Antony Barker has only been director of pensions at the £8-billion ($12.2-billion) Santander Pension Fund, a defined benefit scheme for employees of the UK arm of the Spanish-owned bank, since August last year. Charged with rejuvenating the pension scheme, a worrying source of risk blighting the fortunes of the bank and a thorn in the side of a planned 2014 listing on the London Stock Exchange, Barker, a seasoned pensions professional, has all the support and resources of one of the eurozone’s biggest banking groups. It’s enabled him to shape an innovative strategy to boost returns and hedge the portfolio that is starting to reap real rewards.

The Santander Pension Fund is an amalgamation of seven different schemes gathered through the course of the bank’s UK acquisition trail, including the former pension schemes of UK building societies Abbey National, Bradford and Bingley, and Alliance and Leicester. These schemes, all bringing different strategies and maturities, were amalgamated into one Trust last year. Labouring under a $6-billion deficit on a buyout basis and with only 5000 of its combined 65,000 members active, strategy is now wholly focused on hedging the entire portfolio and steering the scheme to solvency within the next 10 years. Assets are split between fixed income (50 per cent) equities (25 per cent) and illiquid assets (25 per cent), with the scheme targeting returns of just under 6 per cent. It returned 10.7 per cent last year, buoyed both by its large index-linked gilts portfolio along with good returns from alternatives and real estate. “The outperformance is welcome, but we are acutely aware that it is performance relative to the liabilities that is all that matters,” counters Barker.

Replacing physical assets

A proactive strategy means that allocations have been overhauled or de-risked, with derivatives often replacing the holding of physical assets. In the equity allocation, an equity collar put in place in 2011 (but now taken off since equities corrected down) protected against market falls throughout 2012. The strategy, which gives downside protection in return for relinquishing some upside in equity returns, generated profits of up to $213 million. Now, in a new tack, the fund is looking at developing a synthetic equity allocation through holding multi-term, multi-strike, multi-market call options. Replicating the underlying equity market performance without actually having a physical equity position is an effective way to manage tail risk and frees up assets for a common collateral pool for liability hedging, argues Barker.

In another example, Santander reworked its inflation-hedging strategy in anticipation of a change in the United Kingdom’s inflation policy at the beginning of 2013. Government reform threatened profound implications for UK schemes such as Santander with large gilt exposures where interest and capital payments are linked to the Retail Prices Index (RPI). Santander took profits on its inflation-linked gilts allocation and structured an inflation-swap contract whereby a series of cash flows linked to RPI were exchanged for a series of fixed cash flows linked to short-term interest rates. In the event the government decided not to change RPI as a measure of inflation, but the strategy paid off given how pricing had reduced in the uncertain months prior to the decision. “We sold down our pool of linkers but increased our synthetic inflation exposure via swaps just before the CPAC announcement,” says Barker referring to the ‘no change’ announcement by the Consumer Prices Advisory Committee. “Inflation was as cheap as it was in 2004 at the time, so we decided to swap out on a derivative basis.”

Elsewhere the scheme has built a diversified fixed income exposure that ranges from government debt to global credit and higher yielding private debt and insurance-linked securities. Within the mix, the scheme also holds inflation exposure through assets like property leases and is looking to source privately placed primary issuance of corporate debt securities by utilities and supermarkets.

Real world risk

Illiquid allocations account for 25 per cent of the portfolio and investment is aggressively opportunistic. The fund seized on the sought-after commercial property portfolio of Royal Mail Pension Fund, sold off by the government earlier in the year in its bid to prepare Royal Mail for privatisation. Rich pickings in property assets with a return profile that will help meet the scheme’s liabilities included Cambridge Science Park and regional shopping centres. Santander eschews prime real estate to avoid competing with foreign buyers, particularly Canadians “who know the market well”, instead finding opportunities in off-prime areas in London and outside the capital in the next best cities.

