Vista - Lane Clark & Peacock · our latest investment ideas and views. The ideas won’t all be appropriate for all schemes, but we’ve tried to make sure that there’s at least

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VistaIssue 1 December 2014

In this issue

The macro storymore volatility on the way? p4

Smart beta, multifactor investingIs the time now for pension schemes? p5

Protecting your members The greatest economic challenge of the 21st century p6

Private credit Cutting out the middle man p7

Activism A different kind of active management p8

Protecting profitsUsing options to protect profits from equities p9

Our investment view

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Vista is designed to keep you abreast of our latest investment thinking.

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The last few years have seen yields falling ever lower as future expectations of long-term global growth decline. At the same time the public equity

markets have been whipsawing between euphoria and panic. Against this backdrop it can be hard for pension trustees and sponsors to keep abreast of the latest developments, which is critically important if they are to ensure their investment strategies remain fit for purpose.

LCP Vista is designed to help you achieve this.In the following pages we set out a selection of our latest investment ideas and views. The ideas won’t all be appropriate for all schemes, but we’ve tried to make sure that there’s at least one useful action in here for everyone to consider over the next few months.

Firstly, Charles Iversen will set the scene by outlining our views on the current macro-economic environment. Amongst other things he considers how the falls in commodity prices, and the slowdown in the Chinese economy, could affect markets over the next year to eighteen months.

Equities remain the cornerstone of most schemes’ strategies – but many schemes have found selecting successful active managers to be a real headache. Tom Farrell explores ways in which schemes can access successful strategies commonly employed in active equity funds, but in a more cost-effective and risk-controlled way than traditional active management.

John Clements discusses the “Carbon Conundrum”. He will explore why the markets’

views on future energy consumption do not seem to tally with global policymakers’ targets to cut carbon consumption. John suggests how you could make sure that your portfolio is positioned to exploit any realignment of this apparent discrepancy.

Carolyn Schuster-Woldan considers a very exciting investment opportunity that has emerged as a result of the continued weaknesses of the banking sector, combined with the recovery of the economy. Pension schemes could earn good returns by meeting the growing demand for loans from business, where this is not being provided by the banks.

Pension schemes together own a sizable proportion of the UK stock markets. However, very few asset managers actively engage with company management. Joel Hartley discusses the merits of activist investing and how this could help improve returns, as well as meet trustees’ obligations to be responsible investors.

Finally, David Wrigley considers a way that pension schemes could lock-in some of the gains they’ve seen in their equity portfolios, whilst continuing to benefit should equities continue to rally.

If you would like to discuss how any of these ideas could be applied to your scheme then please contact either me, or your usual LCP contact.

In six months’ time we will publish the second edition of LCP Vista, where we will take a look back at these ideas and give you a selection of new ideas for the second half of the year.

Investment markets are in a constant state of change.

3 LcP Vista Investment

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Ian MillsPartner

+44 (0)20 7432 6736

[email protected]

@IanMillsLCP

Ian helps his clients to develop better investment strategies by helping them diversify and hedge risks. As well as advising clients with assets between £50m and £3bn, he leads our research into new asset classes and is a key member of our LDI and derivatives research team.

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Seven years after the financial crisis, the global economy is still reluctant to recover. Although the UK and US are on a sounder footing, much of Europe

remains weak. Many emerging markets face a challenging array of problems. Global growth remains far behind a “normal” recovery.Across developed economies, monetary policy continues to be extremely supportive following years of money-printing and record low interest rates. However, the situation is changing. In the US and UK, rate rises are coming – starting next year, according to the markets – while the Eurozone and Japan continue to announce new measures in an attempt to boost inflation. This divergence in policy has already led to more volatile currency markets, a theme that is likely to continue.

A key recent development has been the fall in commodity prices (especially oil), which benefits consumers in much the same way as a tax cut. The resulting lower inflationary pressure means that the Bank of England and US Federal Reserve can afford to delay rate rises, but could cause headaches for the European Central Bank and the Bank of Japan as they battle the risk of deflation taking hold. For many emerging markets, especially those relying on oil exports,

public finances will become stretched at a time of weakening economic momentum.

