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According to the latest figures, an ambitious turnaround plan at the United Kingdom’s biggest supermarket chain, Tesco, has helped reverse falling profits. Last year the retailer, one of Britain’s largest private sector employers and a landmark in every town since founder Jack Cohen opened his first store in North London in 1929, also changed strategy at its £6.5-billion ($10.2-billion) pension fund to improve performance. In a bid to boost returns and reduce costs in the defined benefit scheme set up in 1973, the retailer brought management in house, setting up City-based Tesco Pension Investments (TPI). Almost a year on, a 35-strong team is now honing strategy and poised to run two-thirds of the portfolio internally. “It’s still very early days. So far the emphasis has been about building our infrastructure and recruiting the team,” says chief investment officer, Steven Daniels, who joined TPI in 2011 and was previously at Liverpool Victoria, the UK’s largest friendly society. “Coming in house was an opportunity to improve the performance and governance with a holistic approach, as well as reduce fees.” The fund now targets annual returns of between 6 and 7 per cent, and wants to get within sight of doubling the portfolio within the next five years.

How the shelves are stacked at TPI

In the last year TPI’s global bond and equity allocations, which account for 20 per cent and 55 per cent of the fund’s asset allocation respectively, have fared best out of the whole portfolio, with average annualised equity returns achieving 8 per cent and bond returns 5 per cent. Despite the new regime, the asset allocation follows a strategic benchmark set by the trustees and won’t change for now. Nor are there any obvious investment themes to follow that have helped signpost returns in previous years, like the plunge into technology stocks in the 1990s or more recently emerging markets, says Daniels. Instead, to hold course in today’s choppy market, which Daniels predicts “still has a long way to go before normal economic conditions return”, TPI will apply a seemingly simplistic approach. “We’ll focus on the right investments over the long-term,” he says. The fund has dropped strategies targeting quick returns and now expects to invest for a minimum of five to six years. “Take equities,” he explains. “You need to hold equities for three to five years to reap the benefit of companies’ undervaluations coming through.”

Dealing with the ticking bond conundrum will require a more nimble strategy, however. The TPI team is poised to react to ensure the value of its bond portfolio isn’t hit when global interest rates, pushed down by governments trying to kick-start moribund economies, start to rise again. “Timing the move out of bonds is a critical decision for fund managers – a question we are constantly asking ourselves,” he says. “The worry is uncertainty. There are such low interest rates around and, although we don’t expect them to go up, markets will start to build in expectations of inflation.” He is positive on the US and says he “can see recovery” in Europe and Asia, but believes the UK could be one of the most vulnerable markets although TPI doesn’t have a big gilt allocation. “Europe, America and Japan are likely to keep interest rates low for a while. The UK is not part of the dollar block or the euro block – bond markets may react to any possible rise earlier on here.”

Tail risk is another worry. To shield against an external shock triggering a sell-off coming in the guise of further recession, the break-up of the euro or more bank insolvency, the scheme uses caps and collars to make sure downside protection is in place. “We may take out the worst possible scenario,” says Daniels.

TPIs allocation to real-estate and alternatives is 10 per cent and 15 per cent respectively. The real-estate portfolio is invested both internationally and in the UK, although not London, since here the size of investment would be too big for the fund. One focus is seeking out distressed property assets from banks and insurance groups. “We are seeing these groups prepared to sell assets at discounted values to release capital.” Other strategies include hotel funds and investing in retail and warehouse space in regional cities. The alternative bucket is divided between a 9-per-cent allocation to hedge funds and a 6 per cent allocation to venture capital comprising infrastructure investment, private equity and buyouts.

In house vs external and the defined benefit scheme

Although the majority of the fund will be managed in house, TPI still plans to place a third of the portfolio with external mandates. Managers haven’t been selected yet but Daniels says external expertise will be used where it adds value and achieves the diversification within an asset class that it can’t achieve in house. Distressed debt and high-yield bonds are both areas where it “wouldn’t be worth building an internal team,” he says. Hedge fund allocations and venture capital, as well as other niche bond, real estate and equity market investment will also be placed externally. “We will be looking to use fewer external managers, but make bigger commitments to the ones that we currently work with.”

