Simon Wong, LSE, interview

Pension funds still struggle to get their head around securities lending. It occupies a tiny component of their investment strategies, so commands a correspondingly small amount of their attention.

Simon Wong, a visiting fellow at the London School of Economics (LSE) who has spent years looking at the governance of pension funds and their relationships with asset managers, says this is symptomatic of a more fundamental problem with the way pension funds are managed.

This knowledge gap was highlighted in a recent lawsuit that was brought by two US pension funds that claimed BlackRock’s iShares business and its affiliates kept too much revenue from their securities lending programmes.

Although the case was dismissed at the end of August by a US district court judge in Tennessee, as BlackRock was not found to be in violation of the Investment Company Act 1940, it reveals the potential for animosity resulting from perceptions of an unfair revenue split.

The issue is the result of long-standing downward pressure on asset management fees that pushes managers to seek revenue from alternative sources, beyond sharing in the performance of the fund.

Wong, referring to the evidence he gave to the UK parliamentary select committee that considered the Kay Review of UK Equity Markets and Long-Term Decision Making, is highly critical of passive fund managers being rewarded solely through the revenue they generate by lending securities.

"I am not against securities lending per se – and I certainly do not think it should be banned – but a serious problem arises when an asset manager is paid exclusively from securities lending revenues." In such a situation there is a "misalignment of interest" as the manager is motivated to maximise only lending revenues and not the total value of the fund.

European attempt
The European Securities and Markets Authority (Esma) took steps to address the issue for Ucits funds (see page 34) by issuing guidelines that state that all securities lending revenue should be returned to funds as of February 2013. Asset managers could still charge fees to cover the operational costs of their custodial or agent lender, which are deducted from the beneficial owner’s gross revenue.

However, a lack of clarity over the definition of acceptable fees has raised concerns that the guidelines could be manipulated and fees charged beyond legitimate costs. The net result could be that beneficial owners receive no additional revenue for the risk of lending their assets – but the asset manager’s profit is renamed as operational cost.

The situation is further clouded where the asset manager and the lender is the same entity. Indeed, Esma chairman Steven Maijoor said at the International Securities Lending Association conference in June that he had already heard some securities lending practitioners talk publicly about how the guidelines could be circumvented. He warned them not to attempt to break the spirit of the rules or Esma would seek to force compliance.

Despite the fact that returning all securities lending revenue to asset owners was one of the 17 recommendations set out in Prof John Kay’s review, published by the Department for Business, Innovation and Skills in July 2012, the UK government decided to leave it to the asset management industry to implement the regime. Indeed, the government will not decide on whether to take further action until summer 2014.

While some asset managers have changed their policies – and advertise the fact to gain competitive advantage – the majority are still running the same policies. Wong suggests that the adoption of an entirely different approach is needed.

"It makes more sense for asset managers to be paid a percentage of assets under management than exclusively from securities lending revenue generated. In addition, managers should be required to invest in their own funds and be paid fees based on multiple-year performance."

Pension funds also need to consider the effect of their securities lending programme on their ability to conduct stewardship over the companies that they partly own. If stock is on loan at the time of an annual meeting shareholder vote, the pension fund loses its voting rights.

"Pension funds should ask their asset managers how frequently they can recall stock so they can vote," says Wong, adding that the asset manager has an incentive for the stock to remain on loan. "Asset managers can lose revenue and suffer reputational harm among lenders and borrowers. I doubt that most pension funds really understand the potential for conflicts of interest here."

Wong says while there is emphasis on disclosing and managing these conflicts, there is not enough focus on trying to avoid them in the first place. He blames the introduction of The UK Stewardship Code for weakening conflict of interest resolution as it only requires that such conflicts be managed.

"Generally speaking, the code focuses on processes and procedures without taking into account the underlying motivations," he says. "The code’s predecessor, the ISC Statement of Principles, was better because it said such conflicts should be minimised or avoided."

In light of this, he has called for the Financial Reporting Council to strengthen this section. Wong believes misalignment of interest is an issue across the wider financial industry that has been given insufficient attention.

"There are greater conflicts of interest in asset management firms that are owned by or part of financial conglomerates because they have to think about their corporate and investment banking clients. These conflicts are very hard to reconcile and often someone – such as a small pension fund – will be short-changed."

Pervasive conflicts
The Kay recommendations place the onus on the asset management industry to drive change for the benefit of their clients. Wong partly blames asset managers for the equity investment culture becoming too short term over recent years.

"It appears that many large investment firms have become asset gatherers as opposed to true asset managers, which leads them to focus on churning and pumping out products rather than genuinely serving their clients well."

While Wong finds this disturbing, he is keen to point out that the asset management industry is not evil or trying to rip off investors. He says fund managers mean well and acknowledges that short-termism is actually forced on them by their clients, a result of performance measurement.

The Pensions Regulator also plays a part by mandating a constant focus on scheme deficits. Indeed, trustees and pensions managers are under constant pressure to bring down their deficits. It is an admirable aim but the reality is that many trustees do not have the necessary knowledge to make complex investment decisions and therefore need to rely on an army of intermediaries and advisers – each with its own motivation for advocating its favoured strategy.

One long-standing trustee of a mediumsized UK pension fund recently told Wong that it did not understand the nuances of the investment market anymore. Such revelations are rare among asset owners, which understandably would rather not admit their shortcomings.

"It is disconcerting that pension fund trustees are sometimes not even aware of their lack of knowledge," says Wong.

The make-up of trustee boards all but guarantee they are not financial experts – member-nominated trustees – potentially shop floor workers – may do an great job of standing up for the interests of their co-workers but even a professional career does not provide adequate preparation to do due diligence on a securities lending programme.

Engine of change
There has been some criticism that Kay’s recommendations place excessive reliance on asset managers to be the engine of change. Wong agrees and says asset owners need to step up their game.

"Asset managers need their clients to lead them on embracing a longer time horizon and incorporating ESG [environmental, social and governance considerations] into investment decisions, and if you speak to them privately, many of them will say that they actually want to hear more from their clients about this."

Wong thinks existing pension schemes can make two improvements. First, they should have fewer but deeper relationships with external managers. This would enable trustee boards to monitor these relationships more closely, although the downside of such concentration would mean a change, when necessary, would be more painful.

The second is to bring investment expertise in-house, which is something Wong says is already happening based on his conversations with pension funds around the world.

"Some large pension funds and sovereign wealth funds have moved away from relying on consultants to recruiting financially sophisticated individuals, both to the management and trustee ranks in order to have a better understanding of what they buy from external providers."

His research on pension funds across the world – he independently advises institutions such as the Organisation of Economic Cooperation and Development and researches corporate governance and capital markets more widely – supports other studies that claim building scale is the key to reducing costs and increasing expertise.

Australia is far down this road with its Super system – considered by many as the gold standard – while in Canada a proposal to transfer assets from smaller pension funds to a collective non-profit vehicle is being considered.

"Building scale in pensions can help tackle the lack of knowledge and experience among trustee boards. As there would be fewer trustee seats, there would be a higher chance of getting good candidates to fill them. Having a non-for-profit asset manager can positively impact the dynamics in the investment industry."

The UK has made progress with the launch of Nest – a government backed not-for-profit, low-cost occupational scheme open to all workers – but Wong believes much more needs to be done to revolutionise the country’s inefficient pension system.

While he is broadly supportive of the Kay review, he believes a key element has been excluded. "The missing link in the Kay recommendations is reform of the governance and structure of pension funds, which is crucial to the success of these recommendations."