He believes UK social infrastructure is still expensive and is unimpressed with the slow progress of the Pension Infrastructure Platform, (PIP), designed to spur pension fund investment in infrastructure. “We will probably invest in the PIP when they get anywhere near making an investment, but given our funding deficit and the opportunities we see, we need to get our money invested now,” he says. In fact, Santander is increasingly looking at global and esoteric infrastructure such as shipping and agriculture in assets that Barker picks according to three primary risks: economy, duration and volatility. “We only see these risks – we are agnostic as to where we get our exposure.” He says that the fund increasingly blurs the line between its infrastructure and private equity pool looking, in both cases, for secondary investments buying from “keen sellers” or “people who need cash now” to move more quickly up the J curve. The fund accesses emerging markets through debt and private equity rather than quoted equity, he adds.

Of all the illiquid allocations, hedge funds have proved the most troublesome. Returns haven’t been any higher than quoted equity and Barker, who says he has grown “cynical about hedge funds”, is selling down Santander’s multi-strategy. Instead he plans to buy stakes in hedge fund managers and invest in synthetic replications of hedge fund strategies, which he believes are both more effective and cheaper.

Sponsor and peer relations

The risk the pension fund poses to the bank’s fortunes has spurred an unusually proactive approach. The scheme can use the bank’s financial expertise to both improve returns (particularly using Santander Asset Managers real-estate expertise) and reduce risk. “We have gone beyond the conventional and built out our own model,” says Barker describing a process that combines the traditional asset and liability projections used by most pension schemes, with the associated accounting and capital impacts for the bank. It has allowed the production of “real time” management information on the true level of the risk the scheme represents to the bank’s profitability and balance sheet. The fund doesn’t use any consultants and runs about 60 separate mandates.

As well as sharing services with its sponsor, Santander works with other big pension schemes. “We have a lot of conversations with other schemes; large pension funds do talk to each other,” he says. Santander has formed two property “clubs” with other schemes to access specialist investments in a strategy now being extended to other illiquid investments. Joint ventures with other schemes with dedicated inhouse resources bring down the management costs of alternatives to something closer to quoted investments, he says.

Environmental risk

Barker doesn’t expect volatility to ease just yet. “The market doesn’t behave as expected so everything, even the good news, is often construed as bad. The volatility in the UK equity market nowadays is such it can move 2 per cent in an afternoon. What used to be the definition of an emerging market is now a feature of the FTSE.” He believes most schemes still miss out on opportunities because they hold more liquidity than they need. “During the financial crisis, banks were crying out for liquidity but pension funds held onto their cash – they missed a trick.” Nor is he relying on any rise in interest rates to help with Santander’s liabilities. “The reality is interest rates will stay low for longer and the current market conditions will persist. We haven’t factored in the hope that rising interest rates will help reduce the cost of our liabilities, but as and when they do, we will look to increase our hedging ratios,” he says. For now he is using other tools to navigate the fund out of deficit and hedge the portfolio. “The pension is the biggest single non-core source of risk to the bank’s future profitability and capital,” he says.

Wall Street is not normally synonymous with sustainability. But today, the United Nations Secretary-General Ban Ki-moon will ring the closing bell at the New York Stock Exchange to welcome NYSE Euronext into the Sustainable Stock Exchanges Initiative, joining NASDAQ OMX and leading emerging market exchanges from Turkey, South Africa, Egypt, Brazil and India.2013-07-24_Closingbell_

Why would exchanges be interested in sustainability? In large part, they are responding to the needs of a key stakeholder: institutional investors. Since the financial crisis and incidents such as the Deepwater Horizon, Marikana in South Africa, phone hacking by News Corporation journalists, and numerous illegal and unethical activities within banks, investors are increasingly aware of how risk can be hidden in a portfolio (and sometimes in plain sight). Health and safety, relations with workers and communities, environmental management, human capital development, corporate integrity and ethics are all areas that, if managed well, underpin the future prosperity of companies. These environmental, social and corporate governance (ESG) factors were traditionally viewed as non-financial and largely ignored by analysts – until something went wrong. No longer. These factors are now being taken very seriously and integrated into investment decisions by many of the largest fund managers and pension funds in the world. And not for ethical reasons, but because these issues – and how they are being managed – matter to investment performance.

