UK funds vote their allocations
Investment professionals from more than 65 UK institutions congregated to talk risk management and asset allocation at Watson Wyatt’s eighth Global Asset Study in London. Participants were split into teams, given a hypothetical UK pension fund and a specific risk budget, and instructed to select allocations to bonds, equity and alternative investments. Prior to strategic decisions, various speakers from Watson Wyatt briefed the tables, at which the delegates were sitting and voting from, and spelt out the consultant’s approach to the different asset classes.
Roger Urwin, global head of investment consulting, opened the meeting by saying that often the question of where to take risks is overlooked. That some pension funds run billions of pounds on a shoestring has encouraged this oversight. According to Urwin, key questions facing managers include the amount of risk to take and were to spend it. Changes to actuarial measures mean the minimum funding requirement/equity model approach is fading while FRED20 and the market value models are in the ascendancy, moves that should produce more accurate risk measurement.
So, when deciding the amount of risk, there are four determinants. First, the covenant of the fund – the stronger the covenant, the more risk is acceptable. Maturity also plays a part in risk allocation. “The longer the payout period and the period of accumulation, the more you can adjust and the more time you have to get your fund in shape, therefore the more volatility and risk you can take,” he said. Surplus funding enables greater risk taking and finally, and somewhat subjectively, is the trustees’ attitude to risk. When asked to choose the greatest determinant of risk, 31% of the audience listed the fund’s maturity, 28% the surplus in the fund, 24% the covenant and the rest, the trustees’ discretion.
Tables were given a straightforward £1bn (e1.7bn) defined benefit fund to work with. Initially, the asset split was set at 30% bonds and 70% equities while teams were allowed to swap equity for alternatives during the afternoon session. Having set a specific risk profile, teams were asked to construct their portfolios, bearing in mind they were to be rewarded for both high returns and low risk – the aim being to maximise return while minimising risk.
Mary Kerrigan, senior investment consultant at Watson Wyatt, gave a talk on bonds and the consultant’s attitudes towards them. During the early 1990s, pension funds treated bonds as little more than an afterthought but, thanks to the increase in guaranteed liabilities and changes to the MFR and accounting standards, Kerrigan said bonds and their management have never received so much attention. They now form much of the bedrock of asset allocation policy for pension funds. “In order to reduce risk, funds have been forced to consider increasing their allocation to bonds,” she said. In 1990 the average UK pension fund held around 10% in bonds, recently this figure stood at over 20% and, according to Kerrigan, this trend is likely to continue.
Issuance of corporate bonds in the UK has doubled in the past three years and, given the UK government is running a budget surplus, the UK non-gilt market is likely to overtake the government debt market in terms of size. Consequently, funds are looking for other bonds – non-gilts and overseas bonds – as government issuance is falling, looking to make their bond portfolios work harder. The situation in the index-linked gilt market is particularly acute with a tiny issuance of £3bn in the UK this year. Although investors are piling into alternative fixed income classes, Kerrigan said that more emphasis is needed on ascertaining the risk associated with these alternative bonds and in understanding which non-gilts offer the best returns.
Questions facing the tables included how to structure the duration of the bond portfolio, whether to have an allocation to credit, other opportunities like overseas bonds and the allocation between index-linked and fixed interest bonds. Kerrigan stressed the importance of a portfolio’s duration suggesting a bond portfolio with a two-year difference relative to its benchmark has an annual tracking error of 1.3%. “This is something we think funds should take account of when setting their bond strategy,” she said. Obviously longer-dated and lower-rated bonds offer better returns but at a risk.
Developing the theme of benchmark selection, Nick Horsfall, a partner at Watson Wyatt, said: “the strategic aim should be to have a benchmark which is sensitive to both duration and credit”. Duration mismatch can be a risk and the shortage of long-term bonds puts great pressure on those wanting to match duration. Hence an inverted yield curve in the UK for high grade credit and gilts. “You’re giving up a lot of return for the privilege of duration matching, if you’re going to do that with high grade debt,” he said. “We believe that all pension funds in the UK who buy gilts, basically overpay for security and liquidity that they do not need... We want to develop a default position whereby a very large proportion of gilt holdings are transferred into triple AAAs.” He added that this step can cut the cost of meeting the benefit profile of investors by about 10%.
