Promotion and Benchmarking of Alternatives by Consultants Questioned: £5bn Underperformance in LGPS revealed.

CLERUS today released a new report which reveals that investment consultant’s promotion of alternative investments to LGPS does not stand up to proper scrutiny. It also raises important professional and ethical questions around the integrity of the performance benchmarks used to assess, and remunerate, alternative managers. Finally, it also highlights the risk to performance where decision-makers lack the expertise to properly challenge the ‘expert’ advice given to them.

Report Summary:

  • Performance assumptions used to promote alternatives to Local Authorities (LGPS) do not stand up to proper scrutiny and are inconsistent with realised past performance
  • Lack of integrity of alternative benchmarks has ‘hidden’ 0.5% per annum, or £ 5 billion in poor performance over 10 years, excluding excess incentive fees paid on below target performance
  • More than £20 billion worth of alternatives and absolute return products benchmarked, and remunerated, inappropriately using cash-like benchmarks in LGPS alone

LGPS regulations require administering authorities to take ‘proper advice’ when making investment decisions. However ‘proper’ is not well defined and does not oblige LGPS to scrutinise the quality of advice prior to making investment decisions. The report highlights the need for improved governance in this area and illustrates why this should include scrutiny of the risk and return assumptions used in various asset-liability simulations to promote alternative investments.

UK consultants’ recommendations also appear to be going against the tide of industry leaders. Examples include California Public Employees’ Retirement System (“CalPERS”) and their decision to divest from hedge funds stating excessive cost and complexity, and the decision in 2013 by the £73bn Danish Labour Market Pension Fund (ATP) to close down its own $1.9bn ‘alpha’ program citing that it had become time-consuming and expensive.

In the event that the original LGPS reform proposals were carried through, Local Authorities would still end up paying £301 million of annual fees, and 58% of total fees, to an 11.5% allocation to alternatives. However, as the data has shown, these alternative investments have historically provided lower return than bonds or equities, and were achievable by simple de-risking.

The dressing-up of investment performance by setting alternative performance benchmarks too low leaves financial intermediaries as winners, while plan sponsors and tax payers lose out.

1) Local Authorities are more likely to be able to report ‘above benchmark performance’
2) Investment advisors can finally report that their ‘buy-rated’ managers beat benchmark
3) Investment managers earn higher fees (including potential performance fees) for longer as their performance looks better than it is and cannot be assessed correctly