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Pensions shore up equity balance

Buying stocks, shedding derivatives

While many ordinary investors flee the stock market, Canadian pension funds are loading up on stocks to rebalance their portfolios and restore their diminished equity holdings, pension advisers report.

At the same time, investment consultants say pension funds are also shedding holdings in complex derivatives and hedge funds to reduce risk levels in their investments.

While pension funds are still willing to use common derivatives for regular currency hedging and other traditional uses, they are increasingly unhappy with the more complex derivative strategies that had been growing in popularity - including use of derivatives to generate greater returns from regular fixed income portfolios.

"Anything now that has leverage involved, nobody wants to touch it," said Robin Pond, head of investment consulting at pension adviser Morneau Sobeco.

Some pension giants, including Quebec's Caisse de dépôt et placement du Québec, have recently confirmed they are unwinding derivatives and currency hedging positions.

Ontario Teachers' Pension Plan has also said it will be less active in credit derivatives and other leveraged fixed income strategies.

"In early September there was a change in our fixed income group," said Teachers spokeswoman Deborah Allen. "It's safe to say derivatives is not a growth area for us."

Beyond derivatives, experts say almost all pension funds in Canada are now grappling with the need to increase their weightings in stocks after seeing their values decline sharply in recent months.

Pension funds set asset-allocation targets for each category of investments and must stay within a prescribed range of holdings. Many funds have typically held 50 per cent to 60 per cent of their portfolios in equities, and are now underweight in the category given the declining value of shares.

Jaqui Parchment, director of investment consulting at Mercer, said some retail investors may be surprised to see pension funds buying new equity positions at a time of such widespread uncertainty, but said the weightings impose a discipline on pension funds and prevent extreme bets.

"Getting back within those ranges is really a way to force plan sponsors to sell high and buy low," she said.

Funds will be forced to buy into equities while they are cheap and sell assets like bonds that have done relatively better, she said.

Nonetheless, pension funds' asset-allocation targets have ranges, so funds have discretion to be at the higher or lower end of the ranges, depending on their views of the markets.

Janet Rabovsky, leader of the investment consulting group at Watson Wyatt, said she is telling pension funds lucky enough to be still within the broad ranges of their targets to wait a while before acquiring more equities.

"If you don't have to rebalance, now is the time to go back and revisit your risk tolerance in its entirety and determine where you want to be before you actually start to take action," she said.

Pension experts anticipate the extraordinary market turmoil this year may encourage debate about whether pension funds should make long-term changes to their traditional investment strategies.

There has long been talk about developing strategies to "de-risk" pensions, but the recent downturn has given new impetus to the search for methods to reduce funding volatility.

"It's still talk at this point," Ms. Rabovsky said. "People are still reconsidering to a large degree."

Ms. Rabovsky said pension funds will soon begin selling more of their "illiquid" investments in alternative asset classes such as real estate or private equity holdings. Many of those assets are valued only quarterly, so many funds have not yet had to record a hit from declining asset values in those categories.

"They're starting - hedge funds for sure," she said. "But things like real estate, infrastructure [and] private equity, we're going to see that soon. They're going to get written down to some degree."

Mr. Pond said funds are grappling with decisions about alternatives, and indeed all other categories of investments. He said he has rarely seen a period in which pension funds have taken such diverging approaches.

"What we are seeing right now is an awful lot of different policy directions being taken by different funds," he said.

© 2007 The Globe and Mail. All rights reserved.

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