Sunil Krishnan, head of market strategy at $62-billion British Telecom Pension Scheme Management Limited (BTPS), the United Kingdom’s largest pension fund for employees of global telecoms operator BT Group, has sage advice for investors contemplating their exposure to emerging markets.

Examining the pros and cons of the asset class, Krishnan counsels caution.

Speaking at a recent National Association of Pension Funds (NAPF) Investment Strategies Conference, he says that although BTPS will increase its existing $2.7-billion emerging market allocation, split between debt and equity, it will be done with a keen eye on risk.

Beneath the fact that emerging markets have led global economic growth since the financial crisis lie deep pitfalls.

“Investors need to be clear at the start about the reasons why they are investing in emerging markets,” says Krishnan, 33, who joined BTPS from Merrill Lynch and Blackrock in a role he describes as “bringing a tactical perspective” and bridging the gap between BTPS’s long-term goals and the macro conditions across the asset classes.

The 321,474-member scheme, of which only 45,000 are active, closed to new members in 2001. According to a triennial valuation in 2011, it is 90-per-cent funded with an actuarial deficit of $6 billion, currently plugged with steady sponsor contributions.

BTPS, which pays out $3.2 billion in pension payments a year, returned 7.5 per cent in 2012 against a benchmark of 7.8 per cent.

The current asset allocation at the fund comprises fixed interest and cash (24.8 per cent), inflation-linked (21.7 per cent), property (10.5 per cent), absolute return (7.3 per cent), alternatives including commodities, hedge funds, credit opportunities and emerging market bonds (12.2 per cent). UK equities account for 5.7 per cent of assets under management and overseas equities 17.8 per cent.

The fine grain of emerging markets

At BTPS there is no presumption that emerging market equities are a door to accessing long-term economic growth in developing economies.

Economic growth doesn’t necessarily mean better returns for listed emerging market corporations: these companies could be state-owned or additional revenues could fail to turn to profit because of governance issues, says Krishnan.

Neither should investors expect emerging markets to bring diversification. Although an emerging market equity allocation improves “diversification chances”, Krishnan believes there is a stronger case for diversification in emerging market debt over equity.

One reason for this is what he calls an “arbitrary distinction” between emerging markets and developed markets, pointing out that 20 per cent of the revenues from MSCI ACWI index now come from economies including India, Brazil, Indonesia and South Africa.

“Chilean bonds are no hedge for investors in UK lenders,” he says in reference to scant evidence of the liability hedging benefits of emerging markets.

He advises against favouring particular emerging markets too. “A Peruvian copper mine is no better than the Turkish middle class.”

He points out that although the most popular emerging market theme of consumption is starting to take over from construction, equity valuations hinged on emerging markets anticipated consumer spend “don’t imply euphoria” just yet.

Where emerging markets can offer diversification is through investment across the spectrum that includes local-currency emerging market debt, mainstream emerging market equities and frontier markets too. Although frontier markets pose challenges around liquidity, “less than half of what happens in frontier markets is explained by other markets” offering real diversification benefits.

Also showing

Other risks “worth monitoring” are China’s water security and the country’s ability to make the transition to a “sustainable economy,” more driven by consumption.

He flags emerging market economies that export to developed markets as particularly sensitive to demand from western economies and warns that volatility in developing markets risks forced selling, although liquidity is no longer such a problem. “You can get your money back, but you can’t get the price.” For those sacrificing liquidity for returns in emerging market private equity or infrastructure assets ensure “top dollar” for the illiquidity premium.

BTPS doesn’t hedge its emerging market currency risk.

“If you believe in an emerging market, we feel this should reflect itself in an appreciation of the currency,” he says. Although bad governance would be “an unlikely source of losses for a scheme”, he warns of the reputational damage of investing in companies hit by scandal and suggests emerging market funds use sub-custody arrangements.

Investors can access emerging markets via world equity indices, which already have emerging market revenues, and he suggests developed-market managers may be able to invest in off-benchmark emerging market opportunities.

