When considering how the assets of a pension fund should be split, remember that ancient proverb: “Have your cake and eat it too.”
In my view, a pension fund should aim to maximise returns over the long term without taking egregious degrees of risk. If we look at the returns as a cake and want to illustrate risk, let’s assume that you like chocolate. Now, if you were to eat a cake made entirely of chocolate, with not a single layer of sponge, you are likely to enjoy the first mouthful, feel full after the second but risk feeling ill if you attempted to consume the entire cake. Why? Because an all-chocolate cake is simply too rich. The same applies to a pension fund. We all want to add value but cannot take the risks involved.
To avoid risk, we manage most of its exposure to the major equity markets on an index-matched basis. I say “most” as we do not want to miss out on the opportunity to make incremental gains against market returns on a strictly risk-controlled basis.Therefore, we use a process known internally as the ‘net zero’.
Each client’s exposure to a market is established through the index-matching portfolio. If the active management team likes and buys a stock in addition to the ‘core’ indexed portfolio, this will have to be matched by an equivalent sale of stock (or of the index future). Thus, there is no effective change to the portfolio’s market exposure, and the active portfolio has a ‘net zero’ additional exposure. Any stock sold by the active manager is borrowed from the index core, which continues to be measured as though it still owned it.
The concept of ‘pairs trading’ may facilitate understanding of the ‘net zero’ approach. For example, the manager who looks at the oil sector prefers the outlook of BP Amoco to that of Shell. If he buys, say, £10m of additional stock in BP, he then borrows £10m of Shell stock from the indexed core and sells it. No matter what happens to the stock market as a whole, this action will add value to the portfolio, provided that BP’s shares outperform those of Shell. This is true even if BP falls by 25% and Shell by 26% while the market as a whole rises by 20%, or if BP rises by 11% and Shell by 10% when the market falls 5%.
Similar trades can be made in each sector: Tesco/Sainsbury, Glaxo/ SmithKline, Canary Wharf/British Land and so on. This simple principle can be extended to trading between sectors. If the active management team believes that oils will outperform food retailers, they may buy both BP and Shell and sell equivalent amounts of both Tesco and Sainsbury’s. Again, it will not matter whether the market rises or falls. The portfolio will benefit as long as BP and Shell outperform Tesco and Sainsbury’s.
A definite advantage is that the additional risk created from such positions can be estimated before the positions are taken, on the basis of normal correlations between sectors and the volatility of each stock. Thus the risk taken in the UK net zero is estimated and controlled as a whole.
Monitoring the success of the net zero is simple, and attribution of the contributions of each position can be seen clearly. We are looking at an absolute profit and loss account, rather than a relative performance fund.
Over the past 20 years, we have developed a strategy that encompasses enhanced valuation techniques on index cores to make incremental gains against an index on a risk controlled basis. By starting with an index core, we view market returns on a very low cost basis.
As a guiding principle, we seek to maximise market return as a whole, and we therefore regard a robust approach to corporate governance as essential. If required, we can provide an enhanced technique as an overlay to this core.
The discipline behind the technique is not only very clear but it benefits clients tremendously, since the active teams do not have to take continual bets against an index. In effect, by doing nothing, our teams lock in those index returns. Having your cake and eating it too? Let’s have an extra fork!
Anthony Esse is director of marketing at Hermes Investment in London