Transport for London, the organisation behind the network of buses, underground or “tube” trains, trams and bicycles that keep the United Kingdom’s capital city on the move, has a reputation for its generous employee benefits. But of all the staff perks on offer, including 30 days holiday a year and subsidised travel expenses, membership of the gold-plated, defined benefit Transport for London Pension Fund (TfL), is the biggest. Investment strategy at the thriving £6.9-billion ($10.5-billion) scheme, grown from $7.6 billion in 2010, has recently shifted with the fund nurturing a growing $1.5-billion alternatives portfolio comprising hedge funds, infrastructure, real estate and private equity in its bid to diversify and improve the scheme’s risk-adjusted returns over the medium to long term.
The shift in strategy comes despite equities being TfL’s best performing asset this year. United States small cap and global equity mandates have led the field, says Padmesh Shukla, investment officer at TfL (pictured right), based in London’s Borough of Westminster. “Listed real estate has also seen a strong performance, and bonds and emerging market currencies fared well, but for the recent market pullback,” he says. The fund runs a large foreign exchange overlay program to hedge currency risk in the equity portfolio and active management has also helped boost returns, with 60 per cent of the equity portfolio actively managed. Active investment mandates include global unconstrained, US small cap, Japan, emerging markets and Asia, lists Shukla. “These markets are generally under-researched and have of late seen dispersions widen, making active management more optimal.” Passive investments are in markets widely regarded as efficient such as Europe, North America and the UK.
The current portfolio is split between equities (55 per cent), bonds (25 per cent), all actively managed bar a “very small holding” for rebalancing purposes, and alternative investments (20 per cent). The expanding allocation to alternatives will increase to 25 per cent over the course of 2013, primarily funded from equities. Additional allocation will be made to unlisted real estate, one or two new hedge fund strategies, “possibly” renewable energy and private equity, says Shukla.
It’s a private equity allocation that is supported by the scheme’s “negligible” liquidity requirements, he explains. “Private equity is a way for us to extract illiquidity premium and earn higher returns, but at the same time try to reduce the market-to-market volatility of public markets,” he says. “Our private equity allocation is driven by a strong fundamental understanding of less efficient segments in the market and less desire to time the markets.” Going forward, the scheme will likely increase its allocation via a separate account format, investing in primaries, secondary and co-investments, diversified “but not overly” by sectors, managers, vintages and regions. Unlike the scheme’s hedge fund program – where it makes direct investments – in private equity, fund of funds is TfL’s preferred approach to better access more specialist and small-to-mid-size managers outside the known big names.
The fund also lacks the resources to build its own private equity specialists. TfL has an internal team of seven covering investments, accounting, finance and compliance, although it is in the process of beefing up its investment and compliance capabilities. “We aren’t FSA-authorised; all investments are done through external managers,” says Shukla.
Hedge fund portions
TfL’s hedge fund allocation is portioned to commodities, structured and distressed credit, emerging market currencies, reinsurance and global macro trends.
“Hedge funds in the distress and event driven space have performed well, both in absolute and risk-adjusted terms,” says Shukla. Over the last year new allocations have gone to Arrowgrass Capital Partners, Och Ziff Capital Management and the world’s largest hedge fund, Bridgewater Associates and its Global Macro Systematic Hedge Fund. Over half of the 4 per cent infrastructure allocation is invested in mature PPP projects predominately in the UK and with limited construction risk in an allocation managed by Semperian PPP Investment Partners.
TfL does run an LDI program, but only plans to expand its strategy to hedge out inflation and interest rate risk if “real rates go up; we believe the current levels are very low.” Although investments are also made in liability-matching proxies such as infrastructure and real estate, the fund’s long maturity profile – it boasts 83,000 members comprising 23,000 contributing members, 18,000 deferred pensioners and 42,000 dependants – means it is still cash positive. “We expect to remain cash positive for a significant period of time – an important consideration in both hedging and investment decisions,” says Shukla. Nor is the scheme weighed down by a huge deficit, with a funding level of 91 per cent compared to 73 per cent at the last triennial valuation in March 2009. “The aim is for a 100-per-cent funding level by 2020 and staging-post targets between now and then,” says Shukla.