Having chatted with Barry Kenneth, CIO of the UK Pension Protection Fund (PPF), about the pension industry and market volatility for an hour, our conversation takes an unexpected turn.
‘I am going to show you something,’ he tells me, pointing at his smartphone. Among his pictur es, there is a snap of his dining room. ‘Here I have my family tartan, four metres long, two claymore swords and a shield. You can definitely say how much I care about Scotland.’
Born in Broughty Ferry, just outside Dundee, Kenneth has now lived in London longer than he has in Scotland, but his pride in his homeland is obvious.
This same pride is clear when he talks about the PPF. Created under the Pensions Act 2004, its main function is to provide compensation to members of eligible defined benefit pension schemes when they go bankrupt or are underfunded.
It is also responsible for the Fraud Compensation Fund, a vehicle that provides compensation to occupational pension schemes that suffer a loss attributable to malpractice.
The £22 billion (€30 billion) scheme funds itself through an annual pension protection levy paid by eligible pension funds, money recovered from insolvent employers of schemes it takes on and returns from its own investments. ‘Perversely, we grow as the industry gets in trouble; we gain more assets as more companies become insolvent,’ Kenneth tells Modern Investor.
He joined the PPF two years ago, when the fund had £11 billion (€15 billion) in assets, after spending eight years at Morgan Stanley. He leads a 13-strong team split between alternatives and private markets, public markets (listed equities and credit) and liability-driven investments (LDI).
When he joined in 2013, the PPF outsourced all its investments to external managers. Under Kenneth, the fund has started to take a more hands-on role in investment decisions.
‘There has been a plan since the first day I was here regarding how to manoeuvre the investment team. Insourcing is just the next phase in that process. The investment team is now effectively taking on a lot more investment decisions, not simply picking managers.’
The road to insourcing
The activities Kenneth is looking to insource are those he expects to pursue in the long term. Over time, he says, the PPF will look more like an annuity company. As such, he is thinking about insourcing his LDIs and corporate bond portfolios.
‘What we don’t do here is physically execute, which is something we will be able to do in the future. Currently, even when we outsource, we make a lot of investment decisions.’
The PPF’s allocation target for 2017 is 58% bonds and cash, 12.5% hybrids, 22.5% alternatives and 7% listed equities. One year ago, the fund had 70% in cash and bonds, 10% in listed equities and 20% in alternatives.
Around 35% of PPF’s fixed income portfolio is allocated to UK government bonds; Kenneth says they match the interest rate and inflation characteristics of some of the fund’s liabilities. What he does not gain in interest rate and inflation exposure through government bonds is achieved through swaps.
Apart from gilts, the fixed income portfolio consists of global sovereigns (10%, cut from 20%), credit (8%), emerging market debt (4%) and asset-backed securities (2%).
‘We have reduced our sovereign bond exposure and taken duration down over the past year. We have also changed our EM debt mandate from a sovereign to an absolute return one. When developing countries are under pressure, like now, our managers switch to a defensive mode.’
Firm on alternatives
By 2017, almost a quarter of the PPF’s portfolio will be invested in alternatives. Currently, the fund has a large allocation to alternative credit, ranging from direct lending all the way through to distressed debt. ‘With the macro environment under some stress, we think these strategies have become quite interesting.
‘Think about US energy: it has been under pressure over the past six to nine months. Some of our managers in that space are looking for opportunistic investments: companies in need of restructuring; firms looking financially robust but suffering from a contagion effect.’
At the end of August, the PPF awarded a £400 million (€542 million) direct lending mandate to the US-based firm Pramerica Investment Management in a push to diversify its fixed income portfolio. ‘This is a standard direct lending mandate, but we do everything from private market lending to structured credit – and we are currently investing more in the US than in Europe.’
The second biggest alternative asset class in Kenneth’s portfolio is global real estate, notably in the US, the UK, Europe and Asia. ‘The managers we pick in Europe have more opportunistic strategies. Debt infrastructure is quite keenly priced at the moment and I don’t think the yields are there.’
