For many trustees, fundamental indexing is still too much of a leap to risk any serious asset allocation. But the £11 billion Glasgow-based Strathclyde Pension Fund, one of the largest UK local authority schemes, plans to invest in the strategy.

The idea is to track an equity index that weights companies according to their economic footprint based on fundamentals including earnings, dividends and sales, rather than market capitalisation.

“It is a little bit radical, a bit of a departure,” admits Richard McIndoe, head of pensions at Strathclyde, pension provider for more than 200 Scottish employers from local authorities and service providers to universities and charities.

“We won’t be allocating a huge amount of money but what it should do is avoid over- and undervaluing companies, help with diversification and reduce our volatility.” Strathclyde has a 15-strong long list of asset managers keen to take on the passive £550 million mandate and hopes to decide the final allocation in the second quarter of next year.

The fund is undecided if buying a license to track one of the well-know fundamental indices would be preferable to creating a bespoke index of its own.

Fundamental indexing isn’t the only new strategy Strathclyde plans. The fund, which was established in 1974 by Strathclyde Regional Council, is also preparing to cope with its growing maturity.

“We’ve got 80,000 active members today compared to 90,000 just four years ago,” says McIndoe who joined the fund in 1996, becoming head of pensions in 2003 and like many CEOs of local authority schemes, has an accountancy background.

“We’re seeing a big migration of our members and the reason is fiscal austerity in the UK.”

 

Maturity means protecting funding levels

 

In local authorities’ scramble to save money, many have slashed payrolls and encouraged voluntary retirement. It’s triggering an early shift in maturity for many schemes. Although McIndoe estimates auto-enrolment could add 10,000 new members over time, the maturity trend will continue. It means the fund has to start to prioritise protecting its funding level and cutting out risk ahead of income and returns. “Focusing on total returns isn’t the best way to pay pensions. We’ve got to use the pension fund to pay the pensions. It’s less fun but it is right and proper,” he says. Strathclyde targets total returns of around 6 per cent over the long-term, although different assets classes like private equity tend to generate more, or less, like government bonds.

The growing maturity of the fund will push Strathclyde to reduce its equity exposure over time. Assets are currently split with a 72.5 per cent allocation to global equity, 12.5 per cent to property and a 15 per cent allocation to bonds; the majority of the equity allocation is now passively managed. The fund’s shift from active management began back in 1998 when it portioned a quarter of its equity allocation to passive. It increased this to 35 per cent three years ago and now, in an acceleration of the strategy, has just bumped it up to 42.5 per cent, managed in pooled fund with L&G. “We grew disillusioned with active management,” says McIndoe. “Some active management costs a lot and is worth it like private equity, but active asset management in the broad equity space has not delivered for us. Apart from one of two managers, it was a long series of disappointments.” The premium for quoted active management is between 20-30 basis points but much more for unquoted, he says. Within this passive allocation most of Strathclyde’s exposure to US equities is now passive. McIndoe says the fund has given up on active returns from the US where “very few managers” outperform.

In private equity, Strathclyde aims for an allocation of between 5-15 per cent; it currently has a 9 per cent allocation but plans to increase this since returns here have finally started to pick up, thanks to Asia’s budding equity culture.

Half the bond allocation is in an absolute return fund managed by Pimco; the other half is passively managed and 1 per cent of the total fund sits in UK gilts. The fund still values its liabilities on a gilts basis, but with an equity premium. Within its property allocation the fund has invested 8 per cent in the UK, mostly in central London retail and office space, however it targets a 10 per cent UK allocation. The scheme is underweight because of what McIndoe calls a “difficult market” and getting badly burnt when the UK’s property boom turned to bust. “We were unlucky with tenant insolvencies and highly geared indirect investments.” The fund has since switched managers and DTZ now handle the portfolio. The remaining 2.5 per cent property allocation is in global real-estate in Europe and Asia – particularly Hong Kong and China – and the US. It’s managed by Swiss-based Partners Group. “We tender all our investment contracts; compared to other providers they seemed to cover all the basis,” he says.

 

Innovation and opportunities

 

In another development Strathclyde recently set up a New Opportunities Fund to invest either via private equity or direct lending to UK business. The fund is a product of the financial crisis.

