When Hurricane Sandy descended on the east coast of the United States and headed inland, it forced the closure of all the nation’s financial markets. Christopher Finger and Oleg Ruben at MSCI thought this was important because, although there are plenty of precedents for natural disasters in terms of economic impact, the storm was singular in forcing the closure of equity markets on Wall Street.

Well and good, but unexpected events such as market closures require some degree of assumption about risk modeling. The authors were driven by the need to find out whether those assumptions lived up to the potential of the havoc Sandy wreaked.

Read the report to make up your own mind.

In a landmark project, the £11-billion ($17.5-billion) Greater Manchester Pension Fund (GMPF), a scheme for 10 local councils and hundreds of small regional employers including schools and charities, will invest in a series of residential housing projects with local authorities. Lauded as a completely new way of funding house building in the city, Manchester council is providing the land while the pension fund is coming up with $40 million in finance; returns will come both on rental income and through selling the properties. “The return is better than on property; we expect more than 7 per cent because of the development risk,” says councillor John Pantall, who hopes the model, which will start with just 240 homes, will soon be rolled out to member councils outside Manchester, also with land to develop.

In another venture – again indicative of the fund’s shift away from pure real estate investment to a broader infrastructure play focused on community assets – the GMPF is helping finance the refurbishment of central Manchester’s iconic St Peter’s Square. Via its real estate development arm, Greater Manchester Property Venture Fund, it has co-invested in the office and retail venture with Argent, the property arm of telecom operator British Telecom’s pension fund. Testimony to the allure of Manchester’s infrastructure assets, foreign funds are also pouncing. Industry Funds Management recently bought a $1.6-billion stake in Manchester Airports Group. The planned developments around Airport City are on the GMPF’s sights, says Pantall.

Value for money throughout the kingdom

Manchester’s innovation and success is music to the ears of the UK government, which is pushing infrastructure investment to support growth in the stuttering economy. Hunting for new sources of capital to fund housing, roads and hospitals, it has just turned to its local council pension funds. In a consultation process that will run until December, it is floating the idea of unlocking town-hall pension pots and allowing them to double their investment in limited partnerships – the asset vehicle they use to invest in private equity, hedge funds and infrastructure. The Local Government Pension Scheme for England and Wales is administered by 89 separate, often tiny, local funds but with combined assets of $250 billion. The hope is that raising the allocation ceiling from 15 per cent to 30 per cent will unleash a wave of additional investment in infrastructure and meet funds’ needs for long-term, inflation-linked returns.

“By lifting the restrictions controlling local pension investments, councils could pump a further $35 billion directly into job-creating infrastructure projects that will boost our economy,” said community and local government secretary, Eric Pickles. “This is potentially a huge development and investment opportunity we simply cannot afford to ignore that also allows us to maintain long-term value for money for the taxpayer.”

Caps off for small fry, but so what?

Although the proposals have been broadly welcomed, the government’s latest initiative to conjure up more investment in infrastructure – it is also developing a Pension Infrastructure Platform with the National Association of Pension Funds and the Pension Protection Fund to encourage more fund investment in the sector – may not have the impact it hopes. In reality, few local authority schemes hit the existing allocation cap anyway. Although GMPF is planning $80 million to $160 million of new infrastructure commitments in the coming year, new investment will only boost its allocation to 3 per cent. “We’ve never had an investor unable to invest because of the allocation ceiling,” commented one infrastructure manager of a pooled fund.

Small and medium-sized local authority funds, which make up the bulk of local authority schemes, will probably stick to straightforward pooled vehicles. These are made up of a diversified mix comprising everything from global infrastructure to clean energy and private fund initiative (PFI) projects. They won’t want to “dabble” in major developments demanding management time and oversight, best suited to large, diversified funds. The notion of local pension funds investing in local infrastructure also carries a health warning. “There could be a temptation amongst politicians to push pet projects, but pension funds mustn’t be diverted into local projects too easily; their primary responsibility is generating returns for members,” argues councillor Peter Jones, head of the $3.2-billion East Sussex Local Government Pension Scheme.

Costly management fees may also put off smaller local authority schemes that are upping their infrastructure allocation. They have neither the inhouse expertise to increase their infrastructure allocations alone nor the negotiating power of larger funds. “Few UK government schemes understand the infrastructure space,” says Graham Robinson at consultancy, Pinsent Masons, “nor do they have the scale to build the intelligence and expertise around infrastructure investment without using fund managers.”

