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The area surrounding the British city of Wolverhampton, near Birmingham, is still called the Black Country although the polluting coal mines and steel mills that sprung up during England’s nineteenth-century explosion of wealth have long gone. Today there is little evidence that Wolverhampton was the cradle of an industrial revolution and the 300-odd public sector and private employers in the area from which the local government pension scheme, the £9.8-billion ($14.93-billion) West Midlands Pension Fund, draws its contributions are involved in new and modern employment. The defined benefit occupational scheme set up in 1972 has earned a reputation among its peer group of local authority schemes for its growing size and innovative, diversified investments. However, now it could have to adjust its strategy to meet the challenges and shifting circumstances of what you might call a mid-life crisis.

Of the pension fund’s 253,000 members, less than half are now contributing members, and Geik Drever, head of pensions at the fund, notices more of the scheme’s small-member employers are closing their pension funds. It’s a maturing profile hastened by the UK government’s austerity policy forcing public sector cuts. The response among many local government authorities has been to encourage voluntary retirement, triggering an early shift in maturity for many of the pension schemes these employees have paid into. “We are open to new members, the profile of the scheme isn’t too bad and auto-enrolment will definitely help,” says Drever, who joined last year from Scotland’s Lothian Pension Fund where she was head of investment and pensions. “We’re not de-risking, but we are maturing and there has been a huge reduction in headcount.”

How to meet maturity?

Results of an actuarial review this year will inform any shift in investment strategy to reduce risk and prioritise protecting funding levels once they improve from current levels of around 75 per cent, “symptomatic of the current climate,” or whether to continue the push for income and total returns. It could be that West Midlands joins a de-risking trend evident for a while among UK and European schemes, such as Dutch funds in which the deficit crisis is the most severe in the industry’s history, but also cropping up in Canada and the United States. Here some of the largest corporate pension funds, including General Motors and Ford, have pursued de-risking strategies in recent years.

Drever is still unsure which strategy West Midlands will follow to meet its growing maturity. Options she is considering include running lower, medium and higher risk strategies to suit the scheme’s different employers, although she says “we won’t be able to manage too many strategies – three or four at most”. Employers will have to gauge their own appetite for risk according to their liabilities and cash profiles. “Each individual employer has a different profile.” It’ll be down to them, she says, to decide whether they can afford to pay more in contributions and reduce their risk or to “not close down risk.” Low risk strategies will comprise the usual “bond-like” allocations; the fund has no liability-driven investment strategies yet, unlike other schemes using the increasingly popular fixed-income-derivative strategies to reduce interest-rate and inflation risk.

Although a maturing scheme will need more cash to pay pensions, Drever is not convinced trading out of illiquid assets like infrastructure and private equity is necessarily the answer. West Midlands has a long track record of infrastructure investment and was one of the first schemes to leap on board the government’s Pension Infrastructure Platform. She says the fund has “ample cash,” particularly through its large quoted-equity allocation. Moreover, the scheme’s well established private equity and infrastructure investments have matured beyond the tendency for negative returns these assets have in their early years and provide a good cash yield. “We’ve got cash coming in from our infrastructure investments,” she says. “In private equity our investments are also paying out, so we’re less worried about our J Curve.” In another indication of the fund’s continued risk appetite, she welcomes the government’s decision to increase the cap placed on the amount local authority schemes can invest through limited partnerships, a structure though which many access property, private equity and infrastructure, from 15 per cent to 30 per cent.

Diversity now

Whatever the future holds, for now strategy at West Midlands is still based on diverse allocations set after the financial crisis. The scheme follows a customised benchmark that targets a 7-per-cent beta return, from assets in quoted equities and alternatives primarily, and a 2-per-cent alpha return from private equity and alternatives, including infrastructure and an absolute return allocation. In the 10 months to January 2013, the fund made an absolute return of 8 per cent. “It hasn’t been too bad, but we’re not shooting the lights out,” says Drever, adding that the pared-down 45-per-cent global equity allocation, where the biggest allocations are to stalwart mining and resource groups, has actually bought the fund its best returns so far. “Overall equities have done tremendously well. If we’d had an extra 15 per cent allocated to quoted equity, we’d have done even better.” A 10-per-cent private equity allocation “hasn’t done too badly,” infrastructure (3 per cent) and property (9 per cent) have “been fine” but commodities (3 per cent) have been “dire.” West Midland’s 20-per-cent fixed income allocation is split between stabilising assets and an allocation to return-seeking fixed income including high-yield and corporate bonds and unsecured loans. A 10-per-cent opportunities allocation includes catastrophe bonds (with which investors cover insurers’ extreme losses from natural disasters), a growing asset class for pension and sovereign funds and endowments seeking a truly uncorrelated market. “Hurricane Sandy put a spanner in the works, but you have to take the good with the bad,” says Drever.

