Foreword
LGC Investment: Our regular special report
Institutional investors are often urged to step in when the economic applecart has been upset. After the global financial crisis, banks restricted their business lending and there was talk of institutional investors filling the gap.
Rachel dalton
Rachel Dalton, special report editor
As chancellor, George Osborne called for institutional investors to back UK infrastructure; first attempting to persuade a mixture of private and public sector funds to join the Pensions Infrastructure Platform, and then by adding infrastructure investment to the list of requirements for Local Government Pension Scheme pooling.
Brexit will likely be no different. As the UK loses millions in EU funding, not all of which the government will replace, will LGPS pension funds come under renewed pressure to fix society’s ills? They are still negotiating as to how infrastructure investing will work under pooling, but when this is decided, will it be deemed sufficient?
Some of the wilder conspiracy theorists claim the government has a long-term plan to seize control of LGPS assets directly. They argue that the increasing scrutiny of LGPS funds’ costs aims to show up the scheme’s reluctance or inability to improve efficiency, transparency and consistency. They suspect that if the LGPS does not meet expectations sooner rather than later, the government will snatch the assets for its own aims, leaving the scheme unfunded like its other public sector cousins.
But officers and elected members - many of whom have been working overtime to run funds, complete valuations and implement reforms - have little time to second-guess the government’s long-term intentions. The tasks immediately ahead of them are significant as pooling enters its stickier stages.
So far funds have come to amicable arrangements about pooling but there are now questions about how to resolve disputes within a group. If, in future, a fund might choose to exit a pool that is not working in its own members’ best interest, should it ensure now that it will be protected from significant losses? The government discourages ‘pool hopping’ and funds in the honeymoon stage are coy about arrangements in the event of a divorce. But if what you bring to a marriage runs into the billions of pounds, wouldn’t a pre-nup seem sensible? Charlotte Moore examines this issue from a legal perspective in Exiting Pools.
The government’s pooling requirements also included a nod towards the various benefits of in-house management. The logic that funds that already have in-house capability can share their expertise with pool-mates is compelling but our feature on in-house management demonstrates that not everyone is convinced this will work for their funds.
As always, investing wisely for the future remains the LGPS’s main concern. In LDI Analysis we examine whether the interest in liability-driven investment is fading out, while our roundtable explores the latest thinking on global equities. Elsewhere, our expert partners explore themes central to the scheme: sensible diversification, finding and assessing new opportunities, and protecting assets. Despite the upheaval of the past few months, business continues as usual.
A low-return world
Managing assets and liabilities in a low return world
The words ‘change’ and ‘challenge’ have been omnipresent in the LGPS in recent years and, although we are only eight months in, 2016 looks to be no exception.
Andy green
Andy Green, chief investment officer, Hymans Robertson
The move towards asset pooling continues and there is an expectation for lower economic growth for longer. At the same time, English and Welsh funds are carrying out their triennial valuation process, requiring sensitive discussions on funding with their employers. To deal with these changes and challenges it is important that funds’ objectives and investment beliefs are clear, suitable governance arrangements are in place, and funds’ investment strategies focus on achieving the right balance of growth, income and protection to generate the required returns.
2013-16
It is important to remember there have been a number of positives regarding the latest English and Welsh funds’ valuation cycle, including strong returns from assets (global equities up by nearly 10% pa in the three years to March 2016 and much more in the months since then) and a general move towards lower investment manager fees.
The impact this asset performance has had on funding positions will vary according to the funding approach adopted. As we did in 2013, we have considered the development of funding on a like-for-like basis using the Treasury’s discount rate for unfunded schemes of a fixed 3% real return or 5% nominal assuming the Consumer Price Index is 2%.
Against this basis, deficits have generally not got any worse, and in most cases funding has generally improved over the three-year period (on average by 6%). If we assume contributions remain unchanged, then for funds to achieve 100% funding on an Treasury basis in 20 years, the required future asset returns are, on average, lower than they were three years ago (now 4.5% pa, compared with 5% pa based on 2013 funding information).
Looking to the future
In previous generations a long-term return target of 4.5% pa would have been a straight-forward (indeed, for most of the 1980s and 90s it would be have been difficult to generate such a low nominal return). However, global interest rates have fallen dramatically in recent years, helping drive up asset returns, which funds have already received, and we are in a world where weak economic growth, coupled with a growing debt burden, weighs heavily.
These twin features – low rates and low economic growth - are expected to act as a considerable headwind and leads us and many market participants to expect future returns to be lower than in the past and for market volatility to increase. In such an environment it will make funds’ required returns, which may look low relative to historic levels, a challenging target to achieve.
These twin features – low rates and low economic growth – are expected to act as a considerable headwind and leads us and many market participants to expect future returns to lower
However, it is not all bad news, in such an environment. Winners are likely to be higher quality equities, infrastructure (where lower rates may justify projects that were previously unviable, meaning that the supply of new investments should be able to meet demand from investors, keeping assets sensibly priced) and income assets. We tend to break this latter grouping into two types: short-term enhanced income and long-term secure income.
Within short-term enhanced income we include high-yield, loans and emerging market debt. While each may experience material short-term mark-to-market volatility, they will pay a decent income. Over the lifetime of a holding, which may only be five years or so, the main risk is default, and even then recovery rates relative to listed equity are attractive.
Infrastructure, property and timber can all provide long-term secure income. In particular, UK property and infrastructure offer yields of 5% pa; a decent real return relative to many other asset classes.
What can you do?
A world of lower future returns, alongside constraints on public sector budgets, is undoubtedly a challenge for the LGPS. Nevertheless, a number of steps can be taken:
- Have a clear understanding of your funding and investment objectives and your investment beliefs. Consider how your funding and investment strategies may change as funding improves and as your fund matures
- Design a robust investment strategy that: Reflects your objectives and beliefs; Has the ability to generate the level of return that you require, as this is one of the biggest challenges funds face, at a level of volatility you can accept; Has flexibility to reflect the current market environment. For us, this means building an investment strategy made up of three main pillars: growth (eg equities), income (eg high-yield bonds) and protection (eg investment grade corporate debt)
- Ensure your governance arrangements remove any return ‘leakages’ – eg make sure fees and costs are understood and competitive, ensure you have rebalancing and cash management procedures in place
- Taking these steps will help enhance your returns and improve your fund’s future outcomes.
Liability-driven investment
Is LDI all over?
Liability-driven investment has not been taken up broadly across the LGPS. Rachel Dalton reports on the factors affecting the strategy’s popularity
During the past decade, the investment management industry has promoted liability-driven investment products to the Local Government Pension Scheme market, after they had previously been taken up by some private sector defined benefit funds.
Private sector final salary funds took to the strategy more enthusiastically and continue to do so. Consultancy KPMG produces an annual report on the uptake of LDI across all UK defined benefit pension funds, and in the 2016 report – covering the year to 31 December 2015 – demand for LDI across pension funds in general shows no sign of slowing.
David walker
David Walker, senior investment consultant at Hymans Robertson
The report says that total UK pension scheme exposure to LDI was £741bn at the end of 2015, having increased from £658bn the previous year. LDI managers won 256 new mandates during the year, bringing the total to 1,278, and total UK pension scheme LDI exposure grew by 13% in the period.
