Speaking about new thinking and trends in investment products and strategies, Philip Robinson, principal at Investit, gave delegates an overview of the size and shape of global and European pensions provision at IPE's tenth anniversary e-symposium. The global institutional pensions market was worth $20trn (€14.8trn), he pointed out.
Robinson, who is responsible for institutional product testing at London-based consultants Investit, showed that pension fund asset allocation was changing, but the shift to alternatives was overplayed.
"A lot of people talk about alternatives, but if you go back to the statistics (excluding property) in the overall asset allocation… the investment consultants say it doesn't make any difference unless you have about five to 10% in these, and in a lot of markets it is significantly lower," he said.
Allocations to alternatives were higher in the Netherlands, Switzerland and Sweden, but very low in the UK, he noted.
Pension funds in Germany and Japan were significantly increasing their equities allocations, while elsewhere, domestic equities allocations were generally down. Foreign equity allocations were up, as were foreign bond allocations - the UK being the only major market where domestic bond allocations were increasing.
Investment consultants were now endorsing alternative asset management, he said, and there was more demand among pension funds for "solutions" rather than "products", continued Robinson; the separation of alpha and beta was increasingly important, he added.
Giving the e-symposium a pension-fund viewpoint, Guenther Schiendl, head of investing at APK Pensionskasse in Austria, explained how the fund assessed new strategies and investment products.
He focused on the common mistakes that investors made. "One of the first errors in investing is a lack of understanding of instruments," he said. Not all investors in commodities investing, for example, are aware of the way futures contracts have been priced and how they trade, he continued, with contango and backwardation - where futures prices trade below or above spot prices - poorly understood.
It was also important to avoid bad timing by being hyped into buying after prices had risen, he said. And the way indices were constructed was quite backward-looking, because they included companies once they have built up sufficient size, thus losing out on initial growth.
"So investors need to be careful, that if they are really looking out for a long-term strategy, that they don't select a product that is linked to an index that may be backward-looking," he said.
Misperceptions and ignorance of fundamental eonomic change sometimes kept investors away from emerging markets, he said. Another mistake was in the treatment of risk measures, he said; investors typically used volatility to measure risk, and seldom drawdown or other risk measures.
When selecting investment products for the APK fund, Schiendl said his team questioned the use of indexed global equity strategies. "We also question active global equity strategies with low tracking error," he went on. "This is because those strategies are linked to the MSCI World Index, where the manager has no room for including emerging markets."
Other examples of typical investment errors were misunderstanding diversification benefits, not staying true to your investment process, not knowing, or not using, your risk budget and misunderstanding time-horizon effects on risk and return.
But despite his list of pitfalls, Schiendl said that generally pension funds did have the processes in place to ensure competent investment. However, he warned: "There are so many products coming up all the time that it pays to dig a little deeper as to how the returns are really being delivered."
Global emerging market fixed income was the focus for the first asset manager presentation by Brett Diment, head of emerging markets at Aberdeen Asset Managers.
This opportunity set had really only developed over the last three to five years, he said. "Since 2004, the net issuance of emerging markets (EM) sovereign debt has declined; the set that we have seen increase has been in the corporate sector," he remarked.
The debt position of some EM countries had been transformed in recent years, he pointed out, with Brazil and Russia both becoming net creditor nations - the latter to the tune of almost $300bn. In general, EM bonds were attractive because of strong GDP growth in the regions, healthy macro-economic fundamentals, and the fact that valuations still seemed reasonable compared with developed markets, said Diment.
Good EM returns come from countries other than the main ones, according to the next speaker, Alka Banerjee, vice president, global index management at Standard & Poor's. "The best performers have been surprisingly not just the BRIC countries [Brazil, Russia, India and China]; there have been many other countries that have given spectacular returns as well," she said.
She identified several promising "new frontiers" in EM, including the six countries of the United Arab Emirates, eastern European countries such as Bulgaria, Croatia, Latvia and Slovenia, and Vietnam. "Vietnam has burst onto the investing scene only in the last couple of years and witnessed double digit returns," said Banerjee.
Speaking about enhanced commodity strategies, Michael Lewis, global head of commodities research at Deutsche Bank, highlighted the divergence between different commodities indices.
"Investors need to be very careful with the commodities index they choose, because our view is that this commodities index divergence is going to characterise performance in future," he said.
Calling contango a "major headache for investors" because of the negative roll yield, he added that the DBLCI optimum yield technology tended to outperform traditional commodities indices in contango markets, while in backward dated markets, the optimum yield roll rules were likely to match a traditional roll mechanism.
Asked what role commodities should play in a portfolio, Lewis said that normally the institutional allocation to commodities was 5%. "Our sense is that 10% is the maximum that portfolios would include."
IPE's editorial director Fennell Betson, who moderated the e-symposium, asked the panellists at the day's first roundtable discussion about their approach to this asset class.
"We're increasing our exposure to emerging markets," said Wim van Irsel, head of external management at Dutch railways pension fund (SPF). "We still think there's enough alpha to be gained in this respect, and especially if you look at the local bonds arena," and possible benefits from currency appreciation, he went on.
