High deficits, low gilt returns, expensive equities and forecasts of further volatility on the horizon – pension fund managers have plenty to navigate. Mark Dunne looks at how they are allocating their assets.
“PE ratios look ridiculously high. They look overpriced at the moment, but the problem has been that there aren’t any other assets to invest in because most other assets look overpriced.”
Mark Hedges, Nationwide Pension Fund
The Nationwide Pension Fund’s portfolio is changing. At the end of December the closed defined benefit (DB) scheme for the Nationwide Building Society was 20% invested in equities. By mid February its allocation had fallen to 15%.
This reduction is the result of chief investment officer Mark Hedges’ rotation into higher yielding assets, such as infrastructure, private equity, private credit, ground rents and property. Private market investments such as these now account for 20% of the £4.94bn fund’s assets.
Hedges is not the only pension fund manager who is increasing his exposure to long-term, higher yielding assets that are less vulnerable to political and economic shocks. Others are taking similar steps to help meet their commitments in a low interest rate environment and head off a repeat of the volatility that hit the markets in 2016.
President Donald Trump’s protectionist policies, the outcomes of several elections in Europe and Federal Reserve policy could be catalysts for turbulence in the coming months.
Church of England Pensions Board (CEPB) chief investment officer Pierre Jameson is another working to alter his portfolio to avoid the low returns and potential market volatility ahead. The assets he is looking at investing in over the next six months are infrastructure and low risk equity rather than low volatility equity.
“Low risk equity is very much like low volatility equity but does not carry the same connotations, shall we say,” Jameson says. “It is a little bit more than smart beta, but there are crossovers.
“Essentially, the kinds of managers we are looking to use are heavily quant-based,” he adds. “So they will be screening historic data within universes for low share price volatility, low risk exposure to the whole range of potential economic and political outcomes. That tends to narrow the universe quite a bit. Then they apply forward looking judgements about how companies might react under new circumstances.”
Also pursuing a specialist strategy to protect against market turbulence is the HSBC Bank Pension Trust. Chief investment officer Mark Thompson, who is in charge of a £3bn defined contribution (DC) scheme, had an idea last year to create a better accumulation fund. This would be built around generating better risk-adjusted returns, include climate change protection and a stronger management engagement policy.
Thompson approached Legal & General, FTSE and an investment consultant with the idea. “The upshot of that is FTSE launched a new index in November, Legal & General announced a new fund for that index and I said I would put £1.85bn in it,” he says.
The idea is to produce a better risk-adjusted return by moving away from a market cap index to a smart beta factor index, based on a number of factors including value, quality and low volatility.
“If you look at how that index would have performed from 2000 to last year, the market cap would have gone up by 7% per annum and the index by 9.6% per annum, but for lower volatility. So a better risk-adjusted return,” he adds.
NEW ORDER JLT
Employee Benefits senior investment consultant David Will says that the search for yield in the current low gilt return environment has gone beyond traditional asset classes.
“People have looked not just at corporate debt but have gone down the rating scale into high yield and other areas of the market,” he adds. This includes floating rate senior secured loans, which are less vulnerable to interest rate rises than fixed income bonds, and commercial property.
The non-traditional and illiquid assets that Hedges has turned his attention to are what he sees as alternatives to investing in index-linked gilts. This means ground rents and property, which are hedged for inflation and generate long-term cashflows.
Hedges is considering investing in insurance catastrophe bonds as part of his search for return. “This is one of the reasons why we sold down our equity position to fund investment in those,” he says.
He is not just looking for higher returns, but also to reduce risk. The private market assets that the Nationwide Pension Fund is moving into are less correlated to GDP and the general economic events that affect equities and gilts. Jameson’s strategy is to have half the volatility of equities in his portfolio over a market cycle, but broadly the same return.
“So 10% volatility but probably still getting 7% to 8% per annum return over time,” he says.
“What you might call smart beta or low volatility strategies, these are the kind of strategies that you might expect to underperform in a rising market, but strongly outperform in falling markets.”
Diversity is at the heart of Nationwide Pension Fund’s focus on long-term income streams and de-risking. And not just by asset class. The scheme has exposure to
Europe, the US and Asia. “The only free lunch in town is probably being diversified,” Hedges says.
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