The day-to-day running of an £8bn (€10bn) pension scheme is complicated enough in an environment of low-yields, increas- ing longevity and ever-changing legislation. But add a shift to in-house investment management and it becomes significantly more complicated – at least in the short term.
Bringing experience from the insurance asset management sector, Steven Daniels, joined the Tesco Pension Scheme in September 2011, and oversaw the creation of Tesco Pension Investments (TPI), the in-house asset management entity, where he is chief investment officer.
Daniels’ team manages around £2.5bn of assets, with activities including real estate management, fixed income analysis, active equity management and manager selection.
The underlying scheme is career-average defined benefit, and with the supermarket giant using the open scheme for its auto enrolment obligation, the company’s young workforce make this pension fund relatively long-dated in terms of payout schedules.
Daniels says this is one of the main differences between the Tesco fund’s investment strategies compared to other UK corporate pension schemes. These have dwindled in existence, or closed to new members. However, Tesco’s positive cash flows would continue for a significant amount of time even if the scheme closed tomorrow, Daniels says.
“This means that we can afford to take a different view to other more mature schemes with regard to asset and liability matching. The strategic asset mix (see box) shows we take a fair amount of investment risk,” he says.
Daniels says TPI is trying to be as creative as possible. “Thought leader- ship is moving away from the consultants and back in-house with the larger schemes,” he says.
“Our inspiration comes from our multi-disciplined team. We are seeing the same opportunities as everyone else, but it is about whether we can put the jigsaw together in a slightly different way to typical funds.”
Daniels strives to go against the grain in terms of investment choices and in bringing assets in house. In addition to the added cost advantages, he says collaboration between the in-house asset teams also allows the fund to break the “silo based nature” of asset allocation that is evident in other pension funds.
This means having the fixed income, alternatives and property teams looking at investments in infrastructure or real estate debt together, without having to worry about which ‘bucket’ the investment fits in: “We have people looking at the whole fund, and teams that can work together.”
TPI’s investment in aircraft leasing is an example, where the fund allocates through a listed equity investment trust. The air- craft are leased for ten years, before being resold and the fund benefits from lease and sale income.
Daniels says the investment should provide 8% yield with capital appreciation on top, making it ideal for the scheme to invest in, but other funds might see it as unsuitable for an equity or an alternatives portfolio.
“For us, it meets the return objective, so we should do it and then worry about [which man- agers to use]. So we will hold quoted stocks in our illiquid or alternatives portfolio, if we feel the investment does the right thing for us.” In-house collaboration and a freedom around investment decisions provides Daniels with considerable satisfaction about the Tesco set-up. He says the abil- ity to make in-house commitments means it is more reactive to market movements, which should result in further outperformance.
There was a tactical asset allocation manager under the previous set-up. But, given the nature of the relationship, recommendations remained limited to quarterly meetings.
“We can look at things as and when they need to be looked at,” Dan- iels says. “If we see markets move we can act there and then, which will help us to be dynamic and have a tactical advantage over time. While we are making good cost savings – which is beneficial to the company and the scheme – what we can generate through outperformance is going to exceed that,” Daniels claims.
With responsibility for 65% of the in-house assets, the seven equity investment professionals share a weighty burden of responsibility for the fund’s overall performance.
The aim is for TPI to manage two-thirds of the equity portfolio internally by next year. Some external passive exposure remains but the plan is for this to be reallocated to active management.
All internal and external mandates run on a global basis and the fund currently manages about 60-80 stocks internally. Other comple- mentary managers will eventually run a third of the portfolio.
“With our internal cost base there isn’t a huge saving between pas- sive and active, and by using a range of managers you limit the down- side risk of one manager underperforming,” he says.
The current external managers have been selected to complement in-house expertise. They manage small cap, quantitative, or more focused investment styles, while the in-house team covers long-term large to mid-cap investments.
“The same name may crop up in more than one portfolio, but we have a look-through to see what happens so we can understand the risks at a scheme level.”
The shift to in-house
In April 2012, the £8bn Tesco Pension Scheme began the pro- cess of shifting its investment management in house, resulting in the creation of Tesco Pension Investments (TPI). In April 2014, TPI added to its internal equities and real estate portfolios and began managing fixed income, moving up towards managing almost a third of assets in-house. By mid-2015, TPI envisages this reaching 65%. The fund will go from using almost 70 asset managers in 2012, down to around five. Originally, it used five investment consultants and that will reduce to two. So far, investment performance is up and TPI is on course to meet its medium-term cost objectives, seeing initial benefits before its two-year target.
