More LDI fans turn to synthetic equity

Synthetic equity is fast becoming a way of enhancing liability-driven investing strategies for U.K. pension funds entering the next phase of pension risk management, according to consultants and managers.

Vanessa James, investment director at the £4 billion London Pensions Fund Authority, said the fund implemented a synthetic equity strategy late last year “to free up capital for collateral and lock in the attractive terms available.” Fund executives decided to sell about £100 million in passive equity assets invested in the U.S., U.K., Europe and Japan. The proceeds were used to increase holdings in cash and government bonds, which could be used as collateral. The equivalent passive equity exposure was obtained through both equity total return swaps and futures.

“It was taking our LDI strategy one step further,” said Ms. James. LPFA was among the first local authority pension funds to implement an LDI strategy in 2005 and now has £1.2 billion, or about 30% of total assets, in its LDI portfolio.

Other pension funds that have implemented synthetic equity strategies include the £26 billion Royal Mail Pension Plan, London, and the £7.3 billion Aviva Staff Pension Scheme, Perth, Scotland. According to Royal Mail's annual reported for the year ended March 31, BlackRock Inc. manages a £11.2 billion LDI portfolio.

“This approach has been picking up more interest in the last 12 months,” said Stephen Woodcock, principal and senior consultant within Mercer LLC's investment consulting group in London. “It's obviously linked to the relative position of gilts vs. swaps.”

Traditionally, inflation swaps and interest-rate swaps were less expensive than the equivalent inflation-linked government bonds, also known as gilts. Therefore, pension funds tended to use swaps to hedge liabilities in LDI portfolios and separately invested cash in growth assets such as equities for additional returns.

But during the financial crisis, pension funds investing in physical bonds got better returns than funds using the equivalent swaps. Following the collapse of Lehman Brothers Holdings Inc. in September 2008, the spread between physical bonds and the swap curve reached as high as 100 basis points but has since narrowed.

“Pension funds are taking advantage of relative value opportunities,” said Tarik Ben-Saud, managing director and head of liability-driven investing for Europe, Middle East and Africa at BlackRock, London.

“If pension funds had stayed in cash equity and interest rate swaps, they would have missed out on an opportunity that could add 10% to 15% at the total scheme level over a period of about 30 years.”

Furthermore, as pension funds mature, a larger portion of the liabilities require hedging, resulting in the need for additional assets that can be used as collateral, such as cash, government bonds and high-grade corporate bonds.

To hold the physical bonds rather than using swaps, pension funds need cash, which they are raising by selling their equity holdings, Mr. Woodcock said. Equivalent equity market exposures are then obtained through derivatives, which require much less upfront capital but effectively shift the leverage from the liability-hedging strategy to the growth assets portfolio, sources said.

The concept of using leverage on an overall portfolio level is not new and recently appeared in the U.S. through risk parity strategies, in which the bond portfolio is leveraged until it reaches the volatility of an equity portfolio. In the U.K., leverage is being used as a more efficient way of deploying capital within an LDI context, consultants said.

“Holding equity, in this case, is a disadvantage because it is eating up capital that could be used as collateral,” said Phil Page, client manager at Cardano UK, based in London. “By transferring the (physical) equity holdings to the equivalent synthetic exposure, pension funds can keep the equity market exposure that's needed for additional returns to get them out of the hole.”

Robert Gardner, founder and co-CEO of independent investment consultant Redington Ltd., London, said his firm has advised pension fund clients to implement synthetic equity strategies with an estimated aggregate value of about £10 billion ($16 billion) in the past year.

For example, a pension fund investing 60% in equity and 40% in government bonds might sell 20% of the total equity assets and buy government bonds. At the same time, replacing the same equity exposure synthetically with futures and/or total return swaps, “the net result is a 60% bond exposure and a 60% equity exposure,” Mr. Gardner added.

From an asset-liability management perspective, “the funding level volatility is less because while the equity exposure is the same, the mark-to-market liability matching portion of the portfolio is now higher.”

If the situation reverses and swaps yield more than physical bonds, then pension funds might go back to investing in physical equities and use interest-rate and inflation swaps to hedge their liabilities, Mr. Gardner said.

Others, however, will continue to take advantage of synthetic equity strategies to add portfolio flexibility.

“Synthetic equity has low frictional cost, so (pension fund executives) are able to use the capital elsewhere,” said Mr. Ben-Saud of BlackRock. “As funds reduce equity beta, it's also easier to liquidate (synthetic equity exposures) quickly when markets reach a level that's attractive.”

BlackRock has helped clients implement synthetic equity strategies with an estimated total value of about £6 billion over the past two years.

Precise data on the value of synthetic equity overlays implemented as part of LDI strategies in the U.K. are not available, but consultants and managers estimated that as much as tens of billions of pounds have been converted from physical equity portfolios in the past year alone.

Synthetic equity exposures are obtained mainly through either futures, which are exchange traded, or equity total return swaps, which are over-the-counter contracts.

Total return swaps are gaining momentum over futures because pension funds can better tailor the contract terms to suit their investment targets, and they don't have to post initial margins as they do with equity futures. “It's more efficient use of capital, and provides additional flexibility” compared to futures, Cardano's Mr. Page said.

Cardano officials are discussing with several clients ways of implementing LDI strategies using synthetic equity exposures totaling several hundred million pounds. Mr. Page declined to name the clients, but added all already have an LDI strategy in place but “want to take it to the next level.”

In the U.K., an added advantage of investing in equity derivatives over physical equity is the tax savings.

Marcus Mollan, head of strategy in the pension solutions team at Legal & General Investment Management Ltd., London, said the firm has worked with an increasing number of clients to implement synthetic equity overlays within LDI strategies this year. As of Sept. 30, LGIM recorded more than £5 billion in segregated synthetic equity transactions — achieved by using either futures and/or total return swaps — for pension risk management clients.

“Most clients are already in the first phase of LDI, which involves hedging interest and inflation risks, and are moving to the second phase of their LDI strategy,” Mr. Mollan said.

Mandates range from £200 million to about £1 billion, and clients have sold mostly passive but also active developed market portfolios and obtained the equivalent equity exposures through derivatives. The cash is then often used to buy index-linked government bonds to hedge liabilities. Some clients have also purchased corporate bonds to add extra return.

So far, it has been the larger pension funds with substantial internal resources that are implementing such strategies, Mercer's Mr. Woodcock said.

But that's changing. In December 2009, F&C Asset Management was the first to launch a pooled LDI fund that uses synthetic equity overlays in a bid to attract small to medium pension fund clients. The fund has about £213 million in assets under management, according to data provided by the firm. F&C also manages similar equity overlay strategies valued at another £3.5 billion in segregated LDI institutional mandates.

“All schemes have a long-term plan to take equity exposures down,” said Alex Soulsby, head of F&C Asset Management PLC's derivative fund management in London. “As funding improves, what will happen is that they'll keep the underlying (fixed-income assets) and reduce the synthetic equity exposure. This approach allows for a derisking flight path that's attractive as much for its simplicity of implementation as the differentials between physical bonds and the (equivalent) swap curve.”