Since Niklas Ekvall took over at the helm of SEK334 billion ($37.8 billion) Swedish buffer fund AP4 last October, he has immersed himself in finding ways to further develop the fund’s investment processes and portfolio.

Pushing change is challenging when a fund has as celebrated a track record as AP4, where core strengths such as a strong domestic equity allocation, ground-breaking environmental, social and governance (ESG) integration and dynamic internal management already set it apart from peers.

Ekvall believes, however, that current investment strategy could better connect with AP4’s liabilities.

The new chief executive of the fund plans to introduce more long-term strategic investments to broaden its risk strategy. Listed shares account for more than half of assets, and in what he calls a “stronger, top-down grip” he wants to make more of AP4’s unique long-term mandate by adding more long-term diversifying assets.

“We want to extend our investment horizon, adding more diversity and capturing the opportunity we have been given by our mandate,” he says. “It is about furthering our risk taking and diversifying our risk on a strategic level to make sure we capture the potential we have to be long term.”

Under his leadership, the fund will review its approach to alternatives, where it allocates just 2 per cent of assets under management, with a focus on infrastructure, private equity and private debt. However, he does emphasise caution.

“Alternative investments are stressed; we won’t chase investments now,” he says. “It is more about reviewing this for the long term.”

Unique fund structure

Ekvall inherits a fund structure put in place in 2013, whereby investment falls into three horizons: 40 years, three-15 years and up to three years.

The 40-year “normal” portfolio is the reference; it comprises several different indices. Equities, because of their high long-term returns, and more volatile short-term returns, account for 66 per cent of the Normal portfolio, with the rest in bonds.

A third of the fund’s assets are in the “strategic” three- to 15-year portfolio. Here, investment includes real estate, Swedish equities including the small-cap portfolio, fixed income and various sustainability initiatives, such as AP4’s low-carbon strategies.

Tactical three-year management invests primarily in fixed income, along with global and Swedish equities, targeting returns above the index. Swedish equity is one of AP4’s standout portfolios, returning 12.4 per cent in 2016 and 14.1 per cent in 2015. It’s an allocation that has benefited from strong internal expertise over the years.

“We have developed an active stock-picking ability and we are close to companies and the best investment opportunities,” says Ekvall, who adds that the breadth, diversity and efficiency of the Swedish market have helped ensure strong returns. Investment decisions are made on the basis of long-term fundamental company analysis, with corporate governance and sustainability integrated into the strategy.

The aim is to outperform the index by identifying companies with good long-term growth value and revaluation potential.

Similarly, corporate analysis in the Swedish small-cap portfolio is fundamental and manual. There is no ready-made template; analysis is complex and differs from company to company. It requires reading and meeting with representatives of companies, and includes focusing on company structure and governance because of their impact on long-term development.

By law, 30 per cent of fund assets have to be invested in highly liquid and highly rated bonds.

“It gives the portfolio diversity and stability,” Ekvall says. “But it is also challenging in the current market.”

Recent strategies have included broadening the allocations to corporate and mortgage bonds, which give a slightly higher rate of interest than government bonds.

Another recent tactic has been increasing the proportion of short-term bonds to slightly reduce the risk of the fund losing capital when interest rates increase to more normal levels.

Ekvall is also considering how to increase allocations towards yielding assets, like emerging-market debt and high-yield debt. These assets sit outside the 30 per cent restriction on the fixed-income portfolio.

“We are in the process of reviewing our allocation to emerging-market debt,” he says. “One of the challenges is managing the foreign exchange risk, which is cumbersome and costly.”

AP4’s currency exposure – the proportion of assets in foreign currencies not neutralised by hedges – amounted to 27 per cent of assets at the end of last year.

Greater ESG integration

AP4 has just been awarded a ‘AAA’ rating in the Asset Owners Disclosure Project (AODP) Global Climate 500 Index, coming eighth out of 500 institutional investors. Under Ekvall’s watch, the fund will continue to extend its sustainability reach even further. It is now looking into how to integrate a number of themes into its investment strategy, including water scarcity and resource efficiency.

