The search for high-quality alpha has been a strong theme among pension funds this year, coupled with an appetite for diversification. Pursuit of alpha has led to greater interest in a wider range of investments: unconstrained equity mandates, emerging market and high-yield bonds, and alternatives such as hedge funds, private equity and currency. Swaps and derivative strategies are also on the increase.
The concept of liability-driven investing (LDI) is the subject of much discussion, but in 2006 it certainly seems to have translated into actual mandates awarded, particularly in the UK. One of the leading LDI houses, Insight Investment, has seen a leap in its LDI assets under management this year, from £20bn in September 2005 to £30bn now.
LDI is also making its mark in the US.
The requirements of the Pension Protection Act have been pushing plan sponsors to recognise risk and hence to link the management of their assets to their liabilities. One result has been for them to opt for longer-duration fixed-income mandates, says Chip Rosenthal, a principal at Mercer Investment Consulting in the US.
“I would say 70 per cent of our clients have adopted a long-duration fixed-income mandate in their portfolios to help hedge interest rate risk,” he says.
New benchmarks
Among UK pension funds, bond portfolios are showing more diversification, with higher allocations to alpha-generating instruments, such as corporate debt, international bonds, asset backed securities and high-yield. The adoption of high-alpha strategies has also led to a redefining of the brief for bond mandates, says Sarah Aitken, head of institutional business at Insight Investment.
“Traditionally you would have seen a bond benchmark plus a half to 1 per cent maximum; now you are now seeing those pushed out to bond benchmarks plus 2 per cent,” she says. “These are very much the new vogue. Arguably they require a different skill set, certainly a wider range of opportunities.”
Specialist fixed income manager Pimco has had notable success in this area. A significant mandate win was a £260m segregated liability-driven investment bond mandate from the Xerox UK Final Salary Pension Scheme.
Another change, highlighted by Watson Wyatt, is the rise in the use of structured products and derivatives over the year among UK pension funds. It estimates the market could exceed £20bn by year end.
“There is a broad realisation among pension funds and their sponsors that there are a variety of derivative instruments that can provide pension funds with protection, enhanced performance and a better match for liabilities,” says Nick Horsfall, senior investment consultant at Watson Wyatt.
In equity the trend has been towards unconstrained mandates, giving the manager greater freedom to pursue their best ideas.
“Trustees want to hire a manager who is going to be able to express their skill,” says John Belgrove, senior consultant at Hewitt Associates. “It may be a lower allocation but a higher return target.”
The target return in these cases, he says, is either a traditional market capitalisation index such as the MSCI World plus 4 per cent or longer-term mandates might have a target of RPI plus 5 per cent.
Among US pension funds the search for alpha has led to high investment volumes into US small-cap funds, which have forced many of them to shut their doors to new money. The search is now on by consultants to identify good small-cap managers.
“The problem is small-cap equity has done well in recent years and it is difficult to find good managers with a significant track record still open for business,” says Mr Rosenthal.
But he adds that, in general, reduced equity allocations are widespread in plan sponsors’ portfolios.
“Historically most plans in the US were between 60 per cent and 75 per cent invested in equity,” he says. “That has changed dramatically. The high end of the range is now probably close to 70 per cent equities, but we see a number of plans now that are well below 50 per cent.”
Increasing allocations to bonds to match liabilities are putting more pressure on funds to up alpha generation from the rest of the portfolio, says Mr Rosenthal. “That has led to more alpha-driven mandates outside the fixed-income portfolio, whether it be hedge funds, or alpha transport products that managers are coming out with. These provide an underlying exposure to fixed income then exposure to another asset class where they look to pick up alpha.”
UK funds have also increased interest in alternative asset classes where returns are not correlated to the rest of the portfolio, particularly hedge funds and private equity.
“There has been demand for hedge funds and private equity but quite selectively,” says Mr Belgrove. “One alternative that has been particularly popular over the last 12 to 18 months has been active currency management.”
This interest in currency is also apparent in the Nordic region, according to Nick Phillips, managing director and head of Nordic region for Goldman Sachs Asset Management.
“The theme of currency as an asset class has been adopted more and more fully over the last 12 months, especially in the first six months of this year when currency managers were experiencing favourable market conditions when there was strong demand across the board,” he says.
