23/03/2011 Author: Shannon Hawthorne

Nest building

The UK’s National Employment Savings Trust (Nest), set up to manage the new employer pension legislation coming into force next year, represents great potential as a possible future hedge fund investor. HFMWeek talks to CIO Mark Fawcett about the scheme’s approach to investing

Fund managers are, on the whole, necessarily adept at dealing with stress. Volatile markets, demanding investors and an onslaught of onerous regulatory changes – on any given day, those working in the industry face a whole range of seemingly neverending challenges. But for one former manager, a move away from fund management has led him to a role that has, arguably, placed even more weight on his shoulders.

Mark Fawcett, formerly a partner at Thames River Capital, is now chief investment officer of the National Employment Savings Trust (Nest), a new national defined contribution (DC) pension scheme scheduled for launch next year. The plan has been set up to all help UK employers adhere to new legislation, set to come into force in 2012, which require all firms to enrol all eligible employees into a workplace pension scheme.

Of the nine million UK employees currently without a pension, up to six million are expected to be automatically enrolled in Nest (formerly, the Personal Accounts Delivery Authority (Pada)), and while, ultimately, the scale of the scheme is dependent on a number of variables – such as how many businesses choose Nest (as opposed to an
alternative pension scheme), or how many eligible employees exercise their right to opt out of the scheme – it’s clear that Nest will eventually represent a substantial chunk of the nation’s pensions savings.

In fact, Fawcett says that research from the Pensions Policy Institute (PPI) suggests that the scheme will represent as much as £250bn ($401.1bn) by 2050. “It’s clear that Nest is likely to be a very substantial scheme, and, at some point, possibly one of the largest DC schemes in Europe,” says Fawcett. “So it’s absolutely right that we should commit resources, energy and intellectual thought into finding the right investment approach.”

Fawcett spent most of his career prior to joining Nest working in fund management, eight years of which he spent at Gartmore, working in Japanese equities and leading a project to redesign and improve the firm’s investment process. “I think that’s when I started becoming interested in designing investment strategies,” he says.

Spells at American Express International, RAB Capital and, most recently, Thames River, followed, with Fawcett once again working in Japanese equities (on both the long-only and long/short side), before joining Nest in December 2008, initially as investment director, before progressing to CIO.

“I was lucky to be building a team at a time when a lot of good people, through no fault of their own, were out of work, and so it was a benign environment to be hiring some really talented, experienced people,” he reflects. It was also a time when the investment approach of DC schemes (broadly speaking, a pension scheme where the ultimate payout is dependent on the amount saved) was evolving – and it continues to do so.

“When I joined Nest, or Pada as it was known then, I realised that a lot of the issues that DB (defined benefit) schemes had faced back in the late 90s and early 00s, DC was facing now,” says Fawcett. “Things like overreliance on equities for returns and a massive home equity bias – these were the issues that DBs had been grappling with.”
Today, a growing number of DC schemes are seeking to diversify their assets away from equities and are looking towards alternatives as a potential investment option – and Nest is no exception.  “That was one of the key themes running through our investment consultation: how we could incorporate non-equity asset classes in a sensible way and manage for risk.”

The consultation in question took place between May and August 2009, following the publication of a discussion paper on designing an investment approach for Nest, and received 67 responses, from a range of firms and institutions including the likes of BlackRock, JP Morgan and BNY Mellon.

It was only last month that Nest appointed its first five investment managers: UBS Life World Equity Tracker, State Street UK Conventional Gilts All Stock Index Fund, State Street UK Index Linked Gilts Over 5 Years Index Fund, BlackRock Aquila Cash Fund and BlackRock Aquila Life Market Advantage Fund. The scheme also began searching for a Shariah-compliant global equity fund, as well as a socially responsible investment (SRI) fund earlier this year.

But where do hedge funds factor in Nest’s future investment plan? With one of the key battles hedge funds face in trying to attract institutional investment being lack of knowledge or understanding of the sector, it’s perhaps heartening for managers to know that the man heading up the national scheme not only understands the hedge fund sector, but has actually worked within it. Indeed, such an investment move is certainly not something Fawcett is ruling out.

“Over time, as we get bigger, we aspire to move into other return-seeking assets, probably on a single asset class basis,” he says. “The asset classes we discussed in our consultation included property, venture capital, private equity, infrastructure and hedge funds, so I think we’re very open minded as to what we should include.”

But there are still challenges to face, not least the public scrutiny that a scheme, potentially investing the pensions of six million employees, will inevitably face. “I think the hardest thing for the trustees, because they are ultimately responsible for the investment decisions, is the level of scrutiny and the risk that the media focus on short-term results when this is a long-term savings plan,” he says. “When you’re saving for a pension scheme, you can afford to take the long-term view and ride the ups and downs of a market, but that does sometimes require buying risky assets at a time when everyone hates them.”

That said, the scheme’s members themselves are unlikely to question the scheme’s investment strategy, as long as it is performing well, says Brian Henderson, head of DC at Mercer’s investment practice.

“If you had a particular make of car which ran very smoothly and got you from A to B with no problems, you wouldn’t necessarily open up the bonnet and try to understand everything that goes on in the engine – and I think the same probably applies to Nest,” he explains. “That’s not to say that its members shouldn’t understand what they’re investing in but it is essentially a delegated function – they’re asking Nest to do that for them and they either have confidence in the scheme, or they don’t”.

But one stumbling block that hedge funds trying to attract a future allocation from Nest are likely to face is the issue of fees. Having made a commitment to be a low-cost savings trust, management fees is a factor that Nest has to be keenly aware of, and this may create an obstacle to investment for certain funds. “In terms of the absolute level of fees, we have to ascertain if we can accommodate them in our budget, and when thinking about funds of hedge funds (FoHF) versus single managers, we have to bear in mind that funds of funds bring in that extra layer of fees,” says Fawcett.

He also points to issues of valuation as a potential barrier to investment, pointing out that Nest has to provide daily valuations for daily dealing. “However,” he adds, “the hedge fund industry is clearly moving in a good direction with products such as Ucits and other unitised funds, which often have weekly or daily valuations, which is helpful for us.”

And with the potential to grow to such a substantial size, Nest is undoubtedly in a strong position when it comes to making demands about fees, transparency and other similar issues. “We have a lot of fund managers very keen to work with us, not just for commercial reasons but because they recognise the positive impact Nest will have on UK society,” adds Fawcett, “and that allows us to make sure we get the best managers for the job.”

The future for Nest is clearly still uncertain, in terms of its investment strategy at least. But with such a substantial potential for growth it seems likely that alternatives will play some kind of role in the scheme’s investment strategy somewhere down the line.

“There’s evidence to suggest that very big schemes do well largely because they’re big enough to be able to afford to invest in these alternative asset classes,” says Mercer’s Henderson. “Nest will, at some point, become big enough and so alternatives may be more attractive to them, once they’ve built up sufficient assets under management.”
But while Fawcett is keenly aware of both the pros and cons of investing in hedge funds, for now at least, the sector is not on the top of his priority list. “Yes, [fees, valuations, and so forth] are challenges we are thinking about, but they are not today’s challenges,” he says.

Nest may only represent a future opportunity for capital, but it’s surely too big an opportunity to ignore. Of course, the fact that it is a national scheme does mean that the demands it places on managers may, out of necessity, be more stringent than the average hedge fund is used to, but for those funds willing to try and meet that challenge, the potential rewards are huge.