You would expect one of the biggest names in global finance to have a sophisticated pension fund, and on that measure the €7-billion ($9.2-billion) contractual trust arrangement (CTA) for Deutsche Bank’s German employees does not disappoint in the slightest. It has carefully engineered a diversified bond-led liability-driven investment (LDI) strategy that is supported by a vast overlay portfolio.

Having a managing director of a firm that has a massive $1.22 trillion under management at the helm has to be a distinct advantage too. Georg Schuh, managing director of Deutsche Asset and Wealth Management and chief investment officer of the CTA, says that since his first involvement with the fund in 2002, “We have seen a continuous transformation from an absolute return to LDI strategy”. The fund currently has an 85-per-cent fixed income weighting, some 10 per cent in equities and alternatives and a 5-per-cent cash pile. Schuh explains the bond dominance by pointing out that in a pure implementation of LDI, “You theoretically only need bonds and some inflation hedging”.

Schuh characterises the CTA’s fixed income portfolio of consisting of “a broad range of spread products”. The focal point is long-duration European investment grade bonds, but the fund has recently looked away from its home continent to make US investment-grade credit close to 11 per cent of the fund – in addition to also taking a small 2.8-per-cent position on US high yield.

Fascinatingly, the fund has a lower allocation to developed world sovereign debt – 6.3 per cent – than it has to emerging market sovereigns at 10 per cent. This marks a distinct transformation from a position several years ago of European sovereign debt being the dominant asset in the fund. Schuh explains that using a unique new benchmark has facilitated this radical change – the fund now measures its investments against a benchmark that incorporates its own inflation measure (a deduction of the break-even rate from inflation swaps), AA long-duration corporate bonds and 13-year-modified interest rates.

 Emerging market enthusiasm

In explaining the fund’s enthusiasm for emerging market, Schuh (pictured right) says “all spread products are in demand due to the environment of quantitative easing and the hunt for yield, but we think the situation is a little more stretched in the high yield and corporate credit space than emerging markets”. Because of its more attractive liquidity, Latin America is the most significant destination for the Deutsche Bank fund’s emerging market debt investments, followed by Eastern Europe.

The fund has exposure to emerging markets in its smaller equity holdings despite not having a strategic emerging equity allocation. It instead aims to access emerging markets across its three “very actively managed” equity mandates, with Asian, German and European small- and mid-cap focuses. “We prefer an Asian mandate to a pure emerging market focus, partially because we are more cautious on Latin American emerging market equities,” Schuh says.

Generally positive on equities

With Frankfurt’s DAX index reaching an all-time record high on the day Schuh spoke, he says he is “generally positive” on equities within the tight constraints of the fund’s risk budget – which allows a maximum of 15 per cent to be invested in equities and alternatives.

Schuh says he is confident the equity rally can continue until Germany’s federal election this September. He grounds that view on the belief that “the tail risk of the eurozone crisis is not imminent in the coming months, while the increased quantitative easing and recent ECB rate cut all support the idea of liquidity driving risky assets.”SCHUH_Georg_EDM

Which begs the question, can an LDI-focused strategy thrive in a low interest rate era?

“For the next quarter I would say yes, and until the middle or end of 2014 we do not see an exit strategy being implement by central banks. With the strategic long-term horizon of a pension investor, I think the time will come in the next few years though to radically rethink the concept of liability matching,” Schuh says.

“We are lucky that the central banks are giving us some certainty for a while, but perhaps the first exit of this QE strategy could be in the US and then things could get ugly,” Schuh argues. Schuh confides that should a sudden spike of yields become a major risk, he would consider asking the fund’s sponsor to increase the risk budget.

Alternatives hard to justify

The fund has 2.7 per cent invested across an alternatives portfolio consisting of real estate, commodities and hedge fund investments. Alternative investments have been hard to justify, says Schuh, due to their low correlation with the CTA’s unique benchmark. While the fund is looking to increase its real estate holdings, he says “you have to be very picky” in European markets, adding that “my 20 years’ experience has taught me that it is very tough with commodities to earn money in an absolute way, or fulfill the kind of diversification or LDI that we aim for”.

