Consultant survey: Setting fixed income mandates

Schemes have been urged to consider how much discretion they allow their fund managers, as well as the fee structures they use, to ensure they protect their assets and get the best value from their investments.

schemeXpert.com and Pensions Week polled 12 of the highest profile UK pension investment consultants to assess their views on fixed income and what opportunities were available to schemes within the asset class.

The consultants said each mandate for different fixed income strategies should be looked at in isolation.

The types of strategies employed and the target return from those approaches should set the tone for how much flexibility managers were given and how they were paid.

“The key question for schemes to consider is what are they asking their fixed income manager to do?” said Matt Tickle, partner at Barnett Waddingham.

“Is it to provide interest rate and inflation rate protection, or is it to enhance returns?”

Levels of discretion

As a general rule of thumb, the consultants advised schemes to allow active managers more discretion when chasing alpha returns, but to set more tightly-controlled mandates or use passive strategies when hedging risk.

“It is of course possible to achieve both through the use of derivatives strategies, but trustees should be aware of the governance implications,” Tickle added.

Schemes should weigh up a number of factors when deciding the amount of discretion they allow fund managers:

• The type of mandate and its expected risks and returns;

• The efficiency of the asset class;

• How desirable beta returns are to the scheme; and

• The fund manager’s demonstrated skill in generating alpha.

Karen Heaven, vice president and investment consultant at Redington, said the amount of discretion in mandates was determined by circumstances, which can often change.

“For example, with a credit mandate, we would argue there is value in using active mandates as we believe that there is some scope for benchmark outperformance in credit,” she said.

“However, there are clear lessons to be learned from the very poor performance of certain credit managers in 2008/2009 and the discretion given to the manager must be appropriately risk controlled.”

The survey also asked consultants whether there were certain asset classes in which schemes should not give their fund managers full discretion.

There was some disagreement here over whether all fixed income mandates should have some degree of discretion, or whether there were some asset classes which should only be accessed through passive strategies, and therefore manager discretion was unsuitable.

The first camp included the likes of LCP, Hymans Robertson, Barnett Waddingham and Muse Associates, who felt all forms of fixed income could benefit from some degree of manager discretion.

Those who believed there were certain asset classes much better suited to passive strategies cite liquidity as a determining factor.

Paul Cavalier, partner, fixed income manager research at Mercer, said some asset classes should be excluded due to their illiquidity.

Meanwhile, Heaven said it was very difficult for managers to outperform a benchmark over a sustained period in very liquid, developed markets such as UK equities, and so passive mandates were more suitable due to having lower fees.

David Clare, managing director at JLT Investment Consulting, added: “The only asset classes a manager should be given no discretion are those in which they can not demonstrate expertise.

“Leveraged loans, non-rated debt and distressed debt are all examples of areas in which fund managers must be able to demonstrate understanding and knowledge and not just going along with the herd.”

Fund manager fees

The survey also asked consultants whether they were seeing a rise in the use of performance-related fee structures for fixed income mandates. The overwhelming response was such structures were still very uncommon.

Pension funds have an inherent dislike of performance-related fee structures – especially when it comes to fixed income mandates.

Evantz Perodin, senior investment consultant at Alexander Forbes Consultants and Actuaries, said schemes which historically worked with performance-related fee structures felt aggrieved to pay the fees when their managers outperformed in 2009 and 2010, having suffered heavy losses in 2008.

This has led to a renegotiation of the fee structures and the establishment of retrospective watermarks.

Watermarks are used to ensure fund managers have to generate new value compared to the previous high point of their absolute performance before receiving a further performance fee.

The consultants disclosed it was very rare for schemes to set up performance-related fee structures for regular fixed income strategies, such as managing against a benchmark

There are however a few asset classes which will often attract a performance-related fee. It is becoming increasingly common for them to be factored into higher alpha fixed income mandates and absolute return strategies.

Performance fees typically emerge when more specialist credit asset classes are used, such as asset-backed securities, credit hedge funds or loan funds.

In such mandates, fee structures are similar to those used by hedge funds with the base fee is often between 1-1.5% of the fund value. The performance share is 15-20% of any additional returns the manager creates, after payment of the base fee.

Base fees for traditional fixed income mandates benchmarked against a market index tend to be lower, typically around 0.2-0.5% depending on the size of the mandate.

Phil Page, client manager at Cardano, said performance fees may also be payable if the manager outperforms the market index.