Roger Urwin, global head of content at Towers Watson and governance specialist, says most organisations don’t spend enough time on it, but transformational change is all about giving time to investment governance.

Culture and leadership, for example is so self-evidently important in people organisations and yet it is understated in asset owners, he says.

“The soft stuff really matters. You have to get the right people on the bus, but you also have to get the wrong people off the bus,” he says. “Culture and leadership, and talent and reward are not talked about. Why not? They are key to asset owner performance. This industry has strong managers, but not strong leaders. Leadership is principled, prioritised and very personal, and we need it in the community.”

Effecting change

Before a board embarks on investment policy work, Towers Watson’s transformational change model says mission, values and goals need to be established, and organisational effectiveness needs to be looked at. This includes culture and leadership, talent and reward and the value chain relationships.

Then investment policy work, including strategy, asset allocation, manager selection, and client delivery, can be honed. Execution, which includes actions and decisions, and measurement and review is the last step.

Urwin has recently worked with RailPen in the UK, CalPERS in the US and a large UAE sovereign wealth fund on transformational change and says execution plays a key role in success.

“These funds are all interesting to learn from. They all had big journeys and have come out feeling confident about their future. The key is execution; not what you did, but how you did it.”

This is all supported by a research paper conducted in 2007 by Urwin and Professor Gordon Clark from Oxford University that shows the key differentiator of the top performing funds was they were excellent in execution: whatever they did, they did well. But Urwin says it has to be self-generated change.

“We are living in a world of complexity and competition. There is a war for talent, it’s a low-yield environment and there is intense competition for returns. Also the bargaining power of external managers means large asset owners have an opportunity to do something different.”

The strength of differentiation, alignment of strategy and good execution are all part of this journey.

“Funds need to recognise the importance of investment governance, incorporating a new investment model, transforming organisational design and behaviours through top-down and bottom-up work.”

Super majority rules

Urwin works with boards, investment committees and the executives of funds to facilitate change.

He says investment beliefs have to be established at the board and executive level then brought together in a system that allows for the ambiguity within which investment decisions lie.

“Consensus is the lowest common denominator in boards, but it’s the dominant governance model,” he says. “There is a lot of inertia around the existing situation and not a lot of action. That’s a culture that’s grown up which should be challenged. A super majority is a good ploy.”

In establishing its investment beliefs, the CalPERS’ board recently used this strategy, with the votes requiring a two-thirds majority to be passed.

“Investment is decision making under uncertainty, so it is always marginal. A 3:5 vote is commensurate with that type of situation.”

The big elephant in the room, according to Urwin, is that investment committees tend to have many promising discussions, but few good decisions are actually made.

“It’s not time well spent on committees. There is too much oversight without insight. There needs to be more insight and engagement with executive teams who are increasingly senior people, so the investment committees need to be more like peer-to-peer relationships.”

 

The National Employment Savings Trust, NEST, the UK government-backed pension scheme set up a year ago with the introduction of auto-enrolment, developed a new allocation to real estate this summer. Now it is planning to add infrastructure to its illiquid allocations in a move reflective of a change of thinking to embrace more risk. NEST’s infrastructure foray is most likely to be via a blended infrastructure fund investing in both listed and direct infrastructure, explained chief investment officer Mark Fawcett at a recent National Association of Pension Funds (NAPF) investment strategies conference in London, where he urged defined contribution schemes to “break the mould” and push greater diversification. “We might add other illiquid assets and we are looking at infrastructure,” says Fawcett, who joined NEST from boutique investment manager Thames River Management. “There are good parallels between infrastructure and real estate. We are looking for growth-seeking and income-generating assets.”

