As the LGPS focuses more attention to cost effective investment, ever-more tactically constructed portfolios and pooled investments, managing exposures to risks with ongoing portfolio management and specifically during transitions between asset classes is important.
Chris Bilsland, executive director, London CIV – chair
Andrien Meyers, treasury and pensions manager, Lambeth LBC
Klaus Paesler, head of currency and overlay strategy, Russell Investments
Peter Wallach, head of the Merseyside Pension Fund
Phil Triggs, strategic finance manager, pensions and treasury, Surrey CC
Rodney Barton, director, West Yorkshire Pension Fund
Fiona Miller, head of pensions and financial services, Cumbria CC
A roundtable event, held on the eve of the LGC Investment Summit in September and sponsored by Russell Investments, aimed to discover how LGPS funds approached exposure management in this environment.
Discussion chairman Chris Bilsland, non-executive director at the London Collective Investment Vehicle (CIV), began by asking the difference between exposure management for funds in transition between allocations, and those that are not.
Klaus Paesler, head of currency and overlay strategy at Russell Investments explained that the principle is the same, but that for the two situations, the tools used might be different.
“Exposure management comes from a position of: what you currently have and where you want to be,” said Mr Paesler.
“That can involve many different things: currency, factor exposures, managers. Say you have a pension fund that’s doing a large asset allocation shift, or even shifting a great deal of managers within that. Hiring a transition manager to manage that exposure is critical.”
Mr Paesler said that a transition manager, in a case where a fund is going through a large asset allocation change, will watch over all of the transactions and plan level exposures in a holistic way.
“Let’s take an example: you’re getting out of one active manager and into a completely different asset class. The manager that’s going to be terminated is not necessarily going to trade in your best interest.
“On top of that, the assets that are liquidated may either be sitting in cash for a period of time, or there potentially could be an asset allocation sectoral or regional shift, and suddenly the plan is exposed to a risk that they don’t want to have.
“The new managers are not necessarily going to have the scheme’s best interest in bringing those assets on, nor will they necessarily have insight into the exposures of the plan as a whole. There are performance holidays, where the manager will say, ‘we won’t be judged on performance until those assets are complete’. That could be a potential enlarged cost.
“An independent party steps in as an interim portfolio manager, looking after the scheme as a whole.”
Schemes that are not planning large asset shifts, however, can also benefit, Mr Paesler said.
“It’s managing all the different exposures in the fund, such as currency and asset allocation,” he explained.
“Given the recent volatility in markets, currency can affect performance more than the underlying assets. Using exposure management either in rebalancing or tactical shifts is also critical, using derivatives, which are a very inexpensive way to shift asset allocation, to rebalance the plan to your long-term strategic target or to make tactical shifts.
“If your investment committees say, ‘global equities are not the place to be’, your options are to go to managers, terminate, get the cash, and figure out what you’re going to do. That can be very inefficient. Having a derivative platform allows you to remove exposures to assets within minutes, in a very cost effective way, while maintaining the alpha potential of the underlying holdings.”
Fiona Miller, head of pensions and financial services at Cumbria CC, asked whether this ability to use derivatives to enable quick tactical moves was relevant to LGPS funds, which may need committee approval for such changes.
Peter Wallach, head of the Merseyside Pension Fund, said his fund has that speedy decision-making capability.
“We were aware that our asset allocation was detracting from performance, so we put in place a derivative overlay on our liquid assets so that we could rebalance back to benchmark when we don’t have a view on the market, and to express a view on markets when we do,” he said.
“We have quarterly meeting when we review the policy and change it and there’s scope to do that on an inter-quarter basis if necessary. For example, when we came up to the election in the UK we took the view that currencies would be very volatile like they were during the Scottish referendum, so we took all our bets off in terms of currencies. That was actually the wrong thing to do from a return point of view, because sterling strengthened, but from a risk point of view was the right thing to do.”
Andrien Meyers, treasury and pensions manager, Lambeth LBC, described the decision-making arrangements at his fund: “We have European property within our mandate and due to the currency movements, we’ve suffered.
“Most funds would do a currency overlay at the fund level rather than at an asset class level especially within the LGPS. We took the decision not to do anything, and leave it as is because it was simply too expensive for us to do that, and our property portfolio is about 9% of the overall fund.
“In terms of the governance, I put this up to the committee. The recommendation was that we do nothing, although I gave them other options. They agreed with the recommendation.
“Tactical rebalancing, on the other hand, is something we look at on a quarterly basis, because research shows that the LGPS can save anything between £4m and £6m if they consistently rebalance.”
Phil Triggs, strategic finance manager of pensions and treasury at Surrey CC, said: “In terms of rebalancing, at every quarterly committee meeting, this information is presented and it has the asset allocation and the position at the end of each quarter. Along with that we take the statement of investment principles (SIP), so on a quarterly basis that statement is approved and there are usually some changes. So every quarter the trustees have the decision to make: do we need to rebalance?
“If there’s a marked shift in markets, we can take it to the chairman along with an independent adviser, so we can get an emergency decision.”
Mr Bilsland asked: “When deciding whether or not to rebalance, do you also measure against your liabilities? In theory, you don’t want to rebalance back to an asset allocation that’s two years out of date against the liabilities.”
But Ms Miller said this would be impossible to achieve given the nature of valuations: “We get a quarterly look-through [of current liabilities], but that is based on the last triennial valuation, so when you’re six months from the next valuation and you’ve had 30% of your workforce leave due to restructuring, the valuation is spurious as to its validity.”
Ms Miller said keeping a close eye on cashflow was proving to be more useful than estimates of liabilities: “At valuation point we  were still cashflow positive. We are now at £2m negative at a contributions level per month.”
