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Holding to your course

Anyone searching for evidence that the dash from equities into fixed income by pension funds was not a universal phenomenon in the UK need look no further than the West Midlands Pension Fund.
The Wolverhampton-based fund, with assets of around £7bn (e9.5bn 8.6bn) administers the Local Government Pensions Scheme (LGPS), a funded defined benefit scheme, on behalf of 210,000 local authority employees in the West Midlands area of the UK.
The fund has always been a firm believer in the culture of equities and currently has an asset allocation of 75% of its portfolio to equities. During the equity bear market of 2000 to 2002 it remained faithful to equities, in spite of two years of double-digit negative returns.
Judy Saunders, who has worked for the West Midlands Pension Fund for 20 years and became its chief investment officer in 2005, says there were never any doubts that it was doing the right thing.
“We didn’t reduce our exposure during those three years because we remained committed to the equity risk premium. Over the long term we do believe that equities really are worth pursuing.” The fund was never tempted to follow other pension funds into higher allocations to fixed income, she says. “Following the herd isn’t the way we manage. Our trustees were totally committed to staying with equities.
“Obviously we had a tough three year on returns, but 2005 saw us achieve top quartile performance.”
Investment in emerging market equities has been particularly rewarding. The West Midlands Pension Fund has invested in emerging markets since the mid 1990s, and last year it was the fund’s best performing asset class returning 53% against a benchmark return of 48%.
The fund is currently reducing its exposure to emerging market equities, says Saunders. “We’re now taking some profits. We were almost up to 4.5% exposure and our strategic benchmark is 2.5%, so from a risk management point of view we are locking in some profit over the next few months and bringing our asset allocation down to 3.5%.”
The fund has no plans to reduce its exposure to equities significantly, she says. “Equities proved extremely lucrative for us in 2005, and we have no reason to believe that 2006 will see a reversal although we don’t necessarily believe returns will be as strong. At the moment, compared with a strategic benchmark of 75% in equities and 15% in fixed interest, we’re 3% over on equities, and 3% under on fixed interest.”
The allocation to fixed interest is likely to increase slightly, she adds. “Over the next few months we will be using some of our cash to slightly increase our overall weighting to fixed interest. We are likely to stay underweight but I think we will probably be bringing up our allocation up towards the 13% mark.”
The West Midlands Pension Fund has a fund-specific benchmark, set as a result of three yearly investment strategy and actuarial reviews. The benchmark is constructed to deliver a long term return of around 8 % per annum against a ‘least risk portfolio’ of 4.6%. This portfolio is the theoretical combination of index linked and fixed interest government bonds whose coupon payments mirror the stream of benefits payable for the fund.
The last review was in summer 2004 and a further review is due next year following the March 2007 actuarial review. However, the objectives as stated in the Funds statement of investment principles (SIP) are unlikely to change significantly, says Saunders.
Although the fund’s solvency level dipped to 75% during the equity bear market, it has since picked up and is now somewhere between 80% and 85%.
“The fund’s solvency level is obviously volatile because like many other pension funds its liabilities are linked to bonds. However certainly since our 2004 actuarial review we will have seen an improvement,” says Saunders.
“We are very comfortable with it as over the long term we believe that our investment strategy will deliver the returns that we need really. On the other hand people are living longer and pension fund liabilities are increasing. So it has to be balanced against that.”
One factor that has ensured that the pension fund can meet its primary objective of paying pensions is a positive annual cash flow into the fund. This is because the fund has an active membership of over 100,000, around 50% of the total membership of 210,000. contributions are paid by both employee and employer. “We have an advantage of being cash positive for the foreseeable future. This is hugely important for us because it allows us to implement our strategy more effectively. We have never been in a position of being forced sellers, for instance,” says Saunders.
“A positive cash flow gives us greater flexibility because it means that we can move quickly into any asset class, assuming we’ve got the liquidity, should the need arise. It also allows the fund to take a longer term view compared with other pension funds.”
The West Midlands Pension Fund carries out a significant amount of investment internally. The Pension Fund Investment Division (PFID) a team of 18 people, including the CIO and eight portfolio managers, manages around 70% of the fund’s investments.
The remaining 30% is handled by external managers. These are chosen for specialist skills and capabilities, says Saunders. “We tend to use external managers for the more specialist assets classes such as emerging markets and private equity. We also use external managers for the slightly more aggressive active mandates.”
In addition, external managers are hired for specialised areas of investment management, she says. One example of this was the appointment of a number of enhanced equity managers both in the UK and overseas in the latter half of last year. “The target over benchmark is only 50 to 150 basis points and the tracking error is 2% or less, so it’s low risk. But it’s highly specialised because it is predominantly quantitative. This is not an approach we have the capabilities of doing in-house.”
Enhanced equity is run currently by long-only managers, although this could change, Saunders says. “I fully take on board that the long-short enhanced is an interesting approach, but at the moment the enhanced managers we use are only long-only. That doesn’t mean that at some point in the future we wouldn’t consider the long-short aspect.”
The fund’s investment approach is broadly core-satellite but with a sizeable and growing satellite. Active management has increased and now represents 50% of the management of the portfolio, says Saunders.
“We look to try to deliver a near market return with
the core approach, and
then to the satellite to
add extra alpha where we think it is possible to add value. “The extra alpha that we’re generating comes at different levels of risk. So we’re not simply 50% passive and 50% trying to shoot the lights out. The active 50% is structured at different levels of risk/return.”
