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Australia, the US, Canada and Denmark have all done it. Kazakhstan and even Oman are talking about it. Increasingly, public sector pension funds are merging or pooling their assets into fewer bigger schemes. It’s no surprise the debate is gathering momentum in the United Kingdom, ripe for consolidation with a Local Government Pension Fund Scheme (LGPS) populated by 89 separate funds with combined assets of £187 billion ($288 billion) but all run individually. The government is conducting a review that could lead to mergers or the pooling of assets, and one of the biggest local authority schemes, the $6.5-billion London Pension Fund Authority, is spearheading the push for half a dozen regional funds of $30 billion to $46 billion each in a drive for efficiency and economies of scale. But the UK is behind the consolidation curve because most local authority schemes remain lukewarm on the idea. With the success of large, private sector funds such as the charitable foundation Wellcome Trust and Railpen, the merged fund for the rail industry, showing that big is best, it’s time for local authority schemes to come together.

Matching liabilities and hedging

Fewer bigger funds will mean schemes are better able to invest in the resources and skills needed for liability-matching strategies. Apart from a few exceptions such as the $1.8-billion Cornwall Pension Fund and the $2.3-billion Royal County of Berkshire Pension Fund, only a handful of local authority schemes hold liability-matching assets or have any hedging strategies in place. Yet LPGS’s are beginning to mature because of the government’s austerity policy forcing public sector cuts. As local authorities scramble to save money, many have slashed payrolls and encouraged voluntary retirement, triggering an early maturing in many schemes. Examples include the $15-billion West Midlands Pension Fund, which recently said it is preparing for a shift in investment strategy to reduce risk and prioritise the protection of funding levels, and Scotland’s $17-billion Strathclyde Pension Fund.

In their defence, schemes say they’re not hedging their risk because of a lack of know-how, but because of regulations dating from a 1998 Pensions Act that makes no provision for derivatives in investment strategies. It leaves liability-driven investment difficult and expensive. The $2.6-billion Dorset Pension Fund, a third fund with a hedging strategy, had to set up a special investment vehicle to circumnavigate the restrictions and manage its inflation risk. Schemes also argue that despite their maturing profiles, what they are facing is more like mid-life crises. Most local authority schemes are still open to new members; they are still in growth mode, less mature and with time on their side they aren’t de-risking or wanting to hedge liabilities anyway.

Simple economies of scale

Where the argument for consolidation makes even more sense is the fact bigger funds are better positioned to either invest directly or co-invest in alternative asset classes. Co-investing in private equity, whereby schemes portion some investment to private equity funds run by managers but the rest goes directly into the same projects in which the fund is investing, incurs a fraction of the fees and enables schemes to better tailor their exposure. But it’s only a strategy open to the biggest schemes. It’s the same when it comes to investing in property or the government’s pet asset class, infrastructure, where giant Canadian and Australian funds’ huge infrastructure allocations have proven that moving as a pack is best.

Encouraging signs of schemes’ willingness to pool funds already exist, such as the $25.5-billion Greater Manchester Pension partnering with Argent, the property arm of BT pension fund in a $154-million office development in Manchester. The Pension Infrastructure Platform (PIP) is another effort by schemes to pool assets in a collective investment vehicle to tap infrastructure.

Larger funds would also have the capacity to build inhouse investment teams. No fund under $15 billion can really afford its own investment team, yet some of the small funds have more managers than the big funds. It can lead to confused, contradictory investment strategies and doesn’t improve performance; the asset management of small council funds comes with much higher fees than larger funds can negotiate.

Any pooling of assets or scheme merger is bound to result in a few years of turbulence and a loss of momentum in investment strategy. And economies of scale can easily turn into diseconomies of scale as asset classes become exhausted. Yet nearly 100 individual schemes of several billion dollars each can’t pack anything like the investment clout of fewer bigger schemes. It will be tricky to keep local accountability, and changing the law or setting up a centralised body would be expensive, but as far as investment strategy goes, big is beautiful.

Real estate is back in fashion, at least according to a range of recent surveys indicating the growing institutional investor appetite for bricks and mortar. After a tough few years for the industry and with European investors’ priorities changing, the possible renaissance might come with a marked change in investing patterns, though.