Alternatives is the only area where the Deutsche Bank CTA uses an external manager, with the rest of the fund tapping the expertise of Deutsche Bank’s own legion of asset managers. The entire fund is invested actively.

The fund completes its strong LDI approach with equity hedging, a tactical asset allocation overlay and a desire to get foreign currency risk “as close to zero as possible”. Separate overlays covering CDS, inflation and inflation-linkage currently total around $13.2 billion.

Deutsche double happiness

With the CTA not being a catchall pension fund for Deutsche Bank’s pension liabilities, it has no direct funding ratio. The CTA is investing currently to a discount rate of around 3.5 per cent, revised on a monthly basis. Schuh says Deutsche Bank Group’s total global pension liabilities of $19.3 billion are 98-per-cent funded, indicating that its intricate LDI approach is doing the job for now. He is confident that the fund can continue to benefit twice from the full range of financial skill at Deutsche Bank – by a sophisticated investment approach that keeps the fund healthily in line with liabilities and by the added support of a successful sponsor.

 

There are two things that drive the newly appointed global chief operating officer of State Street Global Advisors, Greg Ehret, in his bid to improve the client experience: the retirement business is a cause worth working on and the clients are the reason the business exists.

Ehret was appointed to the new position at SSgA, which manages $2.2 trillion, in September 2012, and as COO he is responsible for delivery to clients, which means operations, technology, client relationships, sales and marketing all report to him. It’s basically everything except investments, and there are 440 investment professionals, and 2350 employees in SSgA, so it’s no small task. He and the chief investment officer, Rick Lacaile, report to chief executive, Scott Powers, and interestingly both are based in London despite the firm’s strong Boston heritage.

He believes in what he is selling

Ehret is a State Street man, he believes in what he is selling and says that all evidence he can see points to the fact the manager is the best in the world at passive management.

But he’s not an index tragic. He believes in innovation and business evolution because he is driven by solving clients’ problems.

“Our goal is to be relevant to our clients. Passive is a core strength of SSgA, we are the best indexers in the world. But our goal is to be relevant in facing off clients’ problems, and those problems have changed, so the solution can be indexed, or alternative beta, or active strategies,” he says.

“Many pension funds are under water and there is a real need for alpha and to use efficient sources of beta. ‘Core and explore’ is a key tenet of ours and while I think the secular trend to passive is a long-term core trend, we offer tools to get alpha and efficiently deliver the core.”

Ehret looks at three core concepts – interest rates, returns and risk – and how the needs of clients have changed as those three issues shift.

Driving client solutions

Meeting those changing needs then drives client solutions and product innovation.

One such example is the recent launch of senior debt exchange traded funds developed by SSgA and GSO Capital Partners, the global credit business of The Blackstone Group.

“Rates will be back up eventually; it’s not sustainable for them to be so low or negative,” he says. “The challenge is looking for income now, but in the future we will diversify away from interest rates.”

He says liquid alternatives will become more important in the product-suite offering and points to the hedge fund manager, SSARIS, which is a State Street Global Alliance company, the joint initiative with APG.

“In their multi-strategy and single strategy they have developed strategies that are divergent trades, they go long volatility. In their investment discipline, they are consistently diversified with long volatility and, over the long term, they have lower risk and higher return,” he says. “Volatility is so much more important to clients. We are working on a number of different strategies in alternatives, and liquid alternatives will become more important to us. There is great talent available, so we can do it organically.”

Business savvy

Ehret is a 20-year veteran of SSgA, holding a number of executive positions in operations, sales and product development, including as co-head of the firm’s industry-leading SPDR exchange traded fund business.

While SSgA is fundamentally an institutional investment manager, Ehret says his background means he looks at things differently.

“It’s a roundabout way of getting here, and it’s given me a different view,” he says. “I started in intermediary, not institutional, and the intermediary business is becoming more important to the business. Our initial foray was in ETFs and now the intermediary is asking what else we can do for them, whether it be advice, product differentiation or delivering an outcome to customers. It shows how the firm has changed.”

Service has to be impeccable

Ehret’s goal when he started as global COO was to “improve the client experience”, and first and foremost in that mission is to have a relationship between the client that is spotless.