With £11 million ($17.6 million) under management so far, NEST’s assets are forecast to reach $240 billion by 2050. Allocations in the Growth phase portfolio are divided between equities (50 per cent), real estate (20 per cent) and fixed income (30 per cent), where the portfolio includes corporate bonds and emerging market debt. Although NEST has been in talks with the NAPF’s Pension Infrastructure Platform (PIP), which says it is keen to have defined contribution investors, its need for continuous cash flow and the challenge of infrastructure being “lumpier than real estate and the cash flow varying” makes a blended fund a more likely model. The challenge is to now find the right low-cost manager, says Fawcett. “We are not in the business of paying 2 and 20.”

The property push

The push into infrastructure follows on from NEST’s 20 per cent real estate in the Growth phase allocation made last July. “It did raise eyebrows because it is a high allocation for a defined contribution fund, but it makes sense,” says Fawcett, adding that in Australia the allocation would “be double”. It’s an exposure that comes via Legal and General Property’s Hybrid Property fund in another blended strategy gaining exposure to listed and unlisted property. Here the hybrid structure comprises a 70-per-cent weighting to a UK direct property fund, with the remainder weighted to passively managed listed real estate via a global real estate investment trust (REIT) tracker fund. The addition of the global listed fund enables access in a daily priced, daily dealt manner with a greater amount of liquidity. The management charges are lower, the spread is reduced and there is international diversification, explains Fawcett. “We chose the hybrid because it is cash-flow positive and we thought direct real estate could be lumpy. We will think about a global direct allocation over time. We are aware of the leverage in REITs and that the shares are more volatile because of that leverage.”

Regulation and the members’ market

One of the biggest hurdles facing the pension provider’s new illiquid allocation is the daily dealing and pricing requirements placed on defined contribution schemes – that not the norm in defined benefit funds. These tend to rule out any type of unlisted property fund. One answer has come via NEST’s own internal market and its ability to trade illiquid assets between its own members, with older members selling assets to younger ones able to take on more liquidity. “We are doing this with real estate and are thinking about how to do it with infrastructure to ensure fair transfer between different members,” says Fawcett. NEST is currently working with another pension fund that has set up an everyday proxy to measure the price for infrastructure assets using an index which tracks the daily price movement.

Phase-sensitive allocations

Investment strategy at NEST, where Fawcett says the emphasis is “to get away from the peer group comparisons”, is honed for three distinct periods. For young savers in the Foundation phase, strategy is low risk, aiming for returns that match inflation and encourage saving. The Growth phase, typically lasting 30 years, targets returns of inflation plus 3 per cent in a diversified strategy. The final Consolidation phase invests in inflation-matching assets to de-risk. It seems that in the Growth phase, real inflation-linked assets are increasingly attractive over gilts and bonds. “Big defined contribution schemes should expand into other asset classes,” says Fawcett. “Defined contribution has not got to grips with what real estate has to offer.”

To be a long-term investor requires thematic investing because markets and economies are complex adaptive systems, according to Tim Hodgson, global head of the thinking-ahead group at Towers Watson.

Hodgson told delegates at the Towers Watson Ideas Exchange in Sydney that economies and markets are complex and adaptive, their path is not random and the future is not predictive.

“We don’t live in a linear world. We must hold truths in our head while we navigate the future. A single market price cannot reflect this,” he says.

Towers Watson believes that there are a number of interconnected issues that will converge in the next decades, and which it outlines in its 2013 secular outlook on thematic investing, which will require transformational change.

“It is coming straight at you: the asset owner and you have to deal with it whether you like it or not,” he says.

Recognition of the interconnectedness of these issues is essential.

Hodgson says traditional investment thinking is drawn heavily from economics, which has separate disciplines. The micro side of economics is well developed and the industry is disciplined in how to optimise a portfolio, value a company or price a derivative, all in isolation. But the macro side, including the emergence of bubbles, is almost completely unknown.

Complex system, complex thinking

Hodgson advocates for complexity thinking when it comes to finance, which comes from the study of complex adaptive systems.

Those systems have these common elements:

  • They have simple individual components, but rich complex behaviours.
  • They are adaptive, not in equilibrium and the system behaviour changes in response to external environment.
  • There is signalling and information processing between the components.
  • There is no central control, rather systems are not controlled by any coordinating body, but there is complex collective behaviour.

