April, 2016 Print
Matthew Craig, LAPF Investments.
As the launch of the new LGPS super pools begins to draw closer, Matthew Craig looks at the opportunities for local authoritiy pension funds
Not many years ago, most pension funds had similar investment strategies. In most cases, allocations to equities and fixed income were the main pillars in the 60:40 asset allocation model, named after the relative proportion of equities to bonds. Equities were seen as a powerful source of long-term growth, while bonds provided stability and income. Other asset classes, such as real estate, could also play a role, alongside equities and bonds.
When implementing a mix of equities and bonds, pension funds in the UK traditionally had a relatively high weighting to equities compared to other countries. For example, in 2001, the average UK asset allocation to domestic equities was 46%, with 25% in international equities, giving total equity allocation of 71%. This compared to 59% in the USA, 63% in Australia, 49% in the Netherlands and 35% in Switzerland. 2001 saw a boom in technology stocks which drove up valuations, and since then equity allocations have fallen, due to equity market crashes and greater diversification by pension funds. So by 2013, the average allocation to equities at UK funds was 46%, less than the USA (52% in equities), Australia (63%), but still ahead of the Netherlands (35% in equities) and Switzerland (30%). Still, compared to corporate funds in the UK, LGPS funds usually have a higher equity allocation. Data from the LGPS Scheme Advisory Board show that local authority schemes had 63% in equities as at March 2014, compared to 36% for corporate funds. One consequence of a higher equity allocation can be higher returns, and local authority funds outperformed corporate funds by 2.6% in 2014, although there is less difference over five and ten years (0.9% and 0.1% respectively). In its commentary on the trend away from equities, UBS Asset Management stated: “A recent report from Mercer suggests that the move out of equities is slowing due to improved market sentiment so we might expect to see the equity allocation levelling off over the next few years.”
For local authority pension funds, the triennial valuation plays a key role in determining the investment strategy, as it measures the funding level. Ideally, a pension fund would be fully funded, with assets covering 100% of liabilities. In practice and for various reasons, the local authority pension funds in the UK are underfunded, with an average funding level of 79% across the LGPS funds in England and Wales at the end of March 2013. Increasing life expectancy, lower expectations for future returns and low interest rates are pressures on funding, so LGPS funds face a significant headwind as they design investment strategies for the future. The latest triennial valuations were due at the end of March 2016, with the results to be announced later this year. In the past, these valuation results would be a key factor for updating LGPS investment strategies, but the move towards asset pooling, with the creation of a small number of £25+ billion asset pools will significantly change the design of LGPS investment strategies. It is too early to know in detail what asset allocation will look like in the new asset pools, but there are some signs of what we can expect.
One key consideration for the new LGPS funds will be an increase in infrastructure investment. Chancellor George Osborne has driven reforms in both pension taxation and also the LGPS, with calls for greater investment in infrastructure. In the latest budget, the government said it had received proposals to combine funds to create a small number of British wealth funds. It added: “We will work with administering authorities to establish a new LGPS infrastructure investment platform, in line with their proposals, to boost infrastructure investment.” It should be said that many LGPS funds are already investing in infrastructure. To pick an example, Wiltshire Pension Fund decided to make a strategic allocation of 5% to infrastructure following an investment review in 2011, with the changes implemented in 2012/13. However, central government clearly wants to see infrastructure investment on a scale that will enable UK funds to take direct ownership of UK infrastructure assets. This objective dates back to the purchase of the HS1 high speed rail link from London to the Channel tunnel by Canadian pension funds in 2010; this alerted Whitehall to the lack of scale among UK pensions in comparison to some of the behemoths found abroad.
Another significant change with a British wealth fund approach may well be greater use of passive investment, or index-tracking strategies, particularly in equities. In the consultation on asset pooling, the government has called for passive investing to be used unless funds can show that the benefits of active management will outweigh the increased costs. And some of the first big mandates to be awarded under the new asset pooling approach have been for passive management, for example by the Welsh LGPS funds and also by the London CIV. Investing in a larger combined asset pool passively will invariably bring lower fees and this type of quick win is likely to be a feature for the new British wealth funds. It can also be argued that picking active managers that will consistently outperform is very hard to do.
But there could still be active equity allocations in the new funds. One option will be the use of high conviction equity managers, who aim to achieve high performance. Active equity managers could also adjust their fee structures for LGPS asset pools, with the use of performance fees if they achieve certain return targets and much lower, or even non-existent, annual management fees. One complaint with performance fees is that managers tend to “game” them, or to put it bluntly, to load the odds in their favour. But bigger LGPS funds will be in a better position to negotiate fee structures that they want, rather than accepting a standard contract. There are also signs that some asset managers are looking at more radical fee structures, which could align the interests of investors and managers in achieving active outperformance. For instance, a Canadian active equity manager, Orbis Investments, has announced a policy of only charging a performance fee above a hurdle rate, with no annual management charge. It also rebates the performance fee, if its performance subsequently drops.
Another equity investment issue for the new LGPS funds could be the use of smart beta, or risk factor investing. Investment purists would argue that this is a form of active investment, although fees could be lower than traditional active investing. With risk factor investing or smart beta, investors aim to exploit risk factors such as value, growth, momentum, volatility or size. To gain exposure to a factor, a manager can tilt a portfolio by holding more stocks associated with, say, value, or the tendency for stocks with strong fundamentals in terms of cash flow, or price to the book value of assets, to appreciate over time. This can be done through what have been labelled smart beta strategies. Principal Global Investors managing director, Stephen Holt, commented: “Smart beta is merely an unbundling of traditional active management investment processes into more discreet risk premia, or betas.”
While equities and bonds are still important asset classes, investors have now added a wider range of assets and are ready to combine them in different ways. Larger LGPS funds are likely to use their size to invest in a range of alternative asset classes, such as private equity, hedge funds, real assets such as timber and farmland, or esoteric assets such as aircraft leasing, shipping, or litigation finance. As well as investing directly, funds could invest via an opportunistic bucket, or by giving managers a multi-asset mandate.
Alternative assets can also be used within fixed income, or liability hedging portfolios. Given the low returns on core fixed income, investors are now looking at private debt, or loans directly from an asset manager to corporates requiring finance. Asset-backed securities, real estate and infrastructure debt, or mezzanine finance could also be added to alternative fixed income allocations. On the growth side of the equation, as they need to find a mix of capital growth and income, with diversification benefits if possible, assets such as student accommodation, social housing, direct real estate, long lease property or ground rents, could be useful additions to investment portfolios. Already, pension funds such as Greater Manchester are looking at affordable housing as an infrastructure asset which also benefits the local population.
Another important strand has been added to ESG integration with the growing importance of climate change risk. Local authority funds now face questions over their investments in fossil fuels and after the Paris climate change talks at the end of 2015, it is widely expected that institutional investors will have to play their part in efforts to limit global warming. This may take the form of reducing exposure to fossil fuel assets, or by funds reducing their overall carbon footprint. Investing more in renewable energy or social impact assets, or green bonds, could all be a part of this.
Given these factors, we can expect to see the new LGPS asset pools move away from the traditional 60:40 mix of equities and bonds over time, with increased allocations to alternatives and also infrastructure. Maybe in a few years’ time, we will be talking about 50:25:25 portfolios, or some other configuration. In any event, it will be interesting to see what emerges from the asset pooling process and the latest set of LGPS valuations.