May 2010


Group CIO of Schroders, Alan Brown, is well placed to gauge pension fund concerns. Funds still have time to capture emerging market growth, he tells Nick Fitzpatrick...
Alan_BrownUK pension funds are maintaining their trend towards diversification and seeking more multi-regional mandates since they emerged from the pit of the crisis.

Alan Brown, group chief investment officer at London-based Schroders, says that since the depths of the financial turmoil when pension funds were like “deer caught in headlights”, they have become more active again since the second half of 2009.

As CIO for a high-profile investment house, Brown has a close relationship with many pension funds in the UK, and he notes that UK equities – which have historically been the largest asset class for funds – are shrinking as a portion of portfolios.

“Funds are embracing more multi-regional mandates. UK equities are still important but they are in decline. In recognition of the volatility we have all gone through, pension funds are looking to diversify,” he tells Funds Europe.

“Many pension funds are staring at deeply depressed funding ratios – what were well-funded defined benefit (DB) schemes now have gaping holes in them.

“These schemes are maintaining their risk postures in the hope that markets will take them back to where they were. However, it is only a cautious optimism because people recognise that this recovery is likely to be weaker than most others before it.”

The strength of the recovery is a main concern for DB pension funds, Brown says. “The main concerns are the strength of the recovery and whether it will continue. It is difficult to see how the industry can get back on its feet without the economy doing the same. The corporate sector has to be able to support defined benefit schemes.”

During the crisis, he says pension funds put their long-term plans on hold and that consultants were right to say that transitioning fund structures would have been expensive and highly risky during that time.

But, given that pension funds are often described as slow to react to new investment opportunities, where does this leave them now as the world turns its full interest towards emerging markets?

Brown says: “The boot is on the other foot in terms of where the healthy part of the world economy is. Asian economies have not suffered as much as those in the West. Their fiscal deficits are under control and their banking systems are not full of toxic assets.

“If you think an investment idea is going to do well then you want to overweight that area before it is re-rated by the market. The revaluation of emerging markets started a long time ago, and although the easy money has been made, emerging markets still have many years to go. It will run for decades meaning that pension funds still have time.”

As the world changes, Brown believes benchmarks will have to adapt to new realities.

“The single-minded focus on market-based benchmarks has not served us very well. In prior days these benchmarks were simply a comparator to see how well a fund was performing. Now they are often used as the starting point for portfolio construction.

“We have to go back to basics and put market benchmarks in second place and instead use scheme-specific liabilities as the key benchmark. Trustee reports should be able to explain more about why a scheme’s funding ratio has improved or worsened. We need to think again about how we judge success and failure.

“Market benchmarks and relative returns do not pay pensions,” he says. He says that  pension funds need to earn a real return of something like inflation plus 5% on their risky assets.

Inflationary risks
Inflation has attracted much attention recently from market commentators, with a divergence in views. Brown believes there is still time before the issue of inflation – or deflation – are imminent.

“This could be an interesting decade when at the beginning we may flirt with deflation while at the end we may face coping with inflation. However, inflation will not be a real concern for a couple of years or so. There is so much slack in economies that inflation is really difficult to envisage.”

He warns, however, that there is a risk that central banks, concerned to see that the recovery is well established, will be too slow to reverse quantitative easing and raise rates. If that happens, inflation could rise quite sharply.

“Though still a few years out, it is worth pension funds thinking about this now because an upward jump in inflation is one of the worst things that could happen to risk assets like equities and property.”

An equity bear market for two years or so could be a terrible blow for pension funds already battered by the ‘miserable returns’ of the last decade. To survive, pension funds would have to manage their assets and liabilities in a joined-up way.

“Many pension funds have been hedging out interest rate risk through liability-driven investment (LDI) programmes. But in an environment of rising inflation, it could be equally sensible to remove those hedges so as to get the benefit of falling liabilities as discount rates rise. This would be an important offset to declining asset values.

“Pension funds should focus on these questions now so that they have an action plan ready should inflation prove to be a real possibility.” He says there is a need for more real-world outcome-based products, employing absolute-return rather than market-relative benchmark strategies.

He highlights Schroders’ diversified growth fund, launched in 2006, which gives equity-like returns or better, but for significantly less risk.

“We also have an ‘income maximiser’ fund which writes out-of-the-money call options as an overlay to a traditional equity income fund. It is designed for those who have reached retirement age looking for a high level of distributable income.

“Generally, in the area of defined contribution and hybrid schemes, we think there is a lot of work to be done to create better solutions for the end beneficiaries as they approach retirement.

“LDI is significant here too in the DB market and the industry is already into its fourth generation of products. The next development that we’ll see are hedges
against longevity.”

Post-war growth
It hasn’t just been the worst financial crisis in decades, but in the UK, it has also been the worst winter for decades too. The relevance is that Brown is a believer in climate change science and he thinks solutions to the problem could be the biggest driver of growth in the coming generation.
“The main driver in the post-war period for global growth was credit, and the US consumer’s use of it in particular. So where is growth coming from next?

“Emerging markets is one area, but another possibility – one that could account for 1% of growth in GDP in time – is climate change-related expenditure.” He says this is not just about wind farms and solar panels, but also insulating materials, drought-resistant seeds, video conferencing as people try to cut air miles – the list goes on.  Almost all sectors of the economy will be affected, Brown says.

“We have launched a fund targeted at these areas and it is performing extremely well. We would have expected it to be over $1bn now but it is close to $500m owing, I think, to the credit crisis and equity bear market dampening interest in equities in general. Most of the interest to date has been retail but some institutions came in last year too and we are still seeing a steady flow of funds in.”

But nobody will be thanking fund managers for their role in saving the world. Not yet, at least.

Asked how he feels clients of the funds industry think about their managers post-crisis, Brown says: “Bankers are not the flavour of the month. Fund managers are not bankers but the difference in people’s eyes is a subtle one given that a lot of us work in the City. Anyone who enters asset management and hopes they will be sent a bouquet of flowers for a job well done will be disappointed.”

©2010 funds europe

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