The fund will focus on active management since “it’s the job he’s been asked to do”, however passive allocations will also play a role in markets where adding value is tough. “Outperforming the S&P might be difficult,” he says. Passive allocations will also be applied where the fund goes into a market on a trial basis with no initial long-term strategy. “Markets you’re not going to be in forever and just want beta exposure.” Daniels says Japan Index Investment could be an example here.

The creation of TPI is part and parcel of a wider revamp by Tesco to get its pension scheme in order. The retailer is just one of three FTSE 100 companies still offering new employees the more favourable defined benefit scheme, but it’s a promise that has forced reform at the scheme, which is only around 85 per cent funded. Most companies have sought to limit the growth of their pension liabilities by ditching defined benefit for defined contribution, taking pension risk off their own balance sheet. Last year Tesco, which has 293,000 members of its scheme including 172,000 active workers, asked its employees to work until 67 rather than 65 and aligned the scheme with the Consumer Price Index (CPI), which excludes inflation measures such as house prices, rather than the Retail Price Index (RPI), cutting pension payouts. The hope is savings here will now be stoked by boosted returns too. “The scheme is growing rapidly – we’re looking at $16 billion in the next five years,” says Daniels.

Connecticut-based financial services management consultant, Casey Quirk, and institutional investment specialist publication, top1000funds.com, joined forces in a global chief investment officer survey to measure the sentiment of asset owners, and the extent to which the 2008 crisis has had an effect on the behaviour of internal investment teams, their outlook and corresponding asset allocation. With combined assets of around $5 trillion, pension funds, sovereign wealth funds, endowments and insurance funds all participated in the survey.

Since 2008, nearly half of the respondents (45.7 per cent) had revised their investment performance targets, with a review of objectives and expectations resulting in lower target returns.

Respondents were asked about the impact the crisis had on five aspects of investing: the investment target return, investment benchmark or policy portfolio, a focus on tactical asset allocation or hedging overlays, a dedicated tail-risk allocation, and time spent on manager research.

More than half of the respondents have increased their focus on tactical asset allocation or hedging overlays since the 2008 crisis. Some of the funds surveyed had implemented factor-based asset allocation and an active hedge overlay and, in particular, had moved towards a more dynamic asset allocation approach. And about 20 per cent of respondents had introduced a specific dedicated tail-risk allocation.

Partner at Casey Quirk, Daniel Celeghin, says the renewed focus on dynamic asset allocation and investment policy changes is very consistent with what the consultant has seen in other research.

“The discussion about dynamic asset allocation use before the crisis was settled. Funds would set their strategic asset allocation and not be market timers, they would trust the long-term and rebalance in a disciplined fashion,” he says. “That question is back open to debate. This survey very definitely shows large asset owners, globally, are willing to give dynamic asset allocation another try.”

Downward revision of benchmarks

A related trend, also demonstrated in the survey results, he says is the revision of the target benchmark or policy portfolio. “If you’re going to be doing dynamic asset allocation then your bogey, you’re tying to it also changes. A lot of benchmarks were set many years ago when real interest rates were much higher, and you could get 5 to 6 per cent.”

Celeghin says no matter what the policy portfolio is supposed to reflect – be it expected liability, peer risk, or an output of risk tolerance and asset allocation – the benchmark is coming down. Indeed one of the most significant changes measured in the survey was the number of respondents (60 per cent) who had revised their investment benchmark or policy portfolio as a result of the 2008 financial crisis. Within that revised policy, there was a noticeable decrease in domestic equities (42.2 per cent of respondents had decreased this allocation), and an increase in illiquid alternatives (46.3 per cent) and hedge funds (38.5 per cent).

In the next two years this trend will continue. Domestic equities allocations are expected to decrease further: 35.7 per cent of all respondents said they would decrease these allocations, and 42 per cent of those who had already decreased allocations would decrease them further.

Of those who responded, 42.1 per cent said they would increase both hedge funds and illiquid alternatives in the next two years. Of those who had already increased the allocations, 60 per cent said they would continue to increase their allocation to hedge funds, and 63 per cent said they would continue to increase their allocation to illiquid alternatives.

