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Chapter 1

Foreword

LGC Investment: Our regular special report

 
 

As the delegates gather for this year’s LGC Pension Fund Symposium, they will likely breathe a sigh of relief at having made their final submissions to the government on pension fund pooling.

Rachel dalton

Rachel Dalton, special report editor

The pooling initiative has dominated every aspect of Local Government Pension Scheme management for the past two years. Although the journey is clearly far from over, with most funds having not yet begun to transfer assets into their pools, the July deadline at least draws to a close a period of uncertainty, confusion and intense negotiation, both between funds and with central government.Staffordshire CC’s Andrew Burns highlights the importance of getting the governance of pools right now, during the arrangements’ formative years, to prevent problems further down the line.

Fund officers and elected members have worked hard over this period not only to get pooling right for their funds and for the scheme as a whole, but also to keep up with the demands of the day job. In our interview with LGPS Advisory Board chair Roger Phillips, we highlight the rest of the issues facing the scheme that still must be tackled, from deficits to rising employer numbers, and in a separate feature,we examine the state of the scheme as presented in the board’s latest annual report.

Reform to the structure of the scheme does not mean that funds can take their eyes off the ball when it comes to investing wisely for scheme members’ future, and in this issue, Man Group’s Harry Skaliotis explores the possibilities of achieving returns via liquid alternatives; we report on an LGC roundtable exploring environmental, social and governance issues, sponsored by Goldman Sachs Asset Management; and we explore the latest thinking on
emerging markets as these assets recover from a long period of underperformance
.

Looking ahead, funds face more hard work in the practical implementation of their pooling proposals, coming up with a plan to satisfy the government’s ambitions for infrastructure investment, and dealing with the administrative challenge of increasing numbers of academies joining the scheme. Although this July represents one milestone in the development of the scheme, by April 2018, when pools are meant to be fully operational, so much more will have been achieved.

Chapter 2

LGPS Advisory Board report

Returns on the rise

The third LGPS Advisory Board annual report shows a higher return on investment but increasing employer numbers remain a concern

 

The Local Government Pension Scheme Advisory Board’s third annual report revealed that the scheme achieved a far higher return over 2014-15 than in the previous year.

The board said investment performance, on average, exceeded actuarial valuations set out in the 2013 triennial valuation. It added, however, that negative gilt yields continued to be problematic for LGPS funds, as they are used to calculate the value of liabilities, with low yields inflating liabilities.

This year’s report shows that overall, the LGPS achieved a return on investment of 12.1% in the year to 31 March 2015, compared to a 5.9% return in the previous year. The report puts this success down to “more favourable market conditions” during 2014-15. Total assets in the scheme increased by £25.1bn to £217.2bn during the period, an increase of 13%.

Barry McKay, partner at Hymans Robertson, says: “LGPS funds have a significant allocation to equities. The main driver for the higher returns during 2014-15 was the stronger returns in equity markets in this period, particularly global equity markets.”

Andrien Meyers, senior investment consultant at JLT Employee Benefits, adds: “The 12-month returns were driven by positive numbers from US, global equity and bond assets, including emerging market debt and high yield debt.”

Asset allocation changed little over the period. The greatest changes were an overall scheme decrease in equity investment of 1.7%, to 36.8% of the total assets the scheme holds, and an increase of 1.7% of investment in pooled investment vehicles over the time. There were minor decreases in the total allocation to fixed interest securities (0.6%) and cash (0.4%), and slight increases in the allocation to derivatives and property (both 0.3%).

Mr McKay adds: “Over five and 10 years the LGPS funds have outperformed the corporate sector funds by around 1%, which shows they are being well managed.

“The LGPS is open to new members and so has a longer time period to withstand market volatility and can invest in higher risk assets. Corporate pension funds are often closed to new members with a greater level of matching of liabilities and so may have a lower risk and lower return investment strategy.”

The total membership of the scheme grew by 144,000 people to 5.1 million members over 2014-15, or by 2.8%. This represents a slight fall in membership growth year-on-year; in 2013-14, membership grew by 4.9%, and the year before that by 3.3%.

Each category of membership – active, deferred and pensioner – increased over 2014-15. The proportion of deferred members grew by the most, increasing by 3.7%. Active membership increased by 2.7% and pensioner membership by 1.9%.

The report said that 2013-14 saw greater increases in active members because a large number of LGPS employers began automatically enrolling members in that year. To an extent, the report said, auto-enrolment was still driving the increase in active membership in 2014-15, but less so as smaller employers began auto-enrolling members in that year.

Mr McKay adds: “Auto-enrolment is increasing active membership, but workforce planning and budgetary pressures are reducing the number of new actives and possibly increasing the number of deferred and pensioner members.”

On the growth of deferred membership, Mr McKay says: “This has been steadily increasing for many years. There are number of possible reasons for this, including the mobility of the workforce, auto-enrolment and then members opting back out, and because prior to 31 March 2014 there was a three-month vesting period. This means once an active member had three months’ service they would automatically qualify for a deferred benefit if they subsequently left.

“We saw in 2015 the increase in deferred members slowing down as the vesting period has been increase to two years, so members may take a refund of contributions instead.”

The board said over 2015 it piloted a set of fund ‘health indicators’, which it planned to roll out to coincide with the valuation funds must undertake this year.

“This will enable us to assess and benchmark the overall health of the scheme relative to other large public or private pension schemes, as well as between individual LGPS funds,” the report said.


Partner insight: Pooling LGPS assets - not all transitions are equal

As Local Government Pension Scheme funds in England and Wales continue to outline their approach to creating asset pools, we assess the opportunities and challenges at each stage of the process and conclude that not all transitions are equal.

James sparshott LGIM

James Sparshott, head of local authorities, LGIM

The 89 LGPS funds collectively represent approximately £217bn in assets (as at 31 December 2015), making them one of the 10 largest owners of investment capital globally. With this size comes an opportunity to capture the benefits of management fee savings and improved governance.

Consolidating assets of this scale into a small number of investment ‘pools’ will be a milestone event, yielding significant long-term savings - potentially £200m-£300m per annum by year 10. It is critical that these benefits are not diluted by avoidable transition costs in the short term.

This consolidation is likely to be a sequence of increasingly complex events that will require evolving capabilities as the associated risks increase. Here, we discuss the benefits of passive-to-passive consolidation, the increased risk with asset allocation changes and the challenges of transitioning active portfolios.

Passive consolidation

LGPS funds own £44bn in externally managed passive equity portfolios, run by only five managers. Fees are likely to be negotiated by LGPS at a ceiling price for all managers, ensuring that the primary cost-saving objective of the pooling project for this portion of assets is met.

Transfers are challenging too

Even for passive-to-passive portfolio consolidation, transitions can be multifaceted given the variety of fund managers, administrators, portfolio structures and underlying investment markets involved. Schemes are vulnerable to investment and operational risks and may incur high costs if these are not managed efficiently.

