Debate over whether going - and staying - short is hindering institutional investors’ route to greater diversification across asset classes reached new heights at this year’s British National Association of Pension Funds (NAPF) investment conference Mitesh Sheth, investment director at Henderson Global Investors, says pension funds are crying out for more sophisticated, well thought-out, solutions to boost returns as the equity short bias continues largely unchecked.
“The Holy Grail for pensions is to have investments with equity-like returns but with bond-like volatility and, if we can do something smarter, it will be a real value proposition for pension funds,” says Mr Sheth.
His theory of why pension funds have been sucked in to going short is based on a gravitational pull similar to the effect a black hole has on its surroundings. He explains: “Funds will always be in deficit to some extent, because even if they come out of it, their psychology is such that they are likely to end back in it. Equity market rallies drag funds into surplus, companies then opt to take a contribution holiday, the market corrects itself and the pension is back in the red.”
First mover advantage
Mr Sheth recommends investors stop benchmarking against their peers, quit the obsession with short-term investing, and seize on the first mover advantage. “Whether they like it or not, trustees choose to take investment risk and effectively become risk takers, although they like to be viewed as protectors of an employee’s investments,” he says.
Realising a short duration for the majority of its investments was largely unsuitable, Colin Hately, head of pensions at Kingfisher, the owner of retailers B&Q in the UK and Castorama in France, saw the opportunity to align the interests of Kingfisher management with its scheme trustees when it undertook a liability-driven investment (LDI) review five years ago. This review included taking risk off the table by reducing equity exposure over time and swapping away unrewarded risk by financing bond portfolios.
“We realised we were in the pensions business and not a DIY retailer,” says Mr Hately. The fund, which has assets of £1.4bn (€2.1bn) and liabilities of £1.6bn on a gilts basis, was closed to new hires in 2004 and the fund reduced allocation to equities, finessing its bond portfolio.
It wasn’t just asset allocation that received a much-needed fillip, however. “It got to the stage that we realised we had to ask staff and future contributors to increase contributions, with solvency levels tightened overtime,” adds Mr Hately.
Pushing the message that Kingfisher pension scheme’s investment portfolio should have a long-only slant, its head of pensions found an ally in Kingfisher’s corporate directors. “We agreed that the LDI review should be driven by the corporate and not by the trustees,” says Mr Hately.
The aim, in the long run, is for 100 per cent solvency on a gilts basis over a period not exceeding 20 years. “The key was to agree long-term objectives and agree on the risk budget…and keep our promise we made to our employees,” he adds.
Pulling away
At Henderson, Mitesh Sheth is busy developing investment products for pension fund clients he says will pull them away from the trend of deficit-surplus-and-back-in-to-deficit.
“It is important for trustees to make part of their portfolio objective the assessment of longer-term investment exposure, if not with 10 per cent then what about with 40 or 50 per cent allocation?” he asks.
Mr Sheth recommends diversification for trustees although not if it makes funds buy expensive assets. Property in India, loans, mortality bonds, and carbon emission trading are a few of the investment products on his radar. “Somebody is investing in them, but we know pension funds aren’t at the moment – this is the time to get in,” he warns.
Alan Brown, head of investment at Schroders, concurs with Henderson’s Mr Sheth that now is a perfect opportunity to seek out an alternative to the domestic equities bias that steer a number of pension funds’ investment portfolios in the UK. “Property, private equity, and infrastructure are all possible sources of asset class diversification, in addition to hedge funds to capture a skill premium and high yield bonds to capture a credit premium,” he recommends.
The emphasis on domestic equities and an ever increasing correlation among equity markets has led to a concentration on equity market beta, to the detriment of the scheme’s performance, believes Schroders’ Mr Brown. “Having a concentration in UK equities has really cost pension funds dearly,” he says. “Vodafone was once over 15 per cent of the UK index, but is now down to around five per cent. A typical UK fund lost five per cent of its worth in that re-rate, which is multiples more than a US plan lost through the bankruptcy of Enron.”
Systematic problem
Mitesh Sheth says there are a number of strong, long-biased, investment positions funds could instruct their managers to take, however a systematic problem exists in the industry which is making this tricky.
“If asset managers feel they have to deliver positive returns every year, they will naturally become greedy,” says Mr Sheth, who believes manager reviews that are conducted on a quarterly and monthly basis are not especially conducive to the long-term objectives of the fund.
Instead, he suggests funds should stay put for the sake of “long-term wealth creation”. “The shorter and shorter time horizon you adopt, the less likely funds will end up with real long-term opportunities,” he says.
Mr Sheth notes the average holding period for a stock on the New York Stock Exchange is 11 months, “with most investors trying to beat the gun”. The example of the TMT bubble seven years ago is crucial to his argument: “If you looked at technology in 2000, then most probably you would have sold that year,” he explains, “after which you would have been wrong for a year, then looked really smart.”
But for Mr Sheth, fund managers, and by implication their pension clients, find this holding strategy “hard to wear” especially if the pressure to outperform is on a quarter to quarter basis. Instead, “governance and effective decision-making are the tools to get out the black hole and stay out of it,” he says.
Sticking with LDI
Industry talk at the conference also referenced, unsurprisingly, the use of LDI strategies by UK pension funds.
“Falling equity markets, rising longevity rates, and the onset of accounting standards such as FRS 17, has raised the profile of LDI to the extent that every pension fund ought to consider strategies to harness their investment risks,” according to Schroders’ Alan Brown.
Mr Brown, whose Schroders’ £500m (€735m) pension scheme undertook an LDI review with its trustees and corporate directors in 2005, says LDIs are “neither are cure for all schemes, nor a passing fad”. “We’re not here to beat the market, but pay pensions,” he adds.
“Schroders adopts a holistic approach to LDI management as far as its pension is concerned. “We keep the liabilities of the fund as the benchmark at all times,” says Mr Brown.
He believes the relative strength of the covenant between pension sponsor and the fund guides the LDI policy going forward. “The risk tolerance of the pension is greater if the covenant is strong,” he adds.