It also highlighted the growing competition among fund managers selling the strategy. Three fund managers dominate the market - Legal & General Investment Management, Insight Investment and BlackRock. Schroders and BMO are also gradually increasing their market share.
However, although corporate defined benefit schemes are keen on the strategy, it has had a lukewarm reception within the LGPS.
Some local government funds have embraced the LDI, including those of Lambeth, Surrey and Dorset. Dorset allocated £150m to an LDI strategy in 2011, with Insight Investment, setting up a qualifying investment fund to contain the assets needed for the strategy to ensure it did not fall foul of LGPS investment regulations.
Lambeth implemented an LDI strategy, also supplied by Insight Investment, in 2014, in which it reallocated £89m from bonds to the strategy in an attempt to achieve 25% coverage of its interest rate and 20% inflation risk.
In the same year, Surrey invested £90m in the strategy.
Despite these funds taking up LDI, demand has yet to truly take off and some LGPS commentators claim LDI within the local government scheme is “dead” due to lack of interest.
LDI is primarily a method of protecting a defined benefit scheme against the risk of rising interest rates, inflation or changing longevity increasing the value of their liabilities.
Although corporate defined benefit schemes are keen on the strategy, it has had a lukewarm reception within the LGPS
Though no two LDI products are the same and definitions differ, the strategies usually involve a pension fund buying an ‘overlay’ of interest rate and inflation swaps. The aim is to use the synthetic assets to achieve the same interest rate and inflation risk protection as physical interest- or inflation-linked assets such as bonds would, but at a lower cost.
Inflation and interest rate rises present some risk to the LGPS, as they would any defined benefit pension fund, because if interest rates fall, or inflation rises, the value of future pension payments increase. The question is whether mitigating those risks would be better achieved by hedging against these increases specifically, or by simply investing in growth assets to increase the value of the fund’s holdings, ideally at the same rate or faster than that of liabilities.
For Mike Ellsmore, chair of the pension panel at the Chartered Institute of Public Finance & Accountancy, there is no case to make for LDI.
“My main concern with LDI is in understanding how it fits into the LGPS, where the average funding level in the 2013 valuation was 79%,” says Mr Ellsmore, who was previously director of Bexley LBC’s pension fund.
“In order to get to 100% funding, funds will have to take investment risk. Due to the strength of the covenant, the LGPS is in a better position to manage that risk than many corporates. Therefore, we are better able to ride out the shorter-term volatility and ultimately benefit from the longer-term returns that assets such as equities produce,” Mr Ellsmore says.
He adds that LDI’s focus on hedging against liabilities increasing is problematic. “The other issue regarding LDI is the extent to which we can accurately measure our liabilities. The LGPS [uses] four actuarial firms, all adopting different assumptions,” Mr Ellsmore says. “The Government Actuarial Department has also produced a valuation, again using different assumptions. Basing an asset allocation strategy on what is a moving assessment of our liabilities is in itself high-risk.”
Nick buckland
Nick Buckland, pensions and treasury manager at Dorset CC
However, Nick Buckland, pensions and treasury manager at Dorset CC, says LGPS funds can be too biased towards growth assets. His fund implemented an LDI strategy in 2011.
“I understand the argument that a bigger concern should be closing the deficit gap by allocating to growth assets,” says Mr Buckland.
“However, there needs to be a balance in any portfolio and allocating too much to growth assets, particularly in the current market environment, could prove a very risky strategy.
“It is also possible to discuss with your LDI manager the possibility of using equity-based futures within the strategy to give exposure to growth assets.”
Some have claimed that LGPS funds avoided putting in place LDI strategies because officers and elected members lacked the technical experience or competence seen in private sector schemes and because, under some interpretations, the LGPS investment regulations appear to ban the use of derivatives.
However, David Walker, senior investment consultant at Hymans Robertson, says he does not believe the regulations to have been a barrier to LGPS funds taking up the strategy. He points out that LGPS funds are able to hold derivatives in pooled vehicles in order to access LDI strategies.
This was what the London Pension Fund Authority did with its closed and separate pensioner sub-fund, Mr Walker notes.
Instead, Mr Walker says LDI’s lukewarm popularity is because it does not meet many of the needs of LGPS funds: “One of the sources of volatility in funding is the future service cost, and LDI doesn’t do anything to help manage that risk,” he says.
Mike ellsmore
Mike Ellsmore, chair of the pension panel at the Chartered Institute of Public Finance & Accountancy
He adds that the inflation protection afforded by LDI would be more useful to schemes that are closed, as many private sector schemes are, rather than open to new members, as the LGPS is.
Schemes that are closed to new members and that therefore have a reasonably clear date after which no more benefits will be paid are more likely to want to protect against inflation and interest rate risk in the run-up to the scheme shutting down, says Mr Walker.
But Dorset’s Mr Buckland says his fund’s decision to implement LDI was based on its concerns over inflation and that this still stands.
One of the sources of volatility in funding is the future service cost, and LDI doesn’t do anything to help manage that risk
“The biggest of risk and one we felt we could do little about was longevity. The second risk was inflation, in respect of the liabilities moving in line with a variable inflation rate and us not being able to manage the assets in the same way. We therefore concluded that we needed to appoint a fund manager who could help us to manage this risk in an efficient way,” says Mr Buckland.
“The biggest benefit to us was removing a significant element of the potential movement between actuarial valuations, with an overarching target for the fund to minimise the volatility of employer contributions.”
Mr Buckland concedes that inflation has not presented as much of a risk to the LGPS as had been expected since 2011, but he adds: “We view the last few years as only the start of a very long process. We are viewing this as a very long-term game of 50 to 70 years and so shorter-term inflation rates are not too much of a concern, if you believe that the volatility reduction benefits are still there.
“After this year’s valuation, I would expect the fund to undertake the same exercise as six years before to assess the levels of risk within the strategy. I would expect this to reconfirm the benefit of the approach.”
LGPS funds remain divided over whether LDI could be of benefit to their or any open scheme. The government’s new LGPS investment regulations, due in autumn 2016, will sweep away a number of restrictions on investing in certain assets, including the perceived ban on derivatives.
With inflation remaining low and confidence in growth assets such as equities remaining, however, managers offering LDI may still have some way to go to prove its value.
FROM OUR PARTNERS: Claims based on purchases of unsponsored ADRs held barred by Morrison
In a recent decision, Stoyas v. Toshiba Corp., the United States District Court for the Central District of California ruled that Plaintiffs’ Exchange Act claims were barred by Morrison because the market on which the American Depositary Receipts (ADRs) traded was not an ‘American stock exchange’, and because plaintiffs failed to show that defendant was involved in any domestic US transactions.
Toshiba
Investors (plaintiffs) in Toshiba Corp, the Japanese multinational corporation (defendant), filed a federal class action complaint alleging that defendant violated the Securities Exchange Act of 1934 (the Exchange Act) and Japan’s Financial Instruments & Exchange Act (JFIEA) by applying improper accounting methods to inflate its pre-tax profits and to conceal losses. In September 2015, Toshiba restated more than six years’ worth of financial results to eliminate about one-third of its profits for those years.