More control

The talk from large investors is frequently about gaining more control of their real estate investments, says Casper Hesp (pictured below), research director of European non-listed real-estate-fund investor association, INREV. His group has found that there is significant appetite from European investors to access real estate via joint ventures and ‘club deals’ – essentially small funds with carefully aligned investor priorities. The €29.5-billion ($38.44-billion) Finnish fund, Ilmarinen, and the $170-billion Dutch pension manager, PGGM, have both recently announced major real estate joint ventures.

Robert Stassen, head of capital markets research at real estate consultancy Jones Lang LaSalle, agrees there is a growing trend for direct investment. “One of the natural consequences of the crisis has been for funds that may have previously only invested indirectly to look at an alternative way of accessing real estate,” he says. These are generally being explored by the largest funds though, with those lacking the investment infrastructure for novel funding vehicles or direct investing still reliant on real estate funds, according to Stassen. Clemens Schuerhoff, managing director of the Kommalpha consultancy in Germany, says that liquidity crises in both the open and closed-ended mutual real-estate-fund industries in the country have enhanced the trend towards greater direct investing there.

Unipension, the $17-billion Danish pension provider, has recently shown enthusiasm for real estate funds, however, announcing it would sell its entire direct domestic portfolio and invest in international funds in order to gain “better risk diversification”. According to Hesp, “when the market becomes more positive, I think larger investors will turn to funds again”.

Noticeably, recent cheerfulness about real estate investing appears to have infused investors more in some regions than others. Areas where disappointment in the downturn was hardest felt are seemingly slower to return to investing in the asset class.

A study from alternatives research company Preqin found that Asian institutional investors are more than twice as likely as European ones to invest in real estate funds in 2013. “Asian investors weren’t hit as hard in the downturn as US and European investors, and a lot of Asian investors are also more recent entrants to the asset class,” says Andrew Moylan, Preqin’s real-estate data manager.

Investing from the church spire

Moylan says that in contrast to the past few years when investors have sought “core” real estate, “there is now an increased appetite for higher risk-profile strategies with IRRs of 15 to 20 per cent.” He thinks part of this is due to huge demand for core investments, and says that “there have been a lot of people arguing that core real estate investments aren’t attractive anymore as they have perhaps become overpriced because of the capital chasing them.”

“Opportunistic” investments with lower occupancy, short leases or development needs are gaining popularity, Moylan argues, along with debt and distressed real estate funds. He reckons this is due to “confidence and the belief that there are the opportunities out there to deliver that kind of return”.

While few would doubt the opportunities exist, the ability of pension funds to pursue these riskier strategies appears muted, however. The pension fund respondents to Preqin’s study showed a greater propensity than other institutional investors to claim they will focus forthcoming investments in core real estate funds. Schuerhoff explains that German investors have coined a phrase for a local focus resulting from a need to scrutinise risk in real estate, investing from the Kirchturm or church spire.

Hesp thinks it is large investors that are more likely to have the desire and inhouse knowledge to diversify beyond core holdings, as well as have more room for experimenting with riskier assets. Stassen sees some evidence that pension funds are upping their risk appetite. He claims that “in the UK, pension funds are looking at Manchester whereas two years ago they probably would have just looked at London.” These initial movements are creating their own momentum he adds, with it proving “difficult to get yield play” as plenty of capital chases slightly riskier yet high quality assets.

PensionDanmark’s head of real estate, Mogens Moff, says his fund has diversified its real estate investments to the extent that just 10 per cent are “retail in top locations” and 20 per cent “high quality residences”.

Stassen says opportunities are opening up further up the yield curve as “an enormous lack of debt financing in the European market”, which affects the riskier end of the market, “has significantly improved over the last six quarters”. His colleague Richard Bloxam (pictured right), head of European capital markets at Jones Lang LaSalle, says these improvements have primarily come in the larger European markets like Germany, the UK and France though. The situation is still “extremely restrictive” in Holland, he adds.

Hesp agrees that investors want to “take this risk in countries that are more stable”. Germany and the Nordic countries are the most popular European destinations for real estate investments according to a recent INREV report.

Hesp believes “that the majority of investors aren’t looking at southern Europe yet as they are still looking at the risks associated with the Euro crisis”. Investors are also not convinced that a “full price reflection” has taken place in the most troubled markets, he adds. Bloxam agrees that a pricing gap remains but says there has been “some movement” from Italian vendors and there is an increased interest in the Spanish market. Moff says PensionDanmark remains focused on the domestic market for its direct investments, despite being enthusiastic on overseas infrastructure investments.

