Collective vehicles to drive out fund-of-funds model

Big new funds may replace councils’ old pension property strategy, writes Doug Morrison

Fund managers with UK local authority pension scheme mandates are facing far-reaching changes to the way they do business, following government proposals to cut investment management costs. A major casualty of the proposed reforms is likely to be the fund-of-funds financial model, which has been a favoured strategy for council pension schemes seeking exposure to property, but is now deemed a relatively expensive form of investment.

In its place comes a new idea – the common investment vehicle – harnessing the combined might of the 89 funds of the Local Government Pension Scheme (LGPS) across England and Wales, which collectively hold £178bn of assets. “There could be a fundamental change in the way that local authorities invest in alternatives, including property,” says Gavin Bullock, a pensions and tax partner at Deloitte.

“There is a material chance that there could be a £10bn fund that gets established to invest in alternatives. Given the scale of that fund, there is likely to be a lot more direct investment than has previously been the case. “It is quite feasible that there will be a larger allocation of individual funds’ assets to property than was previously the case, because now it’s a much more financially efficient form of investment.”

Local government minister Brandon Lewis announced this new way of investment for the LGPS on May 1, with surprisingly little fanfare. But the proposals, which are out for consultation until July 11, are radical and comprise two main elements: moving to passive management of listed assets, accessed through a common investment vehicle; and using such vehicles to invest in alternative assets, including property and infrastructure.

Pensions consultant Hymans Robertson, working for the Department for Communities and Local Government (DCLG), estimates that this would bring a combined annual saving of £660m over 10 years. The reaction from the bigger fund managers has been one of deafening silence because, in one form or another, they would feel the brunt of the saving. Such are the sensitivities here that both Standard Life and Legal & General (which helped Hymans in its report to the DCLG) declined to speak to Real Estate Capital, on or off the record, about the possible impact of the proposals. The Local Government Association also declined to comment.


Ian Fletcher, the British Property Federation’s policy director, acknowledges the logic of the proposed reform, but adds:  “I could see it affecting a number of our members in positive and negative ways. Obviously some of our bigger fund managers are providing funds of funds and there is a steer away from those. “On the other hand, if local authorities are not using funds of funds, they are going to have to get more diversity into their own collective investment in larger tranches and that might see more investment flowing into alternatives.”

Bullock concurs and suggests that the pros outweigh the cons in this proposed reform. “It does give the opportunity for there to be more direct ownership of assets,” he says. “In the equities world, that may mean more segregated mandates, rather than investing into other pooled funding. And in the property world that means ownership of direct property assets, rather than investing into pooled funds.”

He adds: “The idea of having the vehicle is that it would offer portfolio opportunities. It could offer a selection of different managers and different strategies that investors could decide to invest in. But the vehicle is not influencing the local pension funds on how or where they should invest. It’s offering the platform that makes that investment more efficient.”

The move away from funds of funds is arguably the most contentious consequence of the proposals, but is inevitable, given the DCLG’s desire for cost savings and greater transparency in local government pensions, according to Christopher Down, chief executive of fund manager Hearthstone. “They can be expensive to run because you have an extra structure in the middle, and there is a very strong argument that with £178bn in the LGPS sector alone, they don’t really need to be doing fund-of-funds structures, which means they will be reducing their management fees,” he says.


Another controversial aspect of the consultation is the fact that outright amalgamation of local authority pension schemes, which Hymans examines in its report, has been rejected by the DCLG. This is a particular blow to both Mayor of London Boris Johnson and the London Pensions Fund Authority (LPFA), both of whom have been lobbying for a merger of the capital’s local authority pension funds into a single scheme, as a means of channelling more investment into infrastructure.

The LPFA further argues that “super pools of LGPS funds” could tackle the £80bn deficit in the LGPS across England and Wales by combining asset and liability management. Following Lewis’s May 1 announcement, LPFA chief executive Susan Martin declared: “We believe that focusing only on asset management misses a significant opportunity for deficit reduction.” Deloitte’s Bullock, however, disagrees. “Merger is now off the agenda,” he says.
“That is helpful, because it means that  asset allocation can be taken at the local authority level, which makes sense because that’s where the liabilities sit. So each authority can decide how much it wants to allocate to equities, bonds, alternatives, and what sort of strategies it would like to follow.”

But Bullock adds: “It does mean there’s likely to be consolidation of asset managers as a result of more efficiency and lower fees, because they go hand in hand.” Quite how the mainstream asset and fund managers will respond to the consultation remains to be seen, but the idea of common, or collective, investment vehicles (CIVs) is gaining traction nonetheless.


Deloitte is working with London Councils, the umbrella organisation for the capital’s 33 boroughs, on a variation of the CIV model, which Bullock says could be launched as early as this time next year, regardless of the DCLG’s consultation. Residential specialist Hearthstone, meanwhile, has recently established its Housing Fund for Scotland with Falkirk Council Pension Fund providing the initial £30m. It is a CIV in all but name.

