Mercer’s chief investment officer, Russell Clarke, explains how manager research helps create the 200 building blocks of an investment operation that has grown from $20 million a few years ago to $124 billion today and which covers – uniquely – all elements along the fixed income curve.

 

Starting from scratch in 1996, Melbourne was the first global office of Mercer to set up a master trust and now its operations oversee money – mostly corporate sponsored retirement funds – in North America ($50 billion), Europe ($49 billion) and Australia and New Zealand ($25 billion).

Russell Clarke, Mercer’s global chief investment officer for listed asset sectors, works in Melbourne, in a posting that was broken by a recent two-year spell in London.

Clarke tells of how the first clients to outsource, due to concern over a lack of sufficient scale and governance, were of the order of $20 million. But for institutional investors, what constitutes lack of scale has grown exponentially.

“You know as much as night follows day that the larger clients will do it,” Clarke says.

Mercer outsources all funds management to about 100 external providers, offers a mixture of tailored and pooled solutions, and has 200 funds which are the building blocks of portfolios.

“We offer customised manager line-ups and governance structures,” Clarke says.

“We take on fiduciary responsibility.”

Mercer does have some large clients, with assets around $25 billion, where it does customised asset allocation. But most clients are smaller than that, and view the running of a pension fund as outside their core business, and in some cases even as a distraction.

“They outsource to someone with scale, making it meaningfully cheaper than doing it in-house,” Clarke says.

Many larger clients outsource the operational aspect of investing, maintaining involvement at the strategy level, but give Mercer full discretion for manager selection and monitoring.

Clarke says a lot of its large defined benefit fund clients, in Europe particularly, are de-risking, and Mercer has a dynamic de-risking solution to match the defined benefit liabilities.

“This requires all parts of the fixed-income curve to be mapped,” he says.

“We have funds as building blocks and can quickly build a tailored solution. This is a unique feature for us.”

The fixed income funds vary from swap-based funds to 50-year duration, demonstrating the degree of granularity in the fixed income suite.

The fixed income funds are mostly passive, and Mercer usually has just one provider. In the US it uses State Street Global Advisors, but there are different providers in different regions.

Despite the passive view for fixed income, however, Mercer does believe in active management, with Clarke adding that the view is not systematically all active versus passive.

“We generally say you can add value and it is possible to pick managers to do that but we look at it on a market by market basis,” he says.

He says Mercer’s clients “buy us because they like our research, and that having 120 people that conduct fund manager research globally is a competitive advantage.

“They all follow a consistent framework in the research and this adds a lot of rigour and richness to our discussion around managers,” he says.

The research covers over 26,800 investment strategies and of these, more than 9100 are rated by Mercer, with about 2600 getting an “A” rating. These latter strategies are the starting point for Mercer when considering what to use for its master trust clients.

Clarke says that the fund manager research program has added value, claiming that at March 31, 2014, the value added since inception has been positive for 93 per cent (62 out of 67) of the product categories covered in its research.

The rolling average value added figures for one, three, five and 10 years are 2.3 per cent, 1.6 per cent, 1.6 per cent and 1.0 per cent per annum, respectively, ahead of the benchmark. Since inception it is 1.4 per cent per annum ahead of benchmark.

In the US the portfolio team is centred in Boston with most of the manager research team in Chicago and St. Louis. European research is based in London, where Bill Muysken, global CIO for alternatives, is based; and European portfolio management based in Dublin. The Pacific region portfolio management is based in Melbourne.

While there are separate pools of money for the three continents, much of the research and manager line-ups are deliberately the same.

“Over the last five to seven years we have become a truly international business in the way we interact from an investment standpoint,” Clarke says.

“We have always talked to each other, but it has become much more integrated and holistic.”

Another theoretical advantage from this scope is local knowledge in several markets. The economist sitting in an office in America or Europe who makes pronouncements on the relative health of the Chinese economy is a staple of the investment news output, but some prognosis can get lost without nuanced local knowledge. Clarke recognises this issue.

“People write things about the Australian resource sector from overseas, but when you live here you realise how shallow a lot of that analysis is,” he says.

“There might be an element of truth in what they are saying, but they may have missed the other third of the story that is really important.”

The large business clients dotted around the globe provide another less expected source of data.

“From a macro standpoint our clients are a great source of information,” Clarke says.

“They are often in the front line industries where if you want to know if the economy is slowing down, we’ll go and talk to the person in that industry to see if it is.”

In each region clients will have a bias towards their local assets, but their global allocations will look very similar. Across clients, roughly 10 per cent is allocated to alternatives and property, with the rest split approximately equally between equities and fixed income assets.

The Q3 outlook to clients from Clarke’s office says low inflation and low interest rates will support solid growth in equity markets in the developed world where the fund is overweight.

It says conditions for emerging markets are more challenging because of the “build-up of imbalances over the last few years”, but notes that favourable valuations and a modestly improved economic performance will lead investors back into the market.

Mercer’s underweight position on bonds is due to very low yield levels, which suggest returns over the medium term are likely to be lower than normal.

All of these positions are subject to rapid change.

