When is manager diversification detrimental? | Insight Investment

Over the decades, employing multiple fund managers has become commonplace for defined benefit pension schemes as a way of reducing the idiosyncratic risk of individual managers. However, mature schemes typically seek greater return certainty, relying more on beta and risk-management strategies than alpha strategies. For them, adopting multiple managers across all aspects of their investments can be detrimental.

We explain why and provide a guide to the factors that may influence your decision on where and whether to employ a multi-manager approach below.

Three reasons to question manager diversification

1) When targeting more certain returns, quality is more important than quantity to minimise risk

Diversifying investments helps to reduce risk where there is a large return dispersion and the returns from each investment are not correlated. Where an investor uses several asset managers that adopt active strategies to try to add value relative to a market benchmark, the tracking error (or risk) of that portfolio can be reduced by adding more managers to the roster – especially if the managers have complementary investment styles or are active in different parts of the market.

However, this is not the case for risk-management mandates, which typically target ‘least-risk’ portfolios, and adding multiple managers can instead increase risk.

DB pension risk managers predominantly hold a combination of gilts and derivatives, chosen to reduce the mismatch between asset and liability valuations. They will typically also hold assets with contractually defined cashflows (such as high-quality corporate bonds) aimed to deliver both the required quantum of return and cashflows at the right time against the liability projections. Different risk managers seeking to build such portfolios will typically target similar instruments and allocations – so using multiple risk managers to manage such portfolios is unlikely to introduce or increase diversification, and there will be high homogeneity (and correlation) of portfolios.

Moreover, fragmentation could decrease the chance of efficiently delivering the ‘least-risk’ portfolio, while also compromising resilience by dividing the collateral pool.

In short, ‘alpha’ benefits from manager diversification, ‘beta’ (in the same asset class) and risk management do not.

2) Investment silos can challenge efficiency and raise fees

Allowing a single, integrated manager to utilise assets for multiple roles can reduce the total assets needed to perform those functions, freeing up capital for other purposes and improving resilience. Here are two examples:

• Managing an integrated LDI strategy can reduce the amount of collateral needed: A single manager responsible for liability hedges and collateral assets could be well placed to ensure the right balance between the liability hedge ratio and size of the collateral pool. A single collateral pool that can be accessed for all hedging purposes could reduce the overall amount of collateral needed, freeing up more capital for growth. It can also potentially reduce the risk of needing to sell other assets at inopportune times, thereby increasing resilience.

• Efficient use of corporate bonds can reduce volatility and increase resilience: Structured appropriately, corporate bonds are capable of hedging and paying the liabilities whilst also offering a return in excess of the risk-free rate to grow the assets. Additionally, corporate bonds can now be accessed for collateral requirements (e.g. through corporate bond repo) which means they do not need to be sold in exchange for cash to meet collateral needs. These synergies allow for larger allocations to corporate bonds and increased certainty over the delivery of return requirements alongside increased resilience of the collateral pool.

In addition, consolidating mandates, such as integrating a liability-driven investment (LDI) strategy with a cashflow-focused bond portfolio with a single manager, can potentially lower fees as the larger asset base allows the manager to pass economies of scale back to the underlying investor.

3) Simpler governance and faster decision-making is possible with fewer managers

Trustees’ governance budgets are increasingly stretched. Monitoring and meeting with a large roster of investment managers can detract from the time and effort spent on strategic priorities. This is particularly important given the events of late 2022, which highlighted the need for greater focus on resilience and speed of implementation.

A single manager with a holistic view of a scheme’s assets, and the ability to make pre-agreed decisions across multiple related asset classes, can act faster and more effectively in a crisis than having the trustee and their advisers coordinate decisions across multiple managers. For example, such an integrated set up can allow a manager to determine how LDI and fixed income assets could work together to secure the funding outcome required, to deliver the returns required, as well as ensure sufficient liquidity to meet liability payments over the journey plan.

The manager could also dynamically adjust investments to align with evolving cashflow and hedging requirements and adapt the risk profile based on evolving return requirements to avoid being more exposed to risk than necessary to achieve the trustee objectives.

We illustrate the benefits of this integrated approach below based on our experience with clients who delegated LDI, cashflow-driven investment (CDI) and credit management to Insight via our Integrated Solutions offering.

• During the March 2020 period of market turmoil prompted by the COVID-19 pandemic, there was a sharp depreciation in sterling relative to the US dollar, which led to losses for pension schemes on overseas, dollar-denominated debt hedged back into sterling which required collateral to cover. Under a conventional investment strategy, this may have forced pension schemes to sell bonds at a loss to generate the required collateral. Under our integrated approach the collateral was sourced from a centralised collateral pool.
• During the 2022 gilt liquidity crisis, effective delegation enabled Insight to ensure the continued resilience of clients’ collateral positions by using a wider range of tools available. For example:

1. 1. Liquidity arising from maturing assets was withheld over 2022 to top up collateral rather than being automatically reinvested into return-seeking assets.
   2. Where assets were sold to top up collateral, the delegated implementation enabled us to sell at more attractive prices, ahead of the wider market sell-off. As markets settled, in some cases we were able to repurchase some of these bonds at lower prices than they were sold.
   3. The ability to choose from a wider array of assets also enabled us to sell assets which were not as badly impaired over the gilt crisis to meet collateral calls; for example, selling US corporate bonds and retaining UK corporate bonds.

The need for manager diversification diminishes as your growth allocation reduces

There are other valid reasons to consider manager diversification, such as:

• Asset-class expertise: It can be difficult to find a manager that has the requisite expertise across all the asset classes used in an investment strategy
• Corporate risk: Diversification reduces the impact of any potential operational, legal or business mishaps occurring at a particular manager, or from any strategic business changes

While the former is relevant during the growth-orientated phase of a pension scheme’s life cycle, it is less relevant when schemes are better funded and are net sellers of assets – here, the investment challenge is more risk-management focused, and the underlying assets held by multiple managers may overlap and focus more on beta. In these situations, the integration benefits are likely to outweigh the fundamental diversification benefits delivered.

Corporate risk is likely to be prevalent at all stages of the investment cycle. To this end, even where the benefits of integration is compelling, it remains important to choose managers with a stable and focused business and strong financial backing, which enable continued investment in technology, infrastructure and human capital to consistently deliver positive client outcomes in a broad range of market scenarios. This is particularly important during times of stress, where specialist expertise and a top-down focus by senior management facilitate quicker and more informed decision making, with the ability to place client interests first.

To help clients, in Table 1 below we summarise where manager diversification may help and where an integrated approach would be beneficial.

Table 1 : When and where diversification or integration is most appropriate 

Conclusion

Improvements in pension schemes’ funding levels have facilitated opportunities to increase certainty through greater reliance on contractually defined returns from maturing assets, instead of diversified market-based returns. In this environment, the benefits of integration become more valuable, and in many cases such benefits now outweigh the traditional benefits of manager diversification, in the optimal delivery of a scheme’s strategic goals.

We encourage trustees who are in this position to speak to your Insight representative and/or consult with your advisers to assess how best to unlock the value of integration and benefits of simplified governance, greater efficiency, enhanced resilience, economies of scale, and more certainty over return generation.