In this first instalment of our annual survey of schemes and their advisers, we look at how funds have diversified their investments – and where consultants see room for improvement
The majority of schemes that took part in this year’s Intelligent Thinking survey said they were reducing risk in their portfolios by investing in a wider mix of assets.
Chairman of trustees, £45m scheme: “We have been investing in a wider range of assets. We have made allocations to high yield debt, global bonds, index-linked bonds – both UK and global – emerging market debt and low-volatility equity funds.”
Non-executive director, £4.2bn scheme: “I wish to match my liabilities and if this is achieved by diversity then good, but if it is achieved by less sexy asset classes or derivatives then I am an equally content. Meeting my liabilities is my fiduciary duty.”
Member-nominated trustee, £500m scheme: “We are about to reconsider our investment strategy, which will include looking for more diversity. An infrastructure investment is already being actioned and property is being considered.”
But the consultants who also took part said too many schemes had a “naive” view of diversification.
“You can kid yourself into thinking greater diversity automatically means less risk,” said Phil Page, client director at Cardano.
“But if the majority of your investments are actually linked to common factors that do well – or badly – in the same scenarios, then diversity may just lead to excessive complexity.”
A wider range of uncorrelated assets will help reduce investment risk and volatility in a pension scheme portfolio – but certain asset classes that appear very different can produce very similar returns.
This year’s Intelligent Thinking survey asked pension schemes and investment consultants how they were facing up to the low-growth, low-interest rate environment.
The schemes that took part – with combined assets of £30bn – outlined their governance practices and how they dealt with the perceived problem of slow, inefficient decision making.
Meanwhile, the consultants offered their views on the latest trends in multi-asset funds and how investment strategies were adapting to the tougher climate.
The route to diversification
The importance of a well-diversified investment portfolio is a mantra pension schemes have slowly been adopting over the past 10 years.
We have been diversifying since 2002 and have largely finished that programme
Accounting rules and sizeable deficits mean pension schemes need to deliver long-term returns for their assets but with a minimum of short-term volatility.
The transition – though far from complete for many schemes – has also seen a switch from the traditional equities-bonds-cash portfolio to making use of a much wider range of asset classes.
From more established assets like property and commodities, to newer waves of investment in emerging market debt and secured loans, schemes are widening the search for uncorrelated returns.
Of the pension schemes that took part in the survey, the vast majority were in the process of diversifying their assets or felt they had already achieved the desired level of diversification.
“We have been diversifying since 2002 and have largely finished that programme,” said the investment director at a £4.2bn public sector scheme.
“However, we are open to opportunities thrown up by the ripples of the credit crisis, provided they meet our investment hurdles and criteria.”
Schemes that have yet to fully diversify their portfolio are looking at a wider range of assets.
The buzz around infrastructure over the past couple of years has increased interest but other survey respondents highlighted their plans to move more of their investments into emerging market debt, high-yield debt and emerging market currency.
“We have been increasing diversification into core property, emerging market currency, multi-strategy alternative credit and sovereign credit,” said a member-nominated trustee of a £4bn scheme.
“The object is to increase diversity of non-correlated asset classes that offer an acceptable level risk and return.”
Scheme naivety over diversification
While the survey showed most schemes were diversifying their portfolios, the consultants who took part suggested many schemes failed to recognise the subtleties involved in achieving lower correlation.
At stressful times in markets, correlations rise so diversification alone is not a silver bullet and pension schemes need to adopt a variety of direct and indirect strategies to mitigate risk
“One of the lessons of the financial crisis has been a naive focus on asset class diversification may not protect investors from stressed scenarios to the degree they might expect,” said Phil Edwards, principal at Mercer.
He added that many of his clients now think about diversification across risk factors and return drivers, as well as by asset class.
“A discussion around the risk factors to which different asset classes are exposed can help provide a greater understanding of the nature of the risks within the investment strategy,” he said.
“In particular, [it can] highlight areas of concentration that might not be obvious when looking at asset class exposures alone.”
Many pension schemes that believed they had a well-diversified portfolio before the financial crisis found out too late that their seemingly differing asset classes had in fact behaved in very similar ways.
This has made it even harder for schemes to identify uncorrelated assets.
“At stressful times in markets, correlations rise so diversification alone is not a silver bullet and pension schemes need to adopt a variety of direct and indirect strategies to mitigate risk,” said John Belgrove, principal at Aon Hewitt.
Next week's survey results focus on what asset classes are finding favour among schemes – and which ones they have lost faith in.