We remain positive on the longer-term outlook for emerging market economies. These countries generally have more favourable demographics, faster levels of growth, improving governance and rising disposable incomes, which should provide diverse investment opportunities. However, there are many shorter-term challenges to overcome: Russian sanctions, slowing Chinese growth, Brazil’s slide into recession, falling oil prices and widespread political uncertainty are just some of them. Good returns from emerging markets may take a long time to come through.

As US quantitative easing draws to a close (shown as a slowdown in the expansion of the Federal Reserve’s balance sheet in the chart below), investor concern is growing. Equity markets have demonstrated their reliance on cheap money. We expect market volatility to rise as monetary conditions tighten in the US, although the effects of this will be mitigated to some extent by expansionary monetary policies in Europe and Japan.

As the global economy continues to muddle along, it is essential to maintain a diversified portfolio and look for new areas of return.

The macro story

more volatility on the way?

4 LcP Vista Investment

Charles IversenInvestment Consultant

+44 (0)20 7432 0643

charles.iversen@ lcp.uk.com

@LCP_cmi

Charles is a key member of LCP’s macroeconomics research team, which helps to shape our investment advice. Charles has responsibility for sourcing views from senior economists and investment managers.

He has also been closely involved in the development of LCP Visualise, our new platform that enables clients to view their assets, liabilities, risk and performance in real time.

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Within equity investing, somewhere between active management and passive management, you find

“smart beta” investing. A smart beta strategy will aim to systematically outperform the market based on a transparent, rules-based investment approach. Within smart beta, the newest type of strategy to emerge is factor investing, and specifically multifactor investing.

So, what is a factor and what is multifactor investing? The five generally accepted factors that are reflected in equity markets are: “value”, “momentum”, “low volatility”, “small size” and “quality”. For example, a stock that has been rising in value faster than average is a “momentum” stock, or a stock with a relatively high dividend yield is a “value” stock. Importantly, stocks that exhibit one or more of these characteristics have been shown to outperform stocks in general

over the long term (eg by the acclaimed academics Fama and French in 1992).

But value managers have been around for years – so what’s changed? Yes, it is important to recognise that factors are not new to equity markets. In fact, most have been well known for decades, and many active managers deliberately skew their portfolios towards some of these factors. Moreover, hedge funds have been aiming to capture the returns generated by factors for years. We should view the fact that factors have been around for a long time as a good thing, it should give us some comfort that factors have been shown to persist over time and thus may well “stick around” in the future.

What is also interesting about factor investing is that each factor has been shown to exhibit low correlation to the others over time. In other words, for example, at times when value has been “out of favour”, momentum or quality has been “in favour” and so on. One of the few generally accepted

rules within investment is that when two or more assets exhibit low correlation to one another, combine them into a single portfolio and you will reap the benefits of diversification. Precisely what a multifactor portfolio aims to do.

So, why now? Governance issues for trustees surrounding investing in hedge funds and overly complex products from active quant managers have meant that many trustees have avoided factor investing up to now. Indeed, over the past few years many schemes have switched their active equity portfolio into passive index mandates.

The most significant development within factor investing, and a potential catalyst for UK pension schemes, is that passive managers have recently been developing smart beta multifactor funds. A passive multifactor fund will preserve all the benefits of passive investing that we love and treasure (such as low cost and low governance) yet aim to deliver a return above the market index, by using a transparent rules-based approach. The perfect ingredients for a pension scheme.

In my view, the newer multifactor products have the potential to generate superior long-term returns compared to passive equities - but importantly, without increasing costs significantly. If the time isn’t now for pension schemes to consider “factor investing” then the time is probably never.

Smart beta, multifactor investing Is the time now for pension schemes?

