Irish SWF emerges solid and sets long-term asset allocation

The equities allocation of the Irish National Pensions Reserve Fund fluctuated enormously in 2009 as the fund was directed to by the Minister for Finance to invest  €7 billion in preference shares issued by Bank of Ireland and Allied Irish Banks to recapitalise the banks. Amanda White spoke to Eugene O’Callaghan, head of the investment manager program, National Pensions Reserve Fund of Ireland and Adrian O’Donovan, secretary to the NPRF Commission about the events of last year and the fund’s long-term asset allocation plans.

The critical economic events of the past couple of years led governments of various kinds to respond in almost as many ways as there are countries. For the Irish Government a domestic bank recapitalisation program was a means to an end, and the capital of the untapped National Pensions Reserve Fund (NPRF) was a vehicle for that program.

At the end of 2008 the NPRF, established in April 2001 with the aim of meeting the costs of Ireland’s social welfare and public service pensions from 2025, had an allocation to equities of about 57 per cent.In the year to come that allocation would fluctuate as high as 80 per cent and then back to an allocation consistent with its long-term asset allocation of about 63 per cent.

It is a credit to the internal investment team and structures of the fund that these fluctuations, due to the requirements of the bank recapitalisation, placed little disruption on the fund’s performance.

In February last year the Irish Minister for Finance, directed the fund to invest €7 billion in preference shares issued by the Bank of Ireland and Allied Irish Banks to recapitalise these institutions.

The terms of the deal, which was negotiated by National Treasury Management Agency (NTMA) included a non-cumulative fixed dividend of 8 per cent on the preference shares and warrants which give an option to purchase up to 25 per cent of the ordinary share capital of each bank following exercise of the warrants.

The investments were funded using €4 billion from the fund’s own resources and €3 billion from a frontloading of the Exchequer contributions to the fund for 2009 and 2010.

The fund avoiding selling equities at market lows in March to fund the purchase of the preference shares, and instead, met the €4 billion required from the fund’s resources mainly from its cash reserves and sale of its government bond portfolio.

As a result, the investment portfolio had an elevated level of quoted equity investment of 80 per cent following completion of the recapitalisation in May compared with 57 per cent before the preference share investments were made.

The fund took advantage of the strong equity market rally to reduce its absolute risk and exposure to the equity markets through phased equity sales of €2.7 billion through the remainder of the year. The investment portfolio’s exposure to the quoted equity markets had been reduced to 63 per cent by year-end.

Commenting on the move from nearly 80 per cent to about 60 per cent in equities Adrian O’Donovan, secretary to the NPRF Commission, describes the circumstances as very unusual.

“But it turned out to be a good call not to sell equities at their March lows to fund the bank recapitalisation,” he says.

The end-of-year return for the discretionary fund was 20.9 per cent, with the combined overall return of 11.6 per cent.

Head of the investment manager program at NPRF, Eugene O’Callaghan, says the government had a specific short-term public policy concern and the commission could assist in meeting that.

“The way Ireland responded to the credit crisis impinged on the NPRF, we were happy to assist to resolve that,” he says.

The fund sold down its allocation to sovereign bonds and used cash to fund the recapitalisation program, with the result, after the wild ride in equities allocations, a significant allocation to cash at the end of the year.

O’Callaghan says the discretionary portfolio had about €2.7 billion in cash at the end of December 2009, which is about 18 per cent of the portfolio.

The NPRF now manages the fund as two separate sub-portfolios, the discretionary portfolio with €15.3 billion, and direct investments on behalf of the minister of finance with €7.07 billion.

The fund is in the midst of an asset class review, the first full review since 2004 when the diversification of the fund out of large-cap equities and bonds began.

While the Commission has not completed the review and so no public information is available, O’Donovan says two issues being explored are the true diversification of the fund and the role of absolute return funds.

“The review is not finished and the commission has not yet made any final decisions on asset allocation. However, one lesson from the financial crisis is the need to consider the extent to which the fund is truly diversified. While the fund has investments across a number of asset classes such as quoted equities, property and commodities which have different economic drivers and tend to perform differently in different economic environments, what we saw in 2008 was all of these asset classes becoming very correlated with investors eschewing all risk assets and there was a flight to safety in government bonds.

“As a long-term investor we can bear short-term fluctuations but we are considering if there is a need to give more emphasis to diversification in all market conditions and to make an allocation to absolute return funds,” he says. “While the fund does not currently have an absolute return fund allocation it does have small investments in a global macro and currency management funds.”

The fund has issued a tender for a fund-of-hedge-funds consultant.

The right mix of active and passive managers is also under review, although O’Callaghan says style is under constant review.

“Our strategy has been for a mix and a substantial element of the fund is passive, overall risk within active is a factor,” he says.

The fund’s sovereign bonds allocation is largely passive; within corporate bonds the fund has one very low-risk Eurozone active mandate; and equities has evolved from 60 per cent active to close to 60 per cent passive in the past two years.

Within equities all of the emerging markets exposure is active; and small-caps is half and half.

The NPRF has a slightly different view to some investors with regard to its large-cap management.

“We believe there are inefficiencies because of behaviour, not necessarily from data and as a result — for example — we have an active mandate in US equities. There is a view you can’t add alpha in developed markets, our internal experience says you can” O’Callaghan says.

Internally there are two teams contributing to public markets’ research and management.

O’Callaghan’s team which is responsible for reviewing, monitoring and selecting all managers, together with the team under head of asset allocation and risk, Ronan O’Connor, include issues like the best mix of active and passive as part of their brief.

O’Donovan says with some exceptions, such as sovereign bonds, the fund’s philosophy is to use external providers rather than get expertise in house.

While O’Callaghan says the fund has no specific plans to change the number of managers, it currently has about 24 separate mandates, the fund has been moving to equalise the risk exposure across active managers in the past couple of years.

“For legacy reasons some managers had larger mandates than others. We need enough active managers to diversify because some can do well according to different conditions, but we have to balance that with having proper relationships, we are happy with the overall balance at the moment.”

The position of director of the fund is currently vacant as John Corrigan was recently promoted to the chief executive of the National Treasury Management Agency which has responsibility for the pension fund but also for the debt management of Ireland, the recently formed bad bank NAMA and two other divisions.

Strategic asset allocation end of 2009 (set in 2006)

% Asset Allocation

Large Cap Equity                    56

Small Cap Equity                    5

Emerging Markets Equity       5

Total Quoted Equity               66

Private Equity                         10*

Property                                  8

Commodities                           2

Total Additional Asset           20

Bonds                                      13

Currency Funds                      1

Total Financial Assets             14

*including a 2 per cent allocation to infrastructure