How we Run our Money: Lothian Pension Fund
Bruce Miller (pictured), CIO at the Lothian Pension Fund, talks to Carlo Svaluto Moreolo about the fund’s inclination towards equities and internal management
The panicked reaction of financial markets as the COVID-19 pandemic broke out in March is often described as unprecedented. That definition may be correct on some levels – for instance, if the speed at which equity markets fell is considered. But those that have worked in financial markets for long enough know that panic and frenzied behaviour are hardly rare.
“Any investor with 30-odd years of experience has learned that panics and bouts of volatility take place regularly,” says Bruce Miller, CIO of the Lothian Pension Fund, the Scottish £8bn (€8.8bn) local government pension scheme (LGPS).
The fund, which is Scotland’s second-largest LGPS, manages pensions for employees of the City of Edinburgh Council and many other public employers across Scotland.
Miller has witnessed, first-hand, several bouts of extreme panic in markets, starting with the 1987 crash that is often referred to as Black Monday. This has all but reinforced his commitment to long-term investing, and to the asset class that is most likely to deliver returns over the long term.
“The market dislocation in March wasn’t so unusual really, although the cause was. As Mark Twain is reputed to have said, ‘history never repeats itself, but it rhymes’. I am confident there will be more rhyming in the next few years and decades. Short-term wealth destruction will always test the resolve and the resilience of those who are managing assets over that period. But if they have patience, I expect they will be rewarded for taking the extra risk that comes with holding equities,” Miller says.
As a UK LGPS, the Lothian Pension Fund is unusual in its particularly heavy allocation to equities, which stands at 65% for its main employer strategy. Most UK LGPS have a high allocation to equities because, as open defined benefit schemes, they are relatively immature, with liabilities stretching far into the future. But the Edinburgh-based fund is on the higher end of equity allocation.
The strategic allocation to equities is lower for some of the fund’s more mature employers. But overall, the fund had 58.3% of its assets allocated to equities as of the end of March. Its return for the 2019-20 financial year was a negative 3.6%, but on the more significant 10-year basis, the fund has outperformed its benchmark.
In addition to the large equity allocation, over the years the Lothian Pension Fund has also built a 22% allocation to real assets, notably real estate and infrastructure. These provide the fund with long-term streams of cashflows with some inflation protection properties.
“While there are no easy answers to the challenge of low interest rates, our equity and real assets investments represent our current answer. Bonds still have a hedge quality, despite the low yield. We saw that in March, when they performed strongly while equities plummeted. But we know that bonds won’t provide much of a return,” says Miller.
“At the moment, equities are yielding significantly more than bonds, and offer the likelihood of modest growth, assuming no cataclysmic economic future. There’s still an equity-risk premium on offer, which hasn’t always been the case in my career. Lower absolute real returns are likely going forward but, as a long-term investor, we should be able to extract that premium over the next decades, albeit with considerable volatility.”
That is not to suggest the pension fund is indifferent to volatility. Miller says: “One of our investment beliefs, backed by academic evidence, is that within asset classes, higher-risk assets deliver worse risk-return profiles. In general, we worry more about permanent capital impairment of assets than lagging behind in exceptionally strong markets over shorter periods. We think that lower risk suits our long-term horizons.
“We believe in diversification too, which is why we have a number of different equity portfolios that we rebalance over time.”
However, the fund does not favour passive approaches tied to market capitalisation-weighted indices. Miller points out how most of the largest market capitalisation companies prior to the bursting of the dot.com bubble in 2000 never recovered their peak market level. Those that did, such as Microsoft and IBM, took more than a decade to do so. The current question is whether the handful of large technology stocks that are winning in today’s markets will suffer a similar fate. Time will tell, but for all the attractions of passive investing, there are dangers too.
“One of my main concerns is that we do not overpay for assets. Although I no longer select individual stocks, I do monitor the largest companies in the index, and I observe that they have developed strong and durable business models that have benefited handsomely from the pandemic. But they’re not without risk, and we try to weigh those risks with the potential for long-term returns,” he says.