A new initiative to help benchmark that is the introduction of a new process in which clients are surveyed when they are new and “onboarded”.

Ehret is also emphasising the power of communication and the delivery of good direct, transparent communication about the firm and the portfolio.

“It has to be good communication, up to date and on time. We have to get in the client’s shoes and remember that delivering a report is not the end of it, rather making sure everyone in our value chain understands the impact on the client. By the way that’s why we’re here,” he says. “Service has to be impeccable, integrity is really important.”

Ehret says that asset managers are partners of their clients, and are frequently asked to do a lot of value added in the investments solutions team.

This includes such things as total portfolio analysis, or liability hedging analysis, or the appropriate use of leverage or derivatives.

SSgA also participates in some unique conversations such as with the chief financial officers of listed corporations to talk about their stock so they can get the opinion of the buy side.

State Street also recently launched Global Exchange, which provides data and analytic solutions.

“We’re in the retirement business; it’s a cause worth working on,” says Ehret.

The United Kingdom’s Co-operative Group, a chain of food, funeral and financial services outlets, markets itself on a popular loyalty scheme whereby customers earn points that are converted into a profit share, or dividend, directly linked to the group’s annual profits. It’s a founding philosophy that can trace its roots back a hundred years and goes a long way towards explaining the Co-op’s longevity on the UK high street. It attributes a similar loyalty among its customer-base workforce to key perks like a defined benefit pension scheme, still open to staff after a two-year qualifying period.

Strategy at the £7-billion ($10.65-billion) pension fund, which provides for 12,000-odd active members and 40,000 deferred, is focused on improving funding levels with an interest rate and inflation hedging strategy. Assets at the fund are currently portioned equally between growth and liability matching strategies, but if funding levels, which are regularly monitored, improve, the scheme plans to tilt its portfolio towards a bigger matching allocation in the coming months. “If the funding level is better, we will use the opportunity to adjust this 50/50 allocation and push towards more liability matching assets, taking more risk off the table,” says Mike Thorpe, pensions finance and risk controller at the scheme.

Equally split

The decision to split the scheme equally between growth and matching assets dates from 2006 and targets 100-per-cent funding by 2026. The scheme is currently 77-per-cent funded on a self-sufficiency basis. “This, of course, is open to review over time, but you need an objective to have a strategy and I would say there is a reasonable likelihood of meeting this target,” says Thorpe, a chartered accountant by trade who joined the pension scheme in 2007 from the insurance industry. It’s a funding position that has gradually improved thanks to returns over the last three years of 10.3 per cent, against a benchmark of 8.7 per cent, and over the last year of 7.4 per cent, against a benchmark of 5.2 per cent, with the liability matching side of the portfolio doing “particularly well.”

Hedge protection

In an interest rate and inflation hedging strategy, the liability matching portion is split between bonds (20 per cent) and liability-driven investment (30 per cent) that together hedges 58 per cent of the interest rate risk and 72 per cent of the inflation risk with plans to increase this to between 75 and 77 per cent. “It’s a program of hedging that has protected us very well,” he enthuses. “From the last triennial valuation in 2010 we can see that if we hadn’t had that inflation and interest rate hedge in place, we would have been 16-per-cent worse funded on a self-sufficiency basis.”

The scheme hedges risk with index-linked and fixed interest gilts (although Thorpe says he is wary of locking in the current low returns from gilts) index-linked corporate bonds and a range of derivatives (interest and inflation swaps, gilt repos and total return swaps). “Compared to other asset classes, like active equities, the LDI portfolio is not expensive but it is complex,” he says, adding that he has found the big US endowments a surprising source of inspiration for the Co-op’s own strategy through their aggressive growth allocations. “They don’t have our liabilities, so invest in a different way, but their growth portfolios are interesting to watch,” he says. A case in point, he explains, is the Co-op’s allocation to GSO Capital Partners high-yield debt fund made at the end of 2011, targeting the full range of sub-investment grade credit. The allocation sits within the 20-per-cent bond allocation in the liability matching side of the scheme’s portfolio to help ensure that part of the portfolio meets its return expectation. “The fund has done well since the investment was made, comfortably beating its target,” he says.

