1. Pensions Conference 2015
24 – 26 June
Hilton, Glasgow
26 June 2015

2. IFoA Pensions Conference 2015 26 June 2015
21st Century
Asset Allocation
2

3. IFoA Pensions Conference 2015 26 June 2015
It Starts with an Integrated Approach to Investment, Funding and Covenant
3
Asset allocation and investment is only part of the solution. There are more levers to pull.

4. IFoA Pensions Conference 2015 26 June 2015
Seven Steps to Full Funding
4
Asset Allocation
A control cycle process for pension scheme investment management.

5. IFoA Pensions Conference 2015 26 June 2015
A Different Way to Categorise Asset Classes, or, An Alternative to ‘Alternatives’
5
• Private Equity
• Insurance-Linked
Securities
• Infrastructure Equity
• Unlisted Property
• Illiquid Multi Strategy
• Regulatory Capital
Relief
• Direct Mid-market
Lending
• Mezzanine Finance
• Distressed Debt
• Infrastructure Debt
• Commercial Real
Estate Debt
• Long Lease Property
• Ground Rents
• Asset-Backed
Leasing
• Commodity Trade
Finance
• IG Credit
• Leveraged Loans
• Asset-Backed
Securities
• High Yield
• Emerging Market Debt
• Long/Short Credit
• Absolute Return Fixed
Income
• Multi-Class Credit
• Credit Relative Value
• Risk Parity
• Volatility-Controlled
Equities
• Trend Following
Strategies (CTA)
• Alternative Risk
Premia
• Active Long-Only
Equities
• Equity Long-Short
• Diversified Growth
Funds
• Global Macro
LiquidIlliquid
Less Contractual
More Contractual
Illiquid Credit Liquid & Semi-
Liquid Credit
Illiquid Market
Strategies
Liquid Market
Strategies
The dimensions for an asset class in this framework are liquidity and certainty of cashflows.

6. IFoA Pensions Conference 2015 26 June 2015
What’s the Problem? Measuring Funding Ratio Sensitivities Reveals All…
6
60%
70%
80%
90%
100%
110%
120%
130%
140%
150%
Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15
PPF 7800 Aggregate Funding Ratio
Gilts Global Equities UK Linkers Sterling IG Credit Spread
Regression Parameter -1.830 0.294 -0.348 0.278
Standard Error 0.112 0.035 0.082 0.134
t-stat -16.403 8.344 -4.218 2.081
p-value 1.69E-34 5.95E-14 4.38E-05 0.0392
Adjusted R² 87%
Source: PPF, Bloomberg; Redington calculations

7. IFoA Pensions Conference 2015 26 June 2015
(Re)Introducing The Fundamental Law of Active Management
7
Easier choice seems to be to increase breadth, i.e. take more bets!
Information Ratio = Return/Risk
𝐼𝑅 = 𝐼𝐶 × 𝐵𝑅
Information Coefficient (IC) = corr[α,θ]
α = expected (ex ante) return
θ = actual (ex post) return
Breadth (BR) = number of independent positions
Choices: (1) Improve IC (i.e. get better at forecasting returns)
AND/OR (2) increase breadth

8. IFoA Pensions Conference 2015 26 June 2015
Case Study: Let’s Look at a “Typical” Pension Scheme
8
Consider a “typical” UK Pension Scheme with the following characteristics:
- 80% Funded
- Asset Allocation Includes:
• 60% equities
• 25% index-linked gilts
• 15% corporate bonds
- 30% Hedge Ratio (Rates & Inflation)
- Expected Return of LIBOR + 218 bps

9. IFoA Pensions Conference 2015 26 June 2015
Putting the Scheme Through the Risk Lens
9
Rates, equities and inflation dominate risk – as expected.
Expected Return: LIBOR + 218 bps / Var95: 26.5% of liabilities
11.7%
1.3% 0.7%
19.9%
8.8%
2.2%
2.5% 20.6%
26.5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Equity FX Credit Interest Rate Inflation Interest Rate
Basis
Inflation Basis Diversification Total
VaR95%
Current VaR 95

10. IFoA Pensions Conference 2015 26 June 2015
Quick Win … Hedge to Funding Ratio
10
Rates and inflation risk moderate with no impact on returns.
Expected Return: LIBOR + 218 bps / Var95: 15.7% of liabilities
11.7%
1.3% 0.7%
5.7%
2.5%
2.2%
2.5% 10.8%
15.7%
0%
5%
10%
15%
20%
25%
30%
Equity FX Credit Interest Rate Inflation Interest Rate
Basis
Inflation Basis Diversification Total
VaR95%
Hedged VaR 95