More inflation caution

A combination of the ongoing hunt for yield and heightened inflation fears appear to have swung the pendulum of real estate sentiment back in the asset class’s favor. There is a “huge difference” between real estate yields and those of government bonds, Hesp points out. Jones Lang LaSalle figures indicate a spread of over 400 basis points between prime office assets and local government bond yields in London, Paris, New York, Frankfurt, Sydney and Hong Kong in the third quarter of 2012. Moff says PensionDanmark is doubling its real estate investments to 10 per cent of its $24 billion portfolio to offer a “solid anchor to compensate for the low yields on bond investments”.

Figures from Swiss investors certainly point to increased popularity of real estate investments at the expense of bonds. Swisscanto data claims that around 50 per cent of Swiss pension funds reduced their bond holdings in 2012 while another 50 per cent increased their real estate allocations. Stassen argues that real estate is also benefiting from expectations of “relatively high or increased inflation” becoming more pronounced as the global economy clicks back into gear.

While real estate offers something difference to bonds and equities, it has to compete for attention in investors’ portfolios against a range of alternative investments like never before though. Stassen says (pictured right), however, that increasing number of funds are seeing real estate and infrastructure as individual asset classes separate to their alternative allocations.

“In the medium to long term we expect investors to continue to diversify into alternatives but maintain their real estate allocation” says Moylan, who argues that pension funds rarely real estate for infrastructure or hedge funds. Stassen points out that while the illiquidity premium of infrastructure is an attraction for some investors, the flexibility of real estate tends to suit those wanting liquidity.

Another bubble?

With institutional capital predicted to increasingly flow into the same kind of assets, is there a risk of another bubble in some segments?

“It is important to understand that institutional investors are different kinds of buyers, buyers typically without leverage and with a balance sheet that allows them to sit it out if needed,” Stassen says. However, Schuerhoff argues that there is widespread talk of a bubble in core real estate in the biggest German cities.

Beyond any asset bubble fears, regulation could also seemingly put the break on increased real estate appetites in Europe. Schuerhoff explains for instance that many German pension vehicles are tied by both “very conservative” domestic regulations on asset allocation and the prospect of forthcoming risk-averse Solvency II insurance regulations. While a study from his consultancy has found that institutional investors would ideally like to double their real estate allocations, he expects a much more gradual increase to ensue, pending the impact of new regulation. Modest risk budgets are also making many funds hesitant to increase real estate allocations, a constraint funds the world over might recognise.

Attempts to apply a formula to asset allocation based on an asset’s historical volatility and relationship with other assets tend to fail when presented with black-swan events. Equities tend to rise along with commodities except when presented with political events such as the price hikes in oil in 1973 that sent equities into free fall. Similarly, the quantitative easing measures in Europe, the US and Japan have also created a stimulus that makes equities and bonds move in ways that are not entirely logical. Furthermore, the lack of a fully reliable model for creating asset allocation has led investors to rely on common sense and, also for reasons of comfort, following allocations that are similar to like-minded investors.

This has not stopped some investors trying to create models that try and do better than this status quo.

The fund manager Blackstone has been using scenario analysis to help make sense of what its clients’ alternative asset allocations should be by using 18 market scenarios to predict the fortunes of individual asset classes. The model looks at the standard variance of asset classes and their interrelationships, but also takes into account a host of topical political and economic themes.

Ian Morris (pictured right), the New York-based managing director of Blackstone’s hedge fund solutions operation who has helped build a team of political, economic and market-based analysts to create these scenarios, believes that the model could reveal where institutional investors are not taking enough risk to achieve their stated aims or where they are taking too much risk.

The best system going

Each scenario, which reflects market fears, hopes and expectations, is weighted according to how likely it is to happen, and all add up to 100 per cent.

In the most recent model, the scenarios include the likelihood of a heavy double-dip US recession, which is rated a 2-per-cent probability, a light double-dip recession rated at 7 per cent, a “deflationary slog” at 10 per cent, “quantitative easing proves effective” at 13 per cent and its most popular forecast, moderate growth, is scored at a probability of 16 per cent. Each month the scores of the scenarios are updated and multiple implications for the return on each asset class are calculated.

Morris does not expect the analysis to be completely accurate, but says it is the best system he is aware of.

