Outline March 2014

March 2014

1

1 Clear Goals and Objectives

2 LDI and Overlay Strategies

3 Liquid Market Strategies

4 Liquid and Semi Liquid Credit Strategies

5 Illiquid Credit Strategies

6 Illiquid Market Strategies

7 Ongoing Monitoring

SEVEN STEPS

Redington designs, develops and delivers investment strategies to help pension funds and their sponsors close the funding gap with the minimum level of risk. We take our clients through a rigorous 7 Steps to Full Funding™, which begins with laying out clear goals and objectives and assigning tasks and responsibilities. The second step is building an LDI Hub, or putting in place a risk management toolkit. Steps 3-6 involve crafting the right investment strategy to fit the need using a full range of tools and bearing in mind the goals and constraints of the scheme. Finally, ongoing high quality monitoring is essential to continually track progress against the original objectives and guide smart and nimble changes of course.

Introduction 2

The Future of Pensions 3

Helicopter Pilots Required 4

The Evolution of ALM: Towards More Helpful Decision-Making Tools 5

Gilt and Swap Rates May Differ 2 6

Future Widening of LDI Toolkit 2 7

DGFs Revisited 3 8

Redesigning Fund Management Around Outcomes 3-6 9

The Balancing Act: Reinvestment Risk vs Illiquidity Risk 5 10

2013 Asset Class Review 1-7 11

Global Macro Overview 1-7 12

Further Information and Disclaimer 13

Contents

O U T L I N E March 2014Contents

STEP PAGE

Introduction

Gurjit DehlVice President, Education & Research

[email protected]

Welcome to the fifth edition of Outline, Redington’s quarterly collection of thought-pieces designed to help institutional investors make smarter and more informed decisions.

This edition features short articles on the future of pensions policy, the complexities of running a pension scheme and how technology can help overcome them, risks inherent from gilt and swap rate differences, an outcome-driven approach to fund management, a review of asset classes in 2013, plus an overview of the global macro environment.

We hope you find the articles interesting and helpful as you consider how best to manage the risk-adjusted return of your portfolios.

For more information on any of the topics, please do get in touch.

Kind regards,

Gurjit Dehl

OUT LINE

2O U T L I N E March 2014Introduction

If we are looking to the future, we must understand how we got to this point and where we may go from here. Is legislation the best path to ensure successful Defined Contribution outcomes, or will the pensions industry lead the way?

Today, there are a number of notable features to UK pensions policy:

1. Consensus from all main parties on key features, such as auto-enrolment, later retirement and a more generous flat rate state pension

2. Too few people are saving enough for retirement

3. Personal responsibility to save lies at the heart of the policy framework

4. Years of negative pensions headlines and a culture that values consumption over saving

5. Defined Benefit (DB) is in its final stages, Defined Contribution (DC) will do the heavy lifting for the next generation of savers

6. State pension looks like it might be on an unsustainable course

The key to understanding the future lies in understanding the progress made by this policy agenda. Firstly, auto-enrolment (AE) appears to have been positively received, despite some influential voices already calling for change. I think compulsory savings are unlikely to happen anytime soon. It is much more likely that we will see a continuing debate about the adequacy of

contribution levels. There is good evidence now that median earners are those most at risk of not building up an adequate pension. Secondly, regulatory reforms in DB have relieved financial pressure on schemes. However, my view is that they will not have any profound impact on the trend away from DB to DC. Thirdly, the real focus on future reforms will be on DC - governance, structure and most important of all, outcomes. This is the most interesting area to me.

Future of DC: Legislation vs Innovation

There is a clear sense in politicians of all Parties that DC is not delivering sufficient levels of retirement income when compared to DB. The Department of Work & Pensions’ (DWP) agenda is now clear: How can we improve DC? Are big bang solutions involving all the paraphernalia of legislation and associated regulation the right way forward, or can the industry craft a way forward?

Legislation is likely to happen. The top-down approach by government is looking at two options – guarantees on the value of an individual’s pension contributions (and possibly some form of investment return guarantee), and Collective Defined Contribution (CDC). I can see the superficial attraction of both options, although the real test of any proposal comes when you look behind the headlines.

Is there an alternative? I would very much prefer a bottom-up approach with the pensions industry itself looking at how we can maximise retirement income and manage the risk of not achieving this. What sort of pension do savers want to realise and how do we deliver this for them? What can we learn from LDI and how can we apply these principles in a DC context? That’s the debate we should be having.

