The United Parcel Service corporate pension fund is finalising an asset liability study this year which will result in a new strategic asset allocation.

The $28 billion US fund, typically has a lower allocation to fixed income than its peers and has a reasonably aggressive portfolio for a corporate defined benefit fund.

It is a young, open plan with a low payout ratio at around 3.3 per cent. It means the investment allocations can be more innovative than a de-risking mature defined benefit fund, and chief investment officer, Brian Pellegrino, and his team have been exploring new ideas to make the most of these structural opportunities.

In the past, fund allocations were primarily focused on the asset side, and it is now focusing the allocation process on meeting future liabilities.

Pellegrino says that while the fund is not trying to solve any particular problem, it’s a good time to look at its liabilities, adding that the company recently hired its first in-house actuary.

“We will look at our cash outflows and our funding status, and will have a special focus on liabilities this year,” he says.

In 2010 the UPS pension scheme moved to a master trust structure, allowing it to easily manage its four underlying plans in a single asset allocation.

It last implemented a strategic asset allocation change in 2009, which was an abnormal or unscheduled change in response to the financial crisis, and had previously implemented a change in 2007.

It will finalise a new asset allocation later this year as a result of the asset liability study, but currently the asset allocation is 42 per cent to global equities, 30 per cent in fixed income 10 per cent to private markets, 10 per cent to hedge funds, 10 per cent to opportunistic liquid alternatives.

The investment staff are given very wide bands around the broad asset allocation, provided they stick within the investment policy, giving them autonomy and flexibility.

“If we function within the investment policy then we can make tactical decisions internally without having to seek approval from our board” Pellegrino says.

By way of example he says the portfolio had a hedge ratio of about 15 to 20 per cent from 2009 to mid-2011 when it started adding duration – mostly in the US Treasury Market – and ended the year with a 40 per cent hedge ratio. That started coming down in 2012 and in 2013 the fund was mostly underweight fixed income and duration, with a hedge ratio of about 20 per cent, and an asset allocation of about 25 per cent to fixed income versus the mid-point of 30 per cent.

“It is prudent to maximise our return seeking assets as we don’t have liquidity constraints,” he says. “Strategically we are looking for investments with a definite life where we can have some confidence in underwriting the upside and downside. You can end up with better risk return characteristics.”

New investments by UPS include structured credit, bank recapitalisation strategies, and an investigation into ownership interests.

The fund has a broad allocation to new and interesting investments across private and public markets.

The lack of liquidity constraints, the ability of the private markets team to evaluate opportunities, and the flexibility to commit capital quickly has meant the fund can actively invest in private markets.

“Opportunities among banks have given us the ability to do some creative things in secondary markets, to set our own fee and performance levels,” he says. “The path we’ve gone down since the financial crisis is that if we are paying the right price and can live with  mark to market volatility, those are the types of investments we look at.”

The opportunistic bucket also targets a low beta, and it is in this asset class that Pellegrino sees a dynamic and creative future. It also set up an internal managed account platform in 2012 which allows for investments in areas that don’t fit in traditional structures.

“I feel the future will be in the opportunistic portfolio: bespoke investments with definitive life span. We are not aggressively looking to do anything in the traditional hedge fund space but always open to new ideas, and we are exploring hedge fund replication strategies.”

While admitting it is very early in the process of determining whether hedge fund replication is appropriate, Pellegrino can see the implications for the portfolio.

“If we can get comfortable with replication strategies , it may lead to changes in our hedge fund allocations, potentially  reducing the exposure or the number of managers.”

UPS currently has 14 hedge fund managers in a direct structure and there are another four or five managers in the opportunistic bucket.

“We look at the themes we think are attractive, determine the best investment vehicle for capturing that, and identify the appropriate structure including legal and fees. For example if we do factor analysis on portfolio and then look at the commodity exposure and decided you don’t want an energy exposure, but you want agriculture or metals, is it the best approach to pay a manager 2:20 for that or to buy liquid ETF exposure in say gold,” he says.

Similarly the number of managers in public markets is now less than 40, and coming down, as active managers have been replaced with custom beta exposures.

