5 questions about Securities Lending
, Kerrie Mitchener-Nissen
Five reasons pooled funds now trump segregated investment accounts
While the segregated account has the potential to offer flexibility for the investor, the cost savings and other efficiencies presented by the pooled fund make it a valued choice for most types of investor, and one which should be front of mind for pension trustees.
In the past, institutional investors have tended to prefer separately managed accounts because they can offer flexibility, enabling the investment strategy to match closely the philosophy of an individual institution. In contrast, while pooled funds enable smaller investors to access investments that would be otherwise out to their reach, these are managed for the benefit of all the investors and are less likely to precisely match the bespoke requirements of one scheme. But there is a downside to the greater control and customisation of a segregated account – it requires much more time to set up the mandate, negotiate the terms, appoint custodians and other service providers, and monitor those relationships. In other words, this creates a significant governance burden for a scheme, which leaves them with much less time to focus on strategic issues that would have a bigger impact, such as fine tuning the investment strategy and communicating with members. Using segregated mandates also makes it harder for trustees to be nimble. Using a pooled fund can cut the amount of time to make an allocation down to weeks, rather than months. The advent of sophisticated institutional platforms makes it possible to improve even further the benefits of a collective investment vehicle, so they more closely resemble a bespoke investment.
Investors’ preference for segregated accounts means the many advantages of using a pooled fund are often overlooked. These include:
The overwhelming benefit of pooled investment funds is that they bring scale, and hence offer significant cost savings for investors. By aggregating the investments of multiple investors, the costs associated with managing the portfolio, such as trading costs and custody costs, are spread across all investors in the fund. Further cost savings may be achieved in an umbrella fund that has multiple sub-funds, as certain costs may be spread across all investors in all sub-funds in the umbrella. And the tax-efficiency of segregated accounts can be achieved by using a tax-efficient pooled fund vehicle, such as a Common Contractual Fund.
Additionally, it’s worth remembering that VAT is not payable on the investment management fees of pooled accounts, but it is on segregated accounts. VAT reclaims may be available, but they take time and resource to administer.
Pooled funds allow smaller institutions to access asset classes that they have insufficient scale to manage on their own, such as property and private debt funds. A pooled fund accessed via a platform allows pension trustees to invest across a number of funds and investment managers, without losing the benefits of scale.
The rigorous governance structure required by collective investment schemes helps trustees to meet their own governance targets. The pooled fund has its own board of directors responsible for overseeing the performance and management of the investment as well as ensuring the best interests of the investors are met. The board will consider matters such as:
Independent directors are subject to personal liability and so have a vested interest in the oversight of the fund.
It’s worth noting that if an investor buys into a segregated mandate, any strategy changes by managers will need to be monitored by those responsible for the oversight of the fund, creating additional overhead for the investor; where the investor has chosen a pooled fund, this responsibility will be subject to the oversight of the directors, taking away an additional governance challenge.
And using a pooled fund for a liability-driven investment (LDI) can significantly reduce the governance burden, particularly in the areas of regulation and reporting. For example, the European market infrastructure regulation (EMIR) requires specific trade reporting and reconciliation. Under a segregated account, the investor has to comply but for a pooled fund this is the responsibility of the fund’s board.
While an institution can delegate this to the investment manager of the segregated account, if they get the reporting wrong, it remains the liability of the pension scheme.
With a segregated account, the client must establish a relationship directly with any required service providers, including selecting and appointing the investment manager and a custodian. The client must then negotiate the contracts and fees (from a smaller and therefore less influential asset base) and undertake the burdensome activity of managing and monitoring these relationships on an ongoing basis. With an investment fund, on the other hand, all service providers are appointed by the fund’s board or its management company, who will then manage these relationships as part of their day-to-day role and will have a full program of monitoring in place.
Trading documents such as ISDA (International Swaps and Derivatives Association) agreements present a pain-point for users of segregated accounts, as the negotiation of these is very time-consuming and can incur significant legal costs. Therefore, many segregated accounts simply decline to make use of derivatives, which can be an important part of a portfolio for risk management activities such as hedging. Funds will have ISDA agreements in place with a panel of counterparties, to ensure that the fund is able to make use of the widest possible range of instruments to meet its investment policy.
A fund may have multiple share classes, which may allow investors with differing requirements to invest into the same fund, and therefore still reap the benefits of a fund such as cost efficiency and diversification from the larger pool. For example, a fund may have share classes denominated in different currencies and may also offer currency hedging. Similarly, investors with differing tax reporting requirements may invest in different share classes of the same fund, providing additional scale benefits. Segregated mandates have no such abilities.
The benefits of a pooled fund can be improved even further by using a platform provider. For example, a platform with significant scale will have even greater ability to negotiate better fees than for a stand-alone collective fund.
A platform can also take on much of the governance burden, overseeing the performance of the board of directors of fund, ensuring they will deliver according to their investment strategy. It can also hold service providers to account.
A platform can also add features that would not usually be included in a pool fund. For example, a platform can make a pooled fund more efficient by ensuring correctly applied withholding tax reclaims, using the correct fund structures.
In addition, a platform can improve the management of operational matters that impact both pooled funds and segregated accounts, such as managing trading errors, reducing liquidity risks and managing treasury functions more effectively.
By offering institutional-only pooled funds, investors’ interests are likely to be more closely aligned than those which also contain retail investors. The platform can also act as conduit between the investment manager and the pool to communicate particular concerns and build consensus among investors.
While a pooled fund may never facilitate the same level of customisation as a segregated investment account, its many benefits, particularly when accessed through an institutional platform, can provide a more cost effective, efficient and robust investor experience, and ensure peace of mind for pension trustees.
Photo credit: Pippa Rudling
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