The Future Of Pensions

3O U T L I N E March 2014Overview

Lord Hutton Of FurnessAdvisor to Redington

They say flying a helicopter is one of the hardest skills to learn. That’s because it involves hyper-multi tasking under pressure: making the helicopter tilt forward and back (pitch), sideways (roll), and varying the “angle of attack” of the main rotor blades - all at the same time.

A delicate combination of gentle pressure and light touch handling is simultaneously required on the cyclic stick, the collective lever and the anti-torque pedals, not to mention the twist throttle. Pull the wrong lever, press the wrong pedal or squeeze the wrong bit and it’s Game Over. A helicopter pilot understands exactly how the levers work (separately and together) and the constraints within which they have to be operated.

This is a metaphor for managing a defined benefit pension fund, which has its own plethora of levers and complex, interlinked, operating constraints. For instance, every pension plan requires a clearly articulated Risk Budget (Lever 1) calculated with reference to the Sponsor’s Covenant (Constraint 1) and the agreed timeframe to achieve full funding (Lever 2). The corporate sponsor may pour extra fuel into the tank (also known as “making additional contributions”) and, alongside this Lever 3, the trustees can re-allocate the plan’s assets, so as to increase Expected Return (Lever 4).

But, as the Bard put it: “The fault, dear Brutus, lies not in the assets but in the liabilities”. It is pension funds’ long-dated, (sometimes inflation linked) obligations that are the source of the world’s defined benefit pension deficits. Lever 5, then, is

the all-important application to the pension plan’s liabilities of a hedge against declining interest rates, whilst Lever 6 is the reduction of the plan’s sensitivity to volatile, rising inflation expectations. These levers (5 and 6) are calibrated against the Discount Rate (Constraint 2) as well as the Funding Level of the pension plan (Constraint 3). Ignore that, and you begin to stress the assets; to ask more of them than you reasonably ought. And, as every pension plan trustee will know (at least, those that have gained their pilot’s licence) the use of Levers 5 and 6 (namely, the application of a hedging strategy) dramatically impacts the plan’s pitch, roll and angle of attack.

Now it starts to get interesting; it may make sense to apply Levers 5 and 6 utilising your long dated, investment-grade bonds, or a portfolio of index-linked government bonds. Sometimes, though, it’s better to use swaps. It all depends on the curiously named z- spread (which happens to be Constraint 4) and the extent to which some of the pension plan’s assets qualify as Eligible Collateral. That’s Constraint 5 - which is dictated (to a large extent) by Lever 1. Talking of Lever 1 (the proper function of which, as we have seen, is closely tied to Lever 2), it is critical that its various sub-levers and pedals are also understood. Without them, you run the peril of allocating a risk budget that ignores the pension plan’s all important Required Rate of Return (Constraint 6).

So, in conclusion, let’s just say this: Those pension plans that are well funded and en route to their destination despite the desperately bad weather? That didn’t happen by accident. And, if most of the above is impenetrable, that’s because, like flying a helicopter, it’s hard to explain in 500 words.

Helicopter Pilots RequiredDawid Konotey-AhuluFounder & Co CEO

[email protected]


The Evolution of ALM: Towards MoreHelpful Decision-Making Tools

How do an engineering degree and a pilot’s license help one build the tools that help pension schemes reach their goals?

As head of the ALM Development team, my previous experience in engineering with the RAF has proved invaluable in building the tools that help pension schemes better measure and manage their risk and returns.

As always teamwork is the key. A good development team will apply consistent hard work to building software, whilst constantly honing their skills. This allows the team to regularly deliver new functionality, but also be able to respond quickly to ideas or client demands. New ideas can come from anywhere and often seem insignificant at the time. It is our role to recognise the good ones, and act on them, as they can often give the company a massive leap forward in capability.

Early days

At the start of Redington, with five people in the firm, we relied on best-of-breed analytics tools built by external parties. This meant that we could get up and running quickly, without building anything ourselves.

Automating the analytics

We pushed these systems hard, modelling multi-asset portfolios and pension liabilities, and soon hit limitations. The most pressing problem was the time it took to run a full ALM analysis using the web interface of our core system, RiskMetrics. We set up a small development team to focus on this problem. Oakley was built to automate our interactions with RiskMetrics, enabling us to quickly and easily run analysis directly in Excel. The outcome was a fivefold increase in productivity.

