Trends in Alpha chasing

Pension schemes are responding to the growing need to match assets to liabilities, enhance returns, make up deficits and protect lump sum payments received from their sponsoring company.

This is arguably reflected by the continuing move away from equity allocations. Although the shift among UK schemes is relatively minimal (figures from Mercer Human Resource Consulting suggest schemes have reduced their equity exposure from 62pc to 61pc over 2006, while equity allocation has reduced by 7pc over the past four years), it is in stark contrast to schemes on the continent, which according to Mercer have been increasing their exposures to equity markets (from 40pc to 42pc) during 2006.

Bank of New York’s managing director Mark Bewick believes these figures reflect the growing need to match assets to liabilities .

He says: “In order to do this, they are effectively operating some form of a liability-driven investment strategy. In particular, over the last year there has been a considerable move into bonds in order to use those assets as collateral for swap programmes.

“Bond mandates have also been put in place for liability matching purposes. UK schemes differ from those in Europe largely because of the demographics of the schemes – schemes are more mature in the UK and the use of swaps etc is more advanced and prevalent than their European counterparts.”

BDO Stoy Hayward Investment Management director David Philips points to the highly regulated conditions in the UK market as the reason for the disparity between UK schemes and their continental counterparts.

He says: “The significant changes of regulation in the UK market and the drive towards LDI modelling are the biggest catalysts for the move away from previous highs in equity holdings.

“Scheme-specific needs for firmer matching of assets to liabilities, backed by scheme sponsors that need to ensure less volatility in their scheme assets, mean that bonds, property and an increased exposure to alternative investments have taken the place of previous highs in equity holdings.”

However, Syndicate Asset Management’s group chief executive John Morton believes UK schemes have traditionally been over-exposed to the UK equity market – and, with stock markets rising strongly, their equity weightings continue to rise above targeted levels. Many schemes have responded to this by consistently selling UK equities.

He adds: “In contrast, European pension funds have traditionally had a significantly lower equity weighting than their UK counterparts, and as they are becoming a little more adventurous, they are generally letting their exposure to stock markets creep higher.

“Given the rising trend of eurozone interest rates and the subsequent headwind for European bond markets, there seems little reason for European pension funds to actively stop this gradual asset allocation shift.”

Hedge funds
The latest statistics from Mercer also show that UK schemes are not as active in hedge funds as their European counterparts, which Morton says could be caused by their heavier weighting in equities.

He explains: “The reluctance of UK pension funds to embrace hedge funds can be attributed, at least in part, to their much higher weighting in equities.

“On the continent, with only 25pc to 35pc in equities, there is a much longer history of investing in alternative asset classes. As such it is easy to see that investing in hedge funds as part of a fund’s bond allocation increases portfolio returns.

“In the UK the philosophical argument centres more on hedge funds as an alternative to equities, and, perhaps with the lesser degree of transparency and higher fee structures, it is a more challenging move for pension fund managers to make.”

Philips adds: “Historically, European schemes have had a far greater bias towards bonds, in contrast to equities.

“Here, the transition from bonds to hedge funds is an easier step: matching low volatility assets with another, rather than reducing equities, which entails a sacrifice of high expectations of long-run returns to lower yielding assets.”

However, UK scheme exposure to the hedge fund sector has been steadily developing – arguably as a result of greater awareness and education as schemes have increased their exposure to new markets and placed more emphasis on their risk budgets.

Bewick explains: “In general, trustee boards in the UK are more risk adverse and conservative than those elsewhere.
“In Europe the nature of the markets tends to revolve around the very large schemes. By comparison, in the UK the market is numerically made up of many more schemes, a large number of which are relatively small and are therefore by their very nature not at the forefront of investing in hedge funds.”

Aspect Capital’s chief commercial officer John Wareham points out that the UK is not the only country with a lower level of interest in hedge funds, as Germany is in a similar position. He says it is more a question of why the Nordic countries are so much more active than the rest of Europe in the asset class.

His answer is that Scandinavia and The Netherlands are more actively involved with seeking alpha providers in an ‘alpha-beta’ separated investment paradigm.

