Pooling - staying a step ahead 

The growing trend towards pooling in the UK and Australia poses specific challenges for transition managers while offering significant opportunities for them to add value. 

The benefits of pooling are becoming more accepted by UK asset owners, following the longer-established practices of pooling among pension funds in countries like France and Germany. Recent growth in the sector has taken the proportion of pooled assets nearly level with that managed in segregated accounts: this year it stood at 45% of the total, according to the UK Investment Association.

For LGPS schemes in the UK, progress towards pooling varies from scheme to scheme. Some, such as the Northern LGPS, a partnership between the Greater Manchester (GMPF), Merseyside (MPF) and West Yorkshire (WYPF) funds, are already heavily aligned. Others are earlier in the process, with a large portion of portfolios still unpooled.

The core appeal of pooling comes from the unequal fee treatment afforded to segregated and pooled accounts. Consolidation among fund managers and the growth of passive fund investing has helped drive fund fees down, without putting an equivalent downward pressure on segregated accounts.

“Over the years, asset managers have slowly reduced the fees in their funds but haven’t done the same with the segregated portfolios,” says David Edgar of Inalytics.

This is a problem given asset owners’ increasing focus on costs. “Cost cutting is the biggest driver today. Asset owners want to manage funds as efficiently as possible. The days of proliferation of segregated portfolios are over; consolidation will continue,” says Graham Dixon of Inalytics.

The result is a steady migration from segregated accounts to pooled funds by major asset owners.

“You are seeing platforms and asset managers merging similar products – for example Luxembourg and Irish funds that are tracking the same benchmark. Managers just can’t afford to keep two products [that are similar]: it means double the annual legal, trustees and custodial fees. Why wouldn’t I collapse them into one and halve my costs?” says Craig Blackbourn, Craig Blackbourn, EMEA head of transition management, Northern Trust.

Pooling suits managers, too. “A manager may have 70 segregated funds measured against the MSCI; retail, insurance and pension money all measured against the same benchmark. If they can put them into a single fund they can make the same offering to any investor, whether the amount is £5m or £500m, meaning their offering is more consistent. And it is more efficient too, resources like compliance can be pooled across fewer funds,” says Dixon.

In Australia the growth of mergers between superannuation funds has spearheaded pooling efforts there (see box Box out – Pooling and Australian super fund mergers).

The total numbers of super funds in Australia have halved since 2010 from 389 to 179 since 2010, according to Rainmaker Information, a research provider. Consolidation has been most pronounced among smaller funds: the number with less than $1 billion under management have dropped from 176 to 52. But further mergers will follow. According to KPMG, more than three-quarters of the sector’s AUM will be managed by the largest 12 funds, all of which will be larger than $50 billion, once the mergers that have been announced are complete.

A role for transition managers

As super funds continue to merge, transition managers are increasingly required to interact with pool products to assist them restructure their manager and asset allocations.

“Pooling usually implies larger portfolios, held in segregated accounts and often managed in-house. These clients face challenges well known to transition managers and can benefit from our experience when transitioning mandates in-house. They are also large users of our pre-trade tools and portfolio execution algorithms that have features specifically designed for the transition manager,” says Cyril Vidal, head of portfolio transition solutions at Goldman Sachs.

“Invariably, a series of restructures take place that require major shifts in asset allocation,” says James Woodward, head of portfolio solutions, Asia Pacific at State Street. He estimates that his team currently works on one or two transitions per year supporting Australian super fund mergers, making up perhaps a tenth of his team’s total workload.

Wherever pooling takes place, participants are becoming more familiar with the cost- benefit trade-off of outsourcing transitions.

This is shifting the balance of clients demanding services from transition managers, says Blackbourn. “Look back 15 years and [most clients] were pension funds, SWFs, central banks and government agencies. Now [a bigger share] is professional investors – asset managers and money managers – seeking to help preserve performance and asset value,” he says.

“Fifteen years ago, an asset manager would have its own trading desk and risk tools. Today even the largest are going to transition managers. [They are chasing] every basis point, with operations effectively and efficiently managed sending savings back to bottom line.”

As asset owners widen the range of assets that they own and, via pooling, collectively own a larger pot, the most efficient structure through which to own them may change.

Here clients may have to consider factors other than cost. Typically, pooled assets limit the ability of an asset owner to vote at AGMs or on exceptional votes, for example. As this becomes an increasingly important route through which they are choosing to exercise their ESG responsibilities, it is taking on increasing weight in decisions.

For emerging market portfolios, limits on transferring beneficial ownership add obstacles to pooling. And it may take time to understand the legal and regulatory considerations of owning assets directly.

Alternatives’ growing role

In the UK, for most local authorities much of the straightforward traditional strategies - the easy ‘lift and shift’ of traditional investment mandates – have been pooled. In many cases, much of the remaining rump comprises alternatives, such as multi-asset credit and private market portfolios. As a result, even as pooling rates among LGPS schemes are well ahead of those for corporate pension schemes, alternatives portfolios represent a disproportionate share of what is left over. In part, this is because they are very hard assets to move, thanks to long lock-up periods required by managers of infrastructure, private equity and private debt funds. That means few or no opportunities to withdraw cash ahead of maturation dates or transact via the secondary market.

