An Alternative to Alternatives

Asset
Class
ANNUAL REDINGTON MAGAZINE 2015
With a greater variety of
assets and approaches
being considered by pension
funds, the label “Alternatives”
is becoming less useful
+
Redington’s
20 Investment Principles
revealed for the first time
An Alternative
to Alternatives
+
INTERROGATION
What’s really going on inside
DGF’s and multi-class credit?
RETHINKING EQUITIES
How our investment principles
influence our equity allocation view
REVISIT
Direct Lending, Risk Parity, CTA’s,
CRE Debt & Volatility Control
Q&A’S
Barry Kenneth,
Pete Drewienkiewicz & Philip Rose
ASSET CLASS
Welcome to
Asset Class
DAVID
BENNETT
Head of Investment
Consulting
David is Head of
Investment Consulting
and a member of
Redington’s Investment
Committee which
meets on a weekly
basis to discuss and
debate all investment
and risk management
strategies put forward
to clients.
Asset Class brings together our latest thinking on attractive
investment opportunities to help our clients reach their goals.
In this edition we share our 20 investment principles, evolved over
the last 8 ½ years and used by our Investment Committee to evaluate
all our recommendations. We show how we apply this philosophy to
allocating to equities, liquid markets and illiquid credit.
We revisit some previously highlighted opportunities to see whether
they still offer value and introduce a couple of assets that we believe are
“ones to watch”. The cover story looks at our approach to the evergrowing “Alternatives” space, a label we feel has become out-dated.
Two popular strategies, diversified growth funds and multi-class credit,
are interrogated using a Redington lens. The Pension Protection
Fund’s CIO, Barry Kenneth, shares his experience of building
their “hybrid” portfolio and his outlook for illiquid assets.
Finally, we look at our new manager research process, with
special focus on our “Red Radar” early warning system.
We hope you enjoy the 2015 edition and welcome your
thoughts and opinions on the ideas.
SEVEN
STEPS
The 7 Steps process
involves designing
the right investment
strategy to fit each
client’s needs across
the risk, return and
liquidity spectrum.
1. Clear Goals
& Objectives
2. LDI &
Overlay Strategies
3. Liquid Market
Strategies
4. Liquid & Semi Liquid
Credit Strategies
5. Illiquid Credit
Strategies
6. Illiquid Market
Strategies
7. Ongoing Monitoring
1.
2.
3.
4.
5.
6.
7.
INVESTMENT COMMITTEE
David Bennett
02
PHILIP
ROSE
CIO –
Strategy & Risk
As Redington’s CIO,
Philip is responsible
for signing off on the
strategic investment
process and ensuring
that all risk management
advice is of the greatest
benefit to clients.
Philip has over 20 years
experience of structuring
solutions for pension
funds and insurance
companies.
PETE
DREWIENKIEWICZ
Head of Manager
Research
Pete’s team is responsible
for the research,
selection and monitoring
of fund managers across
traditional and nontraditional assets, working
closely with the consulting
and ALM teams to
ensure recommendations
are in-line with
clients objectives.
DAN
MIKULSKIS
STEVEN
YANG YU
Dan works with all of
Redington’s clients that
require asset liability
modelling and capital
markets expertise, and
provides a supervisory
role on all quantitative
ALM analysis. He is a
Fellow of the Institute
of Actuaries and has
a particular interest in
risk-focused investment
strategies.
Steven was the second
member of the ALM &
Investment Strategy
team at Redington,
which he co-manages
today in addition to
driving the team’s
strategic direction.
Steven is a Fellow of
the Institute of Actuaries
and committee member
of the Chinese
Actuarial Network.
Co-head of ALM &
Investment Strategy
Co-head of ALM &
Investment Strategy
CONTENTS
CONTENTS
FEATURES
04 REDINGTON
INVESTMENT PRINCIPLES
Our distinct approach revealed
14 AN ALTERNATIVE
TO ALTERNATIVES
The label alternatives is becoming
less useful. Is there a better way
to categorise these assets?
22-25 INTERROGATION:
DIVERSIFIED GROWTH FUNDS
& MULTI CLASS CREDIT
They look the same on the outside
but what’s going on inside?
RE-VISIT
12 INVESTORS AND
BORROWERS GO DIRECT
13 BALANCING
DIFFERENT ASSET RISKS
18 HAS THE TREND
BEEN YOUR FRIEND?
19 HIDDEN VALUE IN CRE DEBT
20 WHEN VOLATILITY
CONTROLLED ITSELF
Q&A’S
08 PETE DREWIENKIEWICZ
Gurjit Dehl quizzes Pete on
whether beauty parades
are a thing of the past
26 BARRY KENNETH
Barry, CIO at PPF, explains their
approach to and outlook for
investing in illiquid assets
30 PHILIP ROSE
Karen Heaven questions Philip
about the making and use of
Redington’s investment principles
ARTICLES
05 RETHINKING EQUITIES
06 NAVIGATING VOLATILITY
07 STAY AHEAD OF THE CURVE
09 AN EARLY WARNING SYSTEM
11 ILS: FROM HOT TO NOT
21 STYLE PREMIA INVESTING
29 ISOLATING ALPHA IN CREDIT
WWW.REDINGTON.CO.UK
03
ASSET CLASS
We’re often asked about our distinct approach to solving
clients’ problems. In the spirit of openness, here are our
20 Investment Principles shared for the first time....
Redington
Investment
Principles
INVESTMENT
STRATEGY
1
All investment strategy
starts with the clear
goals, objectives &
constraints of the client,
including a defined and
agreed risk budget
2
The success of an
investment strategy
is judged by meeting client
objectives, not in predicting
the direction of the market
3
Investment
strategy
should be as
simple as possible
but as complex as
necessary to meet
client objectives
4
Investment strategy
only works if it is
implemented; a strategy
can only be optimal if a
client will execute it
5
Manager selection
should not drive
investment strategy;
rather managers should
be chosen to fulfil the
strategic asset allocation
04
EXPECTED
RETURNS
RISK
MANAGEMENT
6
Risk management
For every
needs to be put in
11
return above place in the good times to
the most effect in
the risk-free rate have
the bad times
there is a risk;
Risks
however some
still
risks offer no
exist if you
or negative
expected returns don’t measure
them, but risks
Our assumptions
where possible
7
can only be
are empirically based
controlled if you
do measure them
Using prudent
12
8
expected return
assumptions incorporates
a margin of safety leading
to better outcomes
9
Going strategically
net short a risk
premia should be subject
to a much higher hurdle
than being long
10
Illiquidity always
increases risk
relative to a liquid
comparable asset and so
needs to offer a higher
expected return to be a
part of an asset allocation
13
Risk management
and asset allocation
are not an exact science;
you need both qualitative
and quantitative judgement
14
We accept that
making mistakes
is inevitable; we commit to
acknowledging, correcting
and learning from them
15
Diversification adds
value over the long
term but cannot be relied
upon to protect the portfolio
in all adverse conditions
STRATEGY
IMPLEMENTATION
16
We accept that our
clients may have
strong market views but
we will encourage them to
right-size the risk they take
in expressing these views
17
Spend more time on
things that will make
a difference to goals and
objectives and less time
on those that won’t
18
Implementation
costs (both trading
and fund management
fees) should be as cheap
as possible but not at the
expense of compromising
client objectives
19
Prioritise the “quick
wins” first before
worrying about how difficult
the harder things are
20
If you
don’t
understand
something, our
advice is don’t
invest in it.
Article
E
quities are one of the lowest cost and
most liquid return sources available,
with a long history of providing
positive returns over cash.
Our investment principles, “investment
strategy should be as simple as possible but as
complex as necessary to meet client objectives”
( 3) and “implementation costs should be as cheap
as possible but not at the expense of compromising
client objectives” ( 18), mean that equities form a
core part of a high return asset allocation.
In looking at the risk and return from equities there
are three sources: first the overall market exposure
(“beta”); then any style tilts and finally any residual
stock selection return (“alpha”).
For a long-only equity mandate most of the risk will
tend to come from beta with both style tilts and alpha
being much smaller components of the overall risk.
Our investment principles “our assumptions where
possible are empirically based” ( 7) and “using
prudent expected return assumptions incorporates
Alpha is a small
source of the total
risk in equities
RETHINKING EQUITY
ALLOCATIONS
A look at how Redington’s investment principles
influence our equity allocation view.
a margin of safety” ( 8) lead us to attribute the bulk
of expected return to beta, followed by style tilts.
Once the beta and style tilts have been taken
into account our investment principle “spend more
time on things that will make a difference to goals
and objectives” ( 17) means that it is reasonable
not to attribute additional return or risk to alpha
(net of fees). Thus, replacing active managers with
passive ones will not meaningfully change risk/
return and thus will be driven by costs and client
views on alpha. Retaining active managers is aligned
with our investment principle “we accept that our
clients may have strong market views but we will
encourage them to right size the risk they take in
expressing these views” ( 14) as the alpha risk is
rarely an outsize risk relative to other risks taken by
the pension fund.