Plaintiffs asserted Exchange Act claims only on behalf of purchasers of ADRs, while they asserted their JFIEA claims on behalf of purchasers of both ADRs and Japanese common stock.
The defendant moved to dismiss the plaintiffs’ complaint. The defendant argued that the plaintiffs’ Exchange Act claims were barred by the Supreme Court’s decision in Morrison v. National Australia Bank Ltd in 2010, which limited claims under Section 10(b) of the Exchange Act to those relating to ‘the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States’. According to the defendant, its ADRs traded on an over-the-counter (OTC) market that did not constitute an ‘American stock exchange’ under this ‘first prong’ of Morrison.
The defendant also contended that because the ADRs were unsponsored and it was not involved in selling or listing them in the US, Morrison’s ‘second prong’ also did not permit it to be held liable under the Exchange Act.
By contrast to sponsored ADRs, which are issued pursuant to an agreement between a securities issuer and a US depositary bank, unsponsored ADRs need not involve the issuer. Rather, a depositary bank can issue ADRs for securities it buys of foreign issuers who meet certain regulatory requirements, such as maintaining a listing on a foreign exchange and making available to American investors English-language translations of the information provided to the issuer’s foreign investors.
The plaintiffs argued in opposition to the defendant’s motion to dismiss that the OTC market on which the ADRs traded was a domestic US exchange. The plaintiffs maintained that the unsponsored nature of the ADRs was not dispositive, arguing that the defendant misled investors around the world, that holders of ADRs – whether sponsored or not – have a beneficiary interest in the underlying stock and the right to obtain the foreign shares on demand, and that the defendant’s position would allow securities issuers to evade liability simply by declining formally to apply to establish an ADR programme, while allowing the sale of unsponsored ADRs.
Holding
The court ruled that the OTC market on which these ADRs traded was just that – a market, and not an exchange. The court found that Morrison’s reference to ‘American stock exchange[s]’ (and to ‘national securities exchanges’) did not include OTC markets, and that the Exchange Act recognised a difference between exchanges and markets, further supporting this conclusion.
With respect to Morrison’s second prong, the court held that, though the ADR transactions occurred domestically, the plaintiffs failed to plead or argue that the defendant was involved in those transactions in any way. The Court acknowledged that Plaintiffs’ Exchange Act claims did not require any privity or direct contractual relationship between plaintiffs and defendant.
The court nevertheless found that Morrison was inconsistent with attaching liability to a foreign defendant based on the independent actions of a depositary bank. Even if the defendant was alleged to have misrepresented its profits to investors across the globe, the court wrote, plaintiffs did not allege that those fraudulent actions were connected to the defendant selling its securities in the US.
Implications
The question whether Morrison permits private securities actions in connection with unsponsored ADRs is increasingly important as this type of security becomes more prevalent. Investors should be mindful of whether an ADR programme is sponsored or not, as it may affect their ability to seek recovery under the US securities laws against the issuer of the security underlying the ADRs.
In-house management
In-house capabilities
The advent of pooling within the LGPS has brought with it a renewed focus on internal asset management. Rachel Dalton reports
On paper, the logic of internal management is clear; Local Government Pension Scheme funds can save money by cutting out the ‘middle men’ – investment managers – and achieve greater stability by running some of their investments themselves rather than periodically switching to new investment managers in search of better performance.
However, the jury is still out on whether internal management truly does save money and improves performance, and if – as funds race to implement pooling – there is capacity in the sector to switch to in-house management on a wide scale.
Research
In January 2016, a group of officers representing about half of the English and Welsh funds, supported by Hymans Robertson, published a report on the benefits and challenges of pooling under the banner ‘Project Pool’.
Part of the report focused on the benefits of in-house management. It said that of the LGPS funds involved in Project Pool, nine managed some of their assets internally. Of their combined total of £55bn, these nine funds’ internally managed assets totalled at £30bn. Most managed about half of their assets in-house but this varied; Teesside, for instance, managed 90% of its assets itself.
There are claims that LGPS funds lack the capacity and skills to manage investments internally but the report found that those nine funds alone employed 80 investment professionals between them, and all employed people with 20 years’ investment experience or more in senior roles.
Drawing on LGPS investment performance data from 1987 to 2015, from WM, Hymans Robertson, CEM Benchmarking and the Chartered Institute of Public Finance & Accountancy, the report claimed that for every £1bn of assets transferred from active externally managed to internally managed arrangements within the LGPS, the scheme could save between £2.5m and £3m per year.
Funds could also reduce portfolio turnover by one third by bringing it in house, the report claimed, which within scheme-wide UK equity holdings alone could save £2m to £2.5m per year.
If funds that currently manage assets in-house were to combine their internal management arrangements, they could also reduce the commissions they pay on transactions by between 25% and 50%, the report added.
Taking all this into account, the report said that the preferred option would be to create pools that have both internal management capability but can still engage external managers when it chooses to do so.
Mixed reaction
Despite the work of Project Pool, not all LGPS officers are convinced by the arguments, and some feel that in any case they would be unable to implement internal management at the same time as pooling itself.
Speaking at the LGC Pension Fund Symposium in July, Mathew Trebilcock, pension and investment manager at Cornwall Council, said: “There is evidence of internal management working and not working.
“To go from where we [in the Brunel pool] are now to active, internal management would increase costs in the short term, but [in-house management] could be something that we built up over time.”
Also speaking at the symposium, Hugh Grover, chief executive of the London Collective Investment Vehicle, said LGPS funds should consider the resources investment management firms have at their disposal and whether an LGPS fund could replace these if it took management in-house.
I would hazard a guess that it is the continuity of in-house teams that supports good investment returns. The cost of changing a fund manager can be big; up to 5% of the value can be lost
“I have to think about what we would lose from those third parties, such as data; I’m not going to be able to replicate that,” said Mr Grover.
He added: “Setting up an internal management team is not on my list right now, but when the time is right and the business case stacks up, we will.”
But speaking on the same panel, Chris Rule, chief investment officer at the London Pension Fund Authority, said managing assets in-house means LGPS funds are not constrained by the capacity of fund managers to take on more clients.
“There’s a limit to how much you can do with one manager; internal management means you’re not dealing with managers trying to diversify clients,” said Mr Rule.
However, he added that although the LPFA manages assets in-house and wants to do more in future, he believes “internal management isn’t a silver bullet”.
The Central LGPS pool brings together a number of funds that manage assets in-house. Geik Drever, strategic director of pensions at the West Midlands Pension Fund, believes that this creates a fertile base for in-house development.
“A number of the funds within the Central pool currently successfully manage quoted equities and bonds internally,” says Ms Drever.
“There is relatively little overlap in the functions that the internal teams currently carry out and it is expected that the pool’s initial internal capabilities will be based around the skills that undoubtedly already exist, and will be delivered by the staff that are currently based within individual funds. It is hoped that these capabilities will be developed further.”
