A Chinese proverb says “women hold up half the sky” and, while Australia may have been among one of the first nations to implement universal suffrage, glass ceilings can still be a hazard for professional women in this day and age. See what Future Fund chair David Gonski has to say on equal representation on super fund boards.
It’s difficult to ignore the clamour around infrastructure investment, the asset class of the moment. Lloyds TSB and the London Pensions Fund Authority recently joined founder members of the Pensions Infrastructure Platform, PIP, a government initiative to encourage pension funds to invest more in infrastructure. The Universities Superannuation Pension Scheme, USS, just increased its allocation to infrastructure debt with a second deal in less than six months providing long-term inflation-linked financing to a UK water company. A survey from Prequin finds that 78 per cent of UK schemes plan more infrastructure investment over the next 12 months and local authority schemes are about to be given greater freedom to invest in infrastructure at a time banks, stalwart lenders to the sector, are restrained from lending long-term by new capital requirements.
Infrastructure makes perfect sense for UK schemes struggling to manage growing liabilities and in search of new long-term, inflation-linked income on account of poor bond yields. UK schemes have lagged behind their counterparts in Canada, Australia and Europe. Foreign funds are now stoking local enthusiasm as they continue to buy prime UK assets: Canada’s £160-billion ($242-billion) Caisse de dépôt et placement du Québec is close to buying a stake in the $3-billion London Array wind park off the coast of Kent in southeast England. Classic asset classes aren’t behaving properly and infrastructure is a tangible, uncorrelated investment offering capital appreciation. It may tick all the boxes but I can’t help thinking that UK pension funds aren’t going to ride to the rescue of the cash-strapped government that wants institutional investors to do the job it no longer can.
Long term, but not too long
Greenfield infrastructure is a bridge too far for most schemes. On one hand the UK’s large mature defined-contribution schemes need a cash yield from day one to meet their monthly pension obligations, which is difficult with greenfield. On the other, the flagship, job-creating type of infrastructure the UK government really wants pension funds to finance, like the proposed new rail service, High Speed 2, which will link the UK’s major cities, are just too risky.
It is eighteen years since the Queen opened the Channel Tunnel between the UK and France, but operating company Eurotunnel is only recently profitable. The project ended up costing nearly twice what it was supposed to and left a trail of bust investors in its wake. When London bid for the 2012 Olympics in 2003, the price tag was $6 billion; by 2007 that had jumped to $10.6 billion. In China it takes two years to build a railway but in the UK complicated planning laws mean it could take 20. In short, running infrastructure assets is the easy bit. The idea of contractors and project sponsors shouldering construction risk doesn’t assuage UK schemes just yet. The real risk comes in the construction phase and few have the appetite or experience to venture here.
The minefield of public opinion
Even if UK pension funds get to the post financing the construction of new infrastructure, they’ll be very choosy which assets to pick. Post-Fukushima, few UK funds will want the political hot potato of nuclear power, a no-go without government and power-price guarantees anyway. “The government needs to convince pension funds nuclear is an investible asset class,” says Marcus Ayre, head of infrastructure at First State. Hospitals, where services are being reorganised and pruned because of financial constraints, carry a health warning. Trustees may even find toll-road projects too political, unpopular in the UK because drivers believe they already pay for the roads through other taxes. Nor is equity investment into schools or prisons proving particularly attractive just yet. For sure, the bigger schemes are venturing into new areas, like the $16.6-billion Greater Manchester Pension Fund (GMPF), shifting away from pure real-estate investment to a broader infrastructure play focused on community assets, investing in social housing and the refurbishment of Manchester’s St Peter’s Square. But smaller schemes lack the size or resources to invest directly in projects that demand management similar time and oversight.
Governments and greenfield
Would government guarantees de-risk greenfield assets enough to make them less speculative? Duncan Hale, head of infrastructure research at Towers Watson, doubts it: “Guarantees aren’t a magic bullet for trustees progressing up the knowledge curve,” he says. Besides, the government is unlikely to offer guarantees anyway. How can it persuade taxpayers to subsidise infrastructure but not get the benefit from any winnings at a time when the chances of taxpayers receiving any of the $98.2 billion they pumped into Royal Bank of Scotland and Lloyds look more remote than ever?