The Lothian Pension Fund’s investment philosophy, as outlined by Miller, does not fall neatly into well-known categories. The fund is neither active nor passive, nor value or growth. This is a fairly common feature among large pension investors, which cannot afford to slavishly follow any particular approach, owing to the complexity of their objectives. Yet it is refreshing to hear the CIO articulate a holistic investment approach that embraces uncertainty, at a time when the fate of markets is particularly precarious.
“The key for us is not to change tack between being a value investor and a growth investor. A hundred years of history tells us that value and growth strategies come in and out of fashion. One of the advantages of being a long-term asset owner is that we do not need to be swayed by the inevitable short-term pressures when a particular strategy is not performing well.
“Furthermore, we know from academic research that much of the underperformance that funds suffer is from changing strategies and managers too frequently and at the wrong time. We want to avoid that whenever possible.”
The fund manages 85% of its assets in-house, including directly-owned real estate, thanks to a team of 18 investment professionals. According to Miller, the team has grown over the past 10 years to reduce costs and to ensure the best possible of alignment of interests.
While most of the fund’s equities are managed internally, there are three externally-managed equity portfolios that are intended to complement the work of the internal equity managers.
The fund’s real assets investments, excluding the directly-owned real estate, are sourced by the internal team but managed externally. Miller explains that the investment team has a hands-on approach to selecting and monitoring those investments. “It’s never about making a commitment and then forgetting about it. We want a close working relationship with our managers to ensure our objectives are aligned,” he says.
There is also a small, externally-managed portfolio of private debt, an asset class for which the fund does not have internal resources.
“From external managers, we are looking for things that we cannot do ourselves. We avoid strategies that are complex and that we do not understand. From our managers we demand transparency and strive for as much alignment with the fund as possible. We look for investor-friendly terms and avoid asymmetric risk profiles, where the managers capture most of the upside and none of the downside,” Miller says.
There may be scope for the share of externally-managed assets to grow further, depending on how the fund’s asset allocation develops. “We certainly don’t claim to be able to do everything ourselves,” he says. But the emphasis remains on internal management, which requires significant efforts, not just in terms of strategy and process, but also in terms of people management.
Miller says: “Ours is a people business. We try to attract people who are like-minded, in the sense that they embrace our long-term culture and believe in doing what is best for the fund, rather than for themselves.
“At the same time, we want a well-rounded view of the investment world, and the world as a whole. So we have tried to build a diverse team, both in terms of perspectives and experience.”
The CIO seems to be succeeding in this complex task. “We have balance in terms of age and gender and we have people of different nationalities. The team is also diverse from an educational perspective, in that we have economists, mathematicians, engineers, scientists and historians. Most of our people have spent as much time in the private sector as they have had in the public sector,” he says.
“If I went back 10 years, I would not have expected to have the same core of people we have. We have built a common culture of respectful challenge, curiosity and mutual trust, all of which are essential in investment management.
“We are all trying to do our best for our members and employers, and that is what keeps the team together. And the prospects for asset owners seem positive in comparison with the asset management sector. We are fortunate in the sense that we have to serve only one master,” he says.
At a time when most investment teams are physically separate, the collaborative culture and resolve that Miller describes is crucial, as is the ability to use technology. The latter is a feature the Lothian Pension Fund is well versed in, thanks to its CEO, Doug Heron, who has extensive experience in private sector financial technology businesses. Heron is implementing the fund’s digitalisation strategy, according to Miller.
The CIO says that the fund has continued to operate effectively during the socially-distanced period, but the long-term effects of the pandemic are still to be discovered.
“We were preparing for an out-of-office business continuity test just before the lockdown, but instead of doing that, we just locked down. Thanks to our technology set-up and resilience, we were able to carry out business as usual, but there is a challenge for all companies culturally as they discover the extent to which they need the social and physical interaction,” says Miller.
“From an investment point of view, clearly some of the trends that were in place already before COVID-19 have accelerated, with technology being a big winner. Going forward, however, I will be very surprised if the next 10 years resembles the past 10 years of persistently declining interest rates and inflation. Changes may come slowly but they are afoot.”