Another approach is to give discretion to a
manager to vary equities allocation according to their
views on the fundamental valuations, an approach
that has delivered attractive returns for Total Return
Long Only (TRLO) DGFs. The long-only approach is in
line with our investment principle “going strategically
net short a risk premia should be subject to a much
higher hurdle than being long” ( 9).
The TRLO DGF approach has the advantage that
it can avoid exposure to an overvalued market that
Words Philip Rose
a volatility control strategy might not and allocate
more to a market that has fallen to an undervalued
but volatile level. The disadvantage is that even if a
manager gets the valuation call right they could be
underweight in the last stage of a bull market when
levels are fundamentally not “justified”.
Our investment principle “risk management
needs to be put in place in the good times to have
the most effect in the bad times” ( 11) leads us to
favour investing in equities with a risk management
strategy in place such as put options.
However implied volatility can vary significantly
through time, often high after an equity market fall
when protection is required most. The premium cost
of options can be high and clients may abandon the
strategy if large amounts of premium have been paid
out without any return.
In line with our investment principle “investment
strategy only works if it is implemented...” ( 4),
option premiums need to be at a low enough level so
that clients will stick with the strategy.
Investing in equities in terms of a set risk budget
(“volatility control”) rather than a set cash allocation
ensures that the purchase price of an option
remains relatively constant through different
market conditions, enabling put options as part
of a long-term strategy.
There are
three sources
of risk and
return in
equities:
the overall
market
exposure
(“beta”); any
style tilts and
finally any
residual stock
selection
return
(“alpha”).
WWW.REDINGTON.CO.UK
05
ASSET CLASS
L
iquid assets play a central role in most
pension funds’ asset allocation. Pension
funds should ensure their allocation
to liquid assets is efficient, resilient
and that downside risk is managed
effectively. This should be supported by a bias
towards strategies with low fees so they do not
drag down returns. Here are 4 principles to make
sure you get what you need:
RISK CONSCIOUS
Successful portfolios consider avoiding the
downside to be as important as riding the upside.
One approach is to scale an asset’s allocation in
the portfolio based on its volatility. Historically,
such an approach produced superior risk-adjusted
returns by helping investors reduce their exposure
to falling markets. The table below shows
examples of risk conscious strategies that can be
combined to build a resilient portfolio.
SPREAD YOUR RETURN DRIVERS
Whilst diversification within each asset class
is important, it is made especially powerful by
diversifying between different strategies which
are managed in a risk-conscious way.
This provides two key benefits. First, each
strategy will be managed to limit its downside
exposure as far as possible. Second,
when one strategy does not perform
another can be expected to drive returns.
ENSURE THERE IS A CLEAR RATIONALE FOR
WHY YOU SHOULD EARN RETURNS
There should be a clear and economically
coherent explanation (backed by historical
evidence) of why a strategy will provide
returns – e.g. style risk premia aims to
exploit persistent market dislocations.
This provides an important sense check so you
do not spend fees on something that does not
have a reasonable basis for its promises.
PREFER LOW-COST APPROACHES
Manager fees are a drag on returns.
Investors should aim to access strategies
through low-cost avenues where possible,
and not spend money unnecessarily.
Liquid assets can provide much of the heavy lifting to erase
pension funds’ deficits, as long as the downside is managed.
NAVIGATING LIQUID
MARKET VOLATILITY
LIQUID
MARKETS
1.Developed
Market Equities
(Active/Passive)
2. Emerging Market
Equities
(Active/Passive)
RISK CONSCIOUS STRATEGIES
STRATEGY
Volatilitycontrolled
Equities
UNDERLYING ASSETS
Equities
Long-only
7.Diversified
Growth Funds
8. Global Macro
9. Equity Long/Short
06
Scale exposure based on recent volatility:
higher volatility means lower exposure
Controlling volatility allows for cheaper downside
protection via put options
Wide range of exposures
(equities, inflation, interest
rates etc.)
Long-only
Exposure to each asset class based on contribution to overall risk:
if one becomes more volatile, the exposure to it is reduced
Overall exposure also managed towards
a target level of volatility
Diversification between different assets
Style Risk
Premia
Exposure to a small range
of assets, mostly equities
Long and short
Diversification primarily between different investment styles
that exploit persistent market mispricing (e.g. momentum, carry)
Overall exposure also managed towards
a target level of volatility
4. Risk Parity
6. Style Premia
RISK MANAGEMENT THROUGH:
Risk Parity
3. Passive Volatility
Control Equities
5. Trend Following
/ CTAs
Words Sebastian Schulze
Trendfollowing
Wide range of asset classes
Long and short
Overall exposure is managed towards a target level of volatility
Diversification between different assets
Diversified
Growth
Fund
Wide range of asset classes
Long only and relative value
Diversification between different assets
Exposure to different asset classes can be changed based
on their risk
Article
1
PRINCIPLE
PURPOSE
Investments must be subject to
a pension fund specific hurdle rate
Investment in illiquid assets should be subject to two hurdle rates:
1 Expected return on the asset (net of fees and expected defaults)
should be in excess of the overall pension fund’s required return
2 The illiquidity premium (excess return over a liquid comparable)
should be sufficient to compensate for:
LOSS OF ASSET ALLOCATION BENEFITS OF LIQUIDITY
COLLATERAL DRAG
MANAGER FEES
2
Pension funds should define a limit
on illiquid asset allocations
Strict limits should be set on overall illiquid asset allocation
(and, if appropriate, certain asset classes) to limit the potential for
a concentration to develop in the future as the fund de-risks.
3
Investors should accept current
spread levels and not use leverage
to enhance returns
When spreads are high, leverage should not be needed to meet required returns.
When spreads are low, leverage may result in poor risk-adjusted returns.
4
Allocation should be risk-driven,
based on the most appropriate risk
measure for the specific asset
Spread volatility is a key risk but default risk and reinvestment risk should
also be considered. 1 year Value-at-Risk will not capture reinvestment risk.
5
Diversify between credit types
Individual asset types are generally relatively undiversified, therefore, diversifying between
asset types is desirable. This is a trade off with the number of asset types satisfying #1.
6
Favour GBP-denominated debt
Currency hedging will create a collateral drag on returns and increase complexity.
With so many choices, how can pension funds make sure
they allocate to the right illiquid asset at the right time?
Words Nick Lewis
U
STAY AHEAD OF
THE ILLIQUID CURVE
By formalising
the exact qualities
you are looking
for it becomes
much easier and
quicker to assess
opportunities as
they arise.
K Defined Benefit
pension funds are
increasingly investing
in illiquid credit. With
potentially attractive levels of
contractual returns, liability
matching qualities and lower
levels of reinvestment risk it is
easy to see why. These assets
can play a significant role both
in reducing funding level risk
and closing deficits.
At Redington, we have
helped a number of clients design a framework
for assessing illiquid credit opportunities not
based on the general asset class but, instead,
on their unique properties and how appropriate
these are for the pension fund’s specific
requirements. By formalising the exact qualities
you are looking for it becomes much easier and
quicker to assess opportunities as they arise.
This is regardless of whether
they are index-linked corporate
bonds or social housing.
As part of this process,
Redington’s Investment
Committee has agreed
an illiquid credit Portfolio
Construction Philosophy.
The key principles of this
philosophy and their purpose
are outlined in the table above.
Investing in illiquid credit
can be extremely valuable
for pension funds but it may become time
consuming and governance heavy.
Outlining a clear philosophy for assessing
opportunities can reduce this burden and can
even be handed over to a fund manager to
select specific assets on your behalf, based
on your pension fund’s specific objective
and constraints.
ILLIQUID
CREDIT
1.Index-linked
Corporate Debt
2.Private
Placements
3.Social
Housing Debt
4.Infrastructure
& PFI Debt
5. Collateral Upgrade
6. Utility Swaps
7. CRE (Commercial
Real Estate) Debt
8. Secured Leases
9. Ground Rents
10.Mid-Market Lending
WWW.REDINGTON.CO.UK
07
ASSET CLASS
Investment Principle 5:
Manager selection should not
drive investment strategy...
585
MANAGERS
RESEARCHED
187
DETAILED
DUE-DILIGENCE
Words
Gurjit Dehl
Gurjit Dehl: Can you briefly describe the
new manager research process?
Pete Drewienkiewicz: We see the purpose of
our manager research team as facilitating the
implementation of our strategic recommendations
for clients, and to allow them to benefit from
systematic and consistent monitoring of all
invested managers. We wanted to design a
systematic process which would allow efficient
implementation of each strategy and enhance
our monitoring. We decided to create short,
high conviction “Preferred Lists” for each asset
class we recommend to clients.