The market for ESG information, both on the broker and the specialist research sides, has increased dramatically in recent years as has the volume of reporting by companies. A study by Si2 and the IRRC Institute found that in the S&P 500 only one company did not disclose some kind of sustainability information. However, in many cases, the information disclosed is not up to the task. Bloomberg data show that only one quarter of the 20,000 or so global listed companies covered provide data across environmental, social and governance issues. Of the companies that do, a minority is providing investors with the metrics and meaningful disclosures they need to compare how well different companies are managing these types of risks. Researchers from St Andrews University found that for the companies which report greenhouse gas emissions, three quarters report emissions from only part of their operations. Many corporate responsibility reports are still too imprecise to be useful to investors and offer little in the way of quality data or frank assessments of the material risks the company is facing around these emerging issues.

Stock exchanges as part of the solution

Stock exchanges are one of the most important intermediaries between listed companies and their investors when it comes to information flows. That’s why a group of 30 institutions, led by Aviva Investors, has been calling on the world’s largest exchanges to encourage better reporting. So what are the leading exchanges doing to help address the problem?

First, they are raising awareness and improving standards among listed companies, using both carrots and sticks. A number of exchanges have developed ESG disclosure guidance and training programs for listed companies, showcasing best practice. In a few markets, such as South Africa, sustainability and integrated reporting have been built into listing requirements. In Malaysia, the exchange has teamed up with the regulator to make sustainability reporting mandatory on a “comply or explain” basis.

Second, they are developing ESG indices. There are now around 50 such indices being offered by 16 exchanges around the world, many of which have stimulated fund products based on them. These include the long running FTSE4Good at the London Stock Exchange and more than a dozen from NYSE Euronext and NASDAQ OMX. Many emerging market exchanges now have ESG or sustainability indices, and companies see inclusion in these as a badge of honour.

Third, they are developing specialist exchanges for niche funds and products such as microfinance, impact investing, carbon trading and other sustainability themes, providing greater liquidity and accessibility to investors.

Exchanges are also beginning to practice what they preach, with many producing their own sustainability reports.

Commitment to trust and investability

While there has been a lot of activity, particularly around the development of ESG indices, delivering the type of quality information from listed companies requires an additional collective push, and that is why NYSE Euronext’s decision to join the Sustainable Stock Exchanges initiative is such good news. The Sustainable Stock Exchanges Initiative – convened by the UN Global Compact, UN Conference on Trade and Development, Principles for Responsible Investment and UN Environment Program Finance Initiative – asks exchanges to “voluntarily commit, through dialogue with investors, companies and regulators, to promoting long-term sustainable investment and improved environmental, social and corporate governance disclosure and performance among companies listed on our exchange”.

For emerging market exchanges, the business case is clear. It is about building confidence, trust and investability. These exchanges have been leading the way on this agenda. For emerging market exchanges, their main goal is building confidence in companies and capital markets, and the best way to build trust is through transparency.

The dynamic is different in developed markets, where many exchanges are now listed companies with their own shareholders, and they operate in competitive markets. There is a perception that if one exchange or jurisdiction gets too far ahead of the rest, then companies may shop around for places to list that make life easier and we end up with a race to the bottom. If the industry recognises that greater transparency and better quality data is what is required – and demanded by investors – then exchanges and regulators need to move in lock-step, ideally on a global basis. The Sustainable Stock Exchanges Initiative is an effort to bring exchanges, companies, investors and regulators together to make this happen.

Today is the second time a UN secretary-general has rung the bell at the New York Stock Exchange. The first was in 2006, when Kofi Annan launched the Principles for Responsible Investment. Since then, over 1200 institutions have signed the principles, with over US$34 trillion publicly committing to invest responsibly. Let’s hope that today, the secretary-general’s  bell ringing represents the start of an equally successful effort to bring stock exchanges, regulators, companies and investors together to deliver the type of corporate transparency that we need.