Transferring assets into a single passive manager for a given pool should be straightforward if the asset allocation strategy remains like for like. Typically, the majority of assets can be moved directly from one investment vehicle to another. Costs fall into two categories (assuming a transfer between pooled vehicles):

  • Frictional costs: direct and indirect costs associated with executing financial transactions
  • Cash costs: costs incurred when in-specie redemptions are not feasible, for example in emerging markets

Asset allocation changes

While a transition is a finite process, asset allocation is integral to the ongoing governance of a scheme. Consolidating passive assets alongside a strategic asset allocation can significantly increase the risks and complexities. The potential costs are greatly in excess of those for a passive consolidation, but still materially lower than an active transition.

Typical transition red flags

Asset allocation changes could involve more emerging market and small capitalisation stocks, which can escalate costs. Exposure to these assets will exacerbate smaller, more mundane differences such as trade date and settlement date cycles, and these interim risks should not be underestimated.

Transitioning active managers

While LGPS passive exposure is highly concentrated, there are approximately 280 active equity mandates with about 85 different managers, half of whom have managed assets for only one LGPS pool. Whether a portfolio is migrating to another active or passive structure, significant risks are associated with the existing portfolio.

Rather than one ‘big bang’, a phased series of transition events is likely to be optimal for the rationalisation of active managers. The full suite of transitions management expertise from planning and analysis to transfer, risk management and finally trading and funding, could be used by LGPS funds.

Costs versus savings

Given the variety of short-term costs likely to be incurred during the transition, it may seem counterintuitive to incur further expense in the form of transition fees. However, the benefits can be far reaching and these fees are often only a small proportion of the total cost of a transition event.

Consolidating active holdings is likely to generate some replication of trading flows across pools. It will be important to carefully coordinate and manage market impact within and across pools to avoid large, unmanaged, uncoordinated trade flows which risk impacting the value of the assets.

Transition costs and complexity typically escalate as the process moves from passive consolidation to a fully-fledged transition of active managers. Costs are split into three categories: explicit costs, implicit costs and opportunity cost. Explicit costs such as commissions and taxes are usually easy to identify. Implicit costs, such as market impact, are harder to quantify. Opportunity cost relates to the risk of not being invested in the target portfolio or allocation.

Conclusion

Transitions are not discrete events; they involve a number of variables and contingencies. The pools may benefit from transition partnerships that can also offer complementary implementation solutions, such as interim management, asset allocation overlay management services, run-off / illiquid asset management and FX hedging.

From our conversations with local authority funds we expect to see many more transitions taking place in the next couple of years, having already worked on over 50 transitions worth more than £6bn since the start of 2015. The expertise of skilled transition partners, especially in the context of active portfolios, could provide LGPS funds with additional resources, risk management and audit tools in a period of seismic change.

For more information, our local authority focused publication LGPS Intelligence is available at

www.lgim.com

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Chapter 3

Portfolio diversification

Diversifying for growth

In association with Man FRM: Efficiencies from proposed pooling arrangements should not come at the expense of maintaining a properly diversified portfolio, argues Man’s Harry Skaliotis

Harry skaliotis

Harry Skaliotis, managing director – institutional sales, Man

“Both governance and cost management are equally essential to the future sustainability of the scheme and should not be considered in isolation. We also propose that best practice with regard to transparency and accountability is extended across all funds,” the LGPS 2014 Project Board said in a joint statement in November 2012.

The objectives outlined by the LGPS in 2014 are both laudable and achievable. The potential cost saving may be the most tangible benefit of the proposed pooling arrangement but it would be self-defeating if this was achieved at the expense of maintaining a properly diversified portfolio (either through undue asset class concentration or over-reliance on passive managers).

Chart 1

It is only relatively recently that liquid alternatives – including hedge funds – have begun to form a meaningful component of institutional investment portfolios. In the aftermath of the 2000-02 bear market, hedge funds became more popular as investors realised that such strategies could participate in market rallies while providing some downside protection in major sell-offs.

During the global financial crisis in 2008, most hedge fund strategies performed poorly (with the exception of managed futures), leading to a period of retrenchment and consolidation. Many low-calibre hedge funds folded, and the survivors strove to improve their processes, controls and transparency. Since then, innovation in these areas has been a key source of differentiation for many successful managers.

At the same time, the demands of investors also increased. Previously, many institutional investors selected hedge funds mainly on the basis of their performance track record. Today, however, investors’ focus extends beyond performance to operational resilience and transparency. Increasingly, investors are looking to ensure that they have the necessary tools to closely monitor how their managers are performing and get transparency about risks, such as style drift.

Clealy, investors care about performance. Yet a recent global survey of 660 asset allocators by Natixis found that diversification was cited as the number one reason for holding alternatives (see chart 1). Perhaps this should not be surprising given how QE has not only inflated equity and bond valuations, but also caused these traditionally uncorrelated asset classes to move more closely in tandem.

Fixed income yields, in particular, are at unprecedented low levels. Investors are justifiably nervous about this. More than four in 10 respondents (42%) to the survey say they intend to reduce their fixed income allocation, while almost the same proportion (41%) plan to allocate more to hedge funds.

A number of LGPS funds have already allocated to hedge funds to tap into the potential benefits of diversifying portfolio returns. So far, the majority of LGPS funds have used fund of hedge fund (FoHF) structures, while a smaller number have allocated directly to single managers.


Redefining the cost base

Detailed analysis undertaken by Hymans Robertson during 2013 (LGPS Structure Analysis, published alongside the government’s consultation on structural reform) established that LGPS funds are already successfully securing external managers at quite reasonable fees. Yet one of the consultation paper’s major suggestions for further increasing cost efficiency is to make greater use of passive investments in equity and bond allocations.

Chart 2

However, this could be problematic, given that ‘index tracking’ is by definition a capitalisation-weighted approach: in effect, it buys into price strength and sells into weakness. Passive strategies are therefore prone to concentration risk when asset price bubbles inflate. Note how the S&P 500 had its highest weighting to the technology sector immediately before the dotcom bubble burst in 2000 (see chart 2).

The problem of cap-weighted indices in relation to bond portfolios is arguably even worse, since index weighting is determined by the amount of debt in issuance. At best, it is questionable that investors have their largest exposures to the most indebted borrowers.

For alternative investments, the consultation paper suggests that it is difficult to achieve an appropriate degree of diversification without using fund of fund approaches. It also points out that these can be expensive because of additional fee layering. The authors go on to suggest pooling assets for alternatives across all of the LGPS funds to reduce costs.

In the liquid alternatives space, we agree that a LGPS collective investment vehicle is a cost efficient solution but we are also mindful of the expertise required to supervise the underlying managers, as well as the need to tailor the portfolio composition to the unique requirements of individual funds.


