Clwyd: Cultivating the difference
“We are conscious we are different and we did not want to be too different, too quickly,” says Philip Latham, pension fund manager at the Welsh pension fund, and multiple IPE Award winner, Clwyd about the stages in which the pension fund introduced its unusual asset allocation strategy.
As a statutory local government pension scheme (LGPS), Clwyd provides death and retirement benefits for local government employees in north east Wales.
Its overall investment objective is two-fold – it aims for a funding level of 100% and long-term stability in its employers’ contribution rates.
This defines its asset allocation strategy, which contrasts wildly to those of other LGPS in the UK, which tend to be more geared towards equities.
But the challenge is not easy, Clwyd’s estimated funding level was at 63% in March 2013, down 9% from 2010.
“To get back to a funding level of 100%, we need an investment strategy that is forecast to generate relatively high returns,” says Latham. “At the same time, we try to manage our equity risk and volatility in order to preserve the stability in contribution rates. Our investments in alternatives – all of which are different in nature and come with different risk profiles – are expected to help us reach our objectives and produce a long-term return similar to that of equities without the volatility. The 2011-12 review from the WM Company, shows that over 20 years, alternatives have one of the lowest risks and highest returns compared with other asset classes.”
At present, Clwyd’s asset allocation strategy consists of 43% equity, 15% fixed interest and 42% alternatives.
Over time, there has been a shift from equities into alternatives. With the exception of the active, alpha-seeking currency fund, which was stopped after 2007, exposure to all alternative asset classes has increased. Investments in timber and agriculture as well as commodities were added in 2007. Tactical asset allocation (TAA) was added in 2004.
Clwyd’s alpha-seeking alternatives portfolio contains a 2% free allocation, which is used for new investment ideas. To date these have included investments in power generation, American solar energy projects and a shipping fund.
In the equities portfolio, UK, US, European and Japanese active portfolios were phased out in 2011. Instead a 19% developed passive, a 5% global unconstrained and a 5% global high alpha/absolute return portfolio were added.
Active mandates to the Far East and emerging markets, meanwhile, increased from 2.5% each in 2001 to 7% in 2011.
Individual allocations in traditional bonds such as UK Gilts and corporate bonds as well as high yield, emerging markets and cash were phased out in 2007 and replaced with one unconstrained mandate, which manages these assets on a tactical basis.
TAA gained in importance following the financial crisis. It is at present managed by three managers: a broad-based GTAA provider; a traditional dynamic asset allocation fund with a focus on capital preservation and; a multi-strategy hedge fund with a macro bias.
“We have two real objectives for TAA,” says Latham. “First, we want to add value to the bottom line over the long term. Secondly, we want downside protection. It has already given us some downside protection in difficult, volatile environments even if it failed to provide additional alpha at total fund level.”
A new development of the revised strategic asset allocation in 2011 was the inclusion of conditional asset allocation (CAA). This gives Latham the flexibility to make changes in asset allocation between equities and fixed income of up to 15% if conditions require, and up to 5% for other assets and TAA. Quarterly meetings with the fund’s TAA managers and consultant are held to discuss the positioning, as well as telephone conversations when market events appear to be moving quickly. But in order to instruct any changes there has to be a clear consensus from all the managers concerned that any events represent a fundamental market change and not just a short-term correction.
“CAA allows us to de-risk very quickly, or alternatively take advantage of the market on the upside,” says Latham. “But, we are not trying to time the market.” Clwyd has not yet used its CAA.
The fund’s overall strategic risk and return profile is determined through its strategic asset allocation. For years, the fund pursued a policy of lowering risk by diversifying both investments and fund managers. Therefore, it maintains positions in a variety of financial instruments including bank deposits, quoted equity instruments, fixed interest securities, property holdings and unlisted equity products. This exposes the fund to a variety of financial risks including credit and counterparty risk, liquidity risk, market risk and exchange rate risk.
“We are cash-flow positive and likely to remain so for the next 10 years, depending on what happens to our 30 public sector employers, who may need to downsize,” says Latham. “We do not need to generate any liquidity from our investments, so we plan to re-invest any income that we have for capital gain. This cash flow position allows us to invest in less liquid assets such as private equity, hedge funds, infrastructure, timber and agriculture.”
Alternative assets are subject to their own diversification requirements. Private equity, for example, is diversified by stage, geography and vintage where funds of funds are not used. Property on the other hand is diversified by type, risk profile, geography and vintage on closed-ended funds, infrastructure by type (primary/secondary), geography and vintage and hedge funds via multi-strategy or funds of funds.
In the wake of the financial market turmoil of 2008, Clwyd put its alternatives into different risk brackets such as alpha seeking, real assets and TAA.
As part of its recovery plan, Clwyd’s return target is UK Gilts plus 3%, assumed 7.5%. For past service, it is Gilts plus 1.4% – assumed 5.9% – and for future service, an investment return of 6.75% per annum is required, in other words, inflation plus 3.75%. But Clwyd assumes 8-10% in the long term with a risk of around 11% to get an information ratio as close to one as possible.
These assumptions are built into a benchmark, using an optimisation model to consider various asset allocations and their impact on risk and return. “Once we have created our asset strategy based on those targets, we try to create our own benchmark to have a benchmark return in line with those targets,” says Latham.
The fund’s investment strategy and implementation are reviewed every three to four years.
Clwyd’s asset management is outsourced and all of its allocation takes place through pooled vehicles. “Initially, pooled investments came from EU procurements but over time managers have come in with pooled vehicles because they deem them more efficient,” says Latham. “We recognised the increased complexity in back office requirements, particularly from an accounting perspective, and having a pooled vehicle simplifies the back office. The downside is that we do not directly vote some of our shares but instead rely on our fund managers to do that.”
As part of its return to a 100% funding level, the pension fund is in the process of implementing a flight path methodology into its overall strategy, which maps the route back to fully funded status over a fixed time period and takes account of both asset and liability value projections based on existing structures including liability-drivers such as inflation and interest rates.
The fund does not expect to appoint a manager until mid-September, with a view to implementing the flight path at a later stage, although possibly not until 1 April 2014.