In-house teams face growing pressures over costs

Equity teams within large pension funds are now bearing the brunt of concerns over costs and the continued underperformance of traditional stock picking.

While the move toward quantitative and passive strategies from active equities is nothing particularly new, the impact of an almost 11-year bull market — albeit one that is being challenged by the current COVID-19 virus outbreak — is forcing asset owners to make big decisions over active exposures that are run in-house.

"In-house teams have been hit by many challenges in the past few years," said Matt Scott, senior investment research specialist at Mercer Ltd. in London. While asset allocators continue to lower equity allocations — and therefore the dollar value of any active returns — "the fixed cost of the management team remains the same," he said.

Over recent months a number of high-profile asset owners have made moves out of active equities and into other equity exposures, including quantitative and systematic allocations. And in some cases these decisions have led to a reduction in headcount.

"What has also come up consistently in surveying plan sponsors is that the biggest or second-biggest concern is cost management," said Jonathan L. Doolan, Frankfurt-based principal, head of Europe, Middle East and Africa at Casey Quirk, a practice of Deloitte Consulting LLP. "We've seen a reduction in total headcount at plan sponsors, and therefore they have to do more with less."

Last month, the £68 billion ($88.1 billion) Universities Superannuation Scheme, London, said it was planning to overhaul the investment approach for about £14 billion of internally managed developed market equities — about half of its listed equities allocation.

Wholly owned investment subsidiary USS Investment Management plans to "reshape" its developed market equities portfolio toward a "longer-term thematic approach which better leverages its internal investment capabilities in matching its pension liabilities," said a statement. The fund's 2019 annual report for the year ended March 31 showed a funding ratio of 92%.

USS said about half of its public equities portfolio would transition away from traditional stock picking, with BlackRock Inc. hired as transition manager to oversee its Japan, U.S. and pan-European allocations, while the change in investment approach takes place. The statement said the decision did not reflect equities' performance.

The assets will then be returned to in-house management and run under a new approach, with quantitative and responsible investment analysts working to identify long-term investment opportunities that will produce returns best suited to meeting liabilities. It means less time focused on individual stocks and more on the impact of environmental, social and governance issues and other long-term factors. And stock selection will remain a focus where there are long-term structural opportunities.

But the move will mean in-house team changes, with 13 roles at risk of redundancy, including Head of Equities Elizabeth Fernando, a spokeswoman confirmed last month. USS said some of these people will be redeployed to other teams. The remaining 18 staff focused on emerging market equities, quantitative analysis and responsible investment will not be affected by the changes.

Another high-profile fund, the 365.8 billion Swedish kronor ($37.6 billion) AP1, Stockholm, has restructured some of its equity strategies — leading to 4 out of 6 in-house equities managers being made redundant, a spokeswoman confirmed.

The fund's latest annual report, as of Dec. 31, said a decision was made to transition to passive or systematic strategies from active fundamental allocations, primarily related to internally managed developed and emerging markets equities. These new passive and systematic strategies will be run internally, the spokeswoman said.

Developed market equities and Swedish equities account for about 12% and 10.5% of the total portfolio, respectively, with the majority run internally. Emerging markets, which make up about 14% of the portfolio, are managed in collaboration with external managers, the report said.

The value of assets affected is not being made public, the spokeswoman said, adding that the majority impacted by the changes will be in developed markets, while Swedish equities "will still be active fundamental."

The changes were highlighted in a commentary accompanying the annual report by acting CEO Teresa Isele. "These changes lay a better foundation for achieving our return targets, while also reducing our annual costs."

Also shifting out of actively managed equities was the New Jersey Division of Investment, which runs the $78.5 billion New Jersey Pension Fund, Trenton. A document related to the annual meeting of the New Jersey Division of Investment's State Investment Council, said the U.S. equity portfolio was transitioned to a passive index-based strategy in 2019. "This approach is consistent with the practice of other large institutional funds with internally managed portfolios," the Jan. 29 document said.

Over the year ended Sept. 30, executives eliminated the $24.1 billion actively managed U.S. equities portfolio and moved $22.8 billion into passive domestic equity, which is all managed internally, according to Pensions & Investments data. Active international equity exposure fell 26% to $2.6 billion, while passive international equity allocations grew by 9% to $11.4 billion for the year ended Sept. 30.

"In the current market, it is difficult to generate market-beating returns on large pools of capital," Deepak D. Raj, chairman of the council, said in the 2019 annual report of the New Jersey State Investment Council. The fund produced a 6.3% return for the fiscal year ended June 30, falling behind a 7.1% benchmark return — primarily due to the domestic equity portfolio failing to top the S&P 1500 benchmark. "The division recognized this and moved decisively to a passive … portfolio for domestic equities," which was completed in September. "Not only does this make it less likely that we will miss market opportunities, it also frees up division resources to be applied to other asset classes," Mr. Raj said.

A spokeswoman for the New Jersey Treasury did not respond to requests for comment.

But New Jersey is not alone in being disappointed by the returns produced by actively managed global equities. As of June 30, 78.52% of U.S. large-cap strategies underperformed the S&P 500 index over five years and 77.53% of European equity strategies were topped by the S&P Europe 350 index over the same period, according to S&P Dow Jones Indices' SPIVA scorecards.

"Many teams utilize fundamental stock pickers," which has proven difficult for a number of reasons, Mercer's Mr. Scott said. He cited low interest rates making it difficult to distinguish firms with poor business models from those that are more robust and that factors like value and momentum — once part of alpha or outperformance — are now available "cheaply and efficiently. The skill set needed for success has arguably shifted."

A move has been made toward employing teams with data science experience, using machine learning to analyze stock performance and using data from a wider range of sources, rather than focusing on financial statements.

"In essence, to outperform now, you may need to have access to unique data sources or be using data in a unique way. Perhaps in-house teams are less able to attract this 'new order' of staff whose skills come at a premium," Mr. Scott said. "After reviewing all the headwinds that their active equity teams face, many CIOs will have taken the decisions to reallocate their fee budget elsewhere in the portfolio."

Gordon Clark, professorial fellow, co-director at the Smith School of Enterprise and the Environment-Zurich Project, at Oxford University, said: "All this is happening because of the success of passive over active investing — it has been successful because of the run-up in markets since at least 2014. A lot of switches from active to passive, from internal to external, has been (on the) premise of that continuing into the future."

Mr. Clark also cited a search in private markets for "a different kind of value investing — be that in private equity, venture capital or infrastructure; this is a search for value but it isn't to be found in active publicly traded equities. Funds need different kinds of people (to run those allocations) from the active equity teams that many funds have been employing or outsourcing to."