“I don’t think anyone has found the holy grail of asset allocation, but this approach works for us. We have put a lot of resources into political, economic and market research so that we can make the forecasts and do valuations. Not everyone has this resource – we think it is fairly unique,” he says. Adding that is relevant to any asset: “It’s applicable to anything that moves.”

Morris explains what the analysis looks like in practice. “In a heavy double-dip recession, Australian private equity might fall 62 per cent, but in a very bullish scenario it might rise 65 per cent. There are some scenarios in which equities and bonds do badly, or where equities rise and bonds fall.”

Model to measure

Blackstone takes the process further by personalising asset allocation recommendations to each investor’s risk tolerances. These are expressed in a line chart that shows, for example, for some investors a loss of 5 per cent might be twice as painful for a risk-averse investor than for a risk seeker.

“For those with an appetite for risk, a 10-per-cent return is twice as good as a 5-per-cent return, and a 10-per-cent loss is twice as bad as a 5-per-cent loss. But for risk-averse investors, a 10-per-cent loss would be more than twice as bad as a 5-per-cent loss.”

“For a very risk-averse conservative investor, it will recognise that you feel the pain of the downside much more than a risk-loving investor and, as a result, it constrains asset allocation,” explains Morris. “It can be absolute return for a given risk-aversion level. For a risk-loving investor, it will produce what it thinks is the highest returning maximising-utility portfolio allocation to generate a high-octane return.”

The idea is that after using the model investors might find that they need to re-jig their asset allocation, as either they are being too cautious in asset classes that could do well according to the analysis or they have too-large an allocation to an asset class exposed to the risks of large falls. The analysis can show this by giving the expected portfolio returns of specific asset allocations.

The analysis, though, is not always as simple as increasing risky assets and decreasing safer assets, say, for a fund that finds it is not taking enough risk to achieve its 7-per-cent return target.

“The fund might hold a risky asset even if it is expected to maybe not do so well in difficult environments. If there are other asset classes that are offsetting that, it could give big gains for that risk-averse investor,” says Morris.

The Middle East is in a state of dynamic flux, with positive change manifesting itself in the countries going through an economic and financial revolution as much as a political one. Institutional investors from all parts of the world have a role to play in that revolution, according to former US ambassador to Egypt and Israel, now professor of Middle Eastern policy studies at Princeton University’s Woodrow Wilson School of Public and International Affairs, Daniel Kurtzer (pictured right).

“The region is in a state of dynamic change; some is positive and some negative. The positive manifests itself in places where revolutions are creating the possibility of some permanent form of democracy,” he says. “Countries like Egypt and Tunisia are likely candidates for change, but it could go in any direction.”

Kurtzer says it is clear for countries such as Egypt, Tunisia, Libya and Yemen that the revolutions have come from the ground up, with citizens “rebelling against the indignity in which they lived”.

“They are rebelling against crony capitalism, inequality and wealth, as well as politics,” he says. “This is an economic and financial revolution as much as political.”

Kurtzer, who was the US ambassador to Israel from 2001 to 2005and is the editor of Pathways to Peace: America and the Arab-Israeli Conflict and co-author of The Peace Puzzle: America’s Quest for Arab-Israeli Peace, 1989-2011, says there are lessons learnt from the Israel-Palestine conflict.

The third party

The most important is the critical need for a third party negotiator.

“Both sides, for different reasons, insist on negotiating face to face and reject an imposed settlement. They don’t trust anyone else to be fair to their own views,” he says.

“They do differ on the role of the third party, Israel is exceedingly nervous because they feel there is too much anti-Israel sentiment, and Palestine, as the weaker party, believes it is one way to balance the power.”

Kurtzer, who also served as US ambassador to Egypt during the term of President Bill Clinton, says “unfortunately” the US has assumed the role of third party, unilaterally and almost to the exclusion of anyone else.

“I say unfortunately because it hasn’t exercised that role and has become distrusted by Palestine,” he says, pointing out that when the US has been successful it has used incentives and disincentives, such as withholding aid.

“The pressure in the Middle East is so great and, whether it is Israel or Palestine, they curl up and go into defensive position,” he says.

Within the US there is a very vibrant pro-Israel community, which complicates the nation’s role.

“The evangelical movement is supportive of the right-wing Israeli view, it is very much part of politics, so as a politician you have to consider domestic opinion in everything you do. We are a democracy and the first rule of democracy is get elected,” he says.