Investment routes and the importance of governance

LGPS funds face a simple choice once they decide to allocate to liquid alternative investments: they can either invest directly by sourcing single managers or go through a FoHF.

Choosing the direct route introduces several challenges. It is quite likely, for example, that the diversification objective will be weakened since most LGPS funds will only invest in a small number of hedge funds. Moreover, the long lead times needed to perform extensive due diligence will make the hedge fund investments relatively static, meaning that the opportunities an actively managed portfolio can seize will be much harder to exploit.

In 2016, for example, merger spreads have moved to historically high levels. This has thrown up an attractive opportunity in merger arbitrage that professional FoHF managers are better placed to identify and exploit than an LGPS fund, which is likely to require a longer time frame to make portfolio changes.

Finally, there is the matter of costs. Not just of due diligence but also of ongoing monitoring and governance – both of which are crucial given hedge funds’ use of derivatives and the complex nature of some of their trades. What’s more, unless an LGPS fund assigns large amounts (£100m-plus) to a manager, they are unlikely to secure fee discounts.

Investing through a FoHF is another option. Typically, FoHFs have faced criticism over their extra layer of fees (in addition to the single manager’s management and performance charges). Add in service provider costs (for auditors, custodians and administrators, among others), and the bill for hedge fund investing can be an expensive one.

Another rap is that FoHF often lack flexibility in accommodating the requirements of specific investors. Additionally, transparency and control can be found wanting, particularly when a FoHF is barred from withdrawing capital allocated to an underlying single manager fund.

How a FoHF solution helps to access hedge funds

It is important to realise that all of these drawbacks have the potential to be substantially overcome with a customised FoHF solution. Using such a solution allows a LGPS fund to delegate responsibility for selecting and managing hedge funds to a specialised team of investment professionals who are experts in sourcing, assessing and combining hedge funds into portfolios tailored to client needs. This team can be nimble in choosing managers and is resourced with the tools to get transparent monitoring of risk and performance, while carrying out ongoing due diligence.

What helps Man FRM deliver these benefits is our 25 years of experience and our infrastructure capability. This makes us an able partner in providing customised solutions and services at low costs that complement our research and advice on fund allocations.

LGPS funds face a simple choice once they decide to allocate to liquid alternative investments: they can either invest directly by sourcing single managers of go through a FoHF

Through Clarus, our online risk analytics platform, an LGPS fund can have access to consistent, detailed information at a position-level. Clarus aggregates data to show time series of key risk and performance drivers. This transparency provides insight into individual managers’ trading which can limit risk and trade breaches, and seeks to avoid undue investment risk.

In many cases, Clarus is supplied as part of Man FRM’s multi-featured managed account platform (MAP). The MAP maximises the standards of governance and control that a LGPS fund can exercise to ensure:

  1. The assets are controlled by the individual LGPS fund and held in their dedicated sub-fund
  2. The assets are legally ring-fenced from other investors and Man Group
  3. Man FRM and the individual LGPS fund sets the liquidity terms, not the manager

This fully flexible solution frees LGPS funds to invest in bespoke combinations of high conviction hedge fund strategies. LGPS funds are also positioned to access our developing range of alternative beta return streams. These alternative beta streams (analogous to smart beta investing in the long only sector) allow investors to access alternative risk premia like value, momentum or size at an attractive, flat fee (without the performance charge levied by ‘active’ hedge funds).


A hedge fund solution for the LGPS

Man FRM is offering LGPS funds the opportunity to access a dedicated, on-shore, multi-fund solution using our managed account platform. This has been created exclusively for the LGPS with the specific intention of satisfying the objectives in respect of collaboration and cost savings, while enabling full investment flexibility for each scheme.

This fully flexible solution frees LGPS funds to invest in bespoke combinations of high conviction hedge fund strategies. LGPS funds are also positioned to access our developing range of alternative beta return streams

The LGPS solution is competitively priced with a simple, flat fee (and no performance charge). The fee structure applies equally to each participating LGPS fund, regardless of size. Even the smallest funds benefit from the same fee discounts as their larger peers. Moreover, the flat fee itself reduces as the collective LGPS assets grow.

Finally, the cost efficiencies that Man FRM can deliver owing to its bargaining power with underlying hedge fund managers and service providers are all passed through to the participating LGPS funds.

Man FRM is keen to continue to build partnerships with the LGPS. We welcome the opportunity to discuss how to diversify sources of returns within a framework that maintains high standards of governance and efficient cost management.


Harry Skaliotis, managing director – institutional sales, Man,

Harry.Skaliotis@man.com


Case Study: Cornwall Pension Fund

Two years ago the Cornwall pension fund grew concerned that the bull market in stocks and bonds was petering out. As a result, it sought to increase its exposure to alternative return drivers.

From its previous experience with hedge funds however, the Investment Committee had issues around fees, transparency and control. Matthew Trebilcock, the pension fund manager, was charged with finding a solution. He says: “Rather than create our own legal vehicle, it made a lot of sense to subcontract the responsibilities of governance to an expert with the appropriate hedge fund expertise and relationships. We conducted an OJEU search for a customised hedge fund solution with a long list of requirements: complete transparency down to the individual positions; and legal control of the vehicle and the underlying assets so that we could replace the manager if necessary without significant cost or disruption; a flexible CIV which allowed other LGPS funds to invest alongside us with their own customised solutions. We also wanted the manager to build this all for us and to provide a collaborative fee scale so that as AUM grew, so everyone’s TER incrementally fell. We wanted our cake and to eat it.

“We selected Man FRM because it offered the highest quality solution in our view. It met all of our criteria, which has led to a vastly improved experience compared to directly investing in single manager hedge funds. To top it off, the cumulative cost is significantly lower than the 2% and 20% fee structure which we have been told is non-negotiable with hedge funds.”

Man frm logo cmyk

Chapter 4

Roger Phillips interview

Interview: Roger Phillips

The new chair of the LGPS Advisory Board talks to Rachel Dalton about the challenges ahead

 

Roger Phillips could be said to be in an unenviable position. The Conservative Herefordshire councillor, a former leader of his authority, was appointed chair of the LGPS Advisory Board in mid-February after what even he wryly terms “a lengthy process”.

Cllr Phillips’ task is to chair a body that serves as an advisor for both the scheme itself and the Department for Communities & Local Government, and as a go-between for the two bodies. There are two challenges inherent in the board’s position and makeup: to maintain accord between representatives of the scheme, employers and employees; and to encourage a better working relationship between the scheme and the DCLG.

The board comprises four subcommittees representing employers, members, advisers and observers, each with between four and six members.

There are three co-opted positions on the board as well, due to be announced in July. Cllr Phillips stresses that the board aims to achieve not only a wide perspective, but to build bridges with central government through its members.

“It’s important that they come with good knowledge, good contacts and good communication skills within the industry,” says Cllr Phillips. “We are a big scheme and of course a funded scheme but we need to make sure that we can build alliances and communication wherever we can throughout her majesty’s government.”