“Complex systems are where the whole is greater than the sum of the parts. You can’t break it down to understand it and put it back together again,” he says. “Markets and economies are complex systems.”

By way of example, he says academic textbooks in finance teach that everyone is making individual decisions in isolation, but that is not true.

“Markets are coupled and interacting; my trades change your prices,” he says.

He also says markets have multiple scales in time and space, and that fat tails are created by market participants.

In this regard, markets do not have a normal distribution, rather a “power law” distribution where the tail is much fatter.

“We shouldn’t be surprised by the large price moves. If you are, you’re using the wrong distribution.”

He also says that market returns are not random and “rejects” the random-walk philosophy.

“Economics and markets are complex and adaptive; the future is not predictive. As a long-term investor, you have to anticipate this otherwise you are at the whim of market prices.”

“Equilibrium is dead. It is the interconnectedness of finance that categorically matters. Tail events are normal,” Hodgson says.

Not alone

Further, his argument is that finance is not the only industry that is complex.

Health, crime, pollution, climate, economies, urbanisation are all complex and all coupled.

In its 2013 secular outlook on thematic investing, the Towers Watson investment committee outlines six key elements: economic imbalance, adverse demography, degradation and natural capital, innovation and technology, business nexus and government.

While acknowledging the thinking is the easy part and a lot of implementation of these ideas is still to come, he believes it will see a shift from dull market-cap portfolios to bright thematic portfolios.

Hodgson says this cannot be achieved by putting in place one or two themes and hoping it all works out. Rather, the themes need to encompass a complex and wide range of outcomes, with an option-like payoff.

 

 

The SEK150-billion ($22-billion) AP7 fund supplies the cream on the top of the Swedish public pension system. It essentially delivers premium pensions (in addition to the much larger pay-as-you go component) with a generous dose of equities. It has been able to further sweeten its offering by leveraging the main chunk of its portfolio.

AP7 chief investment officer, Christian Ragnartz, concedes that the leveraged approach has been made possible by the freedom of the fund’s position in the pension system and its directive from the Swedish government. AP7 has the freedom to set its own risk/return profile in order to seek the best possible long-term returns.

“We believe that leveraging a global equity portfolio is a good long-term strategy for delivering returns,” says Ragnartz. He strikes a confident tone – and as well he might, with equity markets hovering around all-time highs this year and AP7 boasting bumper 17.4-per-cent returns in 2012. These comfortably beat the average 2012 returns for private Swedish premium-pension providers of 5.7 per cent.

Ragnartz’s enthusiasm for the 50-per-cent leverage – placed on the major part of the portfolio that is invested towards the MSCI All Country World Index – is based on much more than the current high equity prices though.

“If you have a very long-term horizon, then you should try to capture the equity premium as effectively as possible,” he stresses. AP7, after all, invests mandatory pension contributions (on a defined contribution basis) for Swedish savers from their early 20s onwards. It invests on behalf of anyone in the country who amasses contributions but doesn’t opt for a private premium pension provider.

“Efficient device”

Ragnartz recommends equity leveraging as an “efficient device” for other investors, as long as their circumstances and liabilities make it a suitable ploy. He stresses, however, it is important to work on the legal details of a leverage and be in a position to handle marginal calls. Ragnartz outlines regularly posting collateral while paying attention to both “reasonable thresholds” and credit ratings of counterparties as being the best ways to manage counterparty risk.

AP7 uses swaps for its leverage, which Ragnartz feels have been relatively easy and efficient despite a mixed experience with pricing. “We are looking into alternative ways of leveraging, depending on new regulations, to be sure of the best cost efficiency,” says Ragnartz. AP7 is also exploring possible legal action over the impact of LIBOR manipulation on swap prices. “Manipulated prices naturally create some winners and losers but, if it is proved we have lost out, it is our duty to aim for compensation for our savers,” Ragnartz adds.