When it came to allocating the bonds none of the tables went for the most aggressive bond allocation and instead most opted for a relatively stable, middle of the road allocation. When pension fund representatives were asked whether the new FRED 20 accounting standards would affect investment policy, around half said not at all, 38% agreed it would in a minor way while 13% felt it would but not significantly so.
During the second session, Robert Hayes, responsible at Watson Wyatt for researching investment managers, briefed the tables before they picked their equity allocation. Appropriate levels of home bias were discussed. The UK is one of the most home-biased markets in the world, even more than the US which, after all, has performed so well. Concentration in the UK market is a serious problem and becoming more acute with the five largest companies making up 29% of the market. Furthermore, the UK sector bias does not mirror the world’s sector division and UK home bias inevitably leads to sector bias.
Jane Welsh, a senior investment consultant at Watson Wyatt, spoke about currency risk and the need to hedge, if at all. Currency management is difficult to describe to trustees and exposure to foreign assets has historically been small. There are also certain governance issues associated with currency hedging – the costs are significant, there’s the question of hedging actual exposures or benchmark exposures to currencies, managing cash flows can be complex and performance measurement can be tricky. Before the tables made their final choice, Welsh gave the Watson Wyatt position on equities. She said the group expected more and more pension funds to move to a 50:50 UK/foreign split. Some of Watson Wyatts’ clients are already on a 60:40 UK/foreign split and in the longer term the UK holding is likely to fall as low as 30%. Such reallocations are being driven by the MFR review and the euro, the introduction of which has blurred the notion of a domestic market.
With regard to currency hedging Welsh said the choice is highly subjective and depends on the individual pension funds. If you’re unconcerned about short-term volatility, for example, there’s no point in hedging. Furthermore, it’s only worth hedging the low-cost currencies but if, as appears likely, pension funds increase their exposure to foreign equities, so they will have to concentrate more on hedging.
Hayes then tackled the choice of overseas benchmark, a decision that can distort at the sector level and on a single company basis. As for global benchmarks, the fixed weight approach has served Watson Wyatt well, particularly as an interim step from the peer group measure. Free float is a hot topic in indexing at the moment and during the conference, Watson Wyatt stressed the choice of index is important in that it must be investable or, in other words, account for free float.
When the tables were given free rein to choose equities and the benchmark, 54% opted for a 30:70 split for UK/foreign equities, a major change from the present situation, 30% went for a full hedge on overseas equities while 53% plumped for a 50% hedge. When asked the appropriate structure of a benchmark for overseas equities, 55% went for fixed weight while 40% went for a market cap benchmark. When the choice was narrowed down to just the pension fund representatives, 66% went for fixed weight while 19% still preferred a peergroup measure.
In the third session, debate moved on to alternative investments including hedge funds, private equity and real estate. Steve Oxley, a partner at the consultants, laid out its approach. Alternatives offer higher returns than equities, albeit it at a higher risk, and also a return that’s uncorrelated. Hedge funds and, to a certain extent, real estate can offer positive returns while equities produce negative returns. Nevertheless, Oxley made a couple of caveats – investors need to be aware of illiquidity and opacity and alternatives also need a considerable governance budget. There is also a lack of regulation covering alternative investments; no insider trading rules, for example, for property and private equity.
However, equities tend to be more sensitive to global factors and are more volatile. Alternatives are therefore useful for diversification. Oxley said 15% in total, split equally between hedge funds, private equity and real estate, was an appropriate upper limit. Teams held mixed attitudes towards alternatives. One felt it was not possible to get sufficient rewards given the fees. There was also a feeling private equity has had a good run and that it’s a hot topic thanks to its track record rather than its own merits. Others felt there’s too much money chasing limited projects.
So, when it came to the tables allocating to alternatives, there was little surprise that 47% weren’t interested in private equity, while half said they would place between 2.5–5% in private equity. Overall, the tables were more bullish with over half of them voting to allocate between 10–12% of the overall portfolio to alternatives. When the choice was left to the pension funds only, the results were revealing. At present, 57% of the funds present have nothing invested in private equity and hedge funds. 14% have about 1% of their total invested in the two while 19% have between 1% and 5%. A mere 5% of pension funds have in excess of 10% invested in the two categories.
When asked what their allocation is likely to be in three years, 37% of the funds said they would like to invest between 1% and 5% while a third said they would raise their stake to anywhere between 5% and 10%. As a finale, the pension funds were asked what would prevent them from investing in alternatives. Some 39% said the governance budget would prevent them while a surprisingly high third said the risk budget would stop them investing in alternatives.