GD: Why did you make changes to the
manager research process?
PD: Over the past 18 months we have been able
to redesign our process from scratch. We are a
relatively new consulting business without a lot
of legacy business in place. This meant we were
able to really think, from a top-down perspective,
what the research process is trying to achieve
and then build it to meet the needs of clients
and the business. Clients’ governance budget is
best used where it can deliver the most value,
which is stated in investment principle #17 .
GD: What have you changed specifically
in how the team is structured or operates?
PD: Every asset class and strategy that is
supported for investment by our investment
committee has a “Preferred List” behind it, with
a small number of managers. We continually
monitor those managers, review the preferred
lists annually and use a proprietary ten factor
approach to select, assess and monitor
those managers.
GD: How did you go about choosing the
factors to select, assess and
monitor managers?
PD: We sat down with everyone in the business
that’s involved in the manager research process
- about 20 people – and asked: What are the
characteristics of good managers?
08
Q
&
A
ARE BEAUTY
PARADES A
THING OF
THE PAST?
Gurjit Dehl
quizzes Pete
Drewienkiewicz.
Selecting a fund
manager should
not be a test of
their presentation
skills.
What are the characteristics of the firms that
we think do a great job investing our clients’
money, and what are the characteristics in
individual investment teams and investment
processes that we believe contribute towards
effective investment?
Criteria like information advantage,
execution advantage, conviction advantage,
kept coming up, and you will see all of these
within our ten selection factors. There was a
high level of agreement over the factors.
GD: Which asset classes and strategies are
covered by the team?
PD: To date, the team has completed 17
Preferred Lists comprising of 49 preferred
managers. They range from areas of traditional
Redington expertise, like LDI or credit, but
also cover newer areas that are seeing client
interest, like direct lending, infrastructure debt,
diversified growth funds and multi-class credit.
We ensure that all areas strategically suitable for
our clients have 2-4 preferred managers.
GD: How do you feel the new process has
benefitted clients?
PD: I think clients value the clarity that
the process gives them. There’s a sense that
‘beauty parades’ and extended manager selection
exercises aren’t the best way to appoint managers.
We are trying to get away from testing
managers’ presentation skills and streamline the
investment process.
Our goal is to know our clients’ managers so
well that they don’t need to; we want clients to
feel informed and in control, so their governance
budget is better spent on stuff that matters most.
Clients that do not have a hugely streamlined
governance process have still been able to make
very large changes to their investment strategy.
This has been done without spending a huge
amount of time worrying about the selection
process of those managers, because it is efficient
and because Preferred Lists are always available
for review by our retained clients.
Resourcing
Article
Business
Management
Culture
Change
49
PREFERRED
MANAGERS
F
und management is a complex business,
but we believe it is vital that investment
consultants help clients understand the
key drivers of both success and failure; to
help clients anticipate, engage and avoid
the worst performing managers.
Every institution, no matter how large, is
vulnerable to failure; fund management companies
can look strong on the outside despite being sick
within. We have found that early symptoms, and
even underlying causes, can be detected and
can be avoided.
We have developed a system that we call
Red Radar to identify and communicate early
warning signals that should be monitored by
clients, in order to assist decision-making around
engagement and, if necessary, timely removal
of fund managers. Overseen by Redington’s
Investment Committee, Red Radar has generated
some clear calls to action in the past 12 months.
Operational
Infrastructure
Risk
Culture
Key Person Risk
Alignment
of Interests
Capacity
Management
& Planning
Team
Stability
Strategic
Suitability
Consultants need to do a better job of helping clients
anticipate and engage with underperforming managers
Words Mitesh Sheth
10 MOST
COMMONLY
USED RED
RADAR FLAGS:
1.Business
management
2. Culture change
3.Operational
Infrastructure
4. Risk culture
5.Alignment
of interests
6.Capacity
management
and planning
7. Team stability
8. Key person risk
9.Resourcing
10.Strategic
suitability
AN EARLY
WARNING SYSTEM
Key man risk had
been well flagged
to clients allowing
them to make
a decision and
move their assets
within 48 hours.
ONE OF THE MOST VALUABLE
FLAGS IS ‘KEY MAN’ RISK
13.08.14: A key manager
of Barings’ Diversified Growth
Fund, Percival Stanion, and two
colleagues left the firm to set
up a competing fund. Red Radar
had stated: “Percival Stanion has
singlehandedly built the team and
process and our conviction lies with
him. He represents a key man risk.”
Given this dependency had been
clearly flagged in advance, upon hearing this news
we could immediately suspend our rating. Following
a meeting with Barings, a quick decision was made
and communicated to clients - to disinvest from
Barings and switch to another manager.
13.10.14: A similar situation arose at Ignis where
the team running their absolute return bond fund
resigned. Again, the key man risk had been well
flagged to clients allowing them to make a decision
and move their assets within 48 hours.
THIS PROACTIVE APPROACH
IS NOT ONLY USED FOR
FUND MANAGERS BUT ALSO
STRATEGIES/ASSET CLASSES:
In 2014 the high yield asset class
was driven to extremely rich levels
and could no longer be expected to
contribute to portfolio returns. So
the Investment Committee amended
the rating to “Remove” and all
clients were advised to allocate
away from the asset class.
Also in 2014, the market for insurance-linked
securities had reached levels of expected return
which, while still attractive, seemed insufficient
to compensate for the “left tail” risk. We advised
clients to allocate away from this asset class.
We believe that fund manager monitoring needs
to go beyond performance and risk reporting, to
actually help clients anticipate issues, engage
systematically and act dispassionately if required.
WWW.REDINGTON.CO.UK
09
RESPONSIBLE
We do what is right
We don’t compromise
on the integrity or
quality of our work
Article
The lack of major natural disasters
recently is not all good news for investors
in ILS. It is time for a rethink.
ILS: FROM HOT TO NOT
O
Words
Neha Bhargava
ver the last three years, Insurance
Linked Securities (ILS) have delivered
a strong and consistent return for
its investors. The flip side of this
performance has been a fall in
their premium levels in the absence of a major
catastrophic event and a steady demand for the
asset class from investors looking for higher yields.
As a result, any future investment in this asset
class has started looking less and less attractive
on both a standalone and a relative value basis
when seen through a holistic risk-return lens.
WHY DO PENSION FUNDS INVEST IN ILS?
The asset class can be a valuable addition to
a pension fund’s asset allocation as natural or
man-made catastrophes have low or even zero
correlation to major financial markets. Investors
also benefit from the increase in insurance
premiums that typically follows major events. By
the same token, however, premiums will tend
to decline following benign natural catastrophe
periods and it is important to continually assess
the returns available against potential losses.
ILS ASSESSMENT: 2011 VS 2014
FILTER
CRITERIA
2011
2014
Return
Expected spreads compared
to other asset classes
✔
✘
Risk
– Secure returns
-– Provides diversification
– Sufficient compensation
for the level of risk
✘
✔
✔
✘
✔
✘
Liquidity
Liquid market
✘
✘
Fees
Reasonable relative to spread
✔
✘
High
High
Complexity Underlying asset
ASSESSMENT
ASSESSMENT
HOW HAS THE MARKET CHANGED?
In 2011, premiums on reinsurance contracts
were particularly high. That year was struck by
multiple natural disasters including the Japanese
Tohoku earthquake, New Zealand earthquake, US
tornadoes and Thailand floods to name a few. The
insured losses incurred due to 2011 events were
estimated at $386bn. The natural reaction of the
market was a significant increase in insurance
premiums. This, along with a number of regulatory
changes in the insurance market, brought about
a particularly attractive opportunity to alternative
capital providers such as pension funds.
Since then, natural catastrophe experience has
been relatively benign. The most often mentioned,
Hurricane Sandy in 2012, generated losses of
under $30bn. Given a relative lack of significant
catastrophes, the market began to “soften” in
2012/2013 (i.e. premiums fell) and this trend
continued throughout 2014. Reinforcing this
trend is that alternative capital is now much more
established and active in the reinsurance market,
further cutting into premiums.
WHY SHOULD CLIENTS REVIEW THEIR
ALLOCATION TO ILS?
Our expected return assumptions for ILS (derived
from premium levels after adjusting for our default
assumptions) have halved over the last year and in
our view, no longer offer sufficient compensation
against the potential left tail risk associated
with this allocation.
We recommend that clients review their
allocation to this asset class in light of the change
in risk-return profile, taking into account potential
practical implications such as divestment terms,
lock-in periods and challenges of potentially
re-entering the trade in the future.
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11
ASSET CLASS
Investors
and Borrowers
Go Direct
Words
Greg Fedorenko
Pension funds can benefit from the opacity and
inefficiencies in the direct lending market.
