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Risk and Portfolio Construction: Beefing up the midfield

Portfolio construction may have become much more erudite since the dark days of the financial crisis, but many pension funds still prefer the barbell approach of equities or growth assets and bonds which provide a hedge or match liabilities. 

There is a move towards a more holistic approach that includes assets with exposure to both economic growth and interest rates – but for various reasons it is more of an evolution rather than a revolution.

Despite much comment around how the benefits of diversification disappeared during the financial crisis, it is precisely seeking extra diversification that has been the movement that has gathered the most steam over recent years – not least because the markets and the financial industry offers investors a much greater choice of risk exposures today than they did seven years ago. 

Fixed income and equity investments offer much more granularity in themselves, but in addition the range of alternatives and multi-asset class solutions has mushroomed. Unconstrained investing has also attracted a large following with traditional fund managers pursuing hedge fund-like strategies. 

Midfield assets

The main drivers not surprisingly emanate from the fallout of 2008 – an ultra-loose monetary policy combined with negative real interest rates and a range of unsolved economic issues. These have all left pension funds with the challenge of generating positive real returns while reducing funding level volatility, according to an asset allocation survey conducted by Mercer. This has led to an expansion of the tool kit, adoption of more dynamic strategies as well as injecting scenario and stress test analysis into the risk management process.

The foreshadowing of rising interest rates could be the next catalyst – although right now few investors seem to be taking the threat too seriously. For example, a recent survey of over 50 pension funds in the UK and Ireland conducted by Pioneer Investments showed that the majority do not foresee bond yields rising dramatically any time soon – with the majority predicting 10-year Gilt yields to be in the 2-3% range at the end of the year. This is in contrast to the market consensus of 3-4%. The view is that the spike will not occur until the second half of 2015 when the Bank of England (BoE) is expected to raise the overnight lending rate.

At its May 2014 meeting the BoE voted to keep interest rates at 0.5% and its bond-buying programme unchanged at £375bn (€460bn) – although an overheated housing market in London and the south-east, combined with a stronger than expected economy, could mean a hike later this year rather than next. If that is the case then the Pioneer study notes that a typical pension fund could lose up to 11% if rates rise by just 1%. This should light a fire under the 45% of respondents who said they did not have a game plan in place to protect their portfolios. A different set of instruments would need to be deployed in this environment should investors want both to match liabilities and generate returns, although few expect it to be a game changer to the way portfolios are built. 

“There have been gradual changes in the way that pension funds construct portfolios, but we have not witnessed a wholesale shift,” says Phil Edwards, European director of strategic research at Mercer. “We are seeing two broad approaches emerge – one that continues with the traditional divide and moves from growth to matching assets as the pension fund matures, and a second which adopts a three pronged approach, with growth, income-focused and matching portfolios.

At a glance 

• There is much more diversification available from financial markets, securities and products today than there was before the financial crisis.
• The expansion of the toolkit comes in response to the challenge posed by negative real interest rates to often-underfunded institutional investors.
• The prospect of rising interest rates could be another catalyst on the horizon.
• While adaptation has been gradual, some investors have started to include ‘income’ assets in-between the pure return-seeking and risk-free portfolio components.
• These are often real assets, long-dated, with an inflation link wherever it is available.
• LDI and other unfunded liability solutions help by freeing-up more capital for greater diversity of return-seeking assets.
• Nonetheless, even some investors that are deploying these alternative assets continue to categorise them within the return seeking/liability-matching framework – which may not be the best approach.
• Ultimately, the distinction may be a simple one of size and governance budget.

“The growth portion is focused on return-seeking assets like equities, hedge funds, high-yield credit and private equity; while the income-focused component includes real assets such as low risk property and infrastructure. The matching assets, which typically consist of Gilts and derivatives, are focused on controlling inflation and interest rate risk.”

“If you look at the defined benefit world, there is still a heavy exposure to equities and traditional fixed income but we are seeing an increase to what we call ‘midfield assets’ that fit in between the two,” Fiona Southall, pension investment specialist at AXA Investment Managers, adds. “They are typically long-dated and often inflation-linked cash flows such as infrastructure, social housing or long lease funds. They enable pension funds to hedge their liabilities while providing a higher yield.” 

