The old and the new
What goes around comes around. Pension funds’ rotation out of the old balanced style of asset management into specialist management has been one of the major developments in UK asset management over the past decade.
Yet a style of asset management has now emerged that some have termed ‘new balanced’. This is the liability led approach to institutional investing. At its simplest, liability driven investment (LDI) means that a pension fund matches its liabilities with government bonds and then looks for active risk either in fixed income, equities or alternatives to add a few percentage points to the liability benchmark.
The vogue for LDI has led to an interest in risk budgeting – deciding how to spend active risk. It has also led to the separation of alpha (manager skill) from beta (market risk).
To some observers, all this looks rather familiar, and they wonder whether trustees can be persuaded to buy ‘new balanced’ strategies when they have only recently been persuaded to move away from ‘old balanced’ mandates.
However, asset managers insist that the new is not like the old. The world has moved on, and pension funds now have a much larger opportunity set of both traditional and alternative investments - and the management skills that go with them.
Certainly the world has changed for UK pension funds. Between 70% and 80% defined benefit (DB) schemes are now closed to new members. Funds have a clearer idea of what their liabilities will be and how they can match them - principally by moving into fixed income. They also have a clearer idea that they need to make their fixed income work - to ‘sweat their assets’.
To do this they must take more active risk. Iain Lindsay, executive director Goldman Sachs Asset Management says the UK market is pushing for higher active bond risks than many parts of the world. “One reason for this is the high allocation to equities provides the capacity to take more active bond risk once diversification benefits are accounted for. The main motive however is the desire to make bonds work harder, not least as the active asset allocation to bond increases.”
Lindsay suggest that UK pension plans are reassessing the role of bonds in their portfolios. “In the days of balanced mandates, the plan sponsor was typically very focused on the equity allocation generating the returns with bonds included to diversity risk and afforded less attention as a consequence.
“Today the focus of attention is switching around. Bonds are now held in much higher regard with their strategic purpose redefined to make a much more significant contribution to returns than before.”
Awareness of risk is growing. Michael O’Brien, managing director European business at Barclays Global Investors (BGI) suggests one of the most significant developments on the UK pensions scene has been the switch from looking for returns to managing risk.
O’Brien says some plans merely want to minimise risk by taking out the two principal risks – interest rate risk and inflation risk. Cashflow matching will achieve this. In most cases, however, the trustees are not reducing risk but re-assessing it. “They are saying ‘assuming my current strategy, what risk is embedded there if I’m measuring risk against liabilities?’”
Pension funds are now beginning to consider such risk measurement tools as Value at Risk (VaR), for years the sole province of proprietary trading desks and insurance companies.
“Here you are saying how bad can it get one year in 20, and am I happy as a trustee to carry that risk? They then have to ask whether or not they are happy with that risk. If they are happy then the next question ‘am I spending my risk in an optimal fashion?’”
The traditionally high allocation to equities meant in the past most UK pension funds focused on only one risk – the equity risk premium. Now funds are broadening their focus to include all kinds of risk
Nick Watts, European head of investment consulting at Watson Wyatt, sees more interest in the sources and management of risk. “People are doing a lot more risk budgeting work which rightly identifies policy risk asset_allocation as the dominant source of risk in a pension fund.
“That led to a number of consequences. First, people are looking at the balance of the risk, ie, that being taken in manager space. This has given some funds a higher appetite for taking more risk in manager space. You could call that sweating the assets, but you could also call it a logical reaction to taking risk where it’s likely to be rewarded. And because it comes from an independent source, it doesn’t add to much total risk.”
Much of the new risk consciousness is driven by corporate plan sponsors as well as the trustees. Miles O’Connor, head of UK sales and client service at Schroder Investment Management, notes that corporate finance directors are now becoming more involved in discussions about the strategy of their pension fund.
This tallies with the approach of asset managers and investment consultants, he says: “In the main those discussions on strategy with asset managers are taking place with the full knowledge and support of the investment consultants because they recognise that in this environment the market place is getting more competitive, and that they shouldn’t be standing in the way of organisations that are seeking to provide new and innovative solutions to their clients.”
Watts at Watson Wyatt welcomes the involvement of corporate sponsors: “To bring the corporate sponsor into these sort of discussions on risk in the pension fund and where it should be taken seems wholly logical. People charged with looking after pension funds have improved their governance considerably over the past few years. However, the complexities of the issues have increased faster than people can keep up. To look at risk budgeting with the corporate sponsor who is used to concepts like Value at Risk is extremely helpful.”
Another advantage of involving finance directors in discussions is that they are likely to be familiar with exotic financial instruments. Joanna Munro, head of global consultant relations and head of UK institutional business at AXA Investment Managers UK says: “We have found that finance directors are themselves very comfortable using derivatives – 95% of the of 500 companies use derivatives as part of their strategy for managing their balance sheet. So these people who are now involved in discussions about pension fund liabilities find it very natural to use derivatives.”