It’s a strategy born from the need to diversify after 2007 when the fund wracked up paper losses of 18 per cent at one stage during the crisis. Drever says West Midlands was able to come back from the lows because it didn’t have to sell anything and crystallise losses; not concentrating assets in any one area became the new mantra. In house, the fund directly manages $4.57 billion in low-risk passive allocations, mostly equity. Another third is actively managed in LP structures, with the remaining third managed externally – the fund uses around 30 managers altogether. The portion managed externally has crept up as the scheme has increased its push into alternatives requiring specialist management, although the pension fund also uses specialist managers in mainstream assets where inefficiencies or market opportunities exist. It’s a strategy for growth that doesn’t acquiesce to the demands of its growing maturity – just yet.

It is easy for long-term investors to avoid short termism, and the solution lies in avoiding momentum and conducting risk analysis using cash flows – not market pricing.

“Diversification is a joke. Diversification and risk analysis relies on pricing, but pricing is distorted because it’s driven by momentum,” says Paul Woolley, chairman of the Paul Woolley Centre for Dysfunctional Markets at the London School of Economics.

Woolley, whose centre has set out the not-so-small task of rewriting finance theory, says the efficient-market hypothesis rests on the premise that prices are always right, no matter whether the time frame is short or long.

Rethinking models

But Woolley and his team, led by centre director, Dimitri Vayanos (pictured below), can show for the first time in a formal model that the long term is not equal to a succession of individual short terms.

“We’ve cracked the issue of the short term in a formal model. We can show that it is optimal to use momentum or ride the trends if your horizon is short, but if it is long term then use fundamental values and look at cash flows,” he says.

Woolley says that if markets have momentum then maybe it does pay to ride that in the short term, but investors should recognise they are forgoing long-term returns by taking that course of action.

“Anything designed to make you concerned with minimising risks and maximising returns in the short term will drive you to momentum because fundamental value investing requires patience,” he says. “It is better for long-term investors to ignore the index.”

Instead he says the benchmark for the whole fund should be real global GDP plus local inflation.

Momentum is growing

Woolley’s career has spanned academia and the private sector, but while living through the tech bubble as a partner of GMO the question around momentum played on his mind.

“The tech bubble was a big turning point for me. Everyone was acting in their own best interest, it was a disaster.”

He retired from GMO in 2006 and still had many ideas to pursue so funded and formed the centre at the London School of Economics, with affiliates in Sydney and Toulouse.

“I had spent a lot of my career exploiting the mispricing of markets, and I wanted to spend time explaining them, the causes of them, and mitigating what I thought was dysfunctional,” he says.

Since then Woolley and his team have been challenging academic theory and the strategy implications of that.

“The prevailing finance theory is why the world’s economy is such a mess,” he says.

While there has been some resistance to the challenge of looking at an alternative paradigm, particularly by academics, ironically “momentum” is growing and the centre will hold a summer school in June for PhD students in dysfunctional finance.

It has also had some intrigue with policy makers and, he says, the theory has had traction with the IMF, Bank of England and the Department of Business, Innovation and Skills in the UK government.

It can’t explain

Perhaps one of the more significant advancements of the argument came from the G30 last month which said in its paper, Long-term finance and economic growth, that national regulators and international bodies such as the IMF and Financial Stability Board should draw up best-practice guidelines for investors with long-term liabilities or horizons.

If this is acted on, it will have “profound implications” for the investment industry and for investment returns, Woolley says, highlighting that the main obstacle is one of terminology and definition.

It is important to recognise, he says, that short-termism is not just a holding period and that long-termism does not equal buy and hold. Rather, the distinction is the investor’s choice between the two basic investment strategies of momentum trading and fundamental investing.

