Taylor Wimpey builds synthetic equities to tackle volatility

The overhaul, which also includes diversifying the fund’s growth allocations away from public equities, comes after the scheme reviewed its investment strategy at the end of 2015.

With managers forecasting yield rises and employers still smarting from the latest round of funding negotiations, rate-conscious trustees will be focused on picking the right time to increase hedging levels.

We advise schemes to start planning now to enable them to act quickly as the opportunity arises

Sorca Kelly-Scholte, JPMorgan Asset Management

The £1.89bn Taylor Wimpey Pension Scheme substantially increased its allocations to nominal and index-linked government bonds in the year to 2016, constituting 88.3 per cent of the total portfolio. The scheme also uses derivatives including repurchase agreements to hedge its exposure to interest rates.

Tool for leverage

The majority of its physical equity allocation, which stood at almost 40 per cent of the portfolio at the end of 2015, was converted into a synthetic exposure. The scheme’s physical equity allocation is now just 8.8 per cent.

The synthetic exposure will use both a volatility-targeting mechanism and the downside protection delivered by put options to manage the scheme’s risk.

“With these changes, the funding level is now expected to be less volatile than previously,” noted Taylor Wimpey’s latest annual report, but conceded some balance sheet volatility could remain.

Converting an equity allocation to a synthetic exposure does not necessarily help to reduce risk, said Simon Cohen, head of investment consulting at Spence & Partners.

The futures contracts used by most schemes to go ‘long’ equities do not themselves reduce risk, but can play a secondary role in derisking efforts.

“Because they don’t need to put 100 per cent of their assets [behind the contracts] it allows them to get leverage,” said Cohen. This frees up money that can be invested in other assets to reduce risk.

He noted that the popularity of such strategies is resulting in a proliferation of pooled, leveraged LDI funds that also include synthetic equity.

But he remained sceptical of the need for downside protection using put options: “You’re paying the premium to protect your equities... but why not just reduce your equities allocation?” he said.

Schemes trying to avoid paying that premium should look at zero-cost collars, where investors sacrifice potential upside to pay for downside protection, he added.

Spread hedge increases out

Despite a recent wobble in US stock markets, manager confidence in listed equities is currently high. JPMorgan Asset Management’s multi-asset team has increased its stock-bond overweight position in response to what head John Bilton called the “best period of coordinated growth since the aftermath of the financial crisis”.

However, rising yields mean many schemes will still be anxious to increase the amount of duration on their books, according to Sorca Kelly-Scholte, head of JPMorgan’s EMEA pensions solutions and advisory team.

“We advise schemes to start planning now to enable them to act quickly as the opportunity arises,” she said, noting that schemes will be in competition with insurers for assets.

Kelly-Scholte added: “We also expect to see pension funds make more use of credit as a venue for hedging their duration profile, making a more refined trade-off between liability hedging and yield [or] return.”

She expected muted global growth to result in gradual long-term increase of hedge levels, but stressed that short-term opportunities may arise.

Cohen agreed that nimble schemes would be rewarded, suggesting a combination of time and trigger-based strategies to ensure a decrease in rate risk while taking advantage of any attractive pricing.

Bucking the hedge fund trend

Taylor Wimpey, which had a £232.7m accounting deficit at the end of last year, has still retained some risk in its portfolio. But the new strategy aims to diversify the scheme’s risk premiums away from traditional equity exposure.

The scheme’s £289m allocation to hedge funds stands in stark contrast to a certain amount of scepticism of the investment strategy found among many pension funds.

Alan Pickering, chairman of professional trustee company Bestrustees, said complex fee structures, issues around liquidity, and exit charges had been the principal drivers of this mistrust.

However, he expected trustees would learn from their lessons and see the nuances within the asset class, taking opportunities where they arise.

“I’ve got to wipe that experience from my mind,” he said. “Hedge funds, like many other phrases used in the world of pensions, are shorthand for describing a fairly heterogeneous family of investment opportunities.”