Refining the risk modelling

As the firm’s advice to clients developed and matured we became restricted by pension specific modelling that generic risk systems just couldn’t do. This became our clarion call; focus on the tricky bits which are most important to pension schemes. From this RedAnalytics was born.

The first module included market consistent yield and inflation curves. This was driven by the need for accurate PV01s and IE01s to design and implement hedge portfolios. Since then RedAnalytics has been continuously extended to cover all the complexities of pension liabilities and LDI portfolios.

What about returns?

Risk is one only one dimension of our advice; the other is return. Analysts put together a Flight Plan model to calculate the return needed for a scheme to reach full funding. By building this into our system we can run 10,000 Flight Plans in a Monte Carlo simulation. This gives us new metrics, Required Return at Risk and Contributions at Risk –showing VaR-type risks for the required returns or contributions.

Productivity

Having all these fantastic models and analytics is great, but not if it takes an age to run the numbers. Over the last 12 months, the team has built Portfolio Blender. This can take outputs from both external and internal systems and mix them in any combination. Results are instantly updated. The team’s productivity has leapt forward again. Freed from much of the manual drudgery analysts can explore many more strategies for our clients.

Excitingly, RedAnalytics and Blender have been combined into an interactive Flight Plan. This tool enables consultants and clients to run “What If…” scenarios. They can instantly see the effect of certain key decisions on their long term trajectory and path, instead of conducting long and drawn-out assessments of actions that may turn out not to be appropriate. Client meetings can focus more on exploring strategies, building consensus and making decisions.

As pension funds navigate through increasingly complex circumstances and financial solutions, we will continue our work in making analyses of these comprehensive, accurate and digestible. Our goal is to offer pension funds the chance to make decisions with greater confidence, thereby ultimately leading to better results for their members.

Peter HowarthDirector, ALM & Technology

[email protected]


Gilt and Swap Rates May Differ

Pension schemes with a set risk budget may find the spread between gilts and swaps dominating it. Daily data for both 30 year sterling swap and gilt interest rates is available back to August 1999. For that period the spread between 30 year gilts and swaps has moved substantially from a high of 169bp in June 2000 to a low of minus 75bp in January 2009.

These movements have been of a similar order of magnitude to movements in absolute rates. Any risk model that is based on historical data during the 1999 to 2014 period should therefore show a meaningful risk that this spread will change in the future. Whilst of course the past does not necessarily predict the future, it would perhaps be imprudent to assume that this spread will not move in the future given the measure’s history.

One of the main risks to a pension fund’s surplus or deficit comes from the variation in the discount rate used to calculate the present value of the liabilities.

If a pension scheme discounts its liabilities using a gilt-based discount rate but hedges the interest rate risk with swaps, it will be left with a large position in the spread between gilt and swap rates. For a pension scheme with a swap-based discount rate

but a gilt-based hedge, the effect will be a similar sized position but in the opposite direction.

A pension fund can of course take the view that, on a hold to maturity basis, the spread between the two rates will converge, but the impact on any deficit or risk measure in the interim may well be substantial.

The easiest way for a pension scheme to guard against this risk is to hedge gilt discounted liabilities with gilts, and hedge swap discounted liabilities with swaps.

However, many LDI mandates give the manager the ability to choose whether to hedge with gilts or swaps according to the manager’s view of which is currently “cheaper”. A pension fund could easily end up with a portfolio of swaps hedging a gilt-discounted liability or vice-versa, depending on where swap spreads happened to be at the time.

The short-term volatility generated from this mismatch can easily end up dominating a pension scheme risk budget for what might be thought to be a relatively low return strategy.

In order not to let this spread risk dominate a risk budget, a pension scheme has two choices:

1. If it wants to retain swap spread risk as a measured risk, then any LDI mandate should have limits on the amount of swap spread risk that the LDI manager can take.

2. If it wants to be able to take large amounts of swap spread risk as implied by an unlimited LDI mandate then the pension scheme should choose a risk budget that excludes swap spread risk.

A similar problem can arise between projecting forward liability cashflows using inflation derived from either index-linked gilts or inflation swaps. The solution in terms of LDI mandate limits or removal from the risk budget measure is the same.

All in all, a pension scheme must be aware of the risks that can be inherent in handing over freedom to a manager or taking what seems like a saving; there is always a case for deep analysis and forethought in the allocation of the risk budget.