The board mirrors those set up for the other schemes under the Public Sector Pensions Act 2013, as part of the coalition government’s move to control spending on public sector pensions. However, it is worth noting that the LGPS Advisory Board is the only one of these public sector pension boards that may give advice to its relevant minister unsolicited, in recognition, perhaps, of the investment expertise fostered within the LGPS thanks to its funded nature.

We are only the advisers. Hopefully the advice will be solid and reliable and will be acted upon, but the power comes from the minister

The board will have no regulatory powers, Cllr Phillips says, despite early fears that it would act as a quasi-watchdog over the scheme’s investments.

The board’s duty is to “generally oversee and support the administration of the funds”, as Cllr Phillips puts it. It will advise funds where they are struggling to meet the government’s requirements but it has no power to compel them to take any course of action.

Take, for instance, the cost cap on the scheme introduced as part of the 2014 benefit structure. The communities secretary may intervene if the cost to employers of future service deficits rises above a certain level. If a fund was struggling to keep costs down, the board’s role would be to assist, not to direct.

“The important thing is to monitor the trends before you get to that, as we are doing now, and you start to take some actions rather than wait for that scenario to happen,” explains Cllr Phillips.

The board’s job, in short, is to step in before the communities secretary does. “We are only the advisers. Hopefully the advice will be solid and reliable and will be acted upon, but the power comes from the minister,” he says. Cllr Phillips hints – albeit politely – at frustration with the attitude towards Whitehall of some within the scheme.

“It’s important that everybody recognises who is in charge of the fund; it is that minister. It’s so obvious that sometimes it’s just forgotten,” he says.

“Ministers make statements and you hear people say, ‘Who does he think he is?’ Well, actually, he runs the scheme.”


To-do list

The LGPS Advisory Board’s work programme for 2014-15 was packed, to put it lightly. Given the chancellor’s ambitious plans for pooling LGPS funds, however, several items for the board’s attention have been shelved until further notice.

These include investigating the impact of asset allocation changes and manager churn on costs; developing knowledge and understanding guidance for committee members; and the potential separation of funds from their administering authorities.

Nonetheless, there is plenty for the board to do, and the first item on the agenda is deficit management. “We’ve reinstated the deficit working party,” says Cllr Phillips. “We have to be realistic about those deficits.”

However, he sympathises with the frustration many feel about the government’s tendency to lump the LGPS in with other, unfunded public sector schemes.

“While people do rightly expose the issue of how much deficit we have, we also have a high level of funding, which does not exist in any of the other public sector schemes. People are inclined to see the 20% of our glass that is empty, rather than the 100% of the glass over there that is empty,” he says.

The board is working on a standardised calculation of funding positions (importantly, not standardised assumptions for valuation purposes, which would not recognise each funds’ unique requirements) and a set of 18 performance indicators that will provide a broad overview of scheme performance.

A major focus of the board is the production of an annual report covering the entire scheme, published for the first time in 2014. Cllr Phillips asserts that this is essential, especially in a period of such radical reform. “There we were, the largest funded scheme in the UK, the fifth largest in the world, and apart from an estimate, we didn’t know how many employers we’d got,” he says, incredulous.

“It’s important for those that will criticise the scheme; if you haven’t got some sort of evidence to base your response on, you undermine your comments. It is useful for the individual funds to see where they are and share best practice.”


Partner insight: Using secured finance to match cash flows

Austerity has increased pressure on the level of contributions paid into local authority pension funds. Despite strong growth in assets last year and performance that was more than double that achieved in 2014, deficits are still high. Some funds face the prospect of payments to retirees exceeding contribution income for the first time. However, there are investment opportunities that can help LGPS funds tackle these challenges.

Sherilee mace

Sherilee Mace, director, institutional business development, Insight Investment

Credit has traditionally been used to diversify growth and provide steady income. However, certain pockets of the credit market face serious headwinds. Liquid securities such as investment grade corporate bonds offer especially low yields. Obtaining greater income through high-yield debt risks potential losses if there is a turn in the default cycle. Other, less liquid options such as subordinate debt offer higher yields, but provide little security in a credit downturn.

Secured finance investments are an alternative that could overcome each of these shortcomings. They potentially possess some of the most attractive qualities within credit today, both on a risk-adjusted basis and given where we are in the market cycle.

It is an area that has only recently become accessible to investors due to the retrenchment of banks in response to changes in regulatory capital requirements. This has created an opportunity for other market participants, such as Insight Investment, to deliver a new proposition to clients. Our team has invested in this field over the past nine years and it is a core asset class in our fixed income offering.

Secured finance strategies provide access to high quality credit investments via collateral-based lending. They typically offer valuable attributes to long-term, conservative investors: potential for excess returns when evaluated alongside comparable alternatives; precise cash flows; seniority within the capital structure; interest rate hedging properties; and diversification. Insight Investment currently has £8.7bn invested in secured finance strategies.

Examples include residential mortgage warehousing where we finance companies to write mortgages; real estate lending where we finance companies to acquire assets like offices; and investments in asset-backed securities. The quality of assets is paramount - they are typically senior secured against collateral, have low loan-to-value ratios and offer high transparency. By providing financing to a borrower for residential mortgage warehousing, returns of 150 to 250bps over LIBOR can be achieved. An equivalently rated residential mortgage backed security trades at around 50bps over LIBOR.

This excess yield can be achieved due to the largely under researched nature of the assets, as well as a shortage in expertise and resources required to understand them across the industry. Insight Investment’s edge comes from a deep understanding of secured finance. Private debt instruments are negotiated on a bespoke basis between a borrower and its lenders. Assets have to be underwritten, valued, structured and quantitatively modelled. With relatively few investors able to pinpoint value, there is little eligible demand for these investments.

Secured finance is a buying opportunity for long-term investors who can accept medium-term illiquidity. The asset class can offer yields substantially above those of investment grade corporate bonds with equivalent credit ratings and targets a total return of 400bps in excess of cash.

How the strategy works

A carefully constructed portfolio of assets with fixed maturities, attractive yields and credit ratings should help LGPS funds invest in areas with the potential for decent returns, while reducing the risk of negative cash flows.

To avoid selling return-seeking assets to meet cash flow requirements, funds could benefit from using investments with fixed maturity dates (see Figure 1). One component of such a plan is to create a ‘drawdown pot’ of highly liquid, short-dated assets: for example, money market investments, cash and short-dated bonds. The fund can use this to pay pensions.

Assets such as infrastructure and equities have the potential for long-term attractive returns but they could be illiquid or suffer from volatile valuations when they are required to pay pensions. However, if the fund maintains its drawdown pot it could leave such investments untouched and free to target long-term performance. When long-term assets achieve their targets, a portion can be sold to reinvest in medium-term assets with fixed maturities, which will generate cash for the drawdown pot. This process can retain the upside generated by long-term assets while reducing the impact of market volatility.

