Is the debate on default fund strategy swinging back towards at least some element of active management? Michelle McGagh investigates
The ‘active versus passive’ investment debate has become more nuanced as pension schemes grapple with stockmarket upheaval and a charge cap.
While politicians and policymakers may feel comfortable trotting out the line that passive is best because it is cheapest, those in the industry are leaning towards a more considered view.
It is not enough for pension schemes to choose between an active or passive investment strategy; they must combine both to ensure investors – particularly those in auto-enrolment schemes – get value for money and meet their investment objectives.
With the first three years’ performance for auto-enrolment default funds showing widely diverse returns, questions are increasingly being asked as to whether workplace pension investors could be being shortchanged as a result of the charge cap. The challenge for workplace pensions professionals is working out how and where active involvement can best add value.
“Can active managers like Neil Woodford really add value? The evidence suggests they can,” says LCP partner Andy Cheseldine.
“The problem is there are not many of them and there are a number of situations where putting active funds within workplace schemes can store up problems for the future.”
The January 2016 summary report of the Joint Working Group of Local Authorities – entitled ‘Findings of Project POOL’ – agreed that positive returns could be achieved through active management.
It said: “Aggregate outperformance by active equity managers of only 0.25 per cent would add more than £150m of value annually, in addition to the fee savings.”
But Cheseldine points out: “I am wary of putting active funds within GPPs because fund managers move but you can then have thousands of members who don’t move.
“There are also issues in the trust-based world. Trustees need to be prepared to make these big decisions all the time.
“And then there are the frictional costs of switching, which can wipe out at least some of the outperformance the active manager may have achieved.”
Cheseldine says the line between active and passive is blurred. He sees merit in fundamental indices, which can be weighted on a range of indices to take away the bias from larger companies.
“The first decision as to which fundamental indices to track can be considered the only active bit, and this can be delivered at something approaching passive costs.”
For Punter Southall senior consultant Guy Plater, the question of whether funds are active or passive is a “secondary focus”, albeit the firm aims to keep costs low so passive funds play a large part in its investment strategies.
“One of the things we like to do is have key passive building blocks as core return drivers, such as developed equity market [index] funds,” he says.
“Then we look to add active management building blocks to supplement that.”
In particular, Plater uses active diversified growth funds “because a strong manager can switch in and out of asset classes to respond to change in the market,” he says.
Punter Southall also uses active management to invest in emerging markets and investment-grade corporate bonds, but only where it has “a strong conviction that value can be added”.
Plater says: “We are typically looking to have corporate bonds in the mix in the period prior to retirement so it makes sense to have active management [at this point]. We have a combination solution: passive building blocks for the general strategy and a tactical approach that sits on top of that. The active management works like a market hedge.
“Greater use of active funds is typically seen as the scheme member ages, when active investment-grade corporate bond funds would be employed.”
With target date funds “it is important to bring in more flexibility later on, and you tend to see more active management as people age”, says Plater.
“This sort of active management is driven by member needs rather than by a factor-driven approach.”
Barnett Waddingham head of DC investment Alex Pocock agrees that the age of the member has a significant impact on whether active or passive funds are used. He says passive funds “are a very good solution” for people in their 20s, although “there is no single right answer – it is down to having the right style of investment management at the right point in time”.
He argues: “Members drawing down value need more stability and may need an active strategy but for someone in their 20s who has never opened their pension statement there is no additional value from active management.”
Target date funds
The choice between active and passive must also be made if a pension scheme chooses to use TDFs. These can be run as either an active or passive strategy.
Pocock says passive TDFs are an “administrative convenience” for the provider, which does not have to worry about fund switches, while active funds see the manager “have to make decisions over a 30- or 40-year period”.
He continues: ‘Target date funds work well for solving an administrative problem but I’m not sure there is a benefit if you do not have that problem.
“Target date funds are a means to an end but, as with anything else, it is about having active and passive in combination at the right point in time.”