In their efforts to match their liabilities more closely, pension funds have discovered a shortage of suitable fixed income instruments – for example with the right duration. Investment banks and asset managers have been quick to suggest a solution – structured product.
Structured products cannot solve the most significant threat to matching - longevity. Although some mortality and longevity bonds are available, the market capacity is small about £500m.
Yet one product that is currently attracting attention is the inflation swap, says BGI’s O’Brien. “A pension fund wants to build a portfolio that includes corporate bonds because they give you a good risk adjusted yield enhancement. But it needs a lot of inflation cover and the physical corporate bond market won’t cover it.”
Inflation swaps offer two ways to provide inflation cover. “One is to buy a portfolio of investment grade sterling corporate bonds and do an inflation swap across it. Here the pension fund agrees to pay say 2.5% compound each year and receives whatever the level of inflation is each year.
“The other way is to buy index linked gilts and sell credit default swaps (CDS) to take on corporate risk. By selling CDS’s on to a portfolio of index-linked gilts you get a synthetic index linked corporate bond fund.”
However, O’Brien warns that although swaps are simple in theory they are complex in practice. Pricing a swap is a particular problem. “An investment manager doesn’t want to take the price the investment bank offers because of the duty of care and best execution. How can managers demonstrate they are doing best execution if they personally cannot test the prices banks have given them?
“As a result asset managers are forced to build pricing models to price these swaps. And that’s been quite a high barrier to entry for a lot of asset managers.”
The trend away from balanced to specialised management in the UK continues. As an indication, the number of mandates awarded by Watson Wyatt’s clients to multi-asset managers fell 41% from 33 to 19 last year. The main beneficiaries of this trend were enhanced indexation and alternatives managers.
The trend is towards ‘target specific’ as well as asset-specific mandates. O’Connor at Schroder IM says: “It is far more usual now to see both asset class specific and target specific mandates being tendered in the market place by the major investment consultants. In the area of UK equities, for example, even for core mandates we are just as likely to be approached specifically for a benchmark plus 2 targets as for a specialist mandates plus 3 or 4 targets.”
The change is driven chiefly by investment consultants, he says. “Potentially this change reflects the evolution of the thinking in the investment consultant community. They have undoubtedly over the last couple of the years worked with their clients to move out of balanced mandates into scheme specific benchmarks and then used a variety of asset class specific managers for mandates to build a portfolio.”
Another broad and continuing trend in the UK asset management market has been the move from relative to absolute returns. Last year UK pension funds advised by Watson Wyatt awarded 16 absolute return mandates to fund managers more than double the number in 2002.
There is also a taste for longer term mandates. Watson Wyatt UK clients have awarded 11 ten-year mandates to investment managers since October 2003 Watson Wyatt introduced the concept of ten-year mandates, a ‘liability plus’ type mandate, as a way of seeking performance in an investment environment that has become too influenced by short-term benchmarks.
Watts of Watson Wyatt says: “What has come through to people is that capital markets benchmarks have served a purpose, particularly when most of your risk is in the equity risk premium anyway. But we as an industry have become their slaves rather than their masters. Significant pension fund deficits and the low return environment have forced the industry to re-think this approach, resulting in an increased appetite for absolute return mandates among pension funds.
“There is a recognition that not all money should be managed on a traditional benchmark basis and also an acknowledgement of short-termism in the industry. The combination has produced significant demand from pension funds for long-term, absolute mandates, which in turn has created demand for different types of investment manager.”
From the asset managers’ perspective, liability benchmarks are a central rather than marginal development in pension fund business. Vincent de Martel, a director in the structured and alternative investment management division at AXA IM UK, says liability driven benchmarks are now becoming the norm in mandates. “This is rapidly becoming a new standard. The degree of accuracy of these liabilities benchmark is varying from one scheme to another, but definitely we are seeing a lot of clients trying to actually know what their liabilities are doing.
“This is something new because until now more or less liabilities were considered a fixed item and not one which was actually moving and one which you could influence.”
Martel suggests that one reason that the move to liability benchmarks may appear less significant than it is client confidentiality. To benefit from ‘first mover’ advantage, pension funds may not want to reveal what they are doing.
Asset managers are also advocating adding alpha - manager risk - to market risk (beta), the so-called portable alpha strategy. Peter Hunt, executive director, head of UK business development at Fidelity Pensions Management, says pension funds are looking to bolt on some active returns to their liability-matching strategies. “Once pension funds have covered their liabilities there is a growing demand for higher returns from the active part of the portfolio that’s on the table. Active must mean truly active so the traditional core, low tracking error 1% type mandates are therefore in decline.”
