What do Tesco and tracker funds have in common?

For a start they are both liked by Warren Buffet. Like Warren I like both of these investments. Like Warren, I am smarting from my losses in Tesco. Tesco has been a painful lesson.but I don't believe that it negates the advice to be long tracker funds.

In his annual letter to Berkshire shareholders, Warren Buffet says:

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain
instructions I’ve laid out in my will. My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee
managers.

Just prior to making this point, he notes:

I have good news for these non-professionals. The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial.

The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal. That’s the “what” of investing for the non-professional.

The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’ observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long term results than the knowledgeable professional who is blind to even a single weakness.

If “investors” frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties. Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.

So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My observations:

- I am hanging on to my holdings in Tesco. At 400p, Tesco's properties were worth as much as the then  market capitalisation of the company. At 170p, this is not the time to blink but to focus on the tangible value in this business. It will take a long time for a competitor to build a retail footprint as dominant as Tesco's position in the UK. Tesco needs to get back to basics and focus on what made it successful - the right products at the right price. Asda has stolen this position from Tesco and Tesco need to claim back that position.

- UK plc is fundamentally still overvalued compared to US Inc. The US economy is a giant when it comes to being flexible as being able to reinvest itself. The UK economy has fewer weapons in its armoury. Don't fight the US - owning a broad cross section of US companies at the current time is probably the best asset allocation decision one could make today. Doing this via trackers funds is probably the second best investment decision one could make.

- Not all trackers fund are created equally, make sure you shop around. When Vanguard launched their trackers funds in the UK the incumbents were forced to drop their asset management fees. The barriers to entry to the 'low-cost' tracker business are high. Choose a tracker fund that is managed by one of the largest providers and you should generally benefit from the best fees as well as low total expense ratios. Globally the top 3 managers would be: BlackRock, State Street and Vanguard - the latter is also liked by Warren.

Using LDI to set pension fund investment strategy

What is LDI?

LDI is a common acronym for Liability Driven Investment. Globally, corporate-sponsored, defined benefit pension funds have embraced an LDI-framework to setting investment strategy. Adopting an LDI strategy means that investment risk is no longer defined predominantly in relation to the standard deviation of investment returns. Rather, the concept of investment risk is extended to include all risk which could impact the volatility of asset values relative to liability values. In summary, LDI is a framework for setting investment strategy which has, as its end goal, the reduction of volatility in asset values relative to liability values.

Importantly LDI is not limited to consideration of a single asset class, for example, bonds; the LDI framework can (and should) be applied across all asset classes in order to arrive at a holistic view of the volatility of all asset classes relative to the liabilities. The table and diagram below sets out the types of risk that will typically be considered when adopting an LDI approach.

Table 1: Factors influencing asset and liability values

Factors influencing volatility of asset values	Factors influencing volatility of liability values
Systematic (or market) risk (e.g. equity market risk for equities or property market risk for property investments	Interest rate risk
Credit risk	Inflation risk
Liquidity risk	Longevity risk
Active manager risk	Model risk

Chart 1: Risk attribution with liabilities

Table 2: Brief description of factors influencing asset and liability values

Factors influencing volatility of asset and liability values	Description
Systematic (or market) risk (e.g. equity market risk for equities or property market risk for property investments	This is risk which characterises the asset class to which an investor is exposed. It cannot be diversified by holding a diversified portfolio of securities within the asset class.
Credit risk	The risk of losing some or all of your investment due to deterioration in the credit-worthiness of your counterparty. While it can be included as part of market risk, for some asset classes, such as corporate bonds, it can make sense to measure this separately due to its importance to the overall risk associated with the asset class. Some quantification of this risk can be made by observing historical, long-term average default rates.
Liquidity risk	The speed and cost at which an investment can be sold for cash.
Active manager risk	The risk that an active manager underperforms its benchmark. When considering its strategic asset allocation, a fund may assume that it can achieve certain market returns, however taking a decision to appoint an active manager means that the manager can underperform the market.
Interest rate risk	The risk that the value of the assets (or liabilities) changes in response to changes in interest rates.  Fixed rate and inflation-linked bonds will typically be the highest contributors towards an asset portfolio’s interest rate risk. Liability cashflows are valued to today’s monetary terms by discounting them to the present day. An increase in the rate of interest used to discount these liabilities will decrease their present value and vice versa. An often quoted, but narrower definition of LDI, is that LDI is about constructing an investment strategy that better aligns the interest rate sensitivity of the assets to those of the liabilities.
Inflation risk	The risk that the value of the assets (or liabilities) changes in response to changes in the market’s expectations for future rates of inflation. Inflation-linked bonds will typically be the highest contributors towards an asset portfolio’s inflation risk.   Liability cashflows are valued to today’s monetary terms by discounting them to the present day. Where future cashflows to be paid increase in line with inflation then an increase  in expectations for future rates of inflation will increase the present value of these cashflows and vice versa. An often quoted, but narrower definition of LDI, is that LDI is about constructing an investment strategy that better aligns the inflation sensitivity of the assets to those of the liabilities.
Longevity risk	This is the risk that the liability cashflows to be paid in the future increases as a result of the recipients of those cashflows living longer than anticipated. Generally, deteriorating longevity (pensioner dying earlier than expected) is considered to be less of an issue as it does not lead to a strain on the finances of the pension fund.
Model risk	This is the risk that the actuary’s projection of future cashflows turns out to be lower than those cashflows that actually materialise. Key demographic assumptions are sometimes embedded in these cashflow estimates, for example, assumptions relating to spouses pensions and early or ill-health retirement experience.  The pension fund’s actual experience is likely to differ from this.