Creating scale and a bubble

A solution to the infrastructure conundrum could be for schemes to join together as one giant fund, creating an economy of scale, argues councillor Jones. “The typical local authority fund only has assets of between $1.6 to $6.4 billion, so their infrastructure allocation will only ever be modest,” he says. By combining all the schemes of England and Wales – Scotland’s local authority schemes fall under the jurisdiction of the Scottish Public Pensions Agency – the total fund would be in excess of $160 billion. “It would put us up there with the major funds. Only then would we have the scale to invest meaningfully,” says Jones.

The government proposals have built on the buzz already circling infrastructure, helping increase understanding of the asset class among council pension funds with small allocations. More pooled vehicles, through which local authority schemes can invest, are likely to spring up and the governance required to assess infrastructure opportunities should get easier. However, some local authority trustees can’t help seeing the latest initiative as another call on pension funds to bail out the government. For seasoned infrastructure investors, politics stepping into the debate is a cause for concern. “The asset class has been around for a long time – all this interest could create a bit of a bubble,” said Pantall.

The pension and funds management industry needs to redefine performance to an absolute return measure, according to The Influential Investor: How Investor Behaviour is Redefining Performance, a paper that is the result of 12 months of research with more than 3000 investors and investment providers across 68 countries.

The report, which sought to uncover the forces that will shape the investment management industry over the next decade, found that while relative performance based on peer groups or indices may serve the provider, the investor’s view of value is more complex and reflects their own personal blend of alpha seeking, beta generation, downside protection, as well as liability and income management.

“In the future, the investor will be the benchmark,” says Suzanne Duncan, global head of research at State Street Centre for Applied Research and co-author of the report.

The Influential Investor states that performance is the most highly rated factor by investors but it is simultaneously the number-one weakness when rating managers.

“Our research finds that the value proposition must evolve to one that defines performance as personal, a new definition of performance in absolute returns,” Duncan says, “but we are yet to see an academic framework that defines performance as personal.”

Personal, in three parts

State Street has developed a framework for this new definition that is made up of three components:

  • an alpha-seeking component, which will only be paid for if it is reached;
  • income management, which will be different for each investor and requires the income stream to be managed and protected in the context of the aims; and
  • liability management, which Duncan says has begun with liability-driven investing but hasn’t gone far enough.

“Investors need to understand current and future cash flows and manage to that,” she says.

The State Street research shows that investors are too busy looking at what their peers are doing and not defining performance as personal to what their own needs are.

“There is so much pressure, so investors are looking at what their peers are doing, but they need to look at their own needs and the needs of their beneficiaries, and manage that. It is an exciting period because there is awareness of the issues and the need for outcome-oriented investing and there can be experimentation around that.”

Industry direction

The impact of this shift will be massive, the industry will need a keen understanding of the role of local intelligence in decision-making systems, the report says.

It will need to streamline the delivery model at both industry and organisational levels to eliminate complexity and bring strategic priorities in line with what investors want most: personal performance.

And it will need to define a formula for sustainable returns to account for investors’ unique performance goals, to align fees with value delivered and to be fully transparent so the investor can appreciate that value.

“Under the new definition of performance, the investor is the benchmark,” she says. “This will have a profound change and impact. The system itself is in the way. There is too much of everything – funds, service providers, fees – the delivery model will be rationalised.

“Everyone has to agree with what we mean by success; there are different expected outcomes by different participants. If there is a precise definition of what performance means then there is a level of commitment. Investors need to measure success on their own income and balance sheet, not some other.”

The research also identified that the investment management industry is very different to other industries in the number of layers and level of participants or players.

“There are too many levels of decision-making in the governance structure. We looked at the added value across each layer, and there is not enough value to have that level of intermediation,” she says.

 How retail and institutional investors behave

Behind these headline findings, State Street examined the behaviour of retail and institutional investors, concluding that investors are not acting in their own best interests.

For example, while retail investors say they will invest more aggressively, they are moving more towards conservatism that is demonstrated by a 30-per-cent average allocation to cash.

Similarly, institutional investors are not acting in their own best interests and are becoming more aggressive due to what they see as artificially high expectations.

For institutional investors, the ultimate allocation in terms of growth is alternatives, but they also cite that their greatest risk is their inability to deal with the risks of these assets.

“There is a divergence of goals by institutional investors: they are looking at alternatives and they also believe they’re not prepared to handle the risks associated with their actions,” Duncan says. “There is nothing wrong with alternatives or risk per se. But there is herding and convergence into alternatives, and they believe that they’re taking on risks and there is a knowledge gap in that. There is not the evidence they have the governance structure or investment knowledge.”

She says investors are also becoming increasingly aware of the system’s instability.

“There is a very low level of trust in markets and in regulators.”

The future investment management business model
1 The value proposition – a new definition of performance
2 Delivery method – must be rationalised
3 Profit formula – or how to measure success  – will be sustainable returns
unique to an individual organisation regardless of others.

