This is the fourth article in an ongoing series on managed funds –Â Part 1: Using the Sharpe ratio to assess fund performance, Part 2: Identifying appropriate benchmarks for private equity funds and Part 3: Evaluating common measures of private equity performance.
"Complexity is your enemy. Any fool can make something complicated. It is hard to keep things simple." – Richard Branson
The business of running a pension fund has grown increasingly complex. That complexity is the product of the ever-increasing breadth and complexity of available securities. The days of a simple conservative portfolio of domestic stocks and bonds have long since passed. Now, as more people retire, pension funds are creaking under the need to deliver better returns. They have turned to a range of asset classes and to specialized managers ranging from commodities to hedge funds to private equity.
Growing securitization, the development of new asset classes and the opening of access to markets around the world have grown the universe of what pension funds can allocate to. At the same time, the assets within these classes have grown in individual complexity. For the most complex asset types, most pension funds rely on specialist managers, such as external hedge funds and private equity funds.
The problem with this growing complexity and specialization is that a concurrent gap has developed between the knowledge of the actors making final investment decisions on the ground and their employers (i.e., the pension fund). That gap is wider still between the investments and the individuals on whose behalf they are made in the first place (i.e. the beneficiaries of the pension fund).
This article explores some of the problems that can arise from growing specialization and diminished communication between the principals (pension funds and their beneficiaries) and their agents (fund managers and specialist asset analysts). As more and more Americans retire, the nation’s pension fund infrastructure will be pushed harder and harder. If retirees care about their financial futures, they should pay much more attention to how their money is being managed.
Greater complexity, greater cost
It is a simple business truism that the more complex an organization becomes the more costs it begins to face. It is a truism that has been proven out in the pension fund space over the past several decades. A study of pension funds in the United Kingdom, for example, found that most pension funds in 1984 employed a single generalist manager who operated across all asset classes in the fund’s mandate. Just 20 years later, virtually every pension fund had numerous employees, most of whom had highly specialized roles and expertise. That pattern has continued unabated to the present.
As assets grow in complexity and become subdivided into new specialized classes, analysts have been pushed to specialize themselves, often because understanding particularly complex asset types requires undivided attention. Yet more specialists means more employees – which tends inevitably to mean more managers. Recent decades have seen an explosion in bureaucratic layers within pension fund structures with mounting costs to match.
Consider this example: A pension fund may start out with two divisions, debt and equity. But that equity division faces pressure to split up into a host of subspecializations. There would be a branching between public equity and private equity. The public equity branch could then be divided between sectoral specialists or strategy specialists (small-cap, dividend, etc.). The private equity branch could likewise be split between categories including real estate, leveraged buyouts and venture capital. Each of these splits will see a new layer of bureaucratic oversight with a class of intermediary managers attempting to collate the various messages coming from each segment they supervise. The result, in practice, is often a byzantine network that carries hefty costs in salaries and time.
Complexity leads to concentration – and trouble
Industry pressure toward extreme specialization and the attendant costs of managing such an operation have led to another interesting consequence: a greater concentration of asset managers. Because there are so many (supposedly necessary) layers of specialization and mediation, there are evident economies of scale. The result in practice has been for smaller pension funds, endowment funds and even family offices to delegate control of their capital to larger funds that can exploit the benefits of scale.
The problem with specialization and subsequent asset concentration is that, as the chain linking the interests of decision-makers (i.e., specialized asset managers) and those of the final principals (i.e., pension fund beneficiaries) grows longer, the alignment of interests may deteriorate. The goals of the actual asset owners begin to fall into the distance for the agents working on the ground day to day, especially for those engrossed in particularly rarefied specialties that may lose touch with the activities of the broader market and with the aims of the portfolio strategy as a whole.
What all this means for investors with money in pension funds – whether employer or state-managed – is that they should be very wary of how their pensions are being managed. For large-scale pension funds, there may be significant communication loss between layers of the operation, leading to inefficient decision-making and possibly deleterious investment decisions.
Pension fund organizations, especially those run by governments, have enjoyed a significant degree of immunity from the prying eyes of the public whom they are meant to serve. Savvy investors and retirees should keep an eye out for bad behavior and promote more streamlined and transparent management practices.
In these uncertain times in which people are living longer and pensions are stretched to breaking, vigilance is all the more important.