According to Down: “This will be a housing fund for Scotland whereby other local authority pension schemes in the country will be able to invest together they get economies of scale and a greater impact for their investment. “We think there are significant benefits to be had and that’s why we didn’t choose to run Falkirk’s money, which was won on a mandate on a discrete, single-investor tradition. We decided to scale it up with the targeting of other local government pension schemes in Scotland.

“This is the way it is going and it’s very clear from the enthusiasm that both Falkirk and other, as yet unnamed, local govern-ment pension schemes have shown us that they recognise the benefits on the whole. “I think they probably want the right balance between having local decisions about where to invest their assets generally, but still obtain the benefits of economies of scale through CIVs.”

However, when it comes to the official LGPS CIVs, there are significant grey areas. The Hymans report does not answer the thorny question of what sort of organisa-tion would run the CIVs, let alone address the issue of compliance. And in identifying potential cost savings across the board, Hymans skirts over the fact that some council pension schemes are successfully run as they stand.

One fund manager, which declines to be named, refers to a £3bn LGPS client that is fully invested and where the cost of running its portfolio is just four basis points, and asks: “How is this proposal for cost savings going to work there?” The manager adds: “If you create a fund of £10bn, £12bn or £15bn, in effect you become the market. That’s exactly what investors want from property sometimes they just want a beta play to get exposure – to the asset class. That can be a good thing, but then, who are you going to appoint to run this vehicle?”


Hearthstone’s Down says: “In some ways  the consultation is about imposing this direction on schemes and that’s why it is  a sensitive conversation. But the same amount of money needs managing, however the LGPS, government and all the other counter parties and stakeholders agree to operate in future. “For fund managers that have LGPS business, the identity of the parties to which they represent their capabilities may change – moving to a more centralised structure rather than working with individual schemes.”

Down adds: “Actually, I think that will  be a better experience for the managers, because one of the challenges in offering investment solutions to this sector is that you have to work at a very local level with each scheme. “We’re very willing to do that but we know that it’s quite a lot of work. Managers will be able to keep the focus more on the investment product they’re offering and less on doing 89 different sales pitches to 89 different local government pension scheme clients.”


Moving to passive management of listed assets, includ ing bonds and shares, accessed through a common investment vehicle. This proposal could save an estimated £230m annually by cutting investment fees and a further £190m  by reducing transaction costs.

Using a common investment vehicle to invest in alternative assets, including property and infrastructure, “ending the use of high-cost funds of funds”, to save £240m a year.


Reform of the Local Government Pension Scheme (LGPS) is inevitable, following the DCLG-commissioned study by consultant Hymans Robertson, which reported that the cost of investment in England and Wales was £790m — much higher than has previously been thought. It is also inevitable that the proposals for a few common investment vehicles (CIVs), as outlined in the DCLG consultation, will reignite an old debate about the value of fund managers and the fees that they charge.

After examining fund performance in the 10 years to March 2013, Hymans concluded that listed assets such as bonds and equities could have been managed passively without affecting the scheme’s overall performance. Many local authorities use funds of funds to achieve the scale needed to invest in alternative assets — including infrastructure, private equity, hedge funds and property. These often include several layers of fees, making them “an expensive way to invest”,  the Hymans report said.

“The £178bn of LGPS assets under management are currently split between a large number of managers, across different asset classes and both passive and active strategies,” according to the report. “Establishing a small number of large CIVs will consolidate these assets to a much smaller population of suppliers, achieving a total £660m of savings with minimal legislative change.”

As such, over time LGPS assets may move out of current mandates into CIV–based mandates. For property, that means moving from a fund-of-funds approach to a direct or funded strategy. Hymans says the benefit will come from the removal of an additional layer of fees, although closed-ended funds would be allowed to “run off”, which means that the benefit would come through gradually over 10 years.

Deloitte partner Gavin Bullock suggests that such a regime could see the emergence of a £10bn LGPS alternatives CIV, based on a 5-7% allocation to the sector. With such collective spending power, it is also likely that the LGPS would become more influential as  a direct property investor, although there would still be a place on the CIV platform for specialist funds.

Bullock says: “You can imagine that if it’s UK property, then potentially there will be more direct ownership, whereas if, for example, a small number of authorities have an interest in investing in Chinese property, that may well be through pooled platforms, because it would be more difficult to achieve that directly in an efficient manner.”

Hymans also explored the potential savings from establishing between two (one each for listed and alternative investments) and 10 CIVs – the fewer the CIVs, the greater the savings. But Hearthstone chief executive Christopher Down warns: “We have got to be careful that we don’t choose so much in the way of savings that we consolidate all investment decision-making or even just the selection of the right manager for each asset class. If you consolidate all that investment decision-making into just one vehicle, it adds a lot of decision-making risk. One error in that decision-making process affects all the capital invested by the LGPS.”