The equity portfolio has two or three managers that run specialty optimisations  such as minimum volatility, emerging market consumer staples, and a frontier portfolio that limits exposure to certain countries.

“We like the Trust Portfolio Manager to perform research in-house, then we find an index provider  to partner with,” he says.

Overall the equities portfolio is 20 per cent passive, 40 per cent custom betas and 40 per cent active which includes a few highly concentrated active mandates such as small cap.

“We want our active managers to do what we can’t do in house – stockpicking.”

Pellegrino’s investment team now numbers 15 including three directors covering compliance and operations, public markets, and private markets. There are portfolio managers for global equities, fixed income, liquid alternatives, private equity, and private real estate with analysts in support. While there isn’t any plan in the near term to bring assets inhouse, as Pellegrino sees “plenty of opportunities to create value under the current structure”, UPS is looking to hire more analysts.

His philosophy is to stay as “close to the manager as possible” which he admits was easier when there were only three internal staff, and materially fewer strategies. Still he makes a conscious effort to join the portfolio managers whenever possible, maintaining the aim of seeing each fund on site at least once a year.

“I try to attend as many of those visits as possible, you can’t replace the value of seeing people on site,” he says.

 

This paper analyses whether the use of uncorrelated underlying risk factors, as opposed to correlated asset returns, can lead to a more efficient framework for measuring and managing portfolio diversification.

The paper, by academics at EDHEC Business School and SYMMYS, acknowledges that the ability to construct well-diversified portfolios is a challenge of critical importance in the context of designing good proxies for performance-seeking portfolios. It shows that a seemingly well-diversified allocation to asset classes may well result in a portfolio that is heavily concentrated in terms of factor exposures. In this context, it argues, it is of high relevance to measure and manage the effective number of bets in a portfolio.

 

To access the paper click below

Risk Parity and Beyond – From Asset Allocation to Risk Allocation Decisions

 

The five Swedish AP buffer funds will be reduced to three, a new responsible body will be set up to formulate long-term return targets and a reference portfolio, and limits on unlisted investments will be lifted under the new plan put forward by the Swedish Government.

These are the findings of The Pension Group, which is tasked with maintaining the pension system and protecting the pensions agreement, following the extensive review of the system and the changes that “need” to be made.

The Swedish system, and in particular the consolidation of funds, has been the subject of much speculation over the years. While now the government has released a plan, it is riddled with ambiguities for the funds and in particular the plan for consolidation of investments, all the funds have unique asset allocations.

Dividing the roles of capital owner and capital manager is consistent with the governance model of the Canadian Pension Plan, often cited as the most robust in terms of strategy and management.

The recommendation in Sweden is a new independent body will be responsible for the management of the buffer capital, which makes about 10 per cent of the entire Swedish pension system,  and make independent decisions.

It will formulate a quantitative target for long-term returns on the buffer fund capital and design a reference portfolio, where categories of investments or strategies won’t be distinguished from one another except for on grounds of risk and return.

But for the five existing funds AP1-4 and AP6, the report is full of uncertainty. It is not clear which funds will cease to exist, or when or how the transition will take place.

Further, it is recommended that the fees and salaries paid to the funds’ staff are in line with those of other government agencies such as capital and debt management at Riksbank, and the National Debt Office. This will have implications for investment staff.

The Pension Group recommends that there be “freer” investment rules combined with a prudent person principle.

The current strict investment rules will be replaced by a more flexible system in which the funds will be able to increase their investments in asset categories such as unlisted assets when this is in the pensioners’ best interest.

Limits on Swedish equities will be retained, including a 2 per cent limit on the total value of the stock exchange and at most 10 per cent of the votes or capital in any single company. The relationship between the investments and sustainability will be investigated.

The Pensions Group says that dividing up the dual roles that AP1-4 currently have, as capital owner and capital manager, between a responsible body and three funds will bring about a clearer division of responsibilities.

It says at least two of the funds should be given the same mandate and be covered by the same reference portfolio – this incites many questions including why have two funds and not one?

Funds will also be instructed to co-ordinate management and mandates in costly unlisted investments. The Sixth AP Fund, it says, has built up a great amount of experience of investments in unlisted shares and this should be harnessed in the new organisation of funds.

How this will be done requires further analysis.

