Independent actuary Rob Rusconi, who blew the whistle on the savings industry a few years back, leading to substantial reforms, has put forward 10 strategies to fix the pension fund and savings industry. He recommends:
• A greater proportion of pension money be channelled to index funds;
• Improved training for trustees:
• Improving the independence of asset consultants:
• Reassessing the asset management fee model:
• Getting a better understanding of the risks taken by hedge funds;
• Focusing marketing spend more on education rather than on buttering up trustees;
• Improving manager performance surveys:
• Requiring trustees to keep a closer eye on the trading activities of asset managers;
• Giving more consideration to long-term socially responsible investing; and
• Requesting trustees to consider whether multi-managers deliver value.
In a paper entitled Whose Money is it Anyway? Rusconi questions why pension funds do not make more use of index tracking funds, which carry lower costs, when it is impossible, by definition, for all fund managers to perform above average.
Rusconi points out that while all fund managers argue they can buy low and sell high, the reality is that there are always two parties to a transaction, so someone must be selling low and buying high.
He argues that, on average, active managers achieve performance no better than that of the average for the whole market. In addition, since active management accrues fees, they must actually underperform the market after costs.
So why is so little institutional investment money channelled to cheaper index-linked funds? Rusconi says part of the problem is an emotional one and talks of an “emotional belief that we would do better to entrust our wealth to an expert with a good track record rather than take the market average”.
Apparently the expert in question is just as prone to this bias as we individuals are. Furthermore there is an entire industry built out of the allocation of assets to active fund managers.
Multi-managers have a strong incentive to sustain the view that active management yields positive after-fees returns and that these successful managers can be identified in advance.
Multi-managers, as the holders of this crystal ball, therefore deserve significant remuneration. A higher percentage of assets allocated to index tracking would significantly reduce the fees of multi-managers.
This argument holds true for brokers and other investment professionals who have a vested interest in promoting the idea that they can select top-performing managers. “This belief sustains a significant proportion of their business, since manager selection is an important part of their work,” says Rusconi.
It would be difficult for an investment consultant to justify his or her fees to the client if he or she was placing the funds in index trackers. Rusconi argues that in the case of pensions, trustees should allocate far higher percentage of their assets to index tracking funds.
They need to understand the vested interests of those representing active fund management as well as the costs involved and how they compare with performance figures.
The current fee model charged by asset managers also comes under fire.
Most fund managers are paid a percentage of assets under management. The logic behind this fee is that an asset manager is rewarded for positive returns. The more the assets are worth, the more the manager makes.
However, Rusconi points out that as this fee is linked to market performance it has no relation to the actual costs incurred by the manager and therefore cannot be described as a fair fee for service.
Secondly, as the financial success of the manager relies on the volume of assets under management, the asset management house will be more focused on acquiring more assets than on performance.
This has been an issue raised by maverick fund managers, who have left large asset management houses, as they feel it becomes more difficult to outperform when their funds become too large.
However, the asset management house is looking at total profit and focusing on marketing and drawing in more assets. As Rusconi points out: “Where a fund ought to be closed to new business because its success is making it difficult for the manager to trade shares without moving the price, the incentive to seek new assets in the pursuit of better revenue is at odds with customer interests.”
Some funds have moved into the area of performance fees, which reward good performance by paying a higher fee to the manger or reduce the fee in the case of poor performance.
But Rusconi argues that these fund managers set the parameters in their favour with unnecessary complexity in the fee structure, such as fee hurdle, sharing rate and high-water marks.
Rusconi says the fee system is fundamentally flawed. Firstly the downside is often not equal to the upside. Rusconi says the benchmark set is one that could be attained more often than not with the benchmark in the middle of the expected range so that the potential downside is smaller than the potential upside revenue. As the fund manager has a better idea than the customer of what benchmark it could achieve, it is able to set the benchmark to its advantage. Rusconi says performance fees might also increase the risk the manager is prepared to take on the fund.
