According to John Corrigan, director of Ireland’s €18bn National Pensions Reserve Fund (NPRF), equities will outperform pure financial instruments by about 3 per cent per annum over the long term.
He claims: “If you go into a simple liability-matching structure and move more towards bonds, you will forego that equity risk premium. You will have the peace of mind of not being on a roller-coaster ride, but on the other hand you will incur a higher funding cost.”
Higher volatility
When Mr Corrigan adds that he can live with the higher volatility that comes with a large equity portfolio, it’s because he is in the fortunate position of overseeing a young pension fund with an investment horizon stretching out decades.
The NPRF was established in April 2001 to provide partial funding of Ireland’s social welfare and public pension costs from 2025. The fund’s long-term investment strategy is reflected in an equity allocation of 77.8 per cent.
Noting that exchequer contributions to the fund at a rate of 1 per cent of GNP per annum will continue to the year 2055, Mr Corrigan does not expect any net withdrawals until the late-2030s.
“Therefore, you have a pension fund which is unconstrained on account of a long -term horizon and because of a strong cash-flow. This has led us to make what many people might regard as an aggressive allocation to equities,” he says.
The fund has a majority weighting in large cap equity, supplemented by a 3.5 per cent and 1.9 per cent allocation to small cap equity and emerging markets equity respectively. These modest investments will grow in line with a targeted a reduction in the large cap equity portfolio to 69 per cent of the overall fund by 2009.
Mr Corrigan comments: “From a tactical point of view, small cap equity has had a very good run relative to large cap equity and this point in the cycle might not be the time to increase the small cap weighting, if you subscribe to the reversion to the mean argument.”
Resurgent markets
The fund attributed a return of 6.9 per cent for the first nine months of 2006 to resurgent global markets following the sell-off of the early summer.
The NPRF’s fixed income portfolio comprises 14 per cent in eurozone government bonds and 0.5 per cent in corporate bonds. The fund has targeted a reduction in the bond portfolio to 13 per cent of the overall fund by 2009. This target allocation would consist of 11 per cent eurozone government bonds and 2 per cent eurozone corporate bonds.
Four per cent of the fund is temporarily in cash awaiting investment in corporate bonds. The view is that with government bonds trading at sub-4 per cent levels in nominal terms and corporate bond spreads and yields insufficient to compensate investors for the extra risk, little opportunity is afforded for wealth accumulation.
While Mr Corrigan is comfortable with but currently unimpressed by investment-grade credits, he views high yield and emerging market debt as “a bridge too far”. Such asset classes “are not for widows and orphans”, he quips.
The fund has been looking at asset-backed securities and collateralised debt obligations and anticipates an allocation to these instruments at some time in the future. Such new mandates would be funded by reducing the government bonds portfolio.
The NPRF recently invested €190m in pooled currency funds as part of a policy to hedge 50 per cent of the fund’s non-euro currency exposure. Goldman Sachs Asset Management and Mellon Capital Management managers have been mandated to allow that 50:50 hedge to float between 40 per cent and 60 per cent in accordance with their view of the FX markets.
“If we get it right, we should pick up in excess of 10 basis points at overall fund level,” says Mr Corrigan.
A small alternative investment portfolio comprises 2 per cent property, 1.1 per cent commodities and 0.3 per cent private equity.
Too complex
The fund has globally diversified property portfolio made up of investments in pooled funds. Direct property holdings are eschewed because the associated management issues are considered too complex.
The NPRF also avoids funds of funds for fiduciary and cost reasons.
Mr Corrigan says: “Except in very specific strategies, we believe that investing through a property fund of funds or a private equity fund of funds is not consistent with the trustee’s fiduciary responsibilities because they are so far removed from the point of investment. Also, there is the question of the higher fees. You typically have to pay a 1 per cent annual management charge plus 10 per cent incentive on top of the 2 and 20 you are paying the underlying manager. So we felt it made a lot more economic and fiduciary sense to recruit a specialist property and private equity investment team directly into the agency.”
During the third quarter of 2006, the fund committed a total of €241m to five property investment funds and €16m to one private equity investment vehicle. An allocation of 8 per cent to both property and private equity is targeted by end 2009.
The fund invests in commodities on a passive basis by tracking the Goldman Sachs energy-rich commodities index. Mr Corrigan says the investment is not a punt on the price of oil, but purely “a diversifier”.
For the time being, the fund is steering clear of hedge funds citing high fees as one of the main reasons.
“The fees are hard to stomach, especially those charged by a fund of funds vehicle Arguably, we can achieve the same result over time by going the more conventional route,” contends Mr Corrigan.
But he is also “not convinced” that hedge funds represent an asset class in their own right. Maybe, he adds, they are just a better way of managing traditional assets.
“For instance,” he explains, “traditional fund managers are now addressing long-short equity with their 130/30 or 120/20 products. So where does one type of product start and the other leave off?”
The recent Amaranth debacle, he says, shows that risk is always a serious consideration in relation to hedge funds.
“Before investing you would want a high degree of confidence and comfort around the internal risk controls. Clearly in the case of Amaranth, the risk controls did not work,” he says.
To a lesser extent, Mr Corrigan is concerned about the impact of capacity constraints on the return-generating potential of some types of hedge fund strategies, such as event-driven. But he says that there is no reason why capacity constraints should affect the popular long-short equity strategies.
Getting tactical
The fund is actively considering the implementation of a global tactical asset allocation (GTAA) programme in early 2007. GTAA, says Mr Corrigan, “is a macro hedge fund by another name”.
In April 2006, the NPRF signed up to the UN Principles for Responsible Investment. The aim of the principles is to integrate the consideration of environmental, social and governance issues into investment decision-making and ownership practices and thereby improve long-term returns.
He says: “Implementing these principles will involve a two-stage response from us in order to meet our obligations and commitments. One is being more proactive in the area of shareholder engagement. Second, we have to introduce a more thought-out and co-ordinated approach on proxy voting.”