Returns of the five existing buffer funds

  • AP1 returned 11.2 per cent last year, and continues to increase its allocation to alternatives including real estate, private equity and real assets.=
  • AP2, which seeks to be a cost-efficient active manager, returned 12.8 per cent in 2013, which was the second highest on record.
  • AP3 returned 14.1 per cent in 2013. It uses a dynamic allocation model to manage risk and splits assets into seven risk classes: equities, fixed income, credits, inflation, currency, other exposure and absolute return strategies.
  • AP4 returned 16.4 per cent after expenses last year. Its best ever earnings, attributable in part to a high proportion of listed equities.
  • AP6 differs to the other AP funds in that invests entirely in unlisted assets. Last year it returned 9.2 per cent.

 

The impact of higher rates on equity returns is a concern for investors and to some extent an unknown. But by applying the concept a threshold correlation, as done with bond portfolios with a duration targeting framework, it is possible to better understand the complex interactions between equity returns and interest rate movements.

The latest portfolio strategy research paper by Morgan Stanley Research’s Martin Leibowitz and Anthony Bova, shows that while theoretical, uses duration targeting for equities and the concept of a threshold correlation to provide some guidance in assessing the impact of rising rates on long-term equity returns.

It finds there is a threshold correlation between equities and interest rates that can be applied to maintain an initial expected require return across a range of interest rate paths.

For a 10-year horizon the threshold correlation was found to be -0.3, so a correlation greater than that leads to improved 10-year returns for positive drift rates and to a deteriorating 10puyear returns for negative rate drifts.

Over shorter horizons, such as five years, the threshold correlation is -0.15

The study focuses on two simulations: rate-driven increases in expected equity return; and realised return drags from adverse equity/rate correlations. It uses a simulation approach with two interconnected random walks for interest rates and equity returns.

 

The detailed paper Portfolio Strategy: A Theoretical Model of Equity / Bond Correlation under Rising Rates, can be accessed in the Morgan Stanley Investment Management Journal InvMgtJournal_2014v4i1

 

From allocating assets in order to achieve a healthy funding status, to keeping up with technology that analyses portfolio risk, the challenges of asset owners are relentlessly evolving. For asset managers, like AQR, the key to their own evolution and success is how to be more relevant to clients.

AQR keeps clients’ needs firmly within its sights. In January it conducted a workshop on how to be even more relevant to clients, which among other things discussed how to better use technology to give clients’ continuous access to their portfolio’s performance.

Co-founder, David Kabiller, says clients are at the centre of the innovation at the firm, with the organisational culture centred around how to recruit the right people and create fertile ground to innovate.

“We have “applied” in our name so our work needs to be relevant and practical. We are interested in practical innovation,” Kabiller says.

All employees of AQR have deep shared values about the power of intellectual rigour, a respect for markets and a belief that there’s an ‘efficient amount of inefficiency’.

“We believe that through intensive research you can beat markets, but it’s not easy,” Kabiller says. “We believe our strategies have a statistical edge and an intellectual honesty.”

The aim is that this research-oriented approach will be economically intuitive, pervasive and persistent through time, but a business risk is “group think”.

“Every now and then we hire professionals who think differently and challenge thoughts,” Kabiller says, naming Michael Mendelson, a principal who is also a portfolio manager of AQR’s risk parity strategies, as an example.

But 16 years since the launch of the firm, something is working. The manager now has more than $100 billion under management, up from $19 billion almost exactly five years ago.

Part of the success Kabiller attributes to an innovation intensity stemming from a “depression-era mentality” earned primarily during the firm’s difficult first year and a half.

“You have to differentiate between a bad period in a good process versus a broken process – you need judgment and research to do that. In 1999 everyone was making money and we were having a difficult time, but then in 2000-01 we performed very well,” he says. “We learnt a lot through that – including humility- but also how to be better investment managers and risk managers as well as the value and importance of client communication.”

This humility, among over-achievers, is a cornerstone of the culture, with Kabiller and his co-founders constantly asking themselves philosophical questions and challenging themselves to make their processes better.

“As a firm we think we always have a lot to prove. There is no substitute for good judgement and for acknowledging that we don’t have all the answers so we have to keep asking questions, keep searching for new and pragmatic ideas,” he says.