The problem for investors, he says, is that the damage this can cause has not been fully explained, because the theory doesn’t allow it, hence his mission to rewrite the very basis of the discussion.

“The rewriting has to come first. The prevailing theory of efficient markets is a dangerous core belief which is misleading everyone. That competition ensures prices are always right and markets are self-stabilising is not a good starting point to explain why prices are distorted,” he says.

By way of contrast, he points to the natural sciences: in physics, for example, there are assumptions of zero gravity or friction but to build machines, you assume situations when those conditions are not met.

“In finance the theory translates directly to practice and working with, for example, perfect competition, is useless and dangerous. The efficient-market theory can’t explain, for example, momentum – it’s the unexplained anomaly.”

“ShareAction has become the premier organisation to give voice to those who wish to invest their values as well as their assets,” enthused former vice president of the United States Al Gore, speaking to a packed audience at ShareAction’s annual lecture in London’s Guildhall last week. ShareAction is only a tiny pressure group but Gore’s ringing endorsement reflects its growing clout when it comes to galvanising pension scheme members and other asset owners to make sure their views are taken into account by the funds responsible for investing their money.

ShareAction, formerly FairPensions, has been around since 2005, when it emerged out of a campaign in the 1990s backed by academics and students to make investment strategy at the £34-billion ($51.5-billion) University Superannuation Scheme socially responsible and sustainable. Multiple events such as the explosion at BP’s Deepwater Horizon rig in 2010 – Gore jibed that shareholders would have avoided losses if “the metrics had been more sophisticated” – to a wave of authoritative studies on the damaging effects of short-term investment, the dire funding levels in many UK pension schemes and the harnessing powers of the internet have helped propel it’s message into the mainstream. It’s building a momentum that the organisation’s chief executive, Catherine Howarth, is determined not to miss.

Rank and change

When it comes to influencing schemes’ investment strategies, one of the most effective tools at the pressure group’s disposal is its ranking system. ShareAction grades the responsible investment performance of the 25 biggest UK funds. With a new ranking due later this year, it’s what Howarth calls a “nudging process” and a “catalyst for change”. “There is still a long way to go,” she explains, “but we’ve seen schemes really improve their responsible investment, transparency and award mandates according to ESG principles as a result of our rankings.” Pension funds are galvanised, particularly, she says, when scheme members push trustees on gaps in their responsible investment criteria highlighted by the rankings. It’s also a process that highlights what she calls a common disconnect between companies with front-office green credentials, but with employee pension schemes still “in the dark ages” when it comes to ESG.

The Co-op, which due to its strong ethical brand is one of the UK’s best-loved retail and financial services chains, was a case in point. One company in the group, Co-operative Asset Management, is even a leading light on responsible investment, truly embracing active ownership because it believes it is part and parcel of being a responsible owner. Yet the Co-op’s $9-billion pension scheme scored 35 per cent, coming fourteenth out of 30 in ShareAction’s 2009 survey. In response, the Co-op overhauled its strategy and beefed up ESG credentials scoring much higher in subsequent surveys. “The fund has gone a long way to implementing all of the recommendations we made,” says Howarth.

Membercentricity and mainstreaming ESG

She is also pushing the novel concept of pension funds shaping investment strategy around their members, putting savers’ values at the heart of fiduciary management. It sounds ambitious but she’s convinced it will happen, pointing out that with some funds, it already is. Research by the UK government’s National Employment Savings Trust, NEST, the new automatic-enrolment pension scheme for employers, found that its target membership is more worried about investment loss than particularly high returns. With this in mind, NEST set its growth target at consumer price index plus 3 per cent, compared to growth phases in other employers’ defined contribution schemes typically coming in around CPI plus 5 per cent. Regarding responsible investment, NEST found its target members highlighted concerns around labour rights and fair pay, wanting investment skewed to support these themes and greater stewarding on these issues of the underlying companies. “This kind of behavioural research is really innovative and others will follow; it’s a pioneering approach” says Howarth. Most importantly, she said, it’s a strategy designed to encourage people to keep saving and not opt out, crucial in NEST’s early years. Howarth contrasts the investment strategy in Australia, where the automatic-enrolment model doesn’t allow opting out and saving is compulsory. She says it has allowed providers there to adopt more bullish investment strategies altogether.

