Oxford 2018

Looming downturn forces moves

Asset owners are diversifying, cutting costs and allocating assets to low-volatility strategies in preparation for a market downturn, a high-level panel discussion at the Fiduciary Investors Symposium at the University of Oxford found.

NEST, a workplace pension fund set up by the UK Government, is preparing for lower returns in the coming years, said Mark Fawcett, chief investment officer of the £1.7 billion ($2.4 billion) portfolio.

“We have put the numbers in, and our expected returns are somewhat lower than in earlier years” Fawcett said, in a discussion chaired by Chris Cheetham, global chief investment officer, HSBC Global Asset Management and chair of the UK’s Mineworkers’ Pension Scheme.

Fawcett explained that one option would be to increase risk, but this strategy worries Fawcett.

“Increasing risk at this point in the cycle feels wrong,” he said.

The option that Fawcett has started to pursue, is to incorporate more asset classes as well as looking to add value in asset allocation and manager selection, although he noted that adding some asset classes to diversify further was challenging because of the fund’s cost constraints.

Affordable options that would help weather-proof the portfolio include NEST’s new allocation to commodities, which will soon bring the asset class into the portfolio for the first time. Fawcett is also mulling other strategies that play to the advantage of NEST’s growing assets under management. Although member pots are still small, contribution rates are climbing. The fund is predicting its assets will double next year and again the following year. A market correction could provide an opportunity for it to buy on the lows, backed up by dry powder from its increasing contribution levels.

Another strategy for a bearish market is writing out-of-the-money put options to capitalise on NEST’s steady equity accumulation. The fund invests about £50 million every month in equity, an amount that will double this year and then again next year.

“Why not try to take the insurance premium and benefit from this while we accumulate the equities we would naturally be buying along the way?” Fawcett said.

Railpen, the £25 billion ($34.9 billion) industry scheme for the UK railways, has sought out diversifying elements such as catastrophe insurance. CIO Richard Williams noted that competition for these assets was steep.

“We invested less than would have liked,” he explained. So far, Railpen has kept its equity allocation at “normal” levels, partly because Williams is circumspect about predicting the extent of the downturn that lies ahead.

“Everyone is expecting low returns in the future but how often is it that the markets deliver what experts expect? I am not convinced we are living in a period of low returns.”

He noted, however, that a prolonged downturn for the pension fund would be worrying, given the scheme needs a 6 per cent to 7 per cent return to meet its funding requirement in real terms.

PGGM, the Dutch asset manager of the €189 billion ($230 billion) healthcare scheme PFZW, is limited in its ability to time the market because of its slow-moving investment process. Instead, it has built in diversification and long-term returns with a passive global equity allocation, smart-beta strategies that include quality and low volatility for resilience in market downturns, and a 20 per cent alternatives portfolio that combines private equity, real estate and infrastructure. The fund has also built a nominal bond portfolio that, like the alternatives allocation, helps hedge liabilities; although principal director, investment strategy, Jaap van Dam, said PGGM had scaled back here because of low nominal bond yields.

Investors are also targeting costs to prepare for lower returns. Railpen has bought assets in-house, which has helped alignment and created efficiencies.

“It has given us the opportunity to do better in a low-return world,” Williams said. The fund’s property investment is one example where it has taken on development risk directly; it has also produced its own smart-beta strategies, creating a tailor-made portfolio with a smaller number of stocks than what is available commercially.

Lowering costs

NEST, which has a total expense ratio of just 30 basis points, works with its managers to devise smart, low-cost strategies. One example is the fund’s climate-aware equity portfolio with systematic tilts and a focus on overweighting companies exposed to renewables and clear transition paths to a low carbon economy.

PGGM has also prioritised costs, trimming 20 basis points over the last five years by bringing management in house, investing directly and renegotiating manager fees. Also, van Dam noted new long-term themes that would help trim expenses at the fund, such as more integrated portfolios, owning fewer assets, greater engagement and a renewed emphasis on “where value is created”.

The panel also referred to the importance of governance and robust management when preparing for a downturn – particularly if they have to move quickly. It is something PGGM has navigated by empowering its board to take ownership of just these kinds of decisions. Van Dam used the example of rebalancing to illustrate how an up-to-speed board was crucial.

“If you have a disciplined rebalancing process and you do regular fire drills to test it, when the big hit comes it won’t take two years to discuss,” he explained. “It will just be done.”

Railpen is also talking through strategies with its stakeholders ahead of time, including the possibility of using more leverage in a downturn. Strategies such as tail-risk hedging and a large allocation to cash are difficult at the fund because it has an ambitious return objective, Williams said.

“We are exploring whether to embrace more leverage and borrow money to buy assets,” he divulged. “We are talking to stakeholders now so that when the time comes, and we make that request or effect that strategy, there will hopefully be a high level of understanding.”

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