European Pensions and Investment Summit 2012

IMPLEMENTING A LONG-TERM INVESTMENT

PHILOSOPHY

1

Roger Gray

Chief Investment Officer, USS Ltd.

PHILOSOPHY

• USS

• How to be a long-term investor• How to be a long-term investor

• Current conditions

2

USS

• Open DB pension scheme since 1974

– 400 UK universities, higher education and research institutions

– 285,000 members: 50% active, 30% deferred, 20% pensioners

– Assets: £33bn (€40bn)– Assets: £33bn (€40bn)

• Target SAA

Equities 50%

Alternatives 21%

Property 9%

Bonds 20%

• Largely internally managed: investment office of 95

3

Strategic Asset Allocation

• Managing twin objectives– Required contribution rate

– Volatility of required contributions

• SAA has become more balanced • SAA has become more balanced – Reducing risk concentrations

• Potential addition of liability hedging overlay– A liability-matched target state

– Current market yields in long-term perspective

4

Gilt Yields – Nominal & Index-Linked

5

6

7

8

9

10

Bo

nd

Yie

ld %

Latest Yields (as of 14 May 2012)

Nominal 3.2%

Index-Linked -0.1%

5

-1

0

1

2

3

4

5

Bo

nd

Yie

ld %

UK 30-Year Nominal UK 30-Year Inflation-Linked

Diversification: Implementation

• From low-cost model …

– In-house manager: Equities, Govt Bonds, Property

– Passive-like costs, some alpha

• ... to cost-effective customised solution• ... to cost-effective customised solution

– Wider range of activities

– Alternatives team; delegated manager fees

– Dynamic asset allocation and A-L risk management

– Greater operational demands

– Increased regulatory scrutiny

6

Diversification: Governance

• Clarification of Delegations

– Board, Committees, Executive

• Additional Specialist Expertise• Additional Specialist Expertise

• Investment Company Subsidiary

– Professional board: executive and non-executive

– Comprehensive investment management agreement

7

• USS

• How to be a long-term investor• How to be a long-term investor

• Current conditions

8

Characteristic Traits

INVESTORS: Short-Term Long-Term

LIABILITIES Short-term Long-term

CASH-FLOW Negative Positive

TURNOVER High (Trading) Low (Stewardship)

RISK Volatility Sustained loss or shortfall

9

RISK Volatility Sustained loss or shortfall

FORECASTS New, direction, technicals Risk premia, inefficiencies

ILLIQUIDITY Low tolerance High(er) tolerance

MANAGER

TENURE Short Long

ASSESSMENT Performance... Process/People...

INCENTIVES Short-term Long-term

Managers: Internal or External

Internal External

ALIGNMENT Career Relationship vs. Transaction?

INCENTIVES Long-term alpha

Risk-adjusted, after-cost

Collective and individual

Benchmarks: Beta vs. Alpha?

Short vs. Long-term?

Luck vs. Skill?

10

GOAL Return maximisation Profit maximisation

FOCUS Investment Asset gathering vs. capacity?

TRANSPARENCY Visibility, control & risk mgt. Integrated/superior reporting?

COST Scale: basis point per AUM? Profit goal, business expense

CAPABILITIES Incomplete, inferior, robust? Accessing best managers?

TIMELINESS Build investment/operations? Selection and due diligence

RISK BUDGET Concentration? Governance burden

ALLOCATIONS Permanent Occasional

Required Risk, Desired Risk

Risk-Taking Capacity

• Funding Ratio

• Strength of Covenant

• Duration of Liabilities

Risk Tolerance

• Contribution Minimisation

versus

• Acceptable volatility of • Duration of Liabilities

• Maturity of the Scheme

(projected cash flow)

• Risk-Sharing

(benefits + contributions)

• Acceptable volatility of

contribution rate

• Regulator’s Tolerance

– recovery period

– return assumptions

11

Sustainable Investment Policies

• Working within your boundaries

– Tolerable contribution rate and funding ratio?

– Acceptable recovery period?

– Reasonable asset performance assumptions?

– Scope for sharing risks and benefits?– Scope for sharing risks and benefits?

• Covenant, fund rules, actuary, regulator, human factors

... Long-term investment based on acceptable risk

12

DAA and Long-Horizon Investing

• DAA: When to take what and how much risk?

– Absolute and relative value

– Time-varying risk premia– Time-varying risk premia

• Equity

• Credit

• Illiquidity

• Insurance

• Long horizon stabilises required rate of return

... The comfort of long-term confidence cones

13

150

200

250

Fun

din

g R

ati

oConfidence Intervals & Risk Tolerance

Liabilities + 3%

Liabilities + 2%

Liabilities + 1%

Assumes:Sharpe Ratio = 0.25

Initial Funding Level = 85%

0

50

100

Fun

din

g R

ati

o

14

• USS

• How to be a long-term investor• How to be a long-term investor

• Current conditions

15

Taking Risk … if you can

• Systemic capacity shortages for

– Taking Risk

– Providing Liquidity

Bearing Complexity– Bearing Complexity

• Tension between our Twin Objectives

– Investment Returns: keep contributions ‘affordable’

– Limiting Risk: avoid (much) higher contributions

... heightened by low funding ratio

16

Some Post-Crisis Issues for SAA

• Instantaneous vs. long-term risk and return– e.g. Term structure distortion

– Playing ‘safe’ can add risk and make you poorer

• Hedge funds: mix your own

• Commodities: of super-cycles and 1-month futures• Commodities: of super-cycles and 1-month futures

• Risks of pro-cyclical risk models

• What data set?– Example of optimal currency hedging:

• With or without 2008

• Asset-liability context

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10.9%

11.0%

11.0%

11.0%

An

nu

alis

ed

Mo

nth

ly V

ol

Optimal FX hedging

Full data set: Excluding H2 2008:

10.8%

10.9%

11.0%

An

nu

ali

se

d M

on

thly

Vo

l

18

10.9%

10.9%

0% 20% 40% 60% 80% 100%

FX Hedge RatioA

nn

ua

lis

ed

Mo

nth

ly V

ol

1.0

1.2

1.4

1.6

1.8

2.0

2.2

1999 2000 2002 2004 2006 2008 2010

Do

llar

& E

uro

100

150

200

250

300

Ye

n

Dollar

Euro

Yen

10.7%

10.8%

0% 20% 40% 60% 80% 100%

FX Hedge Ratio

An

nu

ali

se

d M

on

thly

Vo

l

Investment Conclusions

• Assets serve liabilities

• The ERP is dead, long live the ERP

– Expected rewards for bearers of systematic risk

• Too much of a good thing

– Is policy sustainable? What to do if ‘worst case’ scenario?– Is policy sustainable? What to do if ‘worst case’ scenario?

– Diversification of factor risk

• Contrarianism at extremes

– Can you buy/hold in stressed markets?

– Can you defer return-seeking in complacent markets?

– Can you afford not to?

– Regulatory regime, horizon, covenant strength, human factors

19

European Pensions and Investment Summit 2012

IMPLEMENTING A LONG-TERM INVESTMENT PHILOSOPHY

20

Roger Gray

Chief Investment Officer, USS Ltd.