Reviewing how to increase the amount of global equity in low-carbon strategies from today’s 24 per cent of the allocation, is another priority.

“We want to increase our low-carbon strategies and are currently developing ways to put more pressure on, and incentivise, companies to de-carbonise further,” Ekvall says, adding that the fund is also going to increase efforts to make sure all investment decisions take enough consideration of the risk/return impact of climate change.

Generally, investors are classified into one of two categories. Those who use external management to invest their money are considered allocators. Whereas, those who use internal personnel to invest directly into securities or other assets are labeled investors.

This article will explore that concept a little differently. It will focus only on those that use external managers. It will classify as allocators only those who do not spend the time necessary in their due diligence on the manager to address alignment of interests related to fees and legal terms.

Those who make this a part of due diligence will be acknowledged as investors.

A critical part of due diligence

Is aligning interests important enough to spend a significant amount of time on it in due diligence? The answer is an unequivocal yes!

All too often, the limited partner assumes that the general partner will act in its best interest and fails to conduct a thorough look at the legal documents or the fee structure.

Every limited partner wants to pay less in fees, but some don’t consider the fee structure an important vehicle for directing the behaviour of the general partner. Those same allocators also don’t realise that the general partner wants maximum flexibility in the use of the limited partner’s money, with as little risk as possible.

With attorneys being paid handsomely today, they feel an obligation to get the most for their client. The general partner’s attorneys’ typical strategy is to put everything into a legal document (for example, a lasting power of attorney) that favours their client and let the opposing counsel, representing investors, sift through the excruciating detail to find what needs to be eliminated or discussed.

The value of scrutinising fee arrangements

Let’s look at some examples as they relate to fees and legal terms that can have an impact upon the outcome of the performance of a fund. Note that these examples represent just a handful of the many factors to be considered when performing due diligence; this article is not designed to be comprehensive.

There is growing discussion around fees in the industry, not just around disclosure but calculation as well. This is increasing in importance as fees become a much larger percentage of returns in a lower-return environment. Choosing an appropriate structure is essential.

The 1 per cent/30 per cent model is one of many alternative fee arrangements being seriously studied and is designed to help the limited partner receive a much fairer net return in a low-return environment.

If there are high returns, a 1 per cent/30 per cent calculation provides the manager additional revenue above a traditional 2 per cent/20 per cent model when it becomes more affordable to the limited partner.

There are also flat-fee arrangements with managers, which assure the investor that the management fee won’t increase at market rates of return, while also assuring the manager of a certain dollar amount to cover its business costs if returns are negative.

Further, many investors are negotiating hurdles in this low-return environment. Also, fees should be paid for alpha and not beta. That requires a well-structured benchmark so fees are paid only on the excess return over the benchmark. In such arrangements, investors must also consider what to do if the manager doesn’t meet the return expectations.

Obviously, high-water marks have been around for a long time and were designed to keep the limited partner from paying excessive fees on poor performance over the years. But what about compounding the benchmark as it relates to carry to better match the compounding of the investor’s liabilities? Limited partners who are just allocators probably don’t think about the importance of matching the compounding for both assets and liabilities.

Remember, managers are charging high fees with promises of great returns to the limited partner. Shouldn’t there be an understanding of the needs of the limited partner to meet its liabilities (such as accruing pension liabilities and payouts)?

Make no assumptions about legal terms

Limited partners should take a second look at their negotiation of legal terms with the general partner as well. There are many examples of legal terms to which limited partners that want to be investors must pay attention.

One chief investment officer of a municipal plan was shocked to find out that the settlement payment for a US Securities and Exchange Commission violation by the manager of one of the plan’s funds was charged to the manager’s fund.

The municipal plan’s attorneys had properly negotiated that the expenses for the litigation the manager incurred could not be charged to the fund in the indemnification provision of the agreement, but had failed to consider the judgement or settlement costs.

Another extremely important legal issue is that of fiduciary duty.

The concepts of duty of care and duty of loyalty are both bundled into the fiduciary context. These duties assure good behaviour on the part of the manager. However, clever attorneys representing general partners have been eliminating the statutory fiduciary duty protections for limited partners and replacing them with contractual provisions that favour the manager.