Growth side

The 50-per-cent growth side of the portfolio, which targets returns of LIBOR plus 4, includes a 30-pe-cent equity allocation. It is split between eight different managers with investments in the UK (5.5 per cent), US (7.5 per cent) Europe excluding the UK (7.5 per cent) Japan (2.5 per cent) Asia excluding Japan (2.5 per cent) and emerging markets (4.5 per cent). The emerging market allocation is divided between a dedicated emerging market manager and a global equity manager. The scheme’s global passive manager also has a “tiny” emerging market allocation. Only 10 per cent of the equity allocation is run on passive mandates and this is skewed towards markets in the US and Europe. The reason for the small passive allocation is owed to one of its active mandates actually being “very low risk,” managed by the Co-operative Group’s own Co-op Asset Management. “We didn’t want to over-allocate to the passive equity,” he says, adding: “The trustees believe in active equity management, but keeping an allocation to passive diversifies the equity portfolio. Active management continues to add returns over the higher fees.” Elsewhere in the growth portfolio the scheme has a 5-per-cent property allocation, directly invested in UK property assets spanning retail, commercial and industrial properties. Here the goal is to outperform the IPD UK Monthly Property Index by 1 per cent.

The remaining 15-per-cent growth allocation is portioned to alternatives, steadily built up over recent years. Two per cent of this allocation is with manager Fortress in a multi-strategy fund of funds. The remaining 13 per cent is managed and implemented by Mercer in a bespoke, Qualifying Investor Fund, with investments in an array of alternatives spanning currency, insurance-linked bonds, private equity, tail risk and private debt placed with around 45 different managers. The fund targets returns of LIBOR plus 4 and volatility of 10 per cent per annum. “The idea is to achieve a correlation with equities of 0.3 per cent; we’re after equity-like returns but diversified,” he says. The strategy was born out of the scheme’s desire to tap into alternatives, but without the risk of going it alone. “Because of the wide and complex nature of alternative assets, we came to the conclusion we’d be more comfortable with a specialist team to manage the allocation,” says Thorpe adding that the strategy, begun in 2006, has demanded patience but is now close to paying off. “We’ve spent three years building it up; we’ve put in around $12.2 million in three different tranches. We’ve not hit the target of LIBOR plus 4 yet – it’s all about building up the J-curve with returns coming through in later years. So far we’ve done about 2.5 per cent per annum. Last year was 6.1 per cent so we’re satisfied with progress,” he reassures.

Strict ethics

Environmental, social and governance factors are increasingly prevalent in the fund given the Co-op’s own strong ethical brand. “They want the pension fund to reflect this,” says Thorpe. The scheme hasn’t adopted ESG mandates with specialist managers or “made investment decisions on specific ESG factors” but it does ask its managers “to take account” of ESG factors “and report back to them on how they are doing this.” More boldly however, in a strategy also present among some Scandinavian schemes, it doesn’t hold any allocation to emerging market debt on ESG grounds. “The Co-operative Bank has a strict ethical policy not to do business with countries with questionable human rights records and this is now reflected in the pension scheme. We don’t explicitly allocate to emerging market debt due to ethical concerns and the potential reputational risk for the sponsor.”

There continues to be potential for pension capital appearing where bank lending no longer wants to go. Commentators in the UK and continental Europe have heightened expectations that pension funds will step in to help fill the continent’s bank financing gap. Societe Generale, for instance, recently predicted further “disintermediation” by investors sidestepping banks and looking for greater seniority than bond holding. Over in the US, the news that average yields on high-yield debt have fallen below 5 per cent for the first time, according to the Barclays US High Yield Index, could also give added impetus to funds exploring the higher reaches of the capital structure.

The consultant call

David Bennett, head of investment consulting at Redington, says his consultancy is advocating moves into direct lending investments in the majority of its asset allocation reviews for institutional clients. He argues that the relative value appears quite strong: “The general trend in credit spreads has been considerable tightening, and there are not as many opportunities any more in high-yield or investment grade debt to make the returns that funds need.”