Tailored investment strategies designed for scheme members leads Howarth to her next point – “mainstreaming” the integration of ESG factors. She wants to open up the whole debate around fiduciary obligations altogether, pushing “a more enlightened view” in which trustees have “clear permission” to take long-term decisions rather than invest for short-term profit. Many trustees believe their fiduciary duty is only to maximise returns but this needs to change, with schemes investing for long-term value rather than short-term share prices, she argues. ESG is now applied to a broad range of asset classes and available to investors through a wide range of products, she insists.

Working from the inside

As well as cajoling pension funds to alter their strategies to invest responsibly, ShareAction wants schemes to become more active asset owners. The pressure group doesn’t advocate screening or excluding stocks. On one hand this model is outdated, focusing on so-called sin stocks such as tobacco and pornography rather than asking today’s questions around human rights and environmental issues. On the other, Howarth argues disinvestment, or not investing per se, makes wielding any kind of influence impossible. “We are not big disinvestment people. Once you disinvest, you lose the opportunity to influence. Disinvestment can and does have its uses, but if you sell your shares no one will notice,” she says. Having honed her ability to build tricky alliances between different interest groups and work the system from the inside after years working as a community organiser in London, Howarth’s campaign successes include demanding more transparency from Shell and BP regarding tar sands projects and, together with Oxfam, pushing institutional investors to pressure pharmaceutical group Novartis to ensure the continued availability of affordable generic medicines in India.

Passive investors are just as capable of having the conversation. Managers such as Legal and General Investment Management, one of the biggest passive managers in the UK, is a case in point. Howarth refers to the company’s “brilliant work” on responsible investment. “Trustees may struggle to sell companies because they are invested in a passive tracking fund, but they still have good access to governing boards and can have a powerful effect.”

Howarth is convinced the tide of change is now unstoppable. Lively investor activism in Australia, the US and Europe, is keeping pension providers in check with members’ interests and increasingly offering better value for money. Although Asian institutions continue to lag behind Western counterparts in ESG adoption, with schemes in Asia “less inclined” to alter investment strategies or challenge the companies they invest in, foreign investors in Asian corporates are taking up the mantle and encouraging debate. “It’s our money after all,” she says.

As almost every market in the world looks to move from defined benefit to some sort of defined contribution model, academics at the Pensions Institute of the Cass Business School, City University London have developed a set of 15 principles for designing a defined contribution model. The principles, consistent with the recently published OECD guidelines, are based on more than a decade of research.

First launched in London at an event jointly hosted by the OECD, World Bank and the International Centre for Pension Management (ICPM) earlier this month, the principles cover model specification and calibration, modelling quantifiable uncertainty, member choices and characteristics, plan charges, longevity risk, the post-retirement period.

The principles also leapfrog some of the more developed defined contribution markets, such as Australia, and advocate integrating the pre- and post-retirement periods. It also models additional sources of income, such as state pensions and equity releases, and looks at modelling extraneous factors, as well as scenario analysis and stress testing, periodic updating of the model and changing assumptions.

Head of the Pensions Institute at Cass, David Blake, says a defined contribution model should project both at-retirement pension outcomes and post-retirement outcomes, and consider pre- and post-retirement periods in an integrated way. It should also consider other sources of retirement income outside the members’ pension plan in an integrated way.

He says that most defined contribution pension plans are “very badly” designed.

“A well designed plan will be designed from back to front, that is, from desired outputs to required inputs,” he says.

Speaking at the event, director of ICPM, Keith Ambachtsheer, says building an ideal retirement income system should cover three phases: pre-work, work and post-work, and in doing that answers seven questions.

Length of the three phases
Individual versus collective decisions
Pay as you go versus pre-funding
Embedded risks
Risk-pooling mechanisms
Demographic, economic and capital market prospects
Institutional structures.

According to the Towers Watson Global Pension Assets Study, defined contribution assets represent about 43 per cent of total pension assets, but are growing at a rate of about 8 per cent, compared to 4.6-per-cent growth in defined benefit.

The UK, which is the third largest market in the world and has about 40 per cent in defined contribution assets, is looking closely at its pension modelling. It is estimated that about 11 million people are at risk of an inadequate pension in the UK. Last October the government introduced automatic enrolment and backed NEST, a defined contribution fund for low-income earners.