He also highlights a greater usage of mutual funds by Nordic pension funds in the wake of the greater diversity allowed in funds by the Ucits III regulations.
Fiduciary approaches
“Mutual funds have become more and more relevant to institutional clients,” says Mr Phillips. “Ucits III regulations have allowed managers to offer more varied and more unconstrained asset classes in mutual fund form that are relevant to institutional investors, such as equity funds with 135/35 long/short exposure with a beta of one.”
In the Netherlands, GSAM has chalked up notable successes in capturing fiduciary mandates from a number of pension funds, including a €750m mandate from pension fund Océ, and it has raised the value of its fiduciary mandates to €5.4bn from sector pension fund Vervoer, €1bn from corporate fund Campina, and €1.8bn from health insurance company VGZ.
Dissatisfaction with existing managers is often the first trigger for funds to turn tofiduciary management, says Ruud Hendriks, GSAM’s co-head of AIMG.
“The first catalyst may be that pension funds are unhappy with the performance of their current managers,” says Mr Hendriks. “But a couple of other factors play a role. Second, many pension funds have problems in coping with the increased complexity of new regulations. And point three is that investing itself is also getting more and more complicated. Some pension funds feel they do not have the know-how or the staff or the means to create alpha, so they look for a fiduciary manager.”
Diversification of investments is a theme in Switzerland too, with increasing allocations to alternative assets. “We observed increasing allocations to hedge funds, mainly fund-of-funds,” says Sven Ebeling, head of investment consulting at Mercer in Zurich. “However the average allocation throughout the Swiss pension fund industry is still clearly below 5 per cent.”
As elsewhere Swiss pension funds are broadening the type of assets included in the traditional equity and bond mandates. “A broader credit risk exposure seems to be more popular,” says Ebeling. “We saw interest in global or European bonds over the entire investment grade spectrum. There is also interest in regional equities and/or global equities, often including emerging markets.”
Demand for LDI solutions is, however, limited because of the Swiss way of discounting liabilities, using a technical interest rate rather than a marked to market approach.
As for the asset managers that are having the most success in winning mandates, Mr Belgrove says it is those that can demonstrate the greatest skill among their managers.
They may be firms with a global reach, or small boutiques.
“It’s about accessing skill,” he says. “Clients are much more selective about the team. It’s not so much based on the name or the credentials of the parent organisation but driven more by the skill set of the manager.”
But Simon Males, director of institutional funds at F&C, thinks it is in more niche areas where small specialist houses have the advantage, particularly in alternative assets.
“We have seen small specialist managers taking increasing flows of mandates. Typically that has been among specialist product providers, such as hedge funds, funds of hedge funds, absolute return funds and the property area,” he says.
But in other asset classes, pension funds will be looking to the larger firms, where reputation and resources give reassurance.
“There is great importance of scale when you have a high conviction,” adds Males. “If it’s for globally spread bonds or equities, as a pension scheme trustee you ought to have a clear level of comfort in terms of scope and reach of the asset manager. If they have many analysts across many offices, that can play an important role in giving comfort.”
BIG WINS AND BIGGER LOSSES
In the competitive global equity arena, AllianceBernstein has claimed some notable successes. It picked up four mandates from UK local authorities: the latest, in November, was from Hampshire County Council Pension Fund and was worth £300m. In May, Newton IM won a £150m unconstrained global equity mandate from Falkirk Council Pension Fund.
Bank of Ireland Asset Management and F&C have both experienced sticky patches this year, though BIAM seems to have turned the corner. In October it won a core passive equity mandate worth €3bn from the Irish National Pensions Reserve Fund (NPRF), which it will manage in conjunction with State Street Global Advisors. BGI won a similar mandate for the same amount. Both AIG Global Investment Group and BGI won mandates from the NPRF worth $250m and $500m respectively to run index plus mandates managed against the S&P500 index.
But F&C has suffered significant losses: a £1bn property mandate for the Electricity Supply Pension Schemes and a £1.5bn equity withdrawal from a balanced mandate with Dutch pension fund, Vervoer. An even bigger blow was its £20.1bn loss of a contract running assets for insurer Resolution Life.
Another loser was SGAM which in November was stripped of its US mid-cap equity mandate by the French Fonds de Réserve pour les Retraites because of poor performance. The mandate was worth €331.5m.