Without those protections, the limited partner has limited recourse of action.

All too often, allocators ignore the importance of fiduciary language, thinking the manager is naturally a fiduciary by law. The fiduciary duty language is only one example of the need to perform legal due diligence.

In summary, a good investor must be knowledgeable of the fee structure and legal terms in the fund documents. A good investor realises that the ultimate decision rests with the business partners and not the attorneys.

By working with experienced attorneys, however, an investor can become aware of the pitfalls for limited partners in the fund documents.

Good investors will press the general partner for fair treatment, not fearing harming the relationship. They understand the importance of their fiduciary responsibility and expect the same from the manager.

Bruce Cundick is the chief investment officer of the Utah Retirement Systems.

 James C. Davis is chief investment officer of OPTrust, one of Canada’s largest pension funds. It has assets of C$19 billion ($13.8 billion) and investment professionals located in Toronto, London and Sydney. Davis joined the fund in September 2015. He leads the organisation’s investment strategy and oversees its diversified portfolio, which spans the globe with public market, private market, infrastructure and real-estate assets in North America, Europe, developed Asia and emerging markets. He discusses the fund’s member-driven investment philosophy and how it is transforming OPTrust from an asset-management organisation into a pension-management organisation.

 

conexust1f.flywheelstaging.com: OPTrust has defined itself as a pension management organisation focused on risk allocation and not chasing returns. What has prompted this philosophy? 

James C. Davis: Pension certainty is what matters most to our members. This means earning a sufficient return to pay pensions today and long into the future, and not jeopardising the stability of contribution rates or benefits.

Investment returns are important, but for OPTrust, the plan’s funded status is the most important measure of success. A fully funded plan ensures we are well positioned to meet our pension promise of security in retirement for our 90,000 members. Our member-driven investment (MDI) philosophy is centred around managing risk – returns are the outcome. We strive to take risk purposefully and efficiently, and to be rewarded appropriately for the risk we take, in order to earn the returns required to keep the plan sustainable for the long term. It is this careful balance of risk and return that will enable us to remain fully funded and deliver pension certainty for our members.

 

Can you expand on OPTrust’s member-driven investment strategy?

For any investor, a clear understanding of your objective is critical for every decision you make. At OPTrust, keeping our plan in balance – through stability and sustainability – and remaining fully funded is our singular focus. Our MDI perspective gives us a strong understanding of our liability risk profile and the returns required over a long-time horizon to meet our obligations.

MDI is more than liability-driven investing – it goes beyond mitigating the interest rate sensitivity of our liabilities. Our plan is mature and maturing; we cannot bear the same level of risk as we did 10 or 20 years ago. MDI focuses on allocating risk in the most efficient way, considering all the constraints we face, including those related to plan maturity.

MDI is transforming OPTrust from an asset-management organisation into a pension management organisation. Our focus on funded status is driving a cultural change, [generating] more alignment across asset classes and a total fund focus. Portfolio construction is playing a greater role. It’s not just about alpha anymore, it’s about total return and using risk as efficiently as possible.

 

As an industry, pension funds are facing challenging conditions; market volatility has become the new normal and interest rates have remained low for a prolonged period. How can investors thrive and grow with these macroeconomic challenges?

To be successful as an investor, it is important to have an edge. Competition in the markets is becoming more intense and the challenging macro-environment is making it harder to maintain an edge. At OPTrust, we are striving to build a culture that encourages innovation. Through innovation, we will be able to re-define our edge as the world around us changes.

Our size has proven to be a sustainable edge. It allows us to be nimble and to focus on mid-market deals that larger plans would overlook. We embrace complexity when it makes sense to do so. Some deals may have ‘hair’ on them, causing some investors to shy away. We have a deep private markets team that will take on the challenge of more complex deals and will structure these deals with reward-to-risk payoffs that align with our MDI objectives.

Core to OPTrust’s MDI strategy are strategic relationships. We rely on strong partnerships to show us deal flow and to provide insight. Often, when we are trying something new, we will ask our partners to challenge us. Their insight can help us [develop] a new idea into a competitive edge.

