Are you planning to make any changes now that you are the chief investment officer?
Not to the investment strategy. It is well formed and is on a path we have been on for a while. I have, however, made some changes to the structure of the team. I wanted to make it clearer where the responsibilities and accountabilities lie. In the past, we often had roles stretching across different functions, but I wanted to make it obvious who was doing what and why. The other part of the transition is changing our investment platform.
In the past we underspent on technology and had manual processes in place. We are upgrading our analytics to make portfolio construction and reporting easier. The first phase of that process will probably finish around June.
It is going to be one of those things that is never going to end. There will always be a tweak to how we want to cut things, but at least the basis is there now. All our data is in a usable format, which should make that easier.
The combination of the system changes plus the organisational re-design is a powerful way of focusing the investment team and making it more efficient. Hopefully, it will offer more learning and development opportunities.
Has this also been prompted by the shift to working from home?
Very much so. The shift to working from home has gone well for us so far. Even when we do go back to the office, we will keep some of the positives of the past year. We want to become more focused on when and why we are meeting, and I am sure we are never going to go back to five days a week in the office.
What impact have the events of the past year had on your investment portfolio?
We did an exercise at the end of 2019, which involved some serious stress testing across our portfolio. What I like about these playbooks is that when you have an event, you know what you are going to do and when you are going to do it. While our scenarios did not include a pandemic, we did look at a serious sell-off in growth assets and how we would react to that.
When the pandemic hit, we were in a pretty good place. Of course, the assets were volatile, but over the past five years we have taken a lot of risk out of the scheme and constructed a fairly defensive portfolio. It is fair to say that the portfolio behaved as we expected it to, which is a good start.
As events unfolded, we used our playbook and crystallised value off some of the hedges we had in place and were able to buy some discounted credit assets in March and April last year. Our private credit managers also bought assets, which have generally performed pretty well since.
To summarise, it was volatile, but our portfolio performed as expected and we were able to put some of our plans to work.
Did you reduce exposure to growth assets due to the relative maturity of the pension scheme or because of your investment outlook?
What drives that de-risking is the maturity of the scheme and where our plans are for the next 10 to 15 years. But we also use the markets and our views on the markets to help set the path of that de-risking.
Generally, we take a corridor approach where there is a central path to de-risking with boundaries around it. That means we move in a general direction, but we can adjust the pace at which we move along that central path. But yes, it is dictated by the maturity of the scheme rather than by a specific view on assets.
So, you now have a higher exposure to fixed income?
Yes. Over the past five years we have gone from 60/40 matching to 40/60. That path is continuing. As part of that, our strategy targets cash flow-aware investments, like secure income, corporate bonds…it is looking at our liability profile. As the scheme matures, those liabilities become more predictable.
How do alternatives fit into that strategy?
It depends on what alternatives you are looking at. Our focus is on private credit. We also run exposure to private markets in general and have some private equity and infrastructure in our portfolio.
Our real focus is on morphing some of our existing exposures away from property, for example, where there has always been capital appreciation. We are working with our managers to target income streams that fit our cash flow matching approach and our cash flow coverage ratios. It is transitionary.
You are a relatively mature scheme, so is liquidity playing a bigger role for you now?
It has been prominent for us for a while. We spent some time looking at our liquidity profile about five years ago when we first started our hedging programme. Liquidity means different things over different time periods. We are always thinking about short-term liquidity to generate our pension payments when they fall due.
But it is important that we are doing so in an orderly manner. We do not want to sell assets to fund pension payments, so we are trying to build natural liquidity in the portfolio to meet those payments.
Which asset classes are internally managed and which are outsourced?
Our starting position is that we outsource. There are instances where we believe we can do something more cost effectively or with a better outcome than doing it internally. The main area for that is around liability-driven investment (LDI). We only run our £17bn gilts portfolio in-house, in conjunction with our overlays.
The markets team manages the LDI portfolio and is able to increase or decrease exposure across the five main market risk factors to which the scheme is exposed: rates, inflation, equity risk, credit risk and currency risk.
Bringing the gilts in-house was a decision we took because of the size of the exposure. We needed to better control how that was implemented. We took the view that if we brought it in-house and moved away from a benchmark approach, we could use liquidity pockets in the market and work with certain banks to pace the speed of the hedge.
That has worked well.
One of the things that worked for us is that coming out of 2009, regulation changed for the banks and not many of them were warehousing much of their risk.
There were a handful of banks that realised that if they worked with us, we could take risk down on one side, while they were able to line up transactions on the other, throwing off inflation and some interest rate exposure.
