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Chetan Ghosh: “Our assets now stand at £9.5bn whereas the sponsor’s market cap is around £4bn.”

2 Dec 2019

Chetan Ghosh, chief investment officer of Centrica Pension Schemes, sits down with Mona Dohle to discuss managing risk, controlling assets that are double the sponsor’s market cap and why cash is king.

Centrica has a relatively young defined benefit (DB) pension fund, which has quite a few active members. Does that give you more freedom in where you allocate your money because you will not need to raise significant amounts of cash immediately? Centrica has a relatively young defined benefit (DB) pension fund, which has quite a few active members. Does that give you more freedom in where you allocate your money because you will not need to raise significant amounts of cash immediately?

Yes, that’s right. The historical background behind that is when Centrica spun-out of the British Gas Scheme it only took the active members with it, so in effect it is a 22-year-old scheme.

That is a somewhat unusual, but comfortable position to be in compared to the average DB scheme.

It is certainly unusual, but we are maturing quite quickly. If we did not have deficit contributions coming in, we would still be cash-flow negative.Can you tell us a bit more about the structure of your investment team?

Can you tell us a bit more about the structure of your investment team?

We are a team of seven and based in Windsor. A big part of our ideology is to focus on asset allocation rather than manager alpha. A lot of teams our size split tasks by asset class so that they have fixed income or property specialists. That kind of structure is all about trying to find manager alpha. We don’t do that. We have an asset allocation specialist, someone who looks after illiquid investments, a specialist for private investments and a financial controller.

We are trying to structure the team in a way that is the most productive.

Since joining the scheme 10-years ago you have gradually reduced its equity exposure and introduced a focus on liability matching, which was followed by a cash-flow matching strategy. Are you planning to continue on that trajectory and to what degree are you hedged against interest and inflation risks?

We are reworking a lot of our considerations at the moment due to two important dynamics. Firstly, we finished our actuarial valuation which defines the amount of deficit funding we might need. That in turn changes the level of risk we will be taking. The other important dynamic is that there has been a material change in the strength of the sponsor. If we look at the size of the pension scheme versus the market cap of the sponsor, there has been a big turnaround. 10 years ago, the assets of the scheme were 20% of the size of the sponsor’s market cap; we are now more than twice the size of our sponsor. Our assets now stand at £9.5bn whereas the sponsor’s market cap is around £4bn. That is stark and a lot of it has come in the past three to four years.

That creates a different dynamic when it comes to deciding the attitude to risk, and so we are undergoing an extensive consultation on what to do next. Historically, we had a 35% hedge on interest rate risks and 55% on inflation risks so a fair degree of risk control is already there, especially given that we are a young scheme.

It is one thing to update a regulatory compliance document; it is an entirely different story if that leads to changes in behaviour.

We now need to consider that if the deficit rises will our sponsor’s contributions be affordable? That in turn feeds into the question of how far we can let the deficit worsen in an adverse event. If the answer is that you cannot let it worsen then we need to think about the levers to reduce downside risk.

The next question is how the downside risk can be reduced while retaining the majority of return. That would lead us to the asset classes that allow for more liability-driven investing (LDI) hedging. But that is still an ongoing deliberation; we cannot forecast where we will come out.

Another factor to keep in mind with a cash-flow driven investing (CDI) strategy is that the reinvestment risk can hurt you. When you come to the point where you want to reinvest, rates will be a lot lower so the returns will be lower as well. Having a cash-flow driven strategy without any consideration to the LDI aspects probably is not optimal.

You want to lock down your certainty about the rates you need to achieve when it comes to reinvestment as CDI and LDI go hand in hand.

While corporate bonds in the UK are not yet trading at negative yields, there is now a sizeable chunk of the corporate bond market that is. What does it mean for CDI?

As you said, it does not apply to the UK market yet, if we were to buy European corporate bonds, we would hedge back the currency and get a return from that too. So you end up being not too far off the average return on UK corporate bonds. Similarly, while you get higher yields on US bonds, once you factor in the impact of currency hedging, you get similar yields. The advantage of looking at other markets is that it gives you a wider universe from which to source CDI-type assets.

Is that because the size of the UK corporate bond market is rather small?

Exactly. For us a big part of the CDI strategy has not been in the corporate bond market but rather in illiquid sources of contractual income such as ground rents, long-lease property, commercial property and social housing. These are all areas where UK pension schemes typically would not have fished before and, to some degree, we did not even have UK insurers fishing there.

Are you looking to increase your exposure to infrastructure?

Infrastructure is one of the assets we are sourcing to get that long-dated cash-flow. We are interested in infrastructure assets where we hold the whole asset, things like renewables, biomass, solar and wind have been a big part of our CDI strategy. We see the risk-return and cash-flow generating profiles of these assets as suitable for our goal of having long-term cash-flows to meet pension payments.