Bennett is confident that the area of direct lending will progress from its relatively exotic status to something more mainstream in time. “Provided a fund has capacity for investments in illiquid assets, there seems to be considerable interest as the asset class offers exceptionally attractive risk-adjusted returns,” he reckons.

Bennett says the European direct lending market is much less developed than that of the US despite the greater need for post-crisis refinancing. Relatively unattractive pricing is a major barrier in Bennett’s view. He expects the pricing to become more attractive though, as European borrowers seek out non-bank funding in response to the challenging environment they face when refinancing the so-called “maturity wall”.

 The fund angle

Investors have also raised uncertainty over the structuring of direct lending investments as a stumbling block. Steven Daniels, chief investment officer of the $10-billion Tesco scheme’s inhouse investment arm, told this year’s UK NAPF Investment Conference that pension funds are “potentially good banks, but we are not mugs”, pointing out that it would scrutinise any investments in the area. In a similar vein, Niels Jensen, investment director of the $11.8-billion Lægernes Pensionskasse in Denmark, recently told top1000funds.com that checking that “the spreads are attractive enough” is a vital consideration to the interest his fund has gained in the credit opportunities space after seeing bank credit squeezed.

Brett Cornwell of Callan Associates adds that fees remain a sticking point for many US funds, with a “hedge-fund style” fee structure of 1.5 to 2 per cent in management fees, plus additional performance fees the norm. “Five-year-plus lock-ups are part and parcel of the illiquidity downside,” Cornwell adds.

Cornwell accepts the return advantages can outweigh these concerns in many cases. Andrew Bratt of the Pension Consulting Alliance in California, while also accepting the advantages of direct lending, believes some of the slow take-up among pension funds can be explained by difficulties in “finding the proper portfolio segment for this type of investment”.

Bratt argues that direct lending is “not liquid compared with traditional fixed income and it does not present the opportunity for private equity returns. I see this as a problem for many pension funds, save for those who specifically allocate to this type of product.”

Larger public pension funds are proving thus far to be the most common US direct lending investors, adds Cornwell. He characterises the typical fund exploring the asset class as “having healthy fixed income investments already, and liquidity in other parts of the portfolio, seeking yield, generally being more sophisticated with alternatives, active in private equity and having larger staffs to vet managers.”

The $9.9-billion Orange County Employees Retirement System and $8.4-billion San Diego County Employees Retirement Association are two US funds recently reported to be exploring the direct lending option.

Lending in all shapes and sizes

The most accessible way for funds to benefit from banks’ limits appears to be through direct lending funds. Plenty of skilled providers are competing in this area, Bennett says, despite significant challenges in checking credit worthiness, structuring loans and providing sufficient governance. The likes of M&G Investments’ UK corporate financing fund have been the most notable recent European offerings for their linking of pension funds with small and medium enterprises.

Some of Europe’s biggest investors have gone for something seemingly more ambitious though – making their own infrastructure loans or snapping up debt from banks’ hands. Dutch fund manager APG made an inflation-linked loan in a €80 million ($105 million) road-financing deal last October, a uniquely valuable investment in a country whose government does not issue inflation-linked bonds.

Bennett recognises that infrastructure loans are more of a specialist niche for large investors, saying, “You really need a manager with a specialist hat on”. A great attraction of infrastructure loans, argues Stefan Lundbergh, head of innovation at Cardano and board member of the $35-billion Swedish fund AP4, are their inflation-linking properties – especially if done in partnership with a government.

Lundbergh cautions that funds wanting to take the direct route on infrastructure loans must recognise the level of expertise needed – underwriting loans being far from a simple exercise. His reckons these complexities can limit the number of opportunities, saying “all the legal work, paperwork and negotiations to get the loan in place are worth it for big-ticket investments, but this becomes more difficult for smaller ones”. Liquidity and valuation difficulties will also be acquired when the loans enter the portfolio, but there is no reason why talented medium-sized funds should not be able to rise to this challenge though, he adds.

PensionDanmark also made waves last year by acquiring $350 million in infrastructure loans from the Bank of Ireland as part of a $750-million secondary loan mandate with JP Morgan. Secondary loans also require a “very different” skill set, says Bennett.

New equilibrium?

