Investment Strategies for Pension Funds Christopher Nichols - - PowerPoint PPT Presentation

Christopher Nichols Investment Director, Multi‐Asset Investing Standard Life Investments (UK) Investment Strategies for Pension Funds

Pensions need consistency but markets deliver chaos

Discrete Yearly Performance (%) by Market

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 55.03 25.30 26.07 ‐14.29 73.43 27.48 18.55 40.36 40.24 29.46 44.76 22.51 23.73 ‐21.61 71.56 26.65 10.88 21.34 26.67 27.89 39.44 20.45 6.15 ‐24.12 68.24 23.63 10.38 20.74 22.04 22.06 27.84 19.15 ‐3.39 ‐25.44 56.93 23.06 6.06 17.48 21.85 20.76 25.75 19.06 ‐3.43 ‐25.66 41.58 21.81 5.53 16.80 17.77 17.39 22.57 18.60 ‐4.85 ‐33.73 30.67 21.21 3.36 15.66 8.12 13.76 22.43 4.77 ‐5.00 ‐41.15 22.52 18.74 ‐0.97 14.42 3.29 11.80 20.89 3.58 ‐6.57 ‐42.25 17.62 18.71 ‐11.32 14.22 ‐0.83 9.63 16.91 2.69 ‐7.09 ‐46.77 11.19 11.77 ‐12.51 6.70 ‐1.92 8.46 12.08 2.56 ‐13.29 ‐49.12 9.58 11.16 ‐12.55 5.77 ‐3.02 7.78 11.21 1.56 ‐13.55 ‐50.75 7.54 9.66 ‐12.96 5.40 ‐6.35 7.37 5.85 ‐4.88 ‐24.71 ‐60.73 3.07 4.37 ‐15.44 3.79 ‐6.49 4.33

Global High Yield Bonds UK Equities UK Direct Property Cash UK Investment Grade Bonds European Equities Asia Equities Ex Japan Japanese Equities UK Gilts UK Small Cap Emerging Market Equities US Equities Source: Lipper, total returns, in € terms, 31 December 2014

Rotate based on outlook?

1982

1984 1986 1988 1990 1991 1994 1998 1999 2001 2002 2006 2007 2008 2009

2014

‐4 ‐2 2 4 6 8

‐1 1 2 3 4 5 6 7

Inflation Real GDP

Recession Recovery Overheat Stagflation

• Historical data
• Asset class volatilities
• Correlations
• Capital market outlook
• Intuitive beliefs

Conventional diversification

More likely exactly wrong than approximately right

• Strategic Benchmark
• Asset classes
• Broad weights
• TAA (e.g. +/‐5%)
• Tracking‐Error limit

Governance structure: Derived using:

Source: IPD UK Monthly Property Index, All Property; Federal Reserve Trade‐Weighted Exchange Value of US Dollar vs 6 Countries; Dow Jones UBS – Commodity Index; Barclays Capital Global Corporate Index, Excess Returns; Barclays Capital Emerging Markets Index, Excess Returns; Barclays Capital US High Yield Index, Excess Returns; Standard Life Investments, 31 December 2011

Unstable risk characteristics

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Property FX Basket Commodities Corporate Bonds Emerging Market Bonds High Yield Bonds

2000‐2007 2008‐2011

Correlation to Global Equities of “diversifying assets”

Buy portfolio insurance?

Historically you would have needed to pay 1.7% per quarter,

• n average, to cap losses at 5%

200 400 600 800 1000 1200 1400 1600

S&P 500 Total Return Index Protected index, no cost Protected index allowing for cost Cash Return Index (3m rates)

Tail risk protection as many imagine it would be

2.2% p.a. 1800

Characteristics of strongly‐diversified portfolios

• Benchmark agnostic / adaptable to changing conditions
• Broad Investment freedom
• Risk controls – guard against hubris, concentration and event risk
• Sound philosophy and process

Broad Opportunity Set

Traditional risk‐premia

• Selective Equity, Credit and Real‐Estate exposures
• Security selection – ‘alpha’

Cyclical / Directional opportunities

Interest rates Australian Short‐Term Duration, Brazilian Gov’t Bonds Currencies Long Mexican Peso vs Australian Dollar Volatility Long Equity Variance

Relative value

Geography Japanese vs Korean Equity Sector/Size Large US Tech vs US Small Cap Interest rates EU 10 year vs US and Japan 10 year rates

USD vs CAD and European equity performance

0.85 0.90 0.95 1.00 1.05 1.10 1.15 200 250 300 350 400 450 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14

Stoxx Europe 600 Total Return Index (LHS) USD/CAD (RHS)

