The £8.4 billion ($11.2 billion) Centrica pension fund for employees of one of the UK’s largest energy suppliers is steadily increasing the level of innate defensiveness within its equity and credit portfolios. Recent strategies include a put spread collar to add downside equity protection, switching some equities into convertible bonds that have a floor and don’t sell off as sharply as stocks, and swapping some equity into cash for dry powder.
Within the credit portfolio, chief investment officer Chetan Ghosh has taken down the high yield exposure and reduced the embedded duration in a couple of the mandates to better reflect where government bond yields now sit. It is all based on capital preservation, in case markets fall steeply, he says in an interview from the fund’s headquarters in Windsor, a town on the outskirts of London.
The put spread collar was structured around a zero-premium outlay at the outset. Centrica achieved downside protection but sold off some of the upside to enable this zero premium.
“It was a three-year structure and we only participate in the first 20 per cent of equity returns. By selling off the upside, we could finance the purchase of the protection,” Ghosh explains.
He likes the structure because it is contractual up front and can’t throw up any surprises. He says he will consider a similar strategy at maturity if the equity market still hasn’t gone through a downturn.
“At maturity, the need for protection may have gone away, so we will judge it as and when,” says Ghosh, who joined Centrica in 2009 after working for more than a decade as a pension actuary and investment adviser to UK pension schemes.
He is also spotting opportunities where the fund could deploy its dry powder. He doesn’t expect the same kind of opportunities to appear that manifested in the wake of the financial crisis in the loan market, where the high number of leveraged holders of this type of paper made for rich pickings. Nor does he believe corporate credit will give the same opportunities it did in 2009. This time, he expects more buying opportunities in equity than in fixed income and is shaping a more granular approach. This could include allocating to junk stocks in anticipation of a rally or topping up the emerging-market allocation. He is also looking at special ways to play the high yield market, which could include partnering with managers specialising in recovery plays, given the tail wind to the asset class.
“Being prepared is the main project on our table,” Ghosh says. “If something is expensive, we sell it; if it is cheap we will increase our weightings to it. This is what we do all the time.”
Bold allocation to emerging and frontier equities
Big on the frontier markets
Assets are divided between a 50 per cent allocation to equity and asset classes with equity-like returns, a 25 per cent allocation to a liability matching solution, which includes government bonds alongside assets with long-term contractual cash flows like ground rents and social housing debt. An additional 5 per cent of the portfolio is in UK property and the remaining 20 per cent is in investment-grade and sub investment-grade corporate bond exposure.
Centrica stands out from peers for its bold allocation to a well-constructed and diverse portfolio of emerging and frontier equities that accounts for 25 per cent of the total equity portfolio. The pension fund doesn’t copy the market cap allocation to these markets because it doesn’t want disproportionate exposures to any one country, sector or factor, Ghosh explains.
The allocation rests on his belief in the link between nominal growth and returns on shares from these markets, and the fact that emerging-market growth will come with a demographic tail wind that isn’t present in developed markets and countries. Frontier strategies focus particularly on favourable macro landscapes in emerging economies, he explains.
“We are with one manager who was one of the first to invest in Africa but when the macro landscape moved against Africa, investment shifted to the Middle East,” Ghosh says. “This has worked its way through and we are now putting money back into Africa.”
It’s a regional approach that also focuses on idiosyncratic opportunities in individual countries, which have recently included Vietnam and Argentina. Frontier investments focus on listed equity but, in Africa, steer clear of subsidiaries of large multinationals, where much of the hot money in frontier markets collect.
“If you stick with these well-researched names, you are at the mercy of hot money flows and can buy into overvalued assets.”
Leave active managers to it
All the pension fund’s assets are managed externally, and Ghosh makes no attempt to modify or influence selected manager strategies because he believes it leads to bad investment results.
“We have a distinct philosophy to hire our managers because of the process and approach they have developed over a number of years of experience. We feel if we try to modify or change them it goes against their natural DNA, so we wholly buy into their process.”
About two-thirds of the portfolio is invested in active strategies, where managers are chosen as much for their outperformance skills as their ability to manage risk. Centrica has a different definition of alpha, whereby the pension fund recognises recognises risk savings as much as it does excess returns, Ghosh explains.
“The risk savings piece is materially important because we experience most pain in sharp equity downturns, so if we have managers curtailing that downside, that is materially valuable to us. If a manager can match the index in terms of return but do so with only two-thirds of the volatility, we classify that as alpha as well. We have a large amount of equity capital with fund managers who we expect to do materially better on the downside.”
The fund posted a five-year return of 10.3 per cent.
These kinds of strategies, which combine outperformance with lower volatility and a bias to capital preservation, include allocations to gold or investing in corporate and government bonds to conserve capital when the market is elevated. The pension fund also invests in big blue-chip names that can compound earnings.
“When markets fall off, people stick with these names because they feel they will survive a downturn,” he says. Similarly, the smart-beta portion of the passive equity allocation focuses on material savings on the downside via maximum diversification.
“It means we are getting equity risk premia in the most diverse way and get two-thirds of the volatility of the equity market.”
Go for cash flow
Over the last seven years, Centrica has also steadily boosted its allocation to assets that provide cash flows to match its long-term liabilities. It’s a strategy that views liability management as a cash-generating activity rather than a hedging activity, and assets include ground rents and social housing in a portfolio that now accounts for 11 per cent of assets under management, well in excess of the average among pension schemes.
“We will need more of these types of assets and will take our time in selecting and picking up well-priced assets over next 30 years on our journey.
As for other uncertainties on the horizon, the pension fund isn’t planning any strategy changes around Brexit. After the UK’s vote to leave the European Union, gilt yields moved lower, hitting Centrica’s funding level, and the pension fund was also affected by sterling’s depreciation. It left the fund having to find money to post as collateral against currency hedges for a short time.
“The situation reversed and we got that money back,” Ghosh says. “It was more short-term noise rather than long-term investors. Today, we default to our long-term asset allocation and rest assured that we are properly diversified.”
