The objective of an occupational DB pension scheme is simple pay members their

Transcription

1 October For professional investors only. Please read the important disclosure at the end of this article. spotlight Supporting the liability-hedging and return-seeking demands of a modern LDI strategy Julian Lyne Global head of distribution A firm foundation: absolute-return funds in an LDI strategy The objective of an occupational DB pension scheme is simple pay members their benefits in full and on time. The reality of achieving this premise, however, can be more complex. There are two moving parts within a pension scheme that determine the ease with which benefits can be paid: first, assets that is the amount the pension scheme has available to pay pensioners, and, second, liabilities the amount the scheme owes. Any deficit between those assets and liabilities can only be closed by additional cash contributions and/or investment returns. Changes in regulation, volatile market conditions and increasing life expectancy have caused the gap between assets and liabilities to grow (see exhibit 1 below). Consequently, more schemes are turning to investment strategies that better match the movement in their assets to the movement in their liabilities. Liability-driven investment (LDI) is one such approach. EXHIBIT 1: HISTORICAL AGGREGATE BALANCE (ASSETS LESS SECTION 179 LIABILITIES) AND FUNDING RATIO OF SCHEMES IN THE PENSION PROTECTION FUND UNIVERSE (billions) Aggregate balance (LHS) Funding ratio (RHS) A scheme s section 179 liabilities represent, broadly speaking, the premium that would have to be paid to an insurance company to take on the payment of Pension Protection Fund levels of compensation. Source: Pension Protection Fund 7800 Index, 30 June Data represents estimated aggregate assets and liabilities of the 5,945 UK pension schemes in the PPF 7800 Index % 1

2 LDI strategies create two pools: liability-hedging The first is a liability-hedging pool which focuses on investing in assets that move in the same way as factors that cause liabilities to grow. These factors include falling interest rates, rising inflation, and increasing longevity. Investing in assets that match movements in liabilities is known as liability hedging and typically uses physical bonds and derivatives in order to add leverage to the physical bonds held. Swaps and gilt repurchase agreements are also becoming common instruments for pension scheme trustees. A swap is simply an agreement between two parties to exchange a series of cash flows. For example, a pension fund may pay an investment bank a floating rate of interest, and receive an agreed fixed rate of interest in return. This is similar to a fixed-rate mortgage arrangement which many home owners now choose. return-seeking The second LDI pool is a return-seeking pool, which seeks to find additional return to fill any funding gaps and make it easier to pay benefits. It may include growth assets such as equities. EXHIBIT 2: SWAPS IN ACTION Inflation = expectations Fixed (at expected inflation) Inflation higher than expectations Fixed (at expected inflation) Inflation lower than expectations Fixed (at expected inflation) Pension fund Counter party Pension fund Counter Pension party fund Counter party Floating (actual inflation) Floating (actual inflation) Floating (actual inflation) No net impact on either party For illustrative purposes only. Pension fund gains on swap will have grown Pension fund makes loss on swap will have fallen What is involved in LDI? The starting point with LDI is to understand a scheme s liabilities and how these are likely to grow in the future. Prevailing running yields on risk-free gilts (plus some margin) or AA-rated corporate bonds are often used to determine the EXHIBIT 3: HEDGING CONCEPTS Source: Mercer. For illustrative purposes only. 0% hedged Yields fall 100% hedged Yields fall present value of those future (benefit) liabilities. The lower the yield on bonds, the lower the expected investment return over the period and thus the higher the present value of the liabilities today. It makes sense, therefore, to choose fixed-income assets for a liability-hedging portfolio since they respond to changes in interest rates in the same way as liabilities (see exhibit 3). However, the maturity of fixed-income assets is often too short to provide the long-term hedge needed by most pension funds. Secondly, most bonds (index-linked issues being the exception) fail to provide risk protection against rising inflation. Finally, investing in traditional bonds locks investors capital in and prevents them from seeking additional return elsewhere. Including swaps in an LDI strategy helps to mitigate some of the limitations of bonds by providing better duration matches and, through leverage, freeing up assets to be better employed in seeking return. As LDI has evolved, the approach to both return-seeking and liability-hedging assets has changed, with many schemes now adopting an LDI approach. 2