“It’s about finding opportunity in UK banks reluctance to lend to companies and developers,” says McIndoe. So far investment, which includes the government’s Pension Infrastructure Platform, has been funded from cash. “This fund is an amalgam of different things from alternatives to new opportunities and we’ll have to work out where the allocation sits. We’ll have to balance things by reducing one of out other exposures, maybe equity.”

Strathclyde doesn’t manage any assets itself and uses around 12 managers. Half a dozen were axed earlier this year both with the shift to a greater passive equity allocation and a decision to shelve the active currency strategy, which “didn’t disappoint but didn’t merit the effort either.” Hymans Robertson consults on strategy and McIndoe says the scheme would struggle without them. “They are inexpensive compared to other asset mangers and they help add value.” He does see delegated advisory as a step too far however. “We’ve put a lot of work into building our brand and our employers have a sense of security with us. It would be an abandonment of sorts.”

The decline in membership has already forced Strathclyde to draw in its horns. Three years ago the fund had around $100 million in cash to invest – money earned in contributions above and beyond its pension commitments. Next year or maybe even as soon as this year, the fund will be cash flow negative. In another response to its maturity profile the fund will also start to manage investment income. Until now the fund has never needed investment income – around £160 million last year – to pay pensions and managers simply reinvested it back into the pool. Strathclyde’s priorities maybe shifting to counter risk and lock in funding levels to meet its growing pension obligations. Yet its foray into fundamental indexation goes to show it’s still got the capacity to innovative and surprise.

 

 

Since becoming chair of the $80-billion Future Fund in March, David Gonski has set an agenda to act like a public company chair. An element of that vision is to very clearly delegate to management.

“The general manager has been elevated to a managing director and the six-monthly announcements will be his,” he says.

Another part is to clearly provide the board with the information it needs to make good decisions and setting up a committee structure is part of that process.

“A chair is given the role to organise and be a conductor of a board that has to make decisions, give the board information to make decisions, cultivate discussion, and focus on a decision that’s relevant and timely for the organisation… I’ve brought the same thinking as to what I do in a publicly listed company, I think you need a complete committee structure on our board,” he says. “What I inherited was an active audit committee and a board, since then I have established a risk committee, a governance committee, a remuneration and appointments committee, and a conflicts committee. All of these committees are manned and womaned by people from the board. I asked them to get very involved in what they’re doing and they’ve come to it wonderfully. We’re evolving, we started with one man with a vision with a good concept given to him by government and we need to take it from maturity to blossoming. And this is the way I think we need to do it.”

Gonski is speaking from experience. As well as chairing the Future Fund, he is the current chair of Investec Bank Australia, chair of the Sydney Theatre Company and chancellor of the University of New South Wales. He’s also been the chair, board member or adviser for the ASX, Coca Cola Amatil, ING, Consolidated Press, Transfield Holdings, Westfield and John Fairfax, the Australia Council, and the Art Gallery of New South Wales among others.

 

The simple principles of governance

He has some clear views on what makes good governance and what makes a good chair, and it’s pretty simple.

The first thing for the chair is to work out the structure for how the organisation will be governed, he says. Once the structure is in place, then the job is to hire people and in particular designating who the chief executive will be and working out the relationship with that person.

“Then once you’ve worked that out, you need to nurture it and police it. It is quite often difficult to run that role of nurturing and being a policeman at the same time. A chair also has to keep egos in check and make sure it’s the organisation that’s more important than our own ideas and standing,” he says.

Gonski believes the principles of governance are the same no matter what type of organisation, however there are often different stakeholders and that may require some sensitivity.

“You need to deal with them all with dignity and suitable listening to, but you have to manage and operate in a proper way.”

 

Know yourself

Gonski, who at 25 was the youngest ever partner appointed to law firm Freehills, also had his first board position at age 27. In that time he says he’s seen all types of chairing styles.

“I’ve seen influencing and absent chairs, and both in my opinion are wrong,” he says. “You need to be involved as a chair but you also have to pull yourself back, you have to give people some rope because if you don’t they’re too dependent on you. I expect people who work with me and alongside me and underneath me to be contributing, and when they do, they deserve all the accolades; it’s not just my organisation.”

