An investment banking background brings a different perspective to the role of pension fund chief investment officer, and for the London Pension Fund Authority that means more focus on risk management, quantitative tools and processes, and implementation cost savings. Amanda White speaks with CIO Alex Gracian.

 

Alex Gracian has only been the chief investment officer of the £4.6 billion London Pension Fund Authority (LPFA) since October 2012, but in just over a year his style is infiltrating into the investment philosophy of the fund.

Gracian is a proud quant. He has a degree in theoretical physics and has managed money quantitatively at Lehman Brothers, Deutsche Bank, the TRW Pension Fund and as head of equities at Gulf Investment Management.

“Being a quant, my focus is using quant processes. A lot of fund manager selection can be about who rings the personal assistant of the CIO the most,” he says. “We want a more transparent, holistic, diversified approach.”

Gracian has now put in place a quantitative selection process for all managers, which uses quant filters to narrow the universe, and optimise the short list, a process which he says has some surprising results.

“The initial screens throw up some interesting names, and we’re calling them instead of them calling us,” he says. “We want to be at the stage where we are not having quarterly meeting reviews but instead there is more internal analysis and discussion on their funds which may lead them to be an implementer of our ideas, we want to work together with our managers.”

Gracian says the investment team, which numbers six including him, is working closely with managers, particularly in equities and the asset liability matching space.

Within equities beta is a focus and there is work being done to blend alternative indexes into one portfolio.

“Alternative indexation it is not just about alpha but about diversification, and volatility reduction. For us alpha is not the primary driver,” he says.

Within beta management, Gracian says he is a “big fan of cash equitisation” and the fund is building a futures book with about £300 million managed now.

Over time he plans to optimise that, use it for TAA implementation and as a source of cheap, ultra liquid investments.

The team is also discussing investment techniques with some of the bigger hedge funds to use their long/short skills and presence in the long-only space. It fits well with the fee philosophy at LPFA which advocates low base fees with proportionate and properly constructed performance fees.

In the 2012/13 financial year the investment costs of the total fund went down from 0.65 per cent to 0.55 per cent; and of that 0.17 per cent was spent on performance fees.

 

Global trend

The appointment of Gracian to CIO is part of a global trend where investment banking and investment management professionals are moving in to the pension investment world.

In the UK the new chief investment officer of the Pension Protection Fund, Barry Kenneth, was managing director at Morgan Stanley for eight years. In Australia the investment teams of funds such as UniSuper and First State Super are now headed by ex-investment management professionals, and in North America some of the high-profile examples are Britt Harris the CIO of Texas Teachers Retirement System formerly of Bridgewater, and CPPIB’s chief investment strategist Don Raymond formerly of Goldman Sachs. Virtually all employees at PGGM and APG in the Netherlands have spent time on the sell side.

“An investment banking background brings certain skills, like the minutiae of foreign exchange,” Gracian says, emphasising a focus on implementation costs is one of the benefits that background can bring.

“A lot of people focus on cost savings in pooling assets, but there is often too much emphasis on that, there are other important things.”

Hiring more experienced people – that can make the most of expensive systems and can understand option pricing, swaptions, or the stochastic-ness of options – is a focus for Gracian who says risk management, and liability modelling is a necessity for the fund. He wants a young, “edgy” team and will begin slowly hiring more staff.

“You can get an external provider but that is only good if the board and the non-executive can understand them,” he says.

As part of LPFA’s development, it has undergone significant restructuring at the board level since Edmund Truell joined as chair of the board and the investment committee in January this year.

Gracian says that an early decision between himself and Truell was to “no longer go through the consultant route”.

The board, which has had half of the trustees change in 2013, now has some specific pension and investment skill among its members.

“The board has a lot more experience and there is clear delegation which means decisions can be made a lot more quickly,” he says.

Together with an experienced executive team, this means LPFA is well-positioned to take advantage of some of the investments Gracian believes are real opportunities, such as secondaries and the distressed market.

Gracian is a “big fan” of R-language (he also has a Masters of Science in Information Technology) and is taking big strides in asset-liability modelling including introducing real-time analysis.