Ms Drever says the Central funds expect pooling will save them £200m by 2034, partly through greater use of internal management, as well as through “economies of scale, mandate rationalisation and fee negotiations”.
Ms Drever adds: “There is wider evidence that internally managed funds both in the UK and internationally have on average achieved superior investment performance – lower costs, including not having the requirement to generate profits that external managers typically have – and the ability to take a long-term approach to investment being key reasons.”
However, Chris Bilsland, non-executive director of the London CIV, remains to be convinced of the value of internal management.
“Cost comparison [between internally and externally managed assets] is problematic because not all funds have in the past fully disclosed and accounted for their costs - both internal and external,” he says.
“This is illustrated in the latest Scheme Advisory Board report, where from 2014 to 2015 investment management fees have increased from £519m to £727m. Assets under management did also increase, which partly explains this, but much of the increase will be because more funds are fully complying with recommended accounting practices.”
Mr Bilsland also claims reporting on the cost of LGPS funds’ in-house management teams is not always detailed, further hindering proper comparisons.
“I would hazard a guess that it is the continuity of in-house teams that supports good investment returns.
The cost of changing a fund manager can be big; up to 5% of the value can be lost so keeping an in-house team avoids this,” Mr Bilsland says.
It will be difficult to calculate the value of in-house management until further figures emerge as more LGPS funds take on the task themselves.
The government’s mention of in-house teams in its requirements for pooling, published last November, make one thing clear: funds will be expected to do all they can to cut costs as they bring their assets together.
FROM OUR PARTNERS: Farmland offers distinct opportunity among real assets
Institutional investors have increased exposure to real assets in the past several years as the low return, low inflation backdrop has fuelled demand for alternative investments as a source of income.
Sherilee mace
Sherilee Mace, institutional business development director, Insight Investment
While most of the interest and flows have gone towards property and infrastructure investments, farmland investments have so far been underrepresented in portfolios despite boasting equally, if not more, appealing characteristics.
We believe that now is the time to consider going beyond the core to seek a greater degree of diversification and to also benefit from a unique confluence of factors that should be very supportive for farmland assets going forward.
’The demand for agricultural commodities will grow as world population continues to expand’
The return case
The secular return case for the asset class is premised on increased demand for agricultural production in an environment of constrained supply response.
The demand for agricultural commodities will grow as world population continues to expand.
The supply-side, however, remains constrained due to a combination of short-term limits to growth and the availability of high quality land coming under pressure as climate patterns shift and resources, water in particular, become scarcer. These dynamics will place a premium on quality land in geographies with a comparative advantage that have the ability to grow their production and investors in those regions, we believe, will be rewarded.
Income generation
Farmland assets are also a source of consistent income, which is generated either through leasing out the property to operators or directly managing the assets. The level of income from farmland investments varies by commodity, region and operating model and a well-diversified portfolio can potentially generate an attractive annual income.
Inflation protection
The inflation protection that farmland provides is compelling and ‘inexpensive’ when compared with other alternatives. Whereas inflation-linked bonds may provide the most reliable hedge, the return give-up for investing in them can be substantial and possibly unjustified in today’s extremely low interest rate environment, making them an ‘expensive’ hedge. Farmland investments, on the other hand, would be expected to have a high beta (or sensitivity) to inflation due to the quick response of commodity prices to unexpected inflation albeit less reliable than an inflation-linked bond.
Diversification
Adding farmland assets to a broader portfolio should have substantial diversification benefits, compared with both mainstream and other real assets. Returns for farming are impacted by factors such as the climate, demographics, trade and government policy in ways which are unique to the asset class. Furthermore, farmland investments have substantially less correlation to economic growth than other assets. This is particularly contrasted with timber investments that have a high correlation to economic performance due to the linkage with the real estate sector.
Timing
A tactical opportunity has been created following the sustained drop in commodity prices, which has resulted in downward pressure on farmland prices in many key geographies. Strong short-term supply shocks have resulted in record grain and dairy production during the past four years putting pressure on the prices of cereals, oilseeds and dairy products. The impact has been compounded by shifts in demand coming from China, in particular. Agricultural prices as measured by the Food and Agricultural Organisation’s food price index have fallen by almost 30% since 2011. Against this backdrop, the currencies of key commodity producers have also declined sharply and in many instances without an equivalent offsetting adjustment to the price of the underlying asset, providing a currency tailwind.
Responsible investing
It is important to focus on responsible investment implications in relation to farmland investments and they should be a core consideration as agricultural production is an essential resource for society. From an investment perspective, the key advantage of doing so, we believe, is to enhance performance over the long term while at the same time mitigating downside risk.
Insight believes that the best approach is to embed responsible investment considerations throughout the investment process, from the investment selection phase, through to the day-to-day management and execution. The core of Insight’s approach is based on Integrated Farm Management, a dynamic framework developed by Linking Environment and Farming, which aims to provide guidelines for effectively balancing farming’s key objectives of productivity and profitability with environmental and other considerations.
Institutional investors and asset managers, including Insight, have been proactively looking to formalise guidelines for investing in farmland in a global framework. The main motivation for this has been to foster greater transparency and to encourage investment in an asset class that is deemed to be of long-term interest to investors. The effort has now been incorporated within the UN Principles of Responsible Investment, of which Insight is a founding signatory.
Summary
The case for real assets is well understood in terms of its potential in generating returns over the long term and for its role as a good diversifier. However, the opportunity for greater diversification within real asset categories exists and farmland should play a more significant role in this respect.
Diversification
Local Government Pension Scheme's voyage into diversification
LGPS funds are on a journey to radically revisit their investment approaches, and increased diversification is playing an important role.
John roe
John Roe, head of multi-asset funds, Legal & General Investment Management
Reducing unrewarded risk and earning the ‘diversification bonus’ are easy wins for schemes and outsourcing completion portfolios can be an efficient way to access a range of additional asset classes.
Targeting equity-like returns with lower risk
Diversified growth funds, or DGFs, have become a core part of pension schemes’ allocations. Their key objective is generally to provide levels of long-term investment growth similar to that of developed equity markets, with - crucially - lower levels of volatility. To spread investment risk, a DGF invests in a wide range of underlying investment types, such as infrastructure, emerging market debt and commodities. LGPS have similar objectives and in turn are implementing increasingly sophisticated methods of diversification.
Diversifying not only reduces risk, it also leads to expected rates of return that are higher than a straightforward weighted average of the underlying assets. This means that a diversified asset pool can expect to increase the rate of return investors achieve compared to that from several distinct funds managed independently. This effect is known as the ‘diversification bonus’.
The diversification bonus is an essential component of how managers target similar rates of return to developed market equities, despite normally including some lower-risk assets. It is a low-cost, easily achieved source of return that is attractive for both DGFs and LGPS to access.
The magic of the diversification bonus
The risk management properties of diversification are well understood. What is less well known is that diversification can actually increase the rate of return clients can achieve. The simplest way of explaining the diversification bonus is through an example of the impact of volatility on the overall rate of return on a portfolio.