Funds can benefit from the targeted use of assets with defined maturities which offer the potential for an attractive return within a fixed timeframe. By doing so it is possible to ensure the fund can continue to pay pensions without selling assets. Secured finance investments fit well into this framework as they are typically structured with fixed maturities, pay regular interest with a high degree of certainty, and repay capital at maturity.


Disclaimer: The value of investments is not guaranteed and investors may not get back the full amount invested. Issued by Insight Investment Management (Global) Limited. Registered office 160 Queen Victoria Street, London EC4V 4LA. Registered in England and Wales. Registered number 00827982. Authorised and regulated by the Financial Conduct Authority.

Insight logo

Chapter 5

ESG investment

Building ESG into pooled structures

In association with Goldman Sachs Asset Management: An LGC roundtable addressed the environmental, social and governance issues facing the LGPS. Nic Paton reports

 

The direction of political travel is now firmly set when it comes to the pooling of Local Government Pension Scheme funds within England and Wales. As a result, the focus of discussion within the scheme is moving towards the practical elements of investing effectively while within a pooled structure.

There are many complex issues and talking points that will need to be worked through within this process. As the Department for Communities & Local Government highlighted in its November guidance document on pooling, one of these is stewardship. The DCLG guidance outlined the requirement for authorities to set out how they will consider environmental, social and governance (ESG) issues in the selection, retention and realisation of investments.

But how will this work within a pooled structure, where the weight that funds give to ESG will undoubtedly vary and where different funds will be likely to have different priorities and approaches?

To discuss this and some of the broader issues and challenges facing funds around ESG, LGC brought together a high-level panel of LGPS fund managers and investment advisers to hold a roundtable debate in association with Goldman Sachs Asset Management.


Participants

  • Richard Bates, chief financial officer, Dorset CC and fund administrator, Dorset Pension Fund
  • Keith Bray, forum officer, Local Authority Pension Fund Forum (chair)
  • John Goldstein, co-founder Imprint Capital Advisors and managing director within Goldman Sachs Asset Management’s Alternative Investments and Manager Selection (AIMS) Group
  • Taylor Jordan, co-founder Imprint Capital Advisors and managing director within Goldman Sachs Asset Management’s Alternative Investments and Manager Selection (AIMS) Group
  • Nigel Keogh, manager, National LGPS Procurement Frameworks, Norfolk CC
  • Andrien Meyers, senior investment consultant, JLT Employee Benefits
  • Jeremy Randall, head of finance – strategy and accounting, Kingston upon Thames RBC
  • Karen Shackleton, senior adviser at AllenbridgeEpic Investment Advisers
  • Luke Webster, chief investment officer, Greater London Authority

Keith Bray, forum officer at the Local Authority Pension Fund Forum (LAPFF) and chair of the discussion, opened the proceedings by asking panellists to outline which ESG issues most concerned them.

“Our fund, over the last two to three years, has taken ESG as a very important area,” said Andrien Meyers, who was at the time treasury and pensions manager at Lambeth LBC, but who has since moved to JLT Employee Benefits.

“What have we done to address that? We’ve signed up to the LAPFF on ESG issues. What we’ve also done, as part of our quarterly manager performance updates, is rather than just rate our managers or look at our managers in terms of performance, we have a rating scale on ESG issues from one to five.

“What are some of the problems we’ve had? Mostly it is Freedom of Information requests. You get these FoI requests in, asking for us to divest from certain products; fossil fuels for example. Our question then is, why should we divest? If you go back to the regulations, we’re there to ensure we get better returns for the fund. Also, if we divest, it means we do not have a say as a shareholder. By remaining, we actually have a greater voice in helping to ensure these companies follow good corporate governance standards,” he added.

“Our fund is in a very different place from Lambeth’s in terms of its position on ESG. Our members don’t have a particular view that ESG should be a starting point for our investment strategy,” said Jeremy Randall, head of finance – strategy and accounting, Kingston upon Thames RBC.

The key is ensuring that these arrangments work in the long-term interests of investors

“Our members’ view is that long-term returns are the key driver rather than looking at those particular issues as a primary strategy driver. However, we understand that inadequate ESG arrangements can have a detrimental impact on company values, so we’re concerned that our managers invest in companies with appropriate governance arrangements and ensuring our managers vote appropriately on issues such as executive remuneration and other corporate governance arrangements. The key is ensuring that these arrangements work in the long-term interests of investors.”

Nigel Keogh, manager at the National LGPS Procurement Frameworks initiative at the Norfolk Pension Fund, said: “What I’m working on at the moment as part of the frameworks is a way in which we can better support funds across the UK to understand and discharge their stewardship responsibilities.

“The idea behind the framework is collating in one place a group of suppliers who can assist pension funds with voting, with engagement, with research and with data provision across a range of stewardship issues. Bringing it together under a procurement framework will give funds an easier route to market and offers an opportunity to raise awareness as to how they might approach stewardship in a more holistic way, from policy to implementation,” he added.

“ESG and related issues vary very much from client to client,” said Karen Shackleton, independent adviser at Allenbridge. “Often it is driven by how strongly the chair or one of the councillors on the committee feels about this issue as to how proactive they are in discussing engagement or even exclusion. I have clients who have had a whole evening of training on ESG, through to others who barely discuss it.

“I’m often present at the annual general meeting to speak to pensioners in the scheme and nearly every time somebody asks the question ‘why do we hold tobacco stocks?’ or ‘why do we hold aerospace?’. There are always questions around those sorts of ESG-type issues. So it is obviously something members themselves are concerned with,” she added.

Luke Webster, chief investment officer at the Greater London Authority, said: “The main part of my day job is managing a collective investment scheme for the bodies under the Mayor of London’s control. It is essentially corporate treasury cash; it’s a very sizeable fund, but exclusively operating in the short-dated fixed income space and largely through secondary markets. So the capacity for engagement available to me and my team is perhaps slightly lower than colleagues who are involved in equity-type investments with voting rights.

“Nevertheless, ESG is becoming an increasingly sensitive issue for us. We’ve seen a number of articles over the last few months concentrating on our small exposures to counterparties in the Middle East. While it is acknowledged that there are no obvious problems with the activities of the banks in question, the issue is the association with regimes that may have, in some members’ view, poor human rights records.

“Similarly, any investment outside of the senior unsecured space in financial services has the potential to excite strong views. Airport operating companies are one example we’ve encountered. Equally, other industries can be controversial,” Mr Webster added.

“From Dorset’s point of view, I would openly admit we are probably in our infancy in terms of considering ESG issues,” said Richard Bates, chief financial officer at Dorset CC.

“We are a member of the LAPFF and that is something deemed important in terms of using our collective power to make sure we can hold people to account. Like some have already mentioned, things like the FoI requests come in around these issues. To date we’ve had a stock answer around our fiduciary duties around maximising returns.

