investment perspectivesAutumn 2016

In this issue:Capital Markets Update 3 Capital Markets Focus: an on-off relationship 5 Under the Spotlight: Multi-Asset Funds 7Efficient deployment of capital 10Market returns to 30 September 2016 12

You will see that, in response to feedback, we have consolidated our quarterly Capital Market Service into our quarterly Investment Perspectives. We hope you find the combination easier on your inbox.

Welcome

The key story for the UK remains the implications from the outcome of the EU referendum. However, four months on, we still have very little new news to go on – as the challenge of meeting conflicting desired outcomes sets in, policy decision is not going to be hurried! This provides a number of real challenges for sterling based investors: our Government bond yields continue to be at historic lows; our equity market is hitting all time highs; currency exposure presents a real risk or opportunity, but it is hard to be sure which and of course the price of marmite is going up, well, maybe.

Capturing the oscillations in markets and market sentiment, Graeme Johnston provides an update on capital markets in the first article, before taking a closer look at the recent rally in equity markets and the implications for future returns in the second article.

In the following two articles we focus more on implementation solutions.

First, Adam Porter looks at multi-asset funds. Over the last three years many of these funds have tended to disappoint. Either returns have not been as good as hoped, or quite simply they have not kept pace with the returns on equities and bonds. Adam provides his insight into the performance of these funds and comments on what we can expect looking ahead.

In the final article, Alen Ong and I have set out some thoughts around the efficient deployment of capital. Put simply, investors of pension fund assets are struggling to achieve multiple objectives with a limited pool of assets. The ability to free up money from capital intensive assets using (hopefully relatively mainstream) derivatives in order to make that money available for other purposes will be key to efficient implementation.

Andy Green

Chief Investment Officer andy.green@hymans.co.uk 0131 656 5151

2 Investment perspectives

The early skirmishes of the UK’s disengagement from the EU have left their mark on sterling, the gilt market and domestic commercial property. UK equities have been largely unscathed, driven more by global than domestic considerations.

It has been largely business as usual in terms of global economic developments in recent months. As so often in the last few years, expectations for global growth have been modest and, on balance, the outturn has been marginally disappointing. However, there seems to be little threat of imminent recession in any of the major economic blocs. (Japan, where the strength of the yen is biting, may be an exception.) In the UK, the economy has proved more resilient than the most fervent Remainers might have suggested … or been portrayed as suggesting.

Mark Carney may be the Leavers’ poster boy for bad losers and it would be hard to categorise August’s interest rate cut and QE expansion as premature. (The monetary boost would have had little influence on Q3’s robust growth of 0.5%.) The Bank of England’s concern had related more to next year than this, but November’s Inflation Report has a more sanguine assessment of near-term growth. Nevertheless, the path to Brexit remains uncertain and

complacency about the economic outlook for the UK would be equally premature.

The Bank’s easing of policy has been the key influence on gilt yields since it was foreshadowed in the immediate aftermath of the vote. Prior to that, gilt yields had drifted down in line with US and German yields (Chart 1). The post-referendum plunge was not matched elsewhere – the US Federal Reserve seemed increasingly intent on raising rates if possible, while the ECB looked to be on hold as the Eurozone economy continued to outpace expectations.

The more recent rise in 10-year gilt yields from the August low of 0.6% p.a. reflected the growing conviction that the Bank would not follow through with its intention of cutting rates. Not only was there an absence of evidence of short-term economic pain, but another downward lurch in sterling would stretch even the Bank’s willingness to tolerate above-target inflation in the next few years.

US UK

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Chart 1: 10-year conventional government bonds

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Capital Markets Update

Autumn 2016 3

But if gilt yields are back close to pre-referendum levels, that still means they imply interest rates will never rise above 2.5% p.a. Investing in gilts or hedging interest rates is about finding the least bad option. As has been the case for some time, long maturities – implied reinvestment rates are still as low as 1% p.a. beyond 30 years – seem like the most bad option.

As we have noted before, these low reinvestment rates speak of Japanese levels of nominal GDP growth. Even allowing for a short-term inflation overshoot, they are not easy to square with rising prices for long-term inflation protection (Chart 2). The risks that real yields will rise as the economy struggles back to health, or that inflation will be crushed if it doesn’t, seem rather greater than an unprecedented generation-long stagflation. For all our reservations about long-dated conventional gilts, they look more appealing than equivalent index-linked gilts.

