Riding Out the Storm, Pension Fund-Style

02/27/2012 10:30 am EST

Focus: STRATEGIES

Rob Carrick

Columnist, The Globe and Mail

Investors can learn a thing or two about handling market volatility from an industry that takes the long view, writes Rob Carrick, reporter and columnist for The Globe and Mail.

It's not just individual investors like you who are fed up with the stock market's unpredictability.

Managers of pension-fund investment portfolios are also trying to do something about volatile stock markets. They're looking more and more at alternative investments, they're increasingly diversifying away from a Canadian market that is dominated by just three sectors. And in some cases, they're taking a Warren Buffett-like approach of focusing on high-quality companies.

Pension funds are among the most careful of investors, because they're stewards of money that current and future retirees are counting on for retirement income. Their mission: Seek consistent returns, minimize volatility and keep up with inflation.

If that's what you're trying to do in your own retirement plan, then you'll want to hear more about the latest trends in pension-fund management.

According to David Service, director of investment consulting at global professional services firm Towers Watson, the average pension fund holds about 40% of its assets in bonds and 60% in stocks, real estate, infrastructure, private equity, and other assets. But there's no longer the same unanimity in the industry that this is the ideal mix of assets.

"Within the pension fund space, there is clearly a lot wider variation now than we used to have," he said. "I have one client where it's 60% bonds at this point and 40% equities. We've been de-risking it now for close to ten years. Others are saying they have an intent to move that way."

One of the trends in pension-fund bond investing is to diversify by adding global content. The "more sophisticated" plans are moving some money out of Canadian corporate bonds and into their US or international equivalents, Service said.

[This story was written for a Canadian audience, but if anyone isn't clear, US pension funds that are permitted to are similarly diversifying money into international plays, including Canadian corporates—Editor.]

High-yield bonds have attracted a lot of money from retail investors in recent years, but Service said pension funds have added only a small amount. Typically, they're focusing on US high-yield bonds because of the vastly larger selection when compared with Canada.

With stocks, Canadian pension funds have for the past five or so years been moving a significant amount of money out of Canada and into global markets.

"The main issue people have is that if you look at the Canadian market profile, 77% or 78% of it is in three sectors [financials, energy, and materials]," Service said. "So it's a highly risky market."

An example of how a pension fund breaks down stock-market investments in Canada and abroad can be found in the most recent annual report of the British Columbia Investment Management Corp., which runs public-sector pension plans with total assets under management of $91 billion. Almost 17% of the portfolio is in Canadian stocks, 20.7% is in global stocks, and 6.3% is in emerging-market stocks.

Service said there's a split among pension funds about whether to get stock-market exposure through low-cost index investing or active selection of stocks.

"A number of pension funds are kind of taking the Buffett approach to investing," he said. "You want to buy great companies, and you don't want to overpay for them."

The rationale here is that quality companies will be less volatile than the stock market as a whole. That's how things played out in the Canadian market last year, with many blue-chip dividend stocks delivering positive returns while the S&P/TSX composite index fell 11%.

Retail investors have in many cases done poorly in global markets in the past ten years, and a major reason has been a general rising trend for the Canadian dollar.

Currency hedging can help screen out currency fluctuations, so that investors get the returns of the stocks or funds they hold, but pension funds aren't big hedging enthusiasts. Service said that's partly a cost issue—only in the largest funds is it economical to run a hedging program.

Canada's largest pension funds have gradually been reducing their exposure to publicly traded stocks and replacing it with "alternative investments" such as shopping malls, office buildings, bridges, tunnels, and pipelines. For example, the Canada Pension Plan Investment Board announced investments earlier this month in California shopping malls and a joint venture to develop a building complex in London.

The CPPIB had about 15% of its assets in real estate and infrastructure as of December 31, while the BCIMC had almost 20%. Service said investment in these assets is driven in part by a comparatively small Canadian stock market. When you're a big pension fund, it's tough to trade in and out of stocks without affecting the price.

But infrastructure and real estate also offer the consistent returns that pension-fund managers crave. "They recognize that they have long-term obligations and they're saying, 'I want something stable,'" Service said. "Give me 7% to 8% returns and I'm happy."

Large pension funds are investing directly in real estate and infrastructure, while small funds are buying into investment pools holding these assets. Retail investors have some options for getting exposure to these assets, but they're far from ideal.

The easiest way for investors to buy into commercial real estate is a real estate investment trust, or a fund holding a basket of these securities. "We've actually studied this," Service said. "If you look at REITs versus real estate investment, REITs behave half like an equity and half like real estate."

At least you're getting diluted exposure to real estate with REITs. According to Service, you're hardly getting even that when you buy the shares of companies active in infrastructure or in funds that hold this type of stock.

"They're sort of a quasi-equity," he said. "It's not the same as investing [directly] in infrastructure."

Pension funds also hold some private equity, but Service said there's less of this than there was ten years ago. He describes private equity as a "high-octane" form of equity investment that contrasts with lower-risk infrastructure and real estate.

Individual investors can't follow all the moves being made by pension funds, but there are some broad concepts in portfolio design that they can absorb. Keep a significant weighting in bonds, don't ignore global markets and emphasize investments that provide consistent returns (like dividends, for example).

That's how some of the smartest investing minds in the country are coping with today's unpredictable stock markets.

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