 

Canada’s pension funds have led the world with their approach to investing and asset allocation. OPTrust recently announced its plans to bring trading in-house. Why the move?

Internalising our capital market capabilities is a natural evolution for OPTrust, given our success with the fund’s private-markets and real-estate portfolios, which are largely managed internally.

Agility is key to the success of our MDI strategy and in-house trading will allow us to customise and diversify our investment solutions, rather than relying on third-party, off-the-shelf solutions. It goes beyond trade execution to capital efficiency, enhanced liquidity, market intelligence and direct access. Perhaps most importantly – in a challenging environment where returns are expected to be lower than ever before – costs matter. Internalising our capital markets capabilities will reduce costs.

In many ways, the internalisation of OPTrust’s capital markets activities is inextricably linked to our competitive edge of agility and innovation. The demographic profile of our members, the benefits we pay and our liabilities are unique. We believe the best way to manage risk, and keep the plan in balance, is through customisation.

 

The political climate around the globe is changing and we’ve seen a rise in populism. Looking forward, what impact will this have for institutional investors?

The political climate around the globe creates uncertainty. That uncertainty leads to both risks and opportunities. It means understanding the implication of economic policy changes in the US or elsewhere, anticipating how the markets will react and being prepared to take advantage of opportunities. We start from a position of balance, where we know we can weather the inevitable downturns. Beyond [that], agility and remaining liquid are probably the most important measures we can use to thrive in this environment.

Markets are quick and often overestimate and react in different ways; we have witnessed this with Brexit and the US election. Being prepared, with the right strategy in place to adjust portfolio risks based on policy changes or how the markets are priced, will continue to be core to our success.

 

It’s been said that technological change is disrupting economies and companies. What does innovation mean for investors and why is it so important?

The investment decision-making process will have to change to keep pace with innovation. Today, it’s not just that company A has a new product or idea that may be disruptive to an industry. Rather, it’s how our industry responds to technological change. Big data and artificial intelligence are being used to eke out an edge in investing. As such, we need to be mindful and understand how others may be exploiting and enriching their portfolios with new technology.

Innovation is not new. The steam engine, railway, telephone, commercial aviation – these were all innovative and disruptive at one point. More recently, during the dotcom era in the 1990s, it was hard to predict the winners. Instead, it was easier to target which industries were at risk and what investments to avoid. Being mindful of the potential losers and not just the companies with the newest innovations can go a long way towards improving investment performance.

 

 

 

Are markets just background noise? Should pension funds ignore political risks, overpriced assets and economic forecasts? Are all these just short-term effects that are hard to predict and best left to rich hedge fund managers? Should lesser mortals, like humble pension fund managers, focus just on the long term?

One pension fund’s recent experience offers answers to these questions.

Nationwide Pension Fund adopted a new long-term plan for its Cheshire and Derbyshire (C&D) section that called for a methodical adherence to automatically de-risking as threshold funding levels were reached. The result? C&D reached its objectives with years to spare, despite numerous market disruptions. Here’s how it happened.

A pension fund has only one clear objective – to pay the benefits due to its members, as and when they fall due. This is a long-term objective, even for closed defined benefit schemes. The strategies to deliver this objective generally focus on reducing risk and seeking a degree of certainty about meeting those future cash-flow requirements.

For the UK’s Nationwide Pension Fund, the trustees have agreed that being fully funded on a low dependency (LD) basis, with 100 per cent interest rate and inflation hedging, is a position that gives a strong degree of assurance that the fund should be able to meet its future benefit requirements without recourse to the sponsor.

For the purposes of the fund, the LD valuation assumes that liabilities are discounted at gilts plus 0.2 per cent, while the assets are expected to realise gilts plus 0.5 per cent. The excess 0.3 percentage points are there to cover service and management costs and changes to longevity.

This is not a perfect solution but it significantly reduces risk and the trustees are now more comfortable they can meet the obligations to members. It is certainly a more prudent position than the technical provisions calculations agreed upon with the sponsor, which discount liabilities at a higher level and assume a much greater expected return from assets.

