Padmesh Shukla
Chief Investment Officer, TFL Pension Fund

With around 15% of the portfolio in ‘liquid alternatives’ such as hedge funds and a full 45% in ‘alternative investments,’ the £14 billion (US$17 billion) TfL Pension Fund has made diversification a key priority. In recent years, that focus has well and truly paid off: “Amid various shocks, from Covid to the 2023 European banking crisis and others in-between, this [liquid alternative] allocation has been a bulwark against the wide swings in markets,” says CIO Padmesh Shukla.

Sitting down with bfinance Investor Spotlight, Shukla shed light on the structure and composition of the liquid alternatives portfolio, including some interesting new developments. Notably, the fund recently began using a (highly customised) fund of funds for the first time and is now considering adding equity-driven hedge funds—previously omitted in the interests of low beta exposure—to its line-up of hedge fund positions.

The full interview is available below, including additional insights on portfolio analysis software, flexible governance arrangements, hedging activity, investment opportunities, the macro outlook and more.

Q: You have a larger allocation to alternative investments compared to many of your defined benefit pension fund peers. Could you give us an overview of your approach?

Ten years ago, the allocation to alternative asset classes was around 5-6%, with a portfolio closer to a classic 60:40 equity:bond mix. Today we have nearly 45% of assets in alternatives. We’re convinced that if we’re going to get the returns, we need to think outside of that 60:40 box.

We now invest in pretty much every alternative asset class apart from Emerging Market Private Credit. There’s a large private equity book and a rapidly growing private debt book, quite diversified across regions and sectors. We have exposure to infrastructure and real estate, plus an allocation to liquid alternatives. Overall, the split is around two thirds private markets, one third liquid alternatives.

It’s been quite a journey and there have been challenges. We’ve taken our time with it. This is very different, not just in terms of the investments but from a decision-making and governance perspective. It’s the trustees who ultimately make decisions, but the topics can be difficult and complex; there’s been a lot of learning and education for trustees and some developments to the governance model.

What’s in your ‘liquid alternatives’ allocation and how has this developed?

The liquid alternatives side of things is quite interesting and not many UK pension funds do this. It’s quite an expensive area, it’s not well understood, there are issues from a volatility perspective. But liquid alternatives provide real differentiation in our portfolio – a true diversifier. The objective is not to shoot the lights out but to diversify the key market risks that sit in our portfolio.

Liquid alternatives provide real differentiation in our portfolio – a true diversifier

From a performance perspective, the liquid alternatives portfolio has definitely stood the test of time. Amid various shocks, from Covid to the 2023 European banking crisis and others in-between, this allocation has been a bulwark against the wide swings in markets. For example, 2022 was the toughest year in a long time, with pretty much every asset class down, but our AuM and funding ratio both improved and the hedge fund portfolio was a big part of the story in addition to our low hedging ratio going into rising interest rate environment. It was a great period for macro managers (discretionary and systematic), commodities, reinsurance; trend did well too. The portfolio delivers diversification in theory – 2022 showed diversification in practice.

We moved into both hedge funds and illiquid investments around 2009-10. Our first allocation to hedge funds was a large global macro manager: this was something of a taster; it really helped us to understand what hedge funds could do for us in terms of diversification. At almost the same time we made our first foray into private market investing with a large allocation to the UK PFI space. Initially we invested in hedge funds strategies in a classic 2&20 format. Then as our understanding of the construct evolved, we’ve moved towards more beta-style hedge fund strategies—alternative risk premia—to give better value for money and lower overall cost with flat fees.

Our key portfolio construction principle in the liquid alternatives space is very low beta, especially to equities (we specify a number in our construct). Ideally, we also like low correlation to rates and credit, as far as is possible. We’ve developed a large portfolio of macro managers, both systematic and discretionary. We’ve also built an allocation to trend over the past decade: it’s important not to try to ‘time’ this; it’s there as a left tail hedge and has lost money some years but performance is occasionally off the charts. We also have a large reinsurance portfolio which sits within ‘alternative beta’: again, that’s been there for more than ten years and we don’t try to time it (that would defeat the point). Finally, we’ve got some investments in credit (special situations and relative value credit) and commodities. What we haven’t had—to any significant degree—is exposure to equity-driven hedge fund strategies, but that is changing as spreads widen and active management gets more interesting with the end of the zero-rates economic environment.

This is the first time in the history of our hedge fund book that we’ve appointed a manager that selects funds for us

Within the past year we’ve also introduced a (customised) fund-of-funds: this is the first time in the history of our hedge fund book that we’ve appointed a manager that selects funds for us. This is a new step: previously we selected all of the funds directly. This helps us to create the exposures that we know we want but may lack the governance or resources to implement ourselves. Examples could include emerging managers (typically with smaller ticket sizes), emerging markets managers, or even just good manager names that we’d love to get into but which have been closed to new capital for years. The approach is very customised: we don’t duplicate what we own. We don’t just want diversification overall – we want diversification between the managers in the portfolio.

It’s also worth mentioning that we make use of a tool from one of our global macro managers to get an understanding of exposures across our wider portfolio.

Could you share a bit more detail about that software?

Some macro hedge fund managers provide these sorts of tools for free to clients – web-based systems, risk tools. Our portfolio sits on the BlackRock ALADDIN system, but this tool gives us a much more differentiated and complementary insight. It means we can understand what our managers are doing – in terms of risk, liquidity and more. In Brexit we could model the portfolio and understand what to do. In Covid we could understand questions about liquidity. When thinking about the subject of sustainability we can stress test assets—and, to some extent, liabilities—against various climate scenarios.