11. IFoA Pensions Conference 2015 26 June 2015
A Deeper Look at Systematic Liquid Market Strategies
11
• Private Equity
• Insurance-Linked
Securities
• Infrastructure Equity
• Unlisted Property
• Illiquid Multi Strategy
• Regulatory Capital
Relief
• Direct Mid-market
Lending
• Mezzanine Finance
• Distressed Debt
• Infrastructure Debt
• Commercial Real
Estate Debt
• Long Lease Property
• Ground Rents
• Asset-Backed
Leasing
• Commodity Trade
Finance
• IG Credit
• Leveraged Loans
• Asset-Backed
Securities
• High Yield
• Emerging Market Debt
• Long/Short Credit
• Absolute Return Fixed
Income
• Multi-Class Credit
• Credit Relative Value
Systematic
• Risk Parity
• Volatility-Controlled
Equities
• Trend Following
Strategies (CTAs)
• Alternative Risk
Premia
Discretionary
• Active Long-Only
Equities
• Equity Long-Short
• Diversified Growth
Funds
• Global Macro
LiquidIlliquid
Less Contractual
More Contractual
Illiquid Credit Liquid & Semi-
Liquid Credit
Illiquid Market
Strategies
Liquid Market
Strategies

12. IFoA Pensions Conference 2015 26 June 2015
Risk-Controlled Investment Strategies: Volatility-Controlled Equities and Risk Parity
12
Find more on these strategies at:
http://www.slideshare.net/redingtonmedia/redington-teachinriskcontrolledinvestmentstrategiesmarch2013
Risk Allocation in a Simple Risk Parity Strategy
Equities
Bonds
Commodities
Volatility-Controlled Equities
- Equity exposure managed through futures to
achieve a certain level of volatility
- Results in a relatively constant allocation of
equity risk through time
- Options can be bought on a volatility-
controlled index much more cheaply due to
minimal vega risk
Risk Parity
- The extension of volatility-controlled equities
to the multi-asset space
- Allocate to asset classes on the basis of risk
rather than capital
- Typically involves moderately leveraging low-
risk asset classes
0%
10%
20%
30%
40%
50%
60%
70%
AnnualisedVolatility(%)
Realised Volatility of Standard and Volatility-Controlled Indices
100% Dev 0% EM Index Volatility Control (10% Volatility) Index

13. IFoA Pensions Conference 2015 26 June 2015
Change Equity Exposure to Be Volatility-Controlled with Put Protection
13
Adding volatility-controlled equities significantly reduces risk though brings return down too.
Expected Return: LIBOR + 167 bps / Var95: 10.1% of liabilities
4.8%
0.7%
5.4%
2.4%
2.2%
2.5% 7.8%
10.1%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
Equity Credit Interest Rate Inflation Interest Rate Basis Inflation Basis Diversification Total
VaR95%
Vol Control VaR 95

14. IFoA Pensions Conference 2015 26 June 2015
Most of Norway’s Alpha is Driven by Identifiable Risk Factor Exposures
14
- Though taking relatively little active risk in the Fund, this active risk had been dominated by a number of systematic factors.
- This led to the alternative risk premia movement taking hold with various styles identified that could be invested into directly
What was previously thought of as alpha (active return) is now being described as alternative beta.

15. IFoA Pensions Conference 2015 26 June 2015
A Continuum Between Beta and Alpha
15
Alpha
Style Premia
Market Risk Premia (Risk Parity)
Low
C
A
P
A
C
I
T
Y
High Low
High
F
E
E
S

16. IFoA Pensions Conference 2015 26 June 2015
Examples of Style Premia Families Cutting Across Liquid Markets
16
Style premia are intuitive, robust, pervasive and backed by a body of academic research.
•Involves buying assets that recently outperformed
peers and selling those that recently underperformed
•For example: go long stocks with highest 3 month
return, go short stocks with lowest 3 month return
Momentum
•Consists of buying low-risk, high-quality assets and
selling high-risk, low-quality assets
•For example: go long high return-on-equity stocks, go
short low return-on-equity stocks
Defensive
•Buying assets that are “cheap” relative to their
fundamental value and selling “expensive” assets
•For example: go long lowest price-to-book stocks, go
short highest price-to-book stocks
Value
•Implies buying high-yielding assets and selling low-
yielding assets
•For example: go long highest yielding currencies, go
short lowest yielding currencies
Carry

17. IFoA Pensions Conference 2015 26 June 2015
Diversify Risk Premia … The Final Step
17
A truly diversified portfolio with a similar level of returns but with much less risk.
Expected Return: LIBOR + 221 bps / Var95: 8.5% of liabilities
2.3%
2.3%
2.2%
1.5%
0.7%
4.2%
2.5%
2.2%
2.5% 11.9%
8.5%
0%
5%
10%
15%
20%
25%
Equity Commodity Style Premia Trend Credit Interest Rate Inflation Interest Rate
Basis
Inflation Basis Diversification Total
VaR95%
Diversified Risk Premia VaR 95

18. IFoA Pensions Conference 2015 26 June 2015
Why Aren’t People Doing This Already? Unconventionality.
18
- Perceived complexity and upfront understanding required
- Novelty of approach: what hedge funds have pursued for a long time only now being brought into pension scheme
management (same was said of LDI when it first appeared though now is commonplace)
- Leverage, Shorting and Derivatives – “the 3 dirty words of finance”
- Straying away from peers
- Higher cost for (long/short) alternative risk premia strategies than for market risk exposures.