Ragnartz argues that AP7’s leveraged position is fundamentally “not much more risky” than a lot of specific non-leveraged country funds. “A global portfolio has a much lower volatility than most specific funds, so the diversification element holds true,” he says. AP7 proved how serious it is about reducing volatility by taking measures to abandon any home bias in the portfolio in 2010.

Nonetheless, “of course there will be bumps along the road,” says Ragnartz on the inevitable volatility of an equity position leveraged by derivatives. These include the “stressful” experience of quizzical reactions from the press and public when equity markets plummet – most recently experienced during 2011. “If you have a clear view backed by a mission that matches that, it is easier to argue for this though,” he posits. AP7 can also fall back on pointing to returns that are 22 per cent above the Swedish pension authority’s indicative PPM index over time.

Escaping bubbles

The current buoyancy in equity markets has provided AP7 with the cushion it was looking for from the outset for protection from a market shock, according to Ragnartz. “Hopefully we can be even further ahead of our private competitors before the next crisis,” he says. “Something will happen, but nobody knows when”. That caution comes despite this revelation: “I have a slightly positive view of equities over the medium term. There are challenges, but Europe seems to be on a positive track and there are positive signs from Japan and the US.”

AP7’s global index-linked strategy sees it follow a neutral position on all regions, allowing Ragnartz to stay calm on region-specific concerns. For example, emerging market equities – a key part of AP7’s strong returns in recent years – are expected by many analysts to face difficulties if quantitative easing is unwound. “We’re not particularly nervous on emerging markets as you can say we believe in them, just as much as the aggregate market, as potential difficulties should be priced in by now.”

The fund has been working hard on a nascent tactical element in the portfolio. “There are times when markets act irrationally and we want a layer of analysis to counteract this,” Ragnartz explains.

This newly developed tactical element could lead to AP7 downweighting its leverage at times that equity valuations are too high. “Ideally we would like to avoid being caught up in bursting equity bubbles,” says Ragnartz, “but history has proved that this is extremely hard.”

The global equity portfolio is managed entirely by external managers on a passive basis to help the fund rely on its “cornerstone belief” of cost efficiency. AP7 implements the leverage internally.

Alpha and beta

Alongside the “beta engine” provided by the leveraged portfolio, AP7 has nine unfunded long/short alpha equity mandates in its sophisticated fund, as well as an internal alpha centre. As these mandates invest only long/short, it is difficult to put an exact value on them, but Ragnartz says they account for around 25 per cent of the portfolio.

He is pleased about the fund’s experience with these positions since their introduction in the past few years. “We strongly believe that our managers get comparative advantages and fewer restrictions by working with both the long side and the short side,” he states.

The fund recently hired Invesco to run its first global alpha mandate and added another Japanese alpha mandate.

AP7 runs a relatively small fixed income portfolio (less than 6 per cent the size of the equity portfolio) to enable lifecycling for savers close to retirement. It also invests 3 per cent of its beta equity fund in private equity.

“We are slightly unusual,” admits David Adkins, chief investment officer of The Pensions Trust (TPT), the £5.5-billion ($8.7-billion) pension fund founded after the end of World War II to provide retirement benefits for social workers.

Talking from the trust’s Moorgate headquarters in London, Adkins explains how its umbrella structure has grown to provide pensions for 2400 different employers from the charity and voluntary sector as charities have pooled their pension funds over the years.

“We are a one-trust vehicle with only one investment committee, but underlying this are 36 defined benefit schemes. Each one has its own individual investment strategy, some with low allocations to growth and others with high allocations. We have to do 12 valuations a year, which creates significant activity,” he says in reference to different schemes’ triennial valuations.

 Property plus

Current strategy at the fund, which Adkins joined three years ago from Towers Watson, includes hunting more inflation-linked assets in a move encouraged by the strong returns from these types of investments within TPT’s property portfolio. “We are in the process of setting up a fund that goes out and specifically seeks inflation-linked cash flows with a contractual promise that revenues will rise with the retail price index. Assets could include index-linked corporate bonds, infrastructure debt, social housing and property,” he says.