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The ins and outs of management

When it came to assessing managers, the number-one attribute as ranked by the respondents was investment leadership or the people that ran the manager, this was followed by investment performance, thought leadership, market perspective, portfolio construction advice, ownership, incentives and remuneration and finally client service and support.

Two thirds of the respondents managed at least some assets in house, with 7 per cent managing 100 per cent internally. But 41 per cent of respondents said they expected the amount of assets managed in house to increase in the next two to three years.

Cash (51 per cent) and domestic bonds (42 per cent) were the most likely assets to be managed in house, with non-domestic equities and hedge funds the most likely assets to be managed externally.

While cost was the most likely reason for managing assets in house (37.2 per cent of respondents), it was followed quite closely by control (30.2 per cent). Of the investors surveyed, the cost of external managers was much greater than internal investment resources. The most likely cost of external managers was 50 to 100 basis points (41 per cent of respondents) while more than 75 per cent of respondents spent less than 10 basis points on internal management.

With regard to asset allocation and portfolio construction decisions, the overwhelming majority (71.4 per cent) said they would rely more on internal staff, rather than consultants or asset managers, in the next four years. Since 2008 about 40 per cent of investors have reported spending more time on manager research, which has come in the form of more RFPs, more indepth correlation analysis, using the consultant and manager database information more comprehensively, and as part of a function of performing diligence on a broader range of strategies.

“This survey implies that asset managers globally need to evolve their offerings. Institutions will gravitate towards managers that have a clear role in helping meet their overall return objective, preferably in a fee-efficient manner. This could mean managers with expertise in dynamic asset allocation and risk management, as well as managers that have been able to consistently deliver returns that are uncorrelated to the broader public markets,” Celeghin says.

Want to know what chairman of the Future Fund, David Gonski, thinks about governance? So did we, so we interviewed him. See how Gonski approaches his role as chairman of one of Australia’s largest funds in the second part of our Maverick Series video.

In the first of a new series of video interviews featuring thought leaders in global institutional investment, chair of the $80 billion Australian Future Fund, David Gonski, outlines his views on governance.

Over the past five years, Finland’s 5.4 million people have watched with alarm as the eurozone they joined as founder members has descended into financial turmoil. So it is no surprise that Keva, which manages €34.4 billion ($47.1 billion) on behalf of Finland’s municipalities, as well as administering state and Evangelical Lutheran Church of Finland retirement systems, is also trying to reduce the risk of overexposure to the currency region.

In 2011, as Europe’s sovereign debt crisis worsened, Keva reported a negative return of 1.7 per cent, with eurozone assets helping to drag down performance. Yet at Keva’s headquarters in Helsinki, senior executives say the fund’s recovery in 2012, when it posted a return of 12.9 per cent, is due in large part to a long-held policy to reduce the portfolio’s exposure to Europe. “We are well diversified both in markets and asset classes,” says director Fredrik Forssell, chief investment officer for internal equity and fixed income management. “We are not particularly exposed to the eurozone compared with many of our peers.”

Eurocentric

As Forssell acknowledges, Europe still looms large on Keva’s trading screens; the region accounts for 53 per cent of all assets under management, with a substantial amount invested in the eurozone. Yet at the end of 2007, 71 per cent of Keva’s investments were in Europe, with 20 per cent of the total portfolio in Finland. In the intervening period, Keva has almost tripled its emerging market exposure from 5 per cent to 14 per cent, while raising its investments in North America from 14 per cent to 22 per cent. From a low base, Keva has also more than doubled its hedge fund investments to 2.3 per cent of assets under management and increased private equity holdings to 5 per cent of the portfolio.

In addition the manager has made substantial changes within its two main asset allocations: fixed income has been increased from 39 per cent to 48 per cent of the portfolio since 2007, and equities has been reduced over the same period from 49 per cent to 36 per cent. In fixed income, “Keva has diversified away from a central focus on just government bonds and moved into assets such as high-yield emerging market bonds,” says Forssell. In 2012 this shift paid off handsomely, with fixed income returning 11.5 per cent for the year. It is a similar story in equities, where during the global downturn Keva has lessened its exposure to US and European stocks, and moved more of its allocation into emerging markets. Last year, Keva’s listed equities returned 17.2 per cent.