But he also advises on active management. Not only does this ensure a keen monitoring of the risk, analysis shows emerging markets have regional winners that rotate every five years or so. “Does the bog-standard market exposure give you what you want?” he asks. “A large part of emerging markets aren’t beneficiaries of the Chinese middle class.”

Hermes manages $35 billion of the BTPS portfolio, including all the scheme’s property investments and the majority of its inflation-linked mandates. Hermes also manages a small number of active equity portfolios targeting small and medium enterprises.

The majority of BT’s UK equity allocation passively tracks the FTSE 100, managed by Legal and General. The equity portfolio includes a 4.4 per cent allocation to global large-cap, which seeks defensive exposure to global equities via exposure to 40 financially conservative companies. Elsewhere, M&G manages the majority of the scheme’s UK corporate bond portfolio and Wellington manages a new 5 per cent allocation to global investment-grade corporate bonds.

As for emerging markets, Krishnan concludes that the fact they are cheap and the return case has improved makes for a legitimate allocation. “There is nothing wrong with disagreeing with the market, but you do need to be clear from the start about the reasons for your investment.”

Interest rate risk is the biggest threat to portfolios and the chances of inflation are very high, according to Michael Hintze, founder and chief executive of CQS, who spoke at the AIMA Australia Hedge Fund Forum on September 10.

Hintze believes there is a great deal of moral hazard in today’s markets, mostly in money markets, and the actions of central banks, most notably the US Federal Reserve, to take rates down at the short end has resulted in there being no market signals.

“Printing money is good for equities and credit, but not good for economies or our children. The chances of inflation are very high,” he says. “We are building in a rate-risk measurement as we think that is the biggest threat.”

CQS is a multi-strategy asset manager that places a lot of emphasis on its operational platform, and its liquidity management and risk monitoring capability.

“We are paid to take investment risk, not operational risk,” Hintze says. “This is the reason why we survived the GFC – because we pay attention to this.”

“Long tails are a worry, but the things that really worry me are where I say x and we’ve done y, because that’s a breach of trust.”

The biggest surprise in markets in recent years, he says, has been the correlation to one problem. Outside of markets, the greatest changes have come with the level, and extent, of regulation.

“Normally we would say don’t waste a good crisis. The industry thought about it, but the real change happened with regulation and that is the biggest problem.”

Having said that Hintze believes there is a bright future for hedge funds in institutional portfolios, because “alpha is a big deal; people are hungry for alpha.”

CQS is developing a bespoke alpha product as a response to the search for it. The product will separate volatility, and return and allow investors to put the two together to suit their needs.

“We say here’s the return, here’s the volatility around the return, and then how do we put that together. It’s their product, it’s not commingled.”

But he warns investors to be careful about how much they allocate to hedge funds and to be wary of the volatility within hedge funds

“It comes back to transparency – we talk about that a lot.”

Hintze is interested in the geopolitical background that is the backdrop to markets. He predicts China’s economic growth will drop to 5 per cent due to massive internal change, not the least of which is a move against corruption, but over the full cycle will go up to 7 per cent.

In Europe he believes the periphery countries have bottomed out and there are “opportunities to trade on the short side”.

He describes the US as “remarkable” in its entrepreneurial culture: the demographics are in good shape, and the market sufficiently flushed out poorly performing assets.

Hintze, who speaks fluent Russian and holds science degrees in physics, mathematics and acoustics, is a significant philanthropist and established the Hintze Family Charitable Foundation in 2005.

“Philanthropy is a very big deal,” he says. More specifically he says what “speaks” to him is the Biblical quote in the the Gospel According to Luke (12: 48), famously used by John F Kennedy: “To those whom much is given, much is expected.”

Patrick Groenendijk, chief investment officer of €14-billion ($18-billion) Dutch fund Pensioenfonds Vervoer, seems to be well aware of the value of stability to investors, having striven to find the fund’s ideal fiduciary manager, keep faith in a defensive investment strategy and stay at an arm’s length from government investment initiatives.