For instance, if a portfolio returns -50% in year one and then rises by 100% in year two, the portfolio is only worth the same as at the outset. So even though the average overall return (+50%) might initially seem appealing, the net benefit for an investor is zero. This effect is systematic, in that the impact of a negative return is always bigger than the impact of an equivalent positive return. The larger the swings in investment value, the larger the impact.
Diversification should reduce the likely size of the positive and negative returns achieved on the portfolio and thereby also reduce the potential for large negative returns impacting the overall rate of return achieved. In turn, this should lead a diversified portfolio to offer lower volatility, as well as a systematically higher rate of return than the weighted average returns on the underlying investments would suggest.
Based on both historic and forward-looking analysis of the potential benefits of this approach, we believe that a diversified growth fund could achieve a diversification bonus of as much as 0.6%-0.7% annually over the long term. Even more importantly, this effect compounds over time.
For the diversification bonus to work, it is important that the portfolio rebalances periodically. Otherwise the rate of return achieved will be the same as the weighted average of the underlying investments – just like if they were held as several segregated portfolios of different assets. The result of periodic rebalancing is similar to the old saying, ‘buy low and sell high’, as it systematically reduces exposure to the best performing assets and reinvests into those that have performed least well, to get back to the target portfolio weights.
Completion mandates for outsourced diversification
Investors want to focus their time on the areas that have the biggest impact on their outcomes. This will generally be setting their risk appetite, the high level strategic asset allocation and the selection of managers for their largest allocations. As such, as LGPS funds turn to small allocations of diversifying assets, there is more appetite to outsource the construction of completion portfolios. For example, a portfolio with a 30% allocation to alternatives might well have 8-10 underlying asset classes, with the need to size them allowing for all the existing exposures.
Multi-asset managers already have the expertise and analytics required to size portfolios of alternatives to meet specific risk budgets and objectives. Given the size of LGPS, managers are willing to apply that same expertise on a bespoke basis to build a completion portfolio on a portion of the overall assets.
Outsourcing your asset allocation has practical benefits too, freeing up day-to-day resources to focus on the wider picture of LGPS management. All the while, your end investment outcomes should be less volatile than equities, with a diversification bonus to boot.
Legal & General Investment Management offers diversified growth funds
Exiting pools
Emergency exits
How are LGPS funds protecting themselves from the potential need to leave a pool? Charlotte Moore examines the issue
Local Government Pension Scheme funds are so focused on ensuring they can meet the government’s deadline for forming pools that they may be neglecting exit clauses, warn lawyers and pension consultants.
Exiting a pooled fund is less straightforward than the current arrangement funds have with asset managers. Funds can simply fire a manager with no compulsion to hire a new one straight way.
Fiona Miller, head of pensions & financial services at Cumbria CC, says: “Once the regulations are in place, if a fund comes out of a pool it will have enter another pool.” There are no half measures: if the fund decides to exit, it must leave the pool completely, she adds.
Not only will it be complex to change pools but it will also be frowned on by the government. Ralph McClelland, assistant director at Sackers, says: “There is nothing in the legislation to prevent authorities changing pools but neither the Treasury nor the Department of Communities & Local Government want authorities to change pools.”
However, arrangements still need to be made to ensure a fund can leave a pool if necessary. Even with the best of intentions, it would be naive to assume a pool will never face any challenges.
Some of the current pools have been formed between authorities with good relationships but it would be unrealistic to assume these relationships will last forever, says Steve Simkins, partner at KPMG.
New generations of councillors may have different views or disagree with other members of pool, he adds. This is likely given the political nature of local authorities. If, for example, a Labour-controlled council were to become a Conservative council, there could be a shift in investment philosophy.
There are no half measures: if the fund decides to exit, it must leave the pool completely
Even if there is no change in the political make-up of a particular local authority, the preferences of a particular administering authority might shift over time. Mr Simkins says that this may mean funds’ priorities fall out of step with those of a pool.
Given these possible threats to pooled relationships, it makes sense to consider how such arrangement could be changed. But there are fears that many authorities are neglecting this decision.
Mr Simkins says: “How to exit a pool has not been properly considered in the inevitable rush to form these new structures.”
How easily funds can exit those pools will depend on the structure used. Most of the pools will use an authorised contractual scheme, which is a Financial Conduct Authority-authorised structure. That implies most of the funds will enter into collective investment vehicles.
John Hanratty, head of pensions north at Nabarro, says: “Each fund will effectively hold a proportionate value in the collective investment vehicle, reflecting the individual authority’s investment strategy.”
This unitised approach and the FCA regulatory regime makes it possible for a fund to exit a pool but the ease of exit will depend on the structure of the collective investment vehicle.
Mr Hanratty says: “For example, if an authority enters in to a limited partnership, there could be penalties on the withdrawal from the pool.”
However the investment vehicles are structured, there could be an administrative charge for withdrawing from the pool, he adds.
If a fund does exit, its share of the pool’s assets might have to be sold. Mr Hanratty says: “Transferring the assets from one fund to another may not be possible as it could skew the asset allocation of the receiving pools.” To cover the cost of liquidating assets, the pool could charge a disinvestment or transfer charge.
An inter-pool transfer arrangement similar to the public sector transfer club could also be adopted. Under this scheme an employee retains his or her rights and is transferred without penalty while the receiving scheme picks up any cost. A similar regime could apply to a transferring authority.
Mr Hanratty says: “The receiving pool might be in a position to pick up that disinvestment charge and amortise it over any medium-term asset growth.”
One of the problems facing local authorities is that they are at arm’s length from the discussion. The pools are being established by committees which represent the local authorities.
Mr McClelland says: “These committees appoint their own lawyers to advise on the creation of the pool.” These lawyers will be thinking first and foremost about the rights of the pool rather than the individual members.
“Local authorities should recognise their interests are not completely the same as the newly created pooling manager,” says Mr McClelland.
Some local authorities, however, have ensured they will be able to exit pooled funds. Cumbria is part of the Border to Coast pool, which has 13 member funds and an approximate pool value of £36bn. It is one of the larger pools and it will allow individual authorities to exit.
Ms Miller says: “We are putting termination lengths and a clause in our pool agreement along with how those costs will be picked up.”
Although exiting the pooled fund will be more complex than simply firing an underperforming investment manager, it is possible as long as it addressed before the pool is formed.
Ms Miller says: “It is vital to ensure all the contracts and clauses are in place before the agreement is reached so it’s clear how an exit will happen and how the costs will be borne.”
These details have yet to be finalised but Ms Miller says it’s likely that the cost will have to be paid by the exiting fund.
While it is essential to have the right legal framework in place, exiting a pool is not a decision which will be taken lightly. Ms Miller says: “Transitioning an entire authority’s portfolio out of a multi-asset fund, including closed funds, will be a messy and complex procedure.”
To avoid an authority having to make such a momentous decision, pools should have a common investment philosophy. Ms Miller says: “Our pool aims to work together deliver the best performance.” That includes providing access to detailed performance reporting.
The Border to Coast pool has been structured to ensure action can be taken well in advance of one authority choosing to leave. Ms Miller says: “The shareholders retain the right to appoint and fire the directors of the company.”
Mr McClelland adds: “The design of the pool fund along with its representation, controls and schedules for investment objectives should all be built to allow enough checks and balances to ensure correct functioning of the pool.”
