Hermes: How to Make Your Dough Rise Nicely - Hermes Investment ...

Aug 4, 2016 - Fraser Lundie, Co-Head of Credit at Hermes Investment Management ... scheme's ability to manage collateral calls and liquidity requirements ...
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4 AUGUST 2016

Hermes: How to Make Your Dough Rise Nicely While most consultants continue to concentrate on illiquidity premia, some consultants have shifted their focus to the other extreme1. Fraser Lundie, Co-Head of Credit at Hermes Investment Management looks at how UK pension schemes, like many other areas of finance are grappling with structural change rarely seen to such an extent or evolving so quickly. Ageing populations, political changes, and regulatory shifts are combining to drive “cash” in all its forms, to become one of the most important components of a scheme’s portfolio. Structural Change at work As schemes are maturing and de-risking, they are increasingly positioned for this unwinding stage. This in itself brings cash more into play, as does the increasingly negative cash flow profile that such a mature scheme demonstrates. Pension freedoms have added an additional element of uncertainty over cash calls, as some members opt to cash out. In recent years, pension schemes have increasingly employed leverage, commonly via interest rate and inflation hedges, to improve liability matching. However, this leverage has implications for a scheme’s ability to manage collateral calls and liquidity requirements (settlement payments or pension payments). Indeed, bank regulation around the central clearing of swaps means that, in future,, collateral will have to go beyond just Gilts, which are also becoming less freely available via repo - again an unintended consequence of regulation. So cash is going to be more sought after, indeed, required at the very time its accessibility and expensiveness are adding complexity. Liquidity Laddering Unfortunately, the solution cannot be to just hold more cash. Even if one optimises liquidity facilities, required asset return assumptions are already under the spotlight for their rosiness2. Schemes can ill afford another hit to returns at a time when the liability side is also being inflated by historically low discount rates. A solution being put forward by the market is a ‘liquidity ladder” approach. This comprises three rungs – operational cash – literally, money in the bank. Then comes reserve cash – largely Gilt related exposure, offering a suitable buffer to day to day operational cash. Thirdly, strategic cash, which would be an allocation more tilted to short dated credit, ABS, and Absolute return credit strategies. As liquidity is taken out via the bottom rung, it is replenished by the one above. The net effect of this liquidity ladder will reduce gilt exposure whilst increasing outright cash and credit based strategies at either end of a barbell formation. This barbelling immediately boosts overall liquidity due to the higher outright cash holding, increases asset return due to the higher credit allocation, and reduces the scheme’s basis risk given the reduced assumed gilt vs swap liability. So more liquid, higher return, lower risk – what’s the catch? Allocating to a strategic cash strategy that avoids taking illiquidity premium as a driver of performance is key. Just because a fund has daily liquidity does not mean you are matching cash-like requirements with liquid assets. As such, strategies that employ large portions of illiquid credit, ABS, distressed, loans etc should be kept in their natural home of long-term, return-seeking areas of a scheme’s portfolio. Similarly, high fees, often associated with more illiquid or complex allocations can eat away a sizable portion of what is a relatively small gross return objective. Lastly, within absolute return, there has historically been an overreliance on

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Cash is King, Mette Hansen, The Redington Ampersand Institute, July 2016 http://bit.ly/2aslrVH 'Asset allocation in a world of low interest rates, Saker Nusseibeh & Eoin Murray, Hermes Investment Management, working paper 2016

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interest rate duration as a means of do