Also speaking at the event, chairman of NEST, Lawrence Churchill, says the European Commission has identified four problems with pensions: participation, adequacy, security and sustainability.

“We can transform this in a generation if we address those four boldly, transparently and simultaneously.”

The conference also discussed the importance of communicating to members, a function more prominent in a defined contribution environment, and in particular that any communication with members should have the aim of actually influencing behaviour.

The OCED and the Chilean pension regulator have collaborated to develop a retirement-income tool for members, with which the Chilean regulator actually standardised the assumptions used by providers in communicating benefits to members – also supported by the recommendations of Cass.

Head of private pensions at the OECD, Juan Yemo, says projections have a critical role to play in communicating with members at any age.

“They help with the emotional aspect of losses, not just about volatility or risk, but behaviour when people see those losses,” he says. “This information can change behaviour.”

The Cass Business School is looking for feedback on its prinicples. To access the discussion paper, Good Practice Principles in Modelling Defined Contribution Pension Plans, click here.

The Cass Business School’s principles of designing a defined contribution model

Principle 1: The underlying assumptions in the model should be plausible, transparent and internally consistent.

Principle 2: The model’s calibrations should be appropriately audited or challenged, and the model’s projections should be subject to back testing.

Principle 3: The model must be stochastic and be capable of dealing with quantifiable uncertainty.

Principle 4: A suitable risk metric should be specified for each output variable of interest, especially one dealing with downside risk. Examples would be the 5 per cent value-at-risk and the 90-per-cent prediction interval. These risk metrics should be illustrated graphically using appropriate charts.

Principle 5: The quantitative consequences of different sets of member choices and actions should be clearly spelled out to help the member make an informed set of decisions.

Principle 6: The model should take account of key member characteristics, such as occupation, gender, and existing assets and liabilities.

Principle 7: The model should illustrate the consequences of the member’s attitude to risk for the plan’s asset allocation decision. It should also show the consequences of changing the asset allocation, contribution rate and planned retirement date, thereby enabling the member to iterate towards the preferred combination of these key decision variables.

Principle 8: The model should take into account the full set of plan charges.

Principle 9: The model should take account of longevity risk and projected increases in life expectancy over the member’s lifetime.

Principle 10: The model should project both at-retirement pension outcomes and post-retirement outcomes. The risks associated with the following strategies should be clearly illustrated: the risk of taking a level rather than an index-linked annuity in terms of a reduced standard of living at high ages, and the risks associated with drawdown strategies in terms of taking out more from the fund initially than is justified by subsequent investment performance.

Principle 11: The model should consider the pre- and post-retirement periods in an integrated way. This is necessary to avoid undesirable outcomes at a later date – such as a big fall in the standard of living in retirement. It will also help to determine what adjustment in member choices – in terms of higher contribution rate, an increased equity weighting and later retirement – are needed to avoid this.

Principle 12: The model should consider other sources of retirement income outside the member’s own pension plan. These include the state pension and home equity release. A well-designed DC model will also help with lifetime financial planning.

Principle 13: The model should reflect reality as much as possible and allow for such extraneous factors as unemployment risk, activity rates, taxes and welfare entitlements.

Principle 14: Scenario analysis and stress testing are important. For any given scenario, one should also: make key assumptions explicit; evaluate key assumptions for plausibility; and stress-test assumptions to determine which really matter. This allows the modeller to determine the important assumptions and focus on getting them (as much as possible) ‘right’.

Principle 15: The model will need to be updated periodically and the assumptions changed. Such modifications should be carefully documented and explained in order to make sure the model retains its credibility with users.

Despite upturns in equity and bond prices sending 2012 returns into double digits at many large Danish funds, it appears that successfully implementing infrastructure initiatives remains the holy grail of Danish institutional investing.

Instead of merely basking in 12.9-per-cent annual returns, Industriens Pension, for instance, used its 2012 results announcement to make a commitment to double its infrastructure and real estate investments to DKK10 billion ($1.73 billion).

That marks yet another move in Danish funds’ determined hunt for yield – many of the largest funds have set similar targets with PensionDanmark earmarking 20 per cent of its $23.9 billion portfolio for “stable alternatives”.