It meant that we developed strong relationships with banks that knew we could hold prices and take down the risks over that period. It was rare that we would line up, say, three banks and ask for the best price. We knew we needed to be smarter in how we accessed that market. It meant we were not your standard pension fund price taker. We were able to trade at more optimum levels.
When the mood music starts changing, it will be interesting to see how markets are going to respond.
When we spoke in May last year, you were planning to reduce the overall number of actively managed mandates. How is that working out?
This is something we have been doing for about five years now. Back then we probably had more than 40 relationships with managers. Over time, we have brought it down to between 20 and 25. The reason was twofold.
One was that by having so many mandates, we felt we were washing out a lot of the active management in them. We felt we could drive a harder negotiating bargain with larger and fewer mandates and that has worked well.
The second angle was that we wanted to develop deeper relationships with some of those managers, which has also worked well.
We have replaced some of our passive exposures to more active exposures. This goes back to designing defensive portfolios. The one thing we try to avoid are aggressive sell-offs – that is where we want to outperform. We do not mind giving up some return on the upside, but it is the sell-offs that hurt the scheme, particularly if our liabilities are suffering from lower rates, which tends to be the way it works out.
In working with more active managers, we have been better able to design outcomes that t our scheme requirements. That was one of the drivers behind the more active approach.
It has been a tricky period for active managers. Even during the past year, they did not outperform passive managers.
What we are interested in are not just the returns, but the characteristics of the returns. In the difficult markets of spring last year, our active managers outperformed significantly because they had a defensive portfolio. In turn, they underperformed in the strong rebound, but that is what we expected.
It is not as blunt as looking at the performance against the benchmark. It is the performance being generated in the context of the underlying market conditions that is important to us.
You also announced a plan to make the scheme carbon neutral by 2035. How are you implementing that?
This is exciting. We have been thinking about this for quite a while. It is the nature of our portfolio, especially in reducing its growth assets, that gives us an opportunity to take down some of our emission numbers.
We estimate that roughly 80% of the emissions in the portfolio come from around 20% of the assets. That is across equities and corporate bonds. As we de-risk, it gives us a chance to focus on the implementation side when we go into the credit markets. We are getting under the skin of where the emissions are and avoiding the obvious ones like oil, gas, utilities and chemicals. The state of maturity of the scheme lends itself to bringing down emission numbers.
But reducing your equity exposure reduces your influence when it comes to engagement?
Yes. That is something we are looking at in our sustainable investment approach. It is about looking at dynamic changes and how we have influence by being in the different parts of the credit capital structure. We can still play a part on the advocacy side, we can still engage.
We are also at an inflection point where ESG is becoming so ingrained in society that the argument of not having equities but having bonds is a bit redundant.
We are still an investor. The corporate world has changed in such a way that there is now more of an open door for engagement than there was in the past.
How are you integrating other ESG factors into your portfolio?
We are looking at the whole sustainable investment policy for the scheme. Inevitably, it becomes a lot wider than just single portfolios or targeted portfolios. Again, it is an issue that the investment world is much more aware of and is embracing it a lot more. If we go back to our functional redesign, I have brought the responsible investment piece a lot closer, so we treat it as a completely integrated investment process.
Let’s talk about the broader investment outlook. US treasury yields have been rising this year, could this be an early indication that we might see a rise in prices?
We are at a pivotal point. I suspect central banks are going to keep short-term policy rates low, they have anchored them. If anything, they prefer to see economies running a little hot. Now, whether there is enough capacity in economies to prevent that leading to inflation is where we will have to wait and see.
But if you are looking at bond markets, there is an increased risk of inflation coming. That is a fair reflection given the amount of stimulus being thrown at markets and economies in general. It is not obvious there will be inflation, it depends on the capacity in any economy, but it is certainly a key driver of market activity and will continue to be throughout the year.
The argument against this could be that back in 2008/09 central banks also injected a lot of money into the economy. That did not lead to inflation, so why should it now?
Circumstances are slightly different this time. We have the unpredictable back-drop of the pandemic and the stored-up consumption that could be the driver to that inflation. That is one factor we are watching. Inflation has a big influence on how we run the scheme and is part of why we instigated the hedging programme.
What are the biggest challenges investors could face as the economy emerges from the pandemic?
How markets respond to central bank action. Markets have effectively been supported by central banks for the past 12 years. I have been around long enough to remember when the Greenspan put was introduced. Ironically, if they have it right, then they could turn o this stimulation into a market that has not seen a tightening cycle for 12-years plus.
That is an unusual place to be. The response to that tightening cycle will be interesting to see, particularly towards the inflection point, when central banks signal – and they are going to have to signal, the days of central bank surprises are long gone. When the mood music starts changing, it will be interesting to see how markets are going to respond.