If relationships do break down, however, it needs to be clear from the outset how such a crisis will be dealt with. “This is not something which can be changed post-event,” adds Miller
FROM OUR PARTNERS: Equities to extend summer runs as Brexit shock fades
Percival stanion
Percival Stanion, head of international multi-asset, Pictet Asset Management
Global financial markets have recovered poise as a sell-off after Britain’s vote to leave the European Union proved short-lived.
World economic growth remains moderate and central banks in Europe, Japan and some emerging economies continue to provide monetary stimulus, while the US Federal Reserve is unlikely to raise interest rates before December. This provides a positive backdrop for risk assets.
The US economy is enjoying better growth momentum thanks to higher consumer spending and a solid housing sector. Manufacturing activity is also stabilising while there is a tentative sign of an increase in capital spending. The market is pricing in a one-in-two chance of an interest rate hike in December, but overall monetary conditions should remain supportive of growth as a recent pick-up in inflation is likely to be temporary and the labour market remains tight.
Economic activity is improving in the Eurozone too as private consumption gains pace and external demand recovers somewhat. Sentiment remains fragile after Brexit but the Eurozone economy is proving resilient, allowing for above-potential growth of 1.3% this year. Italy remains a weak link given uncertainty over plans to recapitalise its banks. The European Central Bank made no changes to monetary policy in July but reiterated that it would take necessary action.
We think the ECB may extend the timeframe for its asset purchase programme beyond March to counter any negative surprises to the economy. Japan’s growth is likely to remain below potential at 0.7% this year as business investment remains subdued despite higher public and private spending, an upbeat housing sector and a moderate recovery in external demand. The Bank of Japan expanded monetary stimulus by almost doubling its purchases of exchange-traded funds, but it disappointed investors by refraining from venturing into more unconventional monetary policy.
China’s economy remains stable, thanks to Beijing’s economic support measures on fiscal, monetary and property fronts. However, construction activity appears to be peaking, while credit growth is likely to slow down as authorities begin to rein in excessive growth in borrowing.
Elsewhere in emerging economies, the growth outlook remains underpinned by China’s stabilisation, an on-hold Fed and monetary and fiscal support measures. Expectations for easy monetary and fiscal policy in Japan, China, Britain and the Eurozone are likely to improve global liquidity conditions in the coming months.
Meanwhile, markets are very likely to remain highly volatile and investors would be wise to remain quite tactical in the way they put risk into portfolios.
Pictet Asset Management Limited. Authorised and regulated by the Financial Conduct Authority.
Pictet
Global equities
The right approach to risk and return
An LGC roundtable held in association with Newton Investment Management considered the latest thinking on global equities. Rachel Dalton reports
Participants
- Mathew Dawson, pensions and treasury manager, Warwickshire CC
- Mike Ellsmore, chair of the pensions panel, Chartered Institute for Public Finance & Accountancy (chair)
- Denise Le Gal (Con), chair of pension fund committee, Surrey CC
- Andrien Meyers, senior investment consultant, JLT Employee Benefits
- Julian Pendock, chief investment officer, London Collective Investment Vehicle
- Raj Shant, portfolio manager, Newton Investment Management
- Bola Tobun, investment and treasury manager, Tower Hamlets LBC
- Alex Younger, investment and pension treasury services manager, Norfolk CC
The Local Government Pension Scheme achieved a return of 12.1% in 2014-15, compared with just 5.9% the previous year.
This performance, recorded in its advisory board’s latest report, was largely due to LGPS funds’ significant allocation to equities – 36.8% overall – which rallied over the period.
However, it is this tendency towards short-term volatility that often makes more risk-averse investors nervous about equities. How much risk can investors afford to take? But with a need to grow assets in order to meet liabilities, how much risk can LGPS funds afford not to take?
LGC’s July roundtable, sponsored by Newton Investment Management, tackled these questions.
Opening the debate, the discussion chair Mike Ellsmore, who is also chair of the pensions panel at the Chartered Institute of Public Finance & Accountancy, discussed the extent to which funds’ assets matched their liabilities and how this affected their attitude to investment: “The average funding level in 2013 was 79% and the range of funding ratios goes from 56% at one extreme to 101% at the other extreme.”
This means that most funds need to invest in assets providing significant returns to meet their liabilities, Mr Ellsmore said.
“Risk often entails equities and alternatives. The LGPS is in a much better place in terms of riding out the equity rollercoaster, and can take a bit more risk than the corporate sector, which is often thinking about next year’s balance sheet.”
Raj Shant, portfolio manager at Newton Investment Management, said investors tended to prefer bonds because these were seen as safer. But with bond yields low and in some cases providing negative yields, this approach looked increasingly illogical, Mr Shant said.
“There are just over $17tn of bonds in the world with a 1% or less yield,” he said.
“With negative yields in particular, how are we ever going to explain to generations to come that we locked in those losses to maturity because we were so desperate to avoid risk?”
Mr Shant added: “If you measure it every year, equities seem much riskier than bonds. However once your time horizon is seven years or greater, the volatility for equities is less than that for bonds.”
Mr Shant then introduced an age-old question into the debate: should LGPS funds choose active or passive equities? “When you invest in an index-tracking product, you’ll get roughly the return of that index minus the passive fees. You’re locking in underperformance over time.”
The LGPS is in a much better place in terms of riding out the equity rollercoaster, and can take a bit more risk than the corporate sector, which is often thinking about next year’s balance sheet
Alex Younger, investment and actuarial services manager at Norfolk CC, said investors might take an alternative view.
“I’m guaranteeing [when investing in passive equities] that I get the index performance, minus perhaps the five basis points charges at worst. Across the LGPS, there have been too many active managers that have disappointed to a much higher degree. I wonder if we should just use passive building blocks and think more about strategic portfolio construction; we might ultimately have better investment outcomes.”
Julian Pendock, chief investment officer at the London Collective Investment Vehicle, said the CIV was looking to offer the funds the ability to use equities in a way that should help improve the risk/return profile by reducing individual manager and/or strategy risk.
The CIV will offer funds the opportunity to buy into a variety of active equity strategies at the same time, as opposed to sticking with their existing one or two managers, to diversify their investment.
“We pick the manager for each strategy and they can blend those building blocks to be more or less what they want and that way they get away from individual manager or strategy risk,” Mr Pendock explained.
“If you blend them like this – and most people couldn’t because of the acquisition cost, the search costs, the monitoring costs and the very high fees that go with it – you get a more sensible outcome for your risk/reward.”
Mr Pendock emphasised that the funds would ultimately choose whether they wanted to go down this route or not.
Mr Shant said that active managers now offered investors the opportunity to pay a low base fee and then a fee related to the investment’s performance.
However, Mr Pendock said this did not guarantee good value: “Fund managers say, ‘we get two-thirds of our revenues from performance fees, and if we were a mediocre performer we’re very cheap’. Even if [the base fee] is 20 basis points, if [the fund] is thereabouts a tracker, that’s not a great deal for the investor.”
