Keen on illiquidity

Peter Wallach of the UK’s Merseyside Pension Fund tells Nina Röhrbein how the scheme’s philosophy affects its investment strategy

The 121,000-member Merseyside Pension Fund is the local authority pension scheme for public sector workers in the metropolitan county of Merseyside, in the north-west of the UK. However, it also includes employees of companies that have made admission agreements with the fund - in other words, private companies to which the local government has outsourced work, such as bus companies.

The philosophy behind the scheme is a willingness to accept volatility and the belief that illiquidity leads to outperformance.

“This philosophy obviously has an influence on our investment strategy,” says Peter Wallach, head of the pension fund. “We have always held that approach but made it more explicit in the recent past. Nonetheless, we do have a fairly typical asset allocation for local government pension funds in the UK.”

The pension fund’s strategic benchmark is split between 79% risk assets and 21% lower risk assets.

The latter contains 12% in index-linked government bonds, 4% in conventional government bonds and 4% in corporate bonds plus an element of cash. The corporate bonds are mainly investment grade but their managers have some scope to move outside that range if they see any opportunities.

The risk assets hold 55% equity, 10% real estate and 14% alternatives. The alternatives, in turn, include 5% hedge funds, 4% private equity, 2% infrastructure. The remainder is made up of a so-called opportunities portfolio, which contains short-term investments as well as a few long-term assets.

“The opportunities portfolio is where we invest in anything that we feel is interesting and appropriate for the fund,” says Wallach. “At the moment it holds, among others, senior secured loans, investments in timber, clean energy and waste/recycling.”

In recent years, the scheme’s strategic asset allocation has, remained relatively stable, although the managers of the bond portfolio took advantage of the financial crisis by tactically boosting corporate and reducing government bonds.

Nevertheless, there have been two fundamental shifts - a move away from UK to overseas equities and a move away from equities and bonds to alternatives.

The UK share of the equity portfolio has fallen from 36% in 2004 to 30% in 2007, to 25% in 2010, in favour of overseas equity, which currently stands at 30%.

However, UK equities might not be reduced much further, according to Wallach.
“We are not a fund that has embraced global mandates,” he says. “We are comfortable with our regional and geographical asset allocation and feel that by selling into foreign markets, large UK companies, in particular, have significant overseas exposure anyway. However, it is something we keep under review.”

The overseas share of the equity portfolio includes a 6% weighting in emerging markets - up from 4% in 2007 - and various regional mandates to Europe, the US, Japan and Pacific ex-Japan.

“The reason for selecting regional rather than global mandates is partly historical and partly because we feel managers of regional mandates are more likely to go down in market cap to more mid-cap companies where we feel there is more opportunity for them,” says Wallach.

Across the portfolio, the pension fund has opted for a more passive approach in developed and efficient markets, so while its US exposure is fully passive and the UK exposure a mixture of active and passive, other markets have fully active mandates.
Two-thirds of the total portfolio is externally managed. However, with the help of advisers the fund manages some UK and European equities in-house, as well as some of the alternatives.

Merseyside Pension Fund owns about 28 properties in the UK - with a slight clustering in the Merseyside region. This means that the majority of its property investments are undertaken directly. This is supplemented with a number of property funds to create some indirect exposure to overseas or niche sectors. “This gives us a diversified real estate portfolio in terms of property style and use, as well as geography,” says Wallach.

The pension fund has been investing in private equity for 15 years and in hedge funds for about 10 years, although in the past the scheme did not have a separate allocation to alternatives other than to private equity. Instead, hedge funds were included in the equity portfolios.

“Fortunately, there was no pressure on us during the financial crisis to reduce any of our illiquid assets as we were still cash positive during that period,” says Wallach. “It also turned out to be the right thing to do when markets started rebounding.”

He anticipates that the 14% alternatives exposure will continue to increase in the future due to the attractiveness of real assets in an environment with potential inflationary pressures.

“There is scope for investment in areas such as infrastructure, timber, farmland and other real assets, which potentially match the dynamics that the pension fund is looking for,” he says.

The scheme’s asset allocation is reviewed on a quarterly basis. Formal asset liability management studies are part of the triennial valuation, which is typical for UK local government schemes.

Merseyside Pension Fund uses a framework of consultants and when it comes to manager selection the scheme chooses consultants that it believes have a particular knowledge of the asset class in question. It also works with consultants in setting the quantitative and qualitative criteria used for the screening of managers.

“This makes us aware of managers that traditional consultants would perhaps not put forward although, naturally, we still use an open tender process,” says Wallach. “We also undertake some style analysis on the managers to give us a bit more information about the way they manage their money.”

Since the financial crisis, the pension fund has placed a much stronger focus on risk management - particularly with regard to counterparty, liquidity and reputational risks - and makes additional use of advisers for the management of those risks.

“In terms of reputational risks, we try to make sure that we communicate better,” says Wallach. “It is a matter of being open and transparent and explaining why certain things have happened and what we are doing about them.

“Clearly there are pressures on us to make sure that we manage our assets efficiently. We are waiting to see how the government consults on and implements Lord Hutton’s recommendations, because those have potential ramifications for the fund in terms of its maturity profile and future cashflow. While we have always had a focus on the assets, I think ourselves and other funds will in the future have a greater focus on our liabilities and ways to manage those better.”

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