Do schemes understand multi-asset investment?

Jonathan Reynolds: As a general rule this would form part of your risk portfolio. You tend to have a pretty good idea of what return you are looking for and the level of risk you are prepared to take to get that. 

Generally, unlike other investors – when you say, ‘What do you want?’ and they say, ‘Well, as much as I can get’ – with a pension scheme it is very different. If the actuarial review is based on a 5 per cent return on your risk assets, then if we can get 5 per cent net, with a very low level of volatility, we are delighted. 

We are really coming at it from the return that we are looking for, how much risk we are prepared to take and whether the fund fits the bill, or whether we need something slightly more bespoke. 

Ciarán Mulligan: Do you think, from a trustee perspective, that this strategy should be considered by all pension schemes? 

Reynolds: It should be considered, but there is a major issue in trustees’ knowledge and understanding of what is actually involved, and there may be some statements of investment principles that might restrict or prohibit the investment of assets in a diversified growth fund. 

One of the major issues is that trustees need to understand the use of derivatives. If you ask them to actually explain, some might struggle. I always use the mantra that if you cannot explain it, you probably do not understand it. 

Mulligan: It goes back to understanding the risks: if you cannot understand what is in a fund, how can you understand the potential pitfalls?

Reynolds: I have seen statements of investment principles that actually clearly state the allowable use of derivatives. It might say for example, ‘Efficient portfolio management’. If you ask a trustee, ‘What does that mean?’, there are not going to be many who will be able to sit there and reel off ‘risk reduction’ ,‘cost control’ or ‘return within certain risk parameters’. 

Unless you have specific expertise or a strong investment subcommittee, it is actually quite difficult to get a board of trustees who all understand and say, ‘Yes,  we know what we are dealing with here and we are perfectly comfortable’. 

Allan Lindsay: That is why it is very important that trustees really understand what they are doing before they go in to this. 

A comment comes to mind from a set of trustees describing a fund that heavily uses derivatives and has been very successful. The comment from the trustees was that they had every confidence this fund would do exactly what it was setting out to do and actually provide very well for the scheme, but there is no way they would be able to explain it to the company or even the membership, and therefore they had to say no. That is a very interesting way of looking at it. You might have the confidence, but if you cannot explain it to the members or the company, you probably do not understand it enough to be able to invest in it. 

Ian Smith: Is that the main governance burden, in terms of some of the structures that are used? I want to talk a bit more about volatility, how it is measured, and the promises around volatility and the reduction you spoke about.

Taylor: There are two parts to this. For some funds that have launched in this space the biggest criticism has probably been the lack of transparency. 

It may sound like a very simple idea that people are investing in – taking a position that interest rates will remain low for a period of time longer than the market currently expects, or capturing specific exposure in Asian equities, for example. That sounds very simple, but then suddenly you look at the structure and it has rate swaps, beta hedges, and whatever else. Explaining this in a transparent and clear way is a very important part of the challenge. 

Also, trying to measure volatility is very hard. We use a particular risk model but it is based on the last three-and-a-half years of data, and I do not know if anyone in this room would want to base their investment decisions solely on what has happened since March 2010 – that is a very dangerous thing to do. You need it as a starting point, but then you need to be stress-testing and looking at all the different drivers, using historic and potential-scenario analysis and making it a part of your process. 

Mulligan: There is a danger that derivatives has become a dirty word. It is a case of understanding that if you do have the education and the research from consultancies, it is very plausible to become comfortable with the use of derivatives within strategies now. Whether they are compliant to what is in their Sip is a separate issue. Taking that aside, I do not think we should discount any strategies because they are complicated.

Georgina Taylor: People can be wary. However, we have an idea at the moment where we are investing in Asian equities, and we have hedged that through a part-exposure to Chinese and Australian futures. In this instance, using derivatives has actually reduced the risk, or volatility, of the idea. So here derivatives are part of the implementation, but of course it is important to be visible and transparent on that. 

Allan Lindsay is head of investment consulting, north at JLT Employee Benefits

Ciarán Mulligan is head of manager research and selection at Buck Consultants

Jonathan Reynolds is an independent trustee at Capital Cranfield Trustees

Georgina Taylor is product director, multi-asset at Invesco Perpetual