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Tom FarrellInvestment Analyst

+44 (0)20 7432 3071

[email protected]

@Tom_Farrell_LCP

Tom has a range of responsibilities at LCP including client duties, equity research and a key role on the asset class assumptions group, helping to set many of the underlying asset class assumptions that feed

into the analysis we produce for our clients. Within equities, he initiated our research into smart beta strategies. It was of particular interest to him and he considered it to be of potential interest for some of our clients.

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Christine Lagarde, Head of the International Monetary Fund, recently described climate change as “by far the greatest economic challenge of

the 21st century”. For pension scheme trustees, who have a fiduciary duty to look after their members’ interests for decades to come, it is essential to consider this risk. Make no mistake – climate change risk is not simply an ethical or political issue – it is a large financial risk to your scheme.

There is currently a mismatch between the (long-term) environmental targets of governments and the (short-term) actions of many investors. Governments around the world have set stringent carbon emission limits, in an effort to limit future global warming. However, this implies that a great deal (perhaps most) of the fossil fuel reserves that have already been discovered cannot be burnt. But most oil companies are continuing to embark on further exploration, looking to discover yet more reserves – and the market generally rewards them when they do. At some point, it seems inevitable that something has to give.

One argument, often cited by those in favour of doing nothing, is that this information will surely already have been “priced in” by markets. However, this is not necessarily the case. The timeframe of many investors – as highlighted by the Kay Review – is too short term to properly take account of long-term risks. History is littered with examples, such as the tobacco industry, where markets have spent decades refusing to acknowledge the long-term financial risks to businesses. With the deadline for the successor to the 1997 Kyoto Protocol coming up next year, there is the potential for a “wake up call” to come sooner rather than later. At the very least, the outlook for stocks with significant

carbon exposure (the oil majors for example) appears volatile, fraught with large political and regulatory risks.

Scientific and public consensus on climate change has shifted over time, moving on from being a debate between “believers” and “deniers” to become instead a debate about whether to take action sooner versus later. We are now seeing evidence of investors taking action. There have been many well publicised campaigns to disinvest from fossil fuel investments, with publically declared pledges resulting in around $50bn globally being withdrawn from fossil fuel companies to date. For example, Norway’s $815bn sovereign wealth fund, the world’s largest, has already halved its exposure to coal producers and is considering reducing its exposure further.

How can you manage your climate change risk?The first step for trustees and sponsors should

be engagement: ask your equity managers to explain their views on climate change risk and the steps they are taking to manage this risk. Managers do not necessarily need to screen out companies exposed to climate change risk – indeed some of those companies may be the leaders in the development of solutions to this issue, such as carbon capture and storage or renewable energies. However, a good manager must be able to give you confidence that it understands the issue and is investing your members’ money appropriately.

A more significant step would be to structure your scheme’s investments in such a way to reduce the exposure to climate change risk. A number of equity funds have recently been launched which track “low carbon” indices, with lower exposure to stocks with significant carbon risk than more mainstream indices.

Protecting your members

The greatest economic challenge of the 21st century

6 LcP Vista Investment

John ClementsPartner

+44 (0)20 7432 0600

john.clements@ lcp.uk.com

@john_LCP

John helps his pension scheme clients to serve their members better by implementing strong investment ideas. He is passionate about challenging herd mentality to ensure that his clients reap the benefits of being a long-term investor.

John is a senior member of LCP’s equity research team and leads our environmental, social and governance research programme.

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Pension schemes are increasingly allocating to “private” credit, where long-term lending is arranged without the assistance of intermediary banks. We think that potential returns in this space are particularly attractive

at the moment.In very simple terms, a pension scheme can lend directly to

companies. Of course, no-one would expect a pension trustee board to decide which companies to lend to – instead there are a few specialist asset managers that would take this role.

Income is expected to be the main driver of returns. This income could be used to meet benefit outgo to avoid needing to sell other assets at potentially depressed levels. In a world where economic growth is expected to stay low and capital growth is difficult to envisage, a strategy where income is expected to be the predominant driver of returns looks increasingly attractive.

