With the effects of 2007's credit crunch making themselves felt in the equity markets, the UK's pension funds are looking at ways to reduce risk and volatility. Heather Dale reports from London
The recent credit crisis has led to a general reassessment of risk and how UK pension funds should structure their portfolios to de-risk going forward, according to experts.
It seems UK pension funds have a high level of uncertainty as to how deep the implications of the credit crisis will be and how long it will go on for.
John Hastings, a partner at consultancy firm Hymans Robertson, said: "It is still the case that pension funds have a lot of assets in equities and clearly what happens to the equity markets has an impact on pension fund funding levels."
David McCourt, policy adviser: investment and governance at the UK's National Association of Pension Funds (NAPF), noted as part of de-risking there was now a move away from equities, however, it was not a wholesale move because there were not enough bonds available.
"Pension funds are competing against insurance companies for bonds like index-linked Gilts," said McCourt.
McCourt added there had been some interesting strategies around liability driven investing (LDI), saying consultants and asset managers were coming up with new and interesting ways to use these strategies.
Paul Gibney, investment partner, Lane Clark and Peacock (LC&P), commented: "You are seeing people diversify to reduce volatility and you are seeing people invest in bonds and swaps to reduce inflation and interest rate risk, for a better match against the liabilities."
Deborah Harris, European head of consultant relations at ABN AMRO Asset Management, said there was a demand from UK pension funds for 'dynamic asset allocation' mandates.
These are products seeking to generate equity-like returns with bond-like volatility and they typically target a return of cash plus 4% by switching between different asset classes, regions and styles.
Harris said she expected to see a further increase in demand for dynamic asset allocation products across pension funds of all sizes.
"This will be driven by the ongoing desire to have a diversified portfolio of growth assets to generate returns in excess of cash coupled with the flexibility to move between different asset classes, regions and styles without altering strategic allocations," said Harris.
Historically, UK pension funds have had a high exposure to both equities and property, making the UK pension landscape more conservative than continental Europe in terms of investing into a diverse range of alternative asset classes, according to Simon Chinnery, client adviser, UK institutional, JPMorgan.
However, Chinnery noted he had recently seen allocations to hedge funds and private equity, as well as interest in newer alternatives, in particular infrastructure and active currency.
"UK pension funds started off a few years ago hedging currency risk and now are looking to have an overlay, as they have already stepped into the water," he claimed.
Sam Gervaise-Jones, business development director at investment manager search firm bfinance, also said there had been an increase in mandates for active currency management. He added that as well as looking at the traditional overlay approach, investors were increasingly seeing currency as a distinct asset class, with the latter tending to be implemented on a pooled fund basis as a specific alpha seeking investment.
In the equity space, Gervaise-Jones said he had seen continued demand for more unconstrained and even absolute return mandates. Investors were relaxing benchmark related risk constraints and asking managers to construct "best ideas" portfolios, he asserted.
An example of this was the decision by the £1.4bn Kingfisher pension fund in September to award a 130/30 mandate to Goldman Sachs Asset Management and a second, unconstrained, 130/30 mandate to Wegelin's Active Indexing 130/30 strategy, worth a total of £80m.
Gervaise-Jones said: "The motivation is interesting since, in isolation, these alternative assets could be considered riskier, but in combination with more traditional asset classes, the diversification can help lower overall portfolio volatility. This is one of the benefits driving pension funds to discuss these options."
Harris of ABN AMRO said UK pension funds were also becoming increasingly comfortable with the use of hedge funds in their portfolios, but primarily through the use of funds of hedge funds.
"This approach allows the pension funds to target returns in excess of cash, provides additional diversification and requires a considerably lower level of governance than selecting a number of individual hedge fund strategies," said Harris.
Harris added it was now increasingly common for a UK pension fund to have, or be considering, strategic allocations to investment areas such as active currency management and funds of hedge funds as well as GTAA, infrastructure and private equity, alongside their more conventional allocations to equities, bonds and property.
McCourt of the NAPF also claimed to have seen an increase in allocations to private equity - he said the asset class may have taken a knock this year because of a reduction in cheaper finance due to the credit crunch, but there was a place for it in a portfolio, as there was also a place for fund of funds in hedge funds, derivatives, commodities and different types of property and infrastructure projects.
McCourt added it was up to trustees to think about the levels of risk and prudence they wanted to build into the investment strategy and this was driven by the position of the scheme. "There is a place for alternatives, however, it is not the norm - it's an area that trustees should - and will - look at, some funds may have been put off by the level of fees, but it's about balance."
In terms of the more traditional asset classes, experts expect to see an increase in demand for nondomestic property.
Hastings of Hymans Robertson noted that while the UK property market had been one of the strongest in the last 15 years, it was currently experiencing a savage downturn. "A lot of pension funds have been increasing allocations in property and it is now becoming dreadfully illiquid and hard to get out of," he said.
Harris of ABN AMRO stated that as UK pension funds looked to increase allocations to property, they would seek opportunities for diversification by investing overseas, particularly globally. "In order to access this segment of the market, investment is likely to include the use of property securities," she predicted.
Gervaise-Jones of bfinance had also noticed the diversification and said it was one of the biggest trends he had seen in 2007. "One way to try to protect yourself from underperformance without getting out of the market is to diversify; one would hope that markets would not all have a downturn at the same time."
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