Dr James Gifford is executive director of Principles of Responsible Investment.

www.unpri.org

Distinct regulation of United States public pension funds that links the liability discount rate to expected return on assets, rather than to the riskiness of their promised benefits, sets them apart – in a bad way. US public funds have underperformed other pension fund cohorts because of higher allocations to risky assets. Arguably, regulation is at the core of that decision.

A new paper by Aleksandar Andonov and Rob Bauer from Maastricht University and Martijn Cremers of the University of Notre Dame shows that US public funds have an annual underperformance of more than 60 basis points from 1990 to 2010 compared to their peers.

The underperformance, the authors argue, seems to be driven by the conflict of interest between current and future stakeholders, and could result in significant costs to future workers and taxpayers.

Pension fund asset allocation and liability discount rates: camouflage and reckless risk taking by US public plans? compares the asset allocations, liability discount rates and performance across six groups: public and private pension funds in the US, Canada and Europe using the CEM database.

Distinct from any of the other five groups measured in the study, the US public fund regulation links the liability discount rate to the expected return on assets rather than to the riskiness of their promised pension benefits. This means they behave differently from all other pension funds.

Even within the US, regulation is very different: public funds are regulated by the Government Accounting Standard Board, while corporate funds are regulated under the Pension Act 2006.

Stacking up the stats

Significantly in the past 20 years, the group of US public pension funds measured have uniquely increased allocations to riskier investments to maintain high discount rates – and oddly this is especially the case as more members retired.

On average, the percentage of retired members among private plans increased from 31 per cent in 1993 to 52 per cent in 2010, and from 28 per cent in 1993 to 39 per cent in 2010 among public pension funds.

Economic theory suggests that asset allocation and liability discount-rate choices should be more conservative as the fund matures. But with US public funds, the proportion of retirees relative to non-retirees is positively related to the allocation to risky assets.

The study found that a 10-per-cent increase in the number of retired members of US public pension funds is associated with a 2.05-per-cent increase in the allocation to risky assets, while a 10-per-cent increase in the number of retired members is associated with a 1.16-per-cent lower allocation to risky assets among all other pension funds.

This results in the funds “camouflaging the degree of underfunding” the paper argues.

“If the liability discount rate equals the expected rate of return, it makes liabilities very hard to measure. It is subjective and hard to argue about,” one of the authors, Martijn Cremers says. “Liabilities shouldn’t be hard to define or be so subjective.”

Cremers, who is professor of finance at Notre Dame, says US pension funds need to be objective as possible about their liabilities, which would allow an equally objective assessment of the outcome and current promises.

It is then possible to do asset liability modelling and think about asset allocation with the right perspective.

Peer relative

According to the authors, US private pension funds, and both public and private Canadian and European pension funds are subject to significantly stricter regulatory guidelines. Their regulations generally require that liability discount rates be chosen as a function of current interest rates.

“We argue that the distinct regulatory framework for US public funds gives them strong incentives to shift a larger allocation to risky investments as this increases the assumed expected rate of return on their asset portfolio and thus (through their regulation) results in higher liability discount rates,” the paper outlines. “This in turn helps these pension funds camouflage their degree of underfunding and potentially delay making difficult decisions on contribution levels and pension benefits. Over the last two decades, increased allocations to assets with higher (assumed) expected returns have allowed US public pension funds to maintain high-liability discount rates, even as interest rates significantly declined.”

Cremers argues it is finance 101 to link the liability discount rate to investment grade yields.

Other academics have also argued this (for example, Robert Novy-Marx and Joshua Rauh of the National Bureau of Economic Research), but uniquely it is the regulation of US public pension funds that continues to ignore this finance missive.

Financial theory suggests that future streams of pension benefit payments should be discounted at a rate that reflects their inherent riskiness, particularly their covariance with priced risks.