Gonski says a chair should clearly know what his or her role is, which is sometimes difficult, and try to fulfil that role without doing the jobs of others.

They also have to know their strong points and use them.

“The worst chairs are people who try and do a role like someone else did but they don’t have that prowess. All chairs have strengths and you should play on them within the role that’s designated for you,” he says. “All people know how to work through with people, but sometimes our egos get the better of us. What I’ve been able to do is keep my ego in play, I’m just a cog in a very big wheel, I’m just a player in a much bigger group wherever I am – whether a chair of a stakeholder. It doesn’t matter if you get all the kudos, or if your ideas seem to work, but you should relish the team situation, be discrete and trustworthy.”

 

Conflict, diversity and representation

Gonski resigned his position as chair of the ASX to take up as chair of the Future Fund.

While he says there are some very clear cut cases where there would be an obvious advantage to sit on multiple boards – such as sitting on two of the four major trading banks in Australia – for the most part he says perceived conflicts can be dealt with.

“You need to be totally open about it, the biggest problem is to hide it. You should trump it, and say this is what I am and then it’s up to others, including the chair, to work out whether they are happy to live with it,” he says.

“I have had to live with conflicts of interest. My experience is if you’re transparent and there’s a procedure, it often ends up better. I have some doubt that it’s a conflict to sit on multiple boards of super funds. Decision-making is the key, boards can structure themselves to deal with conflict.”

Gonski says he is “absolutely categorically” in favour of a diverse board including gender, age, geography and education.

“The worst boards I’ve been on were where the other people were clones of me. I wasn’t pushed to the mettle, most people agreed with me because we had the same backgrounds and experience. Diversity is very important – it’s not just gender, but gender is very important. To just select only from 48 per cent of population is ridiculous – we have a small enough population as it is, [so] we should select from 100 per cent.”

Gonski supports equal representation on superannuation boards, with a caveat.

He speaks about his experience on the University Council, which had representatives from all over the university including the students.

“The problem is definitely not that it draws people from all over the place; it is good to have diversity. Most important is the question of representation. When you sit on a board, you sit there for the organisation, you need to put aside representation and this is something people find quite hard,” he says.

“If you ask me do I support having people from different walks of life on the table, then I’m in favour. But if they sit as a representative council, then it’s a flawed model. Once you sit there, however you came, you’re there for the organisation. If the chair says it’s confidential, you tell nobody; when you vote, you vote for the benefit of everyone at that organisation.”

 

 

The risk parity approach to portfolio construction might not deliver results in a “bull stockmarket,” but remained a “robust and rigorous” methodology which also “managed risk regret over time.”

These are the views of Wai Lee, chief investment officer of quantitive investment at New York-based fund manager Neuberger Berman, who was recently named winner of the 2012 Peter L Bernstein award for his article “Risk-Based Asset Allocation: A New Answer to An Old Question.” The article also won an award from The Journal of Portfolio Management.

Wai Lee’s article looks at new approaches to portfolio construction, from minimum variation to risk parity to maximum diversification to equal weighting, and follows on from his earlier work on “de-mystifying” risk parity.

Lee told top1000funds that at Neuberger Berman, which has US$203 billion under management, he was increasingly using risk parity to help clients construct their portfolios, but “tailored for clients because one size does not fit all.”

Risk parity portfolios allocate risk rather than capital, with the inevitable consequence of reducing the portfolio’s allocation to equities, and increasing the fixed income component.

“The risk parity portfolio takes equal risk on every position so that is a differentiator with other portfolios,” says Lee.

“In our portfolios, there are two measures of risk, one is volatility and the other is tail risk, so that means that when we construct a portfolio we have a volatility parity and a tail risk parity which combines with that to deliver an ultimate risk measure.”

Lee acknowledges that while risk parity portfolios have proved resilient in the market turbulence since 2008, suggestions that it was an approach best suited to bear markets were “over generalized.”

“We like risk parity because it produces robust portfolios,” he says.

“If you have a great bull market in stocks, and you are in a risk parity portfolio which is not concentrating risk, then it is hard to imagine that a risk parity portfolio will outperform a portfolio which is 100 per cent equities.