 

 

 

 

 

To access the full report, click The Influential Investor.

 

The Spanish Social Security Reserve Fund is set to be depleted by another €7 billion ($9.05 billion) before the end of 2012, according to IESE Business School pension expert, Javier Diaz Gimenez.

The $90-billion fund has already been asked by the government for $3.8 billion, which is likely to go towards a raise in state pensions this month.

Diaz Gimenez says “there is no question” that Spanish social security system will run into a multi-billion deficit in December at the latest, when pensioners draw an extra Christmas payment.

“That has to come out of the fund,” he adds.

Diaz Gimenez also says that ballooning unemployment in Spain and sharply worsening demographics make the outlook bleak for the Social Security Reserve Fund. Without deep reform of the social security system, it could be forced to make a number of asset sales in the years ahead, he reckons.

Patriotic fund

The fund has almost doubled its holdings of Spanish government bonds since 2008 in what many believe to be an effort to compensate for weakened demand for government debt issues.

Spanish sovereign paper totaled a shade under 90 per cent of the fund’s asset holdings in 2011.

The remaining 10 per cent is a combination of French ($3.9 billion), German ($2.6 billion) and Dutch (€1.6 billion, $2.1 billion) sovereign bonds.

“This was a neat way for the government at the time to cover its financing needs but it has created an accounting fiction at the reserve fund,” explains Diaz Gimenez. “If you buy your own debt, you effectively have nothing, so the government has filled a giant piggy bank with IOUs it has signed itself. There was obviously a hope that a financing bridge could be built, but it hasn’t turned out as planned.”

Diaz Gimenez continued to criticise the strategy of the fund, which was established in 2000 to support Spanish social security commitments by investing budgetary surpluses.

“In reality,” he says, “it has just continued the total domestic exposure you have in an unfunded pay-as-you-go system anyway.”

Diversifying abroad or investing in domestic corporate debt or equity would have placed the fund on firmer foundations, according to Diaz Gimenez.

Sopping up bonds

The fund is managed by a committee of senior civil servants and politicians, headed by the Secretary of State for Social Security.

On a pure investment basis, the fund’s mainly long-term government bond focus has been a success.

The fund has earned average annual returns of 4.14 per cent following its inception in 2000.

Critics warn, however, that this strategy is now set to backfire for the fund’s sponsor government.

A sale of bonds to dissolve a section of the fund could flood secondary markets, dampen demand for newly auctioned debt and raise yields at a critical time for the Spanish government.

The fund also stands to lose out from sales in the secondary market due to low prices for government debt, Diaz Gimenez believes.

The fund purchased $14.6 billion of Spanish government bonds in 2011 on both primary and secondary markets with a full spread of maturities.

Any need for the fund to deplete its holdings would also likely reduce its future potential to soak up government debt issues.

Looking for the best deal

Carmela Armesto Gonzalez-Roson, who sits on the Social Security Reserve Fund’s management committee, refutes suggestions that the fund has invested poorly.

She says that the management committee’s decisions are taken with an advisory committee and “always takes decisions in the best market conditions”.

The fund is obliged to ensure all assets are of “maximum credit quality”, Gonzalez-Roson explains.

Octavio Granado, who was Secretary of State for Social Security until the end of 2011, has defended the recent strategy of filling the fund with debt from Madrid by arguing it is looking to profit from the higher yields on offer.

The $3.8 billion that the Spanish government has requested from the fund will be financed from coupon returns and asset appreciation. The fund has amassed over $18 billion in coupon returns since its inception.

Moving with business cycles, procyclical stocks have been found to yield higher average returns than countercyclical stocks. William Goetzmann and Akiko and Masahiro Watanabe use 50 years of real GDP growth expectations from economists’ surveys to determine forecasted economic states in order to avoid the effects of econometric forecasting model error. The scholars created a priced risk measure by loading the expected real GDP growth rate and from this have discovered the procyclicality premium. Welcome to a snappy new term. Read on to find out how it works.

121109_Procyclical stocks earn higher returns

Despite the constant pull on Railpen chief executive Chris Hitchen’s expertise in other directions, most recently helping to run NEST, the UK government’s new low-cost pension scheme, he is resolute that his primary task is ensuring Railpen, inhouse manager of the £19-billion ($30.4 billion) pension scheme for Britain’s rail industry, successfully delivers on its monthly pension obligations. In a policy shaped by innovative investment ideas and a willingness to diversify, it’s a challenge he relishes.

The Railway Pension Scheme is an umbrella fund for the entire rail sector. Some 170 different rail-related companies – from large train operators to small engineering specialists – as well as pensioners of the former state-run British Rail that was privatised 17 years ago give their pension pots to Railpen to manage. Although the liabilities from the diverse contributors are separate, the assets are pooled into different funds, each with particular risk profiles, like a unit trust. The employers decide how and where to allocate their funds in the different pools Railpen operates with a clear delineation between liability-matching and return-seeking assets.