“Most of our clients are fully discretionary and allow us to move the asset allocation of the portfolio… we put a lot of time into the dynamic asset allocation,” Clarke says.

Since April, Mercer has been positive on growth versus defensive assets, with global developed market equities and emerging market equities in particular looking attractive to it.

It views global government nominal bonds and inflation-linked bonds as unattractive, and has a similar view on US-dollar cash.

As much as Clarke is willing to talk up the strengths of the operation, he also readily concedes the relative lack of status of his role in an organisation that runs based on existing, in-depth research.

Much of his role involves organisation and talking to the teams around the world, rather than being an inspirational, investment guru.

“It is not reliant on one or two key individuals”, he says.

Although anyone who looks at his job and thinks it easy should think again.

“You can find real visionary people, but often they are not very good at making things happen,” he says.

Risk parity is a meaningful and robust approach for building well-diversified portfolios, but it relies on historical volatility estimates, which penalises upside risk as well as downside risk and leads to a massive overweighting of bonds versus equities, even in a low yield environment. The authors from EDHEC Risk-Institute build the case for an alternative method.

 

Risk parity has become an increasingly popular approach for building well-diversified portfolios within and across asset classes.

In a nutshell, the goal of the methodology is to ensure that the contribution to the overall risk of the portfolio will be identical for all constituent assets, which stands in contrast to an equally-weighted strategy that would also recommend an equal contribution but instead simply be expressed in terms of dollar budgets as opposed to risk budgets.

While intuitively appealing and empirically attractive, this approach suffers from two major shortcomings.

Firstly, typical risk parity portfolio strategies used in an asset allocation context inevitably involve a substantial overweighting of bonds with respect to equities, which might be a problem in a low bond yield environment, with mean-reversion implying that a drop in long-term bond prices might be more likely than a further increase in bond prices.

Secondly, standard approaches to risk parity are based on portfolio volatility as a risk measure, implying that upside risk is penalised as much as downside risk, in obvious contradiction with investors’ preferences.

In recent research supported by Lyxor Asset Management as part of the “Risk Allocation Solutions” research chair at EDHEC-Risk Institute, we develop a conditional approach to risk parity, which contrasts with standard unconditional risk parity portfolios based on historical volatility estimates, with an attempt to alleviate the two aforementioned concerns.

In a first step, we recognise that duration is a decreasing function of the bond yield for a coupon-paying bond.

As a result, a decrease in bond yield levels should lead to an increase in bond duration, and as such, an increase in bond volatility should lead, all else being equal, to a decrease in the allocation to bonds for a risk parity portfolio.

By using a robust econometric procedure that explicitly relates unobservable bond volatility levels to observable bond yield levels, we actually obtain an explicit response to the risk parity bond allocation as a function of changes in yield levels.

In a second step, we define a new class of conditional risk parity (RP) portfolios with respect to downside risk measures such as semi-variance, Value-at-Risk (VaR) or expected shortfall.

In all of these cases, conditional estimates of expected returns on stocks and bonds actually impact the estimated risk levels, so that an economic environment where the risk premium is historically high for stocks and low for bonds would lead to a further decrease in the allocation to bonds with respect to an unconditional risk parity technique, but also with respect to a conditional risk parity technique relying solely on volatility as a risk measure.

In a final step, we analyse a competing approach that explicitly accounts for changes in risk premium levels, as opposed to having them indirectly impact the risk parity portfolio through their impact on the portfolio downside risk.

From a formal perspective, this last extension is based on the recognition that risk parity is equivalent to a Sharpe ratio maximisation program under the assumption that all asset classes have the same risk premium and the same correlations.

While this constant risk premium assumption can be regarded as a reasonable, or at least agnostic, prior from an unconditional perspective, it is hardly defendable from a conditional perspective (that is for all possible market conditions), particularly when bond yields are low and dividend yields are high.

In this context, it would be preferable to adjust the risk budgets dynamically around the long-term 50 per cent/50 per cent risk parity target so as to better reflect the current market environment, and we provide an analytical expression for the dynamic adjustment to risk budgets for each asset class that optimally reflects changes in market conditions, by defining these time-varying risk budgets as the set of risk budget targets that makes the risk budgeting portfolio a maximum Sharpe ratio portfolio given current estimated levels of volatility and Sharpe ratios for equities and bonds, while assuming an identical long-term Sharpe ratio for the two asset classes.

 

Duration-based volatility is an instantaneous and observable volatility bond measure that avoids the sample dependency and overweighting of bonds in a low interest rate environment, which inevitably follow from the use of historical volatility measures in the construction of risk parity portfolios.

In response to the two major problems identified with historical volatility, namely sample dependency and backward-looking bias, we introduce in our research an alternative bond volatility measure, which we refer to as “duration-based volatility” (in short, DUR volatility).

This measure is suggested by the model-free approximation of the return on a bond portfolio as the product of the negative of duration times the yield change: thus, DUR volatility equals duration times the yield volatility.

Duration is readily observable, both for a single bond and for a bond portfolio, where it is given as the weighted average of constituents’ durations, but yield volatility has to be estimated.

