Should local authority schemes be forced to invest passively?

And the majority of local government pension funds already consider the benefits of passively managed listed assets alongside their active portfolio.

Passive management is one of many tools pension funds can use to achieve their long-term objectives of deficit recovery and payment of liabilities.

The key issue to be considered by local authority pensions funds is not one of passive versus active management, but rather the need for enhanced transparency and accountability from those entrusted with managing their assets

Passive management is one of many tools pension funds can use to achieve their long-term objectives of deficit recovery and payment of liabilities.

However, there are inherent risks in a large-scale move by local authority pension funds to passive management. It is not clear the savings envisaged will be achieved and can also carry significant risk. 

Passively managed funds include hundreds, if not thousands, of individual securities. Large portfolios are more difficult and more costly to monitor, particularly in terms of the resource-intensive engagement between institutional investors and company boards that is expected under stewardship codes in the UK and similar markets.

Investors being unable to exercise stewardship systematically and effectively would have detrimental implications to the efficient allocation of capital within the economy. Not only would this undermine real economic growth but also counter investors’ ability to protect their own capital by avoiding potentially value-destructive strategies, for example certain merger and acquisition pursuits.

Most passive equity strategies also track indices that are market cap weighted, and therefore skewed towards large-cap companies. For example, more than 80 per cent of the FTSE All Share Index is comprised of large-cap FTSE 100 stocks.

Tracking it is effectively equivalent to following a large-cap momentum strategy, therefore buying high as the risk/reward opportunity shrinks, and selling low as it increases. This goes against common economic sense and diminishes the opportunity set across the whole market, while potentially exposing the portfolio to significant concentration risk (in the UK, financials represent 25 per cent of the FTSE All Share).

It is our fundamental belief that markets are inefficient and that an active approach can benefit investors both in terms of risk and return. The pertinent issue is not the ability of active managers to add value as such, but the extent to which they provide active management for which they charge the corresponding fees. As such it is a question of enhanced scrutiny by pension funds and increased transparency and accountability by fund managers.

The concept of ‘active share’ – a measure of the share of portfolio holdings that differ from index holdings – is an important metric in this context.

Lord Myners reiterated in a 2010 speech that investment management is characterised by “portfolios with high diversification and low exhibited stock conviction”. There are studies demonstrating that genuine active managers outperform their benchmark indices even after fees, while those with a low active share underperform.

And what about fixed income markets? There is a skill to investing in bonds that judges the ability and willingness of issuers to repay debt and accurately price it in a way that reflects inherent risks. Worryingly, as we have seen during the financial crisis, an oligopoly of credit rating agencies, potential conflicts of interest and group think can also lead to large scale mis-pricing of risk in fixed income markets.

Passive management is not a low-cost panacea. It is one tool in an expansive kit available to pension funds to enable them to achieve their long-term objectives of deficit recovery and the payment of liabilities.

The key issue to be considered by local authority pensions funds is not one of passive versus active management, but rather the need for enhanced transparency and accountability from those entrusted with managing their assets. This important fact needs to be at the forefront of the current debate.

Moira Gorman is a client director for local government pension schemes at Threadneedle Investments