Nerves of steel
Hugh Smart of the British Steel Pension Fund tells Nina Röhrbein about his approach to dynamic decision making in a portfolio split between liability matching and return generation
For many defined benefit pension funds, having four times as many pensioners as workers seems to be the ultimate horror scenario, the thought of which they may be just too happy to push into the distant future. However, for the British Steel Pension Fund this is a reality.
On a macro level, the pension fund’s overall strategy is one of total return with an income tilt, according to Hugh Smart, CIO at the fund. “It does not mean that we go after income stocks in particular, but because our asset allocation is bond-heavy it generates a more certain yield,” he says. “The benefit payments amount to around £500m (€570m) a year, but cash flows from our investments as well as employer and member contributions mean that we can avoid being a forced seller, which increases our investment flexibility.” The assets of the British Steel Pension Fund otherwise follow a basic strategic 70/30 split between maturity and growth assets respectively.
“Because of the maturity of the scheme, we need a conservative asset allocation,” continues Smart. “It is appropriate given our current funding ratio and the magnitude of this fund relative to its sponsor.”
The maturity portfolio currently consists of 25% fixed income (both government and non-government), 41% index linked (including US TIPS holdings and corporate index-linked), 1% high yield including distressed and 1% cash.
As part of this mix, the fund has exposure to premium return bond funds such as high yield and distressed subprime mortgage securities, which were bought at attractive levels after the dislocation, according to Smart.
The growth portfolio currently comprises 24% equities - split between 10% UK and 14% overseas - 4% real estate and 4% alternatives such as infrastructure, private equity, commodity hedge funds and timber funds. The fund owns £500m of property in the UK, including farmland. Holdings in foreign property companies make up its overseas real estate exposure.
While the pension fund’s views on oil and metal prices are implemented through long-only equity portfolio construction in-house, its direct commodity exposure is achieved via external, pure alpha commodity hedge funds, such as a long-short agricultural commodities hedge fund and a general long-short commodities hedge fund.
The fund is diversified and open to new asset classes, but Smart emphasises it does not invest in assets like gold or art. “We like our assets to produce a yield, which these fail to do,” he says. “To me the value of an investment is the present value of the cash flow that you can generate with it. But if there is no income, then the present value of zero is zero and relying on terminal value uplifts can be very speculative. Art and bullion may have some defensive qualities but these are not things we need.”
Up until two years ago, growth and maturity assets were equally split. With effect from the summer of 2007 the fund started to hedge a lot of its surplus equity risk as part of a five-year de-risking plan. This was agreed upon after an asset liability study that revealed a one-in-20-year value at risk (VaR) of around £1bn. As the main components of the VaR were equity and inflation risk, the de-risking plan consisted of reducing the fund’s allocation to equities and reducing the inflation mismatch between the scheme’s assets and liabilities.
The fund implemented a £1.6bn equity collar and put-option programme to act as a hedge for its surplus equity holdings against significant adverse market movements. It trapped the equity index in the collar and physically sold equities to reduce the holdings. In total, around £1.8bn was switched from expensive equities into relatively cheap conventional and index-linked bonds at that time, leading to the completion of the de-risking plan more than three years ahead of schedule. “As we sold the physical equities we adjusted the hedge, which worked very well,” says Smart. “We actually made money on our hedge as well as making a lot of money switching on good terms.”
Post-credit crunch, the fund progressively moved out of increasingly expensive gilts into corporate bonds at historically wide credit spreads. “We started scaling up our credit exposure when the financial crisis kicked off because we saw this as a liquidity as much as a credit crunch,” explains Smart. “That is why our allocation to corporate bonds rocketed from 13% to 33%.”
The fund also maintained a relatively high allocation to cash of 3-4% to profit from attractive returns in the money markets. Its equity divestment concentrated to a large extent on the UK. “We used to have a disproportionately high exposure to the UK. Therefore we decided to undertake more UK than overseas sales in 2007,” says Smart. “Despite our sterling liabilities, we felt it was better to diversify away from the UK, as currency risk is only one consideration in such a relatively small market, particularly as we also now apply some currency overlays. We now have a proportionately higher equity exposure to Europe, the US, Asia-Pacific, Japan and emerging markets as compared to the UK allocation than previously.”
The fund remains very active in the equity market by continually applying dynamic tactical switches over much shorter time periods. After buying equities at a low level this March, for example, it went on to sell them in May.
“Due to the longevity risk, a certain level of equity holding is helpful, as apart from longevity swaps there is no other way to offset that risk,” says Smart. “Inflation is another issue for us and that is why we have made extensive use of inflation swaps as an overlay to our corporate bond holdings. These have proved to be helpful at the margin. Other ways in which we address the inflation risk is by investing in property, infrastructure, commodities and timber.”
“Re-investment also poses a risk,” adds Smart. “Corporate bond spreads are very wide, which is why we have become corporate bond heavy post credit crunch. But there is no guarantee that they are going to stay wide. While I do not expect them to become as tight as they were pre-crunch, we, as a long-term institution, need to think about the yield at which we will be able to reinvest the coupons and the redemption proceeds of our existing securities.”
Until March 2007, the performance of the British Steel Pension Fund was measured against its UK peer group pension funds. “But following an asset liability study, we realised it was inappropriate to continue with these benchmarks because our conservative asset allocation distinguishes us from most UK schemes,” says Smart. “Hence, we started to use a scheme-specific benchmark with a 30/70 split and detailed underlying allocations for each of the portfolios, which reflects the scheme’s maturity and liabilities more closely.”
The British Steel Pension Fund also differs from other UK schemes in the way it is managed. It is almost entirely internally managed by around 30 staff, all of whom are scheme members. This has serious cost and alignment advantages, according to Smart. The only assets that currently have to be managed externally are the ones that require specialist knowledge such as commodities, distressed debt and private equity.
Alignment - such as the mix of incentive and baseline fee - is the key issue for the scheme in the selection of external specialist investment managers. “We want to align the contingent fee with the interests of our fund and drive the base fee down as far as possible,” says Smart.
The trustee board overseeing the pension fund is made up of seven employer and seven member representatives, the latter of which are appointed by the membership. A subset of the trustee board - containing six trustees - forms the investment committee, which devises the investment strategy. It is advised by the CIO, who reports to the scheme’s chairman, assisted by three external independent investment advisers.
Although the pension fund started to invest in alternatives as late as 2006, this is one of its big areas of focus for the future. In July 2008, it appointed a dedicated in-house alternatives manager who is responsible for research, due diligence and investment in alternative assets.
Its investments in private equity and hedge funds are relatively small, but Smart nevertheless sees their current price dislocation as an opportunity in the wake of the crunch. “At the end of the day, a lot of alternatives are just a stream of cashflows, regardless of how you package them up,” he says. “Simply putting them in a limited partnership structure topped with leverage does not remove the volatility of the underlying cashflows - it is only apparent diversification, not real diversification. What we are after with our alternative portfolio is real economic diversification, not just the illusion of diversification.”
The scheme’s plans for the future include divesting other growth assets and expanding its allocation to alternatives that continue to increase the diversity of its alpha generation.”Because we run our own money we know the marginal cost of beta production is very low,” says Smart. “But we can complement our internal alpha generation by looking at other alpha sources. Unlike many other institutions, we do not have a particular growth or value philosophy across our equity portfolios. Instead our house style is eclectic because that style diversity in itself presents us with a source of extra diversification.”