In this sense, DUR volatility is quasi-observable, rather than fully observable, but unlike rolling-window (RW) and GARCH volatilities, it reacts instantaneously to changes in bond yields, which translate into changes in bond duration.

As such, DUR volatility also helps to address the issue of bond overweighting in a low-interest rate context. Indeed, duration for a coupon-paying bond can be shown to be a decreasing function of the bond yield.

At the index level, where multiple constituents are involved, making the analysis less explicit, the negative relationship between duration and yield is still confirmed empirically.

The consequence on bond volatility estimates over the past 30 years is shown in Exhibit 1: while RW and GARCH volatilities have been stable or even decreasing slightly, the DUR volatility has followed an increasing trend due to the decreasing trend in bond yield levels, and has eventually exceeded the former measures.

Hence, at the end of our sample period, in December 2012, a risk parity portfolio of stocks and bonds has a lower allocation to bonds when DUR volatility is used instead of RW or GARCH estimates.

To see that this “CRP-VOL-DUR” strategy is also more responsive to changes in market conditions than “CRP-VOL-GARCH” or “URP-VOL-RW”, one can look at the percentage of months in the sample over which bond allocation and bond yield moved in the same direction: Exhibit 2 indicates that this concordance rate is substantially higher for CRP-VOL-DUR. The results shown here refer to portfolios of stocks and bonds, but the same conclusions remain valid when we introduce commodities as a third asset class.

Exhibit 1: Comparison of bond volatility measures; January 1973 – December 2012.

This figure shows the yield of the Barclays US Treasury index, together with its volatility estimated by three methods: a five-year rolling window (VB-RW), a GARCH(1,1) model (VB-GARCH), and a volatility measure proportional to the duration (VB-DUR). Duration is computed using the approximation of Campbell et al. (1997).

 

Risk parity portfolios constructed with a downside risk measure show a higher degree of sensitivity with respect to market conditions, and lead to further decreases in bond allocation in a low yield environment compared to risk parity portfolios constructed on the basis of volatility as a risk measure.

As discussed above, the choice of volatility as the reference risk measure in the definition of risk parity portfolios can be criticised for not capturing investors’ concern over downside risk.

As a result, assets with substantial downside risk can be overweighted as long as they have low volatility, which would be the case for bonds in a low yield environment, when mean-reversion back to higher yield levels would imply that most of the risk faced by investors is on the downside.

A natural idea is to penalise such assets by introducing a downside risk measure in the definition of risk parity portfolios.

The only mathematical requirement is that the measure should be homogeneous of degree 1 in portfolio weights, because this condition is needed to decompose the portfolio risk as a sum of contributions from constituents.

Semi-volatility, defined as the volatility of negative returns, and Value-at-Risk (VaR), defined as the quantile of order of the portfolio loss distribution, both satisfy this condition.

To obtain explicit expressions for these measures as functions of portfolio weights, and to compute the risk contribution of each asset and then to solve for the set of weights that equates these contributions, one needs to make an assumption on the distribution of returns.

A mathematically convenient choice is the Gaussian distribution, but it is hardly appropriate for an analysis of asymmetric and fat-tailed return distributions. In this context, we propose to use the Cornish-Fisher expansion to obtain a correction to the Gaussian VaR that accounts for the presence of non-zero skewness and excess kurtosis levels.

One drawback of these dissymmetric risk measures is that they depend on expected returns, which are notoriously hard to estimate.

Empirical research, however, provides useful guidance with respect to the relevance of state variables such as dividend yields as proxies for the time-varying expected return on equities.

Similarly, intuition suggests that the current yield level can be taken as a predictor for expected bond returns.

Indeed, the price of a bond is a decreasing function of the yield, which exhibits mean reversion. In the current environment, when bond yields have reached historically low levels, bonds appear to be expensive relative to historical standards, thus implying that their expected return is low.

In this spirit, we construct our estimates for expected returns on stocks and bonds in two steps. First, we compute an expected return forecast from a predictive regression, the predictor being the dividend-price ratio for the stock index and the current yield for the bond index. Second, we shrink the forecast towards a prior, which is itself obtained by assuming that the risk premium on the asset equals the current volatility times the Sharpe ratio measured over a very long sample (1926-2012).

 

It appears from Exhibit 2 that the CRP-NGVAR99 strategy, which equates the contributions to the non-Gaussian VaR at 99 per cent, displays a concordance rate (again defined as the percentage of months in the sample over which bond allocation and bond yield moved in the same direction) that is higher compared to other risk parity strategies, notably the one relying on the duration-based volatility measure.

For Gaussian downside risk measures (not shown in the Exhibit), we find that concordance rates are between those of the Cornish-Fisher VaR and the volatility, which suggests that the highest degree of responsiveness to changes in market conditions is obtained with the risk parity portfolio strategy based on the non-Gaussian VaR risk measures.

Interestingly, our results also indicate that the ratio of stock risk to bond risk tends to be substantially lower with this VaR measure compared to volatility or Gaussian risk measures, especially when bond yields are particularly low, suggesting an increase in downside risk for bond portfolios.

As a result, the CRP-NGVAR99 strategy tends to lead to a lower bond allocation than other risk parity strategies tested in our research, especially by the end of the sample period when bond yield have reached unusually low levels.