“But people who criticize risk parity for that are hindsight buyers who only now realise what a great market we had pre- 2008.”

Lee said he liked the risk parity approach because it took account of risk over time and managed “the risk regret.” Neuberger Berman advocated a three year investment horizon to its clients.

“No investor will say that they are anything but long term, but we don’t believe that anything more than three years is effective, because according to our research after three years the benefits from diversification begin to decline,” he says.

“So we see that if you hold anything beyond three years the additional benefits will be very small, so risk parity requires some dynamic balancing over time, with assets moving in an out of what are often very liquid portfolios.”

Lee acknowledged that risk parity was an effective strategy for investors “with no conviction” on the market direction.

Because risk is allocated equally across asset classes, he sees the approach as “a very good starting point” to investors, who may then change their portfolios as their convictions develop.

“Only when you have a very high conviction on the market direction might you want to deviate from risk parity,” he says.

“But to do that, I always recommend that clients go back to the basic rule, of knowing their universe and understanding their investment goals.”

The €2.3-billion ($3-billion) assets at the Volkswagen charitable foundation in Germany are powered by portfolio theory and diversification.

The foundation is so keen on modern portfolio theory that its founder Harry Markowitz gets a mention in its annual report.

Chief investment officer Dieter Lehmann says he is sure “that his correlation analysis isn’t correct at each point in time, but as an average it is correct.”

The foundation, which despite its name has no affiliation with the modern-day Volkswagen company, being formed from the proceeds of a privatisation of the firm in the 19050s, has tried to implement a wide diversification of its assets to adhere to these principals.

It is most evident in the geographic spread of the foundation’s assets.

A mere 15.3 per cent of its $740-million equity holdings are invested in Germany – a proportion outstripped by its investment in both South East Asian and US equities.

A similar story is true in bonds, with a modest 29.4 per cent of its approximately $1.9-billion debt portfolio tied up in domestic government issues.

Some 57 per cent of its $556-million real estate portfolio is held in German properties – another modest proportion in an asset class where investing at home is usually much less complex.

 

Emerging market interest

The foundation made $211 million from its asset management in 2011 – by all accounts a good return in a turbulent year for investors.

Its penchant for diversification is starting to take it into emerging market bonds, with a recent $91-million allocation to the asset category.

Lehmann says that the foundation’s response to the eurozone crisis has naturally been to gain more foreign currency assets. These have been hiked from a long-term average of between 12 and 19 per cent to above 30 per cent.

Four per cent of total assets are now held in Australian dollar-denominated bonds, with additional Norwegian krone debt also recently acquired.

 

Navigating foundation law

Acquiring foreign-currency holdings is currently a necessary inconvenience for the foundation.

This inconvenience arises from Lehmann’s admission that the foundation prefers to manage assets in house, but all foreign currency holdings are mandated to external managers.

Germany’s foundation regulations, which Lehmann terms “special”, provide strict restrictions on any ‘commercial income’ derived from asset management.

The net result of this is that it is easier, and cheaper in Lehmann’s opinion, to run passive in-house portfolios.

Passive management also suits portfolio theory better, he adds, “so you aren’t investing in assets that will later change and ruin your correlation analysis”.

The Volkswagen Stiftung’s bond holdings are run passively to match certain sub-sets of figures from indices, rather than match any one index – an approach it labels ‘semi-active’.

That allows a tie to indices but creates added flexibility.

The bond holdings are invariably held to maturity due to another important condition in foundation law.

Only ‘ordinary income’ – bond interest, dividends or tenant income – can be used for grant making.

Profits from asset sales, on the other hand, have to go onto the capital sheet. That is not to say these returns are neglected, as maintaining the real value of the foundation’s capital is an important objective.

 

Finding the components

The search for ordinary income has an impact on which asset classes that the Volkswagen Stiftung can use.

Investing in private equity, for instance, carries a risk that regulators might scrap its charitable tax status as this would draw commercial income.

Hedge funds is another thorny asset class for the same reasons.

The foundation asked its local fiscal office in 2005 for permission to invest in hedge funds and private equity, with the foundation having identified their use as boosting diversification.

