To preserve recent gains, pension funds are diversifying their assets—and facing the risk issue head-on
What if the best way to control risk was to embrace it?
After seeing asset increases and funded status improvements over the past two years, Canada’s pension funds are now focusing on keeping their gains. They know they can achieve this through de-risking—but, for many of them, giving up returns in the current environment induces anxiety.
So, in an effort to extract much-needed yield while controlling risk at the same time, DB pension funds are adding more opportunistic types of fixed income to their portfolios and increasing their alternative holdings.
“They’re taking a good hard look at the risk side of the equation and making sure that they aren’t assuming too much risk and that they’re positioned for future volatility that we may see in the marketplace,” says Duane Green, head of the Canadian institutional group at Franklin Templeton Investments (No. 15 on the Top 40 Money Managers list).
The issue of risk—when and how, exactly, to take it on—is a tricky one. Risk management usually comes to the forefront when pension plans are in deficit, but that’s also when it’s most difficult—or least affordable—to actually take risk off the table, says Ken Choi, director of investment consulting at Towers Watson. “Conversely, when times are good and plans are in surplus, that’s when plan sponsors have tended to become perhaps a bit complacent about risk.” But it’s the good times that are best for de-risking, Choi explains. Most of Canada’s DB pension plans are currently either fully funded or close to fully funded. “Now is the time to not be complacent about risk because you can afford to do something that you couldn’t do before,” he adds.
So what are pension funds and their portfolio managers doing to manage risk?
Afraid of the Dark?
Historically, pension funds have turned to fixed income in an effort to de-risk. Many pension plans are still increasing fixed income allocations as a de-risking strategy, but it’s not as easy today compared with 10 years ago, when interest rates were higher.
“The challenge is that, 10 years ago, you could almost have a free lunch,” says Choi. “You could hedge your liabilities and get a decent return while doing so.”
In today’s low interest rate environment, if investors want to hedge their liabilities with more fixed income or with longer duration fixed income, they will get lower returns, Choi explains.
“Investors are desperate to try and find yield somewhere,” says Marija Finney, senior vice-president and head of institutional sales and service with BMO Global Asset Management (No. 39). Enter opportunistic fixed income.
To get both yield and hedging out of bonds at a time of exceptionally low interest rates, pension funds are turning to more opportunistic products such as high-yield corporate bonds (also known as junk bonds), other kinds of distressed debt, emerging market debt and catastrophe bonds (high-yield instruments issued by insurers, intended to raise money in the event of natural catastrophes). Some of these fixed income offerings, such as distressed debt and catastrophe bonds, are classified as alternatives.
High-yield types of fixed income can be much less liquid but real alpha generators, adds Green.
Peter Muldowney, senior vice-president of institutional strategy with Connor, Clark & Lunn Financial Group (No. 7), agrees. “If you can get a manager who can add 100 basis points on something, then that added value is quite significant.” Also, he notes, these opportunistic products are not as sensitive to interest rate changes as traditional bonds are.
Since our November Top 40 Money Managers Report, Hillsdale Investment Management has restated its 2013 figure to $354.2 million with a year-over-year increase of 28.9%, putting them at No. 4 on the Top 5 Fastest Growing (5) – Less than $1.0 Billion chart.
Seeing the Light
Opportunistic types of fixed income typically aren’t implemented on a stand-alone basis, notes Carlo DiLalla, vice-president in the fixed income institutional advisory group with CIBC Asset Management (No. 14). Instead, many pension plans are adding these riskier products to their core holdings of investment-grade bonds in order to maximize returns while improving diversification. The resulting approach is known as core plus.
The “core” usually represents 70% to 80% of a core plus portfolio, and the manager’s freedom to add opportunistic assets represents the remaining 20% to 30%, DiLalla explains. “Core plus is basically an enhancement to core,” he says, adding that it does not replace the core fixed income allocation of investment-grade bonds. That core is meant to satisfy a typical pension plan’s need to preserve capital and remain aware of liabilities.
Another fixed income approach that pension funds are using in their search for yield is a global multi-sector strategy. Like core plus, the global multi-sector strategy allows managers to add more opportunistic types of fixed income from around the world. However, “global multi-sector goes further and uses a wider spectrum of fixed income instruments including currencies, mortgages [and] asset- backed securities, as well as derivatives, to manage duration risk,” says Leona Fields, director of York University’s pension fund, which is preparing to deploy that strategy soon. The global multi-sector approach is often described as unconstrained.