Yield spreads in credit markets have continued to decline from the highs of Q1 and are noticeably below long-term median levels. Not by so much that we would be looking to reduce investment-grade exposure in low-risk bond portfolios below neutral levels. In these markets, the overall level of spreads is currently less remarkable than the divergence between financial and non-financial yields (Chart 3). The former continued to be undermined by the impact of low or negative rates on bank profitability and the capital requirements of new solvency rules on insurance companies.

Financial Non-financial

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Source: Datastream

Chart 3: Sterling investment-grade credit

In speculative-grade markets, the absolute level of future returns has been squeezed further, but we still think they offer worthwhile diversification from equities, property and other long-term assets. Returns of 4-5% p.a. over the next few years may turn out to be perfectly respectable in comparison with what is achieved elsewhere. Those who can tolerate illiquidity can still hope to earn a healthy premium in private markets.

UK property valuations took a hit in July. As we suggested at the time, the Brexit vote may have acted as a lightning rod for existing concerns – fading growth in rents (Chart 4) and the low level of income yields. The more serious short-term downturn conjured up by the “fair value adjustments” and dealing suspensions applied by some property funds has not materialised. (Both adjustments and suspensions have now been removed.) Nevertheless, capital values have continued to drift lower. They are still only 4% below pre-referendum highs and our view remains unchanged. Those who have a medium-term need to reduce property exposure should not fall behind plan: those interested in increasing holdings need not rush.

Global equities have pushed on to new highs in the last few months, merely increasing our existing caution. We look in the next article at what has driven the rally in recent years and what that might imply for the future.

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Chart 4: IPD UK Monthly Index

Source: IPD

4 Investment perspectives

Capital Markets Focus: an on-off relationship

In $ terms, global equities, as represented by the MSCI AC World Index, have returned just more than 11% p.a. over the 5 years to 30 September – around 10% p.a. ahead of US CPI inflation, well above long-term norms.

That may seem impressive for a period in which global economic growth has been persistently, if mildly, disappointing. Perversely, it is the sluggishness of the recovery that, particularly in recent years, may help to explain the robustness of the performance. However, that also underlies our caution about the next five years and beyond.

In the spring and summer of 2011, global equities had fallen over 20%. Meanwhile, inflation-linked US Treasury Bonds (TIPS) were prospering – 10-year yields dropped from around 1% p.a. close to zero (Chart 5). That was characteristic of the ‘risk-on/risk-off’ behaviour of financial markets in the years immediately after the recession. Economic conditions that were bad for equities were good for bonds and vice versa. The middle of 2011 saw the full flowering of the Eurozone debt crisis and a credit downgrade for the US.

The initial climb of equity markets from September 2011 may have marked the end of this ‘risk-on/risk-off’ period. US inflation-linked yields continued to drop until late 2012. What was good for bonds was apparently good for equities. Bond yields spiked up in the taper tantrum of early 2013, but equities have continued to be resilient as yields have declined again over the last three years.

The latest collapse in bond yields has encouraged investors to go looking for yield elsewhere. While credit markets may have been the most immediate beneficiaries, equity income has looked increasingly attractive. Global indices were yielding 3% p.a. in September 2011 and dividends have grown strongly over the last five years. Extrapolating that trend could be dangerous. On average, companies were paying out 30% of their earnings five years ago – low by historic standards – but that has risen to almost half – above the long-term average.

Chart 5: An on-off relationship

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Autumn 2016 5

Earnings growth would help to underpin future dividend growth but, here too, it is difficult to make a strong case. Global equity earnings have dropped more than 10% over the last five years when measured in dollars. (About two-thirds of that reflects the relative weakness of other currencies.) The scope for recovery towards previous trends may provide a medium-term boost to growth. Against that, even bullish forecasters might question whether future global economic conditions will support the sort of long-term growth in earnings (about 2% p.a. in real terms) that equities have enjoyed over the past half-century.

For $ investors, dividend income, earnings growth and currency impact have cancelled each other out in the last five years (Chart 6). Equities have generated strong returns entirely because valuations have increased (on the back of the support of lower bond yields). Dividends and earnings

Chart 6: MSCI AC World Index - Returns (% p.a.) in US dollars 30 Sep 11 - 30 Sep 16

growth may pull in the same (positive) direction in the medium term, but that might require an improving economic background that would be associated with a gradual increase in interest rates and bond yields. Even if it is no greater than what is implied by bond markets already – an increase in 10-year inflation linked US Treasury Bond yields from roughly zero to 0.5% p.a. over the next decade – it could be a significant headwind to the progress of equities in contrast to the tailwind of recent years. It may be good for the global economy but, if it’s bad for bonds, this time it may be bad for equities.

