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.