W
hat is Direct Lending?
‘Direct lending’ refers to
bonds or loans directly
negotiated between a
borrower and a single
lender, or a small club of lenders, rather
than being widely syndicated through an
arranger (e.g. leveraged loans, corporate
bonds).
Insurance companies have longinvested directly in investment grade
corporates via the US Private Placement
market (which, despite its name, is
used not only by US but also by UK
and European companies). However,
‘direct lending’ now most usually refers
to direct transactions between pension
funds on the one hand and smaller (‘mid
market’) corporates on the other. These
are typically companies which are too
small to attract financing through the
leveraged loan market but too big for
commercial banks to deal with on their
own, particularly given the ongoing pace
of bank deleveraging in Europe penalising
the ‘highest risk’ transactions with
unrated borrowers.
What Are the Pros and Cons?
For investors, the most significant
advantage to directly-originated loans
is that such transactions can generate
returns significantly in excess of those
on offer in the syndicated loan market,
with spread differentials of c. 200bps for
senior secured credits commonly available.
In addition, mid-market lenders can use
their direct relationship with borrowers to
conduct enhanced, ‘private equity-style’
due diligence on underlying corporations,
12
and to structure bespoke transactions,
often featuring enhanced covenants and
investor protections. For this reason,
evidence suggests that recovery rates on
mid-market loans often exceed those on
more broadly syndicated issues.
The chief drawbacks are largely a
result of the opacity of the direct lending
market, which is made up of a series of
privately-negotiated transactions between
borrowers and lenders rather than a series
of publicly-traded securities. The asset
class is deeply illiquid, both in terms of
the underlying securities and in terms of
the fund structures adopted, and investors
should expect to hold the loans until
their term (usually c. 2 – 5 years, unless
prepayments occur). Managers’ valuation
policies are also frequently the subject
of scrutiny as the market is private and
inefficient, although it is precisely this
inefficiency which good strategies seek to
exploit in order to generate returns.
How Is The Market Changing?
The vast majority of managers active in
this market focus on either the US or
European geographies, as the asset class
is highly dependent on a network of
personal relationships that investment
managers build up with corporations, debt
advisers, private equity sponsors, lawyers,
accountants and others over time. The
market has a considerably greater heritage
in the US than it does in Europe, and
many US managers are newly active on
this side of the Atlantic in expectation of
ongoing European bank deleveraging.
The increasing size of institutional
capital commitments to the European
Directly-originated
loans can generate
significantly
greater returns
than the syndicated
loan market
mid-market in particular poses a risk of
spread compression within the sector,
as lenders compete with one another to
provide funding at lower levels, at higher
leverage multiples or with fewer covenant
protections. We are monitoring these
trends in both the US and European
markets but have not, so far, noted any
replication of the renewed move towards
‘cov-lite’ in the broader loan market
among mid-market issuers.
Does Investment Still Make Sense?
We continue to believe that direct
lending can provide a useful tool to
investors seeking alternative sources of
return in their asset allocation and willing
to tolerate a degree of illiquidity over the
term of their investment. Managers differ
not only by geographical focus but also
by the range and scope of their sourcing
network, and many potential strategies
of varying complexity and target
returns are available.
The asset class shows continued signs
of vitality and a good choice of credible
products is now available.
REVISIT
Balancing Different
Asset Risks
Words
Dan Mikulskis
Risk parity allows investors to allocate across asset
classes based on risk rather than capital.
R
isk parity has become more and more
mainstream over recent years in UK
pensions, with the assets managed by
the largest providers increasing, and a
burgeoning universe of newer products
seeking to differentiate themselves. We now count
over 20 products in the universe.
At a basic strategic level all the providers look to
do a similar thing - essentially take relatively fixed
risk (rather than capital) exposures to different
asset classes. Many pension funds and investors
are familiar with making fixed capital allocations
to different assets, but the reality is that fixed
exposures deliver variable levels of risk through
time. Essentially, risk parity is a strategy that
assumes little predictive power over future returns,
and seeks to gain exposure to market risk (such as
equity risk, bond risk, inflation risk) in the most
diversified manner.
2014 was certainly not a year
where the consensus triumphed.
In a Bloomberg News poll
of 66 economists not a single
one forecast that US 10 year
rates would end up where they
have done. The fact that these
anti-consensus outcomes can
occur, and actually do so rather
frequently, is a big supporting
Choice of asset classes
argument for risk parity.
Risk management
By taking a substantial exposure
Leverage management
WHAT
DIFFERENTIATES
RISK PARITY
PROVIDERS?
to fixed income at the start of 2014, when many
strategists and active managers were arguing against
this, has ensured a very strong year of performance
for risk parity funds generally. Out of the other
main exposures in most risk parity portfolios equity
returns have generally been modest (but positive)
with some regional variation and commodities
have been negative.
The burgeoning universe
of providers creates
more competition and
highlights more of the
nuance and craft
hidden in the detail
While there is no disputing the statement that 10
year rates are low from a historical perspective, we
still caution against assuming too much predictive
power over their future path and continue to find
the mindset of risk parity investing attractive.
The burgeoning universe of providers creates more
competition and highlights more of the nuance and
craft hidden in the detail of actually implementing
a risk parity strategy.
Placing caps on model parameters
Placing caps on exposure
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13
ASSET CLASS
With a greater variety of assets and approaches
being considered by pension funds, the label
“Alternatives” is becoming less useful.
An Alternative
to Alternatives
14
COVER STORY
I
n a world of investments
dominated by equities
and bonds, the category of
“alternatives” offers great
allure to portfolio investors
– the promise of attractive
returns and, at the same time,
potentially both diversification
and downside protection is a
seductive one. It is a “catch-all”
label to help investors quickly categorise
the universe of opportunities.
However, the label “alternatives” also purveys a
sense of mystery, additional complexity and high
fees which create unnecessarily high hurdles for
some assets and strategies that, as a result, are
quickly excluded from consideration.
Such a broad label can leave investors thinking
too myopically about the opportunities available
to them. Before considering an alternative to
this catch-all label, it’s useful to understand
what might be meant by “alternatives”.
SAME ASSETS, DIFFERENT PROCESS [1]
There is a sub-category of “alternatives” which
we describe as ‘same assets, different process’
which can also offer the valuable diversifying
characteristics found in traditional equities and
bonds. The consistent theme is that, whilst the
underlying asset classes are similar, the targeted
risk-return profile is more asymmetric than a
traditional buy and hold (or ‘long-only’) strategy,
making them attractive both in their own right
but also as a complementary holding
alongside traditional solutions.
DIFFERENT ASSETS, SAME PROCESS [2]
These assets are typically managed along the
lines of a traditional buy and hold approach but,
because of their underlying characteristics, can
perform differently to traditional investments,
in addition to providing attractive riskadjusted returns. One such example would be
infrastructure projects which have a specific
risk-return profile and are typically more
defensive and yield-focused.
Given the appeal of these types of underlying
assets, it is unsurprising that they attract such
high levels of demand from pension funds,
sometimes unfortunately to the detriment
of their prospective returns (see “ILS: From
Hot to Not” on page 11).
IS THERE AN ALTERNATIVE
TO ALTERNATIVES?
Rather than simply defining asset classes by their
historic popularity (traditional or alternative),
in an ideal world, each investor could create
its own categorisation based on their specific
context – their clearly defined goals, objectives
and constraints. The universe of asset classes and
investment strategies could then be mapped out
against this specific framework (see page 7 for an
Words
example of how it applies to illiquid assets).
Pete
For example, is the portfolio required to deliver
Drewienkiewicz
a steady income stream? This may allow greater
scope for some credit asset classes which offer
regular and certain cashflows but that may be
less liquid and/or more complex in nature, and
less scope for more volatile asset classes such
as equities. We found this outcome-oriented
approach to be incredibly valuable in mitigating
the potential for asset classes such as social
housing and infrastructure debt to “fall between
two stools” when the spreads on offer were highly
attractive for the risk taken following the financial
1 ALTERNATIVE PROCESS
SAME ASSETS,
DIFFERENT PROCESS
POPULAR
EXAMPLE
Discretionary active
management but without
market benchmarks,
may use short positions
Absolute return - multi-asset or asset class specific
(pages 22-25)
Systematic, or
“model-based” Investing
Trend following (page 18)
Explicit downside
protection
Equities with put option
protection (pages 5 & 20)
2 ALTERNATIVE ASSETS
DIFFERENT ASSETS,
SAME PROCESS
POPULAR
EXAMPLE
Esoteric source of returns
ILS/Re-insurance (page 11)
Illiquid assets
Direct lending (page 12)
Specific risk-return profile
Infrastructure (page 26)
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15
ASSET CLASS
We often look for
alternatives which are
structurally defensive
in nature, as these can
provide an effective
second layer of downside
protection. Some
examples would be:
Explicit downside
protection, provided by
a formal stop loss policy
or purchased downside
protection, or;
A high degree of asset
coverage – ensuring that
an investment retains
value even in a period of
market underperformance,
for example via the
provision of security
over corporate assets or
the existence of a hard
underlying asset such as
an infrastructure project.