Source: Standard Life Investments & Bloomberg

Investment thesis

• US dollar undervalued and safe

haven status

• Canadian economy debt issues and

resource based

• Canadian exporters priced out
• USD / CAD is a risk‐off strategy
• European equities is a risk‐on

position

• Negatively correlated (‐0.17 last 2

yrs) but positive return from each

Broad based return potential with genuine diversity

Correlation to Global Equity

• 1.0
• 0.5

0.0 0.5 1.0

US equity European equity Global equity miners High yield credit Short US Duration Long European payer swaptions Mexican rates v EUR German v French equity Long INR v EUR Brazilian government bonds European v US and Japanese duration Long MXN v AUD European v US and Japanese duration EU corporate bonds Australian forward‐start interest rates US equity tech v small cap Long USD v EUR US butterfly Long USD v CAD

Source: Standard Life Investments, Sungard APT, 31 March 2015

Step 1: Evaluate Current Risk Profile

• Ensure portfolio

exposed to multiple risks & none dominate

• Total stand‐alone

investment risk adequate to achieve the objective

• Portfolio risk analysis

shows the benefits of investment diversification

Source: Standard Life Investments GARS SICAV portfolio, 31 March 2015

Total stand‐alone risk

8.8% 3.7% 0% 2% 4% 6% 8% 10% 12% 14%

Diversification Expected volatility

Directional Market Returns Relative Value

Security Selection

‐28‐26‐24‐22‐20‐18‐16‐14‐12‐10 ‐8 ‐6 ‐4 ‐2 2 4 6 8 10 12 14 16 18

Black Monday 1987 Gulf War 1990 Rate Rise 1994 Mexican Crisis 1995 Asian Crisis 1997 Russian/LTCM Tech Wreck (April 07 ‐ 14, 2000) Sept 11th Equity Sell‐Off (August 23 ‐ October 09, 2002) Equity Rally (October 10 ‐ November 27, 2002) Gulf War 2 (March 01 ‐ 23, 2003) Bond Rally (May 01 ‐ June 13, 2003) Bond Sell‐Off (June 14 ‐ July 31, 2003) Emerging Market Sell‐Off 2006 (May 01 ‐ June 08, 2006) Subprime Debacle 2007 (July 15 ‐ August 15, 2007) Bank Meltdown 2008 (September 12 ‐ October 15, 2008) Euro Crisis (July 22 ‐ August 23, 2011) QE jitters (May 22 ‐ June 24, 2013) % Move

MSCI World (EUR) move over same period* GARS Portfolio

Step 2: Historical Scenario Analysis

* MSCI World Returns prior to 2000 denoted in European Currency Units, except for 1987 which is denoted in German Marks Source: GARS SICAV, RiskMetrics, 31 March 2015

World Economic Forum 2013:

• Economic / Environmental
• Geopolitical / Societal
• Technological

What do you envisage the flashpoints could be?

Step 3: Forward‐looking Scenarios

China crisis Trade war Commodity shock Acropolis Now Dunkin’ Disappointment Cold War 2

China Crisis

Combining expert judgement with quantitative discipline

Description Key Factor

(examples)

Shock

(estimates)

Property market slowdown causes growth to drop sharply Oil ‐47% Fixed asset investment deteriorates Australian Dollar ‐15% Labour market strained, wage growth and consumption slows HSI ‐60% Risk of banking crises as defaults rise 10y US Treas. Yld. ‐50bps Social/political unrest as government forced to recapitalise banks

Sources: Standard Life Investments & Bloomberg, March 2015

Acropolis Now

Description Key Factor

(examples)

Shock

(estimates)

Debt re‐profiling unsuccessful so Greek exit is prepared European Equity ‐40% Depositors withdraw bank deposits and gov’t bonds default Euro ‐15% QE fails to stem contagion through Europe and beyond Italian 10y yld +300bps Political uncertainty in UK and Spain makes investors nervous German 10y yld ‐30bps

Sources: Standard Life Investments & Bloomberg, March 2015

Dunkin’ Disappointment

Description Key Factor

(examples)

Shock

(estimates)

Wages slow, suppressing confidence and spending US Large Cap ‐12% Margins and revenue static, earnings disappoint pressuring wages US$ ‐5% Rate hikes delayed, curve flattens and USD sells off Brazilian Real ‐5% US, as engine for world recovery, causes EM currencies to weaken 10y US Treas. Yld. ‐40bps

Sources: Standard Life Investments & Bloomberg, March 2015

A word on market volatility and outcome uncertainty…

Longer investment time periods appear to make the return more consistent

Source: Standard Life Investments, Datastream, S&P500 Index total return from 1965 to 2014

Market volatility and outcome uncertainty

In fact the outcome for investors becomes more varied

Source: Standard Life Investments, Datastream, S&P500 Index total return from 1965 to 2014

Investment Strategies for Pensions

Portfolio governance that enables:

• Broad Investment freedom
• Balance of portfolio risk
• Sound philosophy and process