AQR now offers 24 funds categorised across alternative investment, momentum, risk parity and equity, and while it’s tempting for a research-based, intellectually rigorous firm to innovate because they can, any innovation comes in the form of improving the offering to clients.

Ultimately, what the innovation question leads to is an enquiry about alpha. Is alpha in portfolio construction or risk control?

“When you realise alpha is ephemeral, it’s difficult to scale, it’s imperative that you properly structure betas,” Kabiller says. “We try to focus on what matters.”

One of the more successful innovations at AQR has been the examination of and conviction in factor styles, which has led to the Style Premia Alternative Fund, but also the ability to empirically decomposes investments and makes each component a building block available to clients.

“We can offer a menu of different risk profiles and exposures to clients. By doing this we can make investment more understandable because we can decompose it. Then our clients can pick and choose, reassemble and customise according to their own risk appetite and need,” Kabiller says.

It’s one way the question of how to become more relevant to clients is being answered.

Principal and head of the global alternative premia group, Ronen Israel, describes the breakdown of the building blocks as consisting of four styles and six asset groups all being captured in a consistent long-term framework.

“The building blocks possess the characteristics we’re trying to capture. Characteristics change through time and the underlying positions can change, sometimes frequently for style rebalancing,” Israel says.

A lot of work has gone into determining, and agreeing to the building blocks: the four styles of value, momentum, carry and defensive and the six asset groups of stocks, industries, equity indices, bonds, currencies, interest rates, and commodities.

“We picked those four styles because they can be applied across those multiple asset groups, they have the most long-term evidence and can be implemented in liquid portfolios,” Israel says.

For Cliff Asness, managing and founding principal, it’s personal.

“A lot of years went into getting the four – to agreeing to those factors I can plant my flag on and say we will get it right seven out of 10 years,” he says.

Asness says the advantage is this building block approach is an exposure to the characteristics it is trying to capture can consistently be achieved.

It’s shifting the focus from specific stocks to factors.

“We can fairly guarantee, in the individual stock world, that no one stocks’ event will kill us or make our year,” he says. “We can’t guarantee this is always going to work but we are taking out small idiosyncratic exposures we don’t have an opinion on.”

Israel says the empirical and economic evidence of the four underlying factors is very similar so allocations are spread equally among all of them in order to avoid a long term tilt. It’s a market-neutral long /short strategy across the six asset groups and four styles.

One of the client/manager crossroads at AQR is about market views and timing.

Given its quantitative nature, most of what AQR employs has little to do with market views. But as Asness points out: “clients care so we care”.

Interestingly the quant nature of the firm, and Asness biases, doesn’t stop him having a view on markets, however.

“It is a fair global statement to say that US stocks and bonds are expensive relative to prices in the last century or so. However we don’t use that information for market timing, we use it for setting expectations. And if we are forecasting 10-year returns then stocks and bonds look expensive versus the history,” he says.

Many of AQR’s clients are US pension funds, which on an average have an 8 per cent return target.

“This is unrealistic,” Asness says, making a quick calculation.

According to his numbers US stock 10 year numbers are 4.5 per cent real, with inflation of 2.5 per cent, that’s 7 per cent on 60 per cent of the portfolio. Bonds are less with real yields barely positive. This means 60 per cent of the portfolio at a 7 per cent return, and 40 per cent at 3 per cent, gives 4.2 per cent plus 1.2 per cent which is a return expectation of 5.4 per cent before fees.

“There is nothing to save us, but realistic expectations and more contributions,” he says of pension funds.

 

 

Even though there has been dramatic globalisation over the past 20 years it still makes sense to segregate global equities into “developed” and “emerging” market buckets, according to a paper by Columbia and Duke academics.

The research, which has important policy implications for institutional and pension fund management, shows that while correlations between developed and emerging markets have increased, the process of integration of these markets into world markets is incomplete.

Emerging markets account for more than 30 per cent of world GDP, but they only account for 12.6 per cent of world equity capitalisation. They argue this incomplete integration along with the relatively small equity market capitalisation creates potentially attractive investment opportunities.

 

To access the paper click here