It's Time to Re-Think Equity Multi-Manager Products at the Pools

This article was originally published on Room 151's website here.  I discuss why the pools' multi-manager equity funds have under-performed the index benchmarks and make some suggestions.

Pool multi-manager funds have not delivered performance

Exposure to equities is at the core of any open active pension scheme such as the LGPS because they deliver growth.  Most of the six LGPS pools therefore offer (or will) an actively managed multi-manager equity sub-fund.  Some, such as LGPS Central, LPPI, and Borders to Coast, have done it from the start.  Others, such as the London CIV, are moving away from single manager funds to that model.

In most cases they have selected a small number of global managers with different style attributes such as growth, value, quality or momentum.  The philosophy is that each manager will add value within their lane while the chosen factors will outperform over time.

The trouble is that it has not worked.  Performance numbers are not publicly disclosed (a pity, I would add) but most have underperformed against the global index over the past one, three and five years, some substantially so.   

Narrow market leadership has been a problem for all active managers

Over the past ten years a small number of large stocks have provided most of the global index’s returns. They have also been the most volatile.  All active managers have struggled with this. The volatility - in technical terms a higher beta - makes it difficult for managers who underweight them in a rising market to outperform.1  But the level and persistence of underperformance within the pools’ multi manager equity products to date would not be tolerated in the private sector.

The focus on sustainability has been timed unfortunately

Another cause is the outperformance of industries such as defence, mining and oil as a result of the Ukraine-Russia and Iran-Israel-U.S. wars.  The LGPS has in recent years been enthusiastic about being good corporate citizens.  This approach has often translated into overweighting ‘sustainable’ stocks and underweighting these sectors.  

Style factor persistence is a third problem

A third reason may be that style factor outperformance has a habit of being competed away.  

If too many investors try and exploit a factor, academic research shows that the alpha diminishes or even disappears.  Relying on long-term style biases is not a guaranteed way to deliver performance.

Portffolio construction risks over-diversification

This article argues that the way the pools have constructed their multi-manager funds is a further contributory factor to poor performance.  Their role is similar to that of the fund of funds of the early 2000s.  They likewise combined a set of managers into a single product for investors.  They aimed to add value by careful mitigation of risks at the fund of fund level, and using judgement or knowledge to make tactical tilts.    

Fund of funds have largely been discredited because they were unable to add sufficient value to justify their fees.  Their risk management also failed at the time of the Global Financial Crisis.  Pools don’t charge fees, but they still need their active products to add value relative to passive and cover the extra costs.   

Combining four global managers, even with different styles, risks over-diversification and a portfolio close to the index.  Large global managers have in recent years compounded this by being generally underexposed to mega-tech.  As explained above, in a rising and concentrated market it has been almost impossible to catch up.

Risk diversification needs to be more effective

In my view the pools should aim to add value to multi-manager equity funds in three ways.  One is the selection and combination of managers.  The second is by mitigating risk at the top level.  The third is by using their skill and judgement to take tactical tilts on sectors, markets, or style factors.

On the first point, what is the right number of managers?  Do you need more than one global manager, or is a core and spoke model more effective, with a single global manager and specialist managers where they can add value?  Specialists should have an advantage in markets such as China, Japan, or indeed tech. 

How do you combine them to avoid doubling up on active bets?  This seems to be where the pools have most fallen down:  they have selected managers who meet their particular style biases without properly considering risk diversification.  Any modern platform or fund of fund type product will have a way of drilling down through the individual fund managers to monitor what risks the product is exposed to at sector, stock, and style level.  On the assumption that that analysis is available to the pools, their risk management processes must be in some way be deficient.    

Of course, a fund of fund is limited in its direct actions: it cannot influence stock selection, and to mitigate risk the pools can only alter the mix of managers or add derivative overlays – both of which carry their own risks and costs. 

Taking tactical tilts

My final point is about taking tactical tilts.  Tactical asset allocation has always been a tetchy subject within the LGPS, mainly because it often hasn’t worked in the past.  My personal view is that it must be done within a disciplined framework to add value.  It also requires patience, as investing in an undervalued market or sector may take time to pay off.  But patience and a long-term investment horizon are two of the LGPS’ useful strengths.

I am aware that at least two pools are conducting major reviews of their multi-manager equity products at the moment.  The new pool vehicles are presumably setting them up.  While this article is clearly critical of past practices, I hope it may be useful grist to their mills as they decide on the future design.  Partner funds need strong and successful core equity products to invest in.

1 See Alphaville article https://ftav.substack.com/p/money-has-ruined-markets.