Setting a strategy to keep an ageing pension fund in fine health is “a lot more challenging than selecting where to invest premiums flowing into a young fund,” reflects Frans Dooren, chief investment officer of the Nedlloyd Pension Fund.

Dooren began to skipper investment strategy at the €1.2-billion ($1.6-billion) fund in 2011, taking over after his retiring predecessor’s 40-year spell at the helm.

Dutch shipping company Nedlloyd hit the economic rocks in the early 1990s and was subsequently swallowed up in mergers with British firm P&O and again with Danish group Maersk in 2005. Nonetheless, the task of paying fund members their due remained and, naturally enough, became more urgent as the numbers of active members declined.

Ensuring the investment strategy protects the downside risk is vital when close to 70 per cent of members are drawing benefits, Dooren points out. It has been made all the more essential though by a curious quirk in the pension fund’s accounts.

On the one hand, the fund has generated enough returns to defy the drain on its assets caused by a steady majority of retired members – increasing its total assets by more than 6 per cent between 2008 and 2012. On the other hand, it saw the funding ratio slip from a healthy 114 per cent in 2009 to 105 per cent at the end of 2012, just above the Dutch Central Bank’s minimum.

A double whammy of rising longevity and falling interest rates sent the funding ratio into reverse, Dooren explains. Extended life expectancies alone produced a recent 9 per cent liability-increasing hit.

That has been tough for the fund to deal with but it has gained some relief in 2013 with the funding ratio increasing somewhat in the course of the year and, Dooren reckons, “our whole funding situation will be solved if interest rates rise again”. His optimism is well grounded: the Nedlloyd fund set itself on course to greatly benefit from rising interest rates in 2010 when it exchanged its interest rate hedges for swaptions, which pay off if rates rise.

Anchoring against downside swell

Hedging has been a key part of an investment strategy designed to stop market misfortune eating into the fund’s benefits. Another pillar of this approach is the 40 per cent of the fund that is invested into a “matching portfolio” of bonds.

The fund has aimed to match 50 per cent of cash-flow liabilities with government bonds with this portfolio, but Dooren concedes low bond yields mean less than this target is currently covered – around 44 per cent of cash flow.

“Low government bond yields are making the performance of our return-seeking assets more important” as a consequence, Dooren explains. Swaps have also been used to help the matching portfolio meet its target.

Hedge caution

Interestingly, the Nedlloyd fund has made a number of alterations to its use of hedging in the past few years.

The most notable case involved exchanging interest-rate swap hedges for swaptions, although “looking at the way interest rates have continued to drop since 2010, you can probably say we went into swaptions too soon,” says Dooren. He remains confident that it was a fundamentally good idea, and one the fund would repeat if placed in the same situation again, due to the good chances of future interest-rate rises. He explains it was made not as a bold or risky macroeconomic bet, but simply to continue covering the downside should rates rise.

Currency hedging was also dropped in 2011. A key reason for that was the desperate outlook for the euro at that time made the fund less concerned about assets held in foreign currencies. Dooren explains that the liquidity restrictions that are a prominent part of a mature fund have also been a big factor for its continued aversion to any currency hedging. “We needed to put up cash for currency hedges every month and we don’t have much access to that,” Dooren emphasises. Much of the fund’s US-dollar exposure comes in the (relatively illiquid) private equity portfolio after all.

“We decided also not to hedge our equity exposure any longer with put-options as it looked too costly in the long term,” adds Dooren. This decision was made following a 2012 asset-liability management study.  A 20 per cent equity allocation also meant equity hedging had only limited potential to benefit the overall funding ratio, he explains.

However, one significant increase in hedging levels was made at the time: a boost in interest rate hedging from 75 per cent to 100 per cent on a nominal basis.

Equities drive return currents

The fund comfortably outperformed its benchmark in 2012, generating 9 per cent returns against a benchmark of 7.9 per cent.

The equity allocation had an important part to play in the fund’s recent investing success, as it also ran ahead of its benchmark in 2012 and 2013.

Dooren attributes strong equity returns to the fund’s faith in active managers paying off, as it does not make any tactical calls on the asset class. “We believe strongly in the value of active management and also in building a portfolio of bottom-up managers with different style and factor exposures,” says Dooren.

A 10 per cent alternatives allocation at the Nedlloyd fund is composed mainly of private equity investments. Alternative assets are currently taking up significantly more than their strategic allocation of 4.5 per cent, but Dooren says their weighting is due to decline in the future. “We are harvesting our private equity investments now and there is a lot of liquidity coming out of them,” explains Dooren.

Keeping liquidity high is a reason for gently reducing the alternatives allocation, although Dooren stresses this is not a major issue for the private equity holdings.