“It’s started to come into a bit more focus recently, firstly with the DCLG document, but also the fact we are part of a South West pooling group that includes the Environment Agency. Including them is starting to raise some interesting issues with us, and I am sure that will develop over the next few months,” he added.

Mr Bray then turned to the panel’s two GSAM contributors, managing directors John Goldstein and Taylor Jordan, members of the GSAM Alternative Investments and Manager Selection (AIMS) Group.

Mr Goldstein and Mr Jordan participated in the debate via video link from San Francisco. They co-founded Imprint Capital Advisors, a specialist ESG investment advisory firm that GSAM bought in July last year.

Mr Goldstein applauded the work Mr Keogh was doing on the framework. “It may be unglamorous but it is unbelievably important. As everyone tries individually to understand the resources at their disposal to do this, to get some help to coalesce that with a supportive range of folks, that is a good idea, and I wish more of that happened over here in the States.”

More broadly, Mr Goldstein said funds had to be “proactive with their approach” on ESG issues. This meant “having a thoughtfully articulated policy with supporting processes, implementation and subsequent communication”.

He added: “It’s not going to make everybody happy but being on the front foot instead of the back foot just makes for better results as an investor and, ultimately, is a better way to deal with stakeholders than having to, in an ad hoc way, scramble to respond to lots of requests as they come in. It sounds like with the pooling there’s a good moment to articulate that policy.”

Mr Jordan said: “One of the key challenges in our space is that everyone conflates alignment issues with ESG issues and so we’ve created a framework to be clear on [whether] you are focused on aligning the portfolio with a set of values or interests, or weaving ESG considerations into your investment process because you believe them to be material to long-term financial performance.

“Most of the conversation is dominated in the alignment question. Should you be out of tobacco stocks? Should you divest from fossil fuels? We tend to try to move clients away from those types of conversations because they are very difficult to implement from an investment perspective, especially if you use active management. We prefer passive approaches where you can actually track the implications of screening. But if you’re using active managers and you’re asking them to change their investment process based on a set of values, that’s not a good investment decision,” he added.

The discussion turned to pooling and the role of ESG within this. As Mr Keogh argued, this was a question that funds needed to consider as an immediate priority.

“People are thinking about how they’re going to design their pools and if your thinking gets so far down the line and you haven’t considered setting out what your aims and objectives are with regard to stewardship, it’s going to be very difficult to engineer that into your governance arrangements in two or three years’ time,” he said.

“It’s the pool’s job to ensure that, when they set up these asset classes, they have an asset class that is ESG-driven,” said Mr Meyers.

“If a fund’s strategy is to go into ESG products, then that product is made available by the pool. For funds that are not interested in ESG and who want sin stocks, they don’t need to go into that. But it is the pool’s objective to make sure those types of products are made available.”

Mr Webster noted that while it was extremely difficult to assess the forward looking impact on performance of exclusion or other ESG policies, there was certainly a cost to the implementation a multiplicity of such strategies. Therefore the forthcoming LGPS pools have an opportunity to generate economies of scale by providing a clearly articulated strategy that will work for all participants.

Mr Bray asked Mr Goldstein and Mr Taylor for concluding remarks.

“From a stakeholder management perspective this no longer can be ignored,” said Mr Taylor.

“So, having some sort of policy that addresses this is important. But it can be broad and it can be focused on materiality to address the fiduciary question. Where we’re really advising clients is on how to craft the right policy that provides the right flexibility, but really to make it an investment consideration, not a stakeholder-specific consideration where you get into the issues of what stocks to screen out or screen in.”

“To use this requirement as an opportunity to play offense and not defence, to define a thoughtful policy that has a set of views that match to something implementable and sensible, and then to go forth with that new reality,” said Mr Goldstein.

“This is a moment where it is both a requirement and an opportunity to do just that. To play the right kind of offense to position hopefully for success in the future, because otherwise the nipping at the heels and the pulling in all directions is not going to stop.”

ESG and impact investing: practical approaches

When the Department for Communities & Local Government asked pools to consider environmental, social and governance (ESG) policy in their proposals, they gave schemes the opportunity to further develop a topic that we expect to become increasingly important.

ESG and impact investing often gives rise to two widely held beliefs: first, that ESG is still a niche, risky subsector of the investing universe; and second, that returns are sacrificed for positive impact. At GSAM we think those premises are fundamentally no longer true. ESG and impact investing has moved into the mainstream, and we believe that now is the time to rethink how local government pension schemes think about, discuss, and act upon this consideration.

As interest in the integration of ESG factors into investment processes has grown, fiduciaries have been caught between competing viewpoints. One side argues that the scheme has a fiduciary duty to maximise returns for the benefit of members. Hence, a focus on any factors besides the bottom line –such as ESG – could be seen as a violation of that responsibility. On the other hand, advocates of ESG-based investing make precisely that point – ESG risk factors could potentially be material to the bottom line, and positive ESG scores may contribute to long-term sustainable value. Accordingly, ESG risk factors could be considered an appropriate input by a prudent pensions or asset manager.

At a recent roundtable GSAM hosted for its partners in Wales, in order to think about and ultimately formulate their ESG policy, we concluded that an ESG policy is much more than a written document. If pools are to genuinely address this issue then they will have to integrate ESG into their identity and only then will they be able to properly define what ESG means for them.

GSAM is well placed to assist in many areas of pooling as a strategic partner and ESG is no different. Our ESG team have made impact investments across asset classes on behalf of our clients and have worked with and advised some of the largest foundations and pension schemes globally. We believe that this experience and ability to knowledge share is invaluable for pools tackling this area of their proposals and is something that sets us apart from our competitors.

Disclosures

This material is provided at your request for informational purposes only. It is not an offer or solicitation to buy or sell any securities.

THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORISED OR UNLAWFUL TO DO SO.

Confidentiality

No part of this material may, without GSAM’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice.

© 2016 Goldman Sachs. All rights reserved. Compliance Code: 50650-OTU-282299.

Chapter 6

Emerging markets

Fly the flag for emerging markets

As emerging markets rally, Charlotte Moore considers the pros and cons for LGPS funds.

 

After more than five years of underperformance, the investment case for the emerging markets now looks compelling.

Asset managers highlight the long-term growth potential of these assets along with their attractive valuations. LGPS funds and their advisors are starting to explore investment options.

From their peak in October 2010, emerging markets equities have drastically underperformed the developed markets, sometimes by as much as 50%, which makes their relative valuation look attractive. In addition, the outlook for these markets is improving as fears about China are abating while commodity prices are stabilising.

As emerging markets currently look well-priced, investment consultants argue that now is a good time for the LGPS to increase its allocation to this asset class. Colin Cartwright, principal consultant at Aon Hewitt, says: “Demographics and economic growth will make emerging markets the growth engine of the global economy over the medium term.” Yet many schemes do not have sufficient exposure to these assets, he adds.