The fund has two sections: Nationwide and the Cheshire and Derbyshire (C&D) section. The C&D is an amalgamation of two schemes blended into the fund following the merger of the Cheshire and Derbyshire building societies into Nationwide in 2009. C&D was reasonably funded then and following a payment of £15 million ($19 million) from the sponsor in 2010, it was fully funded on a TP basis, with £177 ($229 million) of assets.

A target for 2020

At this point, the fund was 40 per cent in equities, 47 per cent in gilts, 10 per cent in active corporate bonds and 3 per cent in alternatives. The trustees quickly agreed to focus on LD as the long-term target for the C&D section. A revised investment strategy was agreed upon that offered an expected return, which combined with a series of de-risking thresholds to provide a 50 per cent chance of reaching the LD target by 2020. This was mechanistic, with no regard for any views on markets beyond a long-term expected return from the assets.

The long-term plan commenced with a restructure into 30 per cent passive equities and 70 per cent passive gilts, and a series of incremental thresholds based on the funding level relative to the LD target. As these predetermined thresholds were reached, the portfolio would incrementally reduce equity exposure and increase the gilt exposure to improve the liability hedge.

Through the course of this strategy, only one further change was made; again, focused only on the long-term aim of achieving the LD position. This was to increase the liability hedging, through some modest leverage to some of the gilt exposure.

In October 2016, almost four years ahead of plan, the C&D reached its objective. It was fully funded on an LD basis and it was fully hedged for both inflation and interest rates. It had a 7.5 per cent allocation to passive equity and 92.5 per cent to gilts, linkers and AAA bonds. No views or opinions on rates, inflation, asset values, economic forecasts or political activity were given consideration on this journey. Again, the only strategy was automatically de-risking as threshold funding levels were reached. Since 2010, the sponsor has made no further contributions.

As this was happening, we experienced the tail end of the financial crisis, quantitative easing, negative interest rates, the European debt crisis, an oil price collapse, the Scottish referendum, Brexit and Trump, among other disruptions. None of these led to a change of direction. Indeed, in the context of the investment strategy, most of them weren’t even worthy of discussion. As at the end of March 2017, C&D had present liabilities, on an LD basis, of £329 million ($426 million) and assets of £333 million ($431 million). Having a long-term plan, sticking to it and putting aside any views on future markets for the sake of the long-term strategy paid off.

So, is worrying about the short term and trying to second guess markets worthwhile for pension fund trustees and their investment teams? If the C&D experience is anything to go on, perhaps a better use of a pension fund’s governance budget is to agree on a long-term objective, plan how to get there and focus on staying with the plan.

Mark Hedges is chief investment officer of the Nationwide Pension Fund in the UK.

Cbus Super executive manager, investment management, Trish Donohue, is publicity shy, while the fund’s executive manager, investment strategy, Kristian Fok, loves the limelight. It is just one of the many differences in their personalities and skill sets that have made them such a winning partnership for nearly two decades, held together by the glue of a shared sense of purpose.

The pair were joint winners of the prestigious Chief Investment Officer of the Year trophy at the Conexus Financial Superannuation Awards 2017, announced at a gala dinner at Ivy Ballroom in Sydney on March 9. Together, they share responsibility for the traditional chief investment officer role at the $A37 billion ($28 billion) construction industry fund.

“Kristian and I have actually been working together for 17 years,” Donohue said as the pair stood together on stage to accept the award on the night. “And while we don’t always agree, we do work well together. I put that down to a shared belief in always looking after the best interests of our members.”

Fok thanked Donohue for her vision in bringing him on board to help implement the fund’s ambitious growth strategy.

“I’d like to thank Trish for guiding me since I joined, and for understanding the enormous potential of the fund,” he said.

Donohue was the founding member of the Cbus investment team in 2000 and has led it ever since. A former Mercer consultant and actuarial analyst, she was originally hired by the fund to oversee its asset allocation strategy and external fund manager selection process.

In 2011, she spearheaded a major review of the fund’s investment strategy that led to the board approving a proposal to bring Fok, the fund’s long-time asset consultant from Frontier Advisors, in-house to share the chief investment officer role.