In common with other UK pension funds, the Tesco scheme’s expo- sure to its sponsor is limited to 5%. Given the fact that Tesco itself accounts for over a quarter of UK grocery sales, and given the breadth of its commercial relationships in the UK economy, it is impossible to take the risk exposure of all these activities into account when selecting other stocks.
Daniels says there is exposure to Tesco in the passive mandates but in-house managers do not buy Tesco stock.“We can buy anything else other than Tesco,” he says. “But it is involved in so many businesses, it would be difficult to construct a portfolio which accounted for this.”
However, the fund is exposed to the sponsor through its real estate holdings and TPI, which uses real estate as an inflation hedge, has conducted several sale-and-lease-back arrangements for its sponsor’s supermarkets.
Daniels says this exposure is small and managed but supermarkets are becoming a common real estate holding for UK pension funds given the availability of long-term lease agreements, highly rated tenants and inflation-linked rental income. This exposure can either be sought directly given the size of these property portfolios or through pooled funds managed by specialist managers.
“We see opportunities with inflation-linked investments where we can match it to pensioner payment increases. So we do not have to go to an investment bank and get the same thing on a piece of paper,” Daniels says.
The same applies to the fund’s infrastructure exposure. However, the five-person real estate team is starting to look at residential prop- erty and student accommodation, with an emphasis on its inflation- linking characteristics.
In summer 2013, the fund announced it was supporting an new office development in the centre of Cambridge. The scheme invested £32m in construction costs, with 90% pre-let to the engineering firm, Mott MacDonald.
Daniels says TPI does not shy away from complex property deals, if the team remains confident of long-term value. “It is an actively managed portfolio, and this allows us to spot the opportunities for re-gearing leases, or changing the structure of tenants to get more value,” Daniels says.
Internal management will not extend to alternative assets, although TPI will retain an alternatives team. This will focus on determining asset class allocations and manager selection, as well as supporting the fund’s overall investment analysis.
The structure of the alternatives portfolio has been debated at trus- tee level, but the board settled on a dynamic approach rather than strict definitions.
Daniels says: “Rather than having a bucket of hedge funds, private equity, venture capital and infrastructure, we will just have an alterna- tives bucket. We will have a diversified portfolio, but not restrict our- selves to fixed percentages in each asset class.” The CIO says he has an aversion to paying fees for investments where the return profile can be achieved elsewhere, particularly where diversification benefits can be overstated, such as with hedge funds.
“A low-volatility, low-returning hedge fund may give a net 4%, but we have paid 2% plus performance fees. We think there are better ways to generate 4% in a low-volatility environment and we don’t have to pay somebody else,” he says.
“Conversely, if we can get a stable and low-volatility 4% return, we may decide to hold that in the fixed income portfolio. It’s mix and match. A bit of the fixed income portfolio could be invested in off- benchmark hedge funds, which have a similar return profile to bonds.”
TPI is beginning to look at direct lending. While any allocation will not exceed 3%, the fixed income and alternatives teams are investigat- ing, and believe the fund could take on longer-term risks, price more competitively than banks, and remain within an acceptable level of risk.
An area the fund rules out in the short to medium term at least is liability driven investment. Daniels says he has no issue closing out risk at the right price and believes opportunities will arise in the future. “It is more a scheme-level opportunity but where we can reduce risk at a reasonable price, then we should be open to doing it,” he says.
Having an investment mindset, Daniels would rather trade LDI strategies to take advantage of pricing, but decisions are the responsi- bility of the fund’s trustees.
Daniels does not want any surprises for the board, but praises the move to bring investment management in house and says it appreciates the added value in terms of outperformance and cost saving. Although, there are cost targets, Daniels remains committed to providing trustees with quality investment services and good performance.
“If outperformance means using managers with the risk of missing cost saving targets, TPI will do that. That’s what we are here to do,” he concludes. “The way we have put this together gives me confidence for the future. We have done some out-of-the-box thinking and have challenged ourselves as to why we are making our investment decisions and whether our decisions meet our long-term objectives. If we do not believe they do then we have to question what we are doing.”