The angst in Europe has calmed down, relatively speaking, but according to Mercer, it will be a long haul, with deleveraging there and in the US taking many years. Investors need to act accordingly.

Part of the problem is that conventionally safe assets, such as US Treasuries, are expensive.

“That will take years to work through and investors need to work assets hard in different ways. For example bond investors need to look outside of the core to a broader range such as private markets, anything that produces an income,” Mercer’s global chief investment officer, Andrew Kirton, says. “This requires thinking more creatively to behave more dynamically.”

Kirton believes there is a role for specialist managers in unique asset classes such as high-yield bonds or private markets, and Mercer has invested in boosting its research coverage of alternatives.

A decade ago bond investing was relatively straightforward, Kirton says, now there is a new product or investment strategy every month.

“It’s a very exciting time. While it remains a challenging time, it is not without opportunity.”

Kirton is encouraging clients to think laterally, to get out of their comfort zone.

“I say to investors they need to be prepared to look at assets that are less familiar to them.”

The biggest mistake investors can make is to lose sight of their objectives, Kirton says.

“Keep a careful eye on the risks to not achieving your objectives in a world where there will be more shocks,” he says. “Look at risk-management issues and the journey you’re on.”

Global head of fixed income at Mercer, Paul Cavalier, says the safety of fixed income has been called into question.

This is especially so in credit markets but also sovereign debt, he says, adding while it is a mistake to call the asset class risk-free, it can still be branded least risk.

The three elements of fixed income

Mercer is advising that fixed-income portfolios need three elements, with the exposures to each varying according to each client’s individual needs.

  1. An absolute-return portfolio that looks at all types of fixed-income alpha.
  2. A core structure in the middle that includes government debt.
  3. Satellite investments, which include emerging-market debt, high-yield debt such as bank loans, and credit opportunities.

 

Beware the benchmark

One of the consequences of the upheaval is investors need to be more cognisant of the benchmark composition.

“Over the past few years benchmarks have come into question, first in credit then in sovereign. In credit, financials represent 40 per cent of the benchmark, which is a large percentage, but financial credit operates differently to industrials. Investors have to understand what they’re getting into.”

The result is that indices are being split, and customised portfolios, such as credit ex-financials, are being built. This happened in equities 20 years ago, he says.

The inherent volatility can be observed by looking at yield levels on indices, Cavalier says.

“In December 2006 the global aggregate index was yielding 4.25 per cent and the US Treasuries 5 per cent; in December 2011 the global aggregate index was yielding 2.25 per cent and the US Treasuries 1 per cent. Is that what people expected?” he says.

“Further, during that period the emerging-market sovereign-debt local-currency index has traded at between 6 and 8 per cent the entire time, so there is a bubble in the risk-free assets.”

Cavalier is a proponent of an emerging-market debt allocation and says there is better value in emerging-market debt than developed-market debt, pointing to better growth, better debt to GDP and ratings upgrades.

“In the developed world the downgrades are outpacing the upgrades, but last year in emerging markets there were 17 upgrades and only 3 downgrades. All indicators favour emerging markets,” he says.

It is Cavalier’s view that fixed-income exposures should not be organised by regional diversification, but different asset classes, with the liquidity premium more important than ever, especially in credit.

“Dynamic asset allocation needs to focus also on illiquid markets – private debt, for example – and giving up liquidity for long-term return. Banks are out, now institutional investors play a role as patient capital.”

Cavalier, who managed money for an asset management firm for 22 years, advises investors to consider specialist managers rather than generalists who can do everything.

Asset management is not a profession he envies in the current environment: “I’m glad I’m a consultant not an asset manager at the moment, I can take a step back.”

Jim Keohane’s first annual results as chief executive of HOOPP have been satisfying. The fund returned 12.19 per cent in 2011, a result well above its peers. It is 103-per-cent funded, and has reached assets of more than $40 billion for the first time. However, he says the unique investment approach and structure that has allowed the fund to reach these heights has been more than 10 years in the making.