Also on the panel was, Guenther Schiendl, who said his institution already had two emerging market debt managers working for it, with a third working on the sidelines. "We believe emerging market debt is about to become mainstream in a global fixed income strategy," he continued, agreeing with Van Irsel that another benefit of holding the asset class was the potential for currency appreciation.
Pointing to the risks of EM bonds, especially in the light of yield compression, Chris Edge, chief executive of Allenbridge EPIC Investment Advisers, said he would go for convertible bonds equally with more conventional issues.
"I would agree with that," Schiendl responded, "but only in the case where we are about to enter a period of higher volatility. I would consider convertible bonds in a global context; although we have seen a good return over the last few years, I think it's still a good opportunity to invest."
Did the panellists favour investing in EM debt actively over the passive option? SPF had more than a tenth of its equities under management in
emerging markets, Van Irsel noted. "We see emerging markets still as an interesting place to exploit alpha, so we would rather go for an active approach than a passive approach …but as a first starter, and if you're very risk averse, I can imagine that you take the passive approach," he said.
Edge saw distinctly greater opportunities for alpha generation for emerging markets equities than from the bond market, mainly because EM bond yields had become so close to developed market yields.
The long process of economic development really resides in equities, he continued. "Many of these countries, notably China and India, will undoubtedly be global forces forever," he said.
"These markets remain very inefficient for a number of reasons - they are much less heavily researched for example, there are fewer hedge funds operating to exploit," Edge said.
Moving onto commodities investment, Van Irsel said SPF had shied away from commodities so far because of the negative roll return on futures contracts.
"I have to say, if you look at this product, they are doing their best to mitigate that negative effect," he admitted. However, as long as the negative roll return existed, he said this would be to the detriment of the return of the asset class.
Edge saw the product as more attractive than some, though it only had a short track record. "Commodities, over the long-term, have dramatically underperformed other investable asset classes, notably equities, although the environment has changed and there are sophisticated ways to get involved," he said.
Next to present was Gilbert Keskin, head of the volatility team at Credit Agricole Asset Management, who explained how the CAAM Funds Volatility Equities fund worked. This was an absolute return fund that allowed the investor to invest in the new asset class of volatility, he said.
Explaining why CAAM considered volatility as an asset class in its own right, Keskin said: "You can buy and sell volatility in the market thanks to option derivatives; volatility can bring performance to the investor." The fund bought volatility when it was high, and sold it when it was low, he said, taking advantage of the mean reversion process.
David Schofield, president of the international division at Intech, spoke to the symposium about "the decade of risk management and the return of alpha". Arguing in favour of risk-controlled equity products, he looked at the evolution of modern portfolio theory, in particular the statement that an investor cannot generate a return higher than the market without taking on additional risk.
This was based on assumptions which did not apply to the real world he said. "There is no theoretical
impediment, even given the cornerstones of modern portfolio theory, to creating a portfolio with market risk but above expected return," said Schofield, adding: "The drive towards indexation is not necessarily the most sensible way to go forward."
Most research advocating passive investment strategies was likely to be time-biased and diversity biased, he claimed. Active managers had tended to outperform when diversity was rising, and underperform when it was declining, he said.
"We believe much greater attention should be paid in attempting to generate alpha in core, large stockmarkets," he said.
The second roundtable discussion began with a question from moderator Dirk Soehnholz, managing director of Feri Institutional Advisers in Germany. Was volatility really a separate asset class?
"That would not have reached most trustees yet, because they see volatility as something that's less of an asset class and more of a problem," said Georg Inderst, independent trustee and consultant. "For defined benefit pension schemes, the most relevant volatility is the funding volatility and how assets compare to liabilities," he remarked, questioning how volatility would fit into an investment strategy.
Finland's Ilmarinen multi-employer pension fund had been including volatility in its structural asset allocation for some time, according to CIO Jussi Laitinen, though he said asset class was a strong term for it.
"We've defined volatility, especially sold volatility, as an asset class. It's like as insurance policy which has a premium. Wherever you receive a premium for something, we would consider that close to an asset class," he said.
On the other hand bought volatility was not an asset class as such, but rather a risk-reducing technique for which one paid a premium, he added. CAAM was mixing both of these in its product, and so Ilmarinen would not see it as an asset class, he concluded.
Reflecting that the panel had just heard two asset managers trying to sell new asset classes, Soehnholz remarked: "Whenever I hear this, I question how many asset classes are really out there."
CAAM's equity volatility fund was a product very much built around the mean reversion of volatility, Inderst noted. "There are a lot of products build around mean reversion ideas," he said. "In hindsight, you can always find mean-reverting ideas quite easily."
"I agree with Georg, in the sense that there are a multitude of products being offered where exactly this tendency to mean reversion is the tactical claim," said Laitinen.
However, over time, this process of deriving a long-term premium could pay off. "Over time if you continue doing this, you should gain a nice excess return from them, because it tends to be that investors are willing to pay more for protection than actual volatility turns out to be," he said.
Turning the discussion to the risk-controlled equity products that Intech's Schofield had talked about, Soehnholz asked how much the panellists would invest in passive, how much in active, and whether they would buy the two in a package?