Mr Wallach said that liability-matching aside, his fund has found derivatives useful when shifting allocations because of the cost saving: “Derivatives are cheaper. We’ve identified that with active managers it is particularly expensive to take money from them, and it could be at the wrong point in the cycle, so it’s quite helpful if you can implement with derivatives, and then implement through the cash markets at a more suitable point in time.”
Mr Bilsland said one of the difficulties of using derivatives was ensuring all committee members understood the instruments: “One of the problems I used to have was people being able to understand exactly what a derivative was, particularly with trustees. There’s always a risk that people don’t understand, therefore you can’t persuade them to do it. Is that an issue for you?”
Mr Wallach answered: “I’d say there are probably still reservations; there are still members that don’t fully understand how derivatives work in practice. We have had training. It’s more that they have confidence in the officers, and in our advisors, and therefore they’re happy for us to undertake the technical side for them.”
Mr Triggs added: “Derivatives is still a contentious word, but when you explain to your trustees that this is not the use of derivatives for making a speculative profit but a method of controlling risk and reducing exposure, then the trustees understand that.”
Mr Meyers agreed: “We’ve been going through LDI ourselves and we had to do four training sessions just on LDI and one entire session was totally focused on derivatives but once you’ve done that training, they seem to understand it.”
Moving the discussion on to more technical aspects, Mr Meyers asked whether if, while a pension fund was moving from one mandate to another, the transition manager it employed could invest to mimic the characteristics of the desired new mandate.
Mr Paesler said this was possible: “That is a huge aspect of transition management.
“The best example was what happened in the US when Bill Gross left Pimco [in September 2014]. Suddenly there were massive outflows. What do you do?Do you leave the monies with Pimco and pay them the active fees until you know where to go; do you sell out and then you’re stuck in cash until you find a new manager; or do you take the money and immediately put it into the first manager you know?
“A transition manager can step in as an interim portfolio manager and take those assets and manage them to a certain risk target. You’re going to be paying a transition manager a fraction of active manager fees, so you’re getting a similar exposure that you had before and not paying active fees until you’re ready to determine where you want to go.”
Ms Miller asked how this would work where the situation is messier: “What if we’re doing a strategy review that is likely to result in substantial change but we’re not quite at the point where we’ve finished all the work? Additionally you’ve got a manager you’re not happy with, you’ve got a strategy review on-going, and you need to move immediately £150m, probably £300m at the end of it, and you’ve no idea if that’s in six months or 12 months?”
Mr Barton asked: “If you’ve got a manager that you don’t believe in anymore, why would you wish to continue that particular portfolio shape? Why wouldn’t you want to move either to passive or something in which you have got confidence?”
Mr Paesler answered: “It really is going to depend on the nature of the assets you want to be exposed to but also a couple of aspects are trading costs, and having these managers in place.
“If you have a lot of passive funds in place, ready to have the assets in and out, it can be a very efficient way. You’re obviously going out of physical assets into physical assets, so there has to be some trading cost involved.
“But not a lot of funds are going to have the array of passive funds that they need to get those exposures they want. If you know it’s going to be 12 months, it may be worth paying a swing factor, and contracting with a new passive manager to do this, but if the timing is unknown, you do want to do an immediate shift, having someone step in.”
Returning to Ms Miller’s point about more complex transactions where fewer aspects are certain, Mr Meyers asked: “Say I’m moving from my active equity manager to a passive manager, and to the London CIV, with four or five other boroughs. How would I manage my exposure in this unique event?”
Mr Paesler said: “That’s where the project management part of transition management is very important.
“The first part of that is looking at the exposures, both regional and manager, that you have and where you want to be.
“Let’s take an extreme example: you want to get out of UK equities and into a global framework. You have three UK equity managers and you want to go into four global equity managers. One way to manage that is we take that portfolio, both cash and physicals, and convert that with derivatives and currency forwards to the type of exposure you want. So we’ll sell UK equity exposure in this example, either physically or with short derivatives, and go long on derivatives from a global standpoint. So from a beta standpoint, at the very least, you are now exposed to the new assets you want to be. Then over time, manage that shift of physicals at the same time as buying those global assets physically, coming out of your long derivative positions and slowly merging them. From day one, you have beta exposure.”
Mr Meyers asked: “You could have a fund that is complex that is going into the CIV, and you could have another fund that is quite straightforward and is going to the same place, and you could have another that is somewhere in the middle. How would a transition manager in this case charge the fees? Because the three funds are going to the same place but are starting from different points.”
Mr Bilsland added: “There has to be transparency to reduce those cross-subsidisations as much as possible.”
Mr Paesler explained: “Because these three funds are individually buying into a CIV, that transaction is the three funds’ responsibility. It’s going to cost more for one that is going from a complex asset allocation to a CIV which is a relatively simple asset allocation. In a very complex asset allocation, you paid a lot to get into it and you have to pay a lot to get out of it.
“However, if you have 12 global equity funds and are moving into the one CIV, there could be a lot of assets in common, and although you’re coming from a relatively complex structure, the costs may not be all that high.”
More broadly on the issue of costs, Mr Triggs asked: “How would you advise a fund to assess how good a transition process has been?”
Mr Paesler said: “The transition management industry has tried to establish standards around this.
“One of the important things is outright cost; brokerage cost is not the correct way to measure it.
“From minute one of the transition, you have your legacy assets and your target assets. Any performance deviation from that of those target assets is your implementation shortfall.”
He added that a variety of things could create implementation shortfall, from a lack of exposures in the transitional allocation to the target allocation, to physical trading costs, the costs of currency trading and the costs of derivatives.
“The transition manager should do a large project management exercise at the start and give estimates of the implementation shortfall. After the event, you want to look at what it actually cost in terms of implementation shortfall. It should be very close to the estimate.”
Sponsored by Russell Investments