What are some of the most pressing challenges that you face at present?
Our scheme has £75bn under management and it is benchmarked against a reference portfolio set by the trustee board in line with the return requirement and risk appetite of the scheme. Our ambition is to outperform, while running less asset-liability risk than the reference portfolio and satisfy other constraints set by the client. This framework presents us with challenges around asset allocation and portfolio construction. One of our challenges is the absence of perfect hedging assets given that our liabilities are linked to the UK's Consumer Prices Index (CPI) but most tradeable instruments such as index-linked bonds are indexed to the Retail Prices Index (RPI) and there is a substantial basis between the two metrics1.
How do you define your asset allocation in the current environment?
When we assess our asset allocation, we are constantly mindful of the sensitivity of our portfolio to both interest rates and inflation, relative to liabilities. These liabilities are linked to the CPI so bonds have to be a significant part of our portfolio - and here we invest in UK index-linked bonds and those from developed markets worldwide. A big chunk of our portfolio is invested in equities (public as well as private) as we believe these generate higher returns over the long term. We are also attracted to credit assets, given their interest rate-hedging characteristics and their expected returns relative to index-linked bonds. Going beyond the credit space, we allocate to real assets such as property and infrastructure too, as we believe they are a good hedge against inflation. Here we include a small allocation to commodities including gold.
Where does gold fit into a pension fund portfolio, in your view?
I think over the long term commodities, including gold, are a good hedge against inflation. At present, our allocation to commodities is around 1%, and gold is just a small proportion of that. We believe that a diversified basket of commodities is preferable to more concentrated exposure because of diversification opportunities within the commodities universe.
Energy, agriculture, precious metals and industrial metals all have distinct characteristics and different degree of correlation to the economic cycle. Gold stands out as unique within the commodities universe given its role as a financial as well as a real asset. A standalone allocation to gold could be a risk diversifier and potentially offer some protection in tail scenarios.
Some pension funds are concerned about making a strategic allocation to gold because it does not pay a coupon or a dividend. Can this investment barrier be overcome?
In a low-yield environment, even bonds do not provide a very high yield so the opportunity cost of holding gold is almost zero. And if we look at gold as a currency, it also offers clear benefits because it is not vulnerable to the same devaluation risks as fiat currencies. However, in order to address the perception that gold is not a suitable pension fund asset, we need to provide both a detailed analysis of history and highlight the forward drivers of the gold price.
If we look back at gold's performance over the past 70 years and beyond, the data would seem to suggest that it can make a positive contribution to pension portfolios over the long term. We know that gold outperforms during periods of stress, such as the 1930s, the 1970s and, more recently, the Global Financial Crisis. But there are signs that it performs on a continuous basis too, in good times as well as in bad. So, even if it does not deliver income, gold does provide capital returns over prolonged periods, particularly during inflationary environments.
With regard to future modelling, the World Gold Council's valuation framework, Qaurum, is a useful tool to understand the drivers of gold's performance and how it may react across various macroeconomic environments. In essence, we need to look at the long-term relationship between assets and liabilities cashflows so that we can ascertain whether including an allocation to gold can help us construct a more robust portfolio allocation. This work is ongoing within our scheme.
What is gold's role within a portfolio?
I think gold could be part of the inflation-hedge bucket but it is also a diversifier and could be treated as such. That is particularly important in the current climate, when returns from traditional assets are so low. If, therefore, we want to increase our allocation to certain riskier assets that we believe can generate higher returns over the long term, we need to have diversifiers in the portfolio to reduce our asset liability risk. Gold and commodities fit that space. They offer diversification. They offer different sources of return from traditional assets and from our reference portfolio.
ESG issues are increasingly important among institutional investors. How much do these issues feature in your investment strategy?
We have been proponents of responsible investing for years. Our first policy was launched in 1999 but our interest has increased considerably since then, not least because we believe that companies and funds with strong ESG characteristics have a track record of producing superior sustainable long-term returns. Today, our investment research process includes ESG screening and any new investment has to go through that process, before we even consider asset allocation. Gold would be subject to the same analysis.
Krishna Nehra is senior analyst within portfolio strategy, Universities Superannuation Scheme
For more information, please contact Claire Lincoln at [email protected]
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