For many trustees, fundamental indexing is still too much of a leap to risk any serious asset allocation. But the £11 billion Glasgow-based Strathclyde Pension Fund, one of the largest UK local authority schemes, plans to invest in the strategy.
The idea is to track an equity index that weights companies according to their economic footprint based on fundamentals including earnings, dividends and sales, rather than market capitalisation.
“It is a little bit radical, a bit of a departure,” admits Richard McIndoe, head of pensions at Strathclyde, pension provider for more than 200 Scottish employers from local authorities and service providers to universities and charities.
“We won’t be allocating a huge amount of money but what it should do is avoid over- and undervaluing companies, help with diversification and reduce our volatility.” Strathclyde has a 15-strong long list of asset managers keen to take on the passive £550 million mandate and hopes to decide the final allocation in the second quarter of next year.
The fund is undecided if buying a license to track one of the well-know fundamental indices would be preferable to creating a bespoke index of its own.
Fundamental indexing isn’t the only new strategy Strathclyde plans. The fund, which was established in 1974 by Strathclyde Regional Council, is also preparing to cope with its growing maturity.
“We’ve got 80,000 active members today compared to 90,000 just four years ago,” says McIndoe who joined the fund in 1996, becoming head of pensions in 2003 and like many CEOs of local authority schemes, has an accountancy background.
“We’re seeing a big migration of our members and the reason is fiscal austerity in the UK.”
Maturity means protecting funding levels
In local authorities’ scramble to save money, many have slashed payrolls and encouraged voluntary retirement. It’s triggering an early shift in maturity for many schemes. Although McIndoe estimates auto-enrolment could add 10,000 new members over time, the maturity trend will continue. It means the fund has to start to prioritise protecting its funding level and cutting out risk ahead of income and returns. “Focusing on total returns isn’t the best way to pay pensions. We’ve got to use the pension fund to pay the pensions. It’s less fun but it is right and proper,” he says. Strathclyde targets total returns of around 6 per cent over the long-term, although different assets classes like private equity tend to generate more, or less, like government bonds.
The growing maturity of the fund will push Strathclyde to reduce its equity exposure over time. Assets are currently split with a 72.5 per cent allocation to global equity, 12.5 per cent to property and a 15 per cent allocation to bonds; the majority of the equity allocation is now passively managed. The fund’s shift from active management began back in 1998 when it portioned a quarter of its equity allocation to passive. It increased this to 35 per cent three years ago and now, in an acceleration of the strategy, has just bumped it up to 42.5 per cent, managed in pooled fund with L&G. “We grew disillusioned with active management,” says McIndoe. “Some active management costs a lot and is worth it like private equity, but active asset management in the broad equity space has not delivered for us. Apart from one of two managers, it was a long series of disappointments.” The premium for quoted active management is between 20-30 basis points but much more for unquoted, he says. Within this passive allocation most of Strathclyde’s exposure to US equities is now passive. McIndoe says the fund has given up on active returns from the US where “very few managers” outperform.
In private equity, Strathclyde aims for an allocation of between 5-15 per cent; it currently has a 9 per cent allocation but plans to increase this since returns here have finally started to pick up, thanks to Asia’s budding equity culture.
Half the bond allocation is in an absolute return fund managed by Pimco; the other half is passively managed and 1 per cent of the total fund sits in UK gilts. The fund still values its liabilities on a gilts basis, but with an equity premium. Within its property allocation the fund has invested 8 per cent in the UK, mostly in central London retail and office space, however it targets a 10 per cent UK allocation. The scheme is underweight because of what McIndoe calls a “difficult market” and getting badly burnt when the UK’s property boom turned to bust. “We were unlucky with tenant insolvencies and highly geared indirect investments.” The fund has since switched managers and DTZ now handle the portfolio. The remaining 2.5 per cent property allocation is in global real-estate in Europe and Asia – particularly Hong Kong and China – and the US. It’s managed by Swiss-based Partners Group. “We tender all our investment contracts; compared to other providers they seemed to cover all the basis,” he says.
Innovation and opportunities
In another development Strathclyde recently set up a New Opportunities Fund to invest either via private equity or direct lending to UK business. The fund is a product of the financial crisis.
“It’s about finding opportunity in UK banks reluctance to lend to companies and developers,” says McIndoe. So far investment, which includes the government’s Pension Infrastructure Platform, has been funded from cash. “This fund is an amalgam of different things from alternatives to new opportunities and we’ll have to work out where the allocation sits. We’ll have to balance things by reducing one of out other exposures, maybe equity.”
Strathclyde doesn’t manage any assets itself and uses around 12 managers. Half a dozen were axed earlier this year both with the shift to a greater passive equity allocation and a decision to shelve the active currency strategy, which “didn’t disappoint but didn’t merit the effort either.” Hymans Robertson consults on strategy and McIndoe says the scheme would struggle without them. “They are inexpensive compared to other asset mangers and they help add value.” He does see delegated advisory as a step too far however. “We’ve put a lot of work into building our brand and our employers have a sense of security with us. It would be an abandonment of sorts.”
The decline in membership has already forced Strathclyde to draw in its horns. Three years ago the fund had around $100 million in cash to invest – money earned in contributions above and beyond its pension commitments. Next year or maybe even as soon as this year, the fund will be cash flow negative. In another response to its maturity profile the fund will also start to manage investment income. Until now the fund has never needed investment income – around £160 million last year – to pay pensions and managers simply reinvested it back into the pool. Strathclyde’s priorities maybe shifting to counter risk and lock in funding levels to meet its growing pension obligations. Yet its foray into fundamental indexation goes to show it’s still got the capacity to innovative and surprise.