Hunt sees a growing polarisation between alpha and beta strategies. “Enhanced index and passive managers are picking up assets to manage purely to capture the market return, while the active managers are being asked to consider higher active mandate types.”
Portable alpha strategies enable pension funds to get the benefits of equity stock picking without being exposed to an equity market risk, says Munro at AX IM: “We will have a benchmark that relates to their liabilities, perhaps index linked gilts, and then we’ll try to beat that benchmark by 2% or 3%. We do that by looking very broadly across the range of potential alpha sources that we have - hedge funds, or some long only bond or equity funds where we have removed the market effect.”
Alpha, in most people’s minds, means hedge funds. At its most extreme, the separation of beta from alpha, market risk from manager skill, would mean adding a hedge fund to an index mandate.
Some pension funds, such as Railpen and the BT schemes, have been happy to hitch their wagons to hedge funds. Yet many trustees are worried about investing in a skill set they know so little about.
O’Brien at BGI suggests that one way of reassuring trustees is to point out that they are already invested in hedge funds to some extent. “Their long only equity portfolio is effectively an index fund with a long-short fund - which is a form of hedge fund - embedded in it. The only difference is the short positions that can be taken are constrained by the index position.
“Trustees are beginning to realise that taking away the shorting constraint frees up a lot more access to manager skill.”
Yet they remain cautious about long-short strategies and are more likely to free up strategies with a long only basis. The renewed interest in tactical asset allocation (TAA). TAA fell out of favour in the 1990s, chiefly because it destroyed rather than created value. Yet the reason TAA failed was because of the narrowness of the bets managers could put on. “If all you held in a portfolio was UK fixed income, UK equities, Japanese and European equities you had to have an awful lot of skill to make that work.”Pension funds have other options besides fixed income strategies and LDI.
They could improve their returns simply by broad asset allocation, says Munro at AXA IM: “Typically UK pension funds are relying on the equity risk premium to deliver their excess return over the long term. We’ve recently done a study that shows that by simply broadening out your asset allocation to include some of the credit asset classes, private equity and property, these pension funds could improve their return by about 75 basis points annual return without increasing their risk.”
O’Brien of BGI suggests the next move by pension funds will be into diversified portfolios, “We are going to see a move to more diversified portfolios with a higher tolerance for a wider variety of strategies - private equity, hedge funds, commodities and property as soon as they can get at it in a more liquid fashion.”
One model for this diversification is the endowment model, typified by Yale and Harvard, in the US, says Fidelity’s Hunt: “Yale and Harvard endowment run the assets for the colleges and they have been probably more progressive than pension funds in terms of their asset allocation across different types of asset classes.
“Consultants are now picking up on this and are looking at how it might work in the context of pension scheme investment here too.”
Pension funds’ demand for more diverse mandates could challenge the traditional approach of UK asset managers to mandate design, says BGI’s O’Brien: “In our business, the way we make money is through scalability, particularly on a pooled fund basis. Right now if five pension funds come in and ask for an active equity mandates the chances are those mandates are going to look and feel the same.
“What we’re going to see going forward is that pension funds will have greater degree of tailoring and specificity of their requirements. We’re going to have pension funds that will look very different. That will be a challenge because we’re going to have to build a business that’s not going to have this very blunt scalability.”
Many asset managers have set up units to respond to this demand. Some of these units, such as AXA IM UK’s team, were already in place servicing the group’s insurance needs. AXA IM UK’s Martel says: “We had been doing asset liability management using derivatives for our parent company since 1997, mainly for insurance companies. But we think that asset liability management in pension funds is becoming very similar to what you can see in other institutions, and we felt that the market was now right to accept these strategies in a broader sense.”
The extent to which concepts like LDI are adopted by UK pension funds will depend largely on the attitude of the trustees. The Myners report, and the UK government response to it, places a new standard of care on trustees where they choose to take investment decisions, and this implies a willingness to consider a wide rage of investment options.
Pension funds now expect their asset managers to bring their trustees up to speed. O’Connor of Schroder IM says there is now more demand from clients for help in trustee training. The need for such training has increased with the move by any funds to diversify their assets “We are seeing far more trustee training as an integral part of the widening of the investment universe that trustee bodies are looking at.
“As trustee bodies move out of a comfort zone in terms of conventional investment products we increasingly have to work harder with them to help them increase their understanding of the alternatives.”
Derivatives pose particular problems to trustees, says Munro at AXA IM. “The trustee community tend to be uncomfortable with new things. So in the sense that derivatives are new to pension fund management there is a hurdle that the trustees have to overcome to get comfortable with them.
“Education is the key, and we work with pension funds and consultants to get trustees comfortable with the concept of swaps.”
Trustee education would also do much to dispel the perception that asset managers are trying to sell something old dressed up as something new. And if they are, trustees will be in a better position to judge.