In addition, pooled options may not be to local authorities’ liking. These are typically complex, high conviction mandates which authorities may have held for many years. They may not be convinced there is a feasible pooled option, or fear the operational logistics of transferring them.

Transferring this rump of local authority assets into pooled vehicles will mean a number of complex transitions in the coming years. “In part, where mandates are driven by specific styles or factors it is harder to create these in a pooled environment, so they tend to come later. This means that as we go forward transitions will continue and get more difficult,” says Steve Webster, direct of transitions and trading solutions at MJ Hudson.

Clients should look to transition managers for a clear funding schedule specifying which funds should be liquidated when to meet cash calls, considering how unbalanced that might leave the residual allocation. Given the nature of pooling, cash infusions may need to be collected from a large number of partner funds at the same time. “There has never been a more difficult challenge: the longer period of opportunity cost clients faces when rotating into alternative is huge,” says Webster. 

Pooling and Australian superannuation fund mergers

In Australia, large-scale pooling is occurring a result of superannuation fund mergers, with many features familiar to European asset owners.

Preparation for such moves may take up to six months and typically requires a huge amount of planning. The demands in terms of project management are significant: the transition manager must understand all the nuances of the portfolio and the needs and constraints of every stakeholder. Stakeholders including not only the client, including all those staff members required to provide authorisation for a transition, but also custodians, investment managers, administrators, those responsible for unit registry and consultants.

“The plan will require precise scheduling of when assets can be redeemed. And it must take in wide variety of stakeholder considerations, including fund and trust notice periods,” says Woodward. “You need to build a picture of the different asset classes, managers, funds and custodians involved and start from there. Every stakeholder has its own processes and procedures; you need a solution that works for everyone.”

Individual structures provide specific challenges, such as which assets can be taken in specie from a trust, effectively negotiating a change of beneficial ownership, to avoid the spread entailed by going through cash. For securities bought or sold in the UK or Hong Kong there is the question of stamp duty. In this case, funds may be eligible for exemptions because a merger will be judged as not having entailed a change in beneficial owners.

As with every transition, maintaining market exposure is key: scheme members who have been sold the cost reduction benefits of merging their super fund will not look favourably on a merger process which results in several percentage points of missed investment gains. As a result, the process commands widespread attention within plan sponsors. “The board, the CIO – all the staff are focussed on the merger and it has the attention of the whole fund,” says Woodward.

Since Australia’s super fund merger process is broadly further advanced than the pooling of local government pensions in the UK, it has seen some funds internalise many of the tools offered by transition managers.

“They are becoming asset manager-type entities, developing discretionary investment management, trading capability in house,” says Samsonov of Citi. In Citi’s case, given its brokerage expertise this means transition manager business can offer more of an execution style relationship, rather than complete end-to-end transition service. “These clients require specific parts of our service, such as access to the market and execution advice and reporting,” he says.

Samsonov says his desk is offering more of a broker-style support, rather than a complete end-to-end transition service. “Clients are requiring specific pieces out of us, such as execution and access to the market. It’s not the full project management service but perhaps advice on execution strategy, or actual execution when it comes to trading,” he says.

Because the merger process is more piecemeal in Australia, clients generally have more flexibility and a wider set of choices about how and when to combine. “There is a range of approaches and an extended timescale – funds may operate side by side for some time; others may choose a full merger from one day to the next. But in the end, all these institutions are trying to save costs, and to do that they must rationalise their investments and this means transitions,” says Vidal. 

How long will it last

While the core argument for pooling is cutting costs, exactly how much is saved by this route is open to question. Clients look hard at the management fee – for example, 0.7% in the pooled fund and 1.2% in the segregated fund. However, redemptions and subscriptions have an impact on other shareholders in a pooled fund strategy and so typically carry a higher cost than building segregated mandates. In pooled fund strategies investors also have less control over their unique investment requirements.“How many clients delve into the prospectus to compare subscription and redemption levies. These can be 3% or 5% in some cases. Exactly what the saving is for moving from a segregated strategy to a pooled strategy is not always clear as total costs are frequently not fully transparent or easily comparable for investors,” says Artour Samsonov, head of transition management and investment solutions at Citi in London.

Specific asset classes carry other problems. In emerging market mandates moves in and out of pooled funds are harder to manage from market risk perspective due to limitations on in-specie transfers. While developed market mandates in-specie transfers trigger stamp duty and financial transaction tax as a result of the change in beneficial ownership. In the case of changing the manager of a segregated account the beneficial owner doesn’t change.

Whether these costs negate the benefits of the move depends in part on how long an asset owners plan to stay in the structure. “The more frequently investors change managers, the less rationale there is to go with a pooled fund allocation as costs are typically higher to go in and out. This trade-off also means that pooled fund allocations are more appropriate for passive investment mandates, rather than active investment mandates,” says Samsonov.

He suggests that the acceleration of pooling in recent years, part of the heightened scrutiny on cost, may be a trend that plays itself out when asset owners better grasp the full associated costs. “I wouldn’t be surprised if, in five or ten years, some clients say this isn’t working for me and move back into segregated mandates, especially as investment manager and custody fees continue to compress.”

This article is part of the Transitional Management Guide 2022, and if you want to download the full guide click here.