USS weighs up costs and benefits of outsourcing investments

USS head of strategic equities Innes McKeand tells MandateWire why the scheme sometimes favours external managers and what steps the fund is taking to position its portfolio for an inflationary environment and a net zero future.

The USS manages about 80 per cent of its assets in-house and is focused on building its internal developed market investment capabilities. In 2020, its annual investment management costs were 30 per cent below the peer investment group median, according to analysis by CEM Benchmarking.

Internal management has the double advantage of being significantly cheaper and allowing for greater control over, for instance, environmental, social and governance factors, McKeand says.

Forward returns will be lower than they have been historically, and cost will be a more significant element

Innes McKeand, Universities Superannuation Scheme

However, the USS will look at employing external managers if they are considered to have a “competitive advantage”. For example, in time, the scheme might consider outsourcing some specialist equity mandates, he notes.

Earlier this year, the pension fund transitioned more than £5bn worth of global equity investments from BlackRock to a climate transition index developed by USS and German indices provider Solactive. The mandate is handled by Legal & General Investment Management.

“We outsourced it because LGIM is better at implementing a passive mandate than we are. We designed the mandate. We asked LGIM to manage it for us because they have a competitive advantage,” McKeand explains.

The USS combined some of the strengths of both internal and external management by working closely with Solactive to build an index that matched its principles.

“We could have taken an index off the shelf, such as a Paris-aligned benchmark, which typically would have cut emissions more on day one,” McKeand says.

“These indices would have cut out energy stocks entirely. We would have felt better owning fewer of these companies, but we wouldn’t have been changing the emissions of anything. Somebody else would have owned the shares instead of us.”

Inflation protection

McKeand argues that cutting investment management costs will become even more important as market conditions evolve.

“My expectation going forward is that the returns we had on markets over the past 20 years, we’re not going to see them anymore. Forward returns will be lower than they have been historically, and cost will be a more significant element,” he says.

In the current environment, the USS is keen on assets that can provide long-term inflation protection. It started within private markets and has now turned to developed markets.

This means looking for “good companies, regardless of sector”, with high margins, high returns on capital, and strong brands that give them a degree of pricing power, McKeand explains. For example, some consumer staples, technology and healthcare companies might fit the bill.

“If we focused on short-term correlation with inflation, we’d invest in energy and miners. But in the long run, we are not convinced they give the best returns,” he adds.

Communications challenge

During the past 18 months, the USS has taken steps to curb its carbon emissions by setting net zero and interim climate targets. It has also invested in renewable energy and in the low-carbon transition.

The next phase is a deeper dive into each asset class to get a better understanding of how to integrate climate into the investment processes. Data quality is an issue, although it has improved over time and “is not an excuse for not getting in it”, McKeand says.

The USS subscribes to the “we can’t divest our way to net zero” philosophy, and its approach is to engage with companies as exemplified by the LGIM passive mandate, which is light on exclusions.

As of September 30 2021, the scheme’s top 100 equities list comprised chunky holdings in companies such as Shell, Rio Tinto and TotalEnergies.

“We think we’ve got a responsibility to help companies to invest and decarbonise,” McKeand notes, while recognising that carbon emissions are a complicated issue that make for a “big communications challenge”.

“How do we have an honest conversation with our stakeholders, which is also about the complexity of this? How do we apply the various principles? How do we avoid greenwashing?” he asks.

“It’s a massive learning curve for us all… There isn’t a ready solution off the shelf, you have to make some progress now and try to crack on with it,” he says.

This article originally appeared on Mandatewire.com