In the second of three articles we focus on question #2 – am I getting value-for-money?

There are three fundamental questions that pension fund Boards should expect answers on:

1.     Are my costs reasonable?

2.     Am I getting value-for-money?

3.     Am I becoming more efficient?

In the first article we explained how to determine if your total costs are reasonable in comparison with others. Understanding how you compare and why you compare as you do is both interesting and important. It doesn’t answer the value-for-money question though. For that you need to factor in performance. When looking at cost, we suggest starting with a ‘whole-of-fund’ view. We should look at performance through a similar lens. 

If you are going to make active management decisions, or pay fees for active management, then it’s reasonable to expect outperformance relative to sensible benchmarks over time, otherwise why invest actively? 

At a whole-of-fund level, the ‘value added’ is a function of all active decisions. This includes the alpha produced by the managers. It also includes the proceeds of decisions made typically by fund staff (or consultants or fiduciaries) in terms of tactical asset allocation, transition management, etc.

The essential value-for-money question therefore hinges on whether paying more than peers (which is often due to paying external managers to exercise judgement) is matched by positive whole-of-fund net value added - outperformance relative to the right strategic benchmark after costs. It’s okay to pay more if you’re getting more.

In the CEM database (which includes many of the world’s top asset owners), over 28 years active management has, on average, been rewarded. The average fund has beaten its strategic benchmark by approximately 60 bps before costs and 20 bps after costs. The net value added is small, but it is positive and contributes to funding levels and ultimately to outcomes for members.  

Private assets, however, are problematic from both a cost and performance perspective. For many defined benefit schemes, private assets, including private equity and infrastructure, can account for over 50% of the cost of running the pension scheme. Private Equity represents just 5% of assets amongst funds in the CEM database but 30% of costs. The fees are big, but are they justified? 

This brings us to a fundamental issue – the widespread use of flawed benchmarks in private markets at a total portfolio level.   

When funds use benchmarks that don’t reflect the characteristics of assets in which they are investing, they don’t have a sensible means to measure the outcomes of their active strategies. For too many funds, net value added contains significant noise caused by bad benchmarks. It tells the trustees nothing about whether active management decisions made on their behalf have been rewarded. The combination of high costs and poor measures makes private assets difficult for boards to properly engage with.

The challenges in finding sensible benchmarks for private assets are well documented. A good benchmark has a number of important characteristics. It should be a low-cost, investable alternative that is fair but tough to beat. It should be a good proxy for risk and a means to provide real accountability. CEM’s research suggests that diversified private equity returns at a total portfolio level are highly correlated to small cap public equity, regionally weighted and with a lag (the optimal lag is different for each fund). This approach ticks all the boxes for a good benchmark, and we believe provides a sensible basis for a better understanding of net value added. We believe that there are better measures than those often used for most funds in infrastructure, hedge funds and property.

This doesn’t mean to say that alternatives should be avoided. On the contrary, they have produced excellent results for many funds. The point is that we need to get the measures of success right before investing. It is only through the right lens that we can get a firm grip on net value added and therefore value for money at a fund level.