Mr Shant said funds should be selective when choosing a manager. “If you’re going for a lower base fee with a performance fee, you want a manager who can demonstrate outperformance over a long period of time and in a variety of market conditions,” he said. “I would say it is possible to add value, because we have been doing this for 20 years in global equities.”
Mr Younger said it was difficult to convince elected members, whose duty is to keep a close eye on costs, that this charging structure represented value for money.
He said: “My trustees would say, ‘If you are very confident in your ability to deliver that performance then I’ll tell you what – you do it for nothing (or not very much) until you deliver, and when you deliver, you get paid and at the level you expect.’”
Mr Younger added that when his fund had invested in products with this charging structure, they had worked if the base fee had been closer to passive fee levels, giving greater risk symmetry between manager and client.
Mr Ellsmore moved the debate on to elected members’ role in running LGPS funds, which is due to change under the pooling reforms.
“Committees are getting bogged down in fund manager selection and they miss the big picture, which is asset allocation,” said Mr Ellsmore. “The pools give a big opportunity to change that.”
Mathew Dawson, Warwickshire CC’s pensions and treasury manager, said he was concerned that when elected members had to choose from a selection of managers picked by their pools, rather than from the entire market, there could be a threat to diversification.
“[Pools] make it a lot riskier because [committees] don’t have that whole marketplace anymore and the risk of picking a wrong manager seems much bigger. I’m sure every pool is doing a really good job but that is a real risk,” said Mr Dawson.
However, Andrien Meyers, senior investment consultant and lead on LGPS pooling at JLT Employee Benefits, said pools and funds could mitigate this risk through good governance.
Mr Younger said that shifting most of the responsibility for manager selection from committees to the pools may improve funds’ performance overall by allowing committees greater time and resources to concentrate on strategic asset allocation.
Mr Ellsmore asked the group what appeal equities had to their funds, as opposed to bonds or alternatives.
Mr Pendock said: “They’re the lowest tranche in the capital structure, so you’ve got an embedded call on growth and a bit of an inflation hedge there and a dividend pay-out, which is higher than the bond yields.”
He added that he was concerned, however, about stability within the US market: “A lot of these dividend aristocrats [companies within the S&P 500 index that have increased their dividends for 20 consecutive years], not only are their shares being boosted by buybacks and horrendous leverage but also the companies are now being run for cash, so you see profitability ratios flattered by the depreciated asset base, unsustainable cash flow metrics and so on. That worries me but elsewhere, equities have a very good case to make.”
Mr Ellsmore asked why an LGPS fund that was only 56% funded would invest “in anything other than equities”.
Mr Meyers asked whether the group felt that equities could help to mitigate interest rate and inflation risk, and what alternative assets could also help with this, such as infrastructure or real estate.
Bola Tobun, investment and treasury manager at Tower Hamlets LBC, suggested high-yield bonds or private debt. Mr Meyers agreed, but added that pension funds should consider the liquidity they needed. Here, equities, as a more liquid asset than private debt or high-yield bonds, had the advantage, he said.
Mr Shant said: “Things like private equity are good rivals, and infrastructure is of interest especially when the government guarantees the revenues, but they can be very illiquid; I can’t help but refer to the property debacle over recent weeks after the Brexit vote.”
He was referring to the spate of property funds that had cut the value of their holdings and in some cases refused to allow investors to withdraw their money as fears spread of a post-Brexit property price collapse in early July.
Simplistically, equities have been a great asset class if you bought a basket of them, put them in a box and went away. It’s a decent long-term asset class
Mr Younger agreed that equities were useful to long-term investors such as pension funds.
“Simplistically, equities have been a great asset class if you bought a basket of them, put them in a box and went away. It’s a decent long-term asset class. Not following fashion too hard and then rebalancing the strategic portfolio regularly is the important thing that is probably going to produce better results,” he said.
Mr Pendock hinted that changes to central bank policy and international monetary management would present risks in the fixed income sector that would make equities look even more attractive by comparison.
Mr Shant agreed, pointing out various instances of governments proposing to use quantitative easing to invest in their own infrastructure and the effect this may have on bond markets. Traditionally, it is believed that in QE, central banks’ buying of government bonds from the private sector increases demand for the assets, pushing bond prices up and yields down.
“Jeremy Corbyn has talked about ‘quantitative easing for the people’; printing money to build stuff. This strategy is getting further support in Japan. Donald Trump is campaigning on something similar. You can see the political pendulum, after 35 years, potentially beginning to change. That would be equity-positive, although short-term it might be a bit negative if bond yields go up and interest rates have to rise on the back of it, but actually equities would still be the bigger beneficiary of the next 10 years,” said Mr Shant.
Denise Le Gal (Con), chair of the pension fund committee at Surrey CC, said the market’s reliance on bonds as a ‘safe’ asset and belief that inflation would not rise anytime soon was cause for concern.
“I was talking to an £18bn fund, not within the LGPS, and they have absolutely zero fixed-interest bonds,” said Cllr Le Gal.
“This is a strategic tactic that they’ve taken on: the only bonds that they’ve retained are index-linked because everyone is saying inflation is dead, and that to me is a big red flag to start thinking differently.”
Mr Ellsmore asked group members if they were concerned about inflation.
Mr Pendock said: “If you accept that QE is deflationary, for reasons of surplus supply and because you get inverse correlation between the quantum of QE and the velocity of money, and that is all policy driven, if there’s a policy regime change, we do have to worry about it. If the central banks control the money supply, they can create inflation.”
He added that “unsterilised QE”, where central banks print money to invest directly into the private sector, could create inflation.
However, Mr Younger argued: “The Bank of Japan is desperate for inflation, and it’s very difficult to introduce. When it comes to it, [central banks] find they can’t [create inflation] because the levers don’t work quite as well as they thought they would.”
Mr Shant said: “You can’t create good inflation. We’ve already got people who have maxed out on credit cards, maxed out on debt, and we’re saying there’s a demand shortfall and trying to stimulate more demand; this is a very unhealthy approach to policy and the economy.
“But you can create bad inflation quite easily: you create a fear that if you’ve got lots of savings sitting there idle, then those savings will get devalued, so you create the fear of inflation and you create activity and faster circulation of money. There is more likelihood that in five to 10 years we will be looking at stagflation.”
Drawing the debate to a conclusion, Mr Ellsmore said: “Equities have a lot to offer. We’ve all been intrigued by the volatility argument.”
Mr Shant concluded: “We’ve got ultra-low and negative bond yields in huge tracts of the world markets and if we’re going to make the returns that our scheme members and investors require, we’re going to have to go out into that choppy world of global equities to find some opportunities.”
The case for global equities
Raj Shant, portfolio manager,
Newton Investment Management
At current levels of funding, it will be very hard for many LGPS funds to generate the kind of long-term returns they require, without some exposure to global equities in their asset mix.
Global equities can provide very substantial diversification benefits while simultaneously providing access to some attractive opportunities around the world. The present exposure to fixed-interest assets, despite the extraordinarily low levels of return available from them (in some cases, the certainty of a negative return), is hard to understand.
