The post-tech bubble bear market coupled with a higher life expectancy has left many pension funds with considerable funding gaps. Healthy stock markets in 2005 have helped repair some of the damage done to pension schemes by the previous slump in equity markets. But, while the current market rally may give some cause to breathe a sigh of relief, it also underlines pension schemes’ continuing vulnerability to market volatility.

In addition, national regulators are now placing greater emphasis on ensuring that funding risks are adequately addressed. In particular, schemes are forced to regularly mark-to-market their liabilities, increasing the interest in liability-led thinking.

At the end of the 1970s, many pension schemes switched from bonds to equities in response to the damage done by the high levels of sustained inflation experienced in the seventies. The 1980s and 1990s seemed to corroborate the wisdom of that stance as privatisation and, more importantly, a secular fall in inflation underpinned steady increases in equity values.

However, the petering out of these trends and the unrealistic expectations of the dotcom era pushed equity markets over the edge. The ensuing years of market decline, compounded by further falls in interest rates, increased liabilities to a level that forced the pension industry to re-examine the validity of their investment strategies. This has led to a renewed recognition that meeting liabilities should be the cornerstone of any pension scheme’s investment strategy. As a result, pension schemes are increasingly adopting liability-led investment strategies whereby relative peer or industry benchmarks are replaced by internal benchmarks based on scheme-specific liabilities.

Given the nature of pension liabilities, this inevitably means a greater emphasis on bonds. This is because liabilities resemble bonds in reverse. Whereas bonds represent a series of known future income payments, a pension consists of a stream of (largely) known future outflows. If you combine all of these outgoing payments, you can plot the total of predicted cash flows that the scheme will need to generate to meet its liabilities. Figure one illustrates an example of what such a structure might look like.

Equities and liability-led investing

Does this mean that equities have had their day? Well, the answer to that lies in a better understanding of risk in the context of pensions. Once a scheme understands the liabilities it needs to meet, the next step is to consider the risk it would feel comfortable taking. Risk is often thought of in terms of probability of loss. However, in the long-term pension context, risk should be linked to the scheme’s liabilities.

Risk has to be taken only if there is an expectation of additional return; otherwise it will be unrewarded. Most schemes would prefer to entertain less risk, however few pension funds are in the position to ignore higher risk assets completely as they need to aim for additional returns, either to avoid locking in deficits or to provide them with a safety margin against unforeseen changes in regulations, member profiles, contribution rates or demography. As a result, the risk budget, i.e. the exact level of funds allocated to risk assets will differ between schemes, reflecting each scheme’s unique maturity profile, solvency position, contribution rates, specific legal framework, etc.

This makes inherent sense: the needs of a scheme whose members are mostly active or young are completely different to that of a pension fund with older members of whom a high percentage are either retired or close to retirement. It is likely that the younger scheme may have a higher proportion of risk assets in its overall portfolio allocation, given that most of its liabilities will only have to be paid out in the distant future. Nevertheless, even a mature pension fund may still need to invest in risk assets to generate the additional return needed to restore or strengthen its funding position. The challenge will therefore be to work these risk assets even harder.

While many pension funds are rightly exploring the possibility of investing in a wider set of asset classes such as property, private equity and even hedge funds, most accept that these can only complement the core asset classes: fixed income and equities. Fixed income investments are necessary to match or closely match liability outflows; however, they are not a substitute for equities when it comes to delivering longer term, enhanced returns. Nevertheless, having experienced a bumpy ride over the last years, many pension funds are ambivalent about investing in equities.

Moving from passive to active and back again

Faced with dwindling equity returns, several schemes have either significantly reduced their equity exposure, possibly taking it beyond a level required by their liabilities, and/or have moved to passive mandates. Neither solution is necessarily satisfactory.

As explained above, equity allocation should be based on the overall liability profile. Reducing equities beyond the level needed by liabilities means foregoing a significant source of alpha generation, which in turn may endanger the scheme’s ability to meet future liabilities.

Moving to a passive mandate seems to make more sense as it leads to lower costs and eliminates the risk of underperformance by an active manager, given that it seeks to keep returns and annual volatility in line with the market as defined by the chosen market benchmark.

However, there are drawbacks to replicating the index: market capitalisation based indices have an inherent ‘success’ bias as large index constituents may be the result of companies having grown through acquisition or through recent market momentum. Passive investors are effectively ‘locked in’ when this phenomenon causes indices to become more concentrated.

The resulting high levels of concentration raise concerns about the degree of diversification that the index is really offering. When momentum in these ‘large’ stocks abates, the case for active management therefore becomes stronger. Furthermore, passive strategies do not allow for manager conviction on the quality of the stock. They can even preclude what is an essential strategy for capital preservation: selling a stock when corporate governance or other issues suggest a sale would be prudent. A sale can only occur after the event, when the damage is done and the affected share has fallen out of the index.

FIGURE ONE: TYPICAL LIABILITY PROFILE- FORECAST (PAYMENTS)

However, traditional active management is also ‘hostage’ to the index. The benchmark index for the equity portfolio has considerable risk of its own against the true benchmark, i.e. the scheme’s liabilities. Suppose a given share represents 8 per cent of a benchmark index and a fund management team believes this share is likely to fall in value: how much should they hold in the portfolio?