Why is there an opportunity?Since the global financial crisis in 2008, there has been a

widening disparity between the supply and demand for lending. This has been driven by a number of factors, including the continued stresses in the banking system. � On the supply side, availability of lending to companies has been

shrinking. This is due in large part to regulatory changes that have reduced the appetite of primary lenders (predominantly banks) to engage in lending activities. Many banks are also still in the process of repairing themselves following the stresses of 2008/9.

� However, a growing economy means that there is now growing demand for loans from companies, many of which will now have to find alternate ways to finance their activities. This apparent supply/demand imbalance has led to an increase

in the returns that an investor can expect to achieve from this asset class.

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Do higher returns mean higher risk?Not necessarily. We think the main reasons the returns are

relatively high is simply because the banks are unable to meet the demand for finance from the corporate world, as opposed to these being “bad” companies. This is likely to remain the case until the woes of the banking system subside.

Some of the returns are due to the fact that the asset class is “illiquid” – it is difficult to sell holdings, as they are not widely traded at all. Instead, investors will need to wait until the maturity of the loan to get their money back.

But there must be some risks….Of course. The key risk is the risk of default, which can be

mitigated by ensuring that most of the lending is carried out on a “secured” basis. Because private credit is illiquid it can be difficult to exit poorly performing investments, so choosing a manager with good sourcing networks and a rigorous and in-depth research capability is really important.

The opportunities available in private credit will change over time. We’ve already seen prospective returns reducing in the real estate lending sector. We believe that a strategy that can invest across different strategies – direct lending, real estate lending, structured credit and other, as yet unknown, opportunities that will inevitably arise as this market develops – will have the highest chance of success.

Private credit

cutting out the middle man

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Carolyn Schuster-WoldanSenior Investment Consultant

+44 (0)20 7432 0617

carolyn.schuster-woldan@ lcp.uk.com

@CarolynSW_LCP

Carolyn is a key member of the fixed income research team, and is responsible for our research into the private debt markets. Carolyn strongly believes that pension schemes can achieve higher returns by investing in areas where long-term investors

can be paid to provide liquidity.

She advises a range of pension schemes on how simple changes to their asset allocation can help them improve their funding levels.

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On the whole, equity markets don’t seem particularly cheap or particularly expensive at the moment. Compared to bond

markets they look like reasonable value – the dividend yield on the FTSE All Share Index is currently about 1% higher than the 10 year gilt yield for instance. On a standalone valuation basis, equities appear less attractive; for example the current price/earnings ratio of the S&P 500 (about 18) is pretty close to its 20 year average (19).

All of this means that I’m finding it quite difficult to get excited about the prospects for equity markets and the potential for equity investors to earn outsized returns over the next few years.

Others might suggest a good old fashioned active management approach to improve your results. You know, the sort where a manager picks stocks to try and generate 1% or 2% pa above a benchmark index. I’m not convinced that this is the solution, especially for institutional investors. Firstly, with so many people analysing the same stocks, the chances that the manager finds what others have missed, and then repeats it consistently, is a big ask. Secondly, assuming your manager does beat the benchmark, how many trustees lock in those gains by switching their manager after a good run? In my experience it normally works the other way around.

One approach that I think could improve returns, given a reasonable timeframe, is an activist approach to equity investing. Essentially what activist managers do is to exert influence as a shareholder to try and create value, which (assuming they are good at it…) should stack the odds of outperforming more consistently in your favour.

Instead of waiting for the market to catch up and recognise value, activist managers engage with companies and importantly seek to act as the catalyst to create value. For example, they might try and help a company allocate capital

more effectively, change the composition of its board or even instigate a value-adding acquisition.

Steps for activist management

Activist portfolios tend to be concentrated, reflecting higher conviction, and the fact you need to be a big shareholder before company management will really listen. Activist managers are relatively unconstrained, which means they tend not to worry about benchmarks.

