These are turbulent times for investors. In March 2020, your assets shrank by around £10bn to £64.3bn, before recovering. What lessons have you drawn from the past year?
That you cannot predict the future. I am not sure if two years ago any of us would have predicted the whole Covid experience. So, you need to be humble when making predictions by recognising that your ability to forecast is exceptionally limited. You also need to have resilience built into how you make your investments so you can cope with unforeseen circumstances.
Having a diversified portfolio is important. Key for us last year was having sufficient cash and collateral within the scheme to ride out volatility without becoming a forced seller. It also helped us buy cheap assets. Ideally, your investment strategy will enable you to take advantage of these opportunities.
The recovery in markets was substantial and surprisingly sudden. Market levels are higher now and the value of the scheme exceeded £80bn by the end of the year. That tells its own story in terms of our ability and courage to react to volatility. You are often not able to take forever when making decisions, you need to make them swiftly.
When you used your cash to get back into the markets, what did you buy?
We bought some corporate bonds at much wider credit spreads than had been present before the pandemic and attractively priced government bonds, particularly in the UK. For several weeks we saw stress in the bond markets and bought some cheap inflation hedging. We also had big positions in US treasuries, which strongly outperformed gilts. We were able to take some of our profits in the US and move them to the UK. What we have also done, but more gradually, is identify attractive opportunities in the private markets during the second half of 2020. We bought some interesting assets there.
Why did you make some major strategic investment changes last year, which included closing your developed markets equity team?
We took that decision before Covid, so it had absolutely nothing to do with it. My conviction is that we often spend more time thinking about the performance of a particular equity portfolio relative to a benchmark than asking why we are investing in equities at all.
What is their strategic position in the portfolio? How should we invest in equities given the other assets that we own? What are our liabilities? I wanted us to step back from stock picking and ask bigger, more strategic questions. That is what we will be doing going forward.
We have appointed Innes McKeand as our new head of strategic equities, who joins from Australian Super [A £101.8bn Australian superannuation fund]. He will be tasked with helping us think about equities from a more strategic top-down perspective. This includes more longer-term strategic thinking, a greater involvement of responsible investment and how our portfolio is constructed holistically by thinking about how assets and liabilities will work together.
This also includes our approach to divestment and exclusions. Last year we concluded that we should no longer invest in coal, tobacco and various controversial weapons. That is linked to that general change in thematic thinking and our conviction that the way in which the world is changing made those poor investments going forward so we will exclude them from our equity portfolios.
USS is an open scheme that has the pressure of the deficit discussions hanging over it. So, does the portfolio have a strong growth focus?
Absolutely. We are not the same as every other investor, so the important question is how we should invest. Equities will remain an important part of our portfolio, but how we invest in equities will be a big question going forward.
It has become increasingly hard for active managers to outperform passive funds in developed markets. Was that behind your decision to restructure the team?
We have a respectable history of investing in equities, and I would particularly call out our emerging markets team who we have retained throughout and who have an outstanding track record of performance, including last year. Our medium-term track record and equity investment relative to the benchmark is fine.
But my conviction is that we were not focusing on the most important questions. Adding or subtracting a little value from investing relative to benchmark is useful. But the key question is how we should invest in the first place. The asset allocation question within equities and the longer-term strategic approach is what I want to focus on.
Stock markets have recovered rapidly from the pandemic, but many underlying businesses are struggling. How concerned are you about the sustainability of equity valuations?
Asset prices are high. Debt, equities, every investment has an elevated price and they are all connected. Ultimately, the price of equities is justifiable, given the incredibly low bond yields we have. It is that bond yield that effectively is the pricing mechanism for all financial assets. If we were to see a sustained increase in bond yields, that would put pressure on equities, but that seems relatively unlikely, given how fragile the world is. It is likely that we will have low bond yields for quite a while.
Of course, we are hoping and expecting to see an economic recovery as the lockdowns are eased. But we will probably see some residual impact from the events of the past 12 months for many years. Some of those will be structural changes. It looks likely that our approach to carbon has changed in a fundamental and long lasting way. In a sense, now is the opportunity for governments to encourage growth and for that growth to be focused in areas that will be sustainable.