 

Exhibit 2: Concordance rates of risk parity strategies invested in stock and bond; January 1973 – December 2012.

  Concordant months (%)
URP-VOL-RW 45.346
CRP-VOL-GARCH 48.687
CRP-VOL-DUR 67.303
CRP-NGVAR99 74.582
MSR-SAME-SR 71.241
MSR-DIFF-SR 73.389

The concordance rate is defined as the percentage of months in the sample in which the yield and the bond weight moved in the same direction. URP-VOL-RW is the standard risk parity strategy that relies on historical volatilities; CRP-VOL-DUR is a risk parity strategy that uses duration-based volatility as the bond volatility measure; CRP-NGVAR99 is a strategy that equates the contributions of constituents to non-Gaussian VaR at 99%; MSR-SAME-SR is a maximum Sharpe ratio strategy that uses the same prior Sharpe ratio for both constituents; and MSR-DIFF-SR uses different priors.

 

The maximum Sharpe ratio portfolio, which can be interpreted as a risk parity portfolio under some conditions (identical pairwise correlations and identical Sharpe ratios), is a less robust alternative to incorporating expected returns in the construction of a well-diversified policy portfolio.

Under some conditions, the maximum Sharpe ratio (MSR) portfolio can be interpreted as a risk parity portfolio.

Indeed, in “The Properties of Equally Weighted Risk Contribution Portfolios” Journal of Portfolio Management, the authors establish that the two portfolios coincide if all assets have the same pairwise correlations and the same Sharpe ratio.

In the case of two assets, this condition reduces to the equality of Sharpe ratios, an assumption which can be regarded as a reasonable agnostic long-term prior, but which is unlikely to be satisfied in all market conditions, in particular if bond yields are extremely low and dividend yields are extremely high.

Alternatively, one can also show that the MSR portfolio achieves risk parity for a risk measure defined as volatility with a penalisation for expected return.

In our research, we test two MSR portfolios, which differ through the priors used for expected returns. Exhibit 2 shows that the concordance rates are close to those of the risk parity strategies constructed from duration-based volatility or Gaussian VaR.

Hence, our results suggest that there are no additional benefits to expect from MSR strategies in this dimension. Another non-negligible drawback of these portfolios over the risk parity portfolio based on the Cornish-Fisher approximation, which uses the same expected return estimates, is that they involve a much higher level of turnover.

This property reflects the well-known fact that MSR weights have high sensitivity to expected returns, and, as a consequence, are more impacted by estimation errors in these parameters. Overall, one key difference between MSR portfolios and conditional risk parity portfolios based on downside risk measures is that even if they both rely on expected return estimates, risk parity strategies treat these estimates as (directional) risk measures as opposed to pure expected return inputs as in the case of the MSR strategy, implying a lower sensitivity to estimation risk.

 

Conditional risk parity strategies display better performance in a scenario of increasing bond yields.

The concordance rates and bond weights give indications on the behaviour of the various risk parity strategies.

In order to see the benefits of the conditional approaches in a more material way, we simulate an increase in interest rates as of December 2012 until December 2017.

The use of Monte-Carlo simulations is almost an obligation here as the historical sample that was available for this study (1973-2012) is mostly characterised by a long decrease in interest rates starting in the 1980s, with no periods of sustained decreases in yields.

To test for the effectiveness of improved risk parity strategies in responding to increases in interest rates, we have simulated two economic scenarios: in the first one, the reversion of bond yields from their current level back to their long-term mean value is complete after five years (on average), while the second scenario assumes a more rapid increase in interest rates, with a mere two-year time period needed to reach the same value. Exhibit 3 provides an overview of the results.

The main observation is that the conditional risk parity strategies perform better over the period of increases in interest rates, if only because they start with a lower bond allocation.

In particular, they avoid the severe losses displayed by the URP-VOL-RW strategy in the first year of the increasing trend for interest rates.

On the other hand, they also have a higher stock exposure, so they are more impacted by the performance of the stock market.

To give a sense of this impact, we have assumed that in the first scenario, the equity market is not impacted, while in the second one, the rapid increase in rates results in a strong market downturn after two years.

We note that the CRP-NGVAR99 strategy displays the worst performance in this year, due to a higher stock allocation, but it recovers in the next two years, where it appears to be the top performer.

 

Exhibit 3: Simulated performance of risk parity strategies invested in stock and bond.

