It’s been over 20 years since Hermes – originally know as PosTel – was founded to manage the pension assets of BT and the Royal Mail, and over the last decade the company has been expanding its business to offer investment solutions to third parties. Hermes’ external clients already include some of the world’s largest pension funds – such as CalPERS and PGGM – insurance companies, foundations and endowments.
Capacity questions
“We can definitely offer value-added to other institutional investors,” says Roger Gray, Hermes’ CIO commenting on the firm’s capacity to expand the management of external assets. “The question of capacity obviously applies to certain strategies. I would say in micro-cap equities, for instance, given the scale of the BT pension scheme and the Royal Mail pension plan allocations to us, our capacity might be limited. But we haven’t actively offered externally a number of areas of capability where we have done very well over the years. I think it is a matter of identifying those parts where we are and we are not capacity-constrained and taking to market, in an appropriate form, those areas where we have the capability and capacity.”
Mr Gray joined Hermes only four months ago after having performed senior investment roles with Rothschild and UBS. At Rothschild he was CIO and head of institutional business. At UBS he was first CIO and CEO of the firm’s asset management division in Switzerland, becoming global head of asset allocation and currency at UBS Brinson after the merger between UBS and SBC. During the four years prior to joining Hermes, Mr Gray worked as an independent adviser for institutional funds and asset management businesses.
“With Rothschild, the investment activity for which I was responsible was based in the UK, just one location. At UBS, unlike Hermes, we had teams around the world and plenty of commuting and video conferences to link them together. We also had a very broad range of assets spanning emerging and developed public markets including timber, private equity, real estate, etcetera, so for an asset allocator it was a very interesting environment.” He highlights: “Hermes in fact brings both of those together – one location and a broad range of assets and strategies.”
Mr Gray says that another attractive factor of working at Hermes is the very close relationship the firm has with the BT pension scheme, their principal client.
Convincing story
“This is extremely satisfying. You have a bond of trust that of course brings with it duties and responsibilities, but it also gives you the ability to move quite quickly when there is a case for investing in an area we should be involved in,” he says. As far as market positioning goes, Mr Gray believes that having successfully provided investment products to the UK’s largest pension fund over the years is “a pretty convincing story that shows we know what we are doing and we do it well. Hermes has a very good name in the market and that name is justified. And on that basis I think we have a strong starting point if we offer a product with the BT pension scheme’s seal of approval to other institutions.”
Mr Gray’s appointment came a year after former CalPERS’ CIO, Mark Anson, joined Hermes as CEO. At CalPERS, Mr Anson was responsible for opening up the organisation to new asset classes and bringing corporate governance to the forefront of the fund’s investment strategy.
Since its creation, Hermes has always been progressive in making the split between active and passive investment management. “This has been called core/satellite in the past but most recently it is referred to as separating beta from alpha,” he explains. “As an engineering approach, and I would say also for cost efficiency, the separation of beta and alpha is very much alive,” he adds.
Today Hermes’ portfolio is invested in many different strategies including index tracking and enhanced indexation, and specialist fixed income and active equity portfolios. Over the last few years, Hermes has opened up its exposure to other asset classes including alternative investments such as private equity, hedge funds and commodities.
Currently, the firm has a fairly even split between the UK and the rest of the world. “That makes the UK much bigger than its proportion of global capitalisation but that proportion has been reduced over time partly to fund alternative investment,” he explains.
Over the last five years, for instance, the company has been building up a team to undertake primary and secondary participations in private equity investments which at the end of September 2006 represented 1.8 per cent of the total portfolio.
Exposure to commodities, which amounts to just around 1 per cent of total assets, is gained via a passive commodity fund but Mr Gray points to the possibility of setting up an enhanced commodity fund in the future which would incorporate active management as well.
“The first motivation for putting commodities into the funds has not been return but the diversification characteristics of the asset class,” Mr Gray says. “The attractions of managing the asset class actively are the same as for any other asset class. If you believe you have a process that is likely to add value then you can undertake that to the appropriate extent. It is rather like the beta and alpha separation again – you do as much of the alpha management as you think is justified on the basis of the probability of success and the independence of that success with other things you are endeavouring to do in the portfolio.”
The firm also invests in hedge funds through the Hermes Absolute Return fund, a fund of funds portfolio which according to Mr Gray “has been very well structured and at this stage has been very successful in meeting its objectives”.
Mr Gray assesses the trend among institutions towards increasing allocations to alternative asset classes as something that depends on the maturity of different portfolios. “Many pension schemes today may have a long enough time horizon in terms of the structure of their liabilities so that they can sensibly have a substantial portion of illiquid assets. If you go forward 20 years, these institutions may find themselves less suited to taking large elements of illiquidity.”
He believes that with time, the optimal asset mix will change. “We are seeing a transition from beta risk, particularly equity beta risk, towards alpha risk,” he says. “The essence of the question is whether we are going to see this move continue, and I think we are.”
Another crucial area for the future of institutional portfolios is the increasing focus on corporate governance issues. Hermes has been a pioneer in this field and one of the first major investment management companies to launch shareholder engagement funds. It started in 1998 by launching the Hermes UK Focus fund, investing in underperforming companies which are fundamentally sound but undervalued due to financial, strategic or governance issues. Four years later the firm established two other Focus Funds, one investing in UK small caps and one investing in Europe. Another fund, the Nissay Hermes Stewardship fund, jointly managed by Japan’s Nissay Asset Management Corporation, follows a similar approach investing in Japanese companies.
Competitive products
“The performance since launch in all cases has been excellent and they are commercially very competitive products,” Mr Gray says. “We would expect this business to grow and that would include broadening investments around the world but also broadening the strategies and the range of securities that we include within those funds.”
Mr Gray says that for him engagement is broader than just a set of corporate governance rules and it should be characterised by ‘responsible ownership’. “If you think about it like that, what is investment in shares other than taking ownership? And do you want to be a responsible owner or just leave it to chance?” he asks. “It is clear that we should aim to play a constructive part in the development of the value of our investments. Different people have interpreted that differently, more aggressively, more constructively, more remotely – through voting but not through engagement with management. There are going to be different strategies towards this across the industry.”
In the coming months, Hermes will continue focusing on expanding product offering and client base and Mr Gray believes they are ready for the challenge of using new instruments and accessing new strategies. “Across our organisation we are thinking about where can we go to find value. That would shift around because what once was an area of potential alpha may be competed down and there may be very little opportunity left. We do have to know where opportunities move on the map of global assets and try to make sure we take advantage of them.”
ROGER GRAY: THE MAKING OF A CIO
Sep 2006: Joins Hermes as CIO
2002-2006: Independent institutional adviser to investment funds and asset management businesses
1997- 2001: He moves to UBS Asset Management in Switzerland as CIO/CEO. Following the merger of UBS and SBC, he becomes global head of asset allocation and currency at UBS Brinson.
1983: He joins Rothschild Asset Management where he latterly becomes CIO and head of institutional business
He studies philosophy, politics and economics at Oxford University and economics as a post-graduate at Harvard University , where he was a teaching fellow in international finance and in commodity and securities markets