Such arguments are proving persuasive for some funds. Sam Gervaise-Jones, head of client consulting for UK and Ireland at bfinance, says: “We have recently carried out a number of projects for LGPS clients to either appoint an emerging market manager or looking at how to better manage this asset class.”

New allocations, however, require pension funds to either divert money from other asset allocations or for them to invest cash. Mr Gervaise-Jones says: “Most of our clients are looking to divert a portion of their allocation to global equities into a dedicated emerging market equity mandate.”

Demographics and economic growth will make emerging markets the growth engine of the global economy over the medium term

For many LGPS funds, it will be easier to allocate new money rather than divert cash from existing investment. John Hattersley, fund director at the South Yorkshire Pensions Authority, says: “Unless a scheme has made a tidy profit from their existing stakes, it makes more sense to invest new money from members or the cash reserves in this asset class.”

A specific emerging market mandate allows LGPS funds to benefit from the growth of domestic emerging market economies rather than just focusing on the globally recognised large companies captured in a global mandate, adds Mr Gervaise-Jones. “This mandate could represent up to 20% of the scheme’s equity allocation,” says Mr Cartwright.

The splits can be taken further than just emerging markets. Mr Gervaise-Jones says: “We have seen some appetite for splitting out a separate frontier market allocation.”

Not only does emerging market equity look attractive, so too does emerging market debt. Developed market yields are not attractive and while they appear ‘safe’ they are not risk-free. Christoph Hofmann, global head of distribution at Ashmore, says: “In contrast, EMD provides better income to developed market assets – there are no negative yields.” In addition, the recent strong performance and the increased market stability is also appealing to investors, he adds.

While both emerging market equities and debt are appealing, there is more demand for equity. Mr Cartwright says: “The returns from equities are higher and this is an asset class the LGPS are more comfortable to this asset class.” Mr Hattersley adds: “Equities are usually easier to access than debt.”

It can also be argued the valuation of emerging market equities is more compelling than for emerging market debt. Mr Hattersley says: “EMD is not as cheap as it was last year while emerging equities are relatively unloved making them looking more attractive.”

If an LGPS does decide to implement a separate emerging market allocation, they could choose between a passive and an active asset allocation. But investment advisors counsel against a passive approach for either asset class.

Mr Gervaise-Jones says: “We have seen our clients in general move towards actively managed emerging equity mandates as this management style has better preserved capital value during the recent volatility.”

Mr Hattersley adds: “As an internally managed fund, we have always taken the view that emerging market equities should be actively managed.” The case for appointing an active emerging market manager is even stronger. “Taking a passive approach to emerging market debt exposes the fund to too many index-related risks,” he adds.

The poor performance of the asset class in recent years means there is greater choice of managers available to LGPS funds. Mr Gervaise-Jones says: “Many of the good active managers had closed their funds to new investors but the lack of investor interest in recent years mean they are now open to new investors.”

But while interest in emerging markets is definitely increasing among the LGPS, some are sceptical whether actual allocations will increase. Mr Hattersley says: “Emerging markets are definitely flavour of the quarter but whether that translates into increased allocation is another matter.”

That’s because most LGPS are too focused on implementing the government’s pooling policy to have sufficient bandwidth to focus on asset allocation changes. In theory, pooling of the LGPS assets will make specific asset allocations to either emerging market equity or debt easier.

Mr Hofmann says: “Larger LGPS funds can take a more nuanced approach to EMD investing and this will become more widespread once pooling is in place.” Mr Cartwright agrees: “Once the investment pool structures are in place, I would expect the pools to offer a straightforward way for funds to implement an emerging market mandate.”

Larger asset size will help smaller funds to access a wider universe of asset classes, including emerging markets, he adds. Mr Gervaise-Jones agrees: “Pooling will help funds to improve diversification.”

Mr Hattersley says: “It’s too early, however, to be able to put a pool-wide emerging market mandate into practice.” The LGPS is still grappling with the basic structures. “We don’t even know which tax-efficient vehicles will be allowed by government let alone how the individual pools will operate on a day-to-day basis,” he adds.

For those LGPS funds that have an existing emerging markets manager, the simplest option might well be to just increase the allocation with the current manager. Mr Hattersley says: “It’s easier to unwind one manager in 18 months, when the new pooling rules are implemented.”


Partner insight: Actively achieving growth with less volatility

Investors expect multi asset funds to diversify portfolio risk when market volatility is high. However, diversification for the sake of diversification is no panacea, particularly when asset classes increasingly correlate under pressure. Our aim is to use our process to make the right asset allocation decisions decisively when stressful market conditions arise.

Percival Stanion, head of international multi asset, Picted Asset Management

Our strategy is based around three pillars - active asset allocation, understanding the unstable risks of assets and the construction of clear and transparent portfolios. Active asset allocation means we are not afraid of making bold moves when required. This may come about when we have conviction about a growth generating asset just as much as when we believe the client would benefit greatly from a stance to protect their capital. Good performance is determined as much by the investments we hold as by those we avoid. We are not wedded to any particular asset class or benchmark. That means every investment decision is high conviction. If we don’t like an investment, it won’t have a place in the portfolio.

’Active asset allocation means we are not afraid of making bold moves when required’

Risk management requires understanding of evolving correlations. The changing relationship between assets makes active risk management an essential part of multi asset investing. Our management of risk starts with the big picture asset allocation decisions we take and then how the active diversification of our portfolio can suit the prevailing conditions. We believe it is impossible to predict risk but it can still be accounted for. Backward-looking risk models average stressed periods with benign ones, so tend to underplay the impact of periods of high stress and extreme correlation between asset classes. Understanding why and how a risk model is generating its results are just as important as the result itself. Given our asymmetric tolerance of risk, we take a more prudent stance, understanding that one disastrous year destroys several years of growth.

Given the emphasis we put on understanding the changing behaviour of assets, having a portfolio made of assets that are clear and transparent, made of traditional building blocks means the risks can be more easily monitored. Under market stress it is often that the most dangerous elements of one’s portfolio are the areas that are most opaque. This transparency also allows our clients to attribute the risks that we are taking to their overall portfolio; such they can better understand and manage their consolidated risk position.


Pictet Asset Management Limited. Authorised and regulated by the Financial Conduct Authority

Pictet logo

Chapter 7

Pooling under scrutiny


Andrew Burns
highlights the importance of good governance for the new arrangements.

Andrew burns

Andrew Burns, director of finance and resources, Staffordshire CC


T
he rationale for the chancellor’s so called ‘British Wealth Funds’ – six pools of Local Government Pension Scheme money each worth £25bn – is that they will save hundreds of millions in investment costs, enhancing the sustainability of the scheme and enabling billions to be invested in regional infrastructure to support the national economic growth strategy.