However, the field of behavioural finance can help: it posits that people are more willing to take risk to avoid a loss, and yet, when it comes to taking risk for potential gains, most people prefer certainty. Maybe that’s why investors still buy bonds (the certainty of the return) even when the available returns are very low or possibly negative. Many well-known studies have shown that in the long run equities tend to generate better inflation-adjusted total returns than bonds and cash.
’Pension funds with long-time horizons should be well placed to look through, or even benefit from, the short-term volatility of equity markets’
Recent studies also show that while equities may be more volatile than bonds in the short run, the longer the time horizon the less volatile equities seem. In fact, if the observation period is seven years or longer, equities are actually less volatile than bonds. Pension funds with long time horizons should be well placed to look through, or even benefit from, the short-term volatility of equity markets.
Even if it is accepted that equities have a central role to play in a portfolio, the value of investing actively is often not recognised, given the cost differential versus passive investing. Passive strategies again offer investors the benefit of certainty – you will certainly underperform the market after fees. An active investment manager that generates target levels of outperformance over the years may prove to be good value if you choose the right one.
A strong, long-term track record, generated by a process and a team that has been through very different market and economic cycles, is one important consideration. Also, aligning interests through performance fees (though maybe not the rather asymmetric ‘2 & 20’ formula often used by hedge funds!) can help. But, ultimately, there is no free lunch. To generate good long-term returns we must take (judicious) risks. The very human need for certainty can drive investors into investments with low, or even no, returns to avoid risk, which we think actually increases the chance of missing out on longer-term opportunities.
Newton logo
Real estate
Real opportunities in a post-referendum world
Despite market volatility, property still remains one of the best sources of income, says Lucy Williams, director – institutional business, UK and Europe, M&G Real Estate reports
As Britain starts preparing to leave the European Union, one of the many questions is what does the referendum result mean for the investment market?
Lucy williams
That’s an important issue that goes far beyond the big banks and institutions; it applies to each and every single one of us who has savings or a pension.
Despite the volatility, real estate still remains one of the best sources of income, particularly with gilt yields moving into negative territory and interest rates now expected to remain low for longer.
It is true that we have already seen some price falls in maistream UK commercial property (particularly in central London offices). While volatility is likely to continue in the short term, in the long run businesses will still need offices and retailers will still need shops.
Fig 1: Housing supply vs demand, Source: Department for Communities & Local Government, JLL
Well-located quality buildings will always be in demand. For investors who have money to place and are willing to tolerate a degree of risk, any post-referendum dislocations in the market could open up attractive investment opportunities.
Now could also be a good time to look beyond the UK commercial assets which have historically tended to dominate local government pension schemes’ property portfolios. Periods of volatility underscore the importance of diversification. We believe that good diversifiers in the current climate include the UK private rented sector (PRS) and core assets in continental Europe.
UK PRS: defensive income
Our research shows that residential property has low correlations with equities and gilts, and also displays weaker correlation with mainstream commercial real estate sectors than those sectors show with each other. Therefore, adding residential property into a multi-asset or commercial property portfolio would be expected to improve risk-adjusted returns.
Fig 2
Source: IPD Multinational Digest, 2015
Residential also benefits from strong defensive characteristics, as people always need somewhere to live. Indeed, during the steep market downturns in both the 1990s and 2000s, residential property recorded a smaller capital decline than commercial and also recovered its initial value faster.
The post-referendum uncertainty is likely to encourage more people to rent in the short term, supporting rental values and helping to maintain an attractive income stream for institutional PRS investors. In the long term, the existing housing shortage and fundamental supply/demand imbalance should continue to support rental growth in our key residential markets, close to or with access to employment opportunities.
The UK population is expected to expand much faster than the European Union average. At the same time, household size is continuing to fall, with more people living alone. As a result, the government estimates that some 240,000 new homes need to be built annually; nearly 90,000 more than were constructed last year.
Local government pension funds and other institutional investors have the opportunity to help address this housing shortage by funding the development of high-quality built-to-rent accommodation with sustainable design.
By focusing on blocks and units designed specifically for rent and taking an active interest in the development of these products, experienced professional investors can ensure greater efficiencies for operation, energy and maintenance. Similarly, by ensuring consistency across developments, it is possible to maximise economies of scale to reduce costs of repairs and enhance overall returns through greater customer satisfaction.
The prospects for growth in the institutional PRS are supported by the trends seen in the student accommodation sector. This has only very recently become a truly institutional market as developers took the plunge and started to provide the kind of stock investors want to add to their portfolios. As a result, last year saw investment in the sector reaching up to £6bn, according to Cushman & Wakefield. It is not hard to imagine that the same will be true of the PRS in the years to come.
Europe: diversification and strong rental growth
Another way to improve portfolio diversification is by investing outside of your home market. As Britain prepares to leave the EU there is, arguably, an even stronger case for British investors to enter continental Europe. International investment does not need to mean high risk; a core, defensive portfolio with low gearing can offer the benefits of diversification without undue risks.
Fig 3
Fig 3: Allocation to Europe can help boost returns. Source: M&G RE
In Europe, those benefits firstly include a recovering Eurozone economy that is on track, with growth expected to continue at a healthy pace (albeit potentially a little tempered by Brexit). Some of the highest economic growth this year is seen in Sweden at 3.5% and Spain at 2.8% compared to the UK at 1.6%.
Secondly, the property market on the continent moved into a growth phase later than its UK counterpart and therefore has more scope for further yield compression. Capital values are supported by investor demand, with transactions in Europe ex-UK rising by 16% in the second quarter versus the previous three months.
Thirdly, the rental growth outlook remains strong. European rental values rose more than expected in the second quarter, prompting our research team to upgrade their forecast for average rent increases over the next three years to 2.3% pa. The European retail sector is expected to perform particularly strongly, boosted by reduced unemployment, strong tourist numbers and the expanding presence of major international retailers across Europe.
Fourthly, the European real estate market offers similar liquidity, maturity and transparency benefits to that of the UK and represents a sizeable opportunity set to suit a wide range of investment objectives and risk/return preferences. One recent trend is the development of the European long lease market, which offers similar ultra-long inflation-linked income streams to those that have proved very popular with pension fund investors in UK property.
Last but by no means least, there are the diversification benefits. The majority of European real estate sectors have correlations with the UK market that are below the 70% ‘strong relationship level. European retail in particular stands out for its low correlations. That means that any downturn in UK occupier demand for shops is unlikely to be seen in Paris or Rome.
Furthermore, our portfolio optimisation analysis shows that adding Europe to a UK domestic portfolio leads to higher risk-adjusted returns (measured by the Sharpe ratio). UK investors can achieve higher returns – both total and risk-adjusted – by including just 10% of continental Europe in an otherwise domestic portfolio. Risk-adjusted returns rise steadily as the allocation to Europe is increased towards the 40% mark.
In conclusion, while we continue to see a strong long-term future for the UK commercial property market, the current turbulence underscores the importance of diversifying your investment portfolio across a range of strategies which have different underlying fundamental drivers but are unified by their individual strong return prospects. We believe that both UK PRS and core European real estate meet those criteria.
This article presents the author’s present opinions reflecting current market conditions. 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.