The upcoming sale of the Nedlloyd fund’s hedge fund investments will enhance the reduction in alternatives, just as it ends a long but somewhat turbulent relationship with the asset class. A performance blow came back in 2009 when one of the fund of funds invested in at the time turned out to have a stake in one of Bernard Madoff’s fraudulent funds. “Hedge funds are a complex, expensive strategy and there is a reputation risk to pension funds, which is why we decided to sell,” says Dooren. He adds though that the small amount invested in hedge funds has not had a significant impact on the total portfolio.

Real estate holdings are also due to be scaled back due to help future liquidity needs, with the fund sitting on a historic 15 per cent allocation.

Overall investment returns in 2013 are down to minus 0.45 per cent for the first six months, due largely to losses on the fund’s matching portfolio. Dooren and the Nedlloyd fund therefore continue to face a challenge in ensuring the strategy keeps the promised benefits flowing. A few fingers will no doubt also remain crossed at the fund’s riverside office, situated a stone’s throw from the Port of Rotterdam, that interest rates eventually rise to bring a more favorable tide when it comes to funding the remaining obligations.

What would the financial services industry look like if it was structured to service the non-financial services sector, rather than itself? Economist John Kay, author of the Kay Review into short termism in UK equity markets, aims to find out.

 

In an ideal world there would be one, maybe two, intermediaries between the saver and the actual investment, says economist John Kay.

Not only are there too many players in the financial service chain, having the effect of diminishing the return to the saver whose money is invested, but almost all players in the investment universe get paid by the level of activity, he says.

“The vested interest in not doing this is too high,” Kay says. “It is a long haul to get to a sensible place, but we need to set out what that is and why it doesn’t need to be how it is today.”

For Kay, that “sensible place” is a back to basics view of the purpose of the industry.

“So much of what the financial services industry does today is trade with each other, and they are making a lot of money. They go out to Canary Wharf and trade paper with each other and then go home,” he says. “We need a better mechanism for lending to business, and a simpler system of mortgage lending. We need  more specialist institutions, with less distinction between debt and equity financing, that will service the needs of start-up business.”

Kay is writing a book on financial services and how to construct a financial services industry based on the needs of the non-financial economy, or what he calls “businesses that do things”.

And to do that, he says, requires imagining a world that is vastly different to the one we live in now.

According to Kay, in the UK, banks engage in about $7 trillion of financial services lending. Only about $2 trillion of that is to the non-financial services sector: and further, about one third of that amount is for non-residential property, consumer credit and non-property related business loans.

“What that reveals is how small bank lending to business really is,” he says.

Kay says he doesn’t want to blame anyone for the current structure of the industry, where financial services companies effectively create work for, and service, themselves and their competitors, but if he did it would most probably be the investment banks.

Still, contrary to other commentators, he contends that the answer is not to have asset owners engaged more with companies.

“I don’t think asset owners have the skills to participate in that role,” he says. “It is more important to get the role of asset managers right than to demand activity from asset owners.”

Last month, the UK Law Commission issued its consultation paper on the fiduciary duties of intermediaries. The project was commissioned by the Department for Business, Innovation and Skills and the Department for Work and Pensions, to investigate how the law of fiduciary duties applies to investment intermediaries and whether the law works in the interests of end investors.

The review, takes up some of the points raised by Kay in his review, and specifically investigates how fiduciary duties currently apply to investment intermediaries and those who provide advice and services to them. It aims to clarify how far those who invest on behalf of others may take account of factors such as social and environmental impact and ethical standards; and to evaluate whether fiduciary duties are conducive to investment strategies in the best interest of the ultimate beneficiaries.

The paper attempts to unpick the various strands of law applicable to financial intermediaries to bring greater clarity to the debate.

For Kay this is an important development in the potential consolidation of financial services players.

“If the legal position can be clarified and then regulatory standards can be stepped up to limit distinction between wholesale and retail clients in terms of counterparty obligation, it will be a potential large lever for disintermediation and functional reform,” he says. “We need less players or more specialised players, more horizontal and less vertical service companies.”

 

A final report by the Law Commission will be produced by June 2014.

