Hermes Pensions Management, still better known by its former name PosTel, manages some L27 bn worth of pension fund monies, making it one of the largest pure pension fund managers in the UK
With nearly 2 per cent of the UK equity market under his firm’s belt, British companies tend to take notice when Hermes’ chief executive officer Alastair Ross Goobey goes public on the subject of, say, rolling contracts for directors. And given his reputation as one of the leading institutional advocates of better corporate governance standards, that can be quite often.
The firm over which Ross Goobey presides has direct management responsibility over some 27 bn of investments, which represent the pension funds of the UK’s Post Office and of British Telecommunications PLC. Those two distinct organisations were once the same business, but were divided in 1981 in anticipation of the privatisation of BT three years later. At that time, and until last year, their pension funds were run by PosTel, Hermes’ predecessor company.
The change – both in name and structure – began to take shape about a year ago. ‘The British Telecom trustees decided that they wanted us to take responsibility for their secretariat and for the liabilities side of their pension fund,’ Ross Goobey explains. ‘As a consequence, they didn’t really want to own just 50 per cent of PosTel, as it then was, so they made an approach to the trustees of the Post Office – which owned the other half – to buy them out.’
Negotiation of the transaction took just over a year, and its eventual completion in March meant finding a new name to reflect the change of ownership. So what prompted the choice of Hermes – better known in the UK as a purveyor of up-market scarves and ties to the well-dressed?
‘It was the CEO’s prerogative to choose the new name,’ says Ross Goobey. ‘I thought Hermes was appropriate because of its classical connotation – it’s a good solid sort of name – and, of course, Hermes was the messenger of the gods, which is fitting since we manage the pension funds of the two biggest communications companies in the country.’ He adds that the name is unlikely to lead to any confusion with the Bond Street neckwear maker: ‘As long as the tie and scarf people don’t go into selling pensions, and as long as we don’t go into making ties and scarves, I don’t think there’ll be any problem.’
On the more serious question of whether the new ownership structure means Hermes (the pensions manager) is likely to start managing pensions for other third party clients – which is what the Post Office now is, in effect – Ross Goobey switches to politico-speak: ‘We have no current intention to look for other business,’ he says. ‘And, after all, the amount of money we have to manage – at 27 bn – is not our problem. Of course, nothing is forever, and if the Post Office decided to take its business somewhere else, we would probably want to replace it.’ But for now, the relationship continues under a contract which enables – but does not oblige – the Post Office to stay with Hermes for up to ten years.
The Post Office also retains indirect representation through the presence on the Hermes Pensions Management board of non-executive director Roy Cox, who was chairman of the Post Office trustees until March of this year. Hermes’ non-executive chairman is Sir James Spooner, chairman of the BT Trustees, who presides over a board that is otherwise made up of Hermes executives. ‘However, this is really only a statutory holding company board,’ says Ross Goobey. ‘The important decisions that would be made by the non-executive directors at a normal company are made by the trustees of the BT pension scheme.’
For both schemes, the investment management process starts with the determination of a strategic asset mix designed to meet the needs of their respective liability structures. ‘They are both very large and very mature schemes. The BT scheme, for instance, has 360,000 members of whom fewer than half are active members,’ says Ross Goobey. ‘We work with the trustees and their actuaries to determine the appropriate long-term asset mix, on an annual basis – although the change each year is usually quite small.’
That process stipulates the mix of equities – UK, American, Japanese, European, emerging market, and so on – as well as the proportions to be allocated to property, fixed-income and other securities. In terms of the Hermes input to this process, a key individual is Alan Ormrod, the director of economics and strategy. ‘He and his team maintain the long-term data for the various asset classes and can tell us what the co-variances are of the respective asset classes, and the returns on them, and so on. The actuaries do the same thing and we then discuss all the recommendations with the trustees, eventually arriving at a benchmark which the trustees are comfortable with and which will reduce the risk of their not being able to meet their liabilities. Our job is then to beat that benchmark.’
With the strategic asset allocation in place, the process then switches to one of tactical asset allocation. ‘Within certain parameters, and between any adjustments being made to the strategic mix on an annual basis, we adjust the current exposure to the various asset classes away from the pre-determined strategic asset mix,’ explains Ross Goobey.
The sheer size of Hermes’ holdings in the UK equity market might lead one to expect that it would have problems making any substantial difference to its asset allocation during the year. ‘In fact, we can do it. We have found that by having a weekly meeting to determine what our tactical asset allocation should be and implementing it on a gradual basis, we can change our ratings in the various areas with a fair degree of efficacy. For instance, it’s perfectly possible that we would move as much as 10 per cent of the fund between asset classes in any one year – which is quite a lot of money.’
As for the tactical decision-making process itself, this is in the hands of the investment committee, chaired by Ross Goobey. Other members are the director of economics and strategy, Alan Ormrod; the director of UK equities, Steve Brown; the director of overseas equities, Allan Conway; the director of bonds and cash, Mike Carter; the tactical asset allocation dealer, Tessa Woodward; the director of property investments, Richard Harrold; and the manager of index matching, Ingrid Kirby.