It leaves most funds constrained to brownfield investment, but the market is already crowded here, with full prices paid for the safest assets with the most stable cash flows. Fixed income, investment-grade infrastructure may be the cheapest and safest way to buy into the infrastructure story, but it offers returns that may not be enough to meet schemes’ underlying liabilities. The UK’s utilities, looking for debt and equity investment, are a better bet. They’re not greenfield, they have stable cash flows and are backed by a regulatory regime that lends financial certainty to investors. Will schemes move up the risk curve with equity stakes? Some will, but most won’t because they only want low leverage and stable cash flows. It’s one of the reasons why the PIP came about in the first place – to get away from these kinds of private equity structures.
At only $1.5 billion, the PIP hasn’t had that many takers and that kind of money doesn’t go far anyway. Most UK schemes are too small to invest meaningfully in infrastructure and it’s an asset that only suits those with long-term liabilities – schemes planning a buyout won’t venture into infrastructure. The idea of savers in the community also being investors in the community is compelling, as is investing in something that you can touch, that you use everyday. UK pension funds have been involved in infrastructure investment for years but until more get properly comfy with the risk, the asset class can’t really take off.
Finnish pension investor Ilmarinen is exploring whether to send a representative to South America as it intensifies its emerging market operations. Timo Ritakallio, who heads investment at the €29-billion ($39-billion) fund, says it is looking to access “more and more emerging market opportunities”.
In January Ilmarinen sent a senior portfolio manager to run a “one-man office” in Shanghai for a year, with a view to maintaining a permanent presence and potentially investing directly in China. “It is working well and we are already looking at the South American market to see if it would be possible to set up a similar system there,” Ritakallio says. “Our first reflections on the Chinese project are that it is extremely useful to have our own person there to procure information for us.”
Given Finland’s strong economic links to Russia, Ritakallio explained that a knowledge advantage in China and South America would bolster Ilmarinen’s position as a leading emerging markets investor.
Some 18 per cent of Ilmarinen’s equities were invested in emerging markets at the end of September 2012, an increase from 16 per cent at the end of 2010.
That represents a holding for Ilmarinen of over $2.6 billion in emerging market equities.
Finnish challenge
Equities are the fund’s largest asset class at 41.2 per cent of the overall portfolio, a fraction larger than Ilmarinen’s bond holdings as of September 2012. While the performance of equity markets has been spectacular of late, Ritakallio says Ilmarinen has missed out on the full benefits of the recent upturn in sentiment on global markets.
Ilmarinen’s 2012 investment return was 7.5 per cent, he reveals. While that is good news for the already healthy funding position of Ilmarinen, it did not allow it to make any substantial progress towards its target of being Finland’s top-returning pension investor – in 2011 it had the fifth-best return figures.
The pension fund’s investment choices were possibly a tad more cautious and patriotic than they needed to be, reflects Ritakallio.
For one thing, Ilmarinen started 2012 underweight on equities, a position it has since changed to neutral. It also made a serious effort to concentrate its bond portfolio on “risk-free” holdings to avoid the fallout from the euro crisis, debt that has delivered slim yields. “Maybe we were a bit too worried about the situation in the eurozone,” Ritakallio admits.
Some 37 per cent of Ilmarinen’s equities are held in Finland, a position Ritakallio describes as “a challenge” as Finnish share indexes have underperformed European ones by around 20 per cent over the past two years.
Domestic equity exposure has been steadily declining since 2010 to make way for an increased appetite for US and Japanese shares, along with emerging market equities.
Ilmarinen wants to combine its tradition as a strong supporter of Finnish companies with its enthusiasm for emerging markets by focusing its domestic equity picks on corporates trading with that part of the world, Ritakallio explains. A strong emerging markets profile will also help US and European companies’ chances of being picked by Ilmarinen.
Standing firm
Ritakallio expresses confidence in Ilmarinen’s broad asset strategy to perform in the future, especially with the improved worldwide investor outlook.
“We expect the equity market to be volatile in the coming years but we have quite a positive view”, Ritakallio adds.
The fund’s diversification activities have seen it take strong positions on real estate (11.7 per cent of the portfolio) and alternatives (6.5 per cent). Both offered steady returns of 3.8 per cent and 5.8 per cent, respectively, in the first nine months of 2012.
Infrastructure is currently an investment focus at Ilmarinen but the fund is keen to route these stakes through the existing asset structure. For instance, Ilmarinen backed a new infrastructure fund from Swedish private equity managers, EQT. That kind of vehicle offers an “optimal solution” for Ilmarinen, which has 4.5 per cent of its assets in private equity, Ritakallio says, a position it aims to boost to 6 per cent in 2015. Some $650 million per year will need to go into private equity to meet that goal – a prospect that might just have managers lining the streets of Helsinki.