While Bennett believes “one day it’s possible that long-dated institutional investors can take a significant proportion of the corporate lending market”, Lundbergh reckons that competition issues will prevent pension funds from making too many inroads into traditional banking territory. Pension funds’ tax-free status in the Netherlands derives from their status as passive investors, which could be compromised by directly underwriting loans, he says. He adds that despite some expectation that pension funds could cover for retrenching investment banks,“I would expect more in the way of partnerships with underwriters”.

Cornwell argues that while externally managed direct lending remains an exotic option, “comfort levels” are definitely increasing. “Ten years ago, high yield was more exotic than nowadays. As you become more comfortable with the capital structure of these corporations and how the lending mechanism works, it opens up space in the marketplace for those able and willing to loan,” he says

As professional investors, any expectations that pension funds can fill in the worst gaps in European lending might be over-ambitious though. Projects in countries saddled with government debt worries might after all only find pension capital offered at rates as unappealing as those offered by the continent’s cautious banks, says Lundbergh.

Then there is the question of how long the window of opportunity will stay open for, as in healthy times banks generally have no trouble lending money. Longer dated infrastructure loans could prove to be the most durable of the current bout of lending from funds, Bennett says. While banks can be expected to eventually expand balance sheets again, instead of simply muscling pension funds out of the direct lending space, a “new equilibrium” could emerge, he argues. The edge institutional investors can gain over banks in long-maturity lending is one Bennett expects them to keep beyond then.

 

An investment-beliefs workshop for the CalPERS board, held in April, revealed five areas, including active management, where the views of the board and staff lacked consensus.

The contentious, or unsettled, topics for discussion were active management, private asset classes, sustainability (environmental, social and governance), investment performance targets and stakeholder considerations.

At the board workshop, Janine Guillot, chief operating investment officer, presented the findings of work the CalPERS investment staff had already completed on distinguishing their own beliefs. This included the summation of 85 detailed questions to the chief investment officer, Joe Dear, his direct reports, the chief actuary, Alan Milligan, and the senior portfolio manager and director for global governance, Anne Simpson.

The process also asked those staff to construct a sample portfolio and how that connected back to the investment beliefs.

Dynamic but doubting ability

The results of the staff questionnaire revealed a support for dynamic asset allocation as a value-added activity, but mixed views on the ability of the staff to carry it out.

With regard to active management, the CalPERS investment staff also had strong consensus to use index strategies where market efficiencies were the greatest, such as public equities, but not fixed income, and there was strong support for alternative indices or alternative beta.

There was also scepticism about the staff’s own ability to select managers that could add value, emphasising that what mattered most was the overall portfolio rather than individual manager performance.

As part of the active management discussion, staff had low conviction that hedge funds should be an important part of CalPERS’ strategy, but despite that most of the staff surveyed still allocated to hedge funds in their model portfolio exercise, albeit a smaller allocation, around 1 to 2 per cent.

Following the board member questionnaire and roundtable consultation, feedback from board member Richard Costigan supported the staff’s skill levels, and was at odds with the staff’s view of their own ability.

“The board members commend staff because we think you can achieve alpha, but the staff says it is difficult to get alpha.”

Strategic bases covered

The aim of the workshop was to draw up a preliminary set of beliefs to discuss at the board’s July offsite, with the goal of adopting investment beliefs at the September investment committee meeting.

The idea is that the investment beliefs provide a strategic basis for the management of the portfolio, a framework for assessing new investment strategies and avoid making changes on an ad-hoc basis, and ensure that alignment between board and staff becomes part of the culture.

The project kicked off in January and has been guided by head of investment content at Towers Watson, Roger Urwin.

Urwin says setting investment beliefs is a feature of big asset owners wanting to sort out their investment process.

They are the “softer” issues that provide the foundation on which to build the portfolio.

Guided by Urwin, staff and the board at CalPERS undertook a detailed questionnaire, which revealed the areas of consensus and those that were contentious.

“We need to understand what we are achieving here,” Urwin said to the board. “And I like to quote JFK: ‘Belief in myths allows the comfort of opinion without the discomfort of thought.’ The investment world has a lot of myths, and we want to talk about them.”

Guillot also emphasised that the investment beliefs don’t exist in isolation.