Noting that funding ratios for UK pension funds had improved, largely because of the beta in their portfolios, Inderst said he was not against alpha. However, it was quite difficult to find those alphas that were positive and avoid those that were negative, he remarked.
Presenting the asset manager's Fixed Income Plus investment fund, Robeco managing director Colin Fitzgerald said the strategy aimed to generate returns of two to three percent over LIBOR or cash gross of fees.
This was a strategy composed of an "enhanced mortgage portfolio", he said. "The mortgage-backed securities sector has the highest risk-adjusted returns of the major sectors in the US bond market," he maintained. "The product mitigates or greatly reduces the credit risk that's entailed by only buying AAA-rated tranches."
Next, Roman Gaiser, European high-yield director at Threadneedle Investments, explained how the institution's high-yield and leveraged finance product worked. Strategies used included relative value trades and capital structure arbitrage.
"There's an underlying need for leverage finance, and that's why we believe that high yield and leverage finance will present ongoing opportunities over time," said Gaiser. A lot of people would focus on the downside - the default risk - he conceded, but added: "If you're lending money, you are being paid a very nice coupon, and the coupon has a moderating effect on the volatility."
Moderator Paul Boerboom, founding partner of pensions strategy advisers Avida International, asked pension fund managers in the day's third roundtable discussion how Robeco's product might fit in their portfolios.
Paul Kessell said the product was probably too granular for the London Pensions Fund Authority, where he was investment manager at the time; he has since moved to the Sainsbury pension fund. "It's a very focused product," he said. "Such a product may hit a road block with our fund at the trustee level, where their understanding of it would be limited."
Silvio Vecchi, administrator of the reserve funds of the European Patent Organisation (EPO), said he saw the advantages in the low correlation of this product with other asset classes, but shared Kessell's opinion.
But Kessell thought some other UK pension funds might be interested in a product like this. "Certainly there has been a move over the past three years to seek out alpha opportunities within the broader fixed income universe," he said.
Boerboom considered a big pension fund, such as ABP in the Netherlands, might have the knowledge and level of sophistication to be able to have a look at this product if it fitted in with their total portfolio. "With smaller funds, obviously this becomes a little complex," he concluded.
The high-yield leveraged finance product from Threadneedle could fit into a broad fixed-interest allocation, according to Kessell. "I think it's probably less complex than the first product," he added.
But Vecchi did not think it suitable for the EPO's fund at the moment.
Boer questioned how Threadneedle distinguished itself from other providers of similar products. "Because it's less complex, there is competition," he noted.
"This is an area Threadneedle has sought to specialise in - LDI and portable alpha-type strategies," Kessell responded. For its part, the team at the London Pension Funds Authority would look at the people in the asset management group, their process, the performance and consistency of the product, he said, remarking that the product had only been running for three to four years - a period when the environment had been benign.
"It's how this product will perform over the full cycle," he said. Vecchi shared his concern, asking: "Is there a clear view on when this benign environment is over?"
Kessell was concerned that bringing non-traditional products such as this into the asset mix could create problems - not only for risk budgeting. "You need to be aware of what those issues are, and what the impact may be of a one-off event," he warned.
Marking IPE's tenth anniversary
PE's fourth e-symposium ‘Leading Edge Investment Strategies' looked at a broad range of investment options from volatility to enhanced commodity indices. These were examined against a backdrop of what is happening within asset management industry as well as looking at how investors assess the array of new strategies and products they face. A recording can be downloaded at www.ipe-symposium.com/programme.php
ABP: investment selection processDeirdre Ypsma, senior portfolio manager in the New York office of Dutch pension fund ABP's investment arm, showed delegates how the fund reviewed and chose investment products.
ABP has €209bn in assets under management, she said; €74bn of this sum was invested in equities, with 60% managed in house and the other 40% in the hands of external managers.
There were several reasons why the pension fund would outsource, she said. For example, the fund might be looking for very specific know-how that was either not available in the Netherlands, or that it did not want to acquire strategically, she said. Or, she added, another market participant might be able to offer better economies of scale in certain strategies.
High alpha strategies and global indexing were two investment areas that ABP did outsource, said Ypsma. When selecting external asset managers, the global manager selection team looked at strategy - unexplored niches and pockets of capacity to fill as well as which manager offered the identified strategy, the level of skill they had, and how that strategy would fit into the fund. A long track record was not necessarily important in terms of the product. "We will select new strategies, but generally not new firms," she said.
After identifying external asset managers to provide the strategy ABP is after, and following the RFP stage, the pension fund then used a range of tools to drill deeper into the product's potential. Tools used included regime analysis, return-based style analysis - to distinguish between real alpha and hidden beta, performance indicators and risk budgeting, said Ypsma.
Looking ahead, there were several developments ABP was aiming for in manager selection, she remarked. There ought to be more automated and detailed holdings-based analysis, and better cash management. Daily reporting on key characteristics was also something the fund could
improve on.The ultimate goal was to integrate all tools into one master report, she said.
"In the end, we feel manager selection requires constant re-evaluation of the process and constant process innovation," she said.
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