Ilmarinen has also experimented with direct investment in infrastructure projects, taking a stake in the E18 highway, a road and ferry route connecting Craigavon in Northern Ireland to St Petersburg in Russia through Scotland, Norway, Sweden and Finland.
Making major equity investments in infrastructure companies is another channel that Ilmarinen has taken to gain exposure in the asset class.
As a large investor in a relatively small market, Ilmarinen’s engagement activities carry a lot of clout in Finland. As a top-three share holder in a number of Finnish companies, Ritakallio says he is satisfied the fund gets a good say in remuneration and board appointment decisions.
Taking its responsible investment approach to China could be difficult though, Ritakallio concedes. Nonetheless, Ilmarinen will give it a good go if it decides to invest directly there, with Ritakallio saying “as a responsible investor we want to be responsible everywhere”.
Jo Townsend, the chief investment officer at REST Industry Super, says the fund is not only investing according to a long-term horizon, but is also willing to depart from the pack when making investment decisions.
“Our fundamental investment belief is that it is possible to add value through active investment management, and we do that through both the use of active investment managers and changes to asset allocation.”
Townsend says the widely stated belief that you can’t add value through active management and, moreover, that they are waste of fees, is contestable.
“We can actually demonstrate that the use of active investment managers has added real value for our members over long-term time horizons after the payment of active investment fees.”
REST uses internal reporting that shows they have been able to add value over asset class benchmarks consistently by using active investment managers. For example, Australian shares asset class is plus 3 per cent per annum and the overseas shares asset class is plus 2 per cent per annum, both over 10 years after all fees. (See table below.)
“These outcomes reflect both the use of active investment managers and our active approach to asset allocation,” says Townsend, adding that the core strategy is the only investment option to which REST applies its active approach to asset allocation.
REST will also make changes to asset allocation that, at times, can be quite different to the activities of other funds in the industry, Townsend says.
A classic example is the tech bubble of the late 1990s-early 2000s when REST had a substantially underweight position in overseas equities – around 8 per cent compared to about 20 per cent in the industry.
A whole other class
In 2008, this led to the establishment of a new asset class to place the structured securities – the “credit opportunities” sector, which sits in the growth alternatives asset class. Townsend says the call has paid off for REST members.
“Our initial allocation was 4 per cent of total FUM and today the allocation is 6.5 per cent,” she says. “…Those assets have been some of our best performing over the past four years or so.”
It all relates to a longer term focus that Townsend identifies as a true differentiator for the fund, which is one of the largest super funds by membership – more than 1.9 million members, and funds under management just about eclipsing $23 billion.
Allocating assets
REST believes bond prices are extremely stretched and that there’s potential for an interest-rate rise to lead to capital losses in those markets. It’s a view that shapes REST’s investment philosophy.
“REST has viewed bonds as being an expensive asset class for quite some time and is defensively positioned,” says Townsend. “Further down the track, we see that there is the potential for inflation to return in view of the extraordinary extent of expansionary monetary policy being practiced right around the globe – which is effectively helping to keep bond yields so low.”
A prime focus for the fund, meanwhile, is real assets, which Townsend says REST is in constant search of, namely direct property and infrastructure investments. More specifically, they are looking for core properties with high levels of income and relatively stable income profiles with moderate levels of capital gain.
Approximately 90 per cent of funds under management and 98 per cent of REST’s membership base, are invested in the fund’s Core Strategy, a mix of shares and bonds, property, infrastructure, alternative assets and cash – 25 per cent defensive and 75 per cent growth.
Fund manager performance
The fund reviews each asset class on an annual basis, which also entails a look at its manager line-up. Currently the fund employs 42 external investment managers across 11 different asset classes.
Townsend says that REST will not terminate a manager because of short-term underperformance, however.
“We will always look to make sure that we understand what is going on with a manager’s performance. There might be very good reasons that a manager is underperforming.
“An absolute reason to terminate a manager would be if they’re not investing in accordance with their philosophy and the reasons they were put into the portfolio.”
Danish pension provider Danica is upping the alternatives portion in its roughly $57-billion portfolio as it looks to boost returns within the country’s strict solvency framework. Alternatives already make up over 4 per cent of the $33-billion Traditional Fund, Danica’s largest and most conventional pension pool, double the proportion the asset class took at the end of 2010.
Peter Lindegaard, Danica chief investment officer, says that infrastructure is at the heart of a drive to treble its alternatives holdings again to a total 20 billion Danish krone ($3.6 billion). “We already have a number of investments in infrastructure funds and it is something we want to continue with as well as going a bit more directly,” he says.