Philip RoseChief Investment Officer - Strategy & Risk

[email protected]

6O U T L I N E March 2014STEP

Figure 1: 30 year swap spreads,1999 to 2014

Source: Bloomberg

Future Widening of LDI Toolkit

7O U T L I N E March 2014

Kenny NicollDirector, Manager Research

[email protected]

An alternative way to manage interest rate risk is coming. NYSE Liffe’s ultra-long gilt future will offer a new way to gain synthetic exposure to gilts, the biggest challenge is whether it gains sufficient market interest to offer an ultra-long-term alternative.

For pension schemes looking to hedge their long-term liabilities, the upcoming ultra-long gilt future could well be of interest. It brings a number of potential benefits, however, its success is not guaranteed.

The new future will target a 30 year maturity, with a 4% implied coupon, £100k notional size and an underlying maturity of 28-37 year conventional gilts for delivery into the future. The 30 year government bond future has been tried before, in Germany, but the UK debt market and LDI demand is arguably different – for example, the UK has a far larger proportion of ultra-long debt outstanding:

Figure 1: UK long dated gilt projections

Source: globalderivatives

Given the high level of issuance (and buying) of ultra-long gilts, there is clearly sufficient demand for this amount of duration from the investment community.

What are the key benefits for investors?

This future provides leveraged exposure to gilts in much the same way as Total Return Swap (TRS) or a gilt repo trade, except the future is better than its Over-The-Counter (OTC) equivalent in a few ways:

• Useful for LDI clients who are full on TRS or repo lines, or do not have GMRA documents in place

• Credit risk is versus exchange rather than a bank

• Margin requirements can be offset against other futures with the exchange

• Typically cheaper to execute and trade out of, particularly compared to break costs of a TRS

• Futures are “future-proof” from Basle 3 regulations, unlike gilt TRS or gilt repo

• Gap risk is lower due to shorter close-out period (2 days) and lower initial margin

• Standardised terms ensure transparency and tight pricings amongst participants

What are the key challenges for the future?

The main challenge is finding natural buyers and sellers to provide sufficient liquidity, as shown by trading volumes of German and US ultra-long futures. Against this, hedge fund managers should like the credit and duration properties while banks are likely to be long gilts so looking to sell the future, both adding to market liquidity.

The other big challenge is the capability of the future to meet LDI hedging needs. With fixed maturity dates, futures cannot provide as exact a hedge as OTC products for LDI hedging. Also, since the future is deliverable on expiry against a basket of underlying gilts with different maturities, cheapest-to-deliver (CTD) risk arises as the CTD gilt can change at short notice. This means the duration of the futures contract will change, so the number of contracts will need to reflect the change in duration relative to a client’s hedging benchmark.

What might the future hold?

For clients who are not set-up to trade futures, or are unable to post initial margin/cash as variation margin, TRS exposure to the 30 year future may also become available from banks as currently exists for 10 year futures.

Ultimately, meaningful volume and interest from the wider investor community will determine whether or not the ultra-long future becomes a liquid and successful product.

STEP

Diversified Growth Funds Revisited

[email protected]

Aniket DasVice President, Manager Research

STEP 8O U T L I N E March 2014

Diversified growth funds (or ‘DGFs’) have come to form an iconic part of the UK investment landscape. Their evolution is ongoing and will take them head on to meet hedge funds.

Multi-asset funds have come a long way in the UK. Balanced funds employing static asset allocations dominated the scene during the 1990s and early 2000s. However with time, the sector evolved as there was increased demand for asset allocation to be performed within a fund. The success of a number of managers in navigating the financial crisis was surely the finest hour for active asset allocation and a great endorsement for the sector as a whole in addition to those skilful managers.

These days, we see a large spectrum of multi-asset managers within the UK and indeed a different name applied to the group. The term ‘DGF’ has emerged within the parlance though admittedly the description is rather vague. We see the DGF universe ranging from balanced funds, whose popularity is undoubtedly waning, to vehicles using dynamic asset allocation in various shades.

Within those funds employing dynamic asset allocation, one can get more granular still. We observe some managers tilting the portfolio from a neutral benchmark (what we term ‘dynamic allocation’ funds), often flooring a minimum equity

exposure at around 30% of the whole portfolio, to those that are ‘benchmark-free’ and willing to swing the portfolio around much more (‘total return’ managers). This latter group does have more variation in performance between managers though arguably this flexibility allows these managers to be better-placed to deliver an outcome (say, cash + 5%) rather than a quartile ranking.

