Sir Henry Wellcome, the early twentieth century pharmaceuticals magnate (pictured below), would be pleased with how well the London-based charitable foundation that bears his name has weathered the global downturn. The Wellcome Trust (WT), which supports medical research in Britain and around the world, reported a total return of 12 per cent for the year to the end of September 2012, boosting its portfolio value to £14.5 billion ($23.2 billion). Since 2009 the WT – based on London’s traffic-clogged Euston Road – has returned a total of 27 per cent, while continuing to reduce its previous overexposure to UK and eurozone assets.

Peter Pereira Gray, the investment division’s managing director, says his team starts with the advantage in volatile markets of having no strategic asset allocation. “It allows us to operate a little differently from typical financial markets-led funds,” observes Pereira Gray. The WT has also benefited from the decision in 2006 by its new chief investment officer Danny Truell – with the investment committee’s support – to rectify what his deputy Pereira Gray calls a “distinct home-market bias”. Today, just 6 per cent of the WT’s assets are in the UK, compared with 33 per cent in 2006. Over the same period, the portfolio’s exposure to Europe as a whole has shrunk from 48 per cent to 13 per cent. In contrast, global investments outside North America, Europe and Japan account for 41 per cent of the portfolio, more than triple the proportion in 2006, with an emphasis on faster growing developing markets such as Brazil and India.

The way to illiquidity

The WT’s strategic shift out of Europe, however, has been carefully paced to negotiate the shocks and aftershocks of the 2008 market crash. “We didn’t see the full extent of the financial crisis that was coming, but we did see the risk, and hence we built up our cash position going into 2008,” recalls Pereira Gray. Between September 2007 and 2008 the WT’s holdings of cash and bonds grew from 5.4 per cent to 9.3 per cent of the portfolio, with a further rise to 13 per cent over the following year. Since then, the WT has become steadily more illiquid, with cash and bonds only accounting in September 2012 for 3.9 per cent of all assets. Pereira Gray declines to specify the amount of liquidity his team is required to hold, but the investment committee endorses Truell’s focus – reiterated in December – to seek long-term “premium returns from illiquid assets”.

Those assets cover three broad asset classes: property, private equity and hedge funds. Real estate, representing 10.6 per cent of the portfolio, typifies the WT’s general move to “a fewer number of larger positions,” says Pereira Gray, who before joining the Wellcome in 2001 was director of property fund management at the Prudential. Since 2006 the WT has sold off almost all its commercial real estate, while 90 per cent of its residential portfolio is invested in just four assets: about 1600 freeholds in the affluent southwest London district of Kensington; some 1500 freeholds spread across southeast England, the UK’s richest region; a UK student housing joint venture with property management firm Quintain; and investments in German residential real estate.

Like other UK property funds, the WT has capitalised in recent years on the continuing rise in upmarket residential real estate prices across London and southeast England. Since 2009, the directly owned residential portfolio has achieved an average annualised return of 15.2 per cent, rising to 17.8 per cent in the year to September 2012. At the same time, the WT continues to wind down its stakes in external property funds, which have performed less well in the same period, due in part to excessive bank lending.

Private equity, which amounts to 27.5 per cent of the total portfolio, is another illiquid asset class in which the Wellcome WT is a strong believer. Both Truell and Pereira Gray argue that the best funds in this sector will continue to produce superior long-term returns to public equities. So far, they have largely been vindicated, despite the improved performance of equities in 2012. In the three years to September 2012, the WT’s private equity portfolio achieved an average annualised return of between 10.3 per cent for distressed private equity and 13.3 per cent for large management buyout funds, compared with a return of 7.7 per cent over the same period by the MSCI World equities index. To sharpen its expertise in this sector, the WT last September appointed Damon Buffini, former chairman of UK private equity firm Permira, as a governor.

Hanging on to hedge funds

The WT has also kept faith with its hedge fund investments, accounting for 16.1 per cent of the total portfolio and total exposure of about $4 billion. Yet like other investors, the WT is wary of backing the many hedge fund duds. Since September 2007, the WT has more than halved the number of its invested hedge funds from 56 to 24, in line with its strategy of consolidating assets. Pereira Gray argues that the remaining hedge fund assets are worth holding in the long term for three reasons.