He believes liabilities valuations are conservative, and on a risk-free basis the liabilities of LPFA are more like £8 billion, against assets of £4.5 billion.

He wants to focus on liabilities, and says “the liability profile is more important than size per se for asset allocation”.

Inflation has been highlighted as one of the biggest risks facing the fund, with the potential to effect the funding arrangements and LPFA’s liabilities, and a hedging strategy is underway to manage this risk.

The fund will have its triennial valuation in 2014, but Gracian says at the strategic level the asset allocation will be similar to what it is now with about 40-50 per cent in equities.

What will change are the vehicles the fund chooses to invest in, with a wider scope for alternative debt such as aircraft leasing and pharmaceutical royalties.

He also says the fund has a bigger appetite for things like development risk.

Over time the fund will increase its illiquid allocations in property, private equity and infrastructure moving away from fund of funds to single funds, co-investments and the secondary market. The team will use its quantitative skills and processes to do some more factor-risk modelling in the illiquid space.

 

 

The LPFA’s 2012/2013 annual report can be accessed here

 

 

As pension funds act more like asset managers, with internal investment responsibilities, they should focus on the competitive advantages to be gained from data and analytics.

 

The healthcare industry has seen a 20 per cent decrease in patient mortality by analysing streaming patient data. The Telco industry has seen a 92 per cent increase in processing time by analysing network and call data. These are two powerful examples used by IBM to demonstrate the return on equity of investing in big data technology.

For many investment managers and asset owners, data remains an untapped resource.

According to Virginia Rometty, chief executive of IBM in an article in The Economist, data constitutes a vast new natural resource, which promises to be for the 21st century what steam power was for the 18th, electricity for the 19th and hydrocarbons for the 20th.

She says that in 2014 a new model of firm will emerge, called the “smarter enterprise”.

“These firms will do the things that organisations have always done: make decisions, create value and deliver value. But they will do them in new ways. Smarter enterprises will make decisions by capturing data and applying predictive analytics, rather than just relying on past experience.”

This new way of thinking of data, as a resource, is very relevant to the  investment management industry which not only has a high volume of data but relies on data for decision making. But according to a survey by State Street there is a real divide in the industry between the data leaders and the data laggards.

The study conducted by the Economist Intelligence Unit, and commissioned by State Street, “Leader or Laggard? – How Data Drives Competitive Advantage in the Investment Community”, surveyed 400 firms and looked at the strategies leading asset managers and asset owners are using to gain a competitive advantage from data.

The survey found that the vast majority of respondents saw data and analytics as a strategic priority (91 per cent), and yet only a small proportion (29 per cent) strongly agreed that they are already gaining a competitive advantage from their data now.

For those that are not, they are missing out. There is a lot for room for investors to use the analytics and interpretation of data, to identify investment opportunities and risks. The State Street report says data analytics can help with managing risk across multi-asset portfolios, enabling smarter and faster investment decisions and learning how to master regulatory complexity.

The importance of data analytics is highlighted by head of State Street Global Exchange Research and Advisory, Jessica Donohue, who says insight into portfolio data allows investors to leverage the “high ticket items” like asset allocation.

“Insight into the portfolio allows you to do things like tilt the portfolio for better return but less exposure, and it allows you to do factor analysis, manager assessment and look at things like manager strategy overlap,” she says.

“The theme of the last four years is it is all about risk, risk, risk, where previously it was all about alpha, alpha, alpha. But they are two sides of the same coin.”

This theme has also played out in the functions of investment firms, where risk was seen as middle to back office function but now it has front office implications.

The State Street report highlights one of the challenges of data, is its sheer volume (the others being velocity and variety), reporting that global IP traffic is projected to reach 554 billion gigabytes per month by the end of 2016. This is more than 110 times all of the information estimated to have been created by human beings from the dawn of civilisation until 2003.

Similarly IBM’s Rometty quotes that by 2020 there will be 5,200 gigabytes of data for every human on the planet by 2020. (To put this into perspective, one gigabyte is the equivalent of about 20,000 reasonably-sized word documents.)

For this industry its worth noting that financial data mirrors the general growth in data, and further, that the infrastructure investors use has not kept up with that growth.