The newest group of DGFs come under the shell of what we term ‘absolute return relative value’. Though Standard Life Investment’s Global Absolute Return Strategies (commonly referred to as ‘GARS’) has been in existence for nearly a decade, we are seeing other managers emerge in this area only much more recently. For these strategies, the focus on risk allocation (rather than asset allocation) and tighter risk management form an integral part of the investment process.

This last category ventures into the territory of global macro hedge funds, which similarly employ a range of long and short relative value positions while utilising options and other derivatives. Indeed we see increased competition between DGFs and hedge funds going forward. The battle is likely to be fought in the crucial areas of skill, fees, capacity, transparency, appropriate vehicles and client servicing, though the real winner should be pension schemes and other investors who will be able to access more efficient investment strategies at lower costs.

Figure 1: Classifying the DGF universe

The vast majority of investment management companies are not structured to help clients meet their long-term needs. They are organised around historical fund, asset class and geographical silos that do not reflect the outcomes clients are looking for.

“Hedge funds”, “equities”, “property’ and “bonds” are unhelpful labels that represent a myriad of different liquidity, risk and return profiles. Our conversations with clients begin with an effort to understand: where they are today; where they want to get to and by when; how much risk they are willing to take; what cashflow or liquidity requirements they have and what other specific covenants, support or contingencies are in place. We find that most clients want outcomes: some want capital preservation, others want to draw a predictable level of income, those with liability hedging in place want to beat cash and many others want to beat inflation over the long term.

These and other client outcomes are difficult to deliver because most products are narrowly managed against specific benchmark indices that do not represent clients’ liabilities and the vast majority of asset managers are fragmented into autonomous and independent teams, with limited dialogue, each competing for resources and rewards. Most fund management groups separate retail, wholesale and institutional distribution teams which won’t make much sense in the future, especially with the blurring of these lines and for example, Defined Contribution Pensions straddling retail and institutional channels. Furthermore, too many CEOs become hostage to stars and successful products of the past that contribute too much to a firm’s revenue to risk losing them. This keeps the industry more backward focused and resistant to change.

There is a need to redesign fund management around the investment outcomes that clients need. A handful of houses have created distinct outcome-oriented teams though the challenge remains to apply this way of thinking to their whole business.

We think there are 3 key considerations for anyone building client-centric outcome-oriented fund management businesses:

1. Focus on your strengths, rather than trying to be all things to all people. Build internal capabilities around areas of ‘structural competitive advantage’ rather than traditional asset or regional boundaries. Many opportunities exist in the gaps between adjacent specialists/teams that don’t talk to each other and use different tools and approaches.

2. Design client solutions that leverage your specialist capabilities. This requires some kind of central allocation or risk budgeting, which can be hard to execute effectively. It can’t be a committee of the great and the good, it can’t be just one star manager and it can’t be larger than 4-5 people. Each person must bring some distinct perspective and therefore value to the group but clear decision-making accountability is critical.

3. Accept that clients’ focus on outcomes will affect your whole business model. Fund managers need to break down silos between funds, between equities and fixed income, between manufacturing and distribution, between retail and institutional and between middle and front office in order to get their business to work together to deliver better outcomes for end clients.

Change is not easy but If we do what we’ve always done, we will get what we’ve always got. As the pensions crisis deepens and spreads, we have to innovate and collaborate or become commoditised and die.

Redesigning Fund Management Around Outcomes

Mitesh ShethDirector of Strategy

[email protected]


The Balancing Act: Reinvestment Risk vs. Illiquidity Risk

Conrad HolmboeVice President, Investment Consulting

[email protected]


In a quest to reduce exposure to reinvestment risk are pension funds jumping out of the frying pan and into the fire by taking on more illiquidity risk, or is there a balance to be struck?

For many pension funds 2013 was a relatively good year. Developed market equities rallied (the S&P500 was up nearly 30%), credit spreads tightened and even real yields showed some improvements, albeit marginally so.

Those funds positioned to benefit from this would have seen their funding ratio rise, and for some, rise faster than anticipated by their flight plan. Those fortunate enough to find themselves in this position will likely be contemplating how to “bank” these gains and take a little risk off the table.