The Pension Trust runs three property mandates comprising a mainstream UK property portfolio, an allocation to European property and a smaller, high lease-to-value vehicle managed by Standard Life, the success of which encouraged the new direction. “We do quite like this,” Adkins enthuses. “The leases are longer than typical, the tenancies are stable and the rental automatically increases with inflation, stipulated in the contract. This is very good for our liabilities and we are looking for more assets like this.” He adds that the trust will increase its allocation to high lease-to-value assets from its European property allocation, which “hasn’t performed the way we hoped”.

Two-thirds passive, one-third active

The Pension Trust’s investments, which include $1.6 billion of defined contribution assets and a “hybrid DC-DB growth plan” are split between a $5.25-billion allocation to growth assets and a $1.9-billion allocation to liability matching assets. The majority of the growth portfolio is invested in global equity, of which two thirds is run passively and one third actively, focused on allocations to Asia and emerging markets. “In my three years, the fund has moved to a passive bias in respect of equities. We recognise that you can find managers that can outperform, but it is difficult to do.” Fundamental indexation, introduced nearly two years ago, now accounts for half of the fund’s passive equity allocation. “We do think this is superior over standard market-cap index tracking,” he says.

Growth assets are also allocated to TPT’s growing alternatives bucket divided between an illiquid and liquid portfolio, a distinction that depends on whether an investment can be turned to cash within six months. The $795-million illiquid bucket includes allocations to property, but also infrastructure and distressed debt. The infrastructure allocation, which Adkins says still hasn’t been fully drawn, is biased towards mature revenue-generating assets rather than development-type projects, although running two mandates means the fund could invest in both. “There is more institutional money chasing infrastructure, but a lot of new infrastructure is also due on stream. There is no obvious supply-and-demand imbalance.”

The liquid allocation is spread across two absolute return funds and an allocation to a fund of hedge funds. More recently, the fund has also invested in emerging market-local currency sovereign debt, managed by Ashmore, and insurance-linked securities. “We do believe in the emerging market story but it’s difficult to know if growth will come from equities, currency or bonds, so our philosophy has been to gain exposure to all three,” says Adkins. Emerging market equity accounts for a 15-per-cent strategic allocation within the broader equity portfolio in an active mandate run by Vontobel. The fund avoids frontier markets for now. “Governance is a concern for us,” he states. “We are not convinced.” The Pension Trust has no allocation to private equity, which Adkins describes as a “geared equity play” and “not the way the fund is travelling.”

Driven by liability

Within the liability matching allocation, TPT has $1.1 billion invested in physical bonds, comprising gilts and corporate bonds. In another recent development, it has also invested $795 million in three bespoke liability-driven investment funds, two of which are for inflation-linked liabilities and one for nominal liabilities, run by BlackRock and in which TPT is the only investor. “If long-term interest rates rise, we will hedge more, but others will be doing the same,” says Adkins. The BlackRock funds are able use a typical range of derivative instruments from plain vanilla swaps to gilt total return swaps and gilt repos, allowing extra duration within the portfolio, he says. Two actively managed corporate bond mandates “add some yield” to the otherwise gilts and swaps-based return.

In other investment themes Adkins plans to increase the scheme’s focus on the impact of climate change on its allocation, looking particularly at the threat around stranded assets. “We are now incorporating ESG factors into our internal manager rating system. We don’t insist our managers sign up to UNRPI, but we encourage them to do so. We don’t want a hard rule; we look at whether they’re following the spirit of UNPRI, even if they’re not actual signatories.” Under his leadership The Pension Trust, battling a $3.1-billion deficit made worse by many member charities unable to make good their pension deficits, strategy has focused on bringing down liabilities with inflation-linked growth assets. “Before, we were very asset-focused, rather than looking at problems around the scheme’s liabilities too. This is one of the things I have really tried to do.”

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.”