For a start, he says, the best hedge funds are very well run and offer excellent returns. Again, the WT’s own balance sheet supports Pereira Gray’s thesis. In the year to September 2012, four of the WT’s long/short equity funds produced annualised returns of 30 per cent by deftly exploiting the uneven recovery in global stock markets. Overall, the WT’s hedge fund assets delivered a 9.5-per-cent return for the year, with only managed futures funds (minus 1.3 per cent) a disappointment.

In second place, Pereira Gray says the WT’s long-term hedge fund investments dampen volatility in the portfolio as a whole, which would otherwise be more vulnerable to swings in equity markets. Lastly, Truell and Pereira Gray see hedge funds as an additional source of liquidity. “When you have a mature portfolio of hedge funds, it is effectively a liquidity pool, because you can typically get your money back on three months’ notice,” says Pereira Gray.

Long-term absolute return investor

Meanwhile, the fund has another potential source of liquidity in the form of about $10.5 billion invested in public equities. Equities today represent 42 per cent of the portfolio, compared with 62.5 per cent in 2006. The WT also now directly manages about 40 per cent of all equity investments, up from 35 per cent in 2009 – although not in markets like Brazil, India and sub-Saharan Africa, where it employs external managers with local knowledge. These markets, called “faster growth” by the WT, have in fact held back the overall performance of the stocks portfolio over the past three years, with the Wellcome WT scoring an annualised return for the period of 7.2 per cent, slightly less than the MSCI World equity index. Pereira Gray is not unduly disturbed, pointing out that all the fund’s equity investments are driven by a focus on underlying earnings rather than the share price. “We are not driven by relative returns,” he says.

As he emphasises, the WT does not regard its investment strategy as marking it apart from other endowments and charitable foundations. “We are not a bunch of mavericks,” says Pereira Gray, but a “long-term absolute return investor”. What is plain, though, is that the WT has been more nimble than many institutional investors in sidestepping the storms that have buffeted global financial markets since 2008.

Its agility has allowed the WT to meet the only benchmark that matters – delivering ever-greater sums to finance increasingly expensive medical research. Between 2012 and 2017, the WT forecasts that it will be able to spend about $5.6 billion on charitable activities, a 25-per-cent increase over the previous five years. Such a figure was beyond the dreams of the Wellcome’s original trustees, who began work in 1936 (the year of Sir Henry’s death) with no offices, no staff and just £74,000 in the bank.

A company pension fund might not be the first place you would think of applying for a mortgage.

According to Matthias Weber, a partner at Zurich consultancy ifund services, the issuance of mortgages by investors is likely to deepen as Swiss pension funds continue on their quest to find good alternative assets.

Weber has just helped to complete a survey of 200 Swiss pension funds’ investment priorities and reckons that the hunt for alternatives is at the top of the list. He expects major Swiss investors to grapple with this in 2013 as they look to reduce bond holdings. Yields of Swiss government bonds dated five years or less have hovered around zero in 2012, placing great strain on their return potential and necessitating a search for new ideas, in Weber’s view.

The typical major Swiss pension funds hold a rather chunky 30 to 50 per cent of their assets in domestic bonds. Government issues are a significant proportion of this, says Weber, as domestic corporate debt offers only a “limited” market.

Alternative ideas

Weber simply does not think that conventional asset classes can soak up all the money that Swiss pension investors will take out of domestic bonds in the next few years. As many pension investors are also looking to de-risk due to the closure of defined benefit schemes, alternatives generating dependable return streams will be the name of the game.

Weber identifies commodities and insurance-linked investments as two asset classes in the alternatives space attracting the attention of major Swiss pension investors.

The survey of Swiss pension funds by ifund services found that 61 per cent already hold commodity investments. The company also knows of seven pension funds looking to take on new external commodities managers in the next year. Commodities allocations rarely exceed 2 per cent of overall portfolios though, according to Weber, with investors wanting to keep their overall performance detached from the well-known volatility of commodity prices.

An even greater number pension funds are said by Weber to have an interest in appointing new insurance-linked investment managers. Some 21 per cent of Swiss funds responding to the survey already hold the relatively new asset class.

Catastrophe bonds in particular are interesting Swiss investors, Weber says.

More than a decade after their introduction he says they have performed well – with returns usually between 4 to 6 per cent – proved to be fairly liquid with low fees. “The market is tiny though, at around $15 billion, so you can only really allocate 2 to 3 per cent to catastrophe bonds” he says.