Bertel Rasmussen, partner at Copenhagen pension consultancy Kirstein, says “funds started off with infrastructure and private equity funds but have been going more directly lately. They are looking for Danish projects and co-investment in a very long-term commitment.”

Due to the limited investment choices defined by strict Danish solvency laws, funds are seeking to make the most of infrastructure, clubbing together to invest and push for public works opportunities.

PKA, for instance, now owns 20-per-cent stakes in two large offshore wind farms under construction, with PensionDanmark holding a similar-sized stake in one and Industriens Pension in the other.

Finn Rasmussen, chief executive of Mercer in Denmark, cautions that a detailed debate between funds and the government on the spread of risk in public-private partnerships needs to be resolved before domestic infrastructure investing can truly take off. And Bertel Rasmussen thinks that Danish investors’ drive in alternatives still has an experimental air to it.

That could be a reason why there has been some notable divergence in performance – even though funds can’t know from a single year’s returns if they have found what they are looking for. Industriens Pension lost over 7 per cent on its absolute return allocation in 2012; Frank Jensen, an analyst on PKA’s asset strategy team, stated that the fund has “not been satisfied” with year’s returns on its timber allocation; yet Danish giant ATP’s hedging portfolio outgrew the fund’s overall increase in liabilities with a return of $7.78 billion; and Finn Rasmussen believes it is simply too early for the hunt for yield to show in investment results.

Counting the gains

While Danish funds bucked the global trend with positive returns last year, Finn Rasmussen says that on the whole they are close to clawing back from the blows dealt in 2008 and 2009.

Michael Nellemann Pedersen, investment director at PKA, says 2012 was an “extraordinary” investing year as decent returns were generated by the fund across all asset classes.

Results at PKA were boosted by a call made to hold on to government bonds in southern Europe during the worst moments of the sovereign debt crisis in 2012. An 18.1-per-cent return from these peripheral holdings pushed the output from nominal bonds above 10 per cent. PKA, which currently counts $35 billion in assets, gained 13.7-per-cent returns over 2012. The result comes on top of the 9.4 per cent it generated in the troubled year of 2011 when the average for investors in the OECD was a 1.7-per-cent loss.

Lønmodtagernes Dyrtidsfonds (LD) also reported decent returns from its fixed income portfolio, helping it to an overall result on its $9.1 billion portfolio of 9.9 per cent in 2012.

For Bertel Rasmussen, booming bond prices are a key reason that Denmark’s labour-market pension funds are shown in a Kirstein study to have performed better in the recent past than the country’s commercial funds.

Rasmussen explains that the generally more conservative (and fixed income-heavy) approach of labour-market funds has made them find their feet better in the low-returns environment after the financial crisis.

The same dynamics might explain another intriguing finding of Kirstein, that there has been limited correlation lately between high investment costs and high returns.

Hello risk

Danish funds saw equity holdings rocket in value in 2012. The asset class generated average returns of 13 to 14 per cent in Bertel Rasmussen’s assessment, with the $57-billion-investor Danica stating that its equity returns were above 15 per cent.

Domestic equities proved particularly spectacular as Copenhagen’s small-cap heavy stock index significantly outgrew the global average.

Industriens Pension generated 26 per cent from domestic equities, while a strong emphasis on domestic stocks also helped LD gain 19.3 per cent in 2013 from its combined listed and private equity bucket – figures that lifted the overall returns.

As with every booming market, those that moved early to tap last year’s upturn in equities were rewarded most. Benny Buchardt, investment director of PenSam, explained the fund’s 12.6-per-cent 2012 return for its traditional plans by saying “thanks to our strong focus on risk capacity, we have been able to invest in shares and corporate bonds from the start”.

Several funds have been increasing equity exposure since the autumn as their outlook gets more bullish, according to Bertel Rasmussen, with the confidence from the 2012 results further boosting risk appetites.

Finn Rasmussen argues, however, that equity investments “will not change too dramatically” due to the strict solvency rules that Danish pension funds operate within. “If it was up to the funds, they would already have moved much more towards equities”, he concedes.

The introduction of new unguaranteed life-cycle-pension products that allow members to define their own risk profile is, however, opening up the scope for greater equity investment in the long term, says Finn Rasmussen.