(a)   Scenario 1 (slow increase in interest rates)

  2013 2014 2015 2016 2017
Yield (av.) 0.02 0.036 0.047 0.054  0.059
Bond index -0.097 -0.053 -0.034 -0.015  -0.005
Stock index 0.061 0.062 0.054 0.059  0.061
URP-VOL-RW -0.061 -0.021 -0.006 0.011  0.020
CRP-VOL-DUR -0.048 -0.012 -0.002 0.013  0.020
CRP-NGVAR99 -0.022 0.003 0.008 0.019  0.025

 

(b)   Scenario 2 (rapid increase in interest rates)

  2013 2014 2015 2016 2017
Yield (av.) 0.031 0.055 0.063 0.065 0.066
Bond index -0.184 -0.047 -0.01 0.007 0.01
Stock index 0.061 0.007 -0.102 0.036 0.102
URP-VOL-RW -0.127 -0.029 -0.029 0.021 0.039
CRP-VOL-DUR -0.11 -0.026 -0.031 0.021 0.038
CRP-NGVAR99 -0.069 -0.018 -0.041 0.026 0.05

This table shows the simulated average bond yield (first line) and the simulated expected excess return of risk parity strategies in a period of interest rate increase. Scenario 1 corresponds to a slow increase with no impact on the equity market, while Scenario 2 is characterised by a rapid increase, and an equity bear market in 2015. Strategies are defined in the legend of Exhibit 2.

 

Conclusion

Overall, our analysis suggests that it is possible to construct alternative forms of risk parity strategies that alleviate some of the concerns posed by the standard approach based on historical volatility measures.

The risk parity strategy relying on duration-based volatility, which is not as dependent on past bond returns as rolling-window or GARCH volatilities, is a first step towards the introduction of an instantaneous cheapness indicator in a portfolio construction methodology that otherwise solely focuses on risk management.

An improved responsiveness to changes in bond yield levels can be achieved through the use of a downside risk measure, such as the Cornish-Fisher VaR, and this increased sensitivity would result in better performance in a period of sharp increases in interest rates.

While the implementation of such strategies requires an estimate for expected return parameters, these strategies show a substantially higher degree of robustness to errors in such estimates compared to standard mean-variance portfolio construction techniques.

The impact of estimation errors on out-of-sample performance and the benefits of correcting weights for parameter uncertainty have been extensively studied in the literature on mean-variance optimal portfolios, but a similar work for risk parity portfolios remains to be done.

 

Lionel Martellini, professor of finance, EDHEC Business School, and scientific director, EDHEC-Risk Institute; Vincent Milhau, deputy scientific director, EDHEC-Risk Institute; and Andrea Tarelli, senior research engineer, EDHEC-Risk Institute.

The research from which this article was drawn was supported by Lyxor Asset Management as part of the “Risk Allocation Solutions” research chair at EDHEC-Risk Institute.

There has been some ambiguity about what being a long-term investor means. For Australia’s Future Fund it means focusing on a few key aspects of our investments: understanding value, the ability to make and implement portfolio decisions and manager alignment.

In this speech at the ASFA Global Investment Forum on infrastructure and long-term investment, Raphael Arndt, head of infrastructure and timberland at the Future Fund discusses how the fund designed a new way of engaging with the infrastructure manager community including a new way of looking at performance fees.

To read the speech click here

Long term investing

The $54 billion United Nations Joint Staff Pension Fund has adapted to be more dynamic in its asset allocation, a result of lessons learned from the crisis and new stress-testing capabilities. The belief in active management still resonates with the fund beating its 10-year policy objectives. Amanda White spoke to the director of the investment management division (chief investment officer), Suzanne Bishopric.

One of the more recent modern investment questions is: what is the ultimate allocation to cash?

Suzanne Bishopric, director of the investment management division of the United Nations Joint Staff Pension Fund, is not a fan of “negative cash” and she says the fact that the practice was widespread and accepted was “emblematic of the time”.  Cash was seen to be a drag on performance, and compared with high returns in illiquid asset classes, seemed a costly place to allocate funds.

She points to a number of university endowments, which on the eve of the financial crisis followed the “negative cash” approach.

“A target of negative 5 per cent sounded low and reasonable, but when the crisis hit the effect was detrimental.  A financial crisis is not the optimum time to apply for a loan or to ask for increased donations” she says.

By contrast, the UNJSPF was overweight cash which meant it could rebalance. But now Bishopric says the question is whether the fund has too much cash which might be acting as a performance drag.

“Cash doesn’t beat inflation, so you want to deploy it properly. But in 2008 everything went down.  There was a correlation of 0.99 among asset classes,” she says. “Some universities had to sell publicly-traded equities at the bottom of the market because of liquidity pressures. My own alma mater, Harvard, was also challenged by underwater swaps.

UNJSPF is relatively new to private equity and only has a 2 per cent allocation now. The plan is to invest around 1 per cent of the fund per year until about 7 or 8 per cent, with Bishopric keen to be thorough in due diligence and also ensure a diversity of vintage years.

“We’ll take a slow and steady approach and take stock around a 7 or 8 per cent allocation, eventually we’ll match the allocations of the Australian or Canadian funds,” she says.

 

While UNJSPF was overweight cash in 2008 it was not immune to the crisis, and also lost money.

The lesson, Bishopric says, is not to be overconfident about assumptions.

“We need to look at everything all the time,” she says. “We try to have a long-term view but there are some periods like in 2011 where there were lots of twists and turns and the reaction is to just get out of everything. But at $40 billion you can’t.”

She says now the whole industry is assessing what asset allocation means, and her fund is looking at different ways to slice the portfolio so it can be viewed in different lights.

“With our own risk management software we look at the total portfolio every week and stress test it every week using historical and imaginary scenarios. It’s helpful for decision making to see how different things move in different parts of the portfolio.”

