Full disclosure

Robert Waugh joined the Royal Bank of Scotland (RBS) Group Pension Fund as chief investment officer in 2010. In a rare interview he tells Sebastian Cheek about his approach to manager selection and portfolio diversification, as well as how he is fighting for better fee transparency across the industry.

“In every other industry you know what it costs to make something, but in this industry we think we don’t have to know and it’s appalling.”

Robert Waugh

Tell me about your role at RBS? There is one large defined benefit (DB) scheme within RBS which has two sections: the Group Fund section, which is £32bn and the AA section which is £1bn. The day job is running the DB scheme as part of the RBS Investment Executive Limited (RIEL) – that is 90% of what I do. Outside of that there is a defined contribution (DC) scheme of which I am chair of trustees and then there are a number of other small schemes within the bank which we help with, so for example, sitting on the investment committee for the Ulster Bank Pension Scheme. Irrespective of the schemes in which we are involved, my team and I work for the trustees of the different pension schemes, rather than for RBS the corporate sponsor of those pension schemes. RIEL is a subsidiary of the trustee company, so our client, manager and owner is the trustee.How big is the team at RIEL? RIEL has eight employees including myself. There is a range of backgrounds: equity fund management, bond fund management, actuarial, legal and company secretarial.Do you outsource all of the asset management? We outsource security selection to the managers, but we try and keep control of the big levers, including asset allocation and single name exposure. So any assets over £40m will come to us before they are bought.How do you set about making investment decisions? Our trustee board sets the integrated strategy on funding, covenant and investment, and from this our investment committee sets the strategic benchmark on which we advise. We agree at the funding committee on the trustee’s opinion of the strength of the bank covenant and we then take that to our risk and audit committee which decides the investment risk appetite based on a stress test of how big the deficit can get, the impact it could have on the bank’s capital and what deficit repair contributions could be affordable based on the bank’s profitability. We then give the investment committee our view on prospective asset returns for the next seven years and agree how much of the risk appetite we want to utilise at any point in time. That sets the strategic benchmark and RIEL runs the fund against that. All manager selection and short-term timing of hedging is done by RIEL, but the amount hedged is set by the investment committee in consultation with us.How does RIEL select managers? This depends on the asset category. We decide at the beginning if we are looking to achieve a beta allocation, for example in making a sector allocation to equities where RIEL has decided to make an allocation and alpha is a lower proportion of the expected return and risk, or if it is a specialised asset category like litigation finance where we need skills available from only a few firms we normally use an outside firm to give us a long list and we will visit them on their own premises. In equities, for example, we try and buy managers who have underperformed recently which goes against most people in the industry. So we look for managers with good long-term track records who are doing badly. We just parted company with a US-orientated growth manager who had a lot of US technology and we are looking to put the money in emerging market (EM) value. US growth has obviously done incredibly well and the manager had outperformed by 6% per annum for the last six years, while EM value has done appallingly and this manager has done really badly in EM value, but we think they are a good manager. So in the equity space we look for extreme style managers and we try and put them together and take style tilts based on where we think the opportunities are at a moment in time.Why do you have this approach to choosing equity managers? Most trustees’ strategies involve buying managers with the best five-year track record, but all the evidence says buying managers that have just done well is a really bad strategy. So then you either go passive or if you want to stay active you have to find a strategy that will work, so why not do the opposite of that and appoint managers who have done badly because their style has done badly and who you believe will mean revert? However, you have to drill down beneath the surface to work out why someone has underperformed because it’s not just about the fact that someone has done badly; for example if a manager owned a stock that went bust that will not mean revert. It has to be that the assets in their portfolio are cheaper than they were previously.How successful has this strategy been? We rotate money from managers who have done well to those who have done badly in our portfolio and since we started five years ago, that rotation has added £90m of alpha and our managers have outperformed by £371m in total. However, it is too short a period to work out whether it is a good strategy. Five years might just be luck; we will know if it is has worked when we have 20 years of data.What changes have you made to the portfolio as a result of this approach? We took a lot of money out of equities in the second quarter of this year because we decided we were running too much of our risk appetite versus our expected returns and we would not have had any scope to rebalance on any falling markets. So we put a large short overlay onto our equity portfolios and we have started to unwind that in the last few weeks because of the market fall. But in the six years I have being doing the job we have parted company with only eight managers and appointed five. Our intention would be to keep managers for 20 years if we could.Looking across the portfolio it is extremely diversified. Why is this? Pension funds of banks are different from most because the scheme deficit comes straight off the bank’s capital, so the mark- to-market deficit really matters to the bank in the short term. In 2010 the fund had a lot of credit, equities and property and clearly there is great benefit for the bank to diversify that risk. So we have spent the last six years looking for assets that will give us returns that are less correlated