3 LDI in action When pension funds enter into a swap arrangement as part of a liability-hedging strategy in LDI, both parties need to provide collateral to secure the deal. In the past, schemes have relied on cash or gilts since these are low risk and liquid. Should the worst happen and the cash reserves not be sufficient to meet collateral agreements, schemes may be forced to sell assets, which can be costly and damaging. In seeking to support an LDI programme and potential cash calls, investing in liquid, return-seeking, and (relatively) low-risk assets alongside cash and gilts can help to mitigate against the dangers of forced selling at inopportune moments. Multi-asset absolute-return funds, unconstrained by traditional benchmarks, can offer a route to stable returns, with the additional benefit of capital preservation Schemes can put a liquidity ladder in place which has cash and gilts on the lowest rungs and gradually adds higher-return options above those. This approach may be particularly useful following the prolonged period of quantitative easing which has sent gilt yields to their lowest levels on record and meant government bonds can arguably be said no longer to enjoy their risk-free status. Those assets might include currency forwards, equity futures, or absolute return funds which invest in a range of fixed-income assets. LDI evolution has not been limited to the liability-hedging pool; the return-seeking side of the approach has also undergone important development. Diversification has become increasingly important in return-seeking strategies both to limit volatility and to allocate tactically to the best market opportunities. Multi-asset absolute-return funds, unconstrained by traditional benchmarks, can offer a route to stable returns, with the additional benefit of seeking to preserve capital. The focus for LDI strategies today, across both their pools (liability-hedging and return-seeking), is the right mix of global diversification, freedom from benchmark constraints and the ability to protect capital against volatility and downside loss. EXHIBIT 4: LDI SUMS For illustrative purposes only. + x% = Liability-hedging pool Swaps (interest rate, x etc.) Options Futures Fixed-income instruments Currency hedges Commodities Fixed-income absolute return strategies + Return-seeking pool Equities Renewables Infrastructure Corporate debt Convertibles Multi-asset absolute return strategies The right ingredients Fixed income is at the heart of the liability-hedging pool in LDI strategies. With bond yields at historic lows, the asset class faces a challenging future, but where a manager is free to invest based on their conviction and knowledge of the markets, opportunities can still be found. An unconstrained manager investing across a range of fixed income assets can use their knowledge, experience and skill to invest in regions, sectors and economies that present the greatest chance of meeting their investment objectives. By employing a dynamic approach, the manager can react to market conditions, as well as divergences between regions, currencies and economic policies, and change course to try to deliver the best outcome. At the same time, by taking risk-offsetting positions and investing in stabilising assets, an investment manager can seek to preserve capital and protect a portfolio from downside loss. Having an absolute-return (e.g. Libor + ) aim for these approaches is also consistent with the wider LDI objective. Using this globally diversified, absolutereturn approach can be beneficial on the return-seeking side. By targeting a higher return and including assets outside fixed income, absolute-return multi-asset funds can provide the necessary return-seeking element needed in an LDI strategy. An absolute-return multi-asset fund invests in a range of assets from traditional bonds, equities, cash and property, to more alternative classes such as renewable energy and infrastructure. These funds also include stabilising assets such as index-linked bonds, commodities, and risk-offsetting currency and equity hedges. 3

4 Where Newton fits in clients LDI approaches At Newton we have two tried and tested strategies that support both the liability-hedging and return-seeking demands of a modern LDI strategy. We have a number of clients using these as part of an LDI mandate. Strategy 1 Newton Global Dynamic Bond strategy Invests in a globally diversified range of fixed-income assets. The strategy is dynamically managed, and bond investments and currency positions are driven by our interpretation of market opportunities and risks. An unconstrained approach gives us the freedom to move dynamically between different regions, asset classes and currencies to try to weather market turbulence while continuing to deliver returns. The focus is in on simple, liquid fixed-income assets which are divided into a returnseeking core and a stabilising outer layer, both of which are dynamically managed. The Global Dynamic Bond strategy aims to deliver 2% a year above one-month LIBOR before fees over rolling five-year periods, and also aims to achieve a positive return on a rolling three-year basis. 1 The Newton Global Dynamic Bond Fund has achieved an annualised gross return of +7.0% since inception in An unconstrained approach gives us the freedom to move dynamically between different regions, asset classes and currencies EXHIBIT 5: A FUND WE BELIEVE IS FIT FOR ALL CONDITIONS: NEWTON GLOBAL DYNAMIC BOND FUND Low return world, too much leverage Credit crunch Quantitative easing Eurozone crisis Mario saves the day Taper Tantrum Commodity deflation Commodity deflation fallout Price (index) Source: Bloomberg, Newton (May 2006 to June 2016) For illustrative purposes only. Performance shown is for the Newton Global Dynamic Bond Fund, in GBP, net of fees since its inception 28 April The strategy aims to deliver a minimum return of cash (one-month GBP LIBOR) +2% per annum over 5 years before fees. In doing so, the strategy aims to achieve a positive return on a rolling 3-year basis. However, a positive return is not guaranteed and a capital loss may occur. 2 Source: Newton, 30 September 2016; inception was 1 May Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested. Please see important information at the end of this document. 4