“We don’t want them to be parked on a shelf and not influence anything,” she says. “We want them to drive the strategic asset allocation to be done in November/December.”

Workers’ models

With regard to the staff’s model portfolios, the strongest consensus was about the role of real estate, with most staff maintaining or increasing the allocation.

“There was an alignment of ideas that the characteristics of real estate deliver something valuable to the fund, cash flows and inflation hedging,” Guillot says, adding there was some concern about the cost of real estate.

Private equity attracted mixed views on whether the returns were sufficient for the illiquidity and complexity of the investments. However, overall the staff would still allocate a significant proportion of assets to private equity, reducing it a little from the current 14 per cent to 7 to 10 per cent due to the concern about deploying that much capital.

There was also concern around infrastructure, Guillot says, and while the staff could see the virtues of the asset class’ characteristics, there was concern about the ability to execute and deliver on infrastructure deals to “move the dial on the fund”.

The staff had strong support for corporate governance and engagement, but there was weaker consensus on environmental and social themes.

Various world views

CalPERS is hosting a sustainability and finance symposium on June 7, with its partner University of California Davis Graduate School of Management, which will be followed by a board workshop on sustainability.

With regard to the investment performance targets, staff say their aim is to deliver a target rate of return and then improve the funding status.

The bigger deliberation was whether there could be alignment of interest between the fund, external managers and staff.

“We tend to measure on relative returns and how that fits in with a total return target, and there were concerns about the time horizon and how to make that work with incentive plans,” Guillot says.

There was also a staff belief that the investment program should be simplified, but there was a difference in how to achieve that.

In addition to the questionnaire put to Dear’s direct reports, the INVO+3 staff was interviewed, which comprises more than 90 people. The issues discussed were the long-term time horizon, active management and alignment of interest.

“The most interesting thing that came out of that,” Guillot says, “is strong feedback that we are saying we are a long-term investor but we don’t act like it, with short-term performance reporting and incentives.”

The most interesting differences in the staff sample portfolios were in the amount of equities or growth risk.

The samples were almost split down the middle, with one camp maintaining or increasing equities and the other would reduce it.

“When asked why they had that approach to equities allocations, both started with the underfunded question but had different world views on how to improve the funded status.”

Nine consensual themes

These investment belief themes had strong consensus among CalPERS board and staff:

  1. Liabilities inform the asset structure.
  2. Strategic asset allocation is the dominant determinant of return and risk.
  3. An expectation of return premium is required to take on risk.
  4. A long-term investment horizon is an advantage.
  5. The market is not perfectly efficient, but inefficiencies are difficult to exploit after costs.
  6. An appropriate premium is required for illiquidity risk.
  7. Cost matters more than most investors think.
  8. Risk is often expressed as volatility or tracking error, but neither measure captures the essence of risk to CalPERS.
  9. CalPERS needs effective teamwork and governance.

 

Pension funds and social housing: it looks like a perfect match as schemes in the United Kingdom seek long-term, index-linked cash flows and housing associations, the not-for-profit providers of this type of affordable housing for low income households, hunt the long-term finance they can’t access via banks. Broad residential housing represents just 1 per cent of UK institutional fund investment compared to 47 per cent in the Netherlands, 15 per cent in France and 13 per cent in Germany. In America, New York City’s five public sector pension funds with combined assets of $128 billion have just upped their existing 2 per cent allocation to the asset class, voting to invest $500 million in residential rebuilding efforts in the wake of hurricane Sandy. Decades of chronic underinvestment have left the UK’s social housing sector in a tailspin similar to the havoc wreaked by Sandy. Now pension funds, scrambling for an alternative to gilts, could ride to the rescue.

Early adopters and their strategies

Local authority schemes have been among the first to dip their toes and are presumed likely trailblazers given any investment’s local impact. The small, £800-million ($1.2-billion) London borough of Islington has invested $31 million with Hearthstone Investments residential property fund. “Our decision reflects our view that investment in this sector will produce good long-term returns for local taxpayers and the members of our pension fund,” says Councillor Richard Greening. Elsewhere, the $16.2-billion Greater Manchester Pension Fund has invested in the construction of 240 new homes in the Manchester area.

