Investment committees must therefore ensure that they are not looking at the process from a purely transactional level, and are instead considering the entire process, the effect on performance, fee value and its impact on risk/return diversification at the total portfolio level.
We believe key to this process is understanding manager diversification and its importance in the de-risking process.
Firstly, it is important to clarify that we feel manager diversification can benefit a pension fund at any stage of its life, rather than only being appropriate for those looking to de-risk their equities portfolios.
As has been well-documented, the majority of active managers (80%1) tend to underperform in the long-run. A pension fund opting to place its equity mandate with one manager is, in effect, making a call on the portfolio positioning of a particular manager – whether that be sector, country, factor or otherwise – and therefore leaving itself exposed to significant performance and manager-specific risk, noting that for all managers, there are inevitably times when the manager’s style is out of favor. In our opinion, a multi-manager approach can often offer institutional investors the most advantageous solution in terms of structure, returns and risk over the entire market cycle.
Our firm view is that such a well-diversified multi-manager structure containing managers that each bring their own approach, style, philosophies and drivers, increases the chance of outperformance while the chances of potential underperformance fall away.
One of the primary issues facing a pension fund on its de-risking path is that they tend to be under-diversified at a manager level, particularly on the equities side of a portfolio. We believe a typical approach to de-risking will tend to exacerbate this issue, as can be seen in the following example.
Take a hypothetical pension fund with $200m in its equities portfolio, distributed equally across four managers ($50m each). As the pension fund looks to de-risk its portfolio, it may look to take $50m out of equities. The most common question in this scenario is which manager to fire?
Investors might choose to get rid of the most expensive manager or the best/worst performer. In our view, the big issue here is not how to choose which manager to fire, but to understand that firing any manager reduces the diversity in the portfolio and therefore reduces that probability of outperformance that a diversified multi-manager structure can give you, as seen above.
Instead of asking which manager to fire a more appropriate question might be "can we reduce the mandates held across all managers?" Yet we find that this still yields a negative outcome when wider factors are considered.
A smaller mandate may often be less efficient for a pension fund from an overall cost and fees perspective, with the asset owner losing firepower in negotiating better rates with a manager. Additionally, mandate sizes might fall to a point where the pension fund is asked to switch from a separate account into a pooled fund, which can make sense, but will incur transaction costs and may leave them exposed to additional tax drag through the pooled fund (unless they are able to take advantage of tax efficiencies that some fund structures offer).
If neither of these options are palatable, it is not beyond the realms of possibility for a pension fund to see its equities allocation end up in a passive strategy, where alpha generation is eradicated and potential for better returns is lost.
With all of the options presenting downsides to the pension fund, this is where we believe a multi-manager fund structure can prove effective as it allows access to different styles and views on the market, while at the same time removing the challenges faced when reducing the equity allocation. Now the pension fund can redeem units in the pooled fund and avoid having to fire a manager and therefore reducing the diversification of the equity portfolio. It also proportionally reduces the allocation to the underlying managers, while not having to worry about breaching minimum sizes or significantly increasing fees.
In summary, we believe that de-risking is a great outcome for a pension fund, but pension committees must take into account the significant impact of rising costs and falling diversity within the de-risking flightpath if they are to truly achieve the best outcome for members.
While historically a traditional de-risking plan may have focused solely on the release of money from riskier assets, as our knowledge of the risks and rewards of that diversification has grown, so has our understanding of how best to structure portfolios in order to maximize their performance.
In our view, multi-manager fund structures can offer pension funds an option that mitigates many of the disadvantages attached to de-risking, particularly around manager diversification and cost efficiency. pension committees may therefore wish to consider this range of strategies more closely when devising a more robust de-risking plan, in order to ensure they meet all their objectives in the most effective and low-risk way.
1Over 5-year basis. Source: S&P Dow Jones Indices LLC. Data as of December 31, 2017
The information included in this presentation is intended for general educational purposes only and should not be relied upon without further review with your Willis Towers Watson consultant. The information included in this presentation is not based on the particular investment situation or requirements of any specific trust, plan, fiduciary, plan participant or beneficiary, endowment, or any other fund; any examples or illustrations used in this presentation are hypothetical.
Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein.
