A report released today finds that inappropriate benchmarks used by local authority pension funds and their advisers for alternative investments have artificially flattered performance, with its authors blaming a governance failure in the sector.
Research conducted over the summer by performance review provider Clerus argues inadequate cash and cash-plus benchmarks reduced return expectations by £1.1bn in the year to March 2013 across diversified growth funds; private equity, including infrastructure; and hedge funds.
This is compared with benchmarking the investments against equities, or a mixture of equities and bonds.
Alternatives such as DGFs are marketed as providing equity-like returns, or a large proportion of equity returns, with a proportion of the risk.
“A lot of the ‘I have beaten the benchmark’ over the past few years has been because they have been loading up on assets that are benchmarked against cash,” said Clerus co-founder Henrik Pedersen.
“This may be intentional or it may be because they are getting the advice they are getting,” he said.
Independent consultant John Ralfe agreed it was “apples and oranges” to be using a cash benchmark for alternatives, adding: “The risk is not a cash risk.”
Ralfe agreed with the report’s suggestion that investment consultants are minded to recommend complicated investment products.
“The investment consultants like complexity, they like manager selection, they like manager reviews, they like manager churn. They do not like simplicity because they do not make any money out of simplicity.”
But Linda Selman, partner at consultancy Hymans Robertson, said judging the success of alternative investments by peer group benchmarks, or those designed for traditional asset classes, was inappropriate.
“Many alternative assets are judged against a cash or inflation-plus benchmark because that is the most relevant measure; the key is that it is cash-plus not just cash, and we ensure that our clients judge the manager performance against that standard,” she said.
“Cash-plus may seem like a soft target when equities are performing well but it will be a much tougher target when they are not.”
Governance challenge
Karen Shackleton, managing director at AllenbridgeEpic Investment Advisers, said consultants would not put their reputations at risk by creating an investment set-up that simply makes them look good.
Many alternative asset strategies such as DGFs were originally designed in the aftermath of the financial crisis for institutional investors looking to reduce the hit from large equity market drawdowns. But the equity bull run over the past three years has given a less flattering picture.
Shackleton said: “Perhaps the sensible thing to do is say, ‘Let’s check that they have performed against a cash-plus benchmark, then once we have got a longer-term performance, have they delivered the equity-like performance?’”
The report calls for local authority pension funds to put in place more scrutiny of investment products suggested by advisers, and to review the current performance benchmarks used.
Pedersen said investors needed to “see through” the propositions that were being made, adding: “Does the consultant believe in [the strategy]? Are they doing it because it actually suits the revenue model? What has been your track record in selecting alternative managers in the past?”
Shackleton added: “Perhaps we should be a little bit more aggressive in our expectations and our challenge of the mangers just to make sure they are not thinking we have got an easy job here.”