A low carbon future is more likely now and more likely to be rapidly achieved than perhaps if Covid had not hit. Some other trends are also likely to be quite sticky. We do expect to see a return to office working, but I am confident that most of my employees will not want to be in the office five days a week, even when it is safe to do so.
We will see permanent differences in how the built environment operates, commuting and in retail. There are dramatic changes that will impact different sectors of the economy and that are likely to be relatively strategic in nature, rather than a quick resumption of the old way of working.
Is that something you are planning to capitalise on as an investor?
Where we can. There are assets we already own that will benefit from that and assets we want to invest in. For instance, we announced in December a major investment in G.Network, a business that is rolling out faster broadband speeds across London. To our mind, that investment is likely to benefit from the change in the way people want to work and want to live. That is an investment that over time will pay dividends.
USS IM is a major investor in UK infrastructure, from Heathrow Airport to shopping centres. How has that portfolio been affected by the pandemic?
Certain sectors have struggled. Anything to do with transport has had a difficult time, but other investments have done what you hoped they would because they are an essential part of daily life.
For example, we are invested in Thames Water, a business that needs a lot of investment to improve the quality of its pipes to reduce leakage. It is a business we are committed to. There is also the broadband roll-out in London, which we invested in at the end of 2020. That is about building fresh infrastructure. There is a huge variety within the general label of infrastructure, some of which has obviously struggled, such as transport, but we expect to see a significant recovery.
We also see significant opportunities for growth within infrastructure, areas that are an essential part of life. Diversification is important to us. We are not going to get every investment right. What we need to make sure is that the overall portfolio can deliver the cashflows to pay our members’ pensions as they fall due.
Are you planning any changes to your infrastructure allocation going forward based on the strategic changes you mentioned?
Where we see an attractive opportunity, we will invest. If we do not see an attractive opportunity, we will not. Investments that have a good chance of returns being linked to inflation are attractive because the pensions we pay to our members are linked to inflation.
Investments with strong linkages to inflation are an attractive, either contractual and explicit through, for example, contractual income being paid by utilities or rental income explicitly linked to inflation. We are looking out for those.
Is this an attempt to hedge the potential risk of price changes?
Yes, especially because inflation means the amount we pay our pensioners goes up. So, in that environment we would want to see the value of our investments go up too. An example of an investment we made last year was buying a 50% share in a long-term sale and leaseback deal for BP’s forecourt business.
That is backed by an inflation-linked rental agreement with BP, so as inflation rises so does the rent we collect. Incidentally, that allows BP to recycle the cash we paid them to decarbonise their business. That is an example of an open investment that has explicit inflation linkage.
We have talked about your ESG stance in equities, but are you also using your position in infrastructure to engage on ESG issues such as tackling climate change?
Very much so. Arguably, much more so. Take for example our investment in Heathrow. We have a board seat, so we directly influence the running of the business. For instance, they have not only made a pledge but achieved a net zero carbon performance for their ground operations. That was something we worked closely with Heathrow’s management to change the way the business operates.
So, as a major infrastructure investor, you have significantly more influence as a private owner of a business than merely investing in publicly listed equities, where you cannot have a board seat. We have a much greater ability to influence from a climate change perspective as a private owner of assets.
So, that is one argument for pension funds to invest in infrastructure?
As a long-term investor, we have the incentive to make long-term decisions and encourage the business to operate in a long-term way. Whereas often in the public markets, management is thinking about their next annual report.
As a result, decision making for many corporates is probably too short term. But, as somebody who is going to invest in the business for the next 10 to 20 years, we can influence management to think about their long-term interests and society’s long-term interests because the two are heavily intertwined.
What is your outlook for the global economy?
I hope we can have conversations face-to-face before long. I am encouraged by the rollout of vaccines that appear to have a significant impact on the way society can operate again.
But equally, it looks like there will be some fundamental changes in the way we all operate and live. There will be greater flexibility in how we do our jobs and greater empowerment. But we are also going to see some legacy scarring.
The level of global debt has increased and is not going to reduce quickly. That is likely to result in lower interest rates for longer and weaker returns for investors for a prolonged period. It is not all sunlit uplands. We are going to be in a period that is challenging for society and financial markets, as we deal with the long-term structural implications of this pandemic.