The Vervoer fund has been known across much of the institutional investing world for the split with its former fiduciary manager, Goldman Sachs Asset Management, in 2010. These days Groenendijk confesses to be “really very happy” with the successor, Robeco, almost two years into its new fiduciary relationship. One advantage is that the new managers are situated close to the pension fund’s Groningen base – as a fund for transport workers, any one of Pensioenfonds Vervoer’s taxi-driving members can take Groenendijk there in 20 minutes.

More fundamental to the geographic proximity is the closeness of the new manager to the fund’s ideals on fiduciary management. “We have elaborate agreements on the divisions of responsibility with our new fiduciary managers, which are very important,” he says.

A flat-fee structure with Robeco is another source of pleasure in the current arrangement. “The advantage of a fixed-fee is there is no discussion about it, whereas if you have a large performance fee component, there is always a debate about the exact calculation,” Groenendijk says.

The consequences of breaking the first tie-up led to the fund last year filing a legal claim against Goldman Sachs Asset Management over disputed investments. Groenendijk insists that despite the travails, the fund’s adventures in fiduciary management have made for a “very worthwhile experience”. When Pensioenfonds Vervoer began the arrangement in 2006, “We were one of the first funds to adopt fiduciary management, so it’s only natural that not everything goes well at the first attempt,” he says.

What advice does Groenendijk’s varied, yet detailed experience offer for other investors willing to hire a fiduciary manager?

“For a start, it’s very important to write down with a fiduciary manager exactly who is responsible for what,” says Groenendijk. He concedes that sounds quite obvious, but argues that implicitness can cloud boundaries. “When things go wrong, it’s likely not on the alpha side with manager selection, but a matter of getting the beta right,” he says as a second main pointer. He also urges investors to consider their desired dependency on a fiduciary manager before entering an arrangement, as “dependency introduces new risks and you want to have other sources of input”. Pensioenfonds Vervoer uses independent risk-management analysts, for instance.

“I would definitely not advise other investors to shy away from hiring a fiduciary manager as we think they can add a lot of value,” Groenendijk says.

On the defensive

One of the main advantages of a fiduciary model, for Groenendijk, is that it enables investors to focus on the fundamentals of setting investment strategy.

On that topic, Groenendijk reveals that the fund’s strategy is still taking a defensive stance, as “basically we’re not yet convinced that interest rates are going to rise”. It has increased its equity holdings, but “switched less aggressively from fixed income to equities than other funds”. Equities were a modest 26.2 per cent of the total fund at the end of 2012, while some 69.5 per cent was invested in fixed income.

The fund is also keeping a conservative 70 per cent of its interest rate liabilities hedged for the foreseeable future. “We simply don’t see sufficient economic growth in Europe to justify a considerable rise in interest rates,” Groenendijk argues.

His outlook on the continent is clouded by skepticism. “The euro crisis is far from over. Spain is still in a case of bluff and denial, and other southern European countries have not actually solved their problems.” On the other hand, Groenendijk states that “we think some regions are interesting in equity markets, particularly the US, maybe Japan and, strange as it may sound, Germany”.

A hunt for yield has been the most important motivation for recent investment strategy calls, says Groenendijk. The fund has added to its high yield, emerging market debt and mortgages allocations. High yield and mortgages made up 28.7 per cent of the fixed income portfolio at the end of 2012, and emerging market debt 26.4 per cent. Groenendijk describes high yield as a “bit of a mixed bag”, with good opportunities remaining, but a definite sense that the boom might be coming to an end at this reach of the credit spectrum.

Pensioenfonds Vervoer is also considering moves into illiquid spaces such as bank loans. Groenendijk emphasises this possibility is “still at the discussion stage”, with plenty of analysis remaining to be done on vital aspects such as liquidity and the rights of banks to recall loans, which could possibly limit the upside.