Kurtzer, who is currently teaching a course at Hebrew University of Jerusalem on American diplomacy, says even though Israel has conducted policies and activities that garner criticism, a certain amount of understanding needs to be given to Israel and its environment.

“Israel has conducted policies and activities that garner criticism but, on the other hand, since it was formed in 1948 there has not been one day of peace with its neighbours,” he says. “Egypt and Jordan now have peace treaties, but it is a formal state of war, a certain amount of understanding needs to be given to Israel in this environment.”

State of opportunity

The Middle East has been, and will continue to be, a source of intrigue and possibility. For investors, searching for diversification and emerging opportunities, the region presents a great potential.

Israel, through its high-tech, knowledge based economy and entrepreneurial spirit; and Palestine, through the prospect of new infrastructure, economic growth and jobs.

From an institutional investors’ perspective, Kurtzer says there are two stories that emerge in this small area.

“Israel has becomes an economic powerhouse, both in terms of GDP per capita and economic output per capita. It has an advanced technological sector and is the country with the second-highest amount of companies on the Nasdaq.”

The combination of technology and entrepreneurial activity has become a way of life in Israel, he says, pointing out that the army is the single biggest incubator of high-tech growth, including both biotech and information technology development.

“Everyone invests in or knows a family member who is inventing the next Google,” Kurtzer says. “It is an economy that is easy to find investment opportunities.”

Investment in Israel is dominated by foreign money, and is as much as 90 per cent. Foreign investors have played a big role in the development of the economy, Kurtzer says, teaching Israelis business sense.

“Foreign investors have schooled Israel on the business side. Israelis knew how to build the next great widget but they didn’t have the business sense. Foreign investors have had a substantial influence through investment and business know how,” he says. “Israel has taken advantage of its own human resources. Until five years ago it didn’t have any natural resources. The education system and the army were incubators; they knew what to do. It’s the same as exploiting the minerals in the mine.”

Opportunity under occupation

While Palestine has been later to come to the party in terms of economic advancement, Kurtzer sees plenty of potential.

“They have been disadvantaged because they have been living under occupation, but in the past five years we are seeing the same roots taking place in Palestinian society,” he says. “Five years ago I had a conversation with the recently retired prime minster, Salam Fayyad, and I wanted to bring a delegation through. He said we’re not ready. Now it is still a really early stage, but it is enough progressed.”

Both countries have public and private investment markets and strong regulatory environments.

“The Tel Aviv Stock Exchange has strong regulation, the financial management has been terrific. Stanley Fischer comes with a resumé that has brought extraordinary stability and credibility.”

Fischer, the governor of Bank of Israel, is the former chief economist of the World Bank.

Kurtzer acknowledges the impact of the political risk on investments in the region, but says the Israeli technology sector has been resilient.

“On the Israeli side, the political risk is higher than, say, Belgium or the UK, but the system has proved resilient in Palestinian uprising and the Lebanon war. The high-tech sector has followed the global trends to a tee. It is different on the Palestinian side and the impact of political risk is more significant. It is high risk, so you would expect a higher return for that.”

Kurtzer is part of a targeted and intimate expedition to the Middle East, hosted by World Pension Forum and Conexus Financial, publisher of conexust1f.flywheelstaging.com, presenting investors with a unique opportunity to visit the region and meet with political and business leaders.

Bavaria is known as the most independent-minded of Germany’s regions, and the pension fund of Bavarian chemical multinational, Wacker, has shown definite divergence from the norm by shedding its holdings of German government bonds.

It is not just German paper – which has seen yields on 10-year bonds below 2 per cent for more than a year – that the fund has rid itself of. Head of investment, Dr Gunar Lietz, explains that the €1.7-billion ($2.2-billion) Wacker Pensionskasse took the step of divesting its entire European sovereign debt portfolio last autumn.

The aim of this move was to relieve the fund of the risk arising from the abnormalities in European sovereign debt created by the euro crisis. It is the likes of Brasilia, rather than Berlin, whose government debt is now part of Wacker Pensionskasse’s diversified strategy. Lietz explains how the fund has instead turned to emerging market debt and global corporate bonds to help it towards a 4.5 per cent performance target – one that he terms “challenging given the regulation we face”.

