The Environment Agency, the 20th largest fund in the UK’s Local Government Pension Scheme, recently appointed six new specialist asset managers to manage £995m (€1.4bn) of its £1.1bn Active Pension Fund. The mandates were the culmination of an asset-liability modelling study carried out by the fund in 2003, which proposed a shift away from balanced management.
Howard Pearce, Environment Agency head of environmental finance and pension fund management, says the review was prompted by a period of poor investment performance and because Watson Wyatt, the fund’s adviser, had warned there were fewer skilled balanced managers to choose from. Another cause for concern was the fund’s solvency level which had had dropped from 112 per cent to 94 per cent.
“We wanted to get back into positive territory. And we also wanted to engage in a bit more shareholder activism,” adds Mr Pearce.
Despite his wish to improve the funding position, he points out that the scheme’s current solvency level lies in the top three of the local government pension funds.
“We didn’t take any contribution holidays as some local government schemes did, and as a result we feel we are in a far healthier position than if we had done. Our contributions are nevertheless still rising towards 6 per cent on the employee and 14 per cent on the employer,” he adds.
Under the old asset allocation and manager structure of the active fund, Legal & General managed a passive multi-asset balanced brief (36.7 per cent), Henderson Global Investors and Merrill Lynch Investment Managers each ran active multi-asset balanced mandates (30.5 per cent and 30.3 per cent respectively) and State Street Global Advisors (SSgA) managed a passive UK equity brief (2.5 per cent) in conjunction with Innovest Strategic Value Added Advisors which supplied environmental ratings.
The old asset allocation was marked by a large investment in UK equities (almost 50 per cent of the fund), gilts and cash.
Under the revised investment strategy, these allocations are being reduced while weightings in global equities and corporate bonds are being increased. New investments are also being made in property and private equity.
Mr Pearce says: “We wanted to lower our risk resulting from an overexposure to the 10 largest companies in the UK which dominate 50 per cent of the stock market. That was a good reason to diversify out of UK equities and to look for better returns overseas.”
Loss of balance
It was not all bad news on the balanced front. The L&G index tracker was performing satisfactorily. However, the two active balanced mandates had fallen short of their outperformance targets of 1 per cent and 2 per cent over a rolling three-year period.
In the pursuit of portfolio diversification, the agency reduced UK equity exposure by 18 per cent and increased its investment in overseas equities by 11 per cent to 31.5 per cent. An active allocation of 14 per cent to corporate bonds was made in addition to allocations of 5 per cent each to property and private equity.
The agency decided to keep 39 per cent of its fund passively managed and handed Hermes Pensions Management an index-tracking mandate worth £425m. SSgA has been retained for a 2 per cent passive UK proxy FTSE 350 tracker, with an environmental overlay applied by Innovest.
“We felt that we should be prudent and retain a large chunk of money in passive but also take on a little more active risk to make the assets sweat a bit,” comments Mr Pearce.
Global equity mandates were awarded to Capital International and SSgA. Mr Pearce says: “We decided to go for global equity mandates rather than a number of different regional mandates because we didn’t want to break the money up into small chunks. Our adviser also told us that the global mandate was easier to manage. ”
Pointing to the lack of emerging markets coverage (the fund has some emerging market exposure through the Hermes passive mandate), he says the agency will consider hiring an emerging markets/Far East specialist manager when the fund’s investment strategy is next reviewed in three years’ time.
The corporate bond portfolio is made up entirely of investment grade securities. “This is quite an active, aggressive portfolio, which should give us good performance,” remarks Mr Pearce. “Both the passive and the bond mandates should be steady performers with the latter providing a good yield. These portfolios form the core while the exciting stuff is in the global equities. We didn’t want huge volatility on the passive and the bond mandates.”
Keen to become more involved in socially responsible investing, the Agency has awarded a specialist environmental equity mandate to Sarasin Chiswell, representing 7 per cent of the total portfolio.
Mr Pearce says: “The environmental mandate is essentially a global mandate as well. The SSgA mandate is quant-based, while Capital International is taking a more stock-picking approach and the environmental mandate is geared around sustainability analysis driving stock selection. We expect greater volatility in these mandates.”
He adds that the private equity and property mandates were viewed as opportunities to achieve good returns and to apply sustainable investment criteria in that the managers have been tasked to make sustainable investments in both of these asset classes.
Declining to reveal the names, Mr Pearce says the Agency will be appointing a fund of funds property manager and a private equity multimanager. The fund of property funds will contain both traditional and sustainable property (for instance, regeneration projects), which will achieve desired social and environmental objectives.
He comments: “We felt that the return on the fund of property funds was good and that it was an easier route into real estate. We did not want to make direct property investments
“Equally, on the private equity side, there were financial opportunities to be had from people involved in green technology and green energy, people who are going to benefit from some of these long-term environmental changes. We are trying to avoid the risks on the downside and take advantage of some of the upside.”
All new managers have been awarded three-year investment contracts. Each manager’s performance will also be assessed on their integration of environmental considerations into risk management, stock selection, company engagement, shareholder activism and proxy voting. Relative performance will also be monitored using corporate governance and SRI indices and environmental reporting tools.
“All managers are taking account of economic and social fundamentals and then applying an environmental thinking,” says Mr Pearce. “On the other hand, Sarasin Chiswell will be focusing on environmental thinking first and then applying the economic fundamentals.”
He explains: “We investigated whether there was a relationship between good environmental management and good financial performance and we found there was a positive link between the two. We found that was a driver for certain types of stock selection. Also, there are environmental risks which could hit our returns, like climate change.
“Many people might think we are adopting a risky strategy but we have done a lot of work to implement it in a responsible way so we are not taking unnecessary risk. It enables us to combine the hard financial rigour with the rigour around the sustainable responsible investments.”
In an effort to become more involved in shareholder activism, the Agency has asked all its managers to implement corporate governance policies. “We want them to have an environmental overlay strategy, particularly on shareholder resolutions and environmental issues.
“Also, we are trying to raise our profile through our membership of organisations such as the Institute for Investor-Driven Climate Change, the UK Social Investment Forum and Carbon Disclosure Project. Historically we have been quiet in these areas,” remarks Mr Pearce.
Performance assessment
He has decided to use “shadow” benchmarks in order to monitor the performance of the mandates against some of the FTSE Corporate Governance indices.
“We are one of the few pension funds that is going to operate shadow benchmarks. We might switch indices or move the financial objectives to those benchmarks. A shadow benchmark would have to be financially more attractive for us to adopt it,” he says.
The Agency has adopted a “wait and see” stance on hedge fund investment. It wants to observe how other local government schemes fare in this increasingly popular asset class.
“We felt hedge funds represented a higher risk than we wanted to take and there wasn’t enough of a performance record,” notes Mr Pearce. “Also, some of our trustees were nervous about hedge funds because of the publicity surrounding the amount of institutional money chasing popular hedge fund strategies.”
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