He continues: “Continental funds were somewhat earlier than their UK counterparts in actively managing their currency exposures – the euro having been seen as a ‘weak’ currency at inception, at a time when sterling was relatively stable, particularly against the US dollar.

“From the experience of managing currency exposures – perhaps passively at first but actively quite soon after – there may have developed a more institutionally tolerant attitude to alternative alpha sources. A further possible explanation is the heavy influence of consultants and trustees in the UK pension fund sector, which have been very conservative in their approach to hedge funds. Essentially, for the managers and the consultants, this becomes a challenge of education.”



Looking overseas
Although UK pension schemes have had a traditional domestic bias when it comes to investment choices, more and more are looking overseas for better return opportunities.

Bewick says: “By diversifying their country exposure, schemes become less dependant on a UK market that is developed and bearing reasonably average returns, and in turn seek greater returns elsewhere in the world.

“In pursuing this increased level of return through more exotic markets, the scheme will naturally increase its currency and market exposure and risk. In some cases this additional risk is still acceptable in the overall strategy of the scheme and needs no further management.”

Morton adds: “The trend for greater overseas equity investment seems only natural given that around 90pc of a pension fund’s equity exposure is in the UK and that many large UK companies are very global in nature – for example, BP, GlaxoSmithkline and Vodafone.

“It is evident how this trend discriminates excessively in favour of the UK market. For instance, the value of only the largest 500 companies in the US market are worth nearly four times as much as the entire UK stock market.

“In our view the increasing allocation to international equities at the expense of the UK will be an ongoing trend and an increasing adoption of active currency management by pension funds will probably go hand-in-hand with this.

“On a more tactical level, with the pound as strong as it has been in 15 years against the yen and US dollar, it looks a good time to be moving money abroad.”

Stern points out that the type of investment is more important than its location.

He says: “Efficient portfolio management requires that risk should be quantified and understood and only risk that will be rewarded should be taken.

“In order to maximise the scope for efficient management of risk, it is entirely appropriate to seek a diverse range of assets. Just as an artist isn’t limited to just one brush, but has specialist instruments to meet key needs, the same applies to assets.”



Tactical asset allocation
There is general agreement that UK schemes are increasing their exposure to active currency management and tactical asset allocation as they seek to diversify risk.

TAA is an active management portfolio strategy that rebalances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors. This strategy allows portfolio managers to create extra value by taking advantage of certain situations in the marketplace.

Morton says: “As asset allocation decisions become more rigorous, it is likely there will be an increasing focus on levels of portfolio risk and a natural extension for a broader consideration of techniques such as active currency management.”
He continues: “It is likely it will take more than a decade before such techniques are used widely, as UK pension funds have traditionally been very slow to invest outside the bond and equity markets.”

However, Credit Suisse’s director of multi-asset class solutions Guy Stern adds that although diversifying risk is one aspect, asset allocation and currencies can also be a source of alpha.

He says: “More clients are seeing the opportunity for managers to add value by using dynamic and active allocation strategies. The effect is, in fact, that magic combination of lower risk and higher return.”

Wareham believes it is very clear that the larger and more sophisticated pension funds are considering tactical asset allocations as a means to diversify their portfolios. This, he argues, reflects a number of factors.

He says: “The last two years have seen a sufficient recovery in global equity markets to bring many pension fund deficits into a more comfortable condition than they were four or five years ago.

“However, there still seems to be an appreciation that the severity of the deficit problems of the early part of this decade was largely the result of an excessive and broadly undiversified exposure to equity markets.

“From this understanding stems a greater willingness to entertain new opportunities to introduce diversifying sources of portfolio performance that can sustain both continued portfolio recovery and diversify portfolios in the event that major equity markets fail to sustain their prolonged period of recovery.

“An extreme, but not isolated, version of this approach is for a pension fund to be seeking a position of complete ‘equity market neutrality’ within the overall portfolio – which inevitably creates a substantial need for varied alpha sources.”

Wareham also points out that schemes that have accepted the use of alternative assets have often settled upon the use of active currency and systematic tactical asset allocation products for a number of reasons, including the returns available and the flexibility of the investment strategy.