The Healthcare of Ontario Pension Plan (HOOPP) has a large derivatives program, amounting to more than 1500 positions worth about $200 billion. The worth of its net assets available for benefits is $40.3 billion.

This unique approach to investing – using its balance sheet as an asset – has enabled the fund to remain fully funded throughout the global financial crisis, an enviable position among its peers.

Chief executive of the fund, Jim Keohane, who was chief investment officer for 10 years before taking up the top job, says HOOPP is clear about its investment strategy and its strategic advantage as a long-term investor.

“We don’t have any strategic advantage in security selection. Where we do have a strategic advantage is we are creditworthy, have a large balance sheet and low liquidity needs. We can find strategies that we can do that others can’t, and that is often non-traditional,” he says.

According to Keohane, the external environment is in the biggest state of flux since he’s been in the pension business.

“There has been high market volatility, low interest rates and changes in government policy. Pensions are on the front page and will be for some time to come.”

Keohane says the fund has been positioned fairly well in this environment, and some of the actions of the past few years to restructure the portfolio have meant it could take advantage of the opportunities as well.

“We have done a lot of long-term option writing. We saw an anomaly had been created, there had been a lot of annuity sold but they hadn’t hedged them. These options provided equity-like returns with nowhere near the risk.”

 

Clear objectives: split and divide

The HOOPP investment portfolio is divided into two: a liability-hedging portfolio and return-seeking portfolio.

Within the liability-hedging portfolio there is a large weighting to long-term bonds as well as real-return bonds and real estate. The investment strategy is to hedge the liabilities, but it also turned out to be a source of 2011 returns.

The fund entered the international real-estate market last year, closing its first deals in the UK and the Czech Republic.

In the return-seeking portfolio, managed by Jeff Wendling, the fund gains equity and credit exposures through derivatives.

The structure of HOOPP’s investment process is most akin to the Danish ATP, which also divides its portfolio into two separate portfolios.

The difference is that ATP uses derivatives for fixed-income exposures and cash for equities exposures, while HOOPP does the reverse.

“ATP does the reverse of us. They use interest-rate swaps to hedge the liabilities and use cash to fund the return-seeking portfolio. We do the reverse, use derivatives for equities exposure, because there is not a well-developed interest-rate swap market in Canada.”

The fund has a list of approved counter parties, which Keohane says can be up to 15 investment banks, and it has a team to manage the credit and collateral management very tightly around that. It has also been cutting-edge in setting up the systems to support that.

Over the past few years the previous chief executive, John Crocker, oversaw the spending of more than $100 million in technology.

The result is a sleek operating system for both investment and administration that will save costs in the long run.

“We spent the money to get daily price feeds on everything we trade, we mark to market daily,” Keohane.

He sees this technology and the particular in-house expertise necessary, as one of the barriers to other funds investing the same way.

“Developing some core in-house expertise is a barrier to others investing the way we do. For example, [with] cash management and collateral management and managing the balance sheet, we have a treasury function similar to a bank. The fund started using derivatives in 1999, it’s taken about 13 years to get where we are.”

Keohane says having very clear objectives of what it is trying to achieve is a key driver of the fund’s success.

HOOPP’s vision is that all healthcare workers enjoy a financially secure retirement. Its mission is to deliver on the pension promise, and it is driven by the values of professionalism, accountability, collaboration and trustworthiness.

A defining characteristic of leading pension funds globally is the cost savings garnered from in-house investment management. An organisational design study by CEM Benchmarking has revealed that “leading” funds have an average of 49 per cent of assets managed in-house, and yet the internal staff and non-manager third-party costs make up only 15 per cent of total investment costs.

The study examined the organisational design of 19 of the world’s largest funds with average assets of $90 billion and found that these funds spend an average of 46.2 basis points on external management, compared to 8.1 basis points on internal investment capabilities.

Partner at CEM Benchmarking, Mike Heale, said the funds with internal management platforms are better performers after cost, and this is largely driven by lower costs of internal management.

The biggest cost savings were from internal private equity, with the median cost of internal management for private equity 25 basis points, while for external private-equity management the median cost was 165 basis points.