Despite this strategic reallocation, manager’s 1.3 million Finnish beneficiaries still owe much to Mario Draghi, the president of the European Central Bank. Since last July, when Draghi pledged to do “whatever it takes” to save the euro, the region’s stock markets have staged a still-fragile recovery, while yields on the sovereign debt of Spain and Italy have narrowed, reducing fears that these countries will need a bailout. “Mr Draghi’s speech has obviously played a major role in helping returns across all of Keva’s asset classes,” says Forssell.

Too many assets too close to home

Yet no one at Keva is complacent about the fund’s prospects, for both international and domestic reasons. In fixed income, Forssell notes, “it will be very challenging to achieve anything like last year’s returns in 2013”. Like other institutional investors, Keva is also not assuming that global equity markets will continue to rise through the year. And, regardless of what happens in these volatile international market conditions, Keva will continue to have significant asset management issues in Finland, which for historic reasons still accounts for about 18 per cent of all investments.

Keva – which has no explicit investment mandate from its municipal owners – is actually less exposed to its home base than the country’s overall pension system. This is one-third focused on the domestic market, according to a review of the system published in December by Nicholas Barr of the London School of Economics and Keith Ambachtsheer from the Rotman International Centre for Pension Management. Barr and Ambachtsheer estimate that the country’s pension funds underperformed their international peers by about 1.5 per cent per year in the period 2007 to 2011.

As Forssell points out, moving more investments out of Finland is easier said than done for Keva, the country’s second-largest pension fund; it would run the risk of disrupting Finland’s small stock and bond markets every time it buys or sells assets. “Liquidity, especially in the domestic stock market, leaves a lot to be desired,” he says. “We are like an elephant in a china shop with Finnish equity.” Yet Finland’s economy is unlikely to achieve much more than 0.5 per cent growth in 2012, meaning that Keva is lumbered with too many assets too close to home that it cannot trade easily.

As in other Nordic countries, Finland’s healthy, ageing population presents another liability for funds like Keva. Female life expectancy at birth is now 83, while males can on average hope to live till they are 79; close to one-fifth of the total population is more than 65, with the proportion bound to grow in the coming decades. “Increasing longevity not only puts pressure on the pension system but also on Finland’s labour supply, and so there is a political debate about increasing the retirement age,” says Forssell.

Planning for the ever-changing present

To cover present and future liabilities, Keva aims to meet a 3 to 4-per-cent annual real-return target, even though the fund does not have a set benchmark. Since the fund’s inception in 1988, it has achieved a cumulative real return of 5.3 per cent per annum, which with capital weighting falls to 3.7 per cent. It is sufficient but, in common with other large European public sector pension funds, Keva cannot afford too many years like 2011 when the return drops below the target. In 2012, for instance, when Keva’s total return shot up to 12.9 per cent, more than three-quarters of its $6.6 billion in municipal contribution income was immediately paid out in pension benefits. Keva invested the remaining $1.37 billion of this income in a pension liability fund, which – thanks to rising global markets – produced a $5.3-billion return on investment for the year.

The hardest part of Keva’s portfolio diversification may therefore only just be beginning, as pension funds everywhere confront growing liabilities from the swelling ranks of their beneficiaries. Forssell says one promising area for further investment could be real estate, which at present accounts for 7.9 per cent of the portfolio. However, most of Keva’s directly held property is in Finland’s flat market, and overall the real estate assets only returned 4.9 per cent in 2012.

Other Nordic institutional investors, led by Norway’s $620-billion sovereign wealth fund, are starting to move more aggressively into overseas real estate, and Keva may follow suit. “We plan to increase modestly our international real-estate holdings, depending on market conditions,” says Forssell with characteristic Finnish caution. Private equity, which returned 10 per cent last year, and hedge fund assets, which returned 10 per cent, could also acquire more weight in the portfolio. As Forssell observes, the key to successful investing in both sectors is finding winners amid the majority of duds.

For Keva, the only strategic option not on the table is standing still. Like other Nordic public sector funds, the days of largely tracking European and US stock and bond markets are well and truly over.