with UK GDP and equities. We have added 15 asset classes in the last six years.Is having a bank as a corporate sponsor a help or hindrance?The advantage of having a bank as sponsor is that your trustees are very financially literate, but the capital issue is a constraint on how you run the fund. The big thing coming down the line is the Independent Commission on Banking Reform (ICB) recommendations to split the bank into a ring-fenced and non-ringfenced bank because the pension fund will also have to work out what it is going to do as ring-fenced banks cannot be liable for the liabilities of non-ring-fenced banks. It will change the covenant so the pension fund’s risk appetite will change and the amount of money we can run in growth assets will change. There are other issues around whether we will have a section 75 debt when the fund splits. The pension fund does not need to be split until 2025 but the bank has to be split in 2019.Have you added any esoteric asset classes recently? We bought four wind farms recently and a US life settlements portfolio last month. Wind farms are interesting because the main risk is regulatory risk which is completely uncorrelated to anything else we have in the portfolio. In addition, the volatility of asset pricing is low, the return looks attractive compared to equities and there is also some inflation-linking because one of the main determinants of return is power prices. The life settlements portfolio was an opportunistic purchase. Everything we have done in this space to date has been extreme mortality, the opposite side to our longevity risk, so we do the extreme insurance for pandemics. In the fund there are some really interesting areas where you can take risks where you already have the counter risk and get paid to do so. We continue to build up our litigation finance portfolio, a shipping portfolio and in 2014 the fund established its own US REIT which owns and rents out 2,000 US houses.How do you approach liability hedging? The fund is pretty fully-hedged with UK nominal bonds, linkers, swaps and swaptions. The key thing for us was not to take money out of growth assets and put it in LDI, it was to work out how much of the interest rate and inflation liability we wanted to hedge so we have been quite comfortable running what is to all intents and purposes a levered portfolio. The key thing to us is the two are separate decisions so our benchmark in growth assets is always a monetary amount which means we don’t think having x% of the fund in growth assets and 100-x% in hedging is sensible. This is because risk is a monetary figure so if bond yields fall and assets go up in value because you have some hedging you should not necessarily put more money into equities which is what you do if you use a percentage figure. So we start with how much assets we have in monetary terms and then look at our hedging portfolio and ensure we have enough collateral under extreme stress to be able to cope with the amount of hedging we want, so we run a lot of cash and gilts.The fund has done a lot of work on fees and transparency recently… We are trying to be more transparent so we have been recording fees that have gone through the accounts and fees that have been charged to the fund (see chart below). When I first started our fund of fund managers could not even tell us what we had paid in carried interest fees because they didn’t even measure it – it was that bad. We measure value-added against fees. If you looked at hedge funds, everything above cash-plus 3% was being paid away in fees and bearing in mind the risk we’re running, was that worth it? We decided not and got out of hedge funds in 2014 because they were not justifying themselves. Our view is we should be keeping 70-75% of the value-added for our members and broadly speaking we are now doing that across the piece. If you look at private equity, your gross performance looks great but net performance versus public market equivalents does not considering you have tied your money up for 15 years. This drives us to not invest in funds of funds but to invest on a different fee basis, i.e. putting larger sums into a smaller number of managers on a preferential fee basis where you are not paying away as much of the value-add. Where else is this a problem? I am very disappointed with the industry’s response to transaction costs because in every other industry you know what it costs to make something, but in this industry we think we don’t have to know that and it’s appalling. We have gone to all our managers and broken down all the transaction costs for 2013/14 and we know in 2014 we spent £33m on known transaction costs and about another £27m of spread. People think private equity charges two-and-20 and we have gone to the private equity managers and got data on all directors’ fees and transaction fees received by the general partner from investing companies and in some years that is another 50 basis points of fees, so you are in fact paying 2.5%-and- 20%. If we start to disclose it we can start to deal with it and the industry has had far too much of a vested interest to hide fees and create complexity to have a bigger pot to share out. I have no objection paying for success but the industry pays for mediocrity.How have you addressed this in the portfolio? Hedge funds cost us a fortune so we got rid of them, we have only invested in co-investments in private equity which has reduced our fee, we have renegotiated our fees down with a number of managers and we have tried to create relationships whereby we can recreate some of the things hedge funds are doing at much lower fees by doing it in a segregated mandate with a manager rather than paying away performance fees. Our fees as a percentage of assets have come down and I expect them to keep coming down at a time when we have had a more interesting portfolio.Are you open to collaborating with other pension funds and investors, such as the Pensions Infrastructure Platform (PiP)? We are happy to collaborate with other like minded funds so with our infrastructure we own 50% of Phoenix Natural Gas and the other half is owned by Australian pension funds. We would happily joint venture with the PiP to buy an asset, but the trouble with big collaboration is you lose control over assets and you have too many people involved in the decision-making. We like to have one manager between us and an asset – we were four stages removed from some of our assets in 2010.