If the team’s objective is to outperform the index, but they are mandated to control tracking error - defined as ex-ante risk relative to the benchmark – then a 6 per cent weight would represent a meaningful underweight. However, in isolation, this obviously appears nonsensical given the negative view on the company. If the conviction of the management team is negative on a given share, an active manager should be able to eliminate the perceived risk completely by selling off the share in question. It is only when an active management team is no longer constrained by benchmark considerations that it can fully leverage its active skills; and this without necessarily adding extra risk.

Truly active management also makes sense from a liabilities’ perspective. Tracking error is an important consideration in an index relative approach because it endeavours to control risk against the benchmark; however, in a liability context what does this actually achieve? The answer is: not much. If one assumes that the total risk is 15 per cent relative to liabilities, and the tracking error of the equity part of the portfolio is 2 per cent then the actual risk of the portfolio relative to liabilities is in the order of 15.1 per cent, not 17 per cent. This is because the risks do not add up linearly; the dominant ‘risk’ decision in a liability context is to be invested in equities.

In liability-led investment, therefore, passive and index-based active approaches constitute similar risks. Both approaches cause exposure to stocks that are not necessarily believed to ‘control’ tracking error, but this has negligible impact on the risk that matters.

At the same time, they may compromise returns by diluting investment conviction. A manager or team with proven stock picking skill will do better with as many opportunities to display that skill as possible: i.e. to allocate active money to positions in stocks held with conviction.

A truly active portfolio

Against this background, an active portfolio with an unconstrained mandate may represent a more efficient way of capturing equity return. This approach might fall into two camps: ‘focus’ and more diversified unconstrained portfolios. Focus portfolios are typically much more concentrated than traditional active products with the number of holdings for a regional mandate between 20 and 25. The more diversified portfolios typically hold in the region of 40 different stock positions.

While traditional indices can be used for benchmarking purposes over three or five-year periods, short-term relative performance volatility may be high since no account of index weights is taken into consideration for portfolio construction purposes. Therefore, tracking error is rendered meaningless. Nevertheless, careful portfolio construction can reduce long-term volatility, often to a level similar or below that of the broad market. In terms of other features, it is important to note that the investment horizon may be longer than for traditional benchmarked funds.

Typical investment parameters would also stipulate that there would be an element of sectoral diversification and no more than 10 per cent of the fund in a single issuer. The appeal of the unconstrained approach is that in addition to eliminating preoccupation with benchmark weights from a portfolio construction perspective, it necessitates high conviction investment: only companies that are believed in are held. Indeed, it is a portfolio that concentrates on a management team’s best ideas and, therefore, may have a higher potential for outperformance.

As figure two illustrates, there appear to be always a number of stocks that significantly outperform the market and, more importantly, deliver positive returns even in difficult market circumstances. Liberated from the shackles of the benchmark, a management team with proven stock picking skills should be able to pick a significant number of these.

Past results seem encouraging. A study in the UK, by independent financial adviser Bates Investment Services1, compared investment management companies’ core and focus fund products based on Standard & Poor’s data, and found that the additional volatility of focus funds was in a majority of cases outweighed by better relative returns over mainstream funds.

No ‘magic formula’

The nature of unconstrained or focus portfolios clearly heightens the importance of the individual fund manager’s insight and research capabilities. Manager selection does therefore require a degree of skill, time and resource. Nevertheless, it is a worthwhile exercise as finding the right team may handsomely repay the effort. The key is to find a team where ideas spread rapidly, but with due consideration, across portfolios. Experience seems to suggest that ideas are best generated in very small groups that work closely together but also have a healthy debating culture.

Sadly, there is no ‘magic formula’ to ensure investment success: instead, it is down to an individual or team’s skill to appraise companies’ fundamentals and evaluate the prevailing share price. Thus, individuals will emphasise the valuation techniques that work for them.

A key element is for the individual or team to remain impervious to market noise to ensure that they remain in command of the dynamics affecting individual positions and of the factors (eg sectoral) that are at work across them. The attraction of the focus approach for clients is the knowledge that the fund manager’s sole aim is to deliver absolute return with no dilution of insight being inadvertently created by tracking error or relative return considerations. This is also, of course, a powerful motivating factor for the fund manager.

Long-term alignment of interests through performance fee structures can further cement this partnership. Focus funds are consequently worthy of consideration once a pension plan has already decided to invest in equities. The focus or unconstrained approach does not substantially increase risk relative to liabilities. Instead, it ensures that once the decision to invest in equities is made, the appointed manager can seek to get the most out of the equity allocation by not compromising his or her investment conviction.

The fact that individual managers’ skill is paramount, presents a challenge for pension schemes, consultants and investment managers alike, but in a liability-led context and in a market where equity returns are likely to be more subdued, it would seem important to empower the active fund manager appropriately.

1Survey conducted by Bates Investment Services Limited based on Standard & Poor’s performance data of UK focus funds and their mainstream equivalents run by the same investment manager on a bid-to-bid basis, with net income reinvested, from the Friday immediately following the launch of the relevant focus fund to 28/02/2005.

CONTACT:

Anthony Biddulph
Merrill Lynch Investment Managers,
33 King William Street,
London, EC4R 9AS
Tel: + 44 207 743 4656
Email: anthony_biddulph@ml.com

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