Helen Morrissey speaks to Roger Gray, chief investment officer of the Universities Superannuation Scheme (USS) about how the scheme's investment approach is evolving
Helen Morrissey: What are the key challenges that the scheme is currently facing and how are you going about dealing with them?
The scheme became underfunded during the financial crisis and, while the funding ratio is much improved, there is still some way to go
Roger Gray: One of the key challenges currently facing the scheme is that of funding levels. The scheme became underfunded during the financial crisis and, while the funding ratio is much improved, there is still some way to go. Also, to address the volatility of the funding ratio, we are looking to increase diversification within the scheme’s investment strategy over time, to introduce an element of liability hedging and to make the asset allocation more dynamic. I suppose the key challenge facing us will be managing these moves appropriately over time.
Helen Morrissey: In what ways are you looking to diversify your asset allocation?
Roger Gray: One of the most important elements of our diversification process is the progressive investment into alternatives (In 2007 USS made the decision to allocate 20% of its portfolio to alternative investments over time). This is being done via a reduction in the quoted equity allocation of our fund.
We have also looked to make small incremental allocations in fixed income. Dynamic allocation involves a number of elements. If you have a target allocation, as we do with alternatives, then that takes time to build up. We also need to strike a balance between the return seeking and risk reducing assets that we have.
As our funding ratio surpasses certain thresholds, it becomes more affordable incrementally to increase our risk reducing assets.
Helen Morrissey: Tell me about how this movement into alternatives is going?
Roger Gray: Maybe I should start by defining exactly what we mean by alternatives. Some schemes will include property as part of an alternatives strategy but we don’t. For us, alternatives encompass asset classes such as private equity and debt, infrastructure, absolute return strategies as well as real assets such as timber and commodities.
Parts of our alternatives strategy remain quite young but others such as infrastructure and private equity are more established. It’s also worth noting that with these kinds of investments, it can be difficult to assess their performance in the early years.
Our absolute return strategy is developing most rapidly at the moment as we completed building up our investment team in this area last year. We are currently up to 2% of the portfolio invested in absolute return strategies. With regards to alternatives as a whole, we have around 10% of the portfolio invested at the moment. A reasonable estimate is for this to grow to 15% of the portfolio over the next two years.
Helen Morrissey: What role do you see infrastructure playing in your asset allocation over the coming years?
Roger Gray: We see infrastructure as being a very interesting potential asset class. In the past, it tended to be accessed in a highly leveraged form but we know there are tremendous sums predicted to be invested in this area both in the UK and globally in the future.
As a long-term investor interested in generating annuity-like streams of income, infrastructure is very interesting. However, we would look to access this area in a more direct and less leveraged way than would have happened a few years ago.
Helen Morrissey: USS is well known for its commitment to responsible investment. How are you taking this forward? What more do you think can be done to increase awareness of these issues?
Roger Gray: We look at environmental and governance factors in terms of how relevant they are to the rewards and risks our investments will expose us to. We have certainly seen issues like governance enjoying an increasingly high profile in recent years.
It has of course been brought into sharp relief by the financial crisis, which suggested that boards and shareholders were not playing their parts. As far as environmental issues go, the focus on climate change has certainly brought some aspects of the environmental agenda into the public policy area. The UN Principles on Responsible Investment (UNPRI) has been a successful initiative in terms of increasing awareness of responsible investment.
In the UK alone, I believe there are over 90 institutional signatories. Another area we have been active in is looking at the governance issues associated with hedge funds and private asset classes. The scope of activity is certainly widening and we will continue to take responsible investment very seriously. We currently have five members of our 75-strong London office dedicated to this area.
Helen Morrissey: How are you managing risk within the scheme?
Roger Gray: Risk is managed on several levels. Both strategic and tactical asset allocations come into play when setting and adjusting the risk position of the scheme. Strategic asset allocation gets reviewed on a periodic basis. We also take a tactical approach and make adjustments to the fund as and when needed – so the ingredients are always changing.
At this point we don’t have any substantial derivative risk management overlay for the scheme but I suspect we will start to engage in that activity. We will look to build up our strategy and risk teams.
Helen Morrissey: What do you think are the key lessons that the industry has learned from the financial crisis and how are they being put into action?
Roger Gray: There are a number of key lessons to be learned from the financial crisis. The system was put under a tremendous amount of stress and this will have left some scars for a good while.
It is important to take on board the lessons to be learned, but also to ensure the right balance is kept. An important lesson is to always consider your risk tolerance relative to the liabilities and how this relates to the funding ratio and the strength of the employer covenant.
We will see more awareness of liabilities going forward. Some of the more specific issues that arose from the financial crisis include asset allocation that appeared to be diversified, but then did not give the extent of protection that was first thought.
We need to contemplate our risk allocations from more than one angle. While the world certainly can’t live without models, we certainly shouldn’t rely on them or any one of them either. This can be demonstrated in areas such as structured credit where models embedded assumptions that turned out not to apply. It’s a matter of being intelligent and maintaining a reasonable degree of scepticism.
While diversification may not always work, a lack of it certainly won’t work either in managing risk relative to liabilities at a reasonable cost. We should never be complacent and we need to consider a range of models and whether what we are doing is sufficiently robust.
Helen Morrissey: So what will you focus on over the shorter term?
Roger Gray: In terms of the next six months or so, we have a number of goals to work through. This includes the strengthening of our strategy team and of our risk and quantitative analysis function.
In terms of our investment allocations, we will continue the process of diversifying as we are doing with our alternatives strategy and also into credit. The markets have been very favourable to us over the past 12 months. This followed a period of time when the markets were much less kind – so we were able to go make up a good part of our losses. It was great to see that the scheme’s stomach was strong enough to make it through the downturn. But I hope we are doing things that will make us less susceptible to that degree of volatility in the future.
Roger Gray is chief investment officer of the Universities Superannuation Scheme. Prior to joining USS in September 2009, Gray was chief investment officer at Hermes Investment Management. Before joining Hermes in 2006, he was global head of asset allocation/currency at UBS Brinson and chief investment officer at Rothschild Asset Management. He has over 25 years of investment management and institutional advisory experience. Gray holds an MA in Politics, Philosophy and Economics from Oxford University and an AM in Economics from Harvard University’s Graduate School of Arts and Sciences.
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