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A Pensions Perspective

“Our Changing Future”. Absolute Return Strategies. A Pensions Perspective. Gareth Derbyshire. 29 January 2008. Agenda. Why absolute return? And why now? Less β , more α Sample asset allocation. 1. Absolute Return – Why Now?. 1990. 2005(ish).

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A Pensions Perspective

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  1. “Our Changing Future” Absolute Return Strategies A Pensions Perspective Gareth Derbyshire 29 January 2008

  2. Agenda • Why absolute return? And why now? • Less β, more α • Sample asset allocation 1

  3. Absolute Return – Why Now? 1990 2005(ish) • (Fairly) static liability valuation bases: • Low volatility • Surplus increases if real asset return > assumptions • Absolute return strategies fairly attractive, if they’d been recognised • Equity vol disguised by asset valuation methods • Liabilities marked-to-market • Bond-like and volatile • LDI hedging unusual • Focus on asset performance relative to liabilities • Absolute return strategies less attractive except as diversifier from traditional assets 2

  4. Absolute Return – Why Now? 2006 / 2007 / 2008 • LDI mainstream: • Liabilities marked-to-market, hedged back to LIBOR • Absolute return well suited to LIBOR benchmark • For those funds not adopting the LDI approach: • Absolute returns for diversification (smaller allocation) 3

  5. The Development of LDI RETURN 2nd Generation: Risk-Managing Assets 2nd Generation: Efficient ‘alpha’ generation Traditional Efficient Frontier 1st Generation Efficient Frontier Traditional Asset Allocation 1st Generation: Liability Hedging 2nd Generation Efficient Frontier RISK 4

  6. Risk Management • Biggest risks usually real / nominal rates & equity β • Manager α relatively small source of risk • More α, less β would lead to better diversification of risk budget… • …but α is more expensive than β Risk Decomposition 5

  7. What Strategies? • ‘Absolute Returns’ not uniquely defined, but generally less β, more α: • Strategies benchmarked vs LIBOR e.g. hedge funds, long-short products (especially market-neutral) • Some capital guaranteed structures e.g. credit-based CPPI, capital guaranteed commodities • Short-duration structured credit (CDOs) • Infrastructure / timber • Or, stretching the definition: • ‘Low-volatility’ equity e.g. cash + call options 6

  8. Sample Pension Fund Allocation % Asset Mix Expected Returns • UK Equity • Global Equity • UK Credit • UK Nominal Gilts • UK IL Gilts • HFoF • Projected Forward Funding Ratio in 10 years = 92% • Downside Risk = 45% • 1 Year VAR95= £72m • Probability of Hitting 105% Target = 29% • 25% • 25% • 15% • 15% • 15% • 5% • 7.5% • 7.5% • 5.25% • 4.5% • 4.25% • 7.0% 7

  9. What About ‘Classical Derisking’? % Asset Mix Comments • UK Equity • UK Credit • UK Nominal Gilts • UK IL Gilts • Projected Forward Funding Ratio in 10 years = 78% • Downside Risk = 70% • 1 Year VAR95 = £18m • Probability of Hitting 105% Target = 0% • 10% • 30% • 30% • 30% • Both nominal and real rate risks hedged out on fixed income assets 8

  10. Try A More Sophisticated Solution % Asset Mix Comments • UK Credit • UK Nominal Gilts • UK IL Gilts • HFoF • Risk Adjusted Equity (RAE) • Projected Forward Funding Ratio in 10 years = 93% • Downside Risk = 59% • 1 Year VAR95= £51m • Probability of Hitting 105% Target = 27% • 15% • 15% • 15% • 5% • 50% • Both nominal and real rate risks hedged out on fixed income assets • Structured equity delivering similar return to index but with reduced volatility 9

  11. Putting It All Together Step 1 LDI hedge – nominal and inflation swaps • Equity • 15% traditional, 15% ‘low vol’ • Bonds • 10% gilts, 10% investment grade corporates, 10% investment grade structured credit / 10% high yield (possibly with CPPI wrapper) • Property • Alternatives • 10% hedge funds, 5% private equity, 5% commodities, 10% infrastructure / timber / others Step 2 Reduce concentration in equity β Step 3 Seek diversified α Asset Mix % • Projected Forward Funding Ratio in 10 years = 111% • Downside Risk = 80% • 1 Year VAR95= £31m • Probability of Hitting 105% Target = 53% • 30% • 30% • 10% • 30% 10

  12. What’s Happening In Practice? • Gradually falling equity allocations (65%→60%→55%) • Greater use of LDI strategies (£35bn inflation swaps¹) • Diversification into alternatives • Pace is a function of market levels: • Resistance to LDI with 50yr index-linked gilt yields <0.7% • Reluctance to de-risk equities when less than fully funded • Shift is slower than many media reports • ________________ • Watson Wyatt 11

  13. Conclusions • Absolute return strategies fit better in an LDI world • Trend away from β towards α, but β is cheaper and still has a significant role to play • Diversification into broader range of alternatives • Trade-off between investment efficiency and complexity – most (smaller) funds unlikely to go all the way? 12

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