USS IM focused on in-house fixed income

The COVID-19 pandemic and its effects are not slowing down USS Investment Management Ltd.'s fixed-income executives from achieving their aim of more internal money management.

Not only are plans moving ahead, but the pandemic also gave the team the opportunity to execute some huge trades.

USS IM is the in-house manager for the U.K.'s largest private pension fund, Universities Superannuation Scheme, London, which had about £82 billion ($111.3 billion) in assets as of Dec. 31. The majority of assets is held in a defined benefit plan, with the remainder in a defined contribution plan.

The fund is currently the subject of proposals, reviews and commentaries due to a ballooning deficit. On a technical provisions basis, the deficit grew to between £14.9 billion and £17.9 billion as of March 31, 2020, depending on the scenario used to value the shortfall — from £3.6 billion as of March 31, 2018. Current proposals from the pension fund include increasing the level of employer and participant contributions.

Even with potential changes on the horizon, the fixed-income team is marching on with its tasks. "I'm building the team so that we can run a greater proportion of the assets in-house — that's very useful for us as the scheme continues to mature," said Ben Clissold, head of fixed income and treasury in London, in an interview. "We can deliver better value for money for members and better alignment with the long-term challenges we face."

The latest available figures, as of March 31, 2020, show the pension fund's asset allocation was 26.9% index-linked bonds, 11% "other" fixed income, 6.5% nominal government bonds and 2% absolute-return strategies. The rest of the portfolio was invested in public equities (38.4%), other private markets (21.9%), real estate (5.5%) and commodities (1.1%). There is also a 13.3% exposure to cash and overlays.

The team runs about £25 billion — meaning about 75% of total fixed-income assets are managed internally — but that includes a lot of leverage, Mr. Clissold said. That leverage is used for protection from moves in interest rates and inflation — which can of course lead to losses but not when looking relative to USS' liabilities because both move in tandem, Mr. Clissold added. There are also foreign-exchange overlays to manage FX risk in non-sterling assets. Assets run in-house include developed and emerging markets government bonds and credit.

The most recent preparation for more in-house management started with last month's appointment of Janet Oram as USS IM's first head of asset-backed securities.

Current USS allocations to ABS — "an area where we as a team was underrepresented," Mr. Clissold said — are immaterial in public markets and there is only a small private markets exposure. Ms. Oram will build a team but how much they will run is "an open question … like lots of areas of credit, (we) may choose to deploy more or less depending on the relative value between (ABS) and corporate bonds."

Mr. Clissold thinks ABS will bring a lot of investment opportunity going forward and, when he joined 18 months ago, thought it was an area of fixed income that USS IM should be doing more in — particularly since "a large proportion of credit in the U.K. is asset-backed."

There's also no target for the percentage of fixed-income assets that will be run in-house — that depends instead on asset allocation decisions and the growth of the team.

But not all of the fund's fixed-income management will move in-house — Mr. Clissold wants to be smart about it. "The way I envisage that working is there's lots of external managers that do a phenomenal job, and we want to get the best out of them. We're not ever going to have the breadth of knowledge of 100 different external managers — it's just not going to be possible. So we want to make sure we get the best out of those partners and pick those partners very carefully, and make sure we have a good, strong relationships" with them.

As is the direction of travel for most large asset owners, the in-house manager will have fewer external managers but stronger relationships. Mr. Clissold declined to comment further on relationships with external managers.

Keeping some of the fund's fixed-income allocations with external managers just makes sense, Mr. Clissold said.

Taking U.S. mortgages as an example — which USS does not invest in right now — "imagine we decided that they look really cheap and we wanted to go and buy some," Mr. Clissold said. "We could try and build a team to do that, (hold the allocation for a couple of years) and then we decide they aren't cheap anymore and we sell them. Would we really want to go out and hire however many individuals you need to run those and then make (the staffers) redundant in two years' time? It's just clearly not very sensible," he said.

There will always be areas of investment where short-term or relatively short-term allocations are warranted, meaning partnerships with external managers. But there are other areas like sterling corporate credit or ABS "where, as a U.K. pension scheme, we're likely to hold those for decades potentially as an open scheme, and having the capability to do that in-house (is) sensible," Mr. Clissold said.

That approach of running certain allocations in-house proved itself in the COVID-19 pandemic.

"Opportunistically, credit spreads were quite a bit wider and there was poor liquidity in corporate bonds last March and April," Mr. Clissold said.

That led the in-house fixed-income team to do a "significant amount" of selling of derivatives that had been used for protection via the Credit Default Swap index, "which allows you to get exposure to those wider credit spreads. And as time went on and markets reopened, we were able to transition into physical credit," Mr. Clissold said. USS IM executives increased corporate bond allocations to just over £3 billion from £1 billion.

While USS IM is a long-term investor, running assets on behalf of a pension fund with more than 450,000 participants employed in the universities and higher-education sectors, short-term external factors are always on executives' minds.

"The world is following the U.S. at the moment — that's often the case at different points but it is very clear at the moment that the U.S. is driving everything," Mr. Clissold said, from central bank action to encouraging workers back into offices, to inflation and the realignment of global supply chains.

But the manager does have extra insight when it comes to central banks and policy — at least in terms of the way a central banker may think — in the shape of Kate Barker, chairwoman of the trustees since September and a director since April 2020. Ms. Barker, who is also a member of the investment committee and the governance and nomination committee, was a member of the Bank of England's monetary policy committee between 2001 and 2010.

"We are incredibly lucky to have a chair of trustees who was on the MPC … We have an enormous amount of knowledge from her and she is incredibly valuable as a resource," Mr. Clissold said.

The topic currently top of mind — as for many investors — is inflation. "There was always going to be an inflationary shock as the rebound out of the pandemic happened, and I don't think it's clear yet as to how that will play out in the long term," Mr. Clissold said.

Given it's a known unknown, executives need to be cognizant of all possible risks — potentially that inflation continues to move higher, although he thinks that's an "unlikely but definitely possible" outcome.

"Only a year ago we nearly saw deflation. The reaction function there could be either, and I think you need to be very aware that there's a huge spectrum of possible outcomes here and manage accordingly," he added. It's hard to be specific on these possible outcomes as there are so many, he said. Rather, the key is being more conservative in how USS executives manage risks and assets. But again, coming back to the manager and fund's long-term mandate, Mr. Clissold is always talking to his team about the need to be calm.

"There shouldn't be something that happens today — whatever it is, however much of a shock it is — that is going to necessarily mean we have to do something immediately. We are looking at these things in multiple years, decades, time frames, and should be cognizant of that and not jump to quick conclusions," he said.