Paper: Three Cheers for Equities Long-Term

Given the return requirements of investors around the world, equities should remain a significant building block in an asset allocation program, Wellington Management concludes.

(March 8, 2012) — Equities will have long-term return benefits for most investors despite the asset class underperforming bonds over the past 15 years, Wellington Management concludes in a newly released report.

In recent years, individual and institutional investors globally have lowered their allocation to equities in favor of fixed-income for many reasons, such as reducing the volatility in their portfolios. While the embrace of a fixed-income heavy liability-driven investing (LDI) strategy is logical for corporate pensions, the majority of investors still need substantial returns and portfolio growth to meet their long-term objectives.

The Wellington paper asks: “Where will the necessary returns come from?”

“A near-perfect environment for Treasuries over the last 10-plus years has resulted in strong bond returns, significantly lower equity allocations, and historically low yields,” the paper co-authored by Conor McCarthy and James Rullo asserts. “At the same time, most investors’ return goals remain high.”

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Ultimately, the authors concluded that they believe that investors should base strategic asset allocation decisions on fundamentals and valuations, rather than on recent returns. While allocations to other areas of fixed-income or to alternative asset classes may be appropriate, there are often limits to their use, such as liquidity constraints and the skill required to select and monitor complex strategies. Thus, the paper asserts: “We believe that current market conditions and historical capital market behavior suggest that now is a good time for investors to examine their fixed income and equity allocations to determine if they have the appropriate exposure to equities to meet their long-term objectives.”

The paper by Wellington follows a similarly supportive paper on equities by UBS Global Asset Management, which concluded that the stage is set for investors who pursue US equities to deliver active returns. Amid heightened market volatility — agitated by the eurozone’s worsening state — the paper urged investors to keep active. “Active investment managers are typically hired to take positions that differ from the market with the aim of adding value by exploiting inefficiencies. Dispersion of security returns is a basic measure of available opportunity and is related to the concept of breadth, which, coupled with skill, enables a manager to generate value,” the paper said. Ultimately, the authors conclude that managers who take bigger active risks stand a better chance of winning compared to ‘closet indexers.’

Additionally, the UBS paper explained that the market has resulted in a flight to perceived safety, creating additional opportunities for active investors. “The flight to safety and elevated level of market volatility have pushed valuation spreads back to very high levels…The good news is that a very high level of valuation spreads is an excellent forward-looking indicator of stock selection opportunities,” the paper said.

The CIO Profile: The United Kingdom’s Pension Protection Fund is 106% funded—and only getting better with age. Who said entities established by the government couldn’t function effectively?

(March 8, 2012) — Ian McKinlay, Chief Investment Officer at the Pension Protection Fund (PPF), the lifeboat for bankrupt company schemes in the United Kingdom, is in a unique position.

Unlike most defined benefit pension fund managers in the UK, it is the assets in his fund that are growing rapidly, not just the liabilities.

The PPF, launched in 2005, was mandated by the government to take on the assets and liabilities of pension funds whose sponsoring employer had collapsed. The ‘lifeboat’ only takes on funds that are in deficit and promises a minimum pension for members. This means that the investment team behind it has to make enough money to cover these payments.

Along with an annual levy that is collected from all company pension funds in the UK – which would allow them access to the PPF should they fall on hard times – the PPF is growing by about £2 billion each year.

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The updated total assets under management will be revealed later this year, but a ballpark figure would put the fund at around £10 billion. As the economic crisis filters through to UK business, the number of company bankruptcies could be expected to rise, ensuring PPF assets also will increase.

“I suppose we are in a unique position – we have to look at what assets we will have in a couple of years’ time when making our investment decisions,” says McKinlay, in a matter-of-fact Scottish lilt.

McKinlay is at home at the National Association of Pensions Investment Conference in Edinburgh – quite literally at home, being born and raised in the Scottish Capital, now re-rooted to surburban South London – surrounded by investors with new ideas and a thirst to do better.

He assumed the role of CIO in March 2009 having been brought in temporarily to look after investments through his former employer, PriceWaterhouseCoopers, and set about constructing the investment portfolio to weather the financial storm that was wreaking havoc in global markets.

“The substantive effects of the decisions we made came into effect in the summer – 18 months ahead of schedule, which we were pleased with. We reduced our 20% equity allocation to 10%, by selling off the majority of our UK holding, and moved the allocation to alternatives.”

The fund now has a target allocation of 20% distributed between private equity, distressed debt, global real estate, GTAA and infrastructure.

“It is a better balance and is tilted away from the UK for better diversification – we don’t just diversify for its own sake.”

The PPF has a broad approach to asset classes – it most recently requested asset managers tender to run timberland and farmland mandates – and this is key, McKinlay says, to the fund’s success.

“We saw the benefit in the summer – when markets were very choppy, from the end of July to September, the typical UK pension fund assets were down 20% while the PPF was only down a couple of percent. Our stakeholders were better protected.”

This event was not a one-off. McKinlay tells me that the PPF’s funding position has decoupled with the rest of the UK pensions universe (which the organisation monitors). At the latest count the PPF was 106% funded – the organisation’s figures last month showed the average UK pension scheme was 80% funded.

So how has the PPF done it?

“I start from a position of thinking how I can improve the exchange rate of risk to return and by diversifying we can improve the return potential. I have been targeted, by the trustees, to make 1.8% over our liabilities with a view to being 110% funded in 2030 and attain self-sufficiency.”

Self-sufficiency means it would no longer demand the annual levy from pension funds – an issue that has proved a thorny one over the years.

The portfolio is divided into three main sections: Liability hedging, diversified investments, and hedging tails.

“To hedge our liabilities we use repos, which is unusual for a UK pension fund although some European funds do it, with which we have a very diverse range of counterparties, maturities and date ranges. We are one of the largest players in this field.”

The investment portfolio continues to be ‘evolved’, McKinlay says. He is looking at diversifying the PPF’s fixed income holding through credit and emerging market exposure to lower the overall risk.

Tail hedging is the final piece – the PPF uses a range of options and put baskets, again all very well diversified, and swaptions to take care of interest rates. The fund also has been put through several scenarios ranging from the collapse of the Euro to a surprise interest rate hike.

With such innovation and sophisticated approach, why does the PPF retain a long roster of asset managers and other providers – with a burgeoning size, is it not time to bring these mandates in house?

“We have thought about it,” McKinlay says, cutting the topic short.

“And?” I venture.

“We have thought about it. And the potential consequences – on a cost-saving basis and looking at the operational risk.”

So it’s a no, at least for now.

“We are just pleased with what we’ve done. It’s fine to talk about portfolio constructions, but they have to work –and ours does. We are constantly refining it, to squeeze a bit more of a return, but I’m happy with what we’ve done.”

He encourages me to take a look at the annual report at the later this year and see what the PPF has achieved.

Regulation prevents him saying any more, but it is likely to make interesting reading.