For example, if towards the end of a measurement period the fund is running below the benchmark, the fund manager might take a higher risk in an effort to bridge the gap. This focuses the fund manager on short-term performance rather than long-term performance.
Rusconi says the performance incentive also tends to reward luck, as well as skill. He argues that a benchmark should be based on the index of the asset class, such as a Share Index or a Bond Index, rather than simply inflation plus X, which in a bull market is very easily achieved.
With regards to consultants and financial advisers, Rusconi argues that there are more appropriate ways to charge fees which accurately reflect the work undertaken. These include an hourly rate and possibly a long-term retainer. The hourly rate can be set by the consultant based on his or her reputation. For longer-term relationships the hourly fee could be converted into a monthly or annual retainer and must be supported by a clear description of the services involved.
How to fix the industry
Trustee training: Rob Rusconi questions the lack of training of pension fund trustees. A PriceWaterhouseCoopers study of retirement fund governance last year found that 41% of funds had not assessed their trustees’ knowledge and understanding, yet these people are responsible for the financial well being of millions of pension fund members.
Lack of independence of asset consultants: Asset consultants find themselves in a conflicted position because the majority work for companies that are providers of other services to pension funds. While the risk of sufficient and appropriate retirement funding was moved from institutions to individuals in the late 1990s, there has been insufficient regulation and supervision to protect consumers.
Hedge funds: While they may have a place in a pension fund there are issues that need to be addressed, including high and non-transparent fees. Rusconi is concerned that hedge funds are often difficult to assess and remain unregulated. Spectacular hedge fund blow-outs suggest that the risks are not always fully explained to investors
Marketing of funds: Rusconi argues that the marketing undertaken by funds has more to do with enticing the trustees than with real education. This is a major cost driver of the investment industry and a waste of resources, which could be directed to better education of members. Marketing also tends to focus on past performance.
Performance surveys: Rusconi says surveys are often complex and it is not always clear what criteria are used. There is also the potential for inaccuracies as surveys are not independently audited. Rusconi argues that it is also possible for managers to hide negative information and highlight the more positive data.
Trading dynamics: Rusconi says fund managers facing unit trust quarter ends can be tempted to use clients’ assets to manipulate share prices through aggressive directional trading. Currently investment consultants do not require asset managers to report on these issues.
Socially responsible investing: This is a key area in which pension funds can make a significant difference to the general environment of their members over the long term. Rusconi argues that trustees need to take a longer-term view on the investment of fund assets.
Multi-managers: Rusconi raises the concern that trustees are handing over their fiduciary responsibility to the multi-manager houses. He also questions whether multi-managers are questioned sufficiently about their processes, as well as the value-add of the fees charged. — Maya Fisher-French
There’s no absolute return
The promise of absolute return managers is that the customer will get performance that is always positive and mostly above the market. Most South African absolute return managers prefer to express this as a target, rather than a promise.
Targets usually start at an investment return of inflation plus three percentage points, but inflation plus seven percentage points is available for those who wish to shoot high.
Waring and Siegel demonstrate that it is not technically possible to make this promise unless the target is cash or some market return measure.
Since the returns of any portfolio are a mixture of elements — market and non-market related — all investing is relative.
Every portfolio aims to meet or exceed the performance of a benchmark, and the promise of absolute returns cannot be made with certainty.
Add to this the reality that many so-called absolute return mandates come with a fee related to performance, the apparent guarantee, and you have a marketing mix par excellence.
The manager need not even create too sophisticated a portfolio. With a reasonable market element the chances are good that, three years out of four, it will outperform the benchmark and superprofits will accrue to the investment house.
It is completely unsurprising that, to borrow another thought from Waring and Siegel, the average performance of absolute return funds, before fees, is, well, average.
Investors should appreciate what they are really buying and what they are paying for it, ignoring the marketing. — Rob Rusconi