“We assess what lower rates of economic growth globally, or within emerging markets, might mean, we then extend that and assess the effect on base metals and commodities and we realised they were embedded in lots of other parts of the portfolio as well, like in very sound mining companies.”

While Bishopric is loath to predict the future, she does say she expects lower interest rates “will be with us longer than we think”.

The surprise of 2014, she says, is that interest rates went even lower, and the number of countries running negative interest rates is at a record level.

“We saw this in the 1970’s when there was different pressure on the US$,” she says. “But I think low interest rates as a way to stimulate the economy has been over-used, it’s unnerving.”

As a result, UNJSPF is at the lowest level of its fixed income range – the allocation is 31 per cent plus or minus 7 per cent, and it is now at 24 per cent. “We’ve remained overweight the benchmark, it’s been a great equities year everywhere.”

At the end of December 2013 the fund’s asset allocation was 65.4 per cent in equities, 24.7 per cent in bonds, 5 per cent in real assets, 3.6 per cent in short term, and 1.4 per cent in alternatives.

The fund’s members are truly global, coming from 23-member organisations including the United Nations, the World Health Organisation, and the International Criminal Court (its most recent Pension Board meetings were held in Rome, hosted by FAO). In line with these liabilities, the fund has investments in 38 countries and 23 currencies.

It has invariably been overweight emerging markets, but Bishopric is selective.

“They can do well, but we need to use good judgement in where to allocate, both at a country and stock level,” she says.

It’s an investment philosophy that resonates at all asset class levels, with the fund a strong believer in active management.

For example within fixed income the allocations are very underweight the Japanese yen but overweight peripheral Europe, such as Poland, which worked well last year.

 

Bishopric and her team will continue to invest with caution.

“It’s a choppier year this year. It’s not more volatile, it’s very dull, but small oscillations make it a difficult environment.”

The conversation around uncertainty is a conversation she has often, and as former treasurer of the United Nations, she’s well connected.

“I was speaking to Paul Volcker today,” she says. “The last time I spoke to him we were talking about Mexican bonds yielding levels under 6 per cent, in our conversation today I said we should have bought them!”

One of the continuing attributes of the defined-benefit United Nations Joint Staff Pension Fund (UNJSPF) is its realistic return target – set at a 3.5 per cent real rate of return. The fund has outperformed its policy objectives in one, seven and 10 year periods with the 10 year return to December 2013 of 7.2 per cent outperforming the policy benchmark of 6.8 per cent

“The people who manage the fund are beneficiaries too and most have worked in different parts of the UN. They have pride and really understand their responsibility,” she says.

 

Good people are at the core of any successful organisation, and that is true for asset owners. Global chief investment officer of Towers Watson, Craig Baker discusses how designing and implementing structures that attract the right people in the right roles can unlock long-term sustainable advantages that the right investment team can offer.

 

It is a truism that good people are at the core of a successful organisation and it is no truer than in the asset-owner world that is characterised by heavy competition for the talent needed to generate superior investment returns.

It is also an environment where complex global operating models are required to maximise those returns. So the challenge for asset owners now is to design and implement global structures that attract, retain and develop the best people possible.  Crucially, this means the right people for their organisations, allied to the right rewards, working in the right roles.

So who are the right people, what environment do they need in order to perform best, and to what extent can this be created through reward structures? What describes the critical roles?

Much has been written about the characteristics that define the best investors in the asset management industry and, while there are similarities in the asset-owner world, the context is different and so is the debate.

At the heart of the matter is the difference in the mission and goals between asset owners and asset managers and the different skills and roles required to fulfil these. A critical aspect is in risk management where the asset owner has to master deeper and longer-term risk factors. Another obvious example is the skills gap between direct investing and choosing external managers, although this is diminishing as asset owners do more direct and co-investment.

Many of the largest global asset owners are charged with safeguarding and growing public funds (whether pensions or national resources) and as such fall under a political or public scrutiny that private sector asset managers do not. This can make it hard to attract the most highly paid talent because of entrenched pay scales and the justification that would be required for such elevated compensation, relative to norms.

Alignment is also a challenge for asset owners.

While the agency problems are fewer than under the traditional structure of outsourcing to asset managers, the tools available to improve alignment are restricted.

For asset managers, measures such as co-investment, employee ownership and performance fees, if structured correctly, can lead to improved alignment.

These options are not generally available to asset owners, and instead they may have to rely solely on carefully calibrated incentive pay in which long-term incentive plans will play a big part.

However, asset owners are culturally well placed to implement these, and because they have strong alignment potential, they should also benefit the organisation. The employee wants a ‘pay for performance’ deal, the organisation, at least in theory, gets ‘performance from pay’.

Among the recruitment challenges is being located outside the traditional financial centres, but many asset owners today have overcome this by applying the popularly captioned “green, grey, and grounded” strategy that Bachher and Monk have described.

The green employees (early career stage) can have greater responsibility and development at large asset owners where they can develop as generalists, whilst only sacrificing a small pay discrepancy to the private sector.

The grey employees can step out of the more cut-throat private arena, give back, mentor the green, and avoid the stresses of competing for capital in the fundraising cycle that is critical to asset manager success.

