In 2019, RPMI Railpen insourced the majority of factor investing strategies in its equity management programme. It is the latest milestone in a five-year journey towards understanding value for money and bringing down costs. The scheme’s Total Expense Ratio has halved in that time. While external managers are still used for certain asset classes and sectors, where there is a strong rationale for doing so, the internally-managed portion now represents over 50% of assets.

Craig Heron
Head of Public Markets, RPMI Railpen

This investor made headlines in 2014-15 by delivering over £50 million per annum in initial savings as a result of radical changes to structure and strategy. Subsequent years have brought continued transformation for the fund, which now manages around £30 billion in pension assets for more than 100 clients associated with the railways industry.

Craig Heron, who joined Railpen in 2011, sat down with bfinance Investor Spotlight to discuss recent developments and what’s in store next. As well as overseeing the public markets group (equities, fixed income and trading), Heron also has portfolio management responsibility for the (multi-asset) Growth pooled fund, which represents two thirds of assets.

Q: Could you briefly outline the key changes at Railpen since you joined?

When I joined the Railpen equity team in 2011 my role mainly involved overseeing asset managers – all of the assets were managed externally at that time. What followed was a programme of transformation, which kicked off in 2014 after some initial analysis in 2013. We restructured, implementing investments through a simplified set of pooled funds that we managed. We made some big changes to investment strategy, such as increasing factor investing in equities. And we began to internalise the management of assets, gradually bringing our public market investments in-house. We’ve moved from 100% external management of assets in 2014 to less than 50% today. Throughout, there has been a strong focus on cost. The total expense ratio of the scheme has halved.

Q: Q: What have been the major changes in the equity, fixed income and other portfolios through this period?

One of the first big changes we made was in hedge funds, where we had a pooled fund of approximately a billion sterling. We wound that down, redeeming from a very diverse pool of Fund of Hedge Fund structures and investing the proceeds in traditional assets. In equities, where we previously had around twenty external managers, we decided to move away from trying to pick alpha generators and instead built exposure to equity risk factors – initially through external managers, though over time we have developed both quantitative and fundamental equity expertise in-house. We had started factor investing in 2010 with an allocation to a Low Volatility manager; in 2013 we introduced a Value exposure and an Income exposure; Quality and Momentum were added in 2015. (Note: the Income exposure was removed earlier this year: it overlaps with Value, and share buyback programmes, particularly in the US, mean that its efficacy as a factor has declined.) We launched internal factor strategies in 2016 and this year we have brought the majority of the equity factor investing in-house.

In fixed income we’ve brought our defensive government bond exposures (e.g. gilts and index-linked gilts) in-house. In credit – global corporate bonds – we still use external managers but we’ve considerably simplified our approach, cut down the number of managers involved and reduced fees. We also developed an in-house team for UK property about two years ago. There is a fairly large exposure to UK property, which was previously externally managed. This is an area where principal-agent problems are particularly severe.

In private equity and infrastructure there has not been a similar focus on bringing things in-house, but we are improving efficiency in other ways, such as doing more co-investment and developing targeted partnerships, as opposed to getting exposure to a lot of different funds. We’d expect to continue having a higher reliance on external specialists for these asset classes.

Q: Looking at the external manager relationships, how has the way you approach fees changed?

Our approach to the fees paid to external managers has changed a lot. Part of this began in 2014 with a lot of thinking about the value chain – deciding what a ‘fair fee’ really represents. Before this we were price-takers rather than price-setters. We’re now far more prepared to walk away from giving someone a mandate if we don’t think the fees are appropriate. We think about fees at the outset of a manager search, rather than what we see some other investors doing – deciding what manager they want and then trying to haggle. When trying to rethink or negotiate fees you’ve got to appreciate your competitive positioning. If we have something that relies on a very specific external specialist, such as the investment we made last year in a music royalties fund, the fees which may be ‘fair’ are likely to be relatively high. We’ve also done quite a bit of fee benchmarking work over the last few years with various partners, both to find areas of improvement and to show that we’re doing a good job in terms of fee levels. Our stakeholders are keen that we continue to benchmark ourselves.

Q: What has underpinned decisions on which strategies should be brought in-house and which shouldn’t?

Firstly, when thinking about insourcing we are thinking about the exposures that we’d expect to have in our portfolio all the time. Switching an allocation on or off is easier when it’s outsourced. For example, we might not always want to have exposure to high yield credit. Emerging market debt is another example, and it needs a substantial team – perhaps eight-to-ten people, with considerable travel requirements. To date we haven’t done any in-house management for either of those. Once you have a sense of the asset classes and strategies with consistent exposure you can do a relatively simple cost/benefit analysis on how much you’ll pay to do it in-house versus through external managers.

It’s important not to be complacent when insourcing. You can unwittingly introduce principal-agent issues and alignment problems among internal teams and staff. One of the best things about working for an asset owner is that everyone is trying to do the same thing – pay members’ pensions. It would be a shame to lose this focus. At the start of this year we actually appointed a Chief Fiduciary Officer for the first time. One of her jobs is to make sure that our internal investment management activity is completely aligned to the needs of our clients.

Q: Looking ahead, what developments are you anticipating next?

There are one or two areas that we’re currently considering. For example, in fundamental equity we’ve only been investing in large caps and may look towards small cap. There’s a pretty big universe of companies that we don’t have exposure to, in a part of the market that has been inefficient historically and now, with MiFID II and declining analyst coverage, is becoming an even more attractive area for stockpickers to add value.

In factor investing in equities, my personal bias right now would probably be to go stronger on the value factor. The growth-value dispersion is the widest it’s been since 1999, which was the widest in history. I do have a belief that this should mean-revert.

More broadly, we’re very aware that the portfolio changes of the last few years have taken place within a pretty benign investment climate. There’s a chance that the end of the cycle will require us to look at what we’re doing and potentially re-evaluate certain aspects. That being said, we anticipate that market turbulence will be good for us: it will allow us to exercise our competitive advantages – a long-term horizon and a captive asset base.

With pension funds and other asset owners continuing to focus on reducing costs and improving efficiency, the RPMI Railpen team provides a fascinating case study. Further information on asset management fees and obtaining better terms can be found in the new bfinance Investment Management Fees report, available here.

Disclaimer: bfinance has provided advisory services to RPMI Railpen.

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