Revaluation TotalCurrencyEPS growth(local)

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Source: Datastream, MSCI, Hymans Robertson

Graeme Johnston Head of Capital Markets graeme.johnston@hymans.co.uk 0141 566 7998

6 Investment perspectives

Multi-asset funds are increasingly under the spotlight amid accusations of disappointing headline performance. Is this justified and how should success be measured?

Under the Spotlight: Multi-Asset Funds

Multi-asset funds (also known as diversified growth funds or ‘DGFs’) caught the attention of the market in the mid-2000s and their popularity has soared since. They allowed investors to access a wider range of asset classes than traditional balanced funds had, with many seen as equity replacements, providing “equity-like returns” but with a volatility lower than equities.

As the asset class has evolved, two main types have emerged:• Directional – typically take long only positions, with

managers altering asset allocations in search of value, though generally have significant exposure to wider market conditions.

• Absolute Return – these can take both long and short positions and aim to provide a positive absolute return regardless of underlying market conditions. They should be less sensitive to the performance of equities and bonds than directional funds.

Within these two very broad categorisations there is an array of sub-sectors and different approaches adopted by managers. This may include a focus on tactical asset allocation, a process aimed at capturing traditional active stock picking or a fund seeking to gain a broad exposure to alternative assets.

Has Multi-Asset Passed the Test?Ironically, judging the success of multi-asset funds is more difficult than judging the success of an active equity or bond fund.

With the multi-asset fund market having grown considerably in size over the past few years, we have begun to see more dispersion in the performance of funds.

As can be seen by Chart 7 overleaf, multi-asset funds (represented by the blue dots) have broadly lagged the performance of equities (represented by the red triangle).

More strikingly, multi-asset funds have underperformed a hypothetical balanced fund (comprised of 60% global equities and 40% global aggregate bonds and represented by the black square) with only a very modest reduction in volatility, meaning they have lagged the previous incarnation that they were meant to improve on. The degree of underperformance has worsened in the last 3 year period compared to the prior 3 years. The performance shown is shown on a gross of fees basis. Fees for multi-asset funds tend to be in the range of 0.5 – 0.8% p.a. so net of fees the position will be worse.

Autumn 2016 7

Multi-asset performance is shown gross of feesWhilst much of the underperformance of multi-asset funds relative to equities and bonds can be attributed to the combined strong run of equities over recent years and continued long-term bond bull market, the performance of multi-asset funds has been disappointing in general.

Many funds initially performed well during the period of rising asset values that followed the loosening of monetary policy by many central banks in response to the global financial crisis of 2008. But then in recent years, when the “easy money” has disappeared, many funds have been failing to meet their performance targets.

Determining Skill vs. LuckOne of the most challenging aspects of assessing multi-asset performance is the failure of most managers to provide meaningful performance attribution that demonstrates skill as opposed to luck. Multi-asset funds are not cheap and the outperformance or ‘alpha’ that is promised by managers through tactical asset allocation and security selection has failed to materialise for many.

We have developed a tool that will aid in differentiating between skill and luck. This tool examines a manager’s performance attribution and assesses the value added by their decisions over the life of their strategy, allowing us to judge whether they have been rewarded for asset allocation decisions. This alone won’t solve the problem but will be a valuable addition to the toolbox.

Charts 8a and b on the next page provide an example. We see that the key contributor to the difference in performance was the (hypothetical) manager’s decision to make a series of reductions in the commodities allocation starting in Q3 2014, just prior to an extended period of poor performance by commodities, and switching assets into index-linked gilts (Chart 8b).

This type of analysis shows how examining the impact of asset allocation decisions over a longer period of time can provide more insight than simply looking at the overall returns.

8 Investment perspectives

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MA Peer Group EquitiesMedian MA FundBalanced Comparator CashBonds

Chart 7: Multi-Asset Peer Group Performance1

1 The Multi-Asset peer group is comprised of 34 funds actively monitored by Hymans Robertson. The indices used for comparison are: Equities – MSCI World Index; Bonds – Barclays Global Aggregate Index (GBP Hedged); UK Property – IPD UK Monthly Property Index; and Balanced Comparator – 60% MSCI World and 40% Barclays Global Aggregate Index (GBP Hedged).

a) 3 Years to 30 June 2013 b) 3 Years to 30 June 2016

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Conclusion With more scrutiny being placed on the asset class, the pressure is on managers of multi-asset funds or DGFs to demonstrate that they can add value relative to cheaper passive alternatives.