Once the strategic
context is set, we consider
the implementation
and selection of fund
managers: can the
manager continue to
produce good ideas and
strong returns repeatedly?
When considering alternative assets and processes, we
disregard categories and labels and look more closely at
the underlying characteristics of the strategy.
crisis, in addition to the matching properties
they could provide.
Recognising this might not be a feasible
starting point for some investors, particularly
where the objectives and constraints are
difficult to precisely define, we find a useful
starting point is to map out both traditional
and alternative strategies according to (a)
liquidity of the asset or strategy and (b)
certainty of cashflows. As this categorisation
is based on what characteristics are offered
by an asset class, it helps investors to quickly
narrow down which asset classes offer
the best fit according to their needs, and
in which order of priority they should be
implemented. This is in accordance with
investment principle 7.
CHALLENGES REMAIN [3]
Even with what we believe is a more
helpful form of categorisation, the
challenges (perceived and real) of asset
classes or strategies that may be unfamiliar
remain. Overriding each of these challenges
is investment principle 20 which is at
the core of everything we do: “If you don’t
understand something, our advice is
don’t invest in it.”
Important questions to ask include:
What does the risk-return profile of the
opportunity look like? What role will the
investment play in the portfolio? Is the
underlying risk premia from which returns
are earned both identifiable and persistent?
SUMMARY
When considering alternative assets and
processes, we disregard categories and labels
and look more closely at the underlying
characteristics of the strategy. This allows
for the selection of assets which should help
investors meet their objectives over time.
An alternative to “Alternatives” is needed
as the label itself is not very helpful.
We believe that assessing assets, both
traditional and non-traditional, by the
“liquidity” and “certainty” of cashflows is
a far better way of understanding their
potential fit within a portfolio. These lenses
enable clients to make decisions about the
outcomes, characteristics and combinations
of seemingly unrelated assets.
Ultimately, manager due-diligence is
essential as we are investing in people and
their processes rather than purely
selecting individual assets.
3. CHALLENGES & IMPLICATIONS OF INVESTING IN ALTERNATIVES
16
CHALLENGE
IMPLICATION
Many strategies lack extended track records when
compared with conventional equities and bonds
It is important to spend time understanding the process
that leads to results rather than just the historical data
When considering complementary strategies, the
diversification properties must be clearly understood
Look both at the underlying risk premia which is being accessed as well as
the manager’s investment process, which can also provide diversification
May be difficult to understand what the
potential downside could be
It is vital to understand the downsides of a given investment strategy
or asset type and consider the risk-return characteristics, in order to
determine whether the investment fits with the objectives of the portfolio
and to ensure that investors’ expectations are appropriately managed
The underlying strategy may consist of a series
of trades or “ideas” which change over time
It is necessary to invest in managers with a consistent and repeatable
investment process
Increased complexity and dynamic
nature of many of these strategies
Risk management is crucial, as is ensuring that
sell discipline is observable and consistent
Less liquidity than traditional assets
Understand the underlying liquidity of the assets being considered, and ensure
that new positions are robustly underwritten when they enter the portfolio
Fees may be relatively high
Ensure that the prospective returns are considered net of all the fees
involved, and apply a higher hurdle
OPEN
We share our ideas and
opinions and welcome the
ideas and opinions of others
We do not stop learning,
understanding and improving
ASSET CLASS
Has the Trend
Been Your Friend?
Words
Aniket Das
Falling asset correlations helped trend-following strategies deliver bumper
returns in 2014, there is still value in making the trend your friend.
C
ommodity Trading Advisors (CTAs, also
referred to as managed futures strategies)
have come alive in the past year as
performance has rebounded from relatively
muted returns in the post-crisis period.
As described in Asset Class 2013, most CTA
managers employ trend following techniques that,
at their most basic level, buy assets that have been
going up and sell assets that have been going down.
Generally, managers take positions using futures
at an overall market level (such as US equities or
German bonds) while most will trade across 30 or
more markets in equities, fixed income, commodities
and currency. Though there are many more nuances
to the models used and the implementation, this
0
25%
0.02
20%
0.04
15%
0.06
10%
0.08
5%
0.1
-0%
0.12
-5%
0.14
-10%
0.16
-15%
Oct-06
CORRELATION (INVERTED)
RETURN
Falling Correlations Have Helped CTA Performance
30%
0.18
Oct-07
Oct-08
Oct-09
Oct-10
Oct-11
Oct-12
Oct-13
Oct-14
NEWEDGE CTA TREND INDEX 12 MONTH ROLLING RETURN (LHS)
AVERAGE 12 MONTH PAIRWISE CORRELATION ACROSS 54 FUTURES CONTRACTS (RHS, SCALE INVERTED)
18
surprisingly simple-sounding strategy has worked
very well historically and has additionally performed
strongly during a number of crisis periods due to
the strategy’s ability to go short. The intuition
behind why trend following strategies work relies
upon behavioural finance explanations that describe
investor tendencies to underreact to information and
to follow the herd.
With the emergence of lower cost CTA strategies
offered by a number of credible managers, this
is a space that offers very good value for pension
funds, in our opinion, though remains relatively
underutilised. While CTA strategies are directional,
in that they may be long a market or short, over the
long-term they tend to be relatively uncorrelated
to major asset classes, adding to their attractive
qualities. Finally, as the strategies invest mostly
in futures markets, they tend to offer very good
liquidity with strategies in the lower cost peer group
providing for the ability to redeem daily.
In 2014, performance picked up as correlations
between various futures markets fell. The post-crisis
environment has been characterised by unusually
high correlations across markets which has reduced
the positive effect of diversification that CTA
strategies partly rely upon.
The chart displays how correlations are related
to CTA returns (higher correlations tend to lead
to lower returns, and vice versa). Though we
don’t believe CTA performance is predictable in
the near term, we do believe that CTA strategies
should strongly be considered by pension funds as a
diversifier to traditional asset class exposures.
REVISIT
Hidden Value
in CRE Debt
Words
Kate Mijakowska
There are still plenty of opportunities in CRE
Debt to find attractive risk-adjusted returns.
I
priced as low as Libor+125bps, as indicated
by some brokers. This has been partly driven by the influx of alternative capital from
pension funds and insurers as well as banks
returning at a surprising speed. According
to Savills’ analysis, the supply of loans has
already outstripped demand, with £75bn
of lending available, against only £40bn
required for the fiscal year 2014 - this does
not account for the heterogeneity of
the asset class.
For the last 12 months, we have been
advising our clients to target pockets of
the market which are less likely to see
such widespread interest, such as <10 year
UK loans backed by good
quality offices, retail, hotels
and industrial properties
outside prime London. We
have also advised clients to
consider strategies which
REDINGTON VIEW
operate at LTVs slightly
ON VALUE
higher than those that
banks and insurance comNEUTRAL
panies are active in.
Although these markets
✔
are more difficult to
operate in, requiring more
expert property insight,
✔
and the equity buffer is
slightly lower, we believe
that investors are still well
compensated for the risk
✘
they are taking. Some
n the last edition of Asset Class,
we explained how the retreat of
banks from the Commercial Real
Estate (CRE) Debt market resulted in an attractive opportunity
for pension fund investors. The spreads
achievable on senior, good quality loans at
up to 65% Loan-to-Value (LTV) were
c. 300bps above Libor. Clients who
followed our advice managed to deploy
capital at these attractive levels.
Since then, spreads have compressed in
the market. This was particularly acute for
super-senior loans backed by very prime
properties in central London. This debt is
HIDDEN VALUE IN CRE DEBT
ASSET FEATURE
1. Loans backed by
prime properties
2. < 10 year UK loans outside
prime London (backed by
good quality properties)
3. Higher Loan-to-Value
ratios than bank or insurance
companies are active in
4. Properties outside UK
(e.g. Spain, Italy, Ireland)
5. Less traditional
strategies (e.g. bridge loans,
development financing)
skilled fund managers are currently able
to achieve spreads of Libor + 250bps on
medium-term loans at 65% LTVs and
below, with the added benefit of significant prepayment protection. This offers
an appealing illiquidity premium over
comparable corporate bonds of c. 120bps
once default assumptions, origination and
management fees are taken into account.
