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UK pension funds continue shift to alternative investments

UK pension funds advisor Watson Wyatt Investment Consulting doubled the number of alternative investment mandates awarded to fund managers in 2004.

The total rose from 16 in 2003 to 32 last year, increasing the assets allocated by the firm's clients to alternative investment mandates by some 40 per cent to approximately GBP 1.75bn - GBP 1bn to hedge funds, GBP 400m to property and GBP 350m to private equity.

Watson Wyatt's results were announced by Nick Watts, European head of investment consulting at Watson Wyatt. Watts is stepping down as head of Europe at Watson Wyatt. He will be succeeded by Kevin Carter, former chief executive of Old Mutual Asset Managers, who joined the investment consulting group three years ago.

Watts said: "The imperative to generate returns to reduce deficits has strengthened, with the result that many funds have moved some of their assets away from benchmark-sensitive instruments to make meaningful allocations to absolute return products, notably to funds of hedge funds."  

The trend towards unconstrained mandates also accelerated significantly in 2004 with pension funds advised by Watson Wyatt continuing to make allocations to high-alpha bonds, long/short equity and emerging-market and high-yield debt. The total number of unconstrained mandates awarded in the past three years has now reached 40.

Watson Wyatt's UK clients have now awarded 15 ten-year mandates to investment managers since October 2003. The firm introduced the concept of ten-year mandates, an 'inflation plus'-type mandate, as a method of seeking performance in an investment environment that has become overly influenced by short-term benchmarks.

 "These new ideas in unconstrained investing are being implemented more quickly as funds, plan sponsors and investment managers are realising the benefits of this type of investing, both short and longer-term," said Watts.
In addition to growth in unconstrained mandate popularity, Watson Wyatt also saw a 40 per cent increase in the number of swap transactions in 2004 compared to the year before.

 "The increasing use of risk budgeting as a means to provide a clear map of the risk present in the pension fund and sponsoring company, combined with a focus on liabilities, has meant that liability-led investment programmes, particularly through the use of inflation-linked swaps, are more feasible,' said Watts. "There is also increasing interest in option strategies and structured credit."

Watson Wyatt, adviser to over 50 per cent of FTSE 100 companies, saw its clients award USD 70bn worth of assets globally in 2004, an increase of 23 per cent from 2003. In addition, there was a 20 per cent increase in the number of selections in 2004 (431) compared with 2003 (360).

The trend away from balanced towards specialised management in the UK was again confirmed in 2004 with the value of mandates awarded by Watson Wyatt's clients to multi-asset managers dropping 82 per cent from approximately GBP 9.1bn to GBP 1.7bn. The main beneficiaries of this trend were enhanced indexation and alternatives managers.

UK pension funds need to gear up for risk

According to a Watson Wyatt investment consulting research publication released earlier this month, a significant number of UK pension funds are not well positioned to take as much investment risk as they do. The reasons relate first to their resilience to absorb risk and second to their competitive positioning to manage risk successfully. The publication, Changing lanes, suggests that in order to be competitively positioned to exploit risk opportunities there are certain prerequisite competencies and disciplines that funds should have, through effective governance structures.

Roger Urwin, global head of investment consulting at Watson Wyatt, said: "The understanding and management of risk remains a difficult subject for both trustees and the sponsor and increasingly requires a relatively high competency level if adequate returns are to be captured in a fast-changing investment environment."

The publication considers the holding of equities within pension funds and debates whether they can add value having accounted for the risks, concluding that a strict application of financial economics' arguments is a flawed approach as it ignores many broader investment issues.

Urwin said: "We believe in a more pragmatic approach to pension fund investing based on the principle that assets, liabilities and risks should be assessed having regard to market rates. Furthermore, investment risk taking should be supported by some form of sustainable competitive advantage such as better governance or a longer time horizon than other investors. These advantages are not possible within a strict application of the financial economics argument."

Watson Wyatt's publication reveals a strong case for investors who have a long time horizon to exploit it through the use of new types of investment strategy (wider use of alternative assets), investment mandates (absolute return managers) and benchmarks (liability-led). In addition, as governance budgets become more expandable, funds will be in better positions to implement more complex investment strategies at lower levels of risk. Such strategies include the concept of portable alpha.

Changing lanes positions risk budgeting as the critical tool to determine the optimum position between increased investment return and a level of risk that is satisfactory for both sponsor and trustee. It also demonstrates how risk budgeting, through the use of the value at risk (VaR) calculation, gives decision makers the ability to be flexible in determining the amount of risk to take in allocations to different asset classes and managers.

Urwin said: "If pension funds are to be successful for both members and the sponsor they need to be able to adapt quickly as circumstances change within the fund, at the sponsor and in the markets. Until now, this has typically not been the position of most funds in the UK, but we think this can change."

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