Isle of Wight's outperformance vindicates active management

Strong index returns and growing concern over cost transparency have hurt the popularity of active funds in recent years, but some suggest a more uncertain outlook for 2017 is levelling the playing field.

One of the smaller funds in the Local Government Pension Scheme, the Isle of Wight is entirely actively managed, in contrast to its peers which are on average 25 per cent managed passively, according to a State Street Global Services review in July.

The scheme’s journey towards an improved funding level has not been smooth. In the year to March 2016 the fund posted a loss of 0.3 per cent, citing “significant market volatility” and UK equity fees turning positive absolute returns into negative performance.

The more active the management, the more transparency becomes an issue

Neil McPherson, Capital Cranfield

That left it in the bottom half of the 86 LGPS funds surveyed, but actuarial valuation results published in November painted a brighter picture.

The fund’s deficit shrunk from £111m to £44m, with the assets generating a 26 per cent return over the three-year period.

Presenting the results to the fund’s committee, trainee actuarial consultant Craig Alexander of Hymans Robertson said: “Your assets have outperformed the discount rate, and all things being equal that will help fill the deficit in the pension fund.”

Councillors were informed that all of the fund’s managers were outperforming their benchmarks, with most also hitting their targets for outperformance.

Still a case for alpha

However, across the active management industry, alpha-chasers have had more difficulty demonstrating that they add value.

Last year, a report by S&P Dow Jones Indices found some 86 per cent of European active equity funds had failed to beat their benchmarks over a 10-year period, raising serious questions for long-term investors.

But such measures might not be a fair assessment of the quality of active management, said Cai Rees, director in SEI’s institutional advice team.

“The active management of capital creates the best passive index,” he said, adding that where bubbles or distortions appear in a market, a passive strategy will leave investors overweight to the overvalued stock.

Source: Isle of Wight Pension Fund

Rees recommended picking managers who invest in value, stability and momentum stocks, with schemes retaining the ability to rebalance between these styles.

Proponents of active management all stress the importance of manager selection. “We’d take the view that the average manager after fees is going to underperform the market,” said Tony Baily, client director at advisory and investment company Cardano.

Nevertheless, he argued for a highly active allocation, explaining that raised asset prices brought about by policies such as quantitative easing had flattered passive indices.

“A big chunk of the active managers that we’ll invest in are managers that can make money when the markets are going up or down,” said Baily.

Not a straightforward choice

For funds such as the Isle of Wight with assets of around £500m, lack of scale makes it difficult to be as aggressive in price negotiations or as incisive in performance analysis, especially where there are already significant problems with cost transparency.

The interim report of the Financial Conduct Authority’s asset management market review found weak price competition in several areas of the industry, with around £109bn invested in equity funds that deviate little from an index but charge high prices.

“Transparency is always an issue and the more active the management, the more transparency becomes an issue, because the implicit costs essentially involved in portfolio turnover... are much more prevalent,” said Neil McPherson, managing director at trustee company Capital Cranfield.

“Fees really matter. If a pension fund costs 1 per cent a year, then [due to negative compounding] 25 per cent of the possible pensions they can pay will be swallowed in fees,” added David Pitt-Watson, executive fellow of the London Business School and former board member of Hermes Fund Managers.

“But there are still good reasons for active management, for example if the indices are inappropriate, or for shareholder activism,” he said.

Get the strategy right

McPherson said while the suitability of active management is largely scheme-specific, DB trustees in particular might focus on strategic decisions including the balance between growth and matching portfolios, leaving manager selection to investment consultants.

“The biggest variability in a pension fund’s investment returns comes from the asset allocation decision,” agreed Danny Vassiliades, managing director of investment consulting at Punter Southall, adding that for smaller funds, the costs involved with manager “beauty parades” might negate the added return available from active.