The grounded employees are location orientated, whether that is a tie or a desire.

This approach to recruitment can build a good base of talent but should be fused with nuanced reward packages, which combine both financial and non-financial rewards and incentives.

In purely monetary terms, compensation needs to align pay with performance.

It should reward appropriate risk taking (not too much nor too little) and align performance with the strategic goals and time horizon of the fund.

A compensation package should have a balance between current and deferred pay. Given investment performance volatility, the deferred, long-term element should be central to the way asset owners remunerate their people. Crucially though, deferred compensation needs to find a balance between being fairly assessed, which gets easier as the assessment period increases, with incentives that motivate people each working day, which becomes harder over that longer time period.

There are many traps lurking including: complexity in design that frustrates and demotivates; asymmetric pay structures that could lead to inappropriate risk taking; too much rough justice in rewarding lucky outcomes not skilful outcomes. Perhaps the biggest trap is imitating the asset managers’ incentive designs that are often over-leveraged to luck and short-termism.

Having remuneration structures that attract and retain talent is one thing, but asset owners need to find the right talent for their organisation while facing the natural temptation to hire ‘star performers’ who have been successful elsewhere.

Groysberg, Nanda and Nohria argue that “in business, the only viable strategy is to recruit good people, develop them, and retain as many of the [resultant] stars as possible”.

To avoid assuming that what works in one organisation translates across to another, asset owners need recruitment practices that benchmark potential employees to a very specific set of desirable traits: skills and experience of course, but values and attitudes too.

These practices are likely to reflect the overall mission, align with the organisation’s cultural norms and fill gaps in expertise. Diversity has many valuable dimensions to asset owners in the extreme competition for returns. The edge mostly comes from focusing on long-term sustainable returns ahead of exploiting short-term market inefficiencies, as well as translating themes, ideas and asset trends into practical decisions and portfolios.

Another consideration for asset owners is to remain aware of developments that will shape the recruitment marketplace, arguably the most powerful of which is the emergence of the so-called ‘Millennials’ generation.

This presages a fundamental shift in the workforce.

According to research, by 2020 nearly 50 per cent of the workforce will be Millennials, rising to roughly 75 per cent by 2025.

Millennials are seen as knowledge workers, who seek employability and a career lattice (not ladder).  They seek motivation, meaning, and flexibility, and have a significant social consciousness.  They are technology natives working in a fast-moving world who thrive in a results-oriented work environment.

As this new group comes to dominate the workplace, the best employers will adapt so as to take advantage of what they offer, for example delivering more flexibility and responsibility in the employee value proposition.

There are examples of this in what Reid Hoffman, co-founder of LinkedIn, describes as ‘The Alliance’ which forges a mutually beneficial deal with explicit terms between the employee and their organisation.

We see some asset owners evolve the roles that their people play to contribute more fully to the generation of the best ideas. The ‘one portfolio approach’ adopted by a rising number of asset owners uses roles that have a line of sight across the whole investment spectrum. The employee often values the greater empowerment delivered in network styles of operating in preference to hierarchy – again evident in certain organisations.

The workforce in 10 years’ time offers many challenges to today’s thinking, but simultaneously it offers changes that asset owners are well placed to take advantage of.

Given the employment currencies of knowledge and transferable skills, there will be a far wider talent pool for asset owners to consider than the traditional competition with asset managers. Asset owners, particularly public funds, also give a direct opportunity for people to exercise their social consciousness.

Indeed, reward itself will also take on a more explicitly non-monetary element.

In ‘Drive: The Surprising Truth About What Motivates Us’, Dan Pink argues that, in a knowledge-based firm, motivation is best realised through giving workers autonomy, mastery and purpose.  These three levers therefore can be used by asset owners as reward elements to attract the right people.

Autonomy is often easier in an asset owner context than at a very large institutional asset manager. The evidence is seen in the considerable extramural activities that many leaders of asset owners pursue.

Mastery could be found through training, professional development, idea generation, challenge and debate; the full spectrum from generalist to specialist. Clearly here, mastery should also offer powerful fuel for fund performance.

Purpose could link closely to the social conscious of the new workforce which publicly sponsored funds can satisfy, especially those with agendas of direct development investing or with committed environmental, social and governance (ESG) policies. The most interesting opportunities for sustainable investing lie with the asset owners.

There is a war for talent and Groysberg, Nanda and Nohria conclude that: “the first step in winning the war…is not to hire stars but to grow them”.

The talent pool is changing and asset owners are well placed to take advantage of this.  However only those that best understand and capture future trends in the workforce, secure the talent that is right for them, and make it work in the right roles in line with their objectives, will realise the long-term sustainable advantages that the right investment team can offer.

Craig Baker is global chief investment Officer at Towers Watson

The Pension Protection Fund was set up nearly a decade ago to protect members of UK defined benefit pension where the sponsor became insolvent.More insurance provider than pension fund it’s risk tolerance is low and its investments conservative. But chief investment officer, Barry Kenneth, says the portfolio is evolving, including a new allocation to hybrids – assets that have both excess return and hedging properties.

