The pressure to deal with urgent considerations can lead to the neglect of less urgent but very effective actions. Considering how to audit such issues can be very effective in fund performance, write James Sparshott, head of local authorities at LGIM, and John Roe, head of multi-asset funds at LGIM. LGIM sponsored comment.
Our conversations with local government pension plan fund committee members revealed striking overlaps with our own multi-asset team. Both are responsible for large asset bases and need to determine how much risk to take, what to invest in and where to use active management.
We want to share an approach we use to help us step back from our day-to-day priorities and see the bigger picture, helping us see the wood for the trees.
A recent session we led for the LGPS on the subject gained a lot of traction. In this case we only had 45 minutes, but we can also work with individual funds to complete a more comprehensive exercise.
When we are all so busy, there is a risk that time will not be used in the best way; the audit helps combat this and is designed to target the main objectives identified in two popular prioritization matrices, as shown at the bottom of this page.
The point both matrices make is that the most impactful decisions aren’t always the most urgent, which means they often don’t get the attention they deserve. The audit provides an easy way to set aside time to review these important decisions.
Identify the big decisions
The first step is to identify the most important and impactful decisions to focus on. These vary, but are generally:
- what assets to own given the acceptable level of investment risk
- their regional exposure
- how much foreign currency exposure to have
- where to use active management
- how to take into account larger structural risks such as climate change.
Unfortunately, there is no universal answer to these questions. To illustrate this, at a February 2022 LGPS-focused seminar, we asked the audience for their views on four topics, as illustrated below.
The wide variety of opinions from the 55 respondents shows that different decision makers will have different investment preferences.
Once a fund is clear about its investment beliefs and has written them down as a set of principles, it can move on to the next stage of auditing. This involves asking how well the current allocation aligns with those beliefs, focusing on the decisions that could have the greatest impact on the end results.
Let’s get auditing – common themes
When an investor performs an asset allocation audit, they typically find a small number of important areas to review. The goal is not to go into detail, but rather to focus on high-impact decisions, like which mix of asset classes and regional exposures to own.
While every fund is different, we notice some common themes when looking at LGPS asset allocations:
Domestic bias in equities. UK equities can potentially offer significant diversification benefits, which could justify a higher equity weighting than implied. For example, in the first quarter of 2022, they outperformed European equities by around 10% and US equities by more than 5%, after having lagged in recent years*. However, UK weightings are often very high, as LGPS funds often reconsider whether this is in line with their regional equity view.
Low allocations to alternative credit. LGPS funds have long been pioneers in embracing diversification alternatives and additional return potential. Typically, they give a higher weighting than corporate plans to assets such as infrastructure, real estate, private equity, hedge funds and commodities. However, allocations to alternative credit assets such as emerging markets and high yield debt generally remain very limited; this area may merit further investigation.
Concentration of risks in active management. As our survey at the conference showed, many LGPS decision makers are proponents of active fund management. It is therefore interesting to review where they use it, to check that it is consistent with their investment convictions. For starters, most investors would agree that all things being equal, more diversification is better; thus, in the case of active management, spreading the risk budget over different asset classes seems intuitively attractive. What we see in practice is that the risk of active managers is concentrated on equities and alternatives; LGPS funds may think this is where it applies most, but when we talk to them, it doesn’t. Typically, they say this is a concentration they would like to reduce by shifting risk into areas like fixed income and asset allocation.
Absence of short-term asset allocation. Beyond the longer-term decisions made by funds, such as how much equity to hold and what new asset classes to introduce, we often find that active short-term asset allocation is very limited. . LGPS funds often say this is not a decision in line with their investment beliefs. Active asset allocation is accessible through multi-asset funds without constraints. Generally, solutions with a very high active risk budget may be the most suitable, so that even a small allocation has a significant impact at the overall fund level.
A boost for your audit
The framework we have described is deliberately transparent and simple to apply, as we believe it helps to effectively target important but non-urgent decisions. You can either go it alone or go to an investment advisory firm to go through the process with the fund or pool.
However, given the similarities between large-scale asset allocators at fund managers and LGPS funds, it may also be worth going through the process with a suitable manager you trust to contribute ideas and remain objective. rather than focusing on propositions that their own company might bring.
We at LGIM would be very happy to help you. Given our footprint within the team, we believe we tackle all the key investment decisions that funds and pools face, from the wide selection of asset classes to where and how to use budget risk of your active manager.
James Sparshott is Local Government Manager at LGIM; John Roe is Head of Multi-Asset Funds at LGIM