WORLD DIVERSIFICATION FOR AN UNCERTAIN

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1 DIVERSIFICATION FOR AN UNCERTAIN WORLD A wave of political uncertainty has proven challenging for markets and investors in recent months. For DC members, short-term volatility can be unsettling. We gathered a group of industry experts to discuss how DC schemes are seeking to guard against volatility. 8 State Street Global Advisors Investment

2 02 Chris Inman Mehvish Avub From Brexit to Trump, 2016 was a year in which the unexpected became reality. Subsequent political uncertainty has contributed to choppy markets and a complex environment for investors, according to our roundtable of experts. Altaf Kassam, EMEA head of strategy and research in SSGA s investment solutions group, summed up the views of many: This is the toughest investment environment that many people have seen in their careers, with interest rates historically low, great political uncertainty and an unpredictable impact on financial markets. Pension schemes are unlikely to get much respite in Kassam pointed to the Italian referendum and the implication of a potential hard Brexit in the UK as particular pressure points. The political risk in Europe this year is worrying, agreed Mark Fawcett, chief investment officer of pension scheme NEST. In particular, the French election I think it s unlikely that National Front leader Marine Le Pen will win, but then we thought it was unlikely that Brexit would happen or that Trump would win the US election. Amid such uncertainty, market sentiment can swing from one day to the next. And any ensuing volatility creates a challenging backdrop for DC schemes and their members. For many schemes, that has elevated the imperative to ensure portfolios are adequately insulated. They re responding with innovative governance solutions and dynamic asset allocation strategies, as well as considering the potential diversification opportunities of alternative asset classes. Governance as First Line of Defence Increasing numbers of trustee boards are electing to delegate dayto-day asset allocation decisions to investment professionals as a way of being better positioned for shifts in the markets. This can take many forms from NEST s in-house asset allocation model to outsourced investment solutions like dynamic multi-asset funds and target date funds. We keep adding asset classes. It s important to keep up with all the opportunities available, said Fawcett. Pension schemes with in-house investment teams are often able to be more nimble and dynamic than trustee boards, which typically meet quarterly. Roundtable Participants Mehvish Ayub Senior Investment Manager, Investment Solutions Group, SSGA Mark Fawcett Chief Investment Officer, NEST Chris Inman Investment Principal and Head of DC Investment Advisory, Aon Hewitt Altaf Kassam EMEA Head of Strategy and Research, Investment Solutions Group, SSGA Ian Maybury Independent trustee Laura Myers Partner and Head of DC investment, Lane Clark and Peacock Chaired by Alistair Byrne, Senior DC Strategist, State Street Global Advisors. Contribute Diversification for an Uncertain World 9

3 Laura Myers NEST s trustees have set parameters for their in-house investment team. They also set a risk budget and high-level return objective for the scheme s growth phase. Fawcett says the constraints give the team plenty of latitude to shift their asset allocation, based on a medium to long-term view, as and when the right opportunities arise. Of course, not every scheme has the scale and resources to support an in-house investment team. Smaller pension funds typically look to investment managers and advisers to help them adjust investments more dynamically. Fiduciary management for DC is growing in popularity, as are multiasset funds, where investment managers invest in a wider range of assets to help manage downside risk and maximise returns. Clear performance expectations should be set for any delegated governance arrangement, cautioned independent trustee Ian Maybury. I think the real challenge for trustees, particularly with an outsourced model, is to establish the value of dynamic asset allocation, because typically we are paying higher fees. Before investing in a multi-asset fund, it is vital to get back to basics, agreed Chris Inman, investment principal at Aon Hewitt. It s about digging down into a multi-asset portfolio s component parts and thinking about what risks I want to mitigate. We need to take it back to first principles and ask: What are we actually trying to achieve? What is the objective? In the absence of clear expectations, trustees can be disappointed about how multi-asset funds perform, said Maybury. If multi-asset is going to do what it s meant to do, i.e. reduce volatility, it s going to underperform at some stage. I think trustees haven t been very good at asking the right questions or advisers haven t been good at explaining the purpose of multi-asset. It's about digging down into a multi-asset portfolio's component parts and thinking about what risks I want to mitigate. Chris Inman Investment Principal and Head of DC Investment Advisory, Aon Hewitt Ian Maybury 10 State Street Global Advisors Investment