The fiscal office was sympathetic and it was granted permission to invest a maximum of 10 per cent in alternatives.

Three different fund-of-fund managers could not provide the returns that the foundation was looking for in a hedge fund portfolio, however, and the holdings were scrapped in 2010.

Private equity holdings have been less disappointing but Lehmann says the foundation has no desire to increase the 3.5 per cent stake in this category.

Matching the kind of private equity investments commonplace for US foundations would in anyway be “impossible” for a German foundation in any case, Lehmann says.

 

Property

A definite goal of the foundation is to reallocate the real estate portfolio towards a greater exposure to European office properties.

Given that over 15 per cent of the real estate portfolio is invested in Holland, over 10 per cent in France, and 5 per cent in Belgium, the customary geographic diversification is evident here.

The current real estate portfolio ties in neatly with the foundation’s charitable interests.

Scientific institutions let two of its key office holdings, in both London and Washington.

Likewise, an eye-grabbing investment in a historic palace in the foundation’s home city of Hannover is set to tie the grant making side of the business to the investment income.

Conferences, workshops and summer schools that the foundation sponsors might be held in the conference center of the reconstructed Schloss Herrenhausen.

The palace was destroyed in a 1943 air raid. Lehmann says the Volkswagen Stiftung can bank four per cent annual returns by financing the rebuilding project.

Publicity for the foundation from conference delegates and the public visits to the palace museum is also a way to profit from this unique investment.

Many of the countries with the largest oil reserves also boast the largest sovereign wealth funds (SWFs). And yet African producers, like newcomer Ghana, Angola, and Nigeria which has been pumping oil since the 1950s, haven’t saved much of their oil revenue. Now, in an effort to replicate the long-term growth of funds like Norway’s $600 billion Government Pension Fund accrued from North Sea riches, and the Abu Dhabi Investment Authority with assets somewhere around $900 billion, all of these African countries are in the process of launching their own SWFs.

Many of the countries with the largest oil reserves also boast the largest sovereign wealth funds (SWFs). And yet African producers, like newcomer Ghana, Angola, and Nigeria which has been pumping oil since the 1950s, haven’t saved much of their oil revenue. Now, in an effort to replicate the long-term growth of funds like Norway’s $600 billion Government Pension Fund accrued from North Sea riches, and the Abu Dhabi Investment Authority with assets somewhere around $900 billion, all of these African countries are in the process of launching their own SWFs.

In Nigeria the government has pledged $1 billion in seed funding to a SWF, promising an additional $1 billion a year targeting $6 billion by 2017. Optimistic forecasters say that one day the fund could top $250 billion.

Last month Angola launched Fundo Soberano de Angola (FSDEA) starting with $5 billion in assets, and Ghana is also planning to save a small proportion of its oil earnings. A law passed last year that allows the government to use 70 per cent of oil revenues to fund its budget and save 30 per cent in heritage and stabilisation funds.

Nigeria’s fund is divided into a future generations fund, a stabilisation fund and an infrastructure fund, each representing at least 20 per cent of the total. Former investment banker 42-year old Uche Orji, who worked at JP Morgan, Goldman Sachs and most recently UBS in New York, has been appointed chief executive after a year-long search run by consultancy KPMG.

Offshore and alternatives focus

No decisions have been made on how the fund will invest but like other wealth funds, Nigeria’s is likely to invest offshore to remove liquidity and inflationary pressure from the domestic economy. Investment strategy will likely focus on global fixed income and equity, aping SWF strategies of other oil producers, especially Norway where the current asset allocation is a highly traditional mix of 60 per cent in global shares, about 40 per cent in bonds and a tiny percentage in property. The stabilisation fund will hold more liquid assets.

Some commentators expect an emerging markets bias. Research from consultancy Monitor Group shows the Asia-Pacific region attracted the largest chunk of SWF direct investments in 2010 at $25.2 billion – nearly half of the total.

Nigeria’s central bank governor Lamido Sanusi recently shifted 10 per cent of the country’s $33 billion foreign exchange reserves into remnimbi saying there was “less appetite” for holding dollars. Some predict Nigeria’s fund may also come under pressure to help lift asset prices on the Nigerian Stock Exchange investing in equities as well as federal and state government bonds.