Hedge fund-style alpha and mortgages

Hedge funds might appear natural bedfellows of Swiss funds looking to diversify and find low-risk, steady returns. Weber explains that Swiss institutional investors were extremely enthusiastic about hedge funds from the late 90s, but there has been widespread disappointment since. Now, many of them feel hedge funds have been “expensive and have not performed well in the past few years”, says Weber, with the Swiss media frequently honing in on concern at hedge fund fees. The ifund services survey found that eight Swiss institutional investors are looking to drop their hedge fund managers in 2013.

Well-managed unconstrained bond funds and alternative UCITS are of interest to Swiss institutional investors looking for hedge fund-style alpha, says Weber (pictured left).

Another developing alternative asset class for the largest Swiss institutional investors is the issuance of credit to replace reduced bank lending in Europe.

Weber says that “some pension funds have begun issuing mortgages to their employees, and there is a feeling that direct lending can bring in good returns at low costs”.

The $15-billion Swiss Railways’ SBB Pension Fund last year acquired $686 million in mortgages while the $10.9-billion Basel City pension fund and $8.3-billion Aargauische Pensionskasse also offer mortgages.

On the whole, Weber reckons that Swiss institutional investors will look for holdings in alternative asset classes of around 8 to 10 per cent of their total portfolios.

Ultimately, with limited interest in existing alternatives and other asset classes just arriving on the scene, a lack of acceptable alternatives might lumber Swiss pension funds with the government bond holdings that many are looking to reduce.

Sticking to the well-trodden path of caution on alternatives and faith in large bond holdings might result in many funds needing to reduce liabilities with benefit cuts, Weber warns.

The established options

Given the scarce supply of alternatives, Weber expects real estate and less traditional bond holdings to prosper even more from a sustained move away from domestic bonds.

Global corporate bonds, high yield and emerging market debt as well as real estate investments offer established alternatives that Weber expects Swiss investors to utilise.

Weber cautions though that “a lot of pension funds might hesitate to swap the safety of Swiss government bonds to emerging markets or senior loans when they don’t know the issuers or the risk.”

The Swiss real estate sector is more of a trusted destination for pension capital, however. The sector has been a beacon of solid performance while its European counterparts have crashed recently.

Any fears that Swiss real estate is overvalued by this resilience are wide of the mark, reckons Weber.

He argues that property price increases have been more modest in Switzerland than elsewhere over the past two decades, offering 3 or 4 per cent net returns on average.

Taking the passive route

The ifund services survey found that around 50 per cent of assets at the Swiss funds responding are managed in passive external mandates. Some 56 per cent of assets in developed market equities are passively managed according to the survey, making this the most passive asset class.

A range of Swiss pension funds want to further increase their use of passive managers, according to Weber, but does not know a single pension investor looking to increase active management.

He thinks that reducing risk relative to benchmarks is the overriding reason why cautious Swiss pension funds have come to embrace passive investing, explaining that most pension fund boards in Switzerland are very conservative and “there is no reason to select active funds if you are not convinced”.

“Many funds feel that the search costs and monitoring of active managers – occasionally revealing big mistakes – are excessive”, says Weber.

United Kingdom pension funds will increase their real estate allocations as bond and equity investments continue to disappoint, according to new research by property consultancy Jones Lang Lasalle. The funds typically hold around 5 per cent of their assets in real estate, but the recent findings predict the pendulum will swing in favour of much bigger allocations in coming years.

The reason is part of a structural shift away from traditional holdings to more “real assets” including property, infrastructure and transport, argues Joe Valent, in JP Morgan’s global real estate team, who believes these alternatives could account for up to 20 per cent of UK pension fund portfolios in the next 10 years. “We’ve all grown up with the idea that pension funds split their assets between equities and bonds,” he says. “But this was when economies were growing at around 5 per cent, bonds were paying 8 to 10 per cent and equities were booming. Economies aren’t growing at the same rate and bonds pay nothing. What is the rational for holding such a high proportion of these assets in portfolios?”

UK funds will look for opportunity in their home market first as big foreign funds continue to swoop on the asset class in their own backyard. The UK has attracted around $4 billion of a total $11 billion cross-border fund investment in real estate in the last nine years, with City and West End investments proving most popular, says David Green-Morgan, global capital markets research director at JLL. He believes London will remain a key investment destination despite fierce competition and pricing-bubble worries. Recent forays by foreign funds include the $172.4-billion Canada Pension Plan Investment Board purchase of the Westfield shopping complex in Stratford, East London. Outside the capital, Norway’s sovereign wealth fund paid $560 million for a 50-per-cent stake in Sheffield’s Meadowhall shopping centre last October.