 

 

When Penny Green joined the Superannuation Arrangements of the University of London (SAUL) as chief executive in 1998, the multi-employer defined benefit scheme had £790 million ($1.27 billion) assets under management and two asset managers. Sixteen years later the pooled fund now manages assets for 49 employers in higher education institutions including the University of London, but also others such as Imperial College and the University of Kent. It has $3.2 billion under management and mandates with 23 managers. Proud of the link between SAUL’s steady growth and her longevity at the helm, it’s no surprise that Green’s investment strategy is also focused on the long term. In an approach which challenges recent criticism that many UK funds are too focused on quarterly capitalism, Green is diversifying the fund and reducing its equity allocation despite SAUL’s buoyant 16.7 per cent return for the year ending March 2013 being attributable to roaring equity markets. “In the last financial year equities have done best, but we never make decisions on an annual basis and quarterly numbers don’t mean anything to us – they are just noise. We are only interested in the long term.”

Improving status

In the last year, strategy at SAUL has concentrated on whittling down the deficit and improving the fund’s 95-per-cent funded status. As of June 2012, all new members have benefits calculated over a career-average basis rather than on a final-salary basis. SAUL has also introduced a hedging strategy whereby 20 per cent of the value of the liabilities are now in a liability-driven investment (LDI) portfolio. Run by Legal and General, the portfolio aims to reduce the downside risk attached to falls in long-term bond yields and any increases in inflation, explains Green. “Talking to employers and unions, we became aware that they were very sensitive to downside volatility.” The LDI portfolio is biased in favour of inflation, which Green “sees rising because there is so much money in the system”, a particular worry since the scheme’s liabilities are fully index-linked. Legal and General increase the hedging on a quarterly basis, which is also supplemented by funding triggers. When hit, the triggers prompt additional inflation and interest rate hedging. They have already been hit twice, says Green. “We would like to get to having 100 per cent of our liabilities hedged and be 100 per cent funded.” SAUL’s assets are split between a 19 per cent allocation to the LDI portfolio, 77.4 per cent in a non-LDI portfolio and 3.6 per cent in cash.

Synthetic equity

In another development, SAUL has sold off its holdings in index-tracking funds covering the UK and US markets, as well as one actively managed equity allocation, investing instead in a synthetic equity portfolio. By investing in equity market futures rather than the underlying companies, Green says she has freed up money to invest elsewhere and built a more flexible portfolio. “If you buy the futures, you get the same performance as an index fund but it takes away the emotion from decision-making. If we want to cut our equity exposure, we can do so quickly.” The downside, she says, is that it introduces more leverage into the portfolio and SAUL has had to invest in a certain amount of expertise to monitor and manage its derivative positions in house.

Some of the cash freed from the equity allocation has gone towards a new risk parity portfolio, accounting for 5 per cent of assets under management – some $128 million of the non-LDI portfolio. First Quadrant was appointed in December last year to invest across equities, bonds and commodities in the strategy, which ensures
risk comes equally from each asset class. It means assets with lower risk, such as bonds, form a larger part of the risk parity portfolio than high risk ones such as equities. In its mandate, SAUL targets equity-like returns but consistent, bond-like stability. “We will grow this allocation if we have the free cash, but right now we are not cash-flow positive.

Protecting capital value

SAUL’s bond portfolio comprises a tiny allocation to fixed interest and index-linked gilts, but a larger allocation to corporate debt accounting for 18 per cent of the non-LDI portfolio. Selling out of passive equities has now allowed the scheme to build its bond exposure developing a new mandate run by Payden and Rygel to include sub-investment-grade credit for the first time. “We looked at our total assets under management and realised there was no exposure to emerging market debt or high yield. We wanted this exposure, but at the same time it makes us nervous because of the equity-like volatility.” The solution was an absolute return mandate in an unconstrained strategy that allows the manager to switch out of high yield to emerging markets or sovereign debt as they see fit. “This absolute return mandate protects against downside volatility. We wanted to put something in place to protect our capital value,” she says.

SAUL was an early investor in private equity but withdrew from the asset class in the late 80s. In 2007 the Trustees decided to build up the portfolio again with allocations to funds of funds run by Morgan Stanley in a broader mixed asset mandate and, more recently, Partners Group. The allocation to Partners includes a direct investment, although Green prefers the funds-of-funds route. “We have no capacity internally; direct investment requires more expertise than we have.”

The recent changes in allocation mean the non-LDI portfolio is now split between a 0.3 per cent allocation to fixed interest and index-linked gilts, a 1.3 per cent tactical allocation, 5.1 per cent to long-lease property, 18 per cent to corporate debt, 24.5 per cent to conventional equity including the synthetic allocation and emerging markets, 27.9 per cent to an equity-based absolute return portfolio and 17.4 per cent to a non-equity based absolute return portfolio. Green hopes the fund will grow with more employers, although she is cautious here too: “We do want more employers, but we are not open to anybody. Our existing members are our priority.”

SAUL doesn’t run any assets internally, although Green’s internal team does manage the cash positions and monitor the fund’s managers – another aspect of the job she views only in the long term. “The average tenure of our managers is about five years. Our longest serving manager has been with us for over 13.”