Practicality trumps patriotism

The 11 per cent of the fund allocated to mortgages gives Groenendijk a unique standpoint on an asset class that remains exotic on an international scale. Mortgages are becoming an increasingly common investment option in the Netherlands though. Efforts made to get pension capital into the domestic mortgage market look set to result in the creation of a bond-issuing national mortgage bank.

Groenendijk is cool on the idea, reckoning that “the returns that we currently get from our mortgage portfolio far exceed the returns we would get from this new structure as is currently discussed”. A state guarantee behind the mortgage bonds would restrict spread and therefore returns on the bonds, he reasons.

Groenendijk confesses to be cynical about the Dutch government’s drive to get pension funds to invest more in key domestic assets, in a so-called orange investing agenda. “If a government has a good idea, I’m always very suspicious,” he says. “We like to have our investment freedom and make our own judgments on where to invest.” He counts 14 per cent of the portfolio as being invested in Dutch financial assets, but stresses this is part of an independent global strategy choice.

A small alternatives allocation of 3.7 per cent in real estate and 1.3 per cent in infrastructure is another notable feature of Pensioenfonds Vervoer’s strategy. Groenendijk explains that there have been no big changes to this alternatives slice in the recent past as “the whole risk monitoring framework is totally different for alternative investments” – due primarily to illiquidity, complexity and opaqueness. As work on an internal risk control framework for the asset class is almost complete, Groenendijk reveals the alternatives allocation may well increase in the next few years – should the fund become more comfortable in the area as is planned. Gradual evolution rather than wholesale change therefore looks to mark the way ahead.

 

How should pension funds in the United Kingdom best prepare for the government unwinding quantitive easing (QE) and tightening monetary policy? The Bank of England isn’t showing any signs of ending QE just yet, its policy begun in 2009 and designed to stimulate the economy by creating new money to buy government bonds. But QE looks likely to taper off in the US, where the Federal Reserve has bought $85 billion worth of US treasuries and mortgage bonds every month during its program. It’s a sign that the liquidity taps may be turned off in the UK too. “We don’t really know what to expect because we have never been in this situation before,” says City University London’s Cass Business School professor of asset management, Andrew Clare. “There is no precedent of a government coming out of the other side of a QE program, so being sure about what happens is difficult. But when Ben Bernanke mentioned tapering asset purchases, the world went crazy and he hasn’t even started,” says Clare, who also sits on the investment committee of the $6.3-billion GEC Marconi Pension Plan and the $4.7-billion Magnox Electric Group Pension scheme. Amid all the uncertainty, he says, investors can count on increased volatility once monetary policy begins to tighten and interest rates rise. Pension funds need to plan now how to best prepare fixed income assets affected by rising rates and volatility, and seek out asset classes that will hold a steady course through the volatility, according to Clare.

Rising yield curve, more illiquid assets

He believes the biggest question currently facing UK pension funds is timing at what point to hedge their inflation or interest rate risk as the yield curve rises. “There is a recognition that yields are going up as QE unwinds,” he continues. “The cost of hedging the risk has fallen, so the question pension funds have to ask themselves is this: do we let it run and benefit from high yields unhedged or say enough is enough, we can afford to hedge at this level and our primary job is to pay the benefits?” Although many funds have taken the opportunity of bond-yield rises to already put in place swap-based hedging strategies, he says further rises in the yield curve will trigger many more schemes to adopt the hedging strategies they have been waiting to put in place.

As volatility increases, Clare advises schemes to seek long-term illiquid assets. Rather than equities, he recommends investing in contractual fixed income-like assets with guaranteed cash flows such as infrastructure debt, real estate (like long-lease properties) and insurance-linked securities in which the income “will pay benefits over time.” He says that the offloading of these kinds of assets by banks in search of liquidity during the financial crisis offered opportunities for pension funds, although smaller funds with less to invest have struggled to access these opportunities. He adds that investing in these new asset classes has required greater governance, and schemes’ appetite for illiquid assets will always be limited.

