South Yorks plumps for alts as equity concerns bite

Unlike the predominantly closed defined benefit schemes of the private sector, constituent funds in the Local Government Pension Scheme and other public sector plans have typically retained a high allocation to risk assets and equities.

In the year to March 31 2017, the nearly £8bn SYPF generated a 22.6 per cent return on its assets, driven largely by its 60 per cent equity allocation.

Following an investment strategy review, the fund’s investment committee recommended lowering that exposure to 50 per cent as early as April last year.

LGPS funds have a twin objective of making the benefits affordable, but also trying to keep contribution rates stable

David Walker, Hymans Robertson

However, continued strength in stock markets meant the fund’s officers struggled to bite the bullet and trim its overweight position, according to treasurer Neil Copley and Steve Barrett, the fund’s interim director.

“There has been a natural reluctance to reduce that exposure and hold large cash balances whilst we endeavour to get money into alternative investments,” Barrett and Copley reported at a meeting of the South Yorkshire Pensions Authority in January.

However, the report also reveals that members of the fund’s investment committee questioned the lack of progress with the agreed allocation changes. With an equity protection strategy tailored to the new 50 per cent allocation already agreed, significant amounts are now being moved into cash pending reinvestment.

Equity investors are getting nervous

Reducing equity exposure after a year of stellar performance may seem counterintuitive, but according to David Walker, head of LGPS investments at consultancy Hymans Robertson, many local authorities are seeking to do so.

That might be motivated by uncertainty about the direction of what are stretched stock markets on a valuations basis, or even by a strategic desire to make returns more predictable.

“LGPS funds have a twin objective of making the benefits affordable, but also trying to keep contribution rates stable,” said Walker.

Open DB funds concerned about the future returns of their equity holdings have two options: diversify away from equities, or seek downside protection on their existing portfolio.

The SYPF has pursued both strategies, using derivatives to build an equity protection strategy, and increasing its allocation to private debt, private equity, and property, in which it is underweight.

But Walker said compression of yields extending even into private credit markets could mean it is hard to find attractively priced assets, making the case for an equity protection strategy, which can be considered cheap at least on some measures.

“The low level of equity volatility means that equity protection on the downside is cheaper than it has been, but there is still a cost,” he said, adding that collar strategies, where investors forgo upside in return for downside protection, could be argued to be expensive.

“They’re having to give up quite a lot of upside if they’re looking for one of these zero-cost solutions,” he added.

Do not derisk for the sake of it

Others argue that open schemes with long time horizons should not be sacrificing upside at all, and that diversification should still be carried out with strong returns in mind.

This argument is reinforced by the fact that LGPS fund covenants are effectively backed by the taxpayer, said Graeme Muir, head of public sector at consultancy Barnett Waddingham.

Muir advocated diversifying to “get a more stable investment return, as long as you’re not going to get a lower investment return.”

He added that new actuarial models that move away from the gilts-plus method can also stabilise contributions.

Private debt needs careful selection

The SYPF’s allocation to private markets follows a well-established trend. Private equity has long been a component of institutional portfolios, and low yields and restraints on bank balance sheets have seen money pour into private debt.

“We are now seeing a lot of funds being set up specifically to provide debt on terms similar to how banks’ loans may have been structured,” said Mike Jaffe, a professional trustee and investment specialist at Law Debenture.

But with the low interest rate environment seeing yield compression carry over into private markets, there are significant issues for pension schemes to navigate when choosing direct lending.

A bfinance paper last year found record amounts of dry powder in global direct lending, while managers chasing investor yield expectations were reportedly incorporating riskier elements of debt into their funds.

“We have seen yields definitely come in in some of the alternatives,” said Walker, adding that this was why some were looking at equity protection. “The problem is, some of the asset classes they are looking to put it into are also quite expensive.”

However, he said the income element of many alternative assets should still mean well-priced assets give schemes the certainty of returns that they need.

Alternatives are tricky to pool

For some LGPS funds, their ventures into alternative assets may clash with another objective; the pooling initiative introduced by government in 2015.

Asset pooling requires individual mandates to be merged and held under the same terms. Highly specific contracts governing limited partnerships and other aspects of private market investments would subsequently be impossible to pool. The SYPF will therefore continue to run these outside the Border to Coast Pensions Partnership.

“We will have assets that are already committed in certain areas around our alternative investments, where we have invested in private equity and private debt funds,” Barrett told scheme members at a meeting in October. “We will continue to manage those in run off, but any new ones will be run through BCPP.”

Pooling will limit local social impact

Even the smallest pool proposals submitted in summer of 2016 reached sizes of £13bn, giving them scale that is largely incompatible with the social impact alternative investments favoured by many LGPS members.

For example, the SYPF’s £90m commitment to alternatives since April 2016 comprises small direct holdings including a biomass plant in Hull, and the fund has separately allocated to social housing.

Pooling limits the ability of LGPS members to invest at this scale, according to Rupert Robinson, managing director of Gresham House Asset Management.

“£25bn size pool funds are likely to result in minimum unit size investments which are above £50m,” he said. “This would imply that development projects and certain housing or infrastructure investments would be too small to invest in. Hence, local investment could well be impacted and constrained.”

Green strategy under scrutiny

For all the SYPF’s endeavours to achieve social impact and ESG-driven returns with its allocations, some campaigners are still not happy.

“We would love to see more pension funds including South Yorkshire investing in renewable technology, but have serious questions about biomass being included or labelled as ‘green’ – in many cases, it carries a significant carbon footprint,” said Janet Paske, a campaigner at divestment group South Yorkshire Fossil Free.

SYPF’s public markets ESG policy incorporates a tilt away from carbon-intensive stocks, and involves sending representatives to annual meetings of major carbon extractors.

While Paske welcomed the use of engagement for companies that use fossil fuels, she said it was inappropriate for use with the big oil companies that make up the largest holdings of the SYPF, and called for it to adopt negative screening.

“Engagement with companies is useful for ‘tinkering around the edges’ but not for asking companies to fundamentally change their core business.”

Consensus is building

From a pure investment perspective, divestment is unappealing as it leads to a loss of diversification and potential return. As such, divestment groups and investors have often been at loggerheads.

This need not be so, according to ShareAction. The campaign group is leading discussions between the SYPF and South Yorkshire Fossil Free, and said schemes should carefully watch for the impact or lack thereof of their engagement efforts.

This would allow them to tilt towards companies making good progress to adapt to a green economy and away from those resistant to change.

“Divestment and engagement are complementary tactics to achieving a low-carbon economy,” a spokesperson said.