INTERVIEW: Diversifying the portfolio – creating a custom approach outside of multi-asset fund structures?

Interviewee: Maire McGuire, Publisher, Clear Path Analysis

Interviewee: David Hickey, Portfolio Manager, Lothian Pension Fund

Maire McGuire: What are the main considerations in your de-risking strategies?

David Hickey: This very much depends on how you view risk. Here at Lothian Pension Fund we see risk as our ability to pay pensions in the future. We are largely unconcerned by statistical measures such as VaR and tracking error. Any changes to risk profile therefore take a view of absolute risk to underlying capital, and this view is largely independent of the asset class being studied. Furthermore, the investment processes we employ take a long-term view, and are inherently cautious. This almost eliminates the need for tactical de-risking strategies.

Maire: How do you balance risk and reward?

David: We have a conservative investment approach and a long-term investment horizon. When setting investment strategy, we pursue a benchmark agnostic approach that focuses on generating an appropriate real return over time. From an equity manager’s point of view this manifests as an aversion to downside risk. The internal equity portfolios are managed in a way that they tend to produce outperformance in falling or moderately rising markets, and will tend to under-perform in very strongly rising markets. This low beta strategy has outperformed in the past when markets have produced returns of less than 15%. While this can cause relative opportunity losses in those years where equity markets perform very strongly, over the long term we expect this strategy to continue to work. This is one reason why short term tactical de-risking strategies are unnecessary.

Maire: Is the search for yield pushing pension schemes into unfamiliar areas? How are you diversifying your allocations to attain return while not exposing yourself to unnecessary investment risk?

David: In looking for alternative sources of yield we moved into high yielding equities back in 2012. When we initially made this move, our target was to produce a yield of 4% while all underlying holdings had very robust finances with credit risk comparable with developed market government bonds. CDS spreads are one proxy for risk that we use. Reiterating the point that we are less concerned with levels of overall volatility and more concerned with risks of permanent capital impairment, and given that the internal fund manager managing this mandate has decades of experience in equities, this move towards “alternative” sources of yield was considered sensible. Since inception, the returns have been positive over every rolling 1 year period and have outperformed UK government bonds by over 5% pa.

Maire: To diversify investment interests, is it not better to outsource to a fiduciary manager with cross-asset class experience?

David: At Lothian Pension Fund, we have diversified our internal direct investment management team, and manage equities, bonds and alternatives in-house. Having this broad base of knowledge allows each of the managers to feed in to the overall investment process. There is a danger in treating each asset class as a silo (whether managed internally or externally) and missing the opportunity to influence across the asset classes. It is of paramount importance to have the necessary skill set for each underlying asset class, and having those skills internally removes agency problems associated with high fee external managers. With increasing collaboration and pooling in local government pensions, there is likely to be a move towards strongly diversified internal investment management teams rather than outsourcing to fiduciary managers.

Maire: What “safe-havens” do you feel exist for pension plans? How has your allocation to risk changed over the past 7 years?

David: Lothian Pension Fund has seen many changes in the last seven years, but these have been tied to structural changes within the team as much as an outright attitude to risk. An in-sourcing of the majority of equity, bonds and currency management has allowed the fund to streamline processes across different asset classes. This shift allows the risk profile of the entire fund to more easily be managed and balanced, without having to worry about the cost drags and inherent agency problems associated with external management.

There are no safe-havens. The closest thing to a safe haven is a very long-term investment horizon coupled with courage of conviction. So much of the market operates on a short time scale that there is an effective time-arbitrage opportunity available to any manager that thinks genuinely long term.

This interview is part of the 2017 De-Risking Investment Strategies, Europe report. Download your free copy here.