Elsewhere, PPF started its private equity programme in 2010, investing initially in the secondary market, then expanding in to the primary market and co-investments last year.
‘Primary strategies try to pick medium-term themes; energy in the US is one of the stories we have committed capital to. We are also looking in to European mid-market buyouts. In these segments, we make sure we co-invest in order to make the fees more efficient.’
Other alternative picks include hedge funds (‘only those truly uncorrelated to the market cycle’), as well as farm and timberland.
Building the hybrid book
The PPF is in the process of building its hybrid assets book, which will represent 12.5% of the portfolio in 2017. But how does Kenneth define hybrids? ‘Think about gilts and swaps: they have no excess returns, they are purely matching assets. On the other side, hybrids deliver excess returns and have hedging properties, too.’
According to the CIO, the new hybrid investments will enable the PPF to overcome regulatory challenges surrounding the central clearing of over-the-counter (OTC) derivatives and the need for banks to hold increased capital against these instruments.
‘We use OTC derivatives and repos, so we rely on banks being able to repackage risk. The new regulation on banks will affect these operations. OTC derivatives are going to be centrally cleared, and this represents a cost for us.’
As part of this process, the PPF awarded new mandates that allow managers to invest across a range of assets to target illiquidity, credit spread, excess return, inflation and duration.
The first significant hybrid asset investment was completed on 30 June 2014, when the PPF directly purchased a large office building in central Manchester with a long-term lease to Royal Bank of Scotland. This will provide the fund with a 23-and-a-half-year lease contract, an annual 3% uplift in rental income and some good liability-matching characteristics.
‘We don’t compare this asset to other property investments, but rather to an unsecured RBS corporate bond. If this asset delivers us a significant illiquidity premium, we have more security than an unsecured corporate bond.
‘Generally speaking, the hybrid portfolio diversifies our exposure and helps offset the higher bank regulation costs. Over the past two years, we have been changing our portfolio steadily in order to be well prepared for the changes in the banking sector.’
Kenneth doesn’t shy away from taking more risky tactical positions in the PPF’s portfolio. He invested into Greek sovereign bonds ‘when the whole stuff kicked off’, and the trade paid off.
‘The position has been volatile, but it came through in the end and we continue to hold it. We could have been wrong and that could have cost us money. But we make investment decisions here; we need to figure out what is a good risk or a bad risk to take.’
The CIO thought it would have been difficult for Greece to leave the eurozone, but nonetheless he completed a large amount of due diligence with his team before investing in the country. ‘Even if Greece had left the eurozone, they would have needed access to international markets. It would just have taken longer to make money on the bonds we hold.’
Looking on the other side of the Atlantic, Kenneth is worried about the Fed’s hike of interest rates, specifically the impact it will have on emerging markets. ‘I am not concerned about developed markets. The US economy is doing well. Low inflation is linked to oil and China. Europe and Japan will implement QE and are slowly reforming their economies.
‘Emerging markets are a different story. A lot of these countries are indebted in US dollar, and will be affected significantly by a rise in interest rates.’
Still, Kenneth, who is underinvested in EM at the moment, is not pessimistic. ‘Is the rate hike going to increase dramatically borrowing costs in developing countries? I don’t think so. EM is overdone a little bit, but it has further to go.’
Speaking about China, the CIO takes a more balanced view than many of his colleagues. ‘Chinese equity market went up 150% in a year, and, after the fall, it is still materially up.’
On slowing growth, he points out that a country expected to grow around 5% or 6% still represents a great story. ‘Is China really a disaster? I don’t think so. The problem is to understand whether the economic figures they chuck out are real or not. The manufacturing PMI are declining, but the services PMI are doing OK, which is in line with the reallocation of the economy from heavy investments to services.’
At the moment, the PPF is invested in China through indices and does not have a specific allocation to the country. ‘Our EM managers don’t have a big exposure to China, since they are absolute return – they do not have to be forcibly invested there.’