Strategies include investing in long-dated index-linked debt where the housing association issues debt secured against its property portfolio – schemes buy the debt either directly or through a pooled vehicle. Another route is to set up partnerships directly with housing associations, while sale and leaseback offers a third strategy. Here, schemes invest in funds that buy existing homes from an association, which then leases them back over a 30-to-50-year period. Social housing bonds typically return between 1.5 per cent to 2.5 per cent above inflation-linked gilts, with higher returns for riskier investments via development partnerships, and sale and leaseback agreements.

Prudential-owned M&G has just finalised a $194-million sale and lease-back deal with a London housing association. “This is a high quality investment with a 35-year retail price index-linked lease that will help us to deliver inflation-linked returns, with good security, to our pension fund clients for a generation,” says M&G’s Ben Jones. “There is significant demand from pension funds for investment into housing and social infrastructure provided it is delivered on a transparent basis and directly assists with their desire for long-term inflation-linked cash flows to match their liabilities.” M&G’s $2.1-billion Secured Property Income Fund has invested in 32 UK assets delivering an annualised return of 7 per cent over inflation in the last three years.

Social benefit versus returns

Protagonists reassure lending to social housing is a safe bet despite its exposure to the moribund UK property market. One thousand seven hundred housing associations provide social housing across the nation but only two have ever run into financial trouble. Moody’s rate the 26 biggest between AA2 and A1 thanks to housing stock acting as collateral and implicit government guarantees. The majority of associations’ rental income comes from local government, with robust rent collection rates, and demand outstrips supply with around 2.5 million households currently living in social housing but another 2 million on waiting lists with housing associations needing to borrow around $23 million to fund planned regeneration and maintenance projects between now and 2015.

Yet changing UK pension funds lukewarm enthusiasm for urban revitalisation could be challenging. A discussion hosted at NAPF’s annual investment conference last February revealed schemes’ enduring worry that investing for public purpose impacts fiduciary duty, sacrificing returns for social good. “The real returns are there but they aren’t as big as we are looking for,” argued Clare Scott, investment manager at the Edinburgh-based $5.4-billion Lothian Pension Fund, which considering the asset class but yet to invest. It’s a sentiment endorsed by a Smiths Institute survey of 100 local authority pension funds that found none would be prepared to accept lower returns in exchange for social benefit.

Complicated risk

Lothian’s Scott says counterparty risk is also an issue – housing associations aren’t risk free. “There has never been a default but that doesn’t mean it’s not going to happen,” she warns. Security around rental income, she says, is also a factor in Scotland, where housing associations don’t own all the housing stock.

Change in government policy is another risk. Since 2005 the government set rent increases for housing associations at retail price index plus 0.5 per cent, linking rental streams to inflation. “Any disconnect between what is collected in rents and what is paid to investors would be a risk,” admits NAPF speaker Phil Ellis, client portfolio director at Aviva Investors, which offers a sale-and-lease-back model with yields of 2.5 per cent. Policy around welfare is already a source of concern since housing associations in the 18 local authority schemes that have piloted new welfare proposals have been reporting arrears in rent payments. “Not all social housing tenants are on welfare benefits, but we believe welfare reform will increase the risk of non-payment,” says Scott, adding, “You have to consider reputational risk too. Would it be acceptable to put rents up?”

It’s a concern shared by other trustees, with one commentator suggesting a preference to invest in social housing outside the boundaries of his own local authority to ward against the pension fund becoming “the evil landlord”. A further layer of complication comes from the fact many housing associations are actually members of local authority pension schemes – and some are in arrears. “It would be imprudent to lend to local housing associations when they actually owe the local authority scheme liability payments,” observed one commentator.

Social housing offers UK schemes liability-matching properties and potential returns that exceed inflation-linked gilts. Investment in the asset class is bound to benefit from funds boosting their broader infrastructure allocations and investment vehicles, still in their infancy and struggling with illiquidity, will develop in time. Twenty-odd years ago, before banks muscled in on long-term lending, pension and insurance funds used to be the biggest lenders to social housing in the UK. Today’s feet finding could see the cycle come full circle.