In recognition of tightening spreads,
some managers tend to allocate more
capital to countries like Spain, Italy, and
Ireland. Their argument is that despite the
macroeconomic risks involved, these are
fundamentally good quality loans made at
low LTVs and backed by prime property
in central locations. We believe that it is
possible to find some attractively priced
opportunities in these pockets of the
market but the potential risks are higher
and more difficult to address than in our
preferred strategy. Apart from the obvious
macroeconomic risks, one also has to take
into account the efficiency and nuances of
the relevant legal system.
We also observe that more managers
have begun to focus on less traditional
strategies, such as bridge loans, development financing, or stretch senior strategies.
We believe these strategies can offer
attractive risk-adjusted returns and are
comfortable with clients investing as long
as the allocation is appropriately sized and
the risks are well understood by the client.
NEUTRAL
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19
ASSET CLASS
Words
Dan Mikulskis
When
volatility
controlled
itself
While volatility was low in 2014, managing equity volatility
and drawdowns will remain crucial to meet portfolio objectives.
V
olatility controlled equities (including put
options) is a theme we have spoken to
clients about a lot in recent years.
It remains one of our preferred ways
of taking equity market exposure due
to the more controlled level of risk (achieved by
automatically curbing exposures to markets at the
most risky times) and downside protection (compared
to a conventional allocation). Uptake of the strategy
has really increased as well, with c. £1.5bn either
allocated or in the process of being allocated.
The rationale behind the approach remains the
same - the equity risk premium is a well-understood
source of return for many clients, but history tells
us that investing in equities comes with the risk of
substantial drawdowns, and periods of high volatility
which often deliver bad outcomes. The last few
years have been relatively benign times for equities.
With plenty of macro risks out there, we think that
by curbing exposure to markets at the riskiest times
and investing in downside protection (put options),
clients will experience a smoother ride compared to
allocating to equity beta in a conventional way.
HOW DID IT PERFORM IN 2014?
Volatility controlled equities (with put) is not set up
to try and outperform from one quarter to the next.
In fact, by limiting exposures at certain times and
paying away a small premium for protection, there
will be many years where one looks back and, from
20
a pure returns’ perspective, would rather have been
allocated to equities in a more conventional way.
2014 was one such year.
2014 was characterised by very low volatility
and generally upward trending equity markets
(led by the S&P 500 and MSCI World, although
some particular markets had a negative year).
That said, there were relatively small but sharp
setbacks that were quickly recovered and, in this
sort of environment, we would expect a volatility
controlled benchmark to deliver lower returns than a
conventional benchmark - which it has done. Having said that, when markets were down c10%
in October 2014 amidst some uncertainty, having
some put option protection in place would clearly
have been very comforting to a pension fund, albeit
on this occasion markets recovered the
losses relatively quickly.
We certainly don’t expect all years to be like
2014 (and history supports this). For this reason,
we continue to feel that strategies that can move
to automatically curb exposure at more risky times,
and have real downside protection in place against
large losses, are a natural fit for investors looking to
generate returns within clear risk parameters.
A natural fit for investors
looking to generate returns
within clear risk parameters.
Article
The performance of
many successful active
managers is driven
signficantly by style biases
Style premia investing can deliver a systematic and lower cost
way to access actively managed equity strategies and more.
Words Aniket Das
BREAK IT DOWN
AND BUILD IT BETTER
T
erms such as smart beta and alternative
beta have generated increasing investor
interest in recent years. Much of this has
been due to greater scrutiny of the costs of
active management relative to its valueadd. Meanwhile, there is a growing body of evidence
that the returns of many very successful active
investors over the years have come mostly down to
“style” biases (e.g. favouring low beta or high quality
stocks). This begs the question whether these style
biases can be invested into systematically? Cue the
introduction of style premia investing…
Style premia investing refers to allocating to
various risk factors (such as
value, momentum, size) that
have been proven to generate
significant risk-adjusted
returns over time. However,
style premia investing
is not new. Quantitative
equity managers have
been pursuing style-driven
strategies for well over two
The new generation
of products resemble
diversified hedge fund
strategies, albeit with
more transparency,
more liquidity and
much lower costs.
decades while academic research has highlighted
these style effects through the years. The big shift
in recent times, though, has been the higher levels
of transparency provided by managers that has fed
into lower costs for investors with more competition
within the space.
There is now a broader range of managers
(and investment banks) with style premia and
alternative beta products. While the basic principles
driving these products are similar, there are many
differences in the detail of the implementation.
When evaluating such managers, we pay particular
attention to areas such as their use of derivatives,
risk management and selection of risk premia.
With evidence of styles such as value, carry and
momentum having applications in asset classes
outside equities, the new generation of products
resemble diversified hedge fund strategies, albeit
with more transparency, more liquidity and
much lower costs.
We believe pension funds looking for returns with
low levels of correlation to their overall portfolio
should strongly consider offerings in this area.
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21
ASSET CLASS
Unpacking
Diversified
Growth Funds
These funds may look the same
on the outside. On the inside, they
use vastly different approaches
to invest in diverse assets.
22
INTERROGATION
Words
Alex Lindenberg
T
he term “Diversified Growth Fund” (DGF) has become common
parlance to describe a range of multi-asset strategies that
seek similar returns to equities but with lower volatility. In
recent years, DGFs have become increasingly popular for UK
pension funds looking for a “one-stop shop” for asset class
diversification and a way to outsource tactical decision-making
to a fund manager.
Perhaps less well understood are the significant differences
in approach within the expanding DGF universe. We believe this understanding is crucial to
selecting a DGF manager that best meets a pension fund’s specific objectives and constraints.
A key factor distinguishing DGFs from most multi-asset investment approaches is that
there is an element of dynamism in the strategy’s asset allocation. This eliminates traditional
“balanced” funds, which maintain relatively static asset allocations over time. After screening
out these products, we divide the remaining universe of funds into three categories:
1
DYNAMIC
DIVERSIFIED
There are long-only
multi-asset strategies
that allocate to different
asset classes dynamically
throughout the business
cycle to take advantage of
relative opportunities across
asset classes (e.g. equities
vs. credit). However, these
funds will tend to maintain
relatively high allocations
to equities, often with
a minimum benchmark
allocation (e.g. 30%)
Most relevant to:
Small pension funds with a
limited number of mandates
and large allocation to DGFs
Governance constrained
pension funds looking
to consolidate key asset
allocation exposures under
single mandate
2
TOTAL
RETURN
LONG ONLY
These are long only
strategies with a
similar focus on relative
opportunities across asset
classes. However, unlike
Dynamic Diversified funds,
these funds are managed
benchmark free and give
the manager flexibility to cut
equity exposure to zero if
judged appropriate.
The allocations therefore
tend to be highly dynamic
over time and with varying
correlations to equities
Most relevant to:
Large pension funds with
small allocations to DGFs
Pension funds looking to
benefit from tactical asset
allocation alpha but with
decision-making outsourced
to the manager
A key factor distinguishing DGFs from
most multi-asset investment approaches
is that there is an element of dynamism
in the strategy’s asset allocation.
3
ABSOLUTE
RETURN
RELATIVE VALUE
This is a long/short multiasset strategy wherein a
manager combines individual
trade ideas (e.g. relative
value, macro or theme-based)
to form a portfolio designed
to deliver positive returns
across market environments.
Similar to global macro
hedge funds, this approach
is characterised by the use of
derivative-based strategies,
a focus on risk-based
rather than asset allocation
and strong downside risk
management. Because the
ideas are often designed
to be market-neutral, these
funds tend to have low
correlations to equities and
other growth assets
Most relevant to:
Trustees comfortable
with more complex
investment strategies
Pension funds looking
to replicate hedge fund
strategies in a more liquid,
transparent and
cost-effective structure
DIVERSIFYING BY APPROACH, NOT JUST ASSETS
Viewing the DGF universe in this way can help pension funds to select complementary strategies.
For example, combining a Total Return mandate with an Absolute Return mandate can provide
access to different sources of manager skill and avoid the pitfalls of “approach-concentration”.
Going forward, we believe that diversification by approach will be just as important as
diversification by asset class. (Further information on pages 14-16)
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23
ASSET CLASS
The
Devil
is in the
Detail
With multi-class credit, investors can access a wide range
of credit assets within a single offering. Beware the details.
24
R
ecently, a similar trend to DGFs has occurred in credit.
This diverse asset class (ranging from corporate loans to Asset-Backed
Securities) has experienced substantial inflows from pension funds over
the last few years. Returns have been very attractive as other traditional
investors (banks, for example) are no longer supplying capital. Also,
the diversity of the underlying assets can help pension funds tailor
Words
investments to their specific risk/return/cashflow requirements.
Sebastian Schulze
INTERROGATION
Offerings are now available which combine
these advantages with the dynamism of a
DGF approach. Interest in multi-class credit
and absolute return bond funds has grown
substantially as a result.