For fixed income the difference was 3 versus 18 basis points, for equities 10 versus 40 and for real estate 21 versus 75 basis points.

Heale says in the past 10 years there hasn’t been a great deal of internal private-equity management, but he believes the industry is on the cusp of change.

According to CEM Benchmarking vice president, Jody McIntosh, the extent of in-house investment management was a driver of many organisational aspects, including the number of staff and the compensation.

“The number of staff at these 19 funds ranged between 20 and 647 full-time investment staff. This is a big variation, and it was interesting to see what was driving that was internal assets under management.”

CEM conducted a regression analysis that revealed 70 per cent of the variation in the number of staff was due to internal management.

McInstosh says most funds plan on increasing the number of staff over the next three to five years, some by as much as 10–20 per cent as they increase internal management.

There was also a clear relationship between the number of front and back-office staff, with 1.7 people required in the back office for every member of front-office investment staff.

“The number of front-office staff is the best predictor of governance, operations and support staff,” he says.

Resource allocation matters

But it is not just the number of staff that distinguishes these funds, it is where the resources are allocated.

Large funds have a substantial number of full-time staff dedicated to asset allocation and risk, with an average of 13 of 135 staff allocated to this area.

A survey of these funds strategic objectives revealed that risk management was the number one priority, followed by organisational leadership, culture, talent and asset allocation.

McIntsosh says the number of internal staff was also a clear indicator of the compensation paid to the senior staff.

“The best predictor of compensation for the highest paid five staff was the number of full-time staff in the organisation. The higher the number of people, the higher the compensation,” she says.

Of the funds surveyed, the highest compensation was in Canada, followed by Europe, US and Australia/New Zealand.

Average salaries at investment departments in Canada was $536,000, in Europe it was $246,000, for the US $148,000, and in Australia and New Zealand $139,000

The average salary of the top five investment staff in Canada was $1.5 million, in Europe $720,000, in the US it was $372,000 and in Australia $297,000.

Heale says the study is part of global leaders program introduced by CEM last year, which looks at understanding the common characteristics of the funds, including big internal operations, sophisticated asset mixes, high need for performance-management information and high allocation to private markets.

The organisation design study is the initial piece of research into which CEM plans to drill deeper.

US public pension funds, under fire for the sustainability of their defined-benefit plans, are increasingly opening a new social-media front line in the battle to influence public opinion.

The Maryland State Retirement and Pension System is the latest to step up its social media presence, posting its first You Tube video, which outlines the positive effects of its $37.7-billion defined-benefit (DB) scheme on the local economy.

The video, which sees senior staff, including chief investment officer Dr Melissa Moye, discussing the system’s investment strategy, is part of a social-media strategy at the fund that included launching a Facebook page 18 months ago.

The 265 likes on Maryland’s Facebook page are dwarfed by CalPERS, which has garnered 2596 likes on its page and exhorts fans to encourage another five of their friends to like America’s biggest public-pension plan.

The Teachers Retirement System of Texas (TRS) is another large fund that says it has “gone social” and now has a presence on Facebook, Twitter, LinkedIn and You Tube.

While pension funds can be media shy, TRS has shown a liking for You Tube, posting one video each month for the last six. Its Twitter feed includes information on upcoming town hall meetings and reminds members when agendas to board meetings are available.

 

Social media reframes public debate

Unlike other social media users, TRS does seem to have ambitions to create a broader online community. On its website, it states that “TRS’ social media presence is not intended, nor created, to be a general public forum”. The message is that social media is viewed as another avenue of member engagement.

However, Maryland’s head of external communications Michael Golden says the system’s push into social media is an attempt to provide balance in a public debate, where it feels opponents of DB public pension schemes have had much more airtime.

“Defined-benefit plans, Maryland’s being but one, have a great story to tell. Unfortunately, that story has not received the same attention and balance that the criticism and challenges levelled at public DB plans have,” Golden says.

“This is our attempt to reframe the discussion about Maryland’s plan, and in a way all such plans that are effectively providing retirement security. It is presenting the facts directly to our members and everyone else who is concerned with the future of these plans and the broader concerns about retirement security.”