There will be times when equities and bonds face significant challenges and at these times multi-asset managers should have greater opportunity to demonstrate skill through tactical asset allocation and security selection. We are confident that there are a number of high quality multi-asset managers who can react positively and, despite the challenged performance, still earn their place in portfolios.

More broadly, multi-asset managers adopt different approaches to achieving their performance and investors should be clear what issue they are trying to solve: for example, is it to invest in a single diversified balanced fund, to gain access to a basket of alternatives, or tactical asset allocation. Identifying the aim at the outset will influence the type of multi-asset manager that is most appropriate.

Having selected the manager, we encourage investors to judge their success on a broader basis than headline performance alone (especially relative to equities). We believe that the mosaic of tools we have at our disposal can provide a more rigorous and robust assessment.

Autumn 2016 9

Total

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Chart 8: Analysis of the Quarterly Performance Attribution of a Multi-Asset Mandate

a) On an Absolute Basis (%) b) Relative to Asset Allocation at Inception (%)

Adam PorterAssociate Investment Research Consultant adam.porter@hymans.co.uk 0207 082 6243

Efficient deployment of capital – making your assets work harder

The era of “LDI” mandates simply referring to the creation of bespoke and leveraged interest rates and inflation exposures may be nearing an end. The next stage in the evolution of mainstream LDI is likely to include leveraged exposures to equity and credit.

Trustees of pension funds have always had to manage their investments to meet more than one objective. However, the extent to which there are demands on fund assets to achieve multiple, and at times conflicting, needs is stretching the envelope.

While there are plenty of nuances, the key investment objectives of any group of trustees will be framed around the following:• To generate enough return to meet the funding target

• To generate enough income to meet the liability payments

• To manage the level of variability in the funding level

To fully achieve these objectives trustees increasingly need exposure to assets equivalent to more than 100% of the assets they actually hold. The combination of ultra-low interest rates and maturing liability profiles is making this all the more challenging.

Most pension fund trustees have implemented some form of interest rate and inflation hedging. However, in many cases trustees know that to control funding volatility they will need to hedge even more of their interest rate and inflation exposure, and that means higher exposures to gilts in future.

Acting against this, few funds are in a position to be reducing their target return. Moreover, a growing proportion of funds are now cashflow negative and, at current yields, the coupon on gilts is not going to provide much of an income stream.

The use of pooled “LDI” funds that use gilt derivatives to gain leveraged exposure to the gilt market relative to the level of the actual amount invested go some way to solving this conundrum. LDI funds have been hugely constructive for pension funds, especially those looking for a relatively “governance-lite” hedging solution, and although not universally used, the funds are largely now considered “mainstream”.

But, as with any form of derivatives, there are potential drawbacks:• When leverage is used to increase exposure without

increasing the amount of cash invested, there is a cost associated with the additional derivative exposure that still needs to be paid for. The cost of this leverage may be referred to as the ‘funding cost’.

• There is a need to have access to collateral that can be posted if the position moves in favour of the counterparty, i.e. in the case of hedging interest rates, when rates rise. This limits the multiple of exposure (or “leverage ratio”) that managers can provide within their LDI funds.

Many of the alternative assets that pension funds hold typically need to be held through physical cash based investments – property, private equity, senior secured loans. However, like gilts, exposure to listed equities and investment grade corporate bonds can be easily, and cheaply, achieved through highly liquid derivatives.

10 Investment perspectives

This introduces new opportunities for trustees:• It is possible to compare the transaction and ongoing

roll cost associated with gilt, equity and credit derivatives to ensure that trustees are implementing leverage where it is most cost effective. As Chart 9 shows it might be cheaper to use equity index derivatives to free up capital that can be invested in physical gilts, rather than holding passive physical equities and using gilt derivatives to gain the gilt exposure.

• Freeing up capital also facilitates implementation of more efficient strategies: by using equity futures and investing the capital freed up into leveraged LDI funds, trustees can increase their hedging while maintaining their equity exposure. Alternatively, by using equity derivatives trustees can boost their pool of available collateral, reducing the risk of being a forced seller of risk assets or having to close out hedges to meet benefits.

Many pension funds hold allocations to Investment Grade corporate bonds, with the aim of clipping an extra return relative to gilts. However, with gilt yields on the floor and credit spreads below long-term average levels, the absolute yield on these corporate bonds is also very low (the yield on the All Stocks non-gilt index is just 2.5% p.a.). Most Investment Grade corporate bonds held by pension

funds are also relatively short-dated, so they provide little interest rate (and no inflation) hedging. In effect, Investment Grade corporate bonds have become a capital intensive asset for limited contribution to meeting pension fund investment objectives.