We believe this approach can provide pension
funds with an exciting new opportunity to
access a diverse asset class that continues to
offer attractive opportunities. However, as usual
there are a number of the proverbial “devils
in the detail” that investors will need to think
through carefully.
Especially important is the background and
skills of the manager as their previous expertise
will colour their approach. The multi-class
credit universe is comprised primarily of
multi-strategy managers (with a secured credit
background) and leveraged finance managers
(with a high yield and loans background).
Credit hedge fund managers and credit
boutiques are clearly differentiated from the
traditional credit managers, who are either
under-resourced or unable to take enough risk
to generate sufficiently attractive returns.
The best managers tend to have differing
geographical focuses. Given the opportunity
set for managers is often a result of less covered
or less liquid issuers and securities, the best
managers are typically capacity constrained so
it makes sense to combine European and North
American managers if allocating a large sum.
Key to picking the right multi-class credit
manager is identifying strengths in screening a
large and esoteric universe, an ability to make
high conviction decisions without relying on
large committees and finally execution expertise.
The table provides an overview of the most
important approaches:
OVERVIEW OF APPROACHES TO MULTI-CLASS CREDIT
BOTTOM-UP APPROACH
TOP-DOWN APPROACH
Manager
Background
Leveraged finance managers:
Focus on credit analysis and fundamentals
Structured finance managers: experts in complexity
Traditional credit managers
(e.g. corporate bond managers)
Key Features
Benchmark agnostic
Select attractive single securities from
different parts of the credit spectrum
Benchmark driven
Allocate between different parts of the
credit market (represented by benchmarks)
based on relative aggregate attractiveness
The Resulting
Portfolio
Advantages
A core/satellite portfolio based upon security selection
Builds upon existing experience
Historical track record can be used to
judge ability to perform
Disadvantages Portfolio will likely be tilted towards assets
the manager has most experience in
Investors may not be comfortable with this
The diversity of the
underlying assets can
help pension funds tailor
investments to their specific
risk/return/cashflow
requirements.
An asset allocation approach where
exposure is moved between different sleeves
Will potentially consider wider
range of assets than bottom-up
New approach for these managers:
No track record available yet
Expertise to allocate between different
sleeves might be limited to a small team:
Key man risk
Just like “credit” itself, the single term “multiclass credit” encompasses a diverse range of
approaches. Each has its own advantages and
disadvantages. In particular, we believe that the
top-down approach has yet to prove its mettle
as it is a relatively new offering.
Investors, therefore, need to ensure that they
have a clear understanding of the multi-class
credit approach they are going for and how it
fits in with the rest of their portfolio.
WWW.REDINGTON.CO.UK
25
ASSET CLASS
Barry Kenneth
(Chief Investment
Officer, Pension
Protection Fund)
Words
Gurjit Dehl
Gurjit Dehl: Why does the PPF have
such an interest in illiquid assets?
Barry Kenneth: ‘Illiquid assets’ is not quite
the right term. We have interest in longdated cash instruments which effectively
provide long-term interest rate and longterm inflation protection. Whether these
assets are liquid or illiquid just determines
the way we look at them.
GD: Which investors do you think
these assets are suitable for?
BK: If we look at the characteristics within
the assets, anyone that has long-term
liabilities which require stable cash flows
will have interest. So DB pension funds
and insurance companies would be the two
obvious buyers of these types of assets.
We tend to invest in illiquid assets which
are either more property-based or a
bit more complex.
GD: How does the PPF go about
considering the opportunities?
BK: Most importantly, whatever asset
we look at in the PPF, we have to have a
risk management framework around that.
Looking at the hybrid portfolio which we
are building, we try to build the whole
concept of illiquidity on top of our risk
framework which didn’t look at illiquidity
as a separate risk factor. We need to ensure
the excess return that we should expect to
generate from these assets meets our criteria.
GD: Typically, how long have you
found it takes from assessing an
opportunity to actually investing in it?
BK: It really depends on the asset.
For example, for the building we bought in
Manchester, from origination to actually
26
Q
&
A
ILLIQUID
ASSETS:
TURNING
INTEREST
INTO
INVESTMENT
Gurjit Dehl quizzes
Barry Kenneth
on whether the PPF
is on track to invest
£3billion in illiquids
pulling the trigger on the deal was weeks,
not months, where other deals may take
slightly longer in terms of the process.
The governance process at PPF means
that turnaround time will not be an issue
as far as PPF is concerned; it will be more
external factors rather than PPF specific.
GD: What are some of these external
factors that can cause delays?
BK: It really depends on the origination
process, so whether there are actually
timescales on specific assets. External factors
include pricing, documentation, and the fact
there may be an extensive book building
process so we might not be the only investor.
One of our major objectives is to ensure
that we get value out of these portfolios.
If you look at the assets that are out there
just now, one problem is there is a wealth
of like-minded funds that look at the same
types of assets and that can tend to drive
the price of some of these assets to a level
whereby we don’t see any value in them.
This effectively means we’ve got to be a
little bit more nimble in our process because
we don’t want to compete with 10/15
other investors. We need to find our angle.
Our angle on the property deal was time.
GD: PPF has been making use of an
illiquid asset framework, how does it
work in practice?
BK: People think about illiquidity in
different ways. We think about it in
probably its cleanest form. The high level
concept here is, if we look at the different
assets that we run in the portfolio, the
longer we believe it takes to sell these assets
at fair value, then the higher the hurdle rate
is for illiquidity. In the context of returns
Q&A
PPF has recently acquired
1 Hardman Boulevard
in Manchester
there is value, then, as a fund, that’s
what we will do as credit spreads and
illiquidity premiums are cyclical. The
alternative is for the government to put
explicit guarantees around these projects.
GD: How do you see illiquid
opportunities developing?
BK: The mandates we set up are risk
factor mandates, rather than specific
asset name mandates. We are looking for
specific risk factors within these assets.
We don’t particularly care what they are
called, as long as it throws off the types
of cashflows that we expect. Whether it’s
a property lease, ground rent, a corporate
bond, private placement, they have all
Now, if opportunities
come up we can turn
them around quickly.
There is nothing worse
than seeing a good idea
and not being able to
invest in it.
and volatilities, it means we should
expect a higher premium for assets which
take longer to sell.
GD: What have been the benefits
and challenges of using the illiquid
framework?
BK: The simple benefit is that if
we buy an asset which has illiquid
characteristics, the framework gives you
some hurdle levels which we should be
looking to achieve in order to cover the
marginal cost of taking on that extra
illiquidity risk. So it gives us some lines
in the sand in which we could look at
the hurdle rate that the formula gives
out and think whether that’s a sensible
price or a sensible return hurdle for any
single asset class.
In terms of the challenges, it’s clearly
finding value. There’s not a uniform
framework to buy these types of assets
so, from a value perspective, sometimes
we can be disappointed and undercut
in terms of the price that some of these
assets are sold at. However, we have to
be true to the framework we look at
and true to the way we think about
value and also the way that we look
at these assets.
GD: Can the industry improve
the availability and access to
illiquid assets, or do you think it is
sufficient?
BK: I don’t think there is a lack of
supply. There is not enough supply of the
assets at the right price at the moment,
that’s clear. The problem just now is
that there are lots of infrastructure
projects that the government talks about,
unfortunately, the returns available in
some of these projects are lower than we
would expect. By definition, it means
we find difficultly in investing in these
projects for the associated risk. We have
just got to be patient. We are a fund
with long-term cash flows to meet, so if
it means we have to step out for a short
period of time when we don’t believe
got the same types of characteristics:
duration, inflation, illiquidity, credit.
We have set out our mandates so banks
and asset managers who help us fill
these mandates are not concerned about
a specific asset class; rather, they are
constrained by specific exposures.
We can continue to fill this mandate
by capturing opportunities as they arise
from a value perspective because we are
not wedded to specific asset classes.
GD: A recent OECD survey
suggested that governance changes
and regulatory action were needed
to help pension funds grow their
investments in infrastructure.
Would you agree with that?
BK: Yes. Since I joined PPF, we have
completely changed our governance
process. It is a lot slicker than it used to
be. Now, if opportunities come up we
can turn them around quickly. There is
nothing worse than seeing a good idea
and not being able to invest in it.
WWW.REDINGTON.CO.UK
27
ASSET CLASS
LEASING FINANCE &
LIFETIME MORTGAGES
Two opportunities for your radar, these assets
could potentially offer attractive opportunities
for pension funds in the years ahead.
L
easing finance involves banks
transferring ownership to
pension funds of assets which
are held on balance sheet and
leased to underlying operators.
