For much of its history, UK pension fund Nest took a broad, systematic approach to equity investing, but recently it decided to add an active, thematic strategy to the portfolio. We speak with Rachel Farrell about the fund’s evolving philosophy on active vs passive strategies
When the National Employment Savings Trust (Nest) was formed in the United Kingdom under the Pensions Act 2008, it started from a small base and it wasn’t immediately clear how quickly it would grow.
Under these uncertain circumstances, it made sense for the fund to invest in passive, low-cost strategies until it had a reached a scale at which it could consider more complex strategies.
But as the fund began to build scale, resulting in the £51.3 billion (AU$ 105 billion) fund it is today, it quickly realised it had a role to play as a responsible owner of assets and shaping the future world that its members would retire into.
“As Nest built up scale, it could start thinking about: ‘Well, what else should be incorporated in the way we invest?’ And very early on, Nest identified its responsibility in the global community as a positive actor in the investment space. So Nest built a responsible investment team,” Rachel Farrell, Director of Public and Private Markets at Nest, says in an interview with [i3] Insights.
“We wanted to take into account a view as a responsible investor, particularly around things like climate, and the original impetus was to say: ‘Well, a pure passive investment doesn’t really necessarily take into account what Nest might want to achieve in terms of its responsible investment goals’.
“That was the first step in the move from purely passive towards something that had elements of active. And so we worked very closely with UBS, who is our developed market equity active manager, to create a strategy that would still reflect the exposure that a passive strategy would give you, in that you just have a very broad exposure to the market.”
But this systematic, climate-aware strategy did have its drawbacks. Climate-aware strategies tend to concentrate in certain sectors, including the technology sector, and doesn’t necessarily address the ‘S’ in ESG.
“Pure passive exposure was demonstrating some considerable concentrations in a certain sector of the market, which is namely in the US, and namely in seven technology-oriented stocks,” Farrell says.
“At the same time, there was a recognition that Nest has a very long-term horizon. Our average member is 40 years old; they will only retire in 25 years’ time. What is that world that they’re going to retire in?
“There was a view that we should also be considering some of the long-term, global trends in the marketplace around climate mitigation and adaption, natural capital and social change. That was why Nest started working on a thematic portfolio and find a manager who would be able to effectively identify winners and losers based on those three themes,” she says.
Although the strategy aims to find outperforming companies based on these long-term trends, it is sensitive to valuation changes and can sell stocks that the manager deems as overpriced. The strategy has been running for a year and the team is still spending a lot of time analysing how the manager is implementing this customised mandate.
Farrell doesn’t expect that this strategy will open the floodgates to other active approaches, since Nest still believes a broad market exposure is appropriate in most cases.
“Frankly, we would have to build very different resources internally in order to build a portfolio of active managers. We would have to build the infrastructure to do that, and I’m not sure that’s a priority right now, partly because we’re also extremely fee-constrained,” she says.
But Farrell is aware of the limitations of a purely passive approach to investing and is mindful of the amount of money that institutional investors have put into these market capitalisation-based strategies, which have the tendency to create their own price momentum.
“The move to passive is so large that it’s not clear whether an active investor can actually overtake that. Active investors would be looking at mispricings, but if so much of the market is just pushing money into passive strategies, then how will that ever get recognised in the market? It’s a super interesting question,” she says.
Partnering for Exposure in Emerging Markets
More recently, Farrell and her team have been considering enhancements to how Nest invests in emerging market equities. The case for active management in emerging markets has been made on various grounds, including poor governance, lack of shareholder alignment, government influence and a less intensely researched investment universe compared to many developed markets.
But the track record of emerging market equity managers can be patchy, especially when compared to systematic strategies that simply cut out the small end of the index, where much of the questionable company practices take place.
There could be value in taking a similar approach here as in its developed market equities, adopting a broad market exposure with some customised tweaks and a focus on responsible investing, governance and engagement.
“We’re currently conducting research in this space, but again we would want to maintain a meaningful partnership-type relationship with one manager,” she says.
“And if the mandate is with one manager, then we wouldn’t want to take a lot of active risk, so we would always look to maintain a pretty tight tracking error. We are always researching the strongest ESG frameworks, in other words not purely passive, but the ability to differentiate between companies that are good actors and bad actors,” she says.
The Question of Internalisation
Earlier this year, Farrell was in Australia to speak with some of her super fund peers and compare notes on the different investment approaches. Farrell, who was previously Country Head of Australia for JP Morgan Asset Management, knows the local market well and has observed the move towards internalisation by a number of large Australian funds with interest.
But she doesn’t think this is necessarily an appropriate strategy for the UK pension fund, at least not in equity markets.
“We’re not anxious to start building investments internally. Because of the model that Nest has built, which is to have large, meaningful relationships with a small number of managers, it has enabled us to negotiate very good commercial terms,” she says.
“We look at the [fees] we’re paying our managers, and we have a hard time thinking this is going to be a cost saving, because when we benchmark ourselves against the fees that we pay for our managers versus what we can find on general benchmarking, we think we’re doing a pretty good job for our members.
“So it would have to be for another reason that we would internalise, perhaps something that we can do that a manager can’t do. That’s being evaluated right now.”
Farrell gives the example of UK real estate, a sector in which Nest is a big player. The fund has almost a quarter of its assets invested in the UK, with a significant chunk in real estate. As such, it has amassed a lot of expertise and relationships in the domestic market and it might make sense to get involved in direct property investments.
“It’s our home market and so we might do something a bit more direct than having a purely outsourced solution,” she says.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.