Samuel Lisse, chief executive of Switzerland’s Vita Sammelstiftung (Vita), is currently in the process of hiring a new head of investment. The new appointee will have plenty resting in the in-tray, it appears, as she starts to assist the investment committee that governs the strategy of the 8.5-billion-Swiss-franc ($9.1-billion) joint foundation. That is not because of any headache-inducing investment performance. Far from it, with 8-per-cent returns in 2012 exceeding the Swiss average and gaining the foundation and its 100,000 small and medium-enterprise members a healthy 2.5-per-cent surplus.

Realigning strategy fundamentals

An issue awaiting the new head of investment is that Vita – like many Swiss investors – has started to question some of its strategy fundamentals.

Lisse says that a majority of Vita’s bond portfolio, worth roughly $4.1 billion, is held in government-issued debt. There is nothing unusual about that in pension investing. However, with yields on 10-year Swiss government bonds hovering around 1 per cent for the last 12 months, Lisse says this position is now under review by the fund’s investment committee, led by Dr Thorsten Hens of the University of Zurich.

It is too early to be certain of any drastic changes, Lisse says, although the fund’s actions in the past year show diminished appetite for bond holdings on the whole.

As part of its standard investment strategy tweaks, Vita began trimming its exposure to Swiss-franc-denominated bonds in the third quarter of 2012 by over 3 per cent and has continued doing so since.

An expectation that interest rates will rise in the near future (and therefore push yields higher) is behind these moves, explains Lisse.

Into equities again

The euro crisis saw Vita’s investment committee move even quicker on its smaller European debt portfolio. Exposure to European bonds was cut by almost a quarter to around $129 million, with the fund having divested almost entirely from the southern European ‘periphery’. Equities have fallen into favor at the same time, with recent stock purchases putting Vita overweight on Swiss, European, US, emerging market and sustainable global shares. Lisse reveals that an altered economic outlook has facilitated an equity drive.

Things certainly seemed gloomy 12 months ago as reflected in Vita’s 2011 annual report. Fortunately, the concerns shared by many investors did not come true.

Buoyant equity markets were a hallmark of a year that exceeded investors’ expectations. Lisse says Vita Sammelstiftung’s investment committee began to feel positive after further eurozone jitters in the summer were resolved, but only after some serious thinking about launching a major hedging operation.

The equity upturn since then has played a major role in Vita’s strong 2012 performance figures, with its approximately $274-million emerging-market-share pot being the strongest of all asset classes.

Swapping bonds for bricks?

As relieved as Lisse is by improving market conditions, his fund still faces its meager bond-yield dilemma. Attempts to find reliable substitutes for some of its bond holdings has led Vita into infrastructure investing for the first time.

The fund has committed 2 per cent of its overall portfolio into an infrastructure vehicle that is about to be launched and insurance-linked bonds are also keenly interesting the fund – catastrophe bonds in particular. Real estate is a more established bond substitute, as far as Vita is concerned, with just over 10 per cent of assets currently held in the class. While the majority of these assets is currently based in Switzerland, the fund is seeking direct investment opportunities in European property as part of its bond-substitution strategy.

This quest to replace some of its bond exposure takes place against the background of a portfolio that is already well diversified. Over 8 per cent of the assets are held in mortgages, and close to 12 per cent in alternatives. The major part of that alternative pot is a roughly $860-million allocation to hedge funds.

In recent years this is asset class has been the subject of controversy in Switzerland due the perception of high fees, despite hedge funds having gained acceptance from Swiss institutional investors more easily than in other markets. According to Lisse, their pleasing performance has outweighed the drawback of expensive fees, but the hedge fund allocation remains a discussion point among the investment committee due to the costs involved.

Selection issues

Lisse reflects that a reason for his fund’s strong hedge fund returns could be a solid selection record. He is confident that Vita’s manager-selection process “is very tightly controlled and thorough”. The foundation gets expert assistance from a full-time team at Zurich Invest that leads the selection work, as Vita is closely connected to the Zurich insurance group.

Active management currently dominates across Vita Sammelstiftung’s portfolio, but Lisse says this approach is another thing under review by the investment committee, especially on equity portfolios.