The SWF should resist such pressure,” warns Ayo Salami at London-based alternative asset manager Duet Management.

In line with the growing trend of Africans investing in their own continent, strategy at Africa’s new SWFs could also have an African bias. Algeria and Libya could be models to follow, suggests Sebastian Spio-Garbrah at DaminaAdvisors in New York. Libya’s secretive fund – it scored a transparency rating of two on the SWF Institute’s Linaburg-Maduell Transparency Index – has between $50-$70 billion of assets under management and had stakes in big European firms like UniCredit, Italy’s biggest bank, but was also invested in hotels, banking and telecoms groups across Africa.

Investing at home is a strategy Angola’s SWF has already identified. It says it will invest in a wide range of asset classes, internationally but also in Africa targeting particularly “infrastructure investments and investments in specific industries which are likely to exhibit strong growth in Sub-Saharan Africa.”

Here the emphasis will be on sectors like Angola’s undersupplied hotel market. Executives at the Angolan fund also stress they are hunting social and financial returns, backing national strategies for growth that make it more sovereign development fund than pure SWF.

“We are committed to promoting social and economic development, investing in projects that create opportunities that will positively impact the lives of all Angolans today and to generate wealth for future generations,” says José Filomeno de Sousa dos Santos, an executive on the fund’s board.

Nigerians believe their fund may also have ambitious alternative allocations. In an investment model already proven by the African Finance Corporation (AFC), a Lagos-based development financier set up in 2007, Nigeria’s SWF may prioritise infrastructure and resource plays.

“The Central Bank of Nigeria provided the Africa Finance Corporation with $1 billion to invest back in 2007. The current set up at the SWF reminds me more of the AFC than a typical SWF,” says Samir Gadio, emerging market strategist at Standard Bank. AFC strategies have included undersea cables linking Europe and West Africa, South African technology groups and Ghana’s Jubilee oil field.

 

Inhouse strategy, outsourced investment management

It’s thought that Nigeria’s fund will run investment strategy in-house but use foreign managers.

“Expect the usual suspect – the big guys in New York – UBS, Goldmans, Mellon,” said Bismark Rewane, chief executive of Lagos-based Financial Derivatives Group.

One hope is that new sovereign funds will encourage Africa’s own asset management industry too. Opportunity to manage the money may be used as a carrot to draw more of the big investment banks to the region.

“I don’t think there are enough Nigerian managers to offer the fund sufficient opportunities to invest with Nigerian managers,” says Salami adding: “although the pressure to allocate the majority of funds to Nigerian managers will be substantial.”

For all the fanfare, Nigeria’s SWF has had a challenging start that doesn’t bode well for the future. Nigeria’s 36 powerful state governors, who under the country’s federal system receive a share of national oil revenue, have hindered progress since money portioned to the SWF means less for their states. For now they have insisted the SWF be managed separately from Nigeria’s other oil savings, the $9.6 billion Excess Crude Account, although the idea is that these funds are ultimately pooled.

“There is a big argument between the federal government and the governors,” says Gary van Staden at NKC Independent Economists in South Africa. “They want to know how they get their share of the pot if it all goes into the SWF and they won’t decide investment strategy until this is sorted out.”

The danger is that the waters will get muddier ahead of the next election in three years time. “The governors will say what they want and there will be a political trade-off somewhere, but as we get closer to the election the trade-off will become more in their favour,” warns Rewane.

It is still early days at Africa’s new SWF. But while developed economies battle sovereign debt Africa is planning how to manage its sovereign wealth.

“There is finally a fundamental change afoot in how these countries manage their oil wealth,” says van Staden.

African sovereign wealth funds

Source: SWF Institute

From a risk management perspective, tail risks and return distribution asymmetries of investments are important to analyse. Norges Bank Investment Management (NBIM) in this note describes a modelling approach that addresses some of the weaknesses of standard risk models.

It uses the model internally as a complement to standard models to evaluate tail risk in foreign-exchange (FX) positions. Examples of tail events for FX positions could be single-currency devaluations or more widespread flight-to-quality/carry-trade-unwind episodes.

To access the reseach click below

Modelling the implied tail risk of foreign exchange positions