“The manager will make—and change—allocations to the various strategies or sectors to get yield and manage risk. The allocation to high-yield bonds will vary depending on where the manager sees value at that time,” Fields says of the global multi-sector approach, adding that high-yield bonds will likely make up less than 10% of her pension fund’s fixed income allocation.
With global multi-sector, the exposure to a wide range of fixed income products does not necessarily exclude the core holdings of the bond portfolio, giving the manager greater latitude.
Finding Shelter
Another way Canadian pension funds are trying to keep their gains while protecting on the downside is increasing and diversifying allocations to alternative asset classes. Which alternatives are most appealing to them? “We see the most interest in real estate, infrastructure and private equity,” says Finney.
These assets don’t exhibit the same kind of volatility that equities do, so they are a great diversifier, Finney explains.
And, Muldowney adds, they’re also not as sensitive to interest rate changes, as long as those changes are moderate.
For all of these reasons, York University’s pension fund plans to increase and diversify its alternative allocations. Currently, the university allocates 5% of its overall pension portfolio to alternatives, all of which is dedicated to infrastructure, according to Fields.
The target is to increase alternative allocations to 20% of the overall portfolio and to include real estate in the alternatives bucket. The goal is for real estate to make up 10%—half of the total alternatives portfolio, Fields adds.
While alternatives used to be accessible only to the biggest pension funds, now even smaller players can access a wider range, thanks to new investment vehicles. In certain instances, the asset management industry is able to create bespoke portfolios at smaller asset levels, says Andrew McCaffery, global head of alternatives with Aberdeen Asset Management PLC (No. 27).
Investors can get these bespoke portfolios by opening new types of separate accounts that don’t require the high amounts of capital typically needed to open them, he explains. “In some cases, we are creating portfolios across alternative investments that can be as low as, or even below, $25 million and $50 million.”
Investors that don’t have the capital or desire to open individual accounts can use different commingled alternative funds, which pool the assets of several investors. Those include funds that use more liquid alternative strategies, such as hedge fund strategies. The liquid alternative vehicles—which are open-end pooled funds and thus have no limitations on the number of shares they can issue—allow individual institutional investors to participate with as little as $1 million, or potentially even less, says McCaffery.
When it comes to less-liquid real assets, pension funds can also invest in open-end real estate and infrastructure funds. Open-end funds target mainly smaller investors so they can get the diversification the big pension funds have, says Muldowney.
“An open-end fund just makes it easier for a smaller investor to get access to these alternatives because it doesn’t come with the same amount of administration the previous vehicle, the closed-end fund, would have assumed,” says Muldowney. Closed-end funds—which trade on the open market and issue a limited number of shares—require greater administration because they have an expiry date. Upon expiration, the assets are liquidated, forcing investors to look for another closed-end fund, if that’s what they want to do.
Additionally, Canadian pension investors can access alternatives through offshore mutual funds, says McCaffery. These funds are based in countries with lower taxes and possibly lighter regulations, which translates into easier administration— and, potentially, lower fees.
This ability to build a portfolio through a wider range of vehicles and exposures allows investors not only to diversify their assets, but also to manage liquidity and cash flow throughout the investment cycle, explains McCaffery. This helps investors avoid excessive liquidity or illiquidity at the wrong times of the cycle.
“You don’t always want to be invested in real estate or private equity or some hedge fund strategies. You want to be able to manage and move your allocations through time,” says McCaffery. “You could hold relatively liquid hedge fund-type strategies if you like them or if you feel they beat a cash holding. But these can quickly be re-deployed into illiquid investments, such as private equity or debt, if valuations suggest it is attractive to do so.”
Pension plans are not only increasing and diversifying their alternative allocations. The most sophisticated ones are also applying alternative strategies directly to the stock and bond allocations of their portfolios. For example, says McCaffery, some are embedding long-short strategies—typically seen in the hedge fund sphere—to their equity allocations in order improve their risk-adjusted equity returns.
This means that, in their effort to control risk, the most sophisticated pension investors are moving away from seeing their portfolios comprising separate stock, bond and alternative portions. “Thinking about alternative exposure across the overall portfolio—rather than seeing it as a small and separate bucket that can protect you against having the majority [of your assets] in equity or bond exposure—can be much more effective,” McCaffery explains.
Canada’s pension funds now have a unique window of opportunity to face their biggest ever-present fear. Some investors are still “in a happier state than they should be because the markets have been very kind,” says Muldowney. However, those that aren’t complacent are taking steps to manage risk: by embracing it, but in a highly calculated manner.
Yaldaz Sadakova is associate editor of Benefits Canada.
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