4 New Diversification Frontiers DC schemes are also exploring new asset class frontiers in a bid to diversify market risk. Multi-asset credit and absolute return bond strategies are the main talking points, given the rotation away from gilts. said Inman. Inman has some concerns about absolute return bonds, however. We re in a rising interest rate environment, so where do we go? Absolute return bonds. But the history of performance hasn t necessarily been there so it's certainly a watch point." Interest in illiquid assets is also growing. Maybury confirmed: In Search of Diversification Alistair Byrne I am really keen to find a way to use some of the illiquid assets in DC, particularly post-retirement. Property Smart Beta Multi-Asset Ian Maybury, Independent Trustee Credit Alternatives Infrastructure Private Debt Absolute Returns Private Equity I am really keen to find a way to use some of the illiquid assets in DC, particularly post-retirement. However, accessing such investments in a world where daily pricing is often an expectation is a challenge. Laura Myers, partner and head of DC investment at Lane Clark and Peacock, cautioned: We are still in the very early stages of being able to do anything in a DC capacity. We are really looking to managers for daily pricing on some of these funds. She continued: There are some funds out there which are using private equity and private debt, but you still have all the issues you get with illiquids, so trustees need to go in with their eyes wide open. It will only really be available to the largest schemes because of the charge cap and having to factor in a performance fee on some of these funds. Fawcett confirmed: We would really like to go into infrastructure at some point. The problem with infrastructure equity is there is so much money chasing the assets. We are happy with the illiquidity; the problem is the cost of access. As we get bigger, we hope there will be more options for us. Contribute Diversification for an Uncertain World 11

5 Despite some reservations, potential solutions may not be far off, according to Myers: We are a lot closer to finding a solution than we used to be a couple of years ago. There has been a lot of momentum from managers to create a solution that is available on platforms. Smart beta strategies are also broadening the opportunity set. Mehvish Ayub, senior investment manager in SSGA s investment solutions group noted: Smart beta can help diversify in a world where markets are not easy to time. I don t think there is a very clear way of pinpointing when is a good time to invest in value or when is a good time to invest in quality for example. I think a well-diversified portfolio of factors in a multi-factor approach is a better direction. Balancing Risk and Return at Retirement Freedom and Choice has put the spotlight on the need for diversification at retirement. Myers remarked, My concern is about clients who haven t updated their strategy since Freedom and Choice Addressing the Diversification Challenge UK DC Growth Expectations (year-on-year) MULTI ASSET 24% PROPERTY AND OTHER 21% Target Date Funds: % of Multi-Asset Allocations EQUITY SMART BETA 42% 1% 27% Source: Spence Johnson The above growth expectations are based on certain assumptions and analysis. There is no guarantee that the estimates will be achieved. WHY ARE SCHEMES CONSIDERING DIVERSIFICATION WITH SMART BETA? RISK-ADJUSTED PERFORMANCE IMPROVED DIVERSIFICATION CHARACTERISTICS VOLATILITY MANAGEMENT COMFORT FOR FIDUCIARIES SIMPLICITY PASSIVE APPEAL Better than traditional capweighted indices over time Compared to traditional cap-weighted-only portfolios Using factor strategies that target Quality or Low Volatility stocks Predictable exposure to specific factors can reduce oversight responsibilities Transparent rulesbased approach is simple for members to understand Lower management fees and low turnover compared with active approaches 12 State Street Global Advisors Investment

6 they may find there are a lot of people with large pots at retirement who are sat in long-dated bonds. Looking at the evidence about what people are actually doing postretirement, can a pension scheme really claim to have thought most members were going to buy an annuity at retirement? More sophisticated approaches to volatility management are especially important as members approach retirement. Myers continued: Members can handle volatility in the early years. However it really does matter closer to retirement which is why it s key to bring in diversification rather than sit in a single asset class like long-dated bonds. Cutting out severe downside risk for savers is a primary research focus at SSGA. said Kassam. We can build in protection mechanisms into portfolios to help insulate investors from risk. Essentially we dial portfolio risk up and down with assets like cash to achieve a target level of volatility. That has been a popular strategy. Lifestyle funds, with their inbuilt derisking, could be on the way out, predicted Inman. Mark Fawcett Cutting out severe downside risk for savers is a primary research focus Altaf Kassam EMEA Head of Strategy and Research, Investment Solutions Group, SSGA Drawing on his experience of the Australian pensions market, he explained that derisking to a set point doesn t make a great deal of sense when savers will be living off their pensions for 20, 30 or even 40 years. It makes a little bit more sense to have diversification the whole way through, different levels of diversification, but without that hard-line switch into cash and fixed income. It s certainly what we sought to do with our Timewise Target Retirement fund range. Asset allocation is designed to account for the flexibility needed for members to use their benefits in different ways while preserving some growth assets at the target date. added Alistair Byrne, senior DC strategist at SSGA. While equity markets recovered strongly post-brexit, ongoing geopolitical uncertainty continues to undermine market confidence. It s a reminder of the need for adequate investment oversight and strategies that are vigilant to the potential for the market s downside to erode member confidence and long-term investment outcomes. Altaf Kassam WATCH Visit ssga.com/ukdc to watch our video on How to Use Smart Beta in DC. Contribute Diversification for an Uncertain World 13

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