The Pension Protection Fund’s main function is to provide compensation to members of eligible defined benefit pension schemes, when there is a qualifying insolvency event in relation to the employer, and where there are insufficient assets in the pension scheme to cover the Pension Protection Fund level of compensation.

It currently protects 6,000 schemes in the UK.

“Our risk tolerance is low risk compared to the industry and we have a global investment strategy so that we don’t correlate to the schemes we underwrite or the UK economy. It’s why we have a large allocation to alternatives and offshore assets.” Kenneth says. “The return driver comes out of the risk tolerance and we model probability of that. We want the probability of success greater than 80 per cent.”

“At the end of the day we’re a deferred annuity provider, given that we are a pensions provider of last resort to qualifying defined benefit schemes. We fall somewhere between a pension fund an insurance provider, and probably more the latter.”

The PPF has a conservative investment approach in line with a return objective of 1.8 per over liabilities with a strategic risk budget of 4 per cent. Importantly there has been a recent evolution of this risk budget, as the fund has added illiquidity as a separate risk factor.

“Given the PPF will pay compensation over a long timeframe, we concluded that there should be a tolerance to have more illiquid assets, although it was paramount we could demonstrate to the Board, that we could quantify that risk and also ensure we are compensated accordingly for tying up capital.”

“As we develop our asset allocation to include assets which have growth and hedging characteristics, many of these assets tend to be more illiquid (e.g. property leases) so being able to quantify all the risk factors from these types of assets is important. A portfolio of swaps, bonds and cash is applied to the portfolio as a swap overlay to mimic the expected liability cashflows.”

Outside UK government bonds, the bond portfolio also contains emerging market debt, investment grade credit, ABS and global sovereign bonds.

The fund is relatively new to alternatives, with this strand of the investment strategy being adopted in 2010, including private equity, infrastructure, real estate, GTA, farmland and timberland and alternative credit.

There will be a larger allocation to what would have been classed as alternative assets in the hybrid allocation as some alternatives such as debt infrastructure or property leases will form part of this portfolio and these assets have both return characteristics as well as stable long term cash flows which assists in hedging the liabilities.

Under the new target allocation the biggest shift will be from cash and bonds to the new hybrid allocation, which will be around 12 per cent, which will result in the deployment of £2.5 billion to £3 billion in this area.

“It is difficult to get these assets, and valuations are high so we figuring out what a realistic allocation might be. We think of them in terms of risk factors, not what the assets are called, it needs to fit both in both the growth and hedging criteria.”

The fund’s hedging portfolio is made up of 30 per cent gilts and 70 per cent over the counter derivatives and will now also include hybrids, which will have liability and asset qualities, marking the key evolution in the portfolio in recent times.

“You can have classification of assets but in the hybrid book the risk factors are more important than the name, so we will be looking for factors such as duration, inflation, credit, illiquidity. Whether that derived from UK corporate bonds, ground rents, leases, social housing is not the main driver it’s the factors,” Kenneth says. “When we think about liquidity/illiquidity in terms of modelling that factor, our driver is how long it takes to sell that asset as close to fair value. For example gilts or listed equities model as having no illiquidity premium as they can be sold on the same day, however if we hold a property lease that would take months if not years to realise fair value. In the context of the fund we need liquidity to pay collateral on derivative positions and to pay our member compensation. In terms of sizing our illiquid assets we are conscious that our liquidity needs are not compromised by allocating more capital to illiquids.”

The fund protects 11 million members in defined benefit schemes across the UK and has about £16 billion in assets.

Kenneth says there are a number of challenges facing the fund in the next couple of years including those associated with using over the counter derivatives. The cost of hedging will go up as central clearing becomes a requirement and bank’s ability to warehouse risk becomes more challenged, through new financial regulations.

“We also worry about the provision of balance sheet from banks on operations such as Repo, given the new bank leverage rules, which we use in our strategy. We therefore need to prepare ourselves for that in terms of buying more assets which give us long term cash flows and have less reliance on derivatives. Banks retreating in certain lines of business could also give us an opportunity to plug gaps where we think there is value i.e. direct lending. This is why we are creating the hybrid bucket.”

“We will have to evolve the way we interact and deal with banks and we are looking at how we can evolve our strategy without getting too hamstrung by additional costs.” “Given our size we can play in more areas, for example property leases and we can we be a material player. Our size is giving us flexibility and we need to use that to become more efficient.”

Kenneth, who has a team of 12, will be recruiting to evolve the team to deal with the growing complexity.

The PPF is also in the middle of a risk system procurement, in order to provide more portfolio information. It is also conducting an emerging markets debt tender. The fund has funded about 30 managers, with a current pool of about 60.

And while everything is managed externally now, one of the agenda items of the next three-year business plan is whether to internalise any investment functions. The fund was 109 per cent funded last year, achieved through investment returns and a levy on the industry of £695 million a year. To be protected by the PPF, a fund has to have a sponsoring corporate that is insolvent and the pension fund has to be underfunded.

“We get claims every year from funds that are underfunded. We charge each fund based on the risk of the scheme and the number of members. Our mission by 2030 is to be self-sufficient.”