Academics have been proposing the use of liability discount rates based on yields on government and municipal bonds and swap rates.

“In our empirical analysis, we find that pension funds generally lower liability discount rates as interest rates decline, which is consistent with both their regulations and economic theory.

However, US public pension funds are again different, as we find no association between liability discount rates and interest rates. This is consistent with their incentives and their distinct regulation that explicitly links liability discount rates to their expected rate of return on assets rather than to the level of interest rates. This result holds even while controlling for the proportion of assets invested in risky asset classes, which means that US public pension funds have made the economically surprising choice of not lowering their nominal expected return estimates on risky assets as interest rates decline.”

In the early 1990s yields were 7 to 8 per cent, so Cremers says it made sense for the return expectation to be 7 to 8 per cent. But as yields have declined, the return expectations have not declined.

A prudent assessment of reality

“The prudent thing is fairly unambiguous. With US public funds, regulation gives strong incentive to kick the can down the road,” Cremers says.

“US public funds are not making asset allocation on where opportunities are or true asset liability matching, but on camouflage, on short-term responses,” Cremers says.

Perhaps the most important aspect of the study, however, is the emphasis on the fact that US public pension funds are not being transparent about the true state of the underfunding position.

“Whatever the policy, it needs to be based on a prudent assessment of reality,” Cremers says. “The first step is to identify the current pension status, which is worse than people say. And regulation that gives incentive to public pension funds to invest in risky assets is imprudent.”

While funds admit that they are underfunded, academics and study by the Pew Report, show the situation is much worse than reported.

Cremers says the average funding level of US public pension funds is 80 per cent, but in reality it is much worse, with Pew estimating it is 57 per cent.

“If a more realistic liability discount rate is used, then it is a more dire picture of funding status. But then we can talk about how to respond, and at least there is a conversation about where we are,” Cremers says.

“As a financial economist, I can say that you make better decisions if you are realistic about where you are.”

As another fiscal year draws to a close Tim Walsh, director of the New Jersey Division of Investment, investment managers of the $75.64-billion New Jersey Pension Fund, reflects on another good year.

“It’s been a double-digit year with the best asset classes, plain vanilla US equities and structured credit,” he says speaking from the Division of Investment’s Trenton headquarters.

United States equities’ contribution to performance was enhanced last May when Walsh positioned the fund to benefit from the equity lift-off even more, upping its exposure by 4 per cent, creating an overweight position of 28 per cent of plan assets. It’s just the kind of agile strategy for which New Jersey is increasingly known.

The Division of Investment invests on behalf of the 769,000 members of New Jersey’s seven public pension funds.

The fund is divided into broad categories comprising a global growth fund (56.79 per cent) made up of US and non-US equity, emerging market equity, plus equity hedge funds and venture capital; income (23.63 per cent) comprising investment grade credit, high yield fixed income and debt-related private equity among others; a liquidity allocation (8.73 per cent) comprising treasury bonds and inflation-linked bonds; a real return bucket (7.65 per cent) including commodities and real estate; and risk mitigation (2.55 per cent).

Wary of the rosy equity view

Walsh has now grown circumspect of the rush into US equities – what he calls the rosy view of the US.

“There seems to be a broad consensus that US stocks are good and everything else is evil,” he says. “It concerns me because the consensus is usually wrong.” Now his eye is on what he calls beaten-down areas, such as high yield.

He believes technology and parts of the energy sector are cheap, but it is emerging markets, one of the worst performing assets of last year, where he sees most opportunity. The fund doesn’t pick individual stocks here but invests via exchange traded funds, currently allocating between 7 and 8 per cent of plan assets to emerging markets.

“We’ll add to this,” he says. “Emerging markets are the asset class to be in. If you could get the state-owned enterprises out of the benchmark, performance would be even better.” Despite the euro crisis, he has been encouraged by the fortunes of some European multinationals in Switzerland and the UK. He’s worried about rates rises “backing up” and predicts that although the markets for the most part are liquid, it will be harder to find opportunities going forward.