What have been the catalysts for this focus on LDI?

Globally we can point to two main catalysts for extending the definition of risk and hence for the focus on LDI:

1. Accounting regulations:

During the noughties changes in global accounting regulations resulted in sponsor balance sheets becoming more responsive to recognising changes in pension fund surpluses or deficits (defined as the difference between assets and liabilities) and the latter moving to the use of mark-to-market approaches to value both the assets and liabilities. Together these developments introduced greater volatility in a sponsor’s balance sheet as a result of changes in the pension fund’s surplus or deficit. CFO’s became increasingly concerned that such volatility could materially (and adversely) impact the company’s financial results for reasons that were unrelated to the company’s core business. This was especially true for companies that had pension fund’s whose liabilities were large relative to the company’s market capitalisation – a small, adverse change in a large pension fund liability could swamp any positive performance in the company’s core business.

The poster-children for the adverse impact that these developments could have on a company were two well-known British companies, British Airways and British Telecom. Table 3 below illustrates that the relative size of the pension liabilities and market capitalisations at these two companies are such that a small change in their liability values would have a large impact on their market capitalisation.  

Table 3: Pension liabilities and deficits (Source: Accounting for Pensions 2010; LCP)

Company	Pension liabilities	Pension deficit	Market capitalisation	Liabilities / Market cap	Deficit / Market cap
British Airways	£12.8bn	£0.6bn	£1.6bn	791%	37%
British Telecom	£33.2bn	£4bn	£6bn	551%	66%

2. Funding regulations:

Following a number of high profile pension fund failures; the result of failure of the sponsor coupled with a poorly funded pension fund, many pensioners were left stranded. Regulators moved to tighten funding regimes for pension funds by emphasising the need for a clear plan to deal with any pension fund deficit and within an acceptable timeframe.  Increasingly, the emergence of deficits in pension funds were at the top of the agenda for company financial managers who could no longer kick the can further down the road. Deficits were having a direct and adverse impact on their cashflows by requiring higher contributions to be injected into the pension fund. All of this was taking place in the midst of the worst financial crisis in history.

In the early part of the noughties these themes played out across Continental Europe and the UK and then, in the latter part of that decade, these changes played out in the US and closer to home in South Africa. Today, corporate pension plans in the US and South Africa are leading the charge to the adoption of LDI strategies with many sponsors in these countries also moving to the “so-called” end-game more swiftly than their UK counterparts, i.e. the transfer of these pension liabilities to an insurance company and, in so doing, entirely eliminating the pension liability from their company balance sheets. But that is a subject for a future article.

LDI in Africa

Defined benefit pension schemes are not as prevalent in Africa as they are in the UK and the US. In South Africa, the continent’s largest pension fund market, defined benefit pension schemes were closed to new entrants in the nineties and their demise was hastened by offering members incentives to transfer out to newly established, defined contribution arrangements. That said, a few large legacy defined benefit pension funds are still in existence and many of these funds have moved towards adopting a LDI strategy, especially for assets backing their pensioner liabilities. The adoption of similar strategies by large pension funds in the rest of the continent is not without challenges due to less developed capital markets but, as discussed, LDI is not about investing in specific assets but rather about the adoption of a framework for the holistic consideration of managing funding level volatility. Adopting such a framework is of paramount importance as a first step towards improved risk management and governance.

Future developments

An LDI framework is not limited in its application and can (and should) be extended to defined contribution arrangements. The absence of a clearly defined or guaranteed liability does not imply the absence of such a liability. In fact, members of defined contribution pension funds are left with no different a challenge – they too need to be sure that they are accumulating sufficient savings in their pension funds on which to ensure a comfortable existence in old age. Arguably, members of these defined contribution arrangements require even greater financial assistance to define clear retirement objectives and goals. LDI can be used to frame such goals by linking savings goals to incomes required in retirement and in this way setting an appropriate long-term investment strategy.

In summary, LDI is a framework for managing investment risk. It has proved to be a useful tool for setting investment strategy especially where there are dual objectives of targeting a long-term savings goal whilst still focusing on the need to ensure acceptable investment outcomes in the short term.  There is an analogy to be drawn between a limited-over cricket game and LDI. In both cases the long-term goal is achieved by the successful achievement of a series of shorter-term goals which when taken together yield the desired end result.