This regulation has a hand in ensuring that despite the European sovereign bond exit, fixed income remains the main asset component of the Wacker Pensionskasse. It takes 65 per cent of the portfolio, roughly half of which is invested directly and half via funds. Lietz says a “high level of granularity” ensures a full range of the yield spectrum is incorporated. “We try not to concentrate the portfolio but make sure we have different currencies and rating classes,” he says.

The fund follows indices in its emerging market sovereign portfolio. Lietz explains that these are tailored though to avoid illiquid bonds and certain countries that it would prefer to avoid like Argentina and Venezuela. Its emerging market corporate debt investments, meanwhile, have an Asian tilt.

On the corporate bond side, Lietz recognises a good run might be coming to an end. He says: “We understand that the kind of returns we have had on corporate debt since 2009, even double-digit returns in investment-grade corporates, cannot continue.” Lietz is enthusiastic about his fund’s exposure to US investment grade bonds though, as despite a similar risk profile to Europe longer duration investments and higher yields of 3.5 per cent can still be found in the American debt market, he argues. That marks about the same yield Lietz expects in emerging market debt.

Local foundations

As the fixed income portfolio is currently not expected to fully match the performance target, Lietz explains that the fund’s other asset classes of real estate, listed and private equity “must make the difference.”

Fascinatingly, real estate overshadows equities in taking a larger, 17-per-cent share of Wacker Pensionskasse’s portfolio. Lietz says this is a “historical” feature of the fund, which has retained a strongly performing portfolio of buildings almost entirely in the Munich area. While Lietz says he is aware of the “concentration risk” of this legacy, the stable returns of the “hot” local property market, and a decision by Wacker Pensionskasse to sit back and avoid any buying or selling has seen the real estate portfolio grow strongly. The position has received a further boost recently, adds Lietz, and yields are now rising as Bavarian rental prices have climbed over the past few years. The Munich headquarters of sponsor company Wacker is also part of the fund’s real estate portfolio.

Social lender, lightweight equity

Like several other German pension funds, the Wacker Pensionskasse has a history of granting mortgages to employees of the sponsor. The “resource-intensive” lending, which takes between 1 to 2 per cent of the overall portfolio, is essentially “a social function” says Lietz. As the mortgages are only open to Wacker’s 10,000 or so German employees, it will never grow beyond the edges of the portfolio. Nonetheless it offers a satisfactory yield at a time when Lietz points out that “everyone is talking about real estate debt.”

The Wacker fund’s 10-per-cent equity holdings more or less matches the average for a German pension fund; and it perhaps looks diminutive on an international scale due to the limits local regulation places on “risk assets”. Despite equity markets breaking all-time record highs lately, Lietz is unenthusiastic when asked if the fund could increase its exposure. “You need so many resources to afford to take the volatility of equities,” he argues, “as volatility is your biggest enemy”.

Despite the lightweight equity position, Lietz is pleased that the fund has gained exposure to all capitalisation sizes in its global equity mandates. Lietz says that in both equity and fixed income, the fund “tries to avoid the home bias”. This approach has seen US stock holdings dwarf German holdings and a healthy exposure being made to emerging market equities. Apart from a passive global large-cap mandate, the rest of the equity portfolio is invested actively.

Lietz explains that in addition to the equity bucket, Wacker Pensionskasse also gets some risk exposure from high yield fixed income, from a “significant amount” of convertibles (that bridge equity and bond risk), and a 5-per-cent private equity portfolio.

Seeking alpha in private equity

Lietz confesses to spending most of his time these days on the private equity portfolio. It is an asset class that Wacker Pensionskasse boasts plenty of experience in, having first invested as far back in 1997.

Lietz traces the development of this experience as follows: “We started with fund of funds, and a mix of venture capital and buyout. It then developed into a managed account into different regions and styles.”

As a next step, Lietz says Wacker Pensionskasse is using its experience to bypass fund of funds. It is able to do this as it has gained the confidence to pick suitable underlying funds. It concentrates on three styles – buyout, mezzanine and distressed – and focuses on Europe and the US.

Alpha from private equity is a key to Wacker Pensionskasse thriving in the low yield environment, and Lietz is therefore dedicating himself to improve the performance contribution of last year. Detailed work on cash flow and allocation patterns in the private equity space, as well as benchmarking, consumes a large part of Lietz’s attention.