It’s a shift the biggest UK schemes have already embraced, with London also the focus for most, but not all, real estate picks. Strathclyde Pension Fund, one of the UK’s biggest local authority schemes, plans to up its UK allocation to 10 per cent of a total 12.5-per-cent property allocation. Managed by DTZ Investment Management, the scheme’s UK investments are focused on central London office and retail space. Railpen, inhouse manager of the $30.5-billion pension scheme for Britain’s rail industry, has around $2.25 billion invested in UK property managed by Orchard Street with a focus on the UK’s fast-growing regional cities such as Cambridge.

Competition, oversupply and strategy

However, some trustees say competition means investment opportunities in the best located and managed properties has become thin on the ground; values in “good quality but not A-grade” investments have plateaued with oversupply weighing on commercial rents. Proponents insist there is enough product to support a substantial switch in allocation – all that’s lacking is imagination. JP Morgan estimates $450 billion in global distressed real estate is coming to the market in the next year as assets that have sat on banks and deficit-laden government balance sheets are sold off. Here the opportunity won’t be in “tier-two markets like Spain or Eastern Europe”, but in key capitals in locations close to central business districts and prime grade-A zones. “There will be opportunity to buy assets that have, for the last five years, been in a state of suspended animation,” says Valent, who puts net returns in these kinds of investments at 15 per cent.

Strategies include buying the buildings directly, accessing the market via fund-of-fund investments or through real estate investment trusts (REITs). The UK’s Pension Protection Fund, $14.5-billion lifeboat fund that takes on the assets of UK schemes if the employer goes bust and honours its pension promises, has a 5 per cent real-estate allocation in its conservative investment strategy that includes REIT investments in the US. “We are exposed to London retail and office space though a fund of funds,” says Martin Clarke, executive director of financial risk at the PPF. One strategy could see more foreign funds partner with local institutional money, argues Green-Morgan. “As competition grows, we expect to see more joint ventures and partnering with two to three groups working together,” he says. “A 2-per-cent allocation is of no benefit to the portfolio – you need a 10-per-cent allocation for it to be meaningful.”

 

 

An absence of appropriate ethical culture at financial services firms has been the biggest contributor to the lack of trust in the finance industry, according to a global survey of CFA Institute members, which attracted more than 6000 responses.

Matt Orsagh, director of capital markets policy at CFA Institute, says to restore integrity in global markets, change must come from within and that ethical culture within financial firms needs to be addressed to solve systemic problems that led to fiscal crisis.

He says the focus on short-term incentives and behaviour has contributed to the problem and created a mismatch when culture is long term in nature.

“Culture takes a long time – a long time to get wrong and a long time to get right. It’s the super tanker metaphor,” he says.

But investment banks and investment managers are not the only participants that need a wake-up call, he says, pointing to the role of institutional investors in accepting their contribution to short-termism and changing their behaviour.

Institutional investors part of the problem

“Institutional investors need to examine whether they’re long term enough, and are they part of the problem,” he says.

Orsagh says a previous study by the CFA Institute, Breaking the short-term cycle, found that institutional investors bemoaned short-termism but also judged managers on a one-year basis, and were hiring and firing to chase returns.

“There needs to be people on the boards of pension funds that have expertise and understand decisions that need to be made, how markets work, fight for lower fees and be more long term. It is hard to be that in a political world,” he says.

Orsagh says the fact 56 per cent of respondents said that a lack of ethical culture within financial firms is the biggest contributor to the lack of trust in the finance industry is a wake-up call for industry.

Further, they also said that improved culture established and encouraged by top management and executives is the most needed firm-level action to help improve investor trust and confidence.

Six areas of cultural influence

A change of culture needs to come from the executive and board level, and the CFA Institute in its paper Visionary boards identifies six key areas where visionary boards and directors can influence to ensure to ensure their companies are well positioned for the long term:

  • Quarterly earnings practices. A visionary board expects management to deliver investor guidance with a longer term bias and in greater detail by identifying long-term value drivers for the company. This approach helps to incentivise share “ownership” among the investors the board represents.
  • Shareowner communications. A visionary board proactively listens to the concerns of its shareowners and consistently communicates its long-term vision and strategy.
  • Strategic direction. A visionary board actively oversees and understands the corporate strategy and regularly monitors, along with management, the implementation and effectiveness of strategic plans. It also focuses on the relationship between corporate strategy and risks associated with that strategy.
  • Risk oversight. A visionary board embraces risk as a board-level responsibility. It oversees robust processes for identifying, understanding and, when necessary, mitigating risks to the operations, strategy, assets and reputation of the company. At the same time, a visionary board understands that companies generate profits by taking risks.
  • Executive/director compensation. A visionary board understands a company’s compensation policies and ensures that the underlying objectives consistently support the long-term strategy and performance of the company, as well as the appropriate company risk profile.
  • Board and corporate culture. A visionary board not only understands the business and industry in which the company operates but also recognises that strong corporate and board cultures are essential to the achievement and sustainability of a company’s long-term value. Therefore, a visionary board diligently seeks to reinforce and build such cultures.

The survey respondents are cautiously optimistic, with 40 per cent of the members saying the economy will expand, up from last year’s 34 per cent who said they thought the global economy would expand.

Another signal of a positive outlook is that employment opportunities for financial professionals has slightly improved

Half of those surveyed expect equities to outperform all asset classes, up from 41 per cent a year ago.

The new chairman of EDHEC-Risk Institute’s international advisory board, chief investment strategist at Swedish pension fund AP2, Tomas Franzen, says institutional investors should embrace academia and be open to applying research in the implementation of practical portfolio construction.

He says that while investing is part art and part science, it is important to employ science as much as possible and have a scientific approach as part of the investment process.

“EDHEC is a nice bridge between a scientific approach and practitioners’ needs and methods for implementation in practical portfolio construction,” he says.

EDHEC was born around the same time as AP2 and Franzen says it has made a relevant contribution to his work at the fund.

In particular one of the areas of focus that institutional investors have employed is the academic work on more efficient indices and benchmarking of equities portfolios.

“We’ve been doing this in various forms at AP2 for years,” he says.

In addition, some of the research on hedge funds, in particular style attribution in portfolios, has been applied by AP2, which has been building portfolios around systematic risk premium.

“This is a huge research area and another example of the relevance,” he says. “This is about a scientific approach and dealing with the issues in a way that makes them relevant.”

He also said asset liability modelling has been a focus of EDHEC that is applicable for some investors.

Harnessing long-term investment policy

The 42-member advisory board at EDHEC-Risk Institute that Franzen now chairs is made up of investors and asset managers from around the world. Its purpose is to help the institute assess research projects for practical purposes; to evaluate research outcomes in regard to their potential impact on industry practices.

“It is important to stimulate thinking differently,” he says. “It’s easy to fall into old tracks.”

As chief strategist at AP2, Franzen says his daily duty is to think and harness investment policy as a long-term investor.

His interest is in investment policy design and asset allocation, which is also where he believes the long-term results are.

Since the global financial crisis, there has been more attention paid to dynamic asset allocation, and not just long-term strategic and short-term tactical asset allocation.

“When we think of dynamic asset allocation, it’s a question of addressing regularly whether financial risks are priced to reward taking on the risks,” he says. “It is good to have the mental preparedness to see that traditional risk premium may not be at the right price.”

To this end, AP2 has made a couple of dynamic allocations, including doubling a global credit allocation in 2007 and buying, then selling, out of convertible bonds.

Ensuring reward for risk

Franzen thinks of asset allocation in risk terms and believes there is an overemphasis on expected return in modern-day portfolios.

“It is more of risk management to be sure you get rewarded for risk. It is easier to describe than do in practice.”

According to Franzen, rather than concentrating on return, volatility and correlation, for example, valuation levels are more important in assessing equity risk in allocations over the long term.

AP2 has even integrated an investment policy roadmap, which has guided the fund.

Broadly, it allocates 52 per cent to equities, 36 per cent to fixed income and 12 per cent to alternatives.

However, he says the fund is still working towards finding the ultimate diversification. Recently it has expanded into real estate and has increased its allocation to non-traditional property such as timber and agricultural property.

Also increasing allocations to emerging markets, AP2 recently received its Qualified Foreign Institutional Investor licence to operate in China, and is now looking for investment managers to manage a domestic Chinese and Asian portfolio.

The fund has also undertaken some advice on hedge funds, which has translated to investment in more generic strategies, but with the aim of extracting alternative risk premium.

Franzen says the decision was made to gain exposure to alternative risk premium, but not invest in hedge funds per se.

The EDHEC-Risk Institute has branches in Singapore, at the invitation of the Monetary Authority of Singapore, the City of London and Nice, France.