He says while younger savers can get away with a passive strategy, “at the point of retirement you need some active management”, although he adds that “different combinations [of active and passive are needed] at different points in the member journey”.
As TDFs charge a flat fee, passive strategies work out expensive at first. But this cost evens out as more active management is brought in.
“You get the value spread across time but you have to cross-subsidise yourself,” says Pocock.
The introduction of pension freedoms has made it increasingly important to get the balance of active and passive right.
“Members can retire in a number of ways,” says Pocock. “They may want to retire in one way but have been put in a strategy that tracks annuities. We need to think about how the member will access their pension savings.”
Greater access to pension savings means that “any strategy can be wrong” if the pension fund does not know what the member’s intentions are.
“You can be in an investment strategy that is the best in the world but solves the wrong problem,” says Pocock. “We cannot stop people making bad decisions. This is the point where we need member engagement.”
When discussing active versus passive, Plater talks not only about a switch between passive funds and active funds. Despite using passive funds predominantly, he implements active allocation.
“The other way active management can be used is in terms of allocation between funds
rather than within the fund, like a multi-fund or multi-manager approach,” he says.
The use of active allocation helps to manage market volatility.
“If you look at [scheme] objectives, the two key drivers are to manage volatility and deliver real growth in excess of inflation.
“One consequence of the need to manage volatility is it may demand a more dynamic approach to fund management, and active management – the multi-fund approach – can manage that volatility and increase member confidence,” he says.
However, Plater does not agree with the general opinion that passive funds cannot take advantage of volatility in the markets.
“We reject that,” he says. “Since 2008 we have seen passive solutions outperform as the market has become more sentiment driven and the fundamentals – market and corporate – have become a secondary concern for investors.”
This scenario creates “more demand for active reallocation between funds and managers but less appetite for active management within funds because of the volatile conditions,” he says.
Chief investment officer at the National Employment Savings Trust Mark Fawcett says focusing on volatility within long-term savings is a pointless exercise.
“We’d discourage people from focusing on short-term volatility,” he says. “Pensions require long-term investing. Our members could be with us for 30, 40, 50 years, so what happens in one or two years, let alone the space of a few days or weeks, is generally not representative.
“However, recent market volatility does demonstrate the importance of a well-diversified default fund.”
The introduction of the 0.75 per cent charge cap for AE schemes and the fact the majority of members choose the default fund option mean that more pension schemes will be pushed down the passive route.
“We have default vehicles for auto-enrolment and we have the charge cap issue and, because of those, to a large extent there is a forced allocation to passive funds,” says Plater.
He adds that despite “lots of low-cost passives doing poorly” the focus on fees has pushed strategies into passive.
Hargreaves Lansdown senior pensions analyst Nathan Long agrees that the price for keeping costs low in default funds was the move to passive strategies.
However, he argues that the fundamental choice that has to be made by members is not between active and passive but between being in the default fund or not – and ultimately between engaging with a pension or not. Those who move out of the default fund tend to opt for more actively managed strategies and are generally more engaged with their pension.
The point at which individuals are more willing to move out of passive default strategies can be based on a number of factors, including age, but Long says it is typically when the fund value gets to a level “where they can’t ignore it any more”.
He says: “For workplace pensions, having a passive default is almost unavoidable given the charge cap. It means the chance of underperformance is lower and there is more confidence in the employer.
“But the optimal solution is to find quality active management to top up the passive strategy.”
With ongoing discussions about lowering the charge cap further, more pension scheme members could be pushed into passives.
Plater says a further reduction to the 0.75 per cent cap would have a negative impact.
“I don’t think the charge cap should be coming down [further]. There is still talk of it and that would make it more difficult to build a solution that can properly meet member objectives,” he says.
Pocock thinks another reduction in the charge cap would be an easy win for the Government, although he does not believe it would help members get better value.
“We have the charge cap and the need to demonstrate value for money,” he says.
“The cap represents fantastic value at 75 basis points and it is politically easy to say this number should be lower.”