Last year, Lothian Pension Fund, the £11 billion Scottish Local Government Pension Scheme (LGPS) worked with one of its investment managers to design a bespoke sterling investment grade bond mandate that integrated responsible investment and enabled two other of Scotland’s 10 remaining LGPS funds to invest alongside at a favourable fee.
“We want to be able to design mandates ourselves and selected the manager on the basis of their flexibility to work with us,” says chief investment officer Emmanuel Bocquet, speaking to Top1000funds.com from Lothian’s Edinburgh offices.
The process showcased Lothian’s standout in-house management capability (which includes property and infrastructure) and negotiating prowess.
It also demonstrated what Bocquet calls Lothian’s “pooling-light” characteristics. Unlike South of the border, there is currently no plan to introduce pooling amongst Scotland’s LGPS funds – although he notes the Scottish government is observing the UK with “increased interest.”
Should the political mood change Lothian, which already manages equity and fixed income investments on behalf of two other Scottish LGPS pension funds, is ready to move.
“If pooling is mandated in the future, then we are already there in many respects,” he says.
Lothian is unusual not just for its FCA-regulated inhouse investment team. Fifty five per cent of the AUM is invested in a active, low-risk equities, deliberately avoiding US tech stocks and although ESG is integrated across the fund, Lothian has not committed to net zero targets which Bocquet believes “feels like an empty gesture that doesn’t drive real world outcomes and can drive the wrong behaviours.”
The pension fund also boasts a funded status of 157 per cent which enabled it to reduce contributions from local employers in 2023 or 2024.
“About 10 years ago, consultants were telling UK pension funds to buy leveraged gilts. And the answer from the team at the time was no, we’ll stay in equities, but we’ll have these lower risk equities. Our funding position today is largely a consequence of this strategic decision to maintain the higher equity allocation and not buy lots of gilts,” he reasons.
The allocation to index tracking gilts currently sits at 15 per cent.
Inhouse investment allows active at the price of passive
Lothian’s 55 per cent allocation to equity is wholly active and invested in defensive, low-risk, high yielding stocks in a “de-risked” version of equities that favours quality over momentum or deep value. The portfolios are global, with three regional allocations to the UK, Europe and US, there is no emerging market allocation.
The portfolio is comfortably positioned in today’s AI-driven, overstretched equity market and in-house management of equities enables an active strategy “at the price of passive.” For diversity, all bar one allocation (mandated to Baillie Gifford) is run in house.
“It’s a significant USP,” says Bocquet.
Over the last three years the equity allocation has returned 10 per cent, underperforming the market but still delivering lower volatility and a strong absolute return to pay pensions in a strategy focused on risk management that has achieved exactly what Lothian requires.
“It’s a question of what we are trying to deliver, and I’m a great believer that what you do with your assets depends on what you’re trying to achieve. Effectively, we should only take as much risk as we need to generate our required return.”
The next valuation is in March 2026 when the strategic asset allocation will be reviewed again.
“Could there be a 5 per cent move down in equities again? Maybe, but it may also remain unchanged given other considerations,” he says.
Being fully active in equities also supports responsible investment, overseen by two members of the in-house team, enshrined in a statement of responsible investment principles (which complements the required statement of investment principles) and egged on by various interest groups that often protest and petition the Pensions Committee.
Being active allows the fund to exclude individual stocks on ESG grounds, says Bocquet, who is reluctant to reduce the opportunity set. Active management also avoids the passive ‘trap’ where investors can find themselves invested in a company that trips their exclusion policies because “it’s in the index”, potentially forcing them to design more costly bespoke exclusion indices with their managers.
Infrastructure and property
The infrastructure allocation, which accounts for the bulk of Lothian’s 20 per cent allocation to real assets, exhibits the same characteristics of low-risk solid performance and has returned about 9 per cent over the long run. It avoids leverage and focuses on local Scottish and UK investments (about 80 per cent of that infrastructure portfolio is based in the UK) in a strategy shaped around buying secondary infrastructure funds directly or co-investing in assets through funds where the team will work with a manager.
In-house expertise enables the fund to assess and evaluate the opportunities and avoid the blind pool associated with primary funds.
“The blind pool issue is the same in infrastructure is as in in private equity. You don’t fully know what the manager is going to do with your money,” says Bocquet.
Not only does buying secondaries give visibility on the underlying assets. It also enables the team to negotiate better terms with the manager and pay lower fees. Typically there is a step down in fees when funds are more mature yet the underlying assets still have decades to run, he says.
The approach tends to avoid development risk and there is no J curve effect, when the initial investors find themselves paying fees but there’s no return being delivered. He also argues there is more than enough life in infrastructure assets to suit secondary investors. “Some of these assets will go on until 2045 and 2050. The funds we buy have been set up with a 30-year life. So even if you buy them 10 years later, they still have 20 years to run.”
In another USP, Lothian also has a successful direct property allocation run inhouse to target a high single digit return. Assets are focused on the UK, but not London-centric, and local impact. “Having an in-house direct property team, which is very, very unusual.”