The investment committees’s job is to agree switches in allocations on the basis of the data provided and Ross Goobey says the fundamental tenet of their approach can be summed up as, ‘Things regress to the mean’. In his view, the temptation to believe that everything really is going to be different this time is nearly always misguided. ‘Valuations can be sustained at very low or very high levels against historical records for periods of time, but unless there really has been some fundamental change – which happens rarely – they will eventually go back to where they’ve been.’
To put that approach into practice, Hermes uses a sophisticated modelling system which displays graphically where valuations currently are – week by week – in relation to where they are normally. ‘It does this for the relationship between bonds, cash and equities, in individual markets. We do this across the world but we’re not trying to compare one market with another; we are trying to compare each market with its own past history.’
Ross Goobey points out that the purpose of this particular black box is not really to predict market movements. ‘One of the great failings in investment management comes from relying too much on attempts to extrapolate current trends,’ he believes. ‘We don’t do that. We think that the best information about the relative valuation of markets is contained in their past history and the relationship between their current and historical valuations.’
This philosophy includes a relative lack of regard not only for sudden market movements but for the macro-economic indicators that often precipitate them. ‘Macro-economic indicators don’t really matter much,’ reckons Ross Goobey. ‘Of course, things like interest rate cuts will have a short-term effect on the market, but research shows that the most important influences are long-term factors – like long-term real dividend growth for equities, long-term inflation rates and real yields for bonds.’
Although Hermes is clearly more interested in the long term, that does not free it from the need to react to change as quickly as anyone else engaged in investment management. ‘We see very dramatic moves in markets on a daily basis now,’ says Ross Goobey. ‘And if valuations change, you have to react quickly. But the sort of time over which we expect things to regress to the mean is probably typically within the 12-24 month range.’
The tactical asset allocation decisions taken weekly by the investment committee are executed on an incremental basis and mainly through derivatives. This means that most of the changes are implemented by Tessa Woodward (the tactical asset allocation dealer) rather than by the fund managers. ‘One of the great joys of this method is that we don’t need to disturb the underlying portfolios,’ says Ross Goobey. And Hermes’ use of derivatives is not just a temporary measure to give the portfolio managers time to unwind positions: ‘It is actually the way we do it. If we’re long UK and short Europe, we’ll be long UK futures and we’ll have sold futures in France, Germany, Holland, Switzerland and Spain. We only change the underlying holdings when we change the strategic weights,’ (which only happens once a year).
Derivatives are not yet available for all areas, notably property and emerging markets. ‘But we are working towards being able to solve that,’ says Ross Goobey. ‘We’re encouraging the growth of derivative instruments in property; and as the emerging markets mature, I think we’ll increasingly be able to find derivatives to allow us to do what we need to do in those markets as well.’
This use of derivative instruments is clearly particularly appropriate for Hermes because of its size. That size also makes it difficult to manage all the investments on a wholly active basis. ‘We have deliberately decided to index a substantial proportion of our portfolios,’ explains Ross Goobey. All the portfolios are structured into three groups: core index portfolios; limited risk active management portfolios (known as net zeros); and higher risk active management portfolios.
In the UK market, the bulk of investments – about 75 per cent – are in the core index group, but more than that is semi-indexed through being in the net zero group. ‘For those, our fund managers start with a portion of the index core – about 800 stocks – at the index weighting. Their job is then to find stocks that they really like but, in order to increase those holdings, they first have to find stocks that they are willing to sell.’ There are maximum and minimum risk levels they have to stay within, but they typically have about 20 active positions at any one time. ‘We believe this system improves the quality of the decision while still reducing the risk, says Ross Goobey.’ And the record seems to bear him out: over the last five years, the UK net zero portfolio has outperformed the UK index every year; the average UK pension fund has only beaten it twice in the last five years.
The higher risk portfolios divide into smaller company portfolios, most managed in-house, and specialist portfolios managed by external fund management firms, taking bigger bets. On the smaller company side, Ross Goobey says that 1-2 per cent of Hermes’ total funds under management are in small-cap stocks around the world, but the exposure varies according to the economic cycle. ‘In the UK we have about 200 mn invested in small companies, so we are one of the biggest investors in this area. We like small companies, partly because they are under-researched and because large companies come from small companies. We also think our support is good for them and over the long-term they have given us a good return. We don’t normally own more than 10 per cent of a small company, however, although we sometimes make a decision to do so in exceptional circumstances.’
Ross Goobey notes that smaller companies also represent a useful training ground for portfolio managers. Hermes tends not to recruit new graduates but to seek out people with experience in related or relevant disciplines – accountancy, banking, academic economics, for example. ‘Companies don’t mind seeing people like that, because they have some maturity and some understanding of business, but they obviously still have some learning to do and small companies are ideal for this,’ says Ross Goobey.
