Traditionally pension schemes invested in four main asset classes: Shares (Equities or Stocks), Bonds, Property and Cash.

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1 Asset Classes Traditionally pension schemes invested in four main asset classes: Shares (Equities or Stocks), Bonds, Property and Cash. Shares (also called Equities or Stocks) are shares bought in quoted Company. Most companies are formed as limited liability corporations. This means that shareholder's liability is limited to their initial investment in the company and no more. If a company fails to meet its obligations then the shareholders cannot in all but the most unusual circumstances be forced to meet the company's obligations themselves. Most large companies list their shares on one or more of the stock exchanges that function around the world and so become publicly quoted companies. This means shares can be bought and sold easily in the UK or overseas. Buying a share means the buyer becomes a shareholder in the company issuing the share. The investor expects to increase their capital (the price they pay for the share) and earn income over the time they hold the share (the dividend). There is no time limit on the investment. Bonds are an IOU where the issuer of the bond (the borrower) makes a legal promise to pay the bond holder (the lender) a fixed rate of interest at pre determined times and to repay the initial amount borrowed (the Principal) over some specified time. For this reason Bonds are also called Fixed Interest and Fixed Income investments or, debt securities. The series of payments and a certainty of cash flow make Bonds attractive to pension funds because in theory payments can be matched to pension payments. Bonds can also be bought and sold fairly easily. Jargon used in bond markets: GILTS UK Government bonds are also known as GILTS reflecting the time when the bond documents were edged in gold. Principal the amount borrowed (also known as face value or par value) Coupon the fixed amount of interest that is payable on specified dates; Maturