Pay the money and take your choice

More flexibility for savers and advisers in the pensions arena is generally a good thing – but wider choice needs greater expertise when it come to selecting funds that will perform well.

The freedom introduced by A-Day can only be considered a good thing, but with that freedom comes greater responsibility for savers, and advisers, looking to take control of their pension assets.

For the proverbial “sophisticated investor” the new rules, even after the government’s recent decision to reduce the range of products that can be included, are a great step forward. But the bulk of clients out there probably fall some way short of having the knowledge required to manage a pension fund more or less under their own auspices.

This is why, for many, the cosy world of pension schemes that are squirreled away into life company managed funds will probably endure for many years to come, regardless of their often poor performance.

In spite of that, a new and significant group of savers will be looking for alternatives. What, realistically, are their options? Residential property is no longer permissible, much to the chagrin of the property-obsessed British public, but the likes of investments in hospitals and prisons are – though these are hardly a product available to your average citizen. So direct property investment is a non-starter for most people. Gold bullion, but not jewellery, remains on the list but is also unlikely to be a core holding for your average pension portfolio.

That leaves the bond and equity markets as the most approachable, cost-effective tools to use. Direct investments in either of these markets are not really appropriate for the unsophisticated investor under most circumstances, particularly when saving for a pension. For the extra layer of costs attached to a collective investment scheme – be it a unit trust, investment trust or Oeic – there is, or should be, a more than commensurate increase in fund management expertise applied to one’s savings.

This, inevitably, leads to the question of choice of fund manager. This is not a question to be taken lightly. After all, it is a commitment that could last decades and, now that drawdown and annuity arrangements have been updated, one that can last well past normal retirement age.

Financial theory would have you believe that an investor should only hold the market portfolio – that is, a tracker fund – because markets are more or less efficient and therefore reflect all publicly available information about a stock. Active investors are only capable of beating the market in short bursts – over time the effect of higher fees should result in underperformance. One can argue about market efficiency ad nauseam but theory stands in stark contrast to reality.

First, the fees for many retail tracker funds are not much lower than active funds and, more importantly, there are a few active managers that have a record of producing consistently superior returns. There are also a significant number of managers who may not be a manager for all seasons but are reliably able to perform well in a given set of market conditions. The recent bull market in commodities, for example, has resulted in some stellar performances by specialist managers in the sector.

Our point is that fund selection is a key skill for anyone looking to take control of their pension assets. This, however, is far from easy – after all, the public at large does not know its alpha from its beta and does not have the ability to talk to money managers in order to understand their methods.

This is why funds of funds have taken so much market share and why this process will only accelerate from here, in our view. Outsourcing of fund selection for a self-invested personal pension helps meet several objectives. A multi-manager’s primary function is to understand which managers are best suited to market conditions going forward. Likewise, fund of funds managers offer products tailored to meet a client’s risk appetite and desired asset allocation.

The cost of this service is a consideration, but is one that we feel is exaggerated. Some funds of funds managers do attempt to minimise costs by, say, avoiding portfolio changes, but this is often self-defeating as they end up sacrificing performance if market conditions change rapidly. While no multi-manager would churn a portfolio for the sake of it, turnover at the right time is an essential part of maintaining performance.

Inevitably, one should caution that funds of funds offer no guarantee of improved performance, but they do at least provide a degree of comfort that a saver’s assets are probably working harder than if they were just handed over to one manager and then forgotten about.

Recent events also suggest that the argument for funds of funds can be taken a step forward to include fund of hedge funds. In our view, the Financial Services Authority’s announcement that it is considering opening up retail investor access to hedge funds of funds is of some significance for both multi-managers and clients.

Hedge funds remain little understood by the public at large, given that they only reach the front pages of the papers when something goes horribly wrong. Ironically, a funds of hedge funds that sticks to well managed, lowly geared, long/short equity funds is usually a pretty low-volatility product.

To some extent, a parallel with with-profits funds can be made. With-profits funds offered a return that mirrored equity markets but with bonuses that smoothed over the bumps. Though the workings of these funds was far from transparent, they worked well until the 2000/3 bear market exposed their flaws.

Funds of hedge funds – at least those that focus on long/short equity – offer a similar profile in their aim of producing absolute returns, but with some correlation to equity markets. This is an attractive profile, particularly when a saver is looking to maintain capital value and minimise volatility, as is especially the case when retirement age approaches.

As yet we do not know what the FSA’s consultation will come up with, so funds of hedge funds will remain off most retail investors’ radars for the moment. However, they represent an opportunity in a fund of funds marketplace that is evolving rapidly to suit the new investment paradigm we have just entered.