Diversify and pay down liability

Diversification is also essential during times of volatility. “If pension funds get it right, diversification ensures a smoother ride in normal times and allows schemes to plan more carefully,” he says. “Diversification was the main lesson from the financial crisis when everything fell – apart from government bonds.” He believes that there is no obvious evidence that active strategies pay off and that the historic performance of private equity is “very poor” unless pension funds access the “very top” tier of private equity funds. He says asset allocation is much more important than any manager selection and advises pension funds to put “all the emphasis” on reducing liabilities. “Liabilities are a negative asset. They are the largest single position pension funds hold and they have to get this right first,” he says.

For investors adopting strategies to cope as QE is unwound, Clare’s message is prepare for volatility. It’s guaranteed even if unwinding is slow and even if it doesn’t actually end for good, which he lists as another possible outcome. It’s a scenario Clare flags up as possible if the UK economy, on a slower recovery trajectory than the US, proves unable to cope with rising rates. “QE could come back,” he says.

Asset owners are not visible in the policy debate about the structural shortage of long-term capital, according to Sony Kapoor, managing director of Re-Define, an economic and financial think tank that advises policy makers and civil society in the European Union.

Kapoor, who recently completed a paper critiquing the Norwegian Sovereign Wealth Fund’s investment strategy, says investors need to be more present in the debate about long-term capital.

“It is extremely frustrating that the fund with the longest time horizon invests on a two-to-three year investment horizon,” he says of the Norwegian fund.

“Long-term financing is fashionable, but I’m frustrated that when you drill down the number of investors that behave long term is very small. When I was working for the European Commission, it was shocking how you saw a small US hedge fund manager dominating the agenda; the large asset owners are not visible. The engagement on policy issues is very low.”

One of Kapoor’s criticisms of the Norwegian fund’s investment strategy is the under-investment in illiquid investments and emerging economies.

He says the bureaucratic incentive structure of the fund centres on “not messing up” and, for the people involved, the upside is limited and the downside reputation risk is large.

He says not every country has been able to save 10 per cent of its GDP every year, and the fund now has about $760 billion in assets, so Norway should be commended for that. But it has also meant there have been some restrictions.

“They have wanted to avoid headlines of investing in dodgy countries or negative investments. They have been wary of damaging the fragile consensus. The fund is now 15 years old and nobody in Norway questions the intergenerational wealth sharing,” he says. “The consensus is no longer fragile and Norway is in a situation it can have a mature debate.”

Norway’s strategy

Kapoor says that Norway’s investment strategy, which invests primarily in developed-market listed equities and bonds, is conservative on the surface.

“The crisis has shown that correlations go to one and that common risk factors matter. On the surface this is a conservative investment strategy, but there is a much larger hidden exposure to systemic risk factors,” he says. “They look at standard deviation as a measure of risk, but there is a structural risk because the portfolio is mostly exposed to OECD countries. They will never see growth rates of 3 to 5 per cent ever again and there is a cross-exposure to financial markets and to each other.”

Importantly, Kapoor says, the fund doesn’t need the liquidity.

The report on the fund, conducted by Re-Define but commissioned by Norwegian Church Aid, recommends the Norwegian government establish a new fund, the Government Pension Fund – Growth, to invest in developing countries, which would result in the dual benefits of job creation and investment returns for the fund.

Norwegian Church Aid, which is a member of the humanitarian Act Alliance, believes that the sovereign wealth fund’s unique long horizon positions it for investment in developing countries and could go some way to providing capital for job creation.

It argues that capital from the Norwegian Sovereign Wealth Fund could be channelled into low and lower middle-income group countries, benefiting the fund by securing its value for future generations, but also providing much-needed capital to developing countries to create jobs and infrastructure.

Currently the Government Pension Fund – Global, invests 94 per cent in developed markets, with a target of 10 per cent in emerging markets. At the end of March 2013, the fund invested 62.4 per cent in shares, 36.7 per cent in fixed income and 0.9 per cent in real estate.