Don’t give up the hunt

Dorrit Vanglo, chief executive of LD, says that while assets across the board pushed returns close to double-digit territory at the fund, she is not counting on replicating the results in the future, noting that interest rates and bond yields seemingly can’t go much lower.

Finn Rasmussen agrees with Vanglo’s point on the bottoming out of rates, but notes with a chuckle that he was also telling people at the start of 2012 that interest rates had almost no room to fall.

Looking to 2013, “I would be very happy to get just half of last year’s result – 5 per cent, that is,” Vanglo says, adding that a future shock to bond prices due to a rise in interest rates is something to be wary of.

Danish funds’ sustained attempts to diversify and find yield thus looks the most predictable feature of the next few years. It might prove an informative exercise for funds in other countries also moving away from classic asset classes.

Certainly, it will add to the vast experience Danes have in low-risk investing. That could be a useful guide in a world where risk is seemingly being squeezed out of pensions – whether by force with the EU’s planned Danish-style solvency provisions or by the natural maturing of closed defined benefit schemes.

If everything continues on schedule, the $60-billion AustralianSuper will begin testing its new internal investment-management systems this month, with a view to managing its first money in house in the third quarter of 2013.

Within four years the fund expects to manage as much as $40 billion in house, funded primarily from cash flow, and to have built an investment management capability the equal of any in the world.

AustralianSuper’s head of investment operations, Peter Curtis, says the fund has the benefit of starting with a blank piece of paper and designing something from the ground up. He says it can focus on doing the things it believes add value for members, such as implementing asset allocation decisions more efficiently and profitably, and outsource the things that are not its core business.

“We’re really starting from scratch and that’s allowed us to work out what we want to do internally,” Curtis says. “Our philosophy has been that we want to do things that are going to add value to the whole investment process, and the returns back to our members. We do not want to get into large-scale processing and we don’t want to get into areas where it doesn’t fit with our core capabilities.”

Curtis says the fund has “outsourced the whole middle office, and that means we’re not putting in a massive system which in itself would probably run to millions of dollars”.

“We’re not going to have a team of 20 people matching contract notes and doing a whole lot of other things,” he says. “We’re going to use an organisation that has that capability and has those systems and the scale to do all that.

Rolling out the plan

The first phase of the project will cost the fund about $5 million, but this expense is dwarfed by the expected cost savings. Curtis says the fund is close to finalising contracts for middle-office services and an execution platform, and is continuing to recruit new members to the investment management team.

“We’re hoping to have the model in, connected, and to have done our testing around the end of May,” Curtis says.

“Our plan is we’ll be doing testing in April and May. We will test the individual components, and then we’ll test the whole end-to-end process to make sure everything works in the manner that we’re expecting.

“That will then allow the internal team to go through the normal process of what’s their style, how are they going to manage the money – a bit like an external manager does a presentation – get the approvals, and then we work out how we allocate capital to them.

“AustralianSuper has very strong cash flow coming in every year, so we expect that we will allocate to these managers from our cash flows as they come into the fund.”

Once the Australian equities team is bedded down and managing money, the next asset class to be brought in house will be Asian equities. “We’re sitting at the bottom of that time zone, and as you’d know from various other things we’ve done – establishing the research office up in Beijing and the Asia advisory committee – Asia is a very critical part of where we believe the fund will be allocating capital in the future,” Curtis says. “We think that the next logical area for us to start to roll out is Asian equities, as the second cab off the rank.

“After Asian equities we then look at fixed interest and cash; and then after that, developed markets.”

Nailing down the costs

As money is allocated to its internal team, a growing proportion of the fund’s assets will be managed at what is affectively a fixed cost. The savings arise from the difference between the expected fixed cost and the cost of having the same funds managed externally. The fund currently spends about $200 million a year on external managers; if those costs continue to grow in line with funds under management, by the time the fund reaches $100 billion, its annual external management costs will hit about $500 million.

“With the internal team, once we get the scale, it’s almost a fixed amount that will be spread over an increasing AUM,” Curtis says. “At the moment we’re in the low 60s [basis points] with our investment costs; we would hope in the next three to four years to see the next step-change in our costs, down to the 40s.

“We want to put in place best-in-class investment management capability. If you look at where the numbers go on our projections, this platform will be running $30 to $40 billion in the next four to five years. We need to be as good as the large fund managers in Australia and large fund managers globally – because it’s going to be a global operation.”

