October, 2012 Print
Matthew Craig, LAPF Investments.
Weak growth and very low interest rates in the developed world have been described as “the new normal”. This implies that investors need to adapt to changing conditions, with Europe and the USA struggling to reduce government debt levels, and emerging markets increasing in importance, but with plenty of ups and downs on the way. For many investors, one consequence of these changes is disenchantment with equities. The move out of equities can be seen in the report Pension Fund Indicators 2012 from UBS Asset Management. This shows the average UK pension fund having between 40% and 60% in UK equities from 1962 to 2000, but now less than 20%. Exposure to overseas equities has risen over the same period from zero to around 25%, but the overall equity allocation has fallen from a peak of over 80% in the early 1990s to less than 50% now. While the move away from equities is understandable, many pundits now see equity valuations as compellingly low. Fidelity global CIO for equities, Dominic Rossi, said he is now cautiously optimistic for equities: “Investors have poured into the safe havens of fixed income, pushing yields on US and German bonds to record lows. Yet, as time has progressed and doomsday scenarios have been avoided, equity markets have switched out of panic mode, and grown accustomed to the possibility of a Greek default and Spanish and Italian bailouts. In my view, these risks are now largely factored into valuations. The tide is beginning to turn for equities, and historically when such a turning point is reached markets can move ahead strongly.”
Another reason for a move out of equities is a shift towards liability matching. In the corporate sector, scheme closures and increasing maturity have caused a widespread shift to liability-driven investing (LDI), with large allocations to fixed income assets which better match liabilities. This trend is less evident among local authorities where 89% of local authority funds have less than 30% of their assets dedicated to liabilitymatching. There are one or two exceptions such as the London Pension Fund Authority, which runs an LDI portfolio to cover the pension liabilities of the old Greater London Council. On LDI, there is an argument that the very low interest rates available at present make government bonds an unattractive investment. John Jones, who is an interim finance director for local authorities, commented that the yield on a recent German Bund issue was so low that with inflation, investors are effectively paying the German government to hold their money. He added: “On the liability side of the equation, interest rates are 0.5%, bond yields are very low and that makes the valuation of liabilities worse. People are in a tight spot and are responding to that with more diversification in order to achieve returns.”
Marc Haynes, a director at Greenwich Associates, commented on the overall shift among UK funds: “Equity allocations have come down. There has been a drop-off in domestic equity allocations for some time and now, for the first time, we are seeing a drop-off in international equities. Defined benefit funds, particularly in the corporate sector, are moving from returning-seeking and into fixed income as they de-risk.” For some, a move away from UK equities, with a rise in international equity allocations is seen as a good thing. Jones commented: “We need to adapt to a more global outlook; we are very UKcentric and people in other countries have a different view of the world. I certainly think we should be looking to try and identify which markets will be growing and looking at macro themes.” This does not necessarily mean higher allocations to emerging markets, Jones said, but also investing in companies that can access them. He added: “We need to understand the risks and downsides of that. Investors in emerging economies need to ensure that they can get their money out, if they need to do so. That partly comes back to the asset managers and their relationship with them, but overall I would suggest that local authority funds need more diversification, more unconstrained mandates and a more global outlook.”
Another trend is an increase in alternative asset allocations at local authority funds, up from a negligible level in 2006 to 7% in 2012. Over the next three years, Haynes said that local authorities expect to cut equity allocations further, and increase allocations to infrastructure, diversified growth funds and absolute return funds, as well as private equity and real estate. As an example of these changes, a source close to the London Borough of Ealing Pension Fund said it is planning a major review of its strategic asset allocation, as it currently still has 70% of its assets in equities. “It is going to increase its property allocation to 10% at the expense of equities and it is considering a greater use of alternatives, such as an opportunities bucket, possibly infrastructure and possibly hedge funds,” the source commented.
Infrastructure is currently attracting a lot of interest among institutional investors, as the need for long-term, stable, inflation-linked incomes that infrastructure may be able to generate is matched by the need among governments to find new sources of finance for desperately-needed new infrastructure projects. At present, there are proposals for a Pension Infrastructure Platform, or PIP, being formulated by the Pension Protection Fund chief executive officer Alan Rubenstein and National Association of Pension Funds chief executive Joanne Segars. It is envisaged that this platform would bring together institutional investors seeking suitable infrastructure assets; returns of inflation, as measured by the RPI index, plus 4-5% have been mooted, with low charges and long-term infastructure investment. Some local authority funds have indicated that they are interested in this project, while others feel that they already have adequate infrastructure investments. One attraction of PIP is that it should give a better alignment between the interests of investors and the end investment product, as opposed to a private equity mindset for infrastructure, where funds are geared up in order to raise returns to justify high manager fees, with assets sold on rather than held for the long term.
If local authority pension funds move to a more diversified investment approach, this may mean that asset allocation needs to become more dynamic. After all, if assets are invested mainly in bonds and equities, then a strategic asset allocation can remain in place for some time with little change. As more assets are added to the mix, there are opportunities to boost returns by tactical switches to take advantage of market movements. For local authorities, this could be a challenge. Jones commented: “One of the problems local authorities have is quick decision-making. In my view, local authority funds need to talk to managers and ask how can we work best with our existing managers? The other approach is to think of more unconstrained mandates, to give managers more discretion to invest.” One obvious area for broadening mandates is in fixed income, where investors can permit their managers to hold more corporate bonds and credits in order to get more returns, although this in turn means a move up the risk profile.
Local authority funds may need to review their use of derivatives if they wish to use dynamic or tactical asset allocation techniques, as it is easier and cheaper to make adjustments to the asset mix through futures and overlays than by physically buying and selling securities. Another issue is how more illiquid assets, such as commercial property, private equity and infrastructure, are handled. Listed funds for these assets may give more liquidity but at the price of greater volatility. A move to more complex asset allocation structures could then drive the debate about scheme mergers among the local government pension scheme members; larger funds should have greater resources and governance budgets, enabling them to use slicker asset allocation techniques. Against this, diseconomies of scale may apply if funds become too large and the governance model of local authority funds may prove hard to upgrade significantly.
All in all, there is no doubt that local authority pension funds will look very different in 10 years’ time than today, in terms of asset allocation. We can expect to see greater diversification, with a wider range of assets held, as schemes seek to avoid the worst excesses of an uncertain world, while gathering in returns which will help them survive.