Why strong manager selection is about quality, not quantity

This set-up typically has been more common among smaller pension schemes, since the lower governance structures make it more cost-effective. 

And while a simple manager structure has its benefits, it does come with significant manager concentration risk.

It is important to note that investment funds and solutions have become more sophisticated, and investment managers have become more specialised.

This evolution has challenged single-manager structures, particularly when a scheme invests in a number of areas where no one investment manager has the expertise to cover all asset classes.

If the scheme looks to invest across a number of asset classes, they can achieve manager diversification, but the selection process is extremely important to ensure each appointed manager is up to the job

A more sophisticated investment strategy, therefore, has tended to force schemes to consider a greater number of managers.

Diversification paradox

Ironically, while this has led schemes to diversify individual manager line-ups, it has created concentration in cases where there are only a few managers providing specialised solutions.

Consequently manager diversification has become evident at the scheme level, while concentration has, arguably, increased at the industry level. 

The rationale for diversification is simple: it looks to spread exposure from a few areas across a larger number of areas, to reduce risk.

Investment manager diversification can help reduce exposure to a manager’s particular styles and biases, and can form an important role within a pension scheme’s investment strategy.

An example is helping to smooth overall return profiles by minimising expected volatility when one manager’s style is out of favour.  

This point is applicable to schemes appointing managers within the same asset class – such as two global equity managers with different styles – and where they are selecting managers in different asset classes, for example one equity manager and one alternatives manager.

However, when trustees set investment targets based on scheme specifics, such as a return profile outperforming a liability benchmark, their view on manager diversification should be reappraised. 

Schemes are increasingly likely to employ single managers for specific mandates. For example:

• a passive manager to provide low-cost access to a particular market or asset class;

• a specialist manager to provide consistent, inflation-linked cash flows;

• a third manager to deliver a targeted return profile; and

• a fourth manager to hedge liabilities.

Selection is paramount

Under this example, it appears that the scheme has achieved a diversified manager line-up.

However, appointing single managers could be viewed as increasing concentration since each asset class is run by just one manager.

As long as scheme trustees are confident in the selected manager’s ability to deliver its objectives, schemes need not be concerned about manager concentration.

That said, schemes with scale might opt to improve manager diversification by adding additional managers within a strategy; for example, a second manager to generate a targeted return profile.   

Such concentration should not be considered negative and schemes need not be accused of following the herd, provided the managers they choose are suitable for their requirements.

If the scheme looks to invest across a number of asset classes, they can achieve manager diversification, but the selection process is extremely important to ensure each appointed manager is up to the job.

Where trustees are intolerable of a single manager’s philosophical biases, diversification can be considered appropriate and schemes should think about making additional appointments within relevant asset classes.

Nick Ridgway is head of investment research at Buck Consultants