19. IFoA Pensions Conference 2015 26 June 2015
What About Illiquids?
19
• Private Equity
• Insurance-Linked
Securities
• Infrastructure Equity
• Unlisted Property
• Illiquid Multi Strategy
• Regulatory Capital
Relief
• Direct Mid-market
Lending
• Mezzanine Finance
• Distressed Debt
• Infrastructure Debt
• Commercial Real
Estate Debt
• Long Lease Property
• Ground Rents
• Asset-Backed
Leasing
• Commodity Trade
Finance
• IG Credit
• Leveraged Loans
• Asset-Backed
Securities
• High Yield
• Emerging Market Debt
• Long/Short Credit
• Absolute Return Fixed
Income
• Multi-Class Credit
• Credit Relative Value
• Risk Parity
• Trend Following
Strategies (CTA)
• Risk Premia
• Global Macro
• Equity Long-Short
• Vol-Controlled Equity
• Active Long-Only
Equities
• Diversified Growth
• Multi-Asset Absolute
Return
LiquidIlliquid
Less Contractual
More Contractual
Illiquid Credit Liquid & Semi-
Liquid Credit
Illiquid Market
Strategies
Liquid Market
Strategies

20. IFoA Pensions Conference 2015 26 June 2015
The Gamut of Opportunities in Illiquid Credit and Illiquid Markets
20

21. IFoA Pensions Conference 2015 26 June 2015
Implementing Illiquid Asset Classes Can be Challenging
21
Calculating the illiquidity premium and de-smoothing returns are as much art as they are science.
- Illiquidity premia can be difficult to measure (e.g. an appropriate liquid market comparator may not always be
available)
- Illiquidity prevents you from changing asset allocation/rebalancing; this has cost which is difficult to quantify though
this figure would need to be netted off from the illiquidity premium
- Return history for newer asset classes are limited at best (e.g. much of the illiquid credit area was previously
dominated by banks)
- In order to get risk measurements consistent with liquid assets, illiquid asset returns need to be de-smoothed:
𝑟𝑡 =
1
1 − 𝜙
𝑟𝑡
∗
−
𝜙
1 − 𝜙
𝑟𝑡−1
∗
where 𝜙 < 1
Geltner-Ross-Zisler Unsmoothing Process
Note unsmoothing only affects risk estimates, it does not affect expected returns.

22. IFoA Pensions Conference 2015 26 June 2015
A Health Warning on Market Timing
22
- Market timing is notoriously difficult (see chart below)
- Any time spent away from an optimal diversified
portfolio is mathematically punished (as shown by
Samuelson)
- That said, where there is skill in this pursuit, this
needs to be evidenced both qualitatively and
quantitatively to have conviction
Source: Deutsche Bank

23. IFoA Pensions Conference 2015 26 June 2015
Benchmarking and Return Decompositions
23
0
50
100
150
200
250
300
350
400
450
Static Allocation Asset Allocation Proxy Fund
3.68%
4.31%
2.09% 10.08%
0%
2%
4%
6%
8%
10%
Static
Allocation
Allocation
Between
Asset Classes
Allocation
Within Asset
Classes
Fund
ExcessReturn
Decomposing By Return
0.37
0.44
0.19 1.00
0
0.2
0.4
0.6
0.8
1
Static
Allocation
Allocation
Between
Asset Classes
Allocation
Within Asset
Classes
Fund
SharpeRatio
Decomposing By Sharpe Ratio
Decomposing a fund’s returns helps to explain the
evidence of skill (or lack thereof!)
Allocation
between
asset
classes
Allocation
within
asset
classes

24. IFoA Pensions Conference 2015 26 June 2015
Conclusions
24
- Asset allocation is one part of investment strategy. Investment strategy itself is part of pension scheme management
alongside covenant and funding strategy.
- Pension scheme investment strategy is still heavily dominated by four risk factors: (long) equities, (short) interest rates,
(short) inflation and (long) credit which represent a narrow set of bets.
- Greater risk balance of these factors and also the introduction of alternative risk factors is likely to lead to a more
efficient investment strategy (either a similar level of return for a lower level of risk or a higher level of return for the
same level of risk).
- Unconventionality is one of they key constraints preventing wider adoption. As with LDI, it will take time for this to filter
through.
- There is a wide array of illiquid asset classes pension schemes are starting to look at. A framework needs to be in
place to assess illiquidity premia and the requisite compensation for illiquidity. Returns need to be de-smoothed to
integrate with liquid asset classes.
- Market timing (i.e. tactical asset allocation) is difficult though where there is ability to add value through this pursuit,
there needs to be evidence of skill. Decomposing fund returns is one way of identifying this.

25. IFoA Pensions Conference 2015 26 June 2015
References
25
Ang, A., W. Goetzmann and S. Schaefer (2009), “Evaluation of Active Management of the Norwegian GPFG”,
Norway: Ministry of Finance
Grinold, R.C. (1989), “The Fundamental Law of Active Management”, Journal of Portfolio Management, 15,
3, pp. 30-37
Samuelson, P.A. (1990), “Asset allocation could be dangerous to your health”, Journal of Portfolio
Management, 16, 3, pp. 5-8

26. IFoA Pensions Conference 2015 26 June 2015 26
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