Fixed Income

Strathclyde cuts equity allocation

Kilchurn Castle reflections in Loch Awe at sunset, Scotland

Eight consecutive years of positive returns have more than doubled the size of the UK’s biggest public-sector pension scheme, the Strathclyde Pension Fund.

The fund has grown to £20 billion ($26.3 billion), since the financial crisis of 2008-09. In 2016 alone, Strathclyde, a scheme for local government employees in the Glasgow area, returned 23.1 per cent, fuelled by equity and currency – the icing on the cake of recent success.

“It has been a stupendous year for us,” chief investment officer Richard McIndoe says in an interview from the fund’s Glasgow offices. “Our overseas exposure is all denominated in non-sterling currencies, so when sterling depreciated last year with Brexit, all that stuff increased in sterling value; a lot of the rise in listed UK equity was also on the base of these companies’ foreign earnings.”

Manager outperformance was a factor, too, he says.

“It’s been absent for a long time, but for the last couple of years, we have done well in terms of outperformance.”

Last year, the strongest managers in the stable for Strathclyde, which outsources all investment management, included Oldfield Partners, which posted a 42.3 per cent return for its concentrated equity allocation, and specialist emerging-markets manager Genesis, which posted a 31.9 per cent return.

“It’s not a no-brainer that active management works,” McIndoe says. “I have certainly doubted it at times, though happily our current experience is that it is working for us.”

Shedding equities to de-risk

Equity markets may have driven recent performance, but strategy is focused on reducing the equity allocation from 72.9 per cent in 2016 to a target 62 per cent allocation. It’s the first phase of a staged process that will result in equity accounting for just 52.5 per cent of the total portfolio.

The pace and asset choice of this de-risking journey will be shaped by the results of an actuarial valuation, due early next year. McIndoe is already preparing for the likelihood that strong investment returns have not offset the growth in liabilities and that the cost of future benefits has probably increased.

“We are definitely on a de-risking path,” he says. “I guess the questions are the when and the what – how quickly, and what do you buy instead.”

One thing is for sure. He is unlikely to buy UK Government bonds, because he is not trying to achieve the kind of liability-matched or completely hedged solution that comes with index-linked gilts.

“It’s not the way we are de-risking,” he says. We are de-risking by spreading assets. We are not hedging and matching, but properly diversifying.”

The diversifying assets will include private debt, emerging-market debt, global credit and UK infrastructure, where the focus is on renewable energy. This allocation is divided between short- and long-term enhanced-yield portfolios, targeting 15 per cent each of total assets under management in step one of the de-risking process.

So far, Strathclyde has boosted its debt portfolio most. It has built up allocations to multi-asset credit run by Babson Capital and Oak Hill Advisors, and embarked on its first allocations to private debt and emerging-market debt. The next phase will probably include more investment in longer-term real assets, particularly infrastructure, where McIndoe is “pondering whether to go overseas or not”, and possibly absolute return.

He acknowledges that competition for real assets may thwart progress.

“There is, unquestionably, more competition for real assets. You have to be patient and careful on the pricing, be selective.”

The fund has opted for new managers in both the emerging-market debt allocation, which was decided via an open tender, and the private debt allocation, where the manager was chosen in a consultant-led process.

“They were new asset classes to us; although a number of names we work with already covered these asset classes, we went with new names.”

In what he describes as “never an easy decision” because “there are a lot of managers out there, even in specialist areas”, Strathclyde chose managers based on organisational structure, people processes, and depth of specialisation.

“We wanted people who are really focused on this, to the extent it is the core of their business,” he explains.

In the wake of last year’s Brexit-triggered currency boosts, McIndoe has decided to lock in gains and is now hedging a third of the fund’s listed-equity currency exposure.

“We looked for the least costly way of doing it, through a passive portfolio that invests in pooled funds. [These] funds are offered on a hedged or unhedged basis and we were previously unhedged. The additional cost is pretty minimal.”

Although all management is outsourced, Strathclyde is building a direct investment portfolio that will ultimately account for about 5 per cent of total assets. Here, an internal team of three focuses on co-investment opportunities in “differentiated” UK assets with strong environmental, social and governance credentials: investments are illiquid and opportunistic, and include a stake in the Green Investment Bank’s Offshore Wind Fund and the Maven UK Regional Buyout Fund, which focuses on small and medium-sized enterprises.

“There is a capacity of £1 billion. We have committed about £800 million and only half of that has been drawn to date,” he says. “It’s pretty early to be measuring return, as they are long-term investments with a J-curve effect, so will profit only in later years. But the numbers from last year are quite positive.”

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