A recent report from experts at the US Treasury’s Office of Financial Research says: “Financial market data volumes are growing exponentially. One should thus expect traditional data management technologies to fail, and they have.”

In particular back offices have not kept up with developments in either their own front offices or other industries.

The good news is the survey shows that investors are addressing this issue, and Donohue says that 86 per cent of respondents have increased their investment in data and analytics infrastructure in the past three years.

“We are in a cost cutting mode across the industry, but it is one of the areas people are spending money,” she says.

In addition to investment in technology, Donohue also highlights the interpretative skills as a barrier in the industry to embracing data as an advantage.

Particularly she says there needs to be continued innovation and specialisation in data analytics and then the visualisation of that data and analysis.

“This will be a powerful tool when it can be put in the hands of the C-suite, and it helps the chief investment officer, or chief risk offer see things in the portfolio and drill down,” she says.

“Having accurate data, and your own portfolio data at hand, is a big deal. “Big data” is a buzz word but there is a sense that your own data is your asset, it’s a tool you want to use. The next step is asking how you can do that and the realisation you should be able to do that.”

State Street Global Exchange is a new division of State Street and Donohue says it is a statement of how important data and analytics play in the role of our clients. It combines capabilities in research and advisory, portfolio performance and risk analytics, electronic trading and clearing, information and data management, along with new innovations to help asset owners and managers gain new insights and execute investment decisions efficiently.

 

The State Street report highlights five steps necessary to becoming a data leader

1. Improving risk tools with multi-asset class capabilities

2. Developing better tools to manage regulation in multiple jurisdictions

3. Improving the ability to manage and extract insight from multiple data sources

4. Optimising electronic trading platforms

5. Developing a scalable data architecture that will grow with your business

Source: “Leader or Laggard? – How Data Drives Competitive Advantage in the Investment Community”,

 

 

 

An equities-biased strategy for the Nottinghamshire Local Government Pension Scheme is against the trend for funds in the UK, but the local government scheme has no plans to de-risk as it tries to make up its funding level.

 

The strategy of the £3.5 billion ($5.7 billion) Nottinghamshire Local Government Pension Scheme, one of the United Kingdom’s many individual public sector pension funds, will remain biased towards equities with the fund holding steady with a 72 per cent allocation to the asset class and no plans to de-risk.

“We are a traditional Local Authority Fund with a high allocation to equities,” says Simon Cunnington in the Pensions and Treasury Management division at the fund which draws its membership from over 100 local employers in the East Midlands and with over 100,000 individual members.

“Our members like us to invest in real assets that generate economic growth and all our investments are long-term. We tend not to worry about quarterly numbers too much and we know equities are volatile, but believe they will continue to outperform other asset classes over 10-15 years.”

In a strategy Cunnington characterises as proudly independent and without any recourse to investment consultants, Nottinghamshire returned 14 per cent last year against its benchmark of 12.5 per cent, boosting assets under management by $653 million.

The equity allocation produced the best returns at 17.7 per cent followed by bonds returning 12 per cent with the fund’s UK property allocation trailing with returns of 1.8 per cent.

Around two-thirds of the equity portfolio is passively managed, mostly in-house by a team of six, but with a portion also invested via Legal and General tracker funds. The remaining third is actively managed by Schroders.

Nottinghamshire uses active management both for diversification and to improve returns, says Cunnington, proven by the in-house passively managed equity portfolio returning 10.4 per cent on a 5 year annualised basis ending September 2013 versus returns in the actively managed portfolio coming in at 12.2 per cent.

Nevertheless, it is not ignoring passive strategies and is currently stress testing all its portfolios in a benchmarking process that looks at the returns possible in passive index strategies versus the active strategies it has chosen to pursue.

“We wanted to measure the impact of our decision to invest differently,” says Cunnington. “It has kicked off a process that may see a few changes.”

One change, he says, will see a reduction in its allocation to UK gilts in favour of sterling denominated corporate bonds that will include European and US companies.

“Our bond portfolio is traditional and low risk with the majority in UK gilts. We plan to reduce our exposure to gilts because we don’t believe performance is going to be as strong going forward,” he says.