Fok’s former boss at Frontier, the firm’s inaugural managing director now its director of consulting, Fiona Trafford-Walker, has observed the dynamic between the Cbus co-CIOs up close.

“I’m sure they don’t always get along perfectly but they are really good at having healthy professional disagreements and I think they bring out the best in each other,” Trafford-Walker says. “It is definitely one of those situations where one plus one equals three. It is very refreshing to see two such senior people in the finance sector who are so much more focused on the long-term goals of the fund than their egos.”

In a crude sense, their respective responsibilities at the fund are split so that Fok now has primary oversight for investment strategy, while Donohue has primary oversight of implementation.

 

Insourcing plans

In August 2016, the Cbus board approved a plan Donohue and Fok assembled to lift the proportion of assets managed in-house from 8 per cent to 20 per cent within five years.

To support this strategy, the board also signed off on the hiring of an additional 25 internal investment staff. The new members of the internal team will mostly be specialists in equities and infrastructure.

As of March 2017, the growing Cbus investment team consists of 55 staff, who are researching and readying to take on mandates. Subsidiary Cbus Property, the fund’s wholly owned real estate developer, manages another 5 per cent of member assets.

Cbus Property employs roughly 35 staff and has created more than 70,000 construction jobs via its direct investment program since the business was created.

The Cbus Property portfolio exceeds $3.2 billion, with a further $5.0 billion of development work in hand.

In total, roughly 10 per cent of the fund’s total assets are managed in-house. Under the new insourcing strategy, and with total funds under management projected to swell to $50 billion by 2021, the internal investment teams are set to be collectively managing at least $10 billion within four years.

The real number could be significantly higher.

“Getting up to 20 per cent is a fairly conservative target. If you look at some of the big international pension funds, 30 per cent internal management is quite typical,” Fok says.

He was adamant that they are in no rush.

“We want to do this right, and let me be clear, we are not looking at removing all external managers. Although [we are already] finding new ways to work with our managers,” he explains. “Things we expect to do more of include co-investments, designing strategies and having them implemented by external managers, and non-discretionary mandates, where the manager produces opportunities and we say yay or nay.”

Donohue takes the lead on negotiating manager contracts and has already had success in reducing costs since the insourcing strategy was announced late last year. The strategy aims to allow the fund to lower member fees by 10 to 15 basis points within five years.

Fok says that estimate is now “looking conservative”.

As well as shaving off costs, these types of structures all make it possible for Cbus to exert more control in their fund manager relationships. By investing in fewer prepackaged products alongside other investors, Cbus is reducing the risk of managers being able to lock-up their members’ funds in the event of another market crisis.

De-risking the portfolio

Even without a significant downturn, the current investment outlook is challenging.

About two years ago, Cbus lowered the target return on its MySuper product by 25 basis points and there remains a risk this may have to be reviewed again, amid meagre global growth and ultra-low interest rates.

Over the past four years, Cbus has progressively reduced its exposures to private equity funds and listed equities, while increasing diversification.

Less headline grabbing than the insourcing strategy, but equally important, is Donohue and Fok’s ongoing effort to de-risk the portfolio.

Another outcome of the investment committee review back in 2011 that led to separating out the strategy and management teams was a change in the investment strategy to focus on absolute returns.

Donohue says this was a pivotal decision because it has freed up the investment team to care less about how they might be performing against rival funds in the short term.

“Peer risk…still needs to be acknowledged but it’s important that it is not allowed to be a big driver of investment decisions,” she says.

Peer risk refers to the risk of members choosing to take their money out of the fund during a period of relative underperformance.

“We are mindful that we are in a choice environment, so people can always switch if they feel the fund is not performing,” Donohue says. “But we don’t want that to be a driver because when you are comparing yourself to others you are always looking backwards.”

Of course, it is easy to say you don’t care about league tables when your fund is doing well. According to data from research house SuperRatings, Cbus MySuper has outperformed its peers over the past one, three, five, seven and 10 years.