So why consider an activist approach now given my less than sanguine views on equity markets? Companies are holding record levels of cash and financing remains cheap (where you can get it). Corporate M&A activity is already picking up. If companies are struggling to generate earnings growth in this environment, it might be a good opportunity to turn to activist investors for fresh ideas.

There are some drawbacks. Fees for activist managers are reasonably high and concentrated portfolios may translate into more volatile performance, in the short term at least. There can be an element of reputational risk too for the underlying investor – activists’ actions are often public and may attract media attention from time to time, with articles about companies coming “under siege” seeming relatively commonplace. In fairness though, whatever your opinions are about the likes of Bill Ackman and Carl Icahn (two prominent activists in the US), many activists see good corporate governance as a key part of their investment process, which I think often aligns them with pension trustees being responsible shareholders.

Activism

A different kind of active management

8 LcP Vista Investment

Joel HartleySenior Investment Consultant

+44 (0)1962 873349

joel.hartley@ lcp.uk.com

@joel_jrh

Joel specialises in helping clients allocate to alternative asset classes, with a particular interest in maintaining good corporate governance, which activism promotes.

Joel is a member of LCP’s absolute return investment research team and regularly meets with fund managers to discuss such strategies. Joel provides proactive investment strategy advice to a number of pension scheme clients with assets ranging from £10m to £1bn.

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Equity markets have been on a fantastic run. An investor putting $100 into the US stock market on 1 January 2012 would currently

be sitting on a profit of about $75. It’s not quite as rosy a picture in the UK, but investors have still done very well - £100 invested in the UK market would have yielded a profit of about £40.

Given these strong returns from the equity market, pension schemes may wish to de-risk and lock in profits. Is there a cost-effective way that pension schemes can do this, while maintaining upside should the equity markets continue to soar? After all, it is notoriously difficult to call the top of the equity market!

How can call options help?By selling equities and spending a small

amount of the proceeds on equity call options pension schemes can: � Retain some upside: if equity markets

continue their upward trajectory then the call options provide a return in line with increases in equity prices.

� Get downside protection: if equity markets fall, the call options may lose value - but the loss is limited to the cost of the call option.

� Ensure capital efficiency: the use of call options frees up assets to be invested elsewhere, either to target additional returns (eg to offset the cost of the option premium) or to increase liability hedging.

Why now? Not only are many equity markets at,

or close to, their historical highs but the costs of buying call options are relatively low. The chart on the right shows historical pricing for 1-year call options on the FTSE 100. For example, 4% was the cost on 31 October 2014 for receiving the total price rise in the FTSE 100 (6,464 at the time) over 1 year.

Equity call options can provide pension schemes with a cost-effective approach to de-risking, reducing the “regret risk” of selling equities at current market levels.

Protecting profits

Using options to protect profits from equities

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David WrigleySenior Investment Consultant

+44 (0)1962 873358

[email protected]

@David_W_LCP

David’s particular area of expertise is in developing efficient investment strategies that manage risks in a cost-effective manner, often making significant use of derivatives.

David is a member of LCP’s LDI and derivatives research team, regularly meeting with investment managers and investment banks to discuss the latest liability hedging and derivative-based risk reduction ideas.

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What are the key risks? � Depending on the performance of

the “freed-up” assets, the premium for the call option can act as a drag on investment returns.

� There may be an increased governance burden of implementing and monitoring an equity call option strategy.

� There are counterparty risks, which can be managed through effective collateralisation processes and careful counterparty selection

Source: Insight Investment

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Jul 2012

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UK equities

US equities

Europe (ex-UK) equities

Global equities

Source: Bloomberg (returns shown in local currency)

CALL OPTION

In return for a cash payment, an equity call option is a contract that gives the holder the right to receive a cash payment equal to the increase in equity prices above a given level.

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Peacock LLP. A list of members’ names is available for inspection at 95 Wigmore Street, London W1U 1DQ, the firm’s principal place of business and registered office. The firm is regulated by the

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Belgium”. © Lane Clark & Peacock LLP 2014.

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