5 Strategy 2 Newton Real Return strategy This strategy, launched in 2004, seeks to deliver an absolute return (of one-month LIBOR +4% per annum over five-year periods and a positive return on a rolling three-year basis), while aiming to preserve capital. 3 It has the freedom to invest in multiple asset classes. Again, the emphasis is on simplicity and liquidity, with the team responsible for its management able to invest across multiple asset classes based on their best ideas. The Real Return strategy invests in traditional asset classes comprising a core of return-seeking assets, which is supported by stabilising assets that aim to hedge risks and dampen volatility. Physical gold Gold equity Stabilising assets / hedging positions Cash / short-dated bonds Current returnseeking assets Corporate debt Currency hedge Active currency positions We choose assets based on our views about long-term trends across the investment landscape, and we adapt to changes in market conditions and economic policies. The strategy aims to keep volatility between that typically shown by bonds and equities. Equity market hedges Equity option strategies Equities Renewables Infrastructure Convertibles Government bond options Conventional government bonds The Newton Real Return Fund has achieved an annualised gross return of +8.8% since inception in 2004, and a gross positive return in every year over that period. 4 Floating rate notes Commodities Index-linked bonds EXHIBIT 6: NEWTON REAL RETURN FUND PERFORMANCE SINCE INCEPTION TO 30 JUNE Total return % Newton Real Return Fund LIBOR 1 Month +4% p.a. MSCI AC World NDR FTSE Govt. All-Stocks Relaunched to new mandate 1 April The Fund aims to deliver a minimum return of cash (1 month LIBOR) +4% p.a. over five years before fees. In doing so, the Fund aims to achieve a positive return on a rolling three year basis. However, a positive return is not guaranteed and a capital loss may occur. Source: Lipper, weekly data, total return, gross of management fees, gross income reinvested. Figures are based on sterling returns. 31 July Comparisons are made to demonstrate correlation only and are for illustrative purposes only. Performance calculated as total return, income reinvested, gross of charges in sterling. 3 The strategy aims to deliver a minimum return of cash (one-month GBP LIBOR) +4% per annum over 5 years before fees. In doing so, the strategy aims to achieve a positive return on a rolling 3-year basis. However, a positive return is not guaranteed and a capital loss may occur. 4 Source: Newton, 30 September 2016; inception was 1 April Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested. Please see important information at the end of this document. 5

6 At a glance Newton Global Dynamic Bond strategy Aim One-month sterling LIBOR +2% per annum over five years before fees, with a positive return on a rolling three-year basis.* Performance Annualised gross return of +7.0% since inception. Strategy size 2.0 billion (as at 30 Sep 2016) Key characteristics Unconstrained, dynamic and actively managed; uses a mixture of returnseeking and hedging techniques; global, thematic approach; focus on traditional fixed-income assets. *A positive return is not guaranteed and a capital loss may occur. Newton Real Return strategy Aim One-month sterling LIBOR +4% per annum over five-year periods, with a positive return on a rolling three-year basis.* Performance A gross positive return in every year since inception, and an annualised gross return of +8.8% since inception. Strategy size 10.0 billion (as at 30 Sep 2016) Key characteristics Emphasis on traditional asset classes; a return-seeking core with particular security characteristics; risk-offsetting positions aiming to dampen volatility and preserve capital; portfolio combines the characteristics of securities and asset classes. *A positive return is not guaranteed and a capital loss may occur. Julian Lyne Julian is responsible for all aspects of Newton s global distribution and marketing efforts. He joined Newton in 2014 to lead the global consultant relations and UK institutional business development team. Prior to joining Newton, Julian was Head of Institutional Business at F&C. Throughout his career he has held various roles covering client and consultant relations across both DC and DB arrangements. Further information Please contact our consultant relations and business development team: Telephone: newton_institutional@newton.co.uk Your capital may be at risk. The value of investments and the income from them can fall as well arise and investors may not get back the original amount invested. 6

7 Important information This is a financial promotion. This document is for professional investors only. Past performance is not a guide to future performance. Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested. You should read the Prospectus and the Key Investor Information Document (KIID) for each fund in which you want to invest. The Prospectus and KIID can be found at Portfolio holdings are subject to change at any time without notice and should not be construed as investment recommendations. Compared to more established economies, the value of investments in emerging markets may be subject to greater volatility due to differences in generally accepted accounting principles or from economic, political instability or less developed market practices. The opinions expressed in this document are those of Newton and should not be construed as investment advice or any other advice and are subject to change. This document is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors. Please note that portfolio holdings and positioning are subject to change without notice. The value of overseas securities will be influenced by fluctuations in exchange rates. Where the portfolio is invested in sub-investment-grade bonds, which typically have a low credit rating and carry a high degree of default risk, please be aware that this may affect the capital value of your investment. In the UK, this document is issued by: Newton Investment Management Limited The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA Tel: Registered in England No Registered office: As above. Newton Investment Management is authorised and regulated by the Financial Conduct Authority. BNY Mellon Asset Management is one of the world s leading asset management organisations, encompassing BNY Mellon s affiliated investment management firms and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation. newton.co.uk 7