The Norwegian Ministry of Finance has responded to the report with a statement on its website in Norwegian.

Kapoor insists he is “not giving up” on the issue and has articles slated for the local Norwegian press, the Financial Times and The Economist.

“There is a structural shortage of long-term capital, way too much short-term capital,” he says. “I want to make sure finance is reformed.”

Kapoor is a visiting fellow at the London School of Economics. He was elected chairman of the Banking Stakeholder Group of the European Banking Authority in mid-2011. During 2011 he was an expert visiting fellow at the European Commission, dealing with economic governance, financial reform and the euro crisis. Prior to this, he was a strategy adviser to the Ministry of Foreign Affairs in Norway from 2007.

Active managers who are increasingly on the ropes as beta strategies encroach upon their alpha returns can take heart from the latest research from index provider MSCI. In the latest insight from Barra, Dynamic Allocation Strategies Using Minimum Volatility: Detecting Regime Shifts to Enhance Active & Passive Investing, Philippe Durand and John Regino argue that although beta has evolved to erode the role of active management, dynamic allocation can add real value within low volatility strategies by strategically targeting periods of outperformance.

Demand for low volatility strategies has ballooned since the financial crisis pushed investors towards their higher returns and reduced risks around those returns. Assets in low-volatility exchange-traded funds have jumped to over $12 billion under management and are accelerating. Research from BlackRock shows the average monthly inflow in 2011 was $100 million compared to 2012 when this rose to $400 million per month, surging again in the first four months of 2013 to $1.6 billion. Most investors have built their exposure to low volatility via cheap, passive strategies but active management can also pay off. “Minimum volatility doesn’t outperform every period. It’s hard to say when it will and sometimes you have to wait a year or even two. We decided to find ways to time our allocation to minimum volatility at the point it does work,” explains Regino, vice president of portfolio management analytics at MSCI.

To test their thesis, Regino and Durand timed switched between a low volatility portfolio especially tailored for dynamic allocation and the parent index, MSCI USA. In the first trial they set a value of 30 on the CBOE Volatility Index (VIX) – a common measure of volatility on the US equity market – as the trigger to switch out of the index to the minimum volatility portfolio. “This level is historically associated with a high level of market stress. Periods with high VIX levels may coincide with periods of risk aversion in the market, potentially resulting in outperformance of the minimum volatility portfolio,” they say.

A second strategy switched to the minimum volatility portfolio and reducing total risk when the index was in decline, dropping below its six-month simple moving average (6M SMA). The last variation used an allocation decision that was based on the prior three-month performance of both portfolios, selecting the one with the higher return. Results from the three tests showed the latter two strategies performed best, capturing the superior returns of the minimum volatility portfolio but with much lower risk relative to the MSCI USA Index. Although the VIX captured volatility spikes quickly, it was slow to react once volatility had dissipated. “Both the 6M SMA and Momentum strategies exhibited higher information ratios than the minimum volatility portfolio. They captured the superior returns of the minimum volatility portfolio, but with much lower risk relative to the MSCI USA Index,” says Regino and Durand.

Regino says their research is only an illustration and says “active managers already have their own, subtle ways of thinking about timing”. Yet the basic theory is already apparent in some investment strategies, such as the $28.4-billion Arizona State Retirement System, which switches between its various risk premia indices at opportune times using Barra models. The key barriers to switching strategies are trading costs and ensuring the “maximisation of upside capture and minimisation of downside capture”. During lower volatility periods, the costs incurred by trading are also high relative to the potential performance benefit. The best active strategy would avoid excessive turnover during low volatility periods.

“In high volatility periods, the returns were greater in magnitude and trading decisions would have a larger impact, so a switching strategy would be more effective,” says the duo. But during spikes in volatility, the evidence is compelling for those managers looking to add extra value. “None of the risk premia tells you anything about timing,” concludes Regino.