Nottinghamshire’s private equity allocation accounts for 2 per cent, around $261 million, of the total equity allocation. In an allocation begun in 2001 most investments are via fund of funds and secondary funds.

Despite the costs incurred in this strategy, Cunnington insists it is essential given Nottinghamshire’s lack of in-house expertise with the asset class. In coming months he hopes to increase the allocation to infrastructure currently made through private equity fund managers Partners Group.

Nottinghamshire is also unusual for its large property allocation accounting for 12 per cent of assets. $473 million of the property portfolio is directly held in domestic property investments managed by Aberdeen Asset Management.

“We like property over bonds because it gives a similar income, but has a better prospect of capital growth. Our UK investments did particularly well up until 2007 and although they have suffered since, we are just beginning to see a turnaround,” says Cunnington, noting that secondary property in particular has struggled.

“There is only a limited supply of prime property so values have held up here but secondary stock has fallen. The key is to keep the rents coming in.”

The remainder of the property portfolio is invested in pooled property funds in the UK and Europe.

Asset allocation at the fund is shaped according to set ranges. The equity allocation ranges from between 55-75 per cent, the property allocation can stretch from 5-25 per cent, the bond allocation between 10-25 per cent and cash holdings between 0-10 per cent.

The large equity allocation is also part of the fund’s deficit recovery program. Nottinghamshire is only 84 per cent funded but because of its buoyant cash flow, with an annual investment income of around $147 million, it can “ride out the volatility.”

Costs are kept low at the fund by a combination of in house management and a limited number of external managers.

The fund had investment management costs of 0.18 per cent net of assets in 2012-2013 and it is driven by the belief that simpler investment strategies lead to lower management fees because of less trading and transition costs.

 

 

 

There may be ‘green shoots’, but 2014 will see no rush for the exit from abnormally loose monetary policies says Neil Williams, Chief Economist for Hermes’ Global Government & Inflation Bonds, in his Quarterly Economic Outlook. Despite volatility over ‘taper-gate’ and concerns that central banks will start withdrawing stimulus, policy rates and bond yields may have to stay low for even longer.

Read full paper here

This research by academics at Duke and Columbia Universities looks at whether it still makes sense to separate equities allocations into developed and emerging market buckets.

 

Given the dramatic globalization over the past twenty years, does it make sense to segregate global equities into “developed” and “emerging” market buckets? This paper argues that the answer is still yes.

While correlations between developed and emerging markets have increased, the process of integration of these markets into world markets is incomplete.

To some degree, this accounts for the disparity between emerging equity market capitalisation in investable world equity market benchmarks versus emerging market economies in the world economy.

Currently, emerging markets account for more than 30 per cent of world GDP.

However, they only account for 12.6 per cent of world equity capitalisation. Interestingly, this incomplete integration along with the relatively small equity market capitalisation creates potentially attractive investment opportunities.

The academics argue this research has important policy implications for institutional funds management.

 

The paper can be accessed here: Emerging Equity Markets in a Globalizing World

The Dutch Philips pension fund has traditionally had a low risk profile, managing a separate liability-matching porfolio and a return-seeking portfolio. A new agreement with its members means it will rethink its  investment strategy, with inflation-sensitivity one of the priorities.

 

The €15 billion ($20 billion) Philips Dutch pension fund is set to go “back to the drawing board” on its investment strategy after reaching a fundamental new pension agreement with its members.

The Dutch electronics giant is no stranger to invention, having produced both the first DVD and compact cassette. A series of changes linked to the introduction of a new national pension agreement in the Netherlands are now set to get its pension fund in innovative mode.

Rob Schreur, chief investment officer of Philips Pensioenfonds, explains that the fund’s trustees have determined to aim for a real rather than nominal benefit ambition in the future.

“Our members also feel a real pension matters, and as a result we’ll need to go back to drawing board to see if our investment strategy matches this objective,” Schreur says.

In addition, an agreement between Philips and the unions was reached regarding the introduction of a collective defined contribution pension agreement, Schreur explains.

