Major Public Pension Gets Agile with Derivatives Overlay

Pension Profile: The UK’s Merseyside Pension is tired of missing out on performance by being too slow to react.

(July 22, 2013) — One of the UK’s largest public sector pension funds is to actively manage its medium term asset allocation and prevent performance drag by holding unintended positions.

The Merseyside Pension Fund is close to appointing a manager who will hedge out changes to the liquid portion of the £6 billion portfolio that are made by market activity.

“The decision has been driven by performance,” Investment Manager Paddy Dowdall told aiCIO. “We have not been able to take advantage of mean reversion in liquid assets.”

Equities and bonds make up around 75% of the portfolio that provides retirement benefits for one of the largest metropolitan areas in the North West of England.

Dowdall said the fund had lost 60 basis points over the last three years by failing to act quickly enough to rebalance to its strategic asset allocation. By employing an overlay manager, the fund hopes to improve returns by £15 million a year.

The governance structure of the local authority pension means the committee that signs off changes in asset allocation meets six weeks after the end of each financial quarter, which is too late to respond to market movement, Dowdall said.

The move should see an end to the cumbersome-and costly-transitioning of assets between managers, Dowdall added.

“The pattern of alpha is different to asset performance,” he added, “and we could be moving money away from a manager just before they were about to outperform.”

A portfolio of derivatives should make the fund’s activity in liquid markets more streamlined and nimble. The fund believes taking asset allocation positions can add value in the medium term. It was able to do this going overweight in Japanese equities whilst hedging currency earlier in the year under its old model-the new model should make it easier to implement such positions.

The fund hopes to have the managers in place by October-November, after all the detailed legal requirements have been completed.

Did they consider a fiduciary manager to carry out the responsibility?

“No,” said Dowdall. “That approach is not suitable for a fund of our size. For something under £500 million, it might be appropriate, but we don’t really know if it would be permitted on a local government pension scheme of this magnitude, and this is not an approach favoured by our Pensions Committee.”

The fund’s consultant Aon Hewitt has been researching and overseeing the process of considering and appointing an overlay manager.

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