Unsatisfied Customers

The survey, conducted by bfinance in December 2008, was completed during one of the most turbulent market periods for investors. It covers 10 countries and 32 pension schemes, both corporate and sovereign, with average assets under management (AUM) of €5.4 billion. The minimum AUM among the participating schemes is €250 million and the maximum is €37 billion. The largest group of respondents is located in the U.K. (43%), followed by Germany (21%) and Canada (15%). Sweden, the Netherlands, the U.S., the United Arab Emirates, Finland, Denmark and Portugal are the other countries represented in this survey.

Different Strokes
A key finding highlights different views between asset managers and pension funds on trading a longer lock-up period for lower FoHF fees. The majority of schemes surveyed (55%) favour lower fees from their alternative managers without conceding to a one-, two- or three-year lock-up in exchange for a 10%, 20% and 30% discount, respectively. Still, a solid 45% of investors said they are willing to consider trading off liquidity against a reduction in fees.

If asset managers are more willing to negotiate on this issue, it is largely because they want to better manage liquidity in the portfolio. In a separate survey, bfinance asked asset managers if they would consider offering a discount to investors if they agreed to a lock-up. The expected decline in FoHF fees could accelerate if the lock-up is at least two years. Indeed, 68% of money managers said they would be prepared to offer a discount if the investor agreed to a two-year lock-up compared to 46% for a one-year lock-up and 79% for three years. (Figure 1 shows what investors are prepared to offer.)

However, there do not seem to be many takers among the surveyed schemes. “In the past, we were in actively managed FoHFs with a one- and two-year lock-up,” says Richard Grottheim, chief investment officer (CIO) of the Seventh Swedish National Pension Fund (AP7), which manages assets of approximately SEK90 billion (C$13.5 billion). “Liquidity is one reason why we have been migrating out of FoHFs and into FoHF replicators. I would like to have the possibility of quick withdrawal in times of crisis.” Grottheim’s exit reflects the break in trust between pension funds and FoHFs, which some believe have failed to sufficiently deliver their multiple objectives of de-correlation, diversification, lower volatility and absolute performance. AP7 has increasingly turned to alternative beta strategies such as hedge fund replicators. “As a rule of thumb, investors paid two and 20 for a FoHF. Replication strategies cost less than 75 basis points. Since last summer, our FoHF replicators have been performing in line or better than FoHFs.”

Great Expectations
This may help explain why FoHFs bear the brunt of investors’ dissatisfaction in our survey, even as they have outperformed actively managed equities. Indeed, equity index returns largely underperformed FoHFs during last year’s stock market rout. Yet the expectation bar for FoHFs was clearly higher—one reason why they may be ill-perceived among pension schemes.

“In general, large capitalization markets are efficient and, as a result, the value of active management fees is not seen,” says Marc Gauthier, principal administrator of Concordia University’s pension fund. “From a Canadian perspective, the large cap market is so concentrated that the market is not efficient. Couple the latter with a down market, and arguments can be made for the value of active management.”

More investors feel they are getting good (27%) or fair (42%) value for their money from active long-only managers. Even single hedge funds, which have never professed the diversification benefits of FoHFs, fared better. Overall, the majority of investors feel they are getting value for money from their managers. There are, however, wide dispersions: investors have a particularly high level of disenchantment with global tactical asset allocation (GTAA) mandates, which received the most poor votes (86%).

We note here that a number of alternative strategies and asset classes, among them GTAA, have relatively low weighting in their portfolios. Investors were also asked how recent market events would impact investors’ portfolio structures for each asset class. The responses seem to confirm our findings from an earlier study: pension funds are likely to increase their allocations to alternatives (GTAA, FoHFs and hedge funds) and to turn more passive in traditional asset classes such as equities and fixed income (see Figure 2).

The death, and pursuit, of alpha is clearly premature. One pension fund, a European auto supplier, recently allocated funds to a GTAA mandate, taking advantage of a lower fee structure. “What we saw in 2008 is that active managers had certain benchmarks to beat, and they failed,” says the CIO of the pension scheme (who asked to remain anonymous). This broad failure has given pension funds more leverage to negotiate fees down, he notes. “We conducted our search for a GTAA mandate in October and already, fees were coming down rapidly. I am paying a base fee of 1% for GTAA and not worried about the performance fee because we don’t think the manager will meet or exceed his Euribor plus 3% target.”

Bargain Hunting
FoHFs are doing more than just slashing fees, notes the CIO. They’re also reducing their minimum required volume. “In 2004, the minimum volume for FoHFs was €20 million. Now it is €5 million. I am only paying 70 basis points for a FoHF with 50 underlying funds compared to 1.5% to 2% several years ago.”
The traditional two-and-20 model (2% flat fee and 20% performance fee) is unlikely to survive last year’s market bloodletting. Our respondents have been negotiating hard with their asset managers to reduce fees. Survey results show that the priority of pension funds is first to pay a lower base fee.

A medium-size pension fund of a Scandinavian insurance company has been negotiating to reduce both base and performance fees on assets that it cannot redeem because of gate restrictions. “These have been extraordinary conditions, which warrant gates,” concedes the CIO of this pension scheme. “However, we have asked to not pay fees on those investments that we have been blocked from redeeming until the next gate period. So far, we have not had any success, but we expect to.”

Marc Godin is managing director of bfinance Canada, and Vicken Berberian is a research associate with bfinance.
mgodin@bfinance.com
vberberian@bfinance.com

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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the Spring 2009 edition of INNOVATE magazine.