Spin-off benefits

Curtis says the initiation of an internal investment management capability will not directly affect the asset allocation decisions the fund makes, but it will have effect how decisions are implemented – including a focus on after-tax returns.

“We think it’s going to give us a number of spin-off benefits,” Curtis says.

“Because we’re going to have an execution capability in the fund, we’re going to be able to think about how we execute our asset allocation changes. So we’ll be able to buy futures directly, if that’s what we want to do, to sell Australian equities and buy international – the ability to implement those asset allocation changes a bit faster and on a timely basis.

“We also think it’s going to give us much better insights into the asset allocation discussions. We’re going to have those direct touch points with the markets; we’re going to have people in different asset classes who are dealing in those markets on a daily basis that the asset allocation research group can talk about what they are seeing in the markets, and what you are hearing from companies when you’re out talking to them.

“The whole one-fund philosophy will continue to gain benefits. We think that the brokers and the counterparties are going to see AustralianSuper as a far more substantial organisation because we’ll be doing more things with them directly, across different asset classes.

“We think that’s going to mean the fund will see more things that are happening in the market. We will become hopefully a preferred client for most of those counterparties in the marketplace.

“We think that flows back into our existing engagement program that we’re running on governance and how we vote at meetings, et cetera. We just see there are multiple spin-offs and intangible-type benefits that will flow into our investment process and discussions we have with companies as shareholders and potential investments. It’s pretty much the virtuous circle.

More information, better decision-making

“The critical thing that the investment committee keeps talking about is, right, we’ve got to make sure that we capture these,” says Curtis, “and we’ve got to monitor that we are getting the benefits back to members and on better investment returns.”

Curtis says that the fund will also take a new look at after-tax investment returns. “One of the pieces we’ve put into the process is a capability from GBST,” he says in reference to the global financial services software provider. “What that’s going to allow us to do, almost as a pre-trade compliance check, the portfolio manager will be able to send the proposed trade file out to this GBST database that will come back to them pretty much instantaneously to say, if you go ahead and do those trades here are those tax implications. So it gives the portfolio manager some insights to effectively consider the tax implications before the trade goes on.”

A less than optimal after-tax result won’t necessarily prevent a trade from occurring, according to Curtis, but it gives portfolio managers “some more information to think about… and factor into your decision-making process”.

“The GBST database we will probably in the 2014 financial year rollout to our external managers, so they will able to ping the database through a website and basically see the same information,” he says.

“It’s one of those areas we’re looking for where we can tweak the investment management model to get some more benefits back for the members and just get a better outcome. We’ve been very pleased to be able to partner up with GBST to partner-up in that process.”

After-tax management is just as important for AustralianSuper’s members in the accumulation phase as it is for members in the pension phase. “Franking credits are of value in the pension as well, because effectively they get the cash value for them,” says Curtis.

Managing complexity

However, with a project the size of this one, unforeseen complexities inevitably arise. “How we fitted into the overall cash management and liquidity management processes [is something] we’ve spent a fair bit of time looking at and engineering in the most efficient manner we can,” he says.

“Once we started looking at how we allocated capital into these portfolios and how that impacts across the broader capital-allocation process, we spent a bit of time working that through so the portfolio managers would have access to how much cash they’ve got each day.”

On the flipside, however, connecting to external counterparts proved to be relatively easier than expected.

“The FIX [Financial Information eXchange] connectivity through NYSE Market has been simpler. We hook up to them and then they hook up to X-hundred brokers globally, and we can just turn them on as we wish. So that’s been relatively straightforward.”

Curtis says the project remains on schedule, but “the whole thrust from day one has been we want to have the right people, processes and systems in place. If we hit the date, that’s good but we’re not going to cut corners purely to hit a date”.

AustralianSuper is in the throes of building its Australian equity management team, before turning its attention to other asset classes. “We’ve made the appointment of Shaun Manuell as the senior portfolio manager for Australian equities,” Curtis says. “On the people front, he’s now looking to build out his portfolio management team. We’re currently looking for a portfolio manager and about four analysts to support that group. Separately, we’ve also appointed Trent Hayes to look after the execution desk and he’s also looking for an offsider for the execution team to focus specifically on Australian equities.”

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