Contact: Ian Howell, (01962) 847540; email: [email protected]

1 Summary

1.1 This report sets out the advantages and disadvantages of applying tactical asset allocation and currency overlay to the Fund's investments. It considers whether further specialist managers should be employed by the Fund to execute tactical asset allocation and currency overlay. It also looks at the need to rebalance the managers' portfolios periodically to keep within the Fund's strategic asset allocation.

2 Recommendations

a) That the Fund's strategic asset allocation be reviewed after each triennial actuarial valuation.

b) That the County Treasurer be authorised to rebalance the investment managers' portfolios to keep the Fund's strategic asset allocation within the ranges set out in Table 2.

c) That no action be taken to apply tactical asset allocation to the Fund's investments.

d) That no action be taken to apply currency overlay to the Fund's investments.

e) That tactical asset allocation and currency overlay be reconsidered when the strategic asset allocation is reviewed.

f) That active currency management be considered as part of the Fund's alternative investments portfolio.

3 Background

3.1 Tactical asset allocation is used to vary the percentage of assets held in the different asset classes, above or below the Fund's agreed strategic asset allocation, in order to take advantage of market pricing anomalies or strong market sectors over the shorter term.

3.2 Currency overlay separates the management of currency risk from the management by the Fund's specialist managers of asset allocation and stock selection. The overlay's hedging is applied separately from the portfolios created by the fund managers, whose activities continue unaffected.

3.3 Prior to the change in the Fund's investment managers on 1 January 2007, decisions on both tactical asset allocation and currency management were taken by the former multi-asset managers, Aberdeen, Schroders and SGAM as part of their day-to-day management of their portfolios, both in terms of the choice between equities and bonds, and between regions and countries. The switch to specialist portfolios from 1 January 2007 has meant that no decisions are now made on the short-term advantages or otherwise between investing in equities or bonds, for example.

3.4 Additional specialist managers could be employed to execute both tactical asset allocation and currency overlay on behalf of the Fund.

3.5 The County Treasurer has sought advice on both topics from the Fund's actuary Hewitt, global custodian Northern Trust and the alternative investment advisers Bramdean. The options have also been discussed with Fund's senior investment managers.

4 Rebalancing the strategic asset allocation

4.1 The Panel has agreed a strategic or long-term asset allocation for the Fund as summarised in Table 1.

4.2 The Panel has also agreed that, over time, up to 10% of the portfolio could be invested in alternative investments. As the allocation to alternative investments increases, the percentage allocation to global equities will reduce. The alternative investment portfolio will be financed from the Fund's positive cash flow over the next few years. Contributions from employees and employers plus investment income are forecast to exceed expenditure on benefits. This surplus of annual income is in line with the actuary's recommendations to reduce the deficit on the Fund.

4.3 The initial allocation of funds to the new managers in mid December 2006 reflected the strategic asset allocation in Table 1. As markets move over time, the Fund's actual asset allocation is likely to diverge from this strategic asset allocation and it will be necessary to rebalance the allocations periodically. Frequent rebalancing could add to costs, however, if some of the managers are forced to disinvest. It should be possible to use the Fund's positive cash flow to smooth out the effects of market movements but it would be sensible to allow the percentage allocations in Table 1 to move within tolerance ranges before rebalancing is required. Suggestions for ranges of +/-10% around the core allocations are set out in Table 2.

4.4 The County Treasurer will monitor the actual asset allocation against the ranges set out in Table 2 and will make the necessary adjustments to the individual managers' allocations to rebalance the Fund using cash flow wherever possible. Any such adjustments will be reported to the Panel.

4.5 The strategic asset allocation will be reviewed every three years after each triennial actuarial valuation of the Fund to make sure that it is appropriate in the light of the latest information on the Fund's liabilities. If Hewitt's work on the Fund's asset/liability study that underpins the current asset allocation proves to be soundly based, major changes to the strategic asset allocation should not be necessary in the foreseeable future.