German institutional investors face an urgent need to reconsider their bond-heavy investment strategies, argues Dirk Lepelmeier, a former investment head at one of the country’s largest pension funds.

Herr Prof Dr Dirk Lepelmeier, to use his appropriate German titles, would rather be addressed as Dirk. That might be of no surprise to many, but it is actually no small statement in a country where accumulated academic appellations are often regarded as sacrosanct.

Lepelmeier, who has a wealth of insight into the German investment industry with 20 years at Dresdner Bank and over 15 years as head of investments at the €10-billion ($13.7-billion) Nordrheinische Aerzteversorgung (NAEV), might be entitled to another name though – Mr Diversification.

Having recently started an independent consultancy, Lepelmeier is seeking to advise Germany’s investors to reach out of their bond-heavy comfort zones. Around 70 to 80 per cent of institutional portfolios in Germany – and notably some other continental European countries – are invested in fixed income, reckons Lepelmeier, a position he calls “extreme”. This has left funds at the mercy of interest rates and “since 2008 interest rates have not been market driven, they have been politically driven”.

“I feel very strongly that we will have very low interest rates for an extended period of time,” argues Lepelmeier. He foresees central banks intervening to keep future increases of rates to a minimum in order to serve government debt refinancing. Few German funds can therefore expect to gain returns of more than 2 to 3 per cent for the years ahead, he forecasts.

Lepelmeier has scrutinised the possible course of action for politicians in a low-interest rate environment in the coming years. “Whatever politicians do, the only answer for investors is to diversify,” he says.

Equity fears and the heart of the devil

Lepelmeier says German investors are already being forced to diversify away from fixed-income investments, but have a long way to go. “With average equity allocation for German investors around 5 to 8 per cent, they have to overcome their reluctance towards equity markets,” says Lepelmeier.

A poor regard for returns on equity risk has been a feature of the history of German investing, points out Lepelmeier. German investors must also work against regulations that effectively penalise equity holdings in favor of bond investments, he adds. Finally, he feels there is fundamentally less faith in markets in Germany than in major English-speaking countries. “We will invest in equities, but there is always some reluctance at the back of you head, and that keeps allocations low,” Lepelmeier reflects.

Real estate, infrastructure and refinancing are other asset classes in Lepelmeier’s prescription for diversification for German institutional investors.

Real estate is a well established asset class in Germany, but infrastructure arguably has great potential for development – in common with many other institutional investment markets. “In Germany we have to appreciate that our infrastructure is getting old and investment is not coming in quickly enough,” he says. Lepelmeier feels that greater political awareness is likely to result in some incentives being offered to German investors to get involved in infrastructure, either via direct investing or refinancing.

With the pressures being placed on their strategies by interest rates, there clearly could be a possibility for German investors to benefit from interest rate derivatives. Lepelmeier feels that inevitable fluctuations in interest rates, no matter if they remain pinned down, will open up a chance to benefit from long-short interest rate strategies.

“You don’t have to just buy bonds, put them in the cellar and pick them up after 10 years when the bell rings. We have to be a bit cleverer,” reflects Lepelmeier after suggesting the long-short ploy. Nonetheless he doesn’t have too many hopes of the long-short technique taking off everywhere, adding: “If equity holdings are close to the devil, then long-short strategies are the heart of the devil as far as many German investors are concerned.” Some larger investors that have been relatively open to hedge funds, such as the $75-billion Bayerische Versorgungskammer, could position themselves to benefit though, he says.

Another crisis ahead?

Lepelmeier is hopeful that German investors can gradually diversify, saying “they are already on a learning curve like investors in other countries; it’s just that the radius isn’t necessarily very big”.

His future market outlook is as pessimistic as his view on interest rates though, placing doubts on whether diversification will be quick enough.

“If you survive a crisis you try to learn from it, but after 08/09 all there have been are minor changes,” says Lepelmeier. “Politicians were desperate to avoid burdening citizens across Western Europe, so looked to plan around the problem rather than solve it,” he argues. He thinks tougher action on complex engineered products on bank balance sheets has been needed.

“With these risks still there, I think the next crisis will arrive within the next 10 years,” argues Lepelmeier. Together with diversifying, he urges investors to run models into predicting political action in the same way they traditionally monitor interest rates and equity prices.

“You have to be bold and stubborn” to diversify given the regulatory pushes, says Lepelmeier, and ultimately only time will tell whether German investors take up this call.

 

The scourge of low interest rates looks likely to be confronting investors for at least a little longer after Washington’s budgetary shenanigans delayed the Federal Reserve’s plans to taper quantitative easing.