In keeping with this active strategy, the fund responds to comments on its Facebook page, clarifying criticism and posting links and responses to articles in the mainstream media.

It also posts research from DB advocate organisations such as the National Association of State Retirement Administrators and the National Institute of Retirement Security in an attempt to more broadly circulate their findings.

 

The Face(book) of pension reform across the US

The push into social media for Maryland came amid efforts by the state governor and legislature to address the funding shortfall in its system.

Maryland managed to cling onto its DB scheme when Governor Martin O’Malley designed a reform program that aimed to address the 65-per-cent funded ratio of the state’s pension system.

It was a win for DB advocates against the recent growing push to shift to defined contribution, or a hybrid mix, in state reforms designed to reign in pension costs.

The drive to tackle funding issues in public pension funds has seen unprecedented legislative reform of state and local pension systems in the last three years.

A recent US National Conference of State Legislature report found that 43 states have enacted major legislative reform of their pension systems from 2009 to 2011.

The report reveals that the number of states instigating reform has more than tripled from 2009 levels, with 32 states in 2011 undertaking major changes to their public-pension systems.

The most common reforms include moves to increase employee contributions, slashing cost-of-living increases, raising retirement ages and changing the years of service required to calculate benefits.

The Facebook pages of public pension plans put a face to these changes, with members of a number of plans commenting directly on the effects of these reforms on their benefits.

Golden sees social media as a way of communicating Maryland’s drive for a sustainable DB plan as part of this broader national debate around pension reform.

“Maryland’s governor and state legislature made it clear during last year’s reform of the pension system that Maryland continues to support a DB plan for its employees,” he says.

“Actions taken, in Maryland and elsewhere, make the case in this debate that DB plans are sustainable. It’s important for everyone to understand how import the pension system is to its members and the community at large.”

Other pension plans, such as CalPERS, have geared up to defend benefit payments to members, investment performance and the sustainability of the fund in the face of a push by state legislatures to reign in pension costs.

Last year the fund launched a blog-style site, CalPERS Responds, that details the fund’s views on a variety of topics, including reform of California’s pension funds.

Reforms include closing the current defined benefit schemes to new public employees and enrolling them in a hybrid scheme.

Other smaller funds, such as the $73-billion Ohio Public Pension Employees’ Retirement System, also have their own blog in an attempt to proactively influence public debate.

Going social, as TRS puts it, is a big step for funds, particularly smaller resource-stretched ones, whose previous public engagement may have been limited to comments from the floor of a trustee board meeting.

While there is always a reputational risk for any organisation entering the social media sphere, Golden says that the reward of getting views into the public domain outweigh the potential risks.

“We have a great story to tell; there is little risk in telling the truth,” he says.

MSCI looks at why investors may have a limited small cap representation in their equity portfolios and how this may potentially impact on both risk and returns.

The researchers find that investors may be making an unintentional decision to minimise their exposure to small caps that could have cost 60 basis points of annual performance over the last decade.

The flight to quality was not limited to certain developed-country debt during the volatility in the second half of 2011. Indeed, Pimco’s global co-head of emerging-markets portfolio management Ramin Toloui says that some emerging-market government bonds are potential safe havens during times of market stress.

He says that the bond giant’s Global Advantage Government Bond Index now has an approximately 35 per cent exposure to emerging-markets.

A standard government-bond index typically has an exposure of around 5 per cent to emerging-market government debt, Toloui says.

Pimco’s Global Advantage Bond Indexes (GLADI) are a series of GDP-weighted, investment-grade fixed income benchmarks. Pimco uses the indexes as benchmarks from which it takes active positions around for its GLADI group of funds. These GLADI funds have more than $9.4 billion in combined assets under management in both government and corporate bond strategies.

An increased exposure to emerging markets also fits into Pimco’s overarching view of the long-term global rebalancing underway, with slow-growing developed markets deleveraging and capital shifting to assets in fast-growing emerging markets.

