Ireland: Strategic and tactical

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Nyree Stewart assesses the National Pension Reserve Fund's strategic deployment to recapitalise two domestic banks, and its move towards more dynamic decision making

The National Pension Reserve Fund (NPRF) recovered from a -30.4% loss at the end of 2008 to post a positive 11.6% return in 2009 and increased the value of its assets from €16.1bn to €22.3bn. But how did it cope with the financial crisis in a country severely affected by the global recession?

Last year did not start well for the fund, with a first-quarter return of -6.7% leaving assets of €15.5bn. But despite this fall, the Irish government introduced an Act in March allowing the finance minister to direct the NPRF to invest in certain listed financial institutions.This allowed for the recapitalisation of two banks - Bank of Ireland and Allied Irish Banks.

Adrian O'Donovan, senior manager and commission secretary at the NPRF, explains that €3.5bn was invested in preference shares in each bank which pay an 8% coupon annually. As part of the deal, the NPRF also received warrants that give it an option to purchase up to 25% of the ordinary share capital in each bank between the fifth and 10th anniversary of the issue of warrants.

O'Donovan says: "This was a major event for the fund, with €4bn coming from current resources and €3bn from the Exchequer. The government is required to pay 1% of GNP into the NPRF each year, equivalent to around €1.5bn, and the Exchequer contribution for the bank recapitalisation means the 2009 and 2010 GNP contributions have been pre-funded."

The €4bn from the NPRF was comprised of its "most liquid assets" - cash reserves and government bonds - and after the recapitalisation the NPRF's assets were split into two portfolios, The direct investments portfolio is the holdings in the banks and equals 31.4% of the total fund, while the discretionary investments section comprises equities, bonds and alternative assets.

However, following the funding of the bank investments, the discretionary portfolio was left with an equity allocation of around 83-84%. "This is not an allocation that we would have held by choice or be comfortable with on a long-term basis," O'Donovan notes.

Eugene O'Callaghan, head of investment management at NPRF, highlights that the fund is a long-term investor and, with equities reaching their lowest levels of the financial crisis, March was not the best time to sell. "Instead we accepted the higher equity position and met the recapitalisation requirement from our cash reserves and sale of our government bond portfolio. This was effectively a tactical call forced on us by the bank investments."

But O'Callaghan adds: "We took advantage of the strong market rally to reduce the fund's absolute risk and exposure to the equity markets through phased equity sales in the second half of the year." This left the discretionary portfolio with an equity allocation of 63% by the end of 2009.

Meanwhile, O'Callaghan points out that an additional operational consequence of the direct investment portfolio was the effect on the fund's cash management.

"When we used all our liquid assets to fund the recapitalisation there was no cash left but, as with many schemes, we still had commitments in property and private equity investments to meet. Consequently, we had to manage the cash in the portfolio more tightly than before - for example, not reinvesting dividends and interest on our equity and corporate bond portfolios."

He confirms that since the sale of equities from June onwards the cash levels have increased "so the need for such stringent cash management went away, but this was a significant operational consequence of the recapitalisation".

Preliminary 2009 figures issued by the NPRF in January showed that the discretionary portfolio returned 20.9%, equivalent to an annualised return of 2.6% since 2001. However, the government's decision to use NPRF assets to stabilise the banks did affect the overall return, and when the direct portfolio is included the result is reduced to 11.6%.

Last year the value of the fund improved from a low of €15.4bn in March to €22.3bn at the end of December. However, O'Donovan notes that the end of year figure includes around €900m in assets transferred from 10 university and non-commercial state body pension funds. He adds: "This is the first phase in a two-phase process. An equivalent value is expected to be transferred in 2010 and these assets will be integrated into the discretionary investment portfolio. The pensions themselves will be met on a pay-as-you-go basis by the bodies concerned.

"This also means we are now pre-funded to 2012 as the transferred assets make up the government contribution for 2011. So it will be sometime in 2012 before the next scheduled contribution into the fund," sayd O'Donovan.

Other developments in 2009 included the completion of an increased allocation to emerging markets from around 2% to 5% of the discretionary portfolio in the fourth quarter. O'Donovan notes that the fund had previously selected managers but not implemented the mandates because of the financial crisis.

Asset allocation at the end of 2009 differed from the target strategy of 66% in equities, 20% in other assets and 14% in bonds and currency. However, O'Donovan says that the NPRF had drifted from its target allocation for very good reasons. In particular it slowed its alternative investment programmes from early in 2007 and ran an underweight equity position through the financial crisis.

Currently, the NPRF is conducting a "root and branch" review of its investment strategy, which is expected to be completed in the first quarter of 2010. The last full review took place in 2004, so the next one was always scheduled for 2009, although the timing means it is expected to absorb lessons from the financial crisis as well as taking into account the expected risk and return features of potential asset classes.

O'Donovan says: "We can't prejudge the results of the investment strategy review but one lesson from the financial crisis is the need to consider the extent to which the fund is truly diversified. While it has investments across a number of asset classes that have different economic drivers and tend to perform differently in different economic environments. What we saw during the crisis was a flight to safety, with investors eschewing all risk assets as they sought safety in government bonds."

"Up to now we have managed the fund by focusing on long-term risk and accepting the volatility that accompanies this. There may be a need in future to give more emphasis to diversification in all market conditions. Absolute return funds represent one possible strategy we are looking at in this context."

He also notes that the fund is looking at the potential to be "more dynamic in different market conditions, taking larger positions away from benchmark when market volatility reaches levels with which the fund is not comfortable or when pricing moves to extremes".

However, O'Callaghan adds: "This would equate to just a small number of moves in extreme conditions, not daily trading. There wouldn't be stuff going on all the time. We have always had the capacity to make tactical decisions and we widened that capacity during the crisis. This is looking at having more authority and structure in advance, but it is just one of the issues we are looking at as part of the review."


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