Donohue says having a focus on absolute returns, rather than benchmark-relative returns, makes the most of the competitive advantages of strong liquidity and cash flow the fund gets from its default status by allowing it to maintain an allocation of about 40 per cent to unlisted assets.

Roughly 90 per cent of the membership is automatically signed up by their employer.

“The fund is very resilient. Inflows have grown significantly this past year, compared with recent years, and forward-looking stress testing indicates continued strong cash flows,” Donohue says.

She is mindful, however, of the risks associated with relying on this.

“We do a lot of work around liquidity stress-testing on a regular basis, to check how the portfolio would react to a number of elements that might affect liquidity, not just if there were changes to default, or another driver of changes to contribution rates, but also to downturns in markets and how that might affect our unlisted assets and other exposures,” she says.

Cbus is holding about 10 per cent of total assets in cash.

“That’s a higher allocation to cash than we would typically have but it is offset by a much lower than typical allocation to fixed income,” Fok says.

Roughly half the cash holdings are managed internally.

“Managing more cash internally, as well as lowering costs, gives us more control,” Fok explains. “In the GFC, lots of funds had their whole cash accounts locked up for periods.”

Donohue adds the fund has spread out the roll-out periods on their cash accounts to make the liquidity profile less lumpy.

Since the global financial crisis, and particularly in the past four years, the fund has expanded its use of sophisticated derivatives and futures overlays. This will allow it to move more quickly if there was ever a rising concern about any potential changes in the liquidity profile.

“There were a couple of lessons from the GFC and, in response, a lot of things have been repositioned and we continue to enhance the strategy’s flexibility,” Fok says. “The great thing about using options is it allows you to generate cash when you need it most.”

Property risks

Flexibility is important when such a high proportion of the fund is in unlisted assets.

The financial year ended June 2016 was a bumper period for Cbus Property, with the portfolio returning above 24 per cent for the 12 months. Over the past 10 years, the property fund has delivered an average annual return of nearly 17 per cent.

But many, including the Reserve Bank of Australia, have questioned the sustainability of the nation’s property boom, which raises the question of whether Cbus Property’s success is another potential source of future vulnerability for the fund.

Donohue and Fok argue that the direct investment structure makes Cbus less vulnerable in the event of a property market downturn than if it only invested via external property funds.

In the GFC, it became quite difficult to redeem out of a pooled property trust. But Cbus was able to liquidate a couple of small real-estate assets it owned directly to tap into cash.

A property downturn could be a double whammy for Cbus, as it might be accompanied by a drop in employer contributions on behalf of its construction industry members.

Someone Donohue and Fok turn to for advice on managing the risks associated with the fund’s property exposures is Cbus investment committee chair Stephen Dunne, who is a former chief executive of AMP Capital, one of the country’s biggest property investors.

Dunne joined the board as investment committee chair in November 2015, bringing a “different personal flavour” to governance than his predecessor Peter Kennedy.

“He’s put a five-page limit on all papers to the committee, which really forces us to be succinct, then questions us to drill down when needed,” Fok says.

Donohue says Dunne’s background at AMP Capital gives him great insights into what the fund is trying to achieve in building up an internal investment team.

As investment committee chair, he will no doubt also have curly questions about how Donohue and Fok are reviewing the performance of internal management teams.

As with external managers, those who do well can expect to see their allocated funds under management increase, while those who underperform long term will face the axe. Frontier has also been engaged to play a formal role in internal manager assessment.

 

conexust1f.flywheelstaging.com has partnered with the Thinking Ahead Institute on a regular column of investment insights to provoke thought and discussion among asset owners and managers around the world. This first column looks at ETFs and looks at when an ETF isn’t closely matched by its underlying components, liquidity can dry up, credit risks can emerge, and other factors can eat away at expected returns.  

Since their introduction in 1990 as a cost-effective means of index replication, exchange-traded funds (ETFs) have grown exponentially in number, variety and asset value.

At the end of 2007, before the main market impact of the global financial crisis, there were 1170 distinct ETFs with a total market value of $851 billion. Nine years on, at the end of 2016, the comparable numbers were 6625 funds valued at $3.546 trillion (according to sector researcher ETFGI) – an increase in assets of 317 per cent over the period.