Increasing regulation is forcing
European banks to divest non-core
businesses to free up capital and reduce
risk-weighted assets. Bank-owned leasing
assets are typically classified as ‘non-core’
and have been targeted for divestment. In
certain cases, banks have divested not only
the assets themselves but also their entire
leasing business infrastructure. This has led
to certain fund managers purchasing whole
leasing business units, including the leases
themselves, in order to provide a readymade system to service existing leases and
(in certain cases) originate new deals.
Leased assets cover a broad array of
sectors (e.g. aircraft, rolling stock, shipping,
computers, containers, medical equipment,
etc.). The main unifying characteristic is
a form of built-in security the lessor has
in the form of ownership of the actual
underlying asset over the term of the lease.
In addition, leased assets often represent
a critical product for the lessee and
repossession may significantly impact on
core business activity.
Many leasing transactions throw off
regular, predictable cashflows generated by
‘business critical’ assets, so the majority of
manager offerings in this asset class employ
substantial amounts of leverage to increase
returns. Most products we have seen focus
on net IRRs in the low-mid teens, with
maturities less than ten years (often c. 5
years, depending on the structure). Care
needs to be taken that leverage is properly
managed in such funds and that the use
of financing does not expose investors to
unnecessary risk for a target return far
in excess of what they may require. In
addition, consideration should be given to
the appropriateness of incentive fee clauses
in funds which use artificial means to
‘generate outperformance’ from ‘dull’ assets.
28
LEASING FINANCE
In certain cases, banks have divested
not only the assets themselves but
also their entire leasing business
infrastructure
LIFETIME MORTGAGES
A growing lifetime mortgage market
would represent a potentially attractive
opportunity for pension funds
Words Greg Fedorenko
L
ifetime mortgages are a form
of ‘equity release’ mortgage
– a transaction which sees a
borrower surrender a portion
of the equity they own in their home in
return for a lump sum or ongoing payment.
Historically, a frequent use has been to
fund residential care in later life.
The traditional players in this market
are general and specialist insurance
companies, many of whom have seen their
business models altered following changes
to the compulsory annuitisation regime
announced in the 2014 UK Budget. In
response, many originators of lifetime
mortgages are seeking access to alternative
pools of lending capital, including those
provided by fund managers.
The lifetime mortgage market, with
c. £1bn of new origination annually,
represents a specialised opportunity
and the number of offerings is currently
extremely limited. Numerous operational
challenges are present, such as very low
liquidity, opaque valuation, and the need to
fund ongoing payments to borrowers who
do not take their entire mortgage upfront
as a lump sum. There is also the issue of the
uncertain repayment profile of the loans
(which usually repay only on the death or
move into residential care of the borrower)
impeding access to the so-called ‘matching
adjustment’ under Solvency II, although
we have seen innovative approaches to
this problem, employing tranching of
prepayment risk, already come to market.
If such challenges can be surmounted,
a growing lifetime mortgage market
would represent a potentially attractive
opportunity for pension funds to gain
access to an asset class offering long-dated,
secure cashflows, with the possibility for
tailoring return profiles in line
with borrower demand.
Net returns of c. 5-6% currently appear
achievable for loans of c. 20 years weighted
average life, although this is dependent on
prepayment assumptions.
Article
Accessing credit
alpha requires
being able to
see the wood
from the trees
Gaining access to credit alpha should not require paying
high fees to take huge directional bets.
Words
Pete Drewienkiewicz
ISOLATING
ALPHA IN CREDIT
I
n the spectrum of credit-related strategies
there is only one type which derives its value
from taking active short positions in single
name credits – Credit Relative Value, which
could equally be described as Credit LongShort or Credit Market-Neutral. These strategies
attempt to profit from dislocations between market
pricing and their fundamental assessment of
underlying value in credit assets, by taking both long
and short positions across the capital structure.
An example would be to buy the secured debt of a
company in difficulty and take a short exposure to
the unsecured bonds, locking in a gain in a wide
range of situations. It is important to note that
this is very much a relative value exercise rather
than a pure arbitrage, which can be rare in today’s
markets.
The risk premia these strategies attempt to exploit
are two-fold: firstly, volatility in the market should
lead to dislocations as described above; secondly,
dispersion in the returns from various credit assets
will be a big positive for strategies of this nature. In
calm markets with low levels of dispersion between
the returns seen from differing credit instruments,
it is unlikely that these strategies will make outsized
returns, and indeed are likely to underperform
traditional credit investments.
Many of the firms within this space are
alternative fund managers or hedge funds, and,
much like with absolute return bonds or multiclass credit, the universe is far from homogenous.
We attempt to categorise funds by the underlying
sources of return and risk rather than their trading
strategy. Hence, for this exercise, we prefer to
focus our attention on funds which attempt to
generate returns without taking large persistent
directional bets in credit.
One reason for this is that long-short credit
strategies are typically quite expensive, often
costing 1.5% or more and charging performance
fees in addition to management charges. Hence,
we prefer to access credit beta via cheaper
directional strategies and look for relative value
strategies which are less directional and more
diversifying in nature. This is a harder job – of the
several hundred long-short credit strategies, we
estimate that no more than 25 to 30 of these
are sufficiently “neutral” to the credit market to
provide any diversification benefit. Of these, we
have selected a number of strategies to work with
as preferred managers: (1) selecting a handful
of managers who operate purely in fundamental
corporate credit; (2) a manager with a particular
speciality in more complex structured finance
securities; (3) another manager with the ability to
access both of these opportunity sets.
These strategies are usually more complex than
many of the strategies we recommend to clients,
and hence are usually more suitable for those
with heavy allocations to credit or higher return
requirements, as well as sufficient governance
budget to monitor the allocations appropriately.
WWW.REDINGTON.CO.UK
29
ASSET CLASS
Philip Rose
(CIO - Strategy
& Risk )
Words
Karen Heaven
Everything else being
equal, the simplest strategy
is the best one, but often
things aren’t equal.
Q
&
A
KH: The principles don’t address taking
market views or preferring asset classes at
one time over another, why is that?
PR: Although we believe that adding value by
taking market views is possible in many, but not
all, asset classes, it requires the right skill-set, the
right amount of time and work, and the right
implementation ability. When we look for fund
managers who have all of those attributes, it’s
really quite a small group. Realistically, if we
look at ourselves as a firm, we do not feel that we
have those qualities that we would require in a
fund manager in order to be able to make money
through market timing. Also, typically, our
clients do not have governance arrangements in
Karen Heaven
quizzes Philip
Rose for an
inside look at the
making and use
of Redington’s
20 investment
principles.
Karen Heaven: Can you describe how the
investment principles were identified?
Philip Rose: It was very much a team effort
by our internal Investment Committee.
The Investment Committee is designed to deliver
the views of the entire firm, so it reflects not just
my views, but also our ALM & Investment
Strategy, Investment Consulting and Manager
Research teams. The aim is to ensure we have a
consistent approach across the firm that
everyone has bought in to and everyone
uses in their day-to-day work.
KH: Is there any scope to change
the investment principles in future?
PR: Yes, there is always scope to change - one
of the investment principles is accepting that
mistakes will happen, and committing to
learning from them. Part of that learning process
is saying we have to have principles that will
potentially change through time.
30
THE
THINKING
BEHIND THE
PRINCIPLES
place to facilitate timing markets either.
We believe that governance budget is best
spent on looking at the overall strategic asset
allocation, rather than trying to “call” an
individual sub-market.
KH: You talk about managing risk rather
than reducing risk, why is that?
PR: This comes back to investment principle #6
– for every return, there is a risk. So if a client is
targeting returns - and most of our clients need
returns in order to meet their investment goals they will need to take some level of risk.
What we are in favour of is the efficient use of
risk, meaning only taking risks that you get
paid for and not taking risks that you don’t
get paid for. Clearly, the overall level of
risk run should be appropriate to the
circumstances of the scheme.
KH: The last principle #20 states that
“If you don’t understand something, our
advice is don’t invest in it”. To what degree
should a client understand something?
PR: Rather than understanding every intricate
detail of the strategy, I think it comes down to
understanding the underlying process that the
strategy uses, what it is designed to do, where the
returns come from, what the potential upsides
are and, importantly, what are the potential
downsides and risks of the strategy. A good
analogy is: I don’t need to know how to build
a car to be able to drive a car, but I do need to
understand what the accelerator does and what
the brake does in order to be able
to drive reasonably.
KH: And what’s your favourite principle?
PR: Admittedly it’s taken from a famous quote
by Albert Einstein, but it’s: “Investment strategy
should be as simple as possible, but as complex as
necessary”. It means that, everything else being
equal, the simplest strategy is the best one, but
often things aren’t equal and sometimes a bit
of complexity can benefit clients.
CLEAR
We take pride in the clarity
of our communications
We use transparent processes
Austin Friars House,
2 – 6 Austin Friars,
London, EC2N 2HD
www.redington.co.uk
Asset
Class
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