Scottish & Newcastle diversifies with 5% in EMD

The £2.3bn defined benefit pension scheme, which closed to future accrual in July 2011, has also decided to reduce its number of active equity managers in an attempt to save money.

Carol Young, pensions manager at the scheme's parent company Heineken, said: "The trustees considered the investment opportunity in EMD within the context of the overall plan investment strategy.

"[They focused on] the impact on the expected level of risk and return and possible diversification benefits."

Schemes that add emerging markets to their fixed income portfolios can get better value than from their developed-world government bond holdings.

But they face a governance challenge picking the right type of asset and monitoring these more volatile markets if they are to protect their members' retirement savings.

Investments shift

The decision to invest in EMD for the first time came as a result of a review of the fund assets revealed in its Trustee Review 2011/2012 newsletter.

You could be looking to generate a 4-6 per cent yield pick-up

David Aird, Investec

The scheme currently has roughly half of its assets in bonds and other liability-matching investments, and the other half in return-seeking assets (see box).

The new allocation will be to local currency debt, which holds higher potential returns but also higher volatility than the other common form of debt issued in US dollars.

Young said: "[This review concluded] that the growth portfolio remained in good shape but opportunities existed to make some incremental improvements, such as the introduction of EMD. 

"Specific risks related to EMD investment were discussed and these included consideration of currency risks, political risks, contagion and sensitivity to further global downturn or increased risk aversion in markets."

Schemes that turn to EMD are being attracted by higher bond yields in developing markets as well as any currency or alpha gains the manager can secure.

David Aird, UK managing director of Investec Asset Management, said: "Our general message is you could be looking to generate a 4-6 per cent yield pick-up compared with the [developed-world] debt."

But the use of high-performing EMD over developed-world debt can introduce more volatility into schemes' investments.

From December 2002 to July 2012, dollar-denominated EMD returned 10.8 per cent a year with a volatility of 9 per cent, according to the JPMorgan Emerging Markets Bonds index.

In contrast, global government bonds provided 6.3 per cent return for 7.2 per cent volatility, according to Citigroup WGBI All Maturities USD figures.

The more risky and rewarding local currency EMD provided 12.1 per cent return for the same degree of volatility, according to JPMorgan GBI-EM Global Diversified Composite Unhedged index.

"The ideal answer for pension schemes if they are taking their first step is to go down the blended-debt route," said Aird.

Rather than choosing between local currency or dollar-denominated debt, these types of funds allow managers to shift their allocation between the two and potentially include other types of debt such as high yield and investment grade.

Streamlining your investments

The Scottish & Newcastle fund has also decided to reduce the number of active managers in its equity portfolio in order to control its investment costs and to allow governance resource to be redirected to the new asset class.

Having a large number of active equity managers does not give you much more diversification

Simeon Willis, KPMG

"It should free up time, cost and resources while maintaining the same expected level of risk and return on plan assets," said Young.

"This allows more governance time to be devoted to other growth opportunities such as EMD, which are likely to have a greater impact on the overall plan's investment return and risk than the impact from the performance of the active equity managers."

There is a realisation among schemes that simply increasing the number of active managers within one asset class such as equities does not provide much protection against poor performance.

Simeon Willis, principal consultant in the investment advisory team at KPMG, said: "Having a large number of active equity managers does not give you much more diversification benefit because most of the returns you are getting are the underlying equity returns."

These active equity managers are subject to the same trading costs and often operate similar investment strategies.

Willis added: "There are a number of different reasons but put simply it is because they are operating in the same market."