ETFs’ rising popularity stems from several benefits they offer investors: they are cheap (the total expense ratio on State Street’s $139 billion SPDR fund is 9 basis points); they provide exposure to numerous asset classes, industries, geographies, factors and indeed combinations of these; and, in theory, because they are listed on exchanges, they offer a liquid means of building, hedging or shorting a position.

ETFs, however, are not without their risks.

Liquidity issues have emerged in the past, in periods of market stress, and remain contentious.

ETFs are structured to provide liquidity at two levels: through trading on the secondary market (investors trade shares in the ETF like a normal listed share); and through primary market liquidity, when they are liquidated or created from their underlying components.

It is instructive to distinguish between “plain vanilla” and exotic ETFs. In the former grouping, the instrument is closely matched by its underlying components, both in terms of composition and liquidity. Provided the ETF is not so large that its dealings have a market impact, plain vanilla ETFs have proved to be largely robust in the past. Capacity management (the market impact point) is the main issue to watch. Despite some temporary divergences from their underlying indices, these ETFs have, for the most part, been true to their stated objective of providing exposure to their underlying holdings.

In contrast, exotic ETFs are characterised by liquidity mismatches, leverage or both – and it is on these products that concerns tend to focus.

In the event of a sell-off in a high-yield ETF, for example, where liquidity in the underlying bonds has all but disappeared, gaps may emerge between the price of the ETF and that of the index it is trying to replicate.

In theory, the action of authorised participants (APs) in the marketplace should prevent this. APs are incentivised, but not obligated, to make a market in ETF shares and exploit arbitrage opportunities when the price of an ETF diverges from what underlies it. However, given that this involves a parallel trade in the underlying securities, APs may withdraw from the market when the liquidity of the underlying holdings dries up, or there is significant market volatility in the price of the ETF’s components.

Under these circumstances, the price of the ETF may diverge significantly from the stated index price, due to supply of and demand for the ETF in the secondary market.

Synthetic ETFs and counterparties

Synthetic ETFs, which are backed derivatives not physical securities, with investment banks as counterparties, also present some issues.

In many cases, the collateral the counterparties post to the derivative arrangement bears no relation to the assets of the underlying index being tracked. At times of stress, this mismatch exposes the ETF to credit risk from its counterparties.

Aversion to holding the collateral basket or dealing with the counterparty bank may cause APs to stop providing primary market liquidity – again giving rise to potential price discrepancies between the ETF and its components.

There are also market structural reasons why the performance of an ETF may not replicate its target index.

For example, in the case of the Volatility Index (VIX), the ETF will replicate its exposures using forward contracts on the index. Owing to the usual state of contango (upward slope) on the VIX futures curve, long-term holders of the ETF will gradually have their capital eroded, relative to the performance of the index, from paying away the roll yield of the futures.

Leveraged ETFs and rebalancing

Leveraged ETFs present other difficulties. Due to the requirement to rebalance leverage daily, investors using such ETFs to match their exposure to an index may find that after three days of market volatility they have not had the gains or losses they expected based on the performance of the index.

Then there are issues relating to ETF operational structures. Given the predictability of ETFs trading in the market when indices are rebalanced or future contracts are rolled over, there is some concern that they are easy targets for speculators, particularly in times of financial stress.

Ultimately, the outcomes from ETFs come down to how they are deployed. To determine this, we invoke our strategies for coping in a complex investment environment.

Investors need to be clear on their investment objective, have a clear understanding of the strategy they are deploying to achieve this, and be mindful of the other market participants trading in ETFs and how they might be looking to exploit structural features of the products.

 

Jeremy Spira is senior investment consultant at the Thinking Ahead Institute, an independent research team within Willis Towers Watson.

The Thinking Ahead Institute is a not-for-profit member organisation that was established to change investment for the benefit of the end saver. It has around 40 members, which account for over US$14 trillion in AuM and is administered by Willis Towers Watson’s Thinking Ahead Group, which was launched 15 years ago to challenge the status quo in investment and identify solutions to tomorrow’s problems.