The direct investments in the asset class have naturally followed from committing to infrastructure funds. “Some of these funds have co-investment opportunities for project equity investment”, Lindegaard says.
While the number of opportunities is limited in small and infrastructurally efficient Denmark, Lindegaard is enthusiastic about potential overseas investments. Danica is approaching infrastructure with a broad scope, according to Lindegaard, and will consider any form of the asset “as long as it’s not too exotic”.
Hedge funds, timber, agriculture, private equity and alternative credit are the other possible components of Danica’s alternatives effort. The alternatives it holds already returned a healthy 10.2 per cent in 2012, clearly a figure that would satisfy the fund in the future.
In another indication of how mainstream the asset class is becoming to Danica’s plans, Lindegaard isn’t too happy with alternatives’ name. “Maybe we should start calling them illiquid investments,” he says.
Limited wiggle room
Like many investors, Danica’s alternatives drive has a clear objective in reducing a dependence on bonds. “Everybody wants to sell government bonds and invest in everything else”, is Lindegaard’s rather frank way of expressing it.
Danica shed $2.3 billion from the bond holdings of its Traditional Fund in the course of 2012, although its conventional debt holdings still occupy 60 per cent of the portfolio.
Lindegaard frequently refers to the fund’s risk budget and buffers. A need to focus on risk stems from the fact that Danish pension-solvency regulations, which came into force in 2002, place strict limits on the amount of “high-risk” assets the country’s pension funds can hold.
Equities occupy a mere 5 per cent of the Traditional Fund’s portfolio, perhaps meaning that Danica has somewhat missed out on the current equity boom, but also ensuring it misses out on the volatility of the asset class.
“As interest rates are so low, we have had to hold onto a lot of bonds and we don’t have a risk budget that allows us take much equity exposure,” Lindegaard explains.
As the Danish solvency regulations are akin to the European Commission’s proposed Solvency II-style limits on pension funds, the decisions Danica has taken in recent years will possibly need to be echoed across the continent in the future.
Lindegaard hopes the controversial forthcoming European regulations are shaped in a way that allows “conscious controlled risk taking”.
Danica has found space within the Danish regulations to take some bolder positions within its debt holdings.
For instance, Danica has largely held intact a significant position it had at the start of 2011 of 2.8 per cent of its customer funds in Irish, Italian and Spanish government bonds. “We are constantly looking for the best risk-reward options, and from this point of view these bonds looked good and still look pretty good,” Lindegaard says.
Outside of its liability-matching bond portfolio, the Danica Traditional Fund also has $5.5 billion in higher yielding “credit investments”. These assets delivered 14.4 per cent returns in 2012.
That is not unusual for Danish pension funds’ credit bonds holdings, Lindegaard says, as “interest rates fell at the same time as the spreads came in”.
Sturdy foundations
Danica also takes a strong position in real estate. Most of its $3.49 billion real estate portfolio is directly owned in Denmark. The fund ranks as one of the country’s most significant owners across the residential, commercial and retail spaces. Lindegaard says Danica plans to increase its real estate holdings further, both in Denmark and by “dipping its toe” in overseas real estate via funds.
He says “there are issues in the Danish property market right now like anywhere else but we can make very interesting new investments as there is a lack of capital out there. If you are the ones that can deploy it you can get relatively good interest rates out of it.”
Some 78 per cent of assets at Danica are managed by Danske Capital, which shares the same parent company to the pension provider in Danske Bank. Another 9 per cent is managed by BlackRock.
Lindegaard reveals that Danica is very neutral on the passive versus active management debate. “We have a mix. In some asset classes it is difficult to beat the benchmark but in others, like emerging markets, you can make a very nice return with some active management,” he says.
If Tony Broccardo, head of Oak Pensions Asset Management, the investment arm of the £23-billion ($35.6-billion) pension fund for employees of London-headquartered bank, Barclays, wasn’t a fund manager he would have been an architect. But Broccardo has applied similar skills of stress testing, planning and making something structurally secure to the return-seeking fund, one of the United Kingdom’s largest and most sophisticated schemes. It posted a per annum return of 11 per cent for the three years to December 2012 and Broccardo, who started out as an investment analyst and strategist at brokerage houses before joining the scheme as its inaugural chief investment officer in 2008 from F&C Investments, attributes success in today’s difficult climate to a strategy combining active management, diversification and flexibility. “We have proved the concept of greater diversification and active management,” he enthuses. “Over the last three years, which includes the crisis period, we added $1.08 billion to the fund. Over five years we have added $2.3 billion over and above what we’d have made with an equivalent passive bond and equity portfolio.”