Over the past 12 to 18 months, Saunders and her team have created what are effectively three levels of equity risk within the portfolio. At the first level, assets are managed passively to capture the beta or market risk. On the second level assets are conservatively managed, with a tracking error of 2% or below and a target of 50 to 150 basis points. This approach reflects the management style in-house, though also includes the external enhanced equity index managers.
The third level is the more traditional active management, where mandates are in excess of 200 basis points (net of fees). This tends to be the province of external managers.
“By ranking risk in this way we are trying to identify how much risk and how much tracking error we are prepared to take over the fund as a whole,” says Saunders. Our in-house managers do run active portfolios as well as passive, but the in-house active is what I would call conservative and is based much more on a core approach, with modest alpha targets and lower tracking errors.
“A similar structure is also seen in the fixed interest portfolio. There is a passive element plus an element structured to return 50 basis points over benchmark. However a very recent addition is a small investment in a fund using portable alpha with a target return of between 200 to 300bp over benchmark. This is the first time we have pursued this type of target in the fixed interest arena. It forms part of the overall risk budget and is tightly controlled but is an interesting ‘toe in the water’,” says Saunders.
The PFID team also draws on tactical allocation advice from an external adviser, Gartmore Investment Management. “It’s a long standing relationship and has worked well for us over the years. Gartmore offer short term tactical asset allocation on a quarterly basis. Their role is advisory, and the in-house managers implement their advice,” says Saunders.
“The implementation is done in consultation with myself and the in-house managers, so we can use our discretion as to the timing of implementation. We are able to have a healthy debate with Gartmore as well, should we have different views. ”
The fund has a strategic benchmark allocation of 2% to alternatives which has not yet been taken up. This situation will change, says Saunders. “This is something that I’m looking at in 2006, and our trustees have yet to determine what asset class that’s going to be. The areas we are looking at are not unusual – commodities, PFI public finance_initiative, infrastructure, emerging market debt, portable alpha, active currency management, to name some.
“But as yet the jury is out on which particular alternative we are going to pursue. We may well split the allocation and put 1% in one asset class and 1% into another, because again it’s a toe in the water approach and tightly controlled from a risk perspective.
“At the moment the allocation to alternatives is sitting in UK equities, and it’s served us well. When we need to finance the alternatives with our 2% we will, but we’ve got enough cash to do that at the moment. So again we will not be forced sellers of UK equities in order to finance the alternatives, although we may decide to lock in some profits with markets having had such strong runs.”
One area of alternatives that the fund has considered and rejected is hedge funds, says Saunders. “That’s the one alternative that we won’t be doing in the foreseeable future.”
The main objection is the lack of transparency, she says. “Our trustees still don’t consider hedge funds are transparent enough, whereas most of the other asset classes are less complex and are more tangible.”
Saunders says that both property and private equity and even emerging markets, which are often included within the definition of alternative investments, are important areas of diversification. They may not be as liquid as other asset classes but they are tangible. The West Midlands Pension Fund invests in property as a mainstream asset class.
“We see property as a very important element of diversification. It has no positive correlation with equities and so it has proved extremely important in times of equity bear markets,” she says.
The fund invests directly in property. “We made a number of acquisitions during 2005 and a small acquisition in 2006. There are no immediate plans for any further acquisitions but obviously our managers are looking for any interesting investment opportunities.”
The current strategic benchmark allocation to property is 8%. “I don’t know what the investment strategy review next year will reveal for property but we’re happy to stay at the 8% level for the time being,” she says.
The fund has invested in private equity for the past 20 years, mainly in the form of limited partnerships. An in-house team is responsible for identifying and monitoring individual funds.
The fund’s strategic benchmark for private equity is 5% and the current weighting is slightly below 4%, says Saunders: “We invest at different stages of the investment cycle, so we maintain the risk diversification. We’ve had a very strong 2005 with returns of over 35% in the UK and 28% overseas. Although we’re actively investing at the moment we’re also receiving more distributions, which is a very interesting problem/challenge to have.
As with other pension funds in a low interest, low volatility environment, the priority for West Midlands is to squeeze extra basis points from whichever asset class or investment strategy can add value always with due regard to risk. An example of this is stock lending. “The LGPS regulations allow us to lend up to 35% of our Fund. This is an efficient use of our assets,” she says.
“Obviously we do all the appropriate risk assessments, and we are very careful about who we have a stock lending relationship with.”
The fund is also careful to retain its voting rights, Saunders says. “We will always hold some stock so we can have our vote. So long as we keep 100 shares then we will always be able to vote. And if we had to call our stock back for any sensitive or contentious issues, we would be able to do that as well. Even when we appoint external managers we retain our voting rights as long as the account is segregated.”
Voting matters to the West Midlands Pensions Fund. “We regard ourselves as leaders in the field of voting and corporate governance, so we see that as particularly important,” says Saunders.
The fund engages with companies through LAPFF, a partnership group of 39 public pension funds with assets of more than £60bn. “We promote investment interests of local authority pension funds through this group because we believe strongly that we maximise our influence as investors by standing as a single group.
“As regards voting the Fund has its own template which is published on its web-site, and we vote nearly all our holdings in the UK, US and Europe.”
Details of the fund’s voting are reported on its website. “It explains why we voted against or supported certain resolutions. For the 12 months up to the end of 2005 we opposed 15% of reports and accounts, mainly on environmental disclosure,” Saunders says. “But the resolution that received the most opposition votes from us was the remuneration report and that received in excess of 30% of votes against.”
Clearly, the West Midland Pension Fund’s views on corporate governance are no less forthright than its support for equities.

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