A 5-per-cent overall return in 2012 and 4.8-per-cent return in 2011 demonstrate Wacker Pensionskasse has been able to consistently perform to its requirements. It is not leaving anything to chance, though, as higher contributions from the sponsor have been needed to match increased longevity risk on the defined benefit plan that closed in 2005. Lietz’s attention to detail will hopefully keep it on target despite the tricky environments of German regulation and globally low yields.

The rise of smart beta has just got another boost thanks to a study commissioned by Norway’s ministry of finance for its Government Pension Fund Global. It asked index provider MSCI to look into the feasibility of running smart beta strategies for large portfolios. Very few institutions with the size of GPFG’s $400-billion equity portfolio have implemented smart beta strategies yet, mostly because of challenges around investability or liquidity. MSCI, which has around $40 billion benchmarked against its various risk premia, or smart beta, indicies, explored the feasibility of investing a hypothetical portfolio of $100 billion and found that large assets can successfully run on these indices without liquidity worries.

Heavy lifting

Smart beta, factor-based investing, customised beta, risk premia, call it what you like, it involves investing in an index tilted towards certain characteristics such as low volatility, size or momentum, and is increasingly popular with investors seeking to outperform traditional indices weighted according to market capitalisation. Smart beta indices do what Roger Urwin, global head of investment content at Towers Watson and advisory director at MSCI, talking during an MSCI webinar Designing Portfolios of Risk Premia: Practical Considerations, described as “heavy lifting.” They offer a passive strategy that falls between bulk beta and alpha, but is cheaper than active management. An estimated $200 billion is already invested in smart beta strategies. Examples include Taiwan’s largest pension fund, the $43-billion Taiwan Labour Pension Fund, allocated $1.5 billion to various MSCI Risk Premia Indices last year. In the United Kingdom, Glasgow-based Strathclyde Pension Fund has also ventured, portioning $824 million of its $16.6-billion portfolio to a fundamental index, rating companies on their economic value as opposed to their size.

Tailored to suit

MSCI developed a set of hypothetical indices for Norway’s GPFG tilted towards value, momentum, small cap and low volatility stocks. The brief from Norway was to measure returns, risk and most importantly investability, using a hypothetical portfolio valued at a quarter of GPFG’s equity portfolio and with a daily trading limit of 10 per cent. “They wanted to know if we could build an investable version of risk premia indices and maintain the return premium for a portfolio of this size,” explains Jennifer Bender, vice president in applied research at MSCI. “We built four indices and the return premium was between 60 and 115 basis points – most of our clients would agree this is a significant premium.”

The past does not guarantee the future, honestly

Investability was the key focus of the study. Unknowns around liquidity and costs hitting net returns for big smart beta investors still abound. A tilt towards systematic risk factors means more trades in a portfolio entailing transaction costs like commission for brokers, explains Bender (pictured right).

Ownership stakes in individual companies and trading volumes in individual stocks can also become large, with trades influencing the price the fund can buy and sell. The study looked at the daily trading limit of stocks and how turnover affects replication costs. “We haven’t answered all the questions yet,” she cautions. “At the end of the day we can’t predict the impact on spreads or prices, which are a big component. We won’t be able to see this until large investors implement these strategies, but we have given some indication of the cost to run this kind of strategy for a large portfolio.”

Nor is there any certainty to MSCI’s findings, she warns. Returns for Norway were based on historical data and simulations. Past performance doesn’t guarantee future results and indices can easily underperform after launch.

Up for the long haul

Like all smart beta indices, the Norwegian test saw periods of weak performance with different indices capturing excess returns at different times. It means investors must sign up for the long haul. “Factor investing requires a strong governance structure with clear investment beliefs and board support to withstand periods of underperformance, while aiming to benefit from the potential premia over a full cycle,” says Bender, adding that varying returns can be mitigated by diversification and pursuing more than one strategy at same time. “Risk premia indices go through underperformance, but by combining them we can smooth out periods of underperformance and limit risk,” she says.

As for GPFG, it isn’t planning to change mandates just yet but the fund says it will act on MSCI’s findings. “The analysis carried out by MSCI suggests that it may be possible to tilt the composition of the equity portfolio of the GPFG towards systematic risk factors to a certain extent,” stated Norway’s ministry of finance. “Investment strategies focused on exploiting systematic risk factors may therefore become important in the Fund.” This could mean GPFG becomes another big investor seeking exposure to risk factors alongside its asset allocation, and so pushing the smart beta trend even further.

Fewer, bigger funds for UK?