One of the major changes in pension fund investing in the last twenty years has been the growth in use of equities and benchmarks to measure their performance. In an inflationary context, bonds were a poor match, and with pensions linked to growth in earnings, equities came into fashion as the better match for pension fund liabilities. Indeed, even those countries initially reticent to the lure of equities began to increase their weightings in the years of the technology bull run. Once the genie was unleashed, there was a ‘race’ to higher equity weightings in portfolios. Index linked gilts were launched as a natural “safe haven” asset for pension funds but were studiously ignored. In the roaring bull market fund managers and clients alike wanted the highest equity weighting and the highest equity relative performance against the index. Positive absolute returns and the “good match for liabilities” became taken for granted, just at the point they became less reliable.

Thus the scene was set for the madness of 1999, when the index funds chased limited free float companies, with tiny revenue, let alone profit, from the ridiculous to the unsupportable in valuation terms. Ultimately, this hubris was followed by the nemesis of a bear market in equities. Coupled with rapidly expanding forecasts of life expectancy, a heavy blow was dealt to pension funds. No surprise then that many schemes are going back to their fundamentals and are examining their liabilities more closely, concluding that what’s right for the mythical average scheme is unlikely to suit them individually.

As we move to the world of liability-led investing and scheme specific benchmarks, what then is the role of equities? In seeking to answer this, we must recognise that riskless return is sadly rather hard to find, whilst returnless risk has been all too common. Risk, as measured by volatility of returns, is inescapable in pension funding, but the nature of the risk which became obscured in the 1985-2000 period, was the risk of failure to match liabilities. This is now being much more closely analysed, and instruments capable of exhibiting close matching of liabilities are now available over fairly long term horizons. The risk budget of a fund reflecting maturity profile, solvency position, contribution rates, covenant of the sponsor etc. will be used to determine the degree to which assets should be closely matched to liabilities and whether there is any role for ‘risk’ assets such as equities (now seen, as an asset class which is a poor match for liabilities) in the mix.

Let’s deal with equity risk first. As we have alluded to, risk in a liability-driven context is the risk of not being able to deliver against a scheme’s liabilities. While tracking error is an important consideration in an index relative approach, because it endeavours to control risk against the benchmark, in a liability context what does this actually achieve? The answer is “not much”! If one assumes that the risk of equities is 15 per cent relative to liabilities, and the tracking error of the portfolio is 2 per cent., then the actual risk of the portfolio relative to liabilities is approximately 15.1 per cent. This is because the risks do not add up linearly. This swamps any considerations associated with tracking error. In liability-led investment terms, it is the decision to invest in equities that is important and not the decision to invest passively.

So if there is little risk benefit from investing passively, is there return upside from investing actively? Clearly any return will rely on a fund manager blending shrewd judgment with skilled risk management to deliver performance. As with all areas of human judgement there are no guarantees, for either the fund manager choosing the right stocks, or the trustee choosing the right fund manager. A manager or team with proven skill, measured by their information ratio, will do better with as many opportunities to display that skill as possible: i.e. to allocate active money to positions in stocks they have conviction in. Country specific indices such as the FT All-Share will limit the “active money” budget, representing a sub-optimal use of the “investment capacity” of the portfolio: an “inefficient” use of capital. Indeed in the FTSE All-Share the weight of the top five stocks has more than doubled over the ten year period to 31st December 2003 to stand at 31.9 per cent. This level of concentration raises concerns about the degree of diversification that the index is really offering. When momentum in these ‘Large’ stocks abates, the case for active management is stronger: according to the Russell/Mellon survey 2003 represented the fourth consecutive year of outperformance by the median of the FTSE All-Share index. If this were not enough, passive strategies do not allow an essential strategy for capital preservation, which is to sell a stock when corporate governance issues suggest a sale would be prudent.

Against this background, an active portfolio with an unconstrained mandate may represent a more efficient way of capturing equity return. These fall into two camps – “Focus” funds and “diversified unconstrained” portfolios. Focus funds are typically not as diversified as traditional active approaches with the number of holdings for a regional mandate normally being below 25, perhaps 15 or so. A diversified unconstrained portfolio might hold 40 stocks. The focus approach will usually have higher absolute risk and volatility than the broad market, while the “diversified unconstrained” will be about the same. While traditional indices can be used for benchmarking purposes over a 3-year period, short term relative performance volatility is likely to be high since no account of index weights is taken into consideration for portfolio construction purposes. Thus tracking error is rendered meaningless. Instead the investment horizon is perhaps longer than for traditional benchmarked funds. Typical investment parameters would stipulate that there would be an element of sectoral diversification and no more than 10% of the fund in a single issuer.

The appeal of the unconstrained approach is that in addition to eliminating preoccupation with benchmark weights from a portfolio construction perspective, it necessitates high conviction investment: only companies that are believed in are owned.

The nature of unconstrained funds heightens the impact of the fund manager’s skill. Sadly, there is no “holy grail” or magic ingredient to ensure investment success: instead it is down to skill to appraise company fundamentals and evaluate the prevailing share price. Thus teams and individuals will emphasise the valuation techniques that work for them. A key element is for the team and individual to remain impervious to market noise to ensure command of the dynamics affecting individual company positions and of the factors (e.g. sectoral) that are at work across positions. Manager selection does therefore require a degree of skill, time and cost, but should be an exercise which repays the effort. The key is to find a team where ideas (best generated in very small groups) spread rapidly, but with due consideration, across portfolios.

The attraction of the unconstrained approach is the knowledge that the fund manager’s sole aim is to deliver absolute return with no dilution of insight being inadvertently created by tracking error or relative return considerations. This is also, of course, a powerful motivating factor for the fund manager. Long term performance fee structures can further cement this partnership.

Unconstrained funds are therefore worthy of consideration once a pension plan has already decided to invest in equities. In isolation, the unconstrained approach does not increase links to liabilities. Instead, it ensures that once the decision to invest in equities is made, the appointed manager can “get the most” out of the equity allocation by not compromising investment conviction. Individual manager skill is paramount, but in an equity return environment that is likely to be more subdued going forward, it seems vital, in a liability led context, to empower the active fund manager appropriately. So, while passive management would appear to provide risk against liabilities without any alpha generation, a well managed, unconstrained, actively managed equity portfolio should deliver helpful returns to pension funds in today’s tougher environment.

Alex Popplewell
Business Manager
UK Core Equity Team
+ 44 (0)207 743 2659