New Jersey, new hedge fund model

New Jersey Pension Fund’s May restructuring also pared the fund’s allocation to hedge funds, honing strategy to especially tap hedge funds in emerging debt and small global macro strategies that bring diversity to the portfolio. Allocations to hedge funds sit across the entire portfolio.

“We don’t have a broad bucket called hedge funds,” explains Walsh, adding that the fund favours customised relationships with its hedge fund managers, with tailored strategies and side-by-side investment.

“The 2/20, no preferred-returns model is dead. We haven’t put any money into a traditional hedge fund for over a year and we have actually withdrawn some,” he says in reference to the model whereby managers charge 2 per cent of the total value of the assets invested and 20 per cent of the returns.

Working alternatives hard

The alternatives portfolio, which “requires a lot of work,” is managed in house by New Jersey’s increasingly sophisticated team of 60, also now managing 90 per cent of the fund’s liquid assets.

It amounts to about 70 per cent of the total portfolio, more than any of other of the 11 biggest US schemes.

Inhouse management paid off particularly well last year with the fund’s active allocation to US equity.

“The active portion was our strong suit,” he says. For Walsh, who joined New Jersey in 2010 from Indiana State Teachers Retirement Fund where management was all external, developing New Jersey’s inhouse operations is one of the best parts of the job. “I do quite a lot of the rebalancing and the asset allocations – it really thrills me.”

New Jersey hasn’t increased its real estate allocation (4.89 per cent) but Walsh does see more opportunity in the asset class from now. It has just split its real estate portfolio into separate debt and equity allocations. Banks selling off their real estate portfolios is one seam.

He believes “industrial is pretty cheap” and also sees potential in hospitality. However, overvalued US markets in downtown Manhattan, Washington DC and Boston are prompting him to cast his eye on assets overseas. “There are better opportunities outside the US, going into China, India and South East Asia.”

New Jersey will get its final numbers on last year in the next couple of weeks. “We are a pension fund with long-term horizons, but we are nimble if we need to be,” says Walsh.

Affluent small European nations such as Denmark easily count among the world’s most outward-looking places, and DKK 95-billion ($16.4-billion) investor Unipension clearly casts its eyes far and wide from its headquarters in suburban Copenhagen.

While nearly all investors look for some exposure in the world’s key markets, Unipension has enhanced its international focus by actively eliminating home bias in spaces where others dare not. The investor – which controls three labour-related pension funds – recently decided to sell its entire Danish property holdings and invest the proceeds in international real estate funds.

A fully international approach is a bold move in an asset class that most investors are more comfortable in close to home. To Niels Erik Petersen, Unipension’s chief investment officer, it was a logical step for the investor.

“In all our investments we have a core-satellite international diversification strategy, but in real estate we only had Danish exposure so we wanted to diversify here as well,” Petersen says. The move, which will also see real estate allocations harmonised at 5 per cent across the three funds Unipension controls, will concentrate primarily on the United States and Western Europe.

Just 5 per cent of Unipension’s liquid portfolio (incorporating all assets excluding real estate) is invested in Danish equities, and Petersen says the fund has tried to avoid a home bias in this asset class as well.

“Denmark has a very small market, so there are a lot of opportunities outside of our region that help us balance the risk of our portfolio,” he explains. Petersen points out though that the international focus should not be interpreted as an abandonment of the investor’s homeland though, with the smooth functioning of Danish capital markets a key focus of Unipension’s active ownership strategy.

Careful global approach

“Diversification is important on our fixed income side, but what’s also important is that you get your money back,” says Petersen. Danish government bonds and high quality Danish mortgage bonds are therefore a significant part of the 39-per-cent gilt-edge-bond portfolio. Other “core” European government paper from the likes of Germany and Holland occupy the rest of that position.

Despite being an international fund, Unipension naturally has no desire to be impacted by regional pitfalls, and it therefore divested from southern European government bonds in 2009.