The scheme, one of the UK’s biggest, is a defined-benefit fund open to new members. Although many defined-benefit funds are closing as employers collapse under the weight of these more generous schemes, Railpen is still attracting enough members to make it work. New, young employees paying into the scheme give Hitchen’s team a long-term horizon and more punch and flexibility in its investment strategy. “Many funds are closing down their risk and investing in government bonds and LDIs. We are not taking unnecessary risk but we still want returns,” says Hitchen, who joined Railpen in 1998 as investment director.

Bold strokes in the growth pool

Of all Railpen’s pooled funds, its bold strategy is best encapsulated in the flagship $9.6-billion Growth Pooled Fund, introduced in 2010 and targeting 5 per cent above the Retail Price Index (RPI) in liquid, return-seeking assets.

Strategies for today’s straitened times include paring down the equity exposure in the growth pool over the last year. “We had 70 per cent in equities, now this is about 30 per cent. We’ve done this not because we know equities are going to do badly but more because we are worried that they might,” he says. The cut in stock-market exposure hit managers BlackRock, which saw its mandate drop from $4.8 billion to $3.8 billion, Pimco, Martin Currie and London hedge fund manager TT International. Railpen oversees asset allocation but has used external managers since 1987 and now has 80-odd, managed by an inhouse team of eight. The switch out of equities has pushed investment towards the other asset classes in the growth pool, including short-dated bonds and non-government bonds, property, commodities, private equity and emerging market debt. “The growth pool is invested for the long term, not to pay next week’s pension,” he says.

Hitchen is pragmatic about the enduring euro crisis. Where needed, the different pooled funds hedge their currency exposure and all are light on peripheral euro countries. The scheme has never had a particularly high allocation to European government risk anyway. “It’s difficult to say what will happen if and when the euro breaks-up – perhaps we should be overweight in German manufacturing,” he says laughingly, although it’s clear he’s not really joking. Last year the largest equity holdings within the growth pool and global equities pool included heavyweight manufacturing groups Samsung Electronics, British American Tobacco, Microsoft and GlaxoSmithKline.

Equities abroad

Another strategy is to push into emerging markets, where the scheme is modestly overweight, focused on greater China particularly, although he wants exposure to the “fantastic economic potential” of some African countries like Nigeria, too. Here, investment is limited to equities rather than resource or infrastructure plays. In China private equity investment via the Private Equity Pooled Fund, which returned 13.9 per cent last year, is Hitchen’s preferred route to market rather than direct equity investment. Access to the benchmark Shanghai Composite Index for shares listed in China, known as A shares, is restricted to foreign investors due to Beijing’s tight control over both its currency and the flow of money across its boarders. China’s stock market is also dominated by retail investors adding to market volatility and risk, he says. “With private equity there is more of a feeling that you are getting to the real economy,” he says. It’s a theme he raises again when explaining Railpen’s shift out of UK equities to a globalised equity portfolio. “UK equities account for 20 per cent of our stock portfolio; 10 years ago that would have been two thirds. Many large UK companies no longer exist. The FTSE isn’t a bellwether for UK PLC.”

PIP, CPI, RPI and the members

That’s not to say Railpen doesn’t see opportunity in the UK. It is one of six founding investors in the government’s Pension Infrastructure Platform (PIP), which will launch as a fund in January 2013, targeting $3.2 billion worth of projects. The Property Pooled Fund has around $3.2 billion invested in UK property, managed by Orchard Street. Here the emphasis isn’t on London, where he thinks returns are still “doubtful” because of oversupply, pointing out that “commercial rents are still lower than what they were 25 years ago”. Instead his focus is in regional property, in places like Cambridge’s Silicon Fen, where a technology cluster spun out of the university has kept the city insulated from the ravages of the recession.

Hitchen is wary of deficit-tackling government policy like the recent pegging of public sector-pension increases to the Consumer Price Index (CPI) rather than RPI. On average CPI inflation is roughly 0.5 per cent to 0.75 per cent below RPI inflation. He admits the reduction in the rate of increase makes his job easier but he is “acutely aware” of the impact on those pensioners who worked on the national railway and who “must now expect less than what they’ve had in the past.” He’s similarly circumspect of the raft of new regulation flowing out of the European Union that he believes will affect the way pension schemes and employers think about investment. A new caution will “tilt the playing field” towards low-risk strategies and “the appalling value” of government bonds.

It’s hardly surprising he’s using all his expertise and influence within the industry to campaign against any changes that would hurt his members. They are his first priority.