He says: “The active currency and, in particular, the broader multi-asset class tactical asset allocation approach offers a set of returns that are both diversified and diversifying. Returns from these managers are genuinely a source of long-term returns that are uncorrelated with the so-called ‘major asset classes’.

“These managers are generally focused on trading exclusively in liquid currency and financial markets, offering to investors the considerable advantages of high liquidity and price transparency.

“A smaller number of these managers are able to provide their alpha-generating expertise in a variety of highly cash-efficient and capital-efficient vehicles, whose alpha-generating profile can be precisely tailored to the client’s individual requirements. For a pension fund seeking precision in its alpha overlay portfolio, without the need for beta bleed, the structuring flexibility of the TAA approach will be highly attractive.”

Philips adds: “Increasing employer and employee contributions is no longer the stock answer. And huge initiatives around seeking growth opportunities with regard to associated risks through TAA will prove the holy grail for schemes seeking to better control deficit situations.

“I would argue that the move to TAA and currency overlays is an attempt to get free alpha extracted from their current manager positions, rather than primarily for risk reduction.”

TAA has been developing for some time and looks set to increase in popularity, Wareham says.

He adds: “As far as the UK is concerned I believe this to be a relatively new feature of the market, but one that will become a clear and developing trend over the coming two to three years.”

Bewick adds: “The larger, more complex schemes have been doing this for some time now.

“But, in the medium-to-smaller scheme range this feature is relatively new, but likely to be ongoing as part of the normal management of the scheme looking forward.”

Stern says TAA represents a “re-discovery” of the value of allocation.

He explains: “Active allocation strategies have been an orphaned product in the UK and US. Pension sponsors, in the search for sources of return, are re-discovering this aspect of value adding.”

Philips says although TAA is not a new concept, it is continuing to develop as an investment strategy.

He says: “Its development and sophistication will be an increasing growth concept in the life of scheme management in the future.

“In terms of sophistication, TAA managers are developing their offerings of utilising assets such as hedge funds and private equity to deliver alpha in the shorter term, which can be linked to the specific levels of risk that the trustees ate prepared to take.”

Active management
Active management, whereby fund managers seek returns in excess of a specified benchmark, has also been receiving a lot of attention. Stern says there has been an increasing emphasis on active management to generate alpha.

He explains: “Clients are demanding that managers of all types move away from ‘closet indexing’ and put meaningful positions in the portfolios.

“In fact the increase in indexing can be seen as a move to a barbell strategy [where maturities of portfolio securities are concentrated at two extremes] of a passive core/active satellite philosophy.”

Bewick adds: “We have certainly seen a degree of movement away from the pooled vehicles or passive arrangements more recently.

“This would indicate it is no longer enough to track an index – more return is required.

“We have also seen an increasing trend of mandates awarded to specialist and boutique managers. Sometimes these have been in conjunction with LDI strategies involving bond mandates, derivatives, as well as alternatives.”

Wareham points out there is “no such thing as a passively managed currency product”.

He says: “Fundamentally, I believe systematic strategies are the most reliable sources of pure alpha or absolute return, as opposed to disguised market beta – particularly within the liquid and transparent asset classes, which are where pension funds have greatest comfort.

“While the term ‘black box’ is often seen as a worrying indication that ‘the computers have taken over’, it is actually the case that the systematic approach provides a greater degree of reliability and consistency to the alpha-generating process.

“This in turn creates a greater degree of confidence in the persistence of the return stream.”

Philips agrees, saying: “The whole concept of generating alpha can only realistically be seen as coming from active management – we don’t see there is any other way.”

Morton says: “With more appreciation of modern portfolio theory has come a recognition that by simply adjusting beta you can increase or decrease the level of market risk.

“It is difficult to time this because behavioural investing theory tells us that people are inclined to reduce risk when in fact they should be increasing it and vice versa.

“Therefore, the pursuit of alpha where excess returns are deemed to stem from stock selection rather than increased risk is seen as more preferable.

“The challenge is establishing who is generating alpha and more importantly, who can generate it consistently.”