Petersen reveals that an unintentionally off-putting research trip led to Unipension moving away from the continent’s more indebted government bonds well before most other European investors followed. He was part of a group that met with a number of figures in Athens a few years ago with the firm intention to increase Unipension’s holding of Greek debt.

Discovering the true extent of the crisis conversely led Unipension to quickly drop its holdings in not only Greek but also Spanish, Italian and Portuguese government debt – a call that looks inspired in hindsight.

A dependence on external managers for Unipension’s vast emerging market portfolio (11 per cent of liquid assets are in emerging market debt and 29 per cent in overseas equities) means no such research is necessary in this space. The emerging market debt holdings have increased in recent years at the expense of gilt-edged bonds, with equity holdings also increasing gradually due to their strong performance.

A 12-per-cent allocation to high yield in the liquid portfolio “has been useful” says Petersen, who indicated Unipension had no doubts about the assets despite high yield investors suffering in this summer’s market turbulence.

Again Unipension appeared to have timed its tactical approach well with a move down from an overweight position on high yield being made in 2012. This was definitely “not a macro call”, Petersen points out though, as the fund simply saw better protection in loans.

Thin pickings lead to alternatives

Petersen explains that implementing a “duration overlay” had been a key strategic change in the recent past in an effort to extend the duration of assets to match liabilities, but this was reversed last year. “

Everything is pointing to a scenario of low returns in the coming years,” he says, betraying an outlook marked by pessimism. The investment head does not expect a “tremendous” performance in equities. Low interest rates also make the prospect poor for bonds in his view.

A natural consequence of that grim view would seemingly be for Unipension to diversify its asset base as much as it has its geographic spread. Petersen confirms this process is well under way with a private equity portfolio being launched in recent years and since increased to 4 per cent of liquid assets.

“We will increase our private equity holdings further, no doubt about it,” he says. The private equity bucket has a US-tilt, while Unipension has discovered a liking for secondary holdings.

The investor could well join other Danish pension funds in making major attempts to develop infrastructure investments, according to Peterson. Unipension’s limited and relatively short liabilities make this less of a pressing need, although it has already looked at various potential projects.

Strong returns in the last few years perhaps make it easier for Petersen to express his fears for the future. Unipension has gained accumulated returns of over 74 per cent since the start of 2009, which is some 14 per cent higher than its benchmark. In 2012 it booked an annual return of over 13 per cent but there has been a noticeable slowdown in 2013, with returns of just under 3 per cent for the first half of the year.

Free but prudent

The trio of funds under Unipension’s control run nearly identical asset strategies, Petersen says, with a system of modulised mutual funds ensuring assets are efficiently pooled. Slight liability differences and risk appetite variations at the three respective boards require some fine tuning though, he adds.

As liabilities are guaranteed on a contingent basis (Unipension promises to deliver at least 1 per cent per year but has a get-out clause if returns fall below that), Petersen says the investor “has a large degree of investment freedom and we can really go for long-term returns”. That allows Unipension a bigger risk budget than its Danish counterparts, although in true conservative Scandinavian tradition, Petersen says the fund has actually kept its risk “very low” under its international diversification drive.

The global outlook of Danes has created a problem for Unipension in that it has found itself under fire at home, along with other pension funds, for emerging market debt investments.

They have been criticised on the basis that the investments might support undesirable regimes. Petersen explains that Unipension carefully follows guidelines and is willing to avoid any investment it deems irresponsible.

“We are here to invest and not make foreign policy, but we do like to invest on an ethically sound basis”, says Petersen, who calls for international guidelines to be developed to make sustainable emerging market debt investments easier.

Unipension includes environmental, social and governance experts on its central investment decision-making organs, and Petersen himself is a respected figure of the sustainable investing scene as member of the United Nations-backed Principles for Responsible Investment Advisory Council. He is pleased to have a leading role in a movement that he deems is gaining increasing importance. “Responsible investing is perceived a lot differently than it was 10 years ago,” he points out.