“If you look at a world where many investors are looking to diversify their global bond holdings, such as sovereign wealth funds in the Middle East and Asia and central banks, a key asset class they are going into is government debt in emerging-market countries,” Toloui says.

“So we think because of this re-allocation, part of that is going to result in yield compression and rising currencies.”

 

Divergence in emerging markets

This year, capital flow research firm EPFR Global notes that movement into local currency emerging-market bond funds enjoyed nine weeks of positive flows up until the first week of April.

Toloui warns that traditional market-weighted bond indexes may, in fact, have a greater allocation to the biggest issuers of debt, namely developed-market economies, diminishing the defensive characteristics typically associated with government bonds.

The strong balance sheets of some emerging countries have meant they have more policy flexibility to deal with market uncertainty than many indebted industrialised countries, Toloui says.

“The key factors are the levels of external indebtedness and the debt-service payments relative to foreign reserves is absolutely essential,” he says.

According to Toloui, passive government-bond strategies that use traditional market-weighted bond indexes have a high allocation to the largest debt issuers, potentially diminishing the defensive characteristics typically associated with government bonds. Pimco prefers GDP-weighted indexes, which its research reveals results in an average gross government debt-to-GDP of 82 per cent across the countries in its government bond index. This compares to an average debt-to-GDP of 138 per cent for an equally weighted selection of three common market cap-weighted indexes.

He points to a necessary shift in the way bond investors should think about how industrialised and emerging-market countries perform in times of global economic stress.

“Traditionally in risky market conditions, you have industrialised-country bonds rally as central banks cut rates and emerging-market bonds face pressure because emerging markets had to raise rates to prevent capital flight and defend the currency,” Toloui says.

“Recently, however, there has been a big divergence in emerging markets with some countries, like Hungary and Turkey, falling into the old model of having to raise interest rates when there is capital flight, but other countries, like Brazil, being able to cut rates aggressively to shield their economies in periods of external stress.”

Brazilian two-year bond yields fell by more than 200 basis points in the second half of 2011, more than those in Germany and the US.

Italy, Turkey and Hungary saw bond yields rise by more than 200 basis points over the same time period.

 

Reconsider bond investments and asset allocation

Toloui makes the point in a new research article that investors who purchased Italian bonds a decade ago would have anticipated that yields compensated for interest rate risk – primarily the volatility of interest rates in the eurozone.

In contrast, purchasers of Brazilian bonds would have wanted a yield that compensated for the potential credit risk of Brazil not paying its debts. This is completely reversed in 2012, with investors perceiving credit risk in Italian bonds, while purchasers of Brazilian local currency debt would have been focused on central-bank policy and its impact on interest rates.

Pimco now makes the distinction between hard interest-rate durations, when yields on these bonds typically fall during times of market stress, and soft-credit duration, when yields rise during market stress.

“The old mental apparatus in investing in bonds seems to be reconsidered, and therefore the asset allocation needs to be re-considered,” Toloui says.

“Investment in emerging market bonds can provide income but can also provide some of the attractive qualities that bonds have in periods of volatility.”

Investors who structure a bond portfolio around the traditional dichotomy of developed markets representing hard-duration interest-rate risk and emerging-market soft-duration risk may, in fact, find they are holding assets that are acting like a credit risk, Toloui notes in his research.

He does, however, acknowledge that the financial markets of emerging markets are currently not deep or liquid enough to deal with large-scale capital in-flows that would result from global investors looking to allocate up to a third of their government-bond portfolios to emerging markets.

Pimco sees considerable first-mover advantage for investors who position themselves early to take advantage of the push into emerging-market debt, but Toloui warns that valuations may be bumpy.

“Positioning yourself there early is a way of taking advantage of the fact that we anticipate that there is going to be large capital flows going in as more investors allocate to these markets,” he says.

“In that journey, we are going to have periods where valuations are stretched where a lot of money moves in in a short period of time and we, as active managers, are trying to be mindful of that. Emerging markets are smaller. Navigating those markets is more difficult than it is in deep, liquid markets in industrial countries, but it does mean that getting there before others is especially important and also being sensitive to valuations as you are making your investments.”