The LGPS sector has responded well to the government’s challenge to collaborate and develop investment pooling proposals within really tight timescales. However, rather like the devolution agenda, much of the deal making to date has been done behind closed doors, away from the public gaze and without the level of stakeholder engagement needed for such big and important decisions.

Clear and effective governance and scrutiny must be a critical element of the final dialogue on LGPS investment pools and proposals for collaboration as arrangements are finalised. The intense media scrutiny about the affordability of and deficits in the BHS and Tata Steel pension schemes provides a resonant backdrop and opportunity to promote and improve public engagement. Have pensions ever been more important or interesting?

Clear and effective governance and scrutiny must be a critical element of the final dialogue on LGPS investment pools

So what is good governance for LGPS investment pooling? The government has called for clear and effective governance which provides the assurance the authorities, beneficiaries and co-investors require. The structure, standards and systems required for an entity regulated by the Financial Conduct Authority provide some technical assurance, but in my view, that is not enough.

The Centre for Public Scrutiny has produced some excellent guidance relating to devolution in its report Devo Why? Devo How? that has real resonance for investment pooling by LGPS funds.

It argues that greater collaboration requires a different approach to scrutiny. Collaboration is a positive opportunity to build governance arrangements which are dynamic, flexible and really add value, rather than perpetuate old assumptions about those arrangements representing a brake on innovation.

Collaboration is also a process, not an event. By adopting the principles of accountability, transparency and involvement from the start local arrangements have a better chance of fitting an acceptable governance framework.

The primary purpose of the LGPS is the payment of current and future pensions of local government staff and not the investment in any particular asset class. Good governance and effective scrutiny can ensure that local government pension fund investment returns are not compromised by thoughts of compulsory investment in local or regional infrastructure, from which the returns may be less certain or sub-optimal.

The CfPS argued that whatever governance arrangements are adopted, they need to satisfy three key requirements for accountability, transparency and involvement:

  • Accountability – Decision-makers must clearly take responsibility and engage with those seeking to hold them to account (non-executives, staff, pensioners, the public, and others); decision-makers also need to have the confidence that systems are in place that allow them to benefit from the insight that those holding them to account (especially the public) can provide
  • Transparency – It must be clear (to professionals, elected councillors, staff, pensioners and the public) who is making decisions, on what, when, why and how. Transparency is key to effective accountability (although the two or not the same thing)
  • Involvement – A sense of being informed by the views and concerns of the public, employers, staff and pensioners. A commitment to public involvement should be seen as central to good governance

All these principles require a central role for non-executives. Scrutiny councillors must be seen as central to any arrangements; they bring the credibility that comes through their electoral mandate and local democratic accountability.

As treasurer of the Staffordshire pension fund, within the proposed Central pool, I am encouraged that the LGPS sector has made good progress in co-designing sensible investment pools with the Department for Communities & Local Government and the Treasury.

We now need to ensure that these vital issues take centre stage over the coming months. I look forward to seeing more leaders and senior decision-makers commit to the principles of accountability, transparency and involvement as we go about designing and delivering collaborative investment pools.


Andrew Burns, director of finance and resources, Staffordshire CC


Partner insight: Managing volatility in a changing world

The challenges faced by pension funds across Europe are well known: regulatory changes and two decades of market shocks. These have resulted in increasing emphasis on derisking at the same time as funding levels have deteriorated.

Tony finding

Tony Finding, fund manager, M&G Investments

Against this background, multi-asset portfolios are being increasingly seen as a solution. Diversification across an expanded opportunity set may offer the best chance of both safeguarding capital while seeking to generate attractive returns. Diversified growth funds (DGFs) is one label for a new perspective on multi-asset portfolios, with greater flexibility to achieve growth-style returns with lower volatility.

However, such funds require an approach to achieving effective diversification that goes beyond the ‘set-it-and-forget-it’ methods of traditional balanced funds. Just as the best assets to hold will vary over time, so will the best ways of managing volatility.


The need for dynamism

A good diversified growth strategy will take an approach based on understanding the changeable nature of correlation patterns and return opportunities. This involves being prepared to be dynamic and active in asset allocation, rather than simply holding a wide range of assets and hoping that past correlation patterns will persist. For example, many investors are used to mainstream government bonds acting as an insurance policy for equities in recent years, but this hasn’t always been the case.

The M&G multi asset team has been running multi-asset portfolios since the late 1990s and over that period has developed the belief that the prevailing economic regime – which is determined by such structural forces as inflation, interest rates and growth – as well as valuations are key determinants of both returns and drive the nature of volatility and correlations.

In the case of government bonds for example, the team believes that it is far more likely to offer portfolio protection in ‘risk off’ periods when yields are higher and inflation is contained, than when the starting level of yield is depressed. Alternatively, there can often be surprising diversification within so-called risky assets when one can identify sections of the market with a significant value buffer in place. However, keeping an eye on these ever evolving dynamics requires active management and experience across multiple investment environments.


Assessing opportunities and risk

The M&G multi asset team believes the best chance to navigate uncertainty is to build, and actively manage, a well-diversified portfolio of global assets for which the current price over-compensates the holder for the level of fundamental risk. This forms the bedrock of the team’s ‘episode’ philosophy, which it has used to manage multi-asset portfolios for more than 15 years .

The ‘episode’ investment process combines in-depth valuation analysis with elements of behavioural finance to exploit attractive investment opportunities anywhere around the world. It is centred on the observation that while value is the key determinant of long-term returns, prices often move for non-fundamental reasons. Such phases or ‘episodes’ can create opportunities to generate returns over long or short-term periods.


Managing volatility

The team also believes that the concept of ‘episodes’ can also tell you about the nature of the riskiness of individual assets. This rests upon a belief that while true risk is more about the possibility of protracted or permanent loss of capital than volatility, understanding behavioural drivers of market moves can help understand likely future behaviour and aid the management of the investment journey.

Most of us are aware that those assets that have delivered strong returns in the past are not guaranteed to do so in the future. However, with prevailing valuation signals, and signs that we have arrived at a crossroads for economic regimes around the world, it may be more important than it has been for much of the past 10 years to be active in negotiating a changing environment.


Multi-asset investing heritage

Dynamic asset allocation is at the core of what the M&G multi asset team do. The skills and experience of our dedicated multi-asset fund managers are applied across a range of multi-asset funds, tailored to suit a variety of risk and return appetites.

The core of the team have been applying the ‘episode’ investment philosophy and process for over 15 years. Today, the team comprises seven fund managers who sit together in M&G’s London office.

At M&G, we believe the stability and heritage of our multi asset team, combined with their robust, repeatable investment process, provides a powerful investment edge in the multi-asset space. To read market perspectives from the M&G multi asset team please visit our blog, www.episodeblog.com


For Investment Professionals only. This article reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance. The distribution of this article does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Reference to individual companies or securities is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.


The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority’s Handbook.


M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the UK Financial Conduct Authority.

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