Instead, trustees could replace their corporate bond holdings with Investment Grade credit derivatives (called credit default swaps or CDS) plus long-dated gilts or LDI funds. The outcome is to achieve more hedging but with a similar level of income and target return, as illustrated in chart 10 above moving from the strategy A to strategy C. Strategy B is an illustration of how the return is reduced if simply moving corporate bonds to leveraged LDI funds.

1y Gilt Repo vs 3m LIBOR 1y MSCI World vs 3m LIBOR

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Source: BlackRock

Chart 9: Comparison of equity and gilt derivative costs

Andy GreenChief Investment Officer andy.green@hymans.co.uk 0131 656 5151

Yield over gilts Interest rates hedged

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Chart 10: Comparison of credit and hedging implementation solutions

Obviously, any level of derivative exposure introduces different complexities and risks that need to be managed, and if trustees use more derivatives, then they need to pay particular attention to operational and collateral risks.

However, we see the role of LDI mandates moving on from one of just hedging interest rate and inflation risk to one that looks more broadly and manages target exposures across liquid markets. We expect to see a growing market in pooled funds to facilitate this for those requiring governance-lite solutions.

Alen OngSenior Investment Research Consultant alen.ong@hymans.co.uk 0207 082 6328

Market returns to 30 September 2016

Yield % p.a. Returns to 30 September 2016 (sterling, % p.a.)

30 Jun 30 Sep 1 year 3 years 5 years

Equities

Global 2.7 2.6 31.3 13.9 15.4

UK 3.7 3.5 16.8 6.6 11.0

Developed markets ex UK 2.5 2.4 31.9 15.2 16.9

Emerging markets 3.2 3.0 36.6 8.4 7.4

BondsConventional gilts 1.4 1.2 12.6 8.8 6.2

Index-linked gilts -1.4 -1.8 24.1 14.3 10.5

Sterling corporate bonds 3.2 2.5 15.9 9.1 9.5

High yield (US) * 7.6 6.6 12.8 5.3 8.2

Emerging market debt 6.8 6.7 37.0 4.5 3.4

UK Property - - 3.2 12.6 9.5Hedge Funds * - - 0.0 2.5 4.3Commodities - - 15.9 -5.6 -4.3

* Return in $

Source Datastream:FTSE All Share FTSE World Developed ex UK FTSE All World FTA Govt All Stocks FTA Govt Index Linked All Stocks iBoxx Corporate All Maturities BofA ML US High Yield Master II JPM GBI-EM Diversified Composite UK IPD Monthly Credit Suisse Hedge Fund S&P GSCI Light Energy

If you would like to find out more about any of the topics discussed in this publication please contact your usual Hymans Robertson consultant or:

Andy GreenChief Investment Officer andy.green@hymans.co.uk 0131 656 5151

Graeme JohnstonHead of Capital Markets graeme.johnston@hymans.co.uk 0141 566 7998

Mark BakerHead of Investment Research mark.baker@hymans.co.uk 020 7082 6340

This communication has been compiled by Hymans Robertson LLP, and is based upon their understanding of legislation and events as at September 2016. It is designed to be a general information summary and may be subject to change. It is not a definitive analysis of the subject covered or specific to the circumstances of any particular employer, pension scheme or individual. The information contained is not intended to constitute advice, and should not be considered a substitute for specific advice in relation to individual circumstances. Where the subject of this document involves legal issues you may wish to take legal advice. Hymans Robertson LLP accepts no liability for errors or omissions or reliance on any statement or opinion.

This information is not to be interpreted as an offer or solicitation to make any specific investments. All forecasts are based on reasonable belief. Please note the value of investments, and income from them, may fall as well as rise. You should not make any assumptions about the future performance of your investments based on information contained in this document. This includes equities, government or corporate bonds, currency, derivatives, property and other alternative investments, whether held directly or in a pooled or collective investment vehicle. Further, investments in developing or emerging markets may be more volatile and less marketable than in mature markets. Exchange rates may also affect the value of an investment. As a result, an investor may not get back the full amount originally invested. Past performance is not necessarily a guide to future performance.

Hymans Robertson LLP (registered in England and Wales - One London Wall, London EC2Y 5EA - OC310282) is authorised and regulated by the Financial Conduct Authority. A member of Abelica Global. © Hymans Robertson LLP. 4737/MKT/Inv0416

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