It is something we will look to add to. The challenge is, are there enough of these assets to go around at a fair price and can we access the asset in a format that we want it in. To give a bit of colour on that, if I have a windfarm or solar park, we want to own it for its lifetime, we do not want to own it via a private equity structure where you have the added risk of leverage and then having to sell in five or seven years’ time because of the nature of the private equity vehicle.

As a result of Brexit, infrastructure investment could be withdrawn from the UK. If, for example, European Investment Bank funding was no longer available, could that be an opportunity for institutional investors to fill the funding gap?

Potentially, but a lot of it is already available to institutional investors. I am not sure that institutional investors should be relying on that now.

As a pension scheme you need to think about where you have the competitive advantage and stick to it.

One of the issues could be that pension funds are generally looking to allocate relatively large sums whereas the individual investment opportunities might be small.

Exactly. The question is, how much can the fund management industry invest for pension schemes? If that number is quite small, then it is not commercially attractive for consultants to go and scope out whole industries. If they cannot scale it, they cannot offer it to their whole client base.

Could that be an issue for LGPS pooling initiatives?

You need to be entrepreneurial to find the assets that are going to be suitable for cash-flow management purposes.

How precise would the returns be compared to other asset classes?

If I take solar panels and wind farms, the accuracy of the return forecasts are very good. Obviously, you get periods where there is not enough sunshine or wind, but we are long-term investors, so the day-today performance of assets is not a major concern, it is whether it is delivering that central 5% per annum expectation.

How much would you like to increase your allocation to infrastructure over the medium term?

One important challenge is dealing with illiquidity. This is not really an asset you would want to be holding if you were to position yourself for the endgame, say a move towards a buy-out.

Let’s not forget that we have a lot of liability hedging derivative exposure, to back those derivatives we need a core amount of liquidity in our portfolio. While it is a fantastic asset in theory, we have operational challenges as well. So we have to take the liquidity dimension into account.

But to be clear, we do not have a separate infrastructure budget. So the income we get from investing in social housing and the returns on ground rents, for example, are all very much part and parcel of our CDI strategy.

What do you make of the industry’s shift from momentum into value stocks in September?

UK pension schemes by and large have not segmented their portfolios by value and growth; it is more something US investors might do. We have been conscious for quite a few years now that there has been this growing divide between the fortunes of value and growth stocks, but value continued to underperform. We have seen a couple of bounces, but overall value continued to underperform.

We cannot time markets. Trying to make decisions about the relative merits of value and growth is even harder and we have little competitive advantage in doing that so we would not structure [ for that] on a short-term basis.

As a pension scheme you need to think about where you have the competitive advantage and stick to it. Are we going to be the world leader in calling value versus growth? No. Are we going to be able to take advantage of our long-term horizon to buy some good quality longdated contractual income assets that many other investors can’t touch?

We are capable of doing that so let’s just focus on those areas. That is important to how we approach our overall investment strategy.

How much of your equity portfolio is actively managed?

About two-thirds.

Does the recent change highlight some of the pitfalls of factor-based investing?

That might be an interesting option to explore; we can see that factor investing is creating mini bubbles in certain pockets of the equity markets. As a general investment principle, we just do not want to go into spaces that are poorly priced. If all investors would stick to this principle, then they could avoid a lot of problems.

You are holding quite a lot of cash, more than £100m according to your latest annual report. What are you planning to do with it?

That is predicated on the view that a lot of asset classes have become extremely expensive. At this point in time we just want to bank a little of our 10-year windfall and create some dry powder so we can invest with the best risk-adjusted return opportunities.

But it is not a long-term strategic position.

It is not typical in the UK. A lot of the consultant advice is to stay fully invested because you cannot time markets. We do not disagree with the general principle but when we have earned enough money and we are nervous about the risks associated with current pricing, to us it feels like good risk management. This feels like good risk management rather than a tactical activity.

If we did not have deficit contributions coming in, we would still be cashflow negative.

Could those opportunities come sooner than you think?

Absolutely. Within wind and solar, for example, a lot of these opportunities are equity market independent.

At the same time, while I cannot disclose the numbers, the reality is that as gilt yields have fallen, liabilities have increased so a big part of the challenge is dealing with our rising deficit.

Are the measurements of DB pension liabilities reflecting a lot of the volatility we are seeing at the moment?

Yes, a lot of people are pigeon-holed by this but for us it is worth taking a step back knowing that the LDI assets are there.

You might see your asset base becoming a lot more volatile as a result of having those further tips in place.

In October, pension schemes started disclosing their ESG policies as part of their Statement of Investment Principles. How big of an impact has it had on your scheme?

I do not think there is a pension scheme in the land that did not need to make changes to their statement of investment principles.

But it is also worth keeping in mind that pension schemes have had to have statements on that since 2007.

The most obvious change now is that the regulator is asking us to become much more explicit about the impact of climate change on our portfolio. It is one thing to update a regulatory compliance document; it is an entirely different story if that leads to changes in behaviour.

I suspect the actual change of behaviour will take much longer. I don’t think that is because a lack of willing but because of a lack of time and budget, given that there are now so many things on trustees’ agendas.

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