De-Risking

De-risking can take many forms but it will typically involve moving out of more volatile, less predictable and higher returning assets (such as equities and hedge funds) into more stable and predictable sources of returns, such as credit.

However, as pension funds systematically reduce their exposure to risks such as equity, interest rates and/or inflation (i.e. those that can be measured using a Value-at-Risk model) other risks that may require additional lenses to quantify and monitor, start to become increasingly significant.

Some may even come to dominate a pension fund’s overall risk profile.

Reinvestment Risk

A pension fund’s longer dated liabilities cannot be perfectly matched with allocations to liquid credit, such as corporate bonds, as these are typically much shorter dated. Pension funds will therefore be exposed to a significant amount of reinvestment risk, especially as they increase their allocation to credit through time.

Reinvestment risk is the risk that when it comes time to reinvest the coupons and/or principal payments, credit spreads may have tightened to such a degree that a pension fund might have to seek riskier/higher yielding investments to meet their required return, and maintain the flight plan.

To counteract this risk many pension funds are increasingly making allocations to longer dated, and more illiquid credit, such as commercial real estate (CRE) debt, secured long leases and infrastructure debt.

The main benefits of these asset classes are typically: longer maturity profiles, an illiquidity premium and low correlation to traditional asset classes.

Thus a pension fund is able to lock into higher/more attractive spreads for longer, which can help mitigate their exposure to reinvestment risk. But at what cost?

Illiquidity Risk

As a rule of thumb, the longer dated the asset the more difficult it will be to sell at short notice for fair value (i.e. the more illiquid it becomes).

In addition, increasing the allocation to illiquid assets, at the expense or more liquid assets, reduces the overall liquidity of a fund’s portfolio.

This could have a negative impact on a pension fund’s ability to make benefit payments and/or collateral payments (on any out-of-the-money derivative positions), in the event of a crisis.

The Balancing Act

There is no one-size-fits-all solution for determining the appropriate balance between illiquidity and reinvestment risk.

But the important thing to note is that there is a balance to be struck. Clearly no pension fund should be 100% allocated in illiquid assets, nor 100% blind to the risk reinvestment poses to their chances of meeting their long term funding objectives.

Pension funds considering what the appropriate balance might be can develop bespoke tests aimed at determining an appropriate “Illiquidity Budget”. This could consist of a maximum allocation to illiquid assets dictated by the fund’s short/medium term collateral requirements, medium/long term cash requirements to pay member benefits and long term desired asset allocation.

Integrating the Illiquidity Budget into the day-to-day decision making of the fund will ensure that a pension fund always maintains an appropriate balance between these two risks.

As we move from the year of the Snake into the year of the Horse, a few key movements in 2013 are worth a conscious review.

In 2013, long term inflation expectations increased, with the 30 year zero-coupon RPI swap ending the year around 0.5% higher than it started at 3.74%. This compares to the lows of around 3.2% in 2012 and recent highs over 4% seen in 2008. Real yields generally fell back into negative territory over the course of the year.

Overall, interest rates in most major markets ended the year higher than they started. In the UK, long dated interest rates (measured by the 30-year zero coupon swap rate) ended the year close to their highs at 3.4%, up 0.5% from the start of the year. The yield on the 2042 gilt ended the year at 3.61%, rising by slightly more than the corresponding swap rate and highlighting the increasing attractiveness of gilts compared to swaps for long-dated liability hedging.

Benchmark 10-year interest rates in major developed markets all followed a similar path over the year, reacting to investor expectations on the tapering in the US. The US 10 year yield rose from 1.6% to 3%, the UK gilt from 1.8% to 3%, and the German bund from 1.4% to 1.9%.

Economic fundamentals in most developed economies improved, especially in the UK and the US. The UK’s improvements resulted in economists’ upward revision of 2013 GDP estimates, enabling an upbeat Autumn Statement. Sterling strengthened against both the dollar and the Euro in the second half of the year, the pound closing the year on its high against the dollar of $1.66, having started the year at a similar level and fallen at times to lows of $1.48.

Most developed equity markets experienced returns well above long term averages, with the highest annual return since the 2009 bounce from the market lows. Significant differentiation among markets continued. The MSCI World was up 24%, compared to 14% in 2012, with the Nikkei and S&P500 leading the way with a 50% and 30% return respectively, which took the S&P into new highs, some 30% above the 2007 peaks. The FTSE 100 index experienced a gain of 14% in price index terms, compared to a gain of 7% in 2012, a -2% return in 2011 and a +11% return in 2010. In Europe, the DAX and Eurostoxx both experienced higher returns than the FTSE in 2013, with the DAX up 25% and the Eurostoxx up 18%.

