandates allow trustees to shift the burden of complying with Regulation 28 of the Pension Funds Act onto the manager. There are also different types of balanced funds to choose from, to suit different risk profiles.
What is often misunderstood, however, is that while there may be only one asset management house to deal with in a balanced mandate environment, there are still multiple mandates, and often multiple individual portfolio managers. This means multiple decisions to be made, and multiple performances to be tracked and analysed. A typical balanced fund may be invested in as many as six or seven different asset classes. These would include local equities, foreign equities, bonds, cash, property, and foreign fixed interest. Then, there is the tactical asset allocation mandate, which may be undertaken by a separate portfolio manager within the team, or by one of the managers also managing an asset class.
When it comes to a large fund it wouldn’t always be prudent to allocate to a single manager, so trustees may decide to diversify across two or more fund managers, in which case the number of mandates to manage increases further. In addition, the different managers may be taking asset allocation ‘bets’ that cancel each other out. Not only do trustees still have multiple mandates to deal with in a balanced fund, they are unlikely to be getting the best expertise in every asset class. Few asset management houses, if any, have outstanding skills in every asset class. Some houses may be widely admired for their skill in picking equities, but are coming in last on the performance tables in cash, for example. By simply choosing a different manager for the cash component of a portfolio – even one that is an average performer, as opposed to the worst performer – without changing the asset allocation, trustees can increase returns. The ability to select the best manager for each asset class, and thereby increase overall returns, is one of the primary arguments for specialist mandates.
The second argument in favour of specialist mandates is that it gives trustees the ability to tailor their asset allocation to match their fund’s liability profile. A moderate balanced fund, for example, may have 50% or 60% in equity, but if a pension fund is comprised primarily of 20 year olds or 30 year olds, it should be invested to the maximum level of equity allowed by Regulation 28, which is 75%. Alternatively, if the fund has a high weighting of 50-60 year olds, the asset allocation should have a high weighting of instruments such as inflation linked bonds, and less equity than a typical balanced fund.
Irrespective of whether a pension or provident fund is a defined benefit or a defined contribution fund, its trustees will have chosen a long term strategic asset allocation, based on the profile of their members, that best approximates their liability stream. When they invest in a balanced fund, trustees are unlikely to invest in a fund that best supports what they are trying to achieve.
Another issue in favour of the specialist route is that when they manage money, balanced portfolio managers focus on building up a pool of capital and then protecting it against any permanent losses. In other words, they focus on capital protection. This results in them holding a certain portion of the portfolio in cash, which is perceived as a risk free asset. However, in a low interest rate but high inflation environment, the cash portion of a portfolio will be earning negative real rates; but this is not the manager’s primary concern as his performance target is not inflation.
For pension funds, on the other hand, their target must be providing retired members with an income that increases by inflation. In other words, they are targeting inflation-linking income as opposed to capital protection over a period of time. There is a fundamental difference between these two objectives, which should translate into a different mix of assets.
Additionally, managers in the balanced space often hold quite a large portion of cash, often as much as 10-15%. This means they’re earning a high fee for doing relatively little on 10-15% of the assets.
Finally, with proper structuring and negotiation, a portfolio comprising specialist mandates is less expensive than the average balanced fund. This is because, with a specialist mandate approach, the sum of the fees paid for each component is typically lower, resulting in a lower cost overall.
Prasheen Singh, Head of Consulting