Integrated

Bill Street, head of investments for EMEA at State Street Global Advisors, also believes pension funds need to be much more forensic in their analysis of liabilities. 

“I definitely see a heightened awareness about using more sophisticated tools to neutralise liabilities which then releases more of the risk budget for growth assets,” he says. “However, to-date, the awareness is higher than the application. As with liability driven investing, it will take time for pension funds to become comfortable and I do think this type of investing will be the path of the future.”

Street advocates a flexible, diversified asset allocation approach that employs target volatility triggers that are adjusted over time to ensure that the assets are suitable for a pension fund’s flight path. 

For example, the need for protection against market volatility rises as the end game nears. It would also include market regime indicators that monitor market conditions and assess multiple risk factors in order for the portfolio to be rebalanced in order to capture opportunities for growth and minimise downside risk.

Rafael Silveira, strategist at JP Morgan Asset Management notes that splitting the portfolio between hedging and growth assets remains popular. 

“Pension funds are investing in a wider range of asset classes but still putting them into these two different buckets,” he observes. “However, I would argue that a holistic approach is a better way to optimise. Instead of looking at two different matrices, plans should take an integrated approach that accounts for each asset’s exposures to different factors such as volatility, duration, liquidity and interest and inflation rates. By looking at these different components you can build more diversity into the portfolio and use hedging instruments to provide liquidity when the growth portion may lack it.”

Sorca Kelly-Scholte, managing director, client strategy, at Russell Investments agrees. “The compartmentalising of strategies is less efficient today because it excludes a range of assets and strategies that are in the middle ground,” she says. “We believe that pension funds need to look across the spectrum and the different risk return characteristics across the portfolio. Although these will differ, there are two to three common themes that we have identified such as taking a non-directional view which could mean assets with low duration such as loans and asset backed securities that are not sensitive to interest rate moves. There is also tactically buying puts on equities to help manage the downside.” 

Rethink

One of the challenges of these strategies is that they are skill-based, potentially complex and expensive. 

“We do see this sentiment but if you follow that and retrench back to liquid equities and liability matching then there is possibility of greater volatility and that can be a greater cost to investors,” says Kelly-Scholte. “The benefit of a skill-based process is that it not only generates alpha but can help to manage the overall volatility within a portfolio.”   

Not every pension scheme can shoulder the cost. In general, a reconfiguration of portfolios will depend on the size, covenant strength of the corporate sponsor, funding levels, guidelines and governance structures. Typically it is the larger pension funds that have the in-house capabilities and deeper pockets that are able to forge a new path while their smaller brethren do not have the same resources. 

“Larger pension funds are the ones that are having the rethink,” says Saker Nusseibeh, chief executive of Hermes Fund Managers. “The way we are seeing smaller pension funds approach it is they will invest, for example, in direct lending or real estate debt which has an inflation linked return with some form of income but within the barbell structure. A move from barbell to specific factors would require the retraining of trustees and many fund managers.”

The relative minnows of the pension world though want the same dynamism and flexibility but in a cost effective structure. That may explain why diversified growth funds (DGFs) and multi asset credit (MAC) have surged in popularity since 2008. MAC strategies, though, have seen their collective star wane over the past year as spreads have compressed. Value can still be extracted but the pickings are not that easy as in the past and institutions will have to set their performance sights lower.

DGFs are still held in high regard, with many pension funds using them as part of the core growth strategy. They are not new but the list of alternatives that they can and do hold continues to grow, ranging from hedge funds to private equity, loans, real estate, credit instruments, derivatives, fixed income and currencies.  

“Pension funds want to build all weather portfolios,” says Chris Redmond, global head of fixed income manager research at consultancy Towers Watson. “Pension funds have been building much more diversified portfolios and reducing their exposure to equities. However, one of the challenges is that if everyone pursues the same strategies and asset classes then the benefits erode, which is why managers and funds likely need to be more dynamic and mindful of valuation.”   

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