In the belly of OPAM
The fund, which manages assets for around 250,000 current and former Barclays employees, was restructured in 2010 when the bank set up its own asset manager, Oak Pensions Asset Management (OPAM). Like other big UK schemes such as the Universities Superannuation Scheme, the closed coal-industry pension schemes and retail giant Tesco, Barclays took back control of strategy from external advisors in a decision Broccardo says allowed both flexibility and “real-time investment management solutions”. The OPAM team is split three ways comprising manager selection – trustees handled all fund-manager oversight before OPAM – an implementation team and an asset allocation team. Most members of the 14-stong internal team have hedge fund backgrounds and, excluding private equity, the fund uses 40-odd managers. Managers responsible for at least 5 per cent of the total assets under management include BlackRock, Aberdeen Property Investors, Russell Investment Group and Towers Watson. The use of an overlay allows “huge flexibility” in selecting the best active managers and Project Smart, an internal initiative applied to all active mandates, measures strategies using smart benchmarks and indices to see how managers are doing. “We apply SMART to all allocations. It is very much the case that the trustees want Oak to focus on strategy; they allow us to use more or less managers as the opportunities arise.”
Within its 20-per-cent equity allocation, OPAM has steadily increased its risk levels, pushing active management of mandates and “much higher exposure” to emerging markets – three times more than what it was in 2010. Broccardo has also introduced tilts to its equity portfolio, shifting allocations to take advantage of specific pockets of outperformance. “Last year we increased our exposure to Europe out of US equities. We’ve also increased our exposure to global companies and the tilts in place here have done very well,” he says, adding that OPAM will continue with a strategy to gradually pare down its equity allocation in favour of alternatives.
Diversification pays
The fund currently has a 12-per-cent allocation to private markets comprising property, infrastructure and private equity. Private equity investment is global and includes stakes in technology, clean energy and medical start-ups. “Diversification has paid off; we’ve gained an illiquidity premium investing in private equity over public markets,” he says. Infrastructure investment lies across “different industries” but the fund has only recently made its first foray into the UK in a strategy to tap both growth and hedge against inflation risk. It’s a trend increasingly evident among other UK schemes, pouncing on domestic infrastructure assets as banks pull back from the sector because of new capital rules. In its second private placement to a UK water company, the Universities Superannaution Scheme has just structured a $147-million loan for London water authority, Affinity. “We’re looking to benefit from increases in the value of the underlying investment, but also get exposure to UK inflation and rate rises. Our liabilities are in the UK so we do have a preference for UK infrastructure,” says Broccardo.
OPAM allocates 35 per cent of its portfolio to liability-driven investments and 20 per cent to credit. Here the approach is “wholly proactive” fashioned to both lock down liabilities but be flexible and creative too. The focus, explains Broccardo, is on rebalancing the mix of exposures and replacing one strategy with another – tilts are applied here too. For example, in a bid to tap medium-term returns further down the credit spectrum the allocation is titled to high yielding assets in the credit market like issuers in countries such as Spain or Italy. It’s a risk appetite apparent again in the 12 per cent allocation to diversified assets. Global tactical asset allocation mandates to exploit short-term market anomalies, macro strategies seeking profit from economic uncertainty and commodity and niche currency exposure all come under this umbrella. “The majority of these strategies are implemented by hedge funds, specifically focusing on strategies less correlated with equity or credit risk,” says Broccardo.
One fund, one strategy
Looking ahead, OPAM will continue to “modestly increase risk.” Positively, Broccardo believes there is less tail risk thanks to recent policy action in the US, although “adverse outcomes could still have an impact on markets”. A fall in corporate profit margins may still negatively affect equity portfolios and rising interest rates impacting long-dated debt is the other concern. “History suggests that if the market is concerned about inflation, the sell-off will be abrupt.” He says OPAM’s focus is on spare capacity within larger economies with so-called output gaps. The idea to “assess where there is still headroom for growth before inflation expectations kick in,” he says.
OPAM’s success begs the question – will they run money for other pension schemes? It’s a model developed by Hermes, set up as inhouse manager for telecoms operator BT’s pension scheme but now with mandates from other pension schemes too. But Broccardo won’t be drawn: “We just think about how to improve the outcome of one fund and one strategy,” he says. No, his eye is firmly on how big the Barclays fund, up from $27.8 billion in 2007, could one day become. “We can look back over a number of years and see how we have moved the dial. We are now big enough to move the dial.”