The other high risk portions of the BT and Post Office pension scheme investments are mostly in the hands of external managers, who run active portfolios in the UK, the US, continental Europe, the Far East ex-Japan, and Japan. ‘They provide a counterbalance to the base of low and limited risk investments,’ says Ross Goobey. The management firms responsible for these higher risk investments are Schroder Investment Management (in Europe, Japan and the Far East ex- Japan), Mercury Asset Management (UK equities), Jardine Fleming (in the Far East ex-Japan), Lazards (in Europe), Foreign & Colonial, Wellington and State Street (all in the US).
So does the fact that most of the high risk investing is being done by third party firms mean that Ross Goobey and his colleagues are missing out on the fun? Not at all, he says. ‘I think the most important thing in any fund management business is to define what your unique attributes are. I think we have seven areas of particular expertise; and I don’t think any fund management group can seriously claim to be all things to all people – unless it is effectively a conglomerate of different firms. It’s very difficult to have all the investment styles in one place.’
Ross Goobey counts the seven core areas of particular expertise at Hermes, as follows: its tactical asset allocation; cheap and efficient management of core index portfolios; low risk active management (the net zeros); small companies investment in the UK and US; bonds and index-linked gilts; property investments; and, in a rather different vein, corporate governance.
Hermes’, and particularly Ross Goobey’s, leadership role on corporate governance issues may seem surprising, given the firm’s broadly top-down approach to investment. Apart from smaller companies, the firm does relatively little fundamental research. ‘Nevertheless, we do keep in good contact with companies, at two levels,’ he says. ‘One involves our portfolio managers talking to whoever takes responsibility for investor relations at the companies concerned, mostly on questions of corporate profitability and trends, and their effect on shorter-term share price movements. At a higher level, I try to see as many CEOs or chairmen as I can to talk more about strategic questions and about our relationship with them.’
Ross Goobey stresses that this is a two-way street. ‘We like to see corporate governance being done in a way that we are happy with and we will complain if it is not. But we will also support management if we are content with that element and if we think they are doing a reasonable job. The press tends to focus on the first – when we criticise; people don’t hear so much about the positive support we give. It’s not news when we see a company we think is well-run.’
For Ross Goobey, corporate governance all boils down to whether a company is being run in the long-term interests of shareholders or in the short-term interests of its management. ‘Everything is guided by that. There’s no moral crusade here,’ he says. ‘We’re interested in structures of boards and remuneration which do not reflect that mutuality of interest. If you have a chairman and CEO running a board that is made up of his friends and relations, we don’t feel there is a sufficient counterbalance to his power – in larger companies, at least. We want to see independent, non-executive directors, and a fair number of them.’
On the remuneration side, he wants to see structures skewed towards long-term rewards for good relative performance against a suitable peer group, preferably in terms of total shareholder returns. ‘We don’t like large short-term bonuses, long rolling contracts or share option schemes that merely reflect the fact that a share price has gone up,’ says Ross Goobey. ‘We think that directors should be awarded shares on the basis of out-performance against a peer group over three to five years and that they should have to keep them for a considerable period.’
The critical thing, in Ross Goobey’s view, is that managements, unions, institutional investors and political parties should sign up to a transparent structure that they all accept, so that there can be an end to the high-profile public tussles about individual cases. ‘I don’t think that we as shareholders have any complaint about people making a lot of money for doing a job extremely well. But there has to be a method of their proving that they have done it extremely well. There’s too much temptation under the current system for managements to play fast and loose with shareholders’ money.’
The establishment of such a structure would also put paid to the oft-quoted idea that shareholders should have a role in taking individual decisions, for instance about management compensation. ‘I think that’s a dangerous road,’ says Ross Goobey. ‘If shareholders vote on the CEO’s pay package, why shouldn’t they vote on the advertising campaign? The purpose of boards is to act on shareholders’ behalf. That’s why we have a holistic approach to boards: either we think they are acting in our interests or we don’t. Obviously there’s a spectrum, but there’s a point at which we will tell boards that they have lost our confidence. And we have been instrumental in replacing boards from time to time.’
Hermes has an ‘escalation strategy’ for such circumstances. ‘If we can’t get satisfaction from talking to the board privately we make it clear that we reserve the right to drum up support among other shareholders or to go public, to see if we can build momentum against it. And eventually, if necessary, we will call an EGM to vote the board out – or seek a bid or a management buy-in, if that’s more appropriate.’
Part and parcel of Hermes’ diligent approach to corporate governance is its policy of voting, or lodging proxies, whenever it has the opportunity to do so. It’s in the happy position of having just two ‘clients’ to clear voting or governance policy with, which it does on the basis of broad strategy, rather than on a vote-by-vote basis. Ross Goobey says the trustees have been very supportive of his outspoken approach to corporate governance: ‘They don’t particularly like us going public. But then nor do we. Nevertheless, going public is an important weapon in the armoury.’
