“Our Changing Future”
Absolute Return Strategies
A Pensions Perspective
Gareth Derbyshire
29 January 2008
Agenda

Why absolute return? And why now?

Less β, more α

Sample asset allocation
1
Absolute Return – Why Now?
1990

2005(ish)
(Fairly) static liability
valuation bases:

Liabilities marked-to-market
– Bond-like and volatile
– Low volatility
– LDI hedging unusual
– Surplus increases if real
asset return > assumptions
– Focus on asset performance
relative to liabilities
– Absolute return strategies
fairly attractive, if they’d
been recognised
– Absolute return strategies
less attractive except as
diversifier from traditional
assets
– Equity vol disguised by
asset valuation methods
2
Absolute Return – Why Now?
2006 / 2007 / 2008

LDI mainstream:
– Liabilities marked-to-market, hedged back to LIBOR
– Absolute return well suited to LIBOR benchmark

For those funds not adopting the LDI approach:
– Absolute returns for diversification (smaller allocation)
3
The Development of LDI
RETURN
2nd Generation:
Efficient ‘alpha’
generation
2nd Generation:
Risk-Managing
Assets
1st Generation:
Liability Hedging
Traditional
Efficient
Frontier
Traditional
Asset
Allocation
1st
Generation
Efficient
Frontier
2nd
Generation
Efficient
Frontier
RISK
4
Risk Management

Biggest risks usually real / nominal rates & equity β

Manager α relatively small source of risk

More α, less β would lead to better diversification of risk
budget…

…but α is more expensive than β
Risk Decomposition
600
500
400
300
200
100
0
Real Rates
Nominal
Rates
Equity β
Property β Manager α Diversification Total Risk
5
What Strategies?

‘Absolute Returns’ not uniquely defined, but generally less β,
more α:
– Strategies benchmarked vs LIBOR e.g. hedge funds, longshort products (especially market-neutral)
– Some capital guaranteed structures e.g. credit-based CPPI,
capital guaranteed commodities
– Short-duration structured credit (CDOs)
– Infrastructure / timber

Or, stretching the definition:
– ‘Low-volatility’ equity e.g. cash + call options
6
Sample Pension Fund Allocation
Asset Mix
%
Expected
Returns
UK Equity
25%
7.5%
– Projected Forward Funding
Ratio in 10 years = 92%
Global Equity
25%
7.5%
– Downside Risk = 45%
UK Credit
15%
5.25%
– 1 Year VAR95 = £72m
UK Nominal Gilts
15%
4.5%
– Probability of Hitting 105%
UK IL Gilts
15%
4.25%
HFoF
5%
7.0%
7
Target = 29%
What About ‘Classical Derisking’?
Asset Mix
UK Equity
%
Comments
– Projected Forward Funding
Ratio in 10 years = 78%
10%
– Downside Risk = 70%
UK Credit
30%
Both nominal and real
UK Nominal Gilts
30%
– 1 Year VAR95 = £18m
rate risks hedged out on
fixed income assets
– Probability of Hitting 105%
Target = 0%
UK IL Gilts
30%
8
Try A More Sophisticated Solution
Asset Mix
UK Credit
%
Comments
– Projected Forward Funding
Ratio in 10 years = 93%
15%
UK Nominal Gilts
15%
UK IL Gilts
15%
HFoF
5%
Risk Adjusted
Equity (RAE)
50%
Both nominal and real
rate risks hedged out – Downside Risk = 59%
on fixed income assets
– 1 Year VAR95 = £51m
– Probability of Hitting 105%
Structured equity
delivering similar
return to index but
with reduced volatility
9
Target = 27%
Putting It All Together
Step 1
LDI hedge – nominal and inflation swaps
Step 2
Reduce concentration in equity β
Step 3
Seek diversified α
Asset Mix
%
Equity
30%
15% traditional, 15% ‘low vol’
Bonds
Ratio in 10 years = 111%
30%
10% gilts, 10% investment grade corporates,
10% investment grade structured credit / 10%
high yield (possibly with CPPI wrapper)
Property
Alternatives
– Projected Forward Funding
– Downside Risk = 80%
– 1 Year VAR95 = £31m
10%
30%
10% hedge funds, 5% private equity, 5%
commodities, 10% infrastructure / timber /
others
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– Probability of Hitting 105%
Target = 53%
What’s Happening In Practice?

Gradually falling equity allocations (65%→60%→55%)

Greater use of LDI strategies (£35bn inflation swaps¹)

Diversification into alternatives

Pace is a function of market levels:
- Resistance to LDI with 50yr index-linked gilt yields <0.7%
- Reluctance to de-risk equities when less than fully funded

Shift is slower than many media reports
________________
1. Watson Wyatt
11
Conclusions

Absolute return strategies fit better in an LDI world

Trend away from β towards α, but β is cheaper and still has a
significant role to play

Diversification into broader range of alternatives

Trade-off between investment efficiency and complexity –
most (smaller) funds unlikely to go all the way?
12