Discussions are due to be held at the end of 2013 on questions such as if and how to build inflation sensitivity and protection into a new-look investment mix. Any major investment changes will need to be approved by regulators at the Dutch Central Bank.

Questions about implementation “with the best way being not in a hurry” would then need to be addressed, says Schreur.

As “there are a lot of things going on in financial markets and a lot of things that could happen, we need to be careful implementing any new strategy,” he adds.

As it stands

Currently, the largest chunk of the fund is invested in a €10.5 billion ($14.2 billion) liability-matching portfolio. This is mostly invested against a benchmark of core European government bonds. A 13 per-cent inflation-linked component within the matching portfolio mostly consisting of inflation-linked swap exposure.

The fund adopted a liability-matching concept back in 2005.

Schreur concedes that while the approach has many strengths there are also weaknesses. He outlines these as getting a precise picture of liabilities, setting an effective discount rate and finding instruments to match the risk assumed in the discount curve.

He reflects “there has been and probably will continue to be a lot of discussion regarding the regulatory curve used to discount liabilities, which in itself is a case in point regarding the various, prudent, curves which might be considered.”

Even from a market valuation perspective, it is hard to say whether a swap curve (and Libor obligations) are better than using a government curve for a market valuation of liabilities, reckons Schreuer.

“However, you have to admit over the last couple of years that government bonds across the world have a lot more risk than was expected 10 years ago,” he says.

Schreur is confident that the Philips fund’s liability-matching portfolio has continued to deliver decent returns despite low government bond yields.

“In the run up to the low yields the matching portfolio had a particularly good return, and our 6.5 per cent average total returns over the last five years are higher than most Dutch funds,” he says.

The low-yield environment and the Euro crisis in particular have inevitably led to some changes.

“What we did over the last couple of years was try to get a good view of what might happen in Europe and adapt the risk profile of the matching portfolio to balance the risk of continuing turmoil in the Euro area or even a break-up,” says Schreur.

Greater international diversification has proved a suitable answer to the dilemma. Interestingly though, despite lowering its exposure, the Philips fund showed determination to cling on to Italian and Spanish government debt by lowering its minimum credit requirements.

“We felt it was worth keeping some Italian exposure rather than getting negative real yields from Germany,” Schreur says, but of course this was a risk-balancing act, he adds.

Mortgage investments are held by the Philips fund to aid the diversification of the liability-matching portfolio.

“The spread on mortgage investments is attractive at a couple of per cent over government yields in the Netherlands,” he says.

Schreur takes pride in the fact all these changes were managed while the fund maintained its low-risk credentials.

“Using a cost-effectiveness analysis and comparing to other funds we are at the lower end of the risk profile, with asset risk slightly over 3 per cent compared to a median of 8 per cent,” adds Schreur. “All that is history though, and we have to look forward.”

 

Rich returns

The fund’s €4.5 billion ($6 billion) return portfolio is dominated by equities, which has a 55 per cent strategic weighting. Real estate takes 15 per cent strategically, with 10 per cent in both emerging market and high yield bonds, and another 5 per cent earmarked to both commodities and cash.

The return portfolio aims to cover the fund’s longevity risk. This has been quite a challenge, reflects Schreur “as longevity risk is a difficult beast” with unexpected increases liable to occur.

Schreur comments that the fund has received some valuable help from the Dutch government with its increase of the national retirement age to 67, and the tying of future increases to longevity.

Commodities are set to be reviewed to see if they have a place in the new investment mix, reveals Schreur.

Emerging market bonds have had a difficult time in 2013 “but this kind of volatility was more or less to be expected,” he says. Hard currency bonds look most attractive from a tactical perspective though, he adds.

Returns have been “flat” for the first three quarters of 2013 across the whole fund at 0.6 per cent – caused by a 0.7 per cent loss on the liability-matching portfolio. This is a disappointment that has been compensated for by a clear improvement in the vitally important funding ratio up to 109 per cent – made primarily by an increase in interest rates.

That development might not be nearly as thrilling as anything you can listen to on an old cassette or watch on a DVD. It is nonetheless a product of some very different work at Philips’ Eindhoven base that should nevertheless end up pleasing a lot of Dutch savers.