When we appoint asset managers it’s like having an X-ray: we can screen their returns, see whether they’re doing what they say, understand the attribution in a very differentiated and sophisticated way. Sometimes I feel like we know more about the portfolio than many of the managers themselves from a relative risk-return perspective and in terms of biases to various economic environment.

I wish pension funds would make more use of technology. Pension funds typically have limited resources – which is always a constraint. We should use the technology that is available to us as much as possible. Right now, I’m doing quite a lot of work to try to educate myself on newer developments in AI, trying to get on top of the subject. It’s important to be an intelligent client.

You mentioned the importance of governance as the alternative investment programme has developed. Can you give some insight into how the governance model has changed?

Firstly, it’s absolutely vital that pension funds have the right governance for the investment activities they want to do. Without the appropriate governance for your asset classes and strategies, you can’t invest in them effectively. You can’t put the horse before the cart.

One of the best things we did in terms of alternative investing is reorganise our governance

One of the best things we did in terms of alternative investing is reorganise our governance before we started going deep into this area. Our Investment Committee is still in place and has always been in place: it meets four times per year and focuses mainly on equities and bonds. That was fine for the old portfolio, but the alternative investments needed a more nimble yet granular approach.

A new investment governance structure was put in place by Mr Stephen Field, the Fund Secretary, with the creation of the Alternative and Liability Hedging Committee a little over ten years ago. It was a very smart move with an incalculable value to the scheme. This committee is smaller: it has four members, all four of whom are also on the investment committee. It also meets as many times as is required: we started with ten meetings per year but arranged many more around unique opportunities that required a quick turnaround. This group can call a quick meeting, discuss the decision and delegate to the fund office effectively. And, because it only has four members, we were also able to support stronger training and education for them. The Investment Committee does still have to be fully involved, of course: specifically, they have to agree on the funding for alternative investments (which essentially comes from equities). But the more detailed time-sensitive decision-making sits with the new committee.

The resulting (more nimble) governance has been one of our key strong points. I can’t think how else we’d have done what we’ve achieved. For example, when the Covid lockdown produced a liquidity crunch, we were sitting on liquidity and we were able to deploy hundreds of millions of pounds quickly and smartly; in hindsight those have been some of our best investments.

What are you doing with your Alternative Risk Premia allocation?

This has been a mixed story over the past few years: it did well, then it stalled, then it struggled. We’ve scaled the programme back over the past 12 months (roughly halving the size) and are asking tough questions about whether the concept is working. It’s been in place for a bit more than five years – that’s probably enough time for a review. The scrutiny is well deserved.

How has your approach to Liability Driven Investing changed following the UK pensions LDI crisis of late-2022?

We’ve had an LDI programme in place for the past 14 years. The programme always had a real rate trigger that was essentially not triggered – it was out of the money – while real rates were zero or negative. The structure was effectively in hibernation for nearly ten years. Since we’re an open scheme, our thinking about risk is different versus a closed scheme. Our thinking was: why should an open scheme with open liabilities be locking in real rates of -3%? As a result, our hedge ratio going into the LDI crisis was very low – around 8%. Within that we held close to 900bps of collateral headroom (that’s just within the LDI structure, not including the liquidity outside the LDI structure). Because our hedge ratio was minimal when our real rate triggers were actually triggered, we were not really affected at all.

Our hedge ratio has now increased from 8% to around 30%

In fact, the LDI crisis and what happened to real rates has given us a springboard to move towards hedging aggressively. Rates are now well in excess of the trigger levels established several years ago. Our hedge ratio has now increased from 8% to around 30%. We didn’t hedge when others seemed to be hedging at any price – but now we are. The LDI crisis has allowed us to lock in those improved rates in our LDI structure. It’s also a segregated structure, so we’re not affected by the problems that the pooled LDI funds face. In fact, the LDI crisis has reminded us the value of our long-term investment horizon – one of our core investment beliefs.

Finally, where do you see the most attractive investment opportunities now?

The most interesting area from a strategic and duration perspective is real rates. In the UK, the economy has been struggling to grow at 1% in real terms, so a real rate 50bps higher than that looks quite attractive. I believe that over the long term the real rate will settle between 0-50bps. I would not be surprised they revert to sub-zero territory as long-term secular challenges like demographics and productivity remain very much intact and some of tailwinds of the previous two decades (such as globalisation, efficient supply chains, a relatively well-behaved geo-political backdrop and cheap energy) unwind in quite a spectacular way, while new challenges such as climate change emerge. Having said that, I do not want to underestimate the power of human ingenuity and innovation. If even a fraction of innovation in the pipeline from AI and battery technology to genetics and fusion power succeeds, the implications in terms of higher growth and lower inflation are quite real.

Building on that, for now, 3% real returns in corporate bonds is not a bad level for the risk characteristics, so I think corporate credit is very interesting now and quite scalable.

In the alternatives space I’m less bullish on private equity right now from a tactical perspective but it is very difficult to time this asset class, so a long-term approach is required. It could be considered a good time to build the PE programme as there are more GP choices and the secondary market is definitely more attractive. If you want to deploy capital and can take illiquidity risk, I do think private credit is attractive now.

It’s also worth calling out emerging markets – the perpetual under-shooters. For years investors have been going there for growth, with attractive fundamentals, but it hasn’t really translated into investment results. It’s been a decade of disappointment. But if you can get the manager selection right on equities, fixed income (corporate and hard currency) and real assets, particularly green infrastructure, there are some very attractive risk/returns available to long-term investors.

bfinance thanks Padmesh Shulka and TfL Pension Fund. We look forward to seeing the ongoing development of the team and investment portfolio.
Related reading:
Rise of the Allocators: Multi-manager Strategies for Alternative Investing
Global Macro – Sector in Brief
How to Build a Hedge Fund Allocation

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