5 Tactical asset allocation

5.1 Aside from rebalancing the strategic asset allocation, adjustments could be made to the asset allocation for short-term or tactical reasons if, for example, particular sectors or markets were expected to provide better returns in the near future. This could be executed in two ways:

· an asset allocation fund which does not reflect the Fund's actual holdings. This would be similar to the asset allocation fund used on behalf of the Fund by Deutsche and Aberdeen in recent years. The risk would be limited to the book value of initial investment in the asset allocation fund (3% of their portfolio in the case of the Deutsche/ Aberdeen fund which failed to meet its targets)

· an asset allocation overlay which takes account of the Fund's holdings and uses derivatives to adjust the asset allocation. This approach could result in volatile cash calls if markets moved in unexpected directions and, in the extreme, could result in unlimited losses compared with the asset allocation fund approach.

5.2 Both approaches would require the appointment of a further specialist manager. Part of the Fund would need to be allocated to tactical asset allocation. The advantages would be the potential for additional investment returns for the Fund if the specialist manager is successful. The disadvantages would be the risks of losses if the manager is not successful, the fee costs and the need for the Panel and officers to monitor the activities and performance of yet another manager.

5.3 There are also other reasons for the Fund not to employ tactical asset allocation:

· the Fund has adopted a global approach to its investment of a large part of the equity portfolio and for the whole of its small fixed interest bonds portfolio. This global approach eliminates the need to apply tactical asset allocation between regions and countries as the Fund's global managers will take such decisions as part of their normal investment process

· the Fund's 5% allocation to global fixed interest bonds is so small that there is limited scope for gains from tactical asset allocation decisions on the split between equities and bonds

· the split of the Fund between UK and global assets was a strategic decision and the Panel may not wish to see that split varied for short-term tactical reasons

· the 20% allocation to UK index linked bonds was also a strategic decision that reflects the nature of the Fund's liabilities. Significant switches away from index linked bonds could affect the risk profile of the Fund's investments.

5.4 On balance, the arguments against employing a specialist tactical asset allocation manager appear to be persuasive.

6 Currency overlay

6.1 With just over 40% of the Fund invested in global assets (equities, bonds and European property) and its pension and benefit liabilities paid in sterling, the Fund is potentially exposed to adverse currency movements. A specialist currency overlay manager could be employed to protect the Fund against currency movements by simply hedging back to sterling and also, if desired, to seek additional returns from active currency management. This could be achieved either by a currency overlay or a currency management fund, with the same risks as described in paragraph 5.1.

6.2 Other considerations include:

· the Panel's decision to allocate part of the Fund to global investment assets was intended, in part, to access the returns (and risks) available in those markets, part of which could be a return on currency. That return could be negated if the portfolio is hedged back to sterling

· the Fund's global equity and bond managers (Aberdeen, Alliance-Bernstein, Newton and Western) are all aiming for `high performance' targets. The managers, particularly AllianceBernstein and Western, use currency management as a source of performance returns, so it would be inappropriate to hedge the portfolios back to sterling

· currency is one of the markets exploited by hedge fund managers and it would be more appropriate to consider proposals for active currency management alongside other hedge funds as part of the Fund's alternative investment portfolio.

6.3 Bramdean have prepared a report for the County Treasurer on whether the benchmarks used as targets for the Fund's managers should be hedged to sterling. Their conclusion is that, for equity portfolios, hedging has no significant impact on long-term returns, volatility or diversification. For bond portfolios, whilst hedging has little impact on the level of long-term returns, Bramdean consider that it does reduce volatility of returns and increase the correlation between global bonds and UK bonds. However, for Hampshire, the allocation to global bonds is very small at 5% of the total Fund.

6.4 Overall, this analysis points to taking no action on currency management within the global equity, global bond and European property portfolios. Active currency management as a source of additional returns can be considered in the context of the alternative investments portfolio.

7 Conclusion

7.1 Tactical asset allocation and currency overlay are relatively novel concepts and, if the suggestions in this report that neither approach should be adopted at present are agreed by the Panel, it would be sensible to keep them under review alongside the strategic asset allocation following the next actuarial valuation.

Section 100D - Local Government Act 1972 - background documents

The following documents discuss facts or matters on which this report, or an important part of it, is based and have been relied upon to a material extent in the preparation of this report.

NB: The list excludes:

None.

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