A policy portfolio is a poor reflection of investor preferences, argued Peter Bernstein. This philosophical question has now been empirically tested by MIT’s Mark Kritzman, who shows the inter-temporal disparity of a policy portfolio’s risk profile. He suggests a simple framework for addressing this deficiency.

Kritzman encourages investors to replace rigid policy portfolios with flexible investment policies.

It’s not unlike a dynamic asset allocation idea, except he uses different information or signals as the conduit for any change.

Kritzman, who is a senior lecturer in finance at the MIT Sloan School of Management and the president and chief executive officer of Windham Capital Management, presents empirical evidence, and a potential framework, to the philosophical argument put forward by finance historian Peter Bernstein.

Bernstein argued that a policy portfolio is a poor reflection of an investor’s preferences; instead, it may simply be a benchmark for determining the success or failure of active management.

Selecting a portfolio of asset classes that best meets an investor’s objectives, given the outlook for expected returns, risk and correlations at a point in time, is not desirable because it changes over time.

“The return distribution implied by a particular portfolio at one point in time may be quite different at another point in time – and investors want the distribution, not the portfolio. The portfolio is simply a means to an end. The solution to the problem, therefore, is to revise the portfolio as needed to preserve the desired return distribution or at least to give the next best distribution,” Kritzman argues in his latest paper, Risk Disparity. “Or in other words, to replace a rigid policy portfolio with a flexible investment policy.”

Addressing conflict

He says that investors have two conflicting goals of growing their assets and limiting their exposures to significant drawdowns.

“The policy portfolio is supposed to be a way of balancing those. There is an implicit assumption that a policy portfolio will deliver consistent risk profile, but they are actually highly changeable,” he says, adding that the standard deviation of a broadly diversified portfolio can range from 3 to 25 per cent.

“It is not a valid argument that a reference portfolio is giving you stability,” he says. “I argue that you should replace a rigid portfolio with fluid allocation to get stability.”

Kritzman says that investment strategy defined as a set of fixed weights doesn’t do a good job at all of seeing an investor’s risk preference.

“Fixed asset weights don’t do the job they’re supposed to,” he says. “Further, our two measures of risk, beyond standard deviation and correlation, give a more reliable measure of when markets are dangerous and a portfolio is susceptible to that.”

“Investors can get a more stable risk profile by opportunistically changing their exposure to risky assets,” he says.

While typically dynamic asset allocation is driven by metrics of valuation such as stocks versus bonds, Kritzman suggests a change in allocations by drivers of risk, and he looks in particular at two different types of risk.

Predicting volatility

Predicting portfolio volatility is a tricky science.

Implied volatility and historical volatility are both of limited value according to Kritzman, who instead argues investors use the absorption ratio to anticipate shifts in portfolio volatility.

He says this measure captures the extent to which a set of assets is unified or tightly coupled, which means they will exhibit a unified response to bad news.

Over the years Kritzman and various co-authors have used this measure to predict broad market fragility and among other uses the US Treasury Department’s Office of Financial Research used it in the analysis of early warning signals of financial crises.

Kritzman says it can be applied to measuring the fragility of any set of assets, including the components of an individual portfolio.

“It’s a measure of the fragility in external markets. For example, if US stock markets are tightly coupled then they are more susceptible to shocks. We have taken the same methodology and applied it to a portfolio. We end up having a measure of risk that gives external danger measures.”

He also looks at the intrinsic fragility of a portfolio, which is dependent on the assets in that particular portfolio.

What this means in practical sense, he says, is investors can start with a policy portfolio and if there is no external or intrinsic fragility, then stay with the status quo.

“In the paper I show that if there is a measure of one of these, then there is heightened fragility and the equities portfolio should be cut in half. If both show fragility, then cut back virtually all equities. This is a pretty extreme move and in reality it would probably mean cutting equities by 25 to 50 per cent,” he says.

Such a dynamic approach is possible because of the use of exchange traded funds or futures exposures and, as such, avoiding implementation costs.