Emerging Markets performed badly, reacting to tapering, with the MSCI Emerging index falling 5% over the year. The volatility experienced by most equity indices during 2013 was low by historical standards, with the market pricing of option hedging against market falls reflecting this.

The three main classes of credit all performed strongly for the second year in succession. For example, UK Investment Grade credit returned 5% in excess of swaps over the year compared to returns of 7% in 2012.

Commodity indices generally fell during 2013, with the DJ-UBS index ending the year around 10% lower than it started, having been flat in 2012. The main driver of this was Gold.

There is a continuing, growing appetite for risk-based and risk-controlled approaches to investing such as Volatility Controlled Equity and Risk Parity, particularly when they are combined with portfolio downside protection. Given the large divergence in returns this year between equity, commodities and fixed income (with equities substantially positive and both commodity and fixed income negative) multi-asset portfolios with an overweight to equities have outperformed those with an equal balance of risk among asset classes.

Dan MikulskisCo-Head of ALM & Investment Strategy

[email protected]

2013 Asset Class Review

11O U T L I N E March 2014STEP

Global Macro Overview

The macro outlook appears rosy, with rising GDP forecasts and falling unemployment. Is the global economy finally out of the woods?

Equity markets are at or close to their all-time highs. Credit spreads continue to tighten. UK CPI inflation has finally fallen below the 2% target. Economic indicators are showing improvements and pension scheme funding ratios have generally improved also. Apart from an early wobble in “emerging” markets, 2014 seems set to be a good year for markets. Taking a closer look though, there are several things which could derail the recovery.

Risks to the outlook and schemes

At a recent Redington teach-in, Gavyn Davies (Chairman, Fulcrum Asset Management) outlined four key macro risks:

1. US unemployment fall prompting the Fed to tighten too early

2. China being unable to guide its economy to a soft landing

3. Eurozone is unable to prevent “Japanifcation” (prolonged deflation and low interest rates)

4. Bubble in equities as rising prices driven by policy stimulus rather than fundamentals (Gavyn thinks equity bubble risk remains low at present)

At the same event, Neil Williams (Chief Economist, Hermes Fund Managers) rightly pointed out that “tapering is loosening!...” Reducing asset purchases by $10bn at each Federal Reserve meeting still adds an extra $460bn in 2014.

Figure 1: The Bank of England’s main policy rate, 1694 to 2014

Since the teach-in, the Bank of England and US Federal Reserve have softened their guidance on how the unemployment rate will influence the timing of tighter monetary policy, replacing it with a stronger focus on inflation (and deflation).

David Miles, a member of the BoE’s Monetary Policy Committee, has warned that rates are likely to be below their historical average of 5% for a sustained period (see Figure 1). “One factor behind the recent sharp fall in real yields – changing perceptions of the level of risk in the world – is likely to be persistent,” he said. In recent weeks, members of the Fed and ECB have stated they remain vigilant to downside risks and are willing to take action if necessary.

Will QE actually end? There is a chance central banks opt not to sell their QE holdings at all, instead making use of their balance sheets to lend QE assets to the market via reverse-repos. This would allow them to remove liquidity and set short-term rates using an alternative to Base Rate. The Fed has said it is investigating this option. Central bank liquidity may remain abundant for a while yet, holding down rates (see Figure 2).

Guarding against the risks

It is vital to understand the key asset and liability risks to your pension scheme, to decide if you are comfortable running those risks, and then to construct an investment strategy that is appropriately robust and resilient to many outcomes. For example, schemes can make use of risk factor investing and volatility-controlled equity strategies to diversify and manage downside risk. Illiquid credit and absolute return bond strategies can help to boost the expected return from assets above those available from liquid credit. Whilst there are still many macro risks, there is also a growing number of ways to measure, manage and mitigate them.

Figure 2: Liquidity expectation of global central banks, % of GDP, 12 months change

Gurjit DehlVice President, Education & Research

[email protected]


Source: Bank of England Source: Fulcrum Asset Management LLP

If you would like more details on the topics discussed, please contact your Redington representative, the author, or email [email protected]

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13O U T L I N E March 2014Further Information and Disclaimer

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Outline March 2014

Economy & Finance