Over in the more sedate surroundings of Helsinki, this is keeping the pressure on the investment policy of Varma, a €36-billion ($49-billion) Finnish pension investor. Mikko Koivusalo, Varma’s investment director for capital markets, agrees that “it is far from easy to handle continued low interest rates as we need to hold on to government bonds for liquidity purposes”.

Finland’s “bond-orientated solvency-formula” regulations have also contributed to Varma retaining a 34 per cent fixed-income allocation. Nonetheless, the equity allocation has continued to rise in 2013, reaching 36 per cent at the end of June.

A strong preference for alpha-generating hedge funds and private equity has been another key for Varma in keeping its returns ticking along in the low-rate environment. A 7.7 per cent return on assets in 2012 was followed by 3.2 per cent growth in the first half of 2013.

Nothing wrong with hedges

A 13 per cent allocation in hedge funds – an asset class Varma has been invested in for over 10 years – is relatively high compared to the fund’s peers. It also exceeds Varma’s real estate allocation of 12 per cent.

“We have enjoyed good stable returns of around 7 per cent per year with hedge funds with low volatility,” explains Koivusalo enthusiastically. The returns are of course a particular boost in the current low-interest rate environment.

Varma deploys several different hedge fund strategies, which are roughly split into market neutral and opportunistic components.

Koivusalo attributes the investor’s experience with hedge funds to being extremely selective with the aid of the “very good resources and partners” that a fund of its size brings. “You have to do a lot of work and do plenty of due diligence to find some very good and disciplined hedge fund strategies,” he explains.

While he acknowledges that many institutional investors may have experienced disappointments with hedge funds as “it’s a huge universe and quality varies dramatically”, Koivusalo reckons “there is a very strong institutional part to the industry these days and there are certainly advantages because of that”.

Varma’s private equity allocation – a fifth of the fund’s total equity exposure – meanwhile offered stellar returns of 13 per cent in 2012, helped by brisk activity in US financial and acquisition markets.

Fixed income changes

“We have added a lot of corporate bonds to the fixed-income allocation as that moderates the impact of low interest rates a little bit,” Koivusalo explains. Government bonds now amount to 9 per cent of total assets and are spread chiefly around European governments. Varma mitigates its European government bond exposure with the help of some of Finland’s non-eurozone Nordic friends, with Swedish and Danish bonds making up 16 per cent of its sovereign allocation.

Finnish pension funds have been seeking some help from their government on the low-interest rate dilemma, and a government committee is discussing possible changes to the solvency regulations. Koivusalo says “this has been a help”, but it will apparently likely not result in any changes until next year.

Varma’s current equity allocation of 36 per cent is testament to its “belief in equities in the long run”. A five-year chart in Varma’s latest annual report shows equity investments have dramatically increased – at least fivefold – since 2008. Koivusalo argues this jump is misleading, though, and is due to the emergency measures the fund took in that year of tumult.

Strong Finnish

Varma maintains a 50 per cent exposure to Finnish equities in its listed portfolio. This is part of a proud commitment to its domestic economy that even sees the fund have representatives on the boards of many companies. “Finnish companies are very internationalised, despite our economy having many challenges, just like other countries,” says Koivusalo.

He points out that the private equity and hedge fund investments go a long way to mitigating the home bias, in particular with the strong US exposure of these alternatives. He also suggests a further international diversification of the portfolio is a strong possibility in the future.

Varma has a “low” emerging market exposure as part of a 10 per cent allocation within listed equities to “other countries”. Poor performance in emerging markets this year has therefore had little impact on the fund, Koivusalo stresses.

Varma generally hedges most of its currency risk along with making a 5 per cent investment in inflation-linked investments.

A cornerstone of Varma’s investment philosophy is investing internally whenever possible to gain cost efficiency – it boasted overall investment charges as low as 0.06 per cent in 2012. The private equity and hedge fund mandates are, however, run externally. “They are expensive,” Koivusalo says, “but you generally get good returns. If not, you would fly away from there.”

Koivusalo will clearly be happy to keep it that way to ensure Varma retains its rosy health. With the fund’s solvency ratio peeking above 30 per cent in 2013, things are in excellent shape for now, whatever the challenge posed by global interest rates

There is no way to predict whether the price of stocks and bonds will go up or down over the next few days or weeks. However, it is quite possible to foresee the broad course of the prices of these assets over longer time periods, such as the next three-to-five years.

These findings, which may seem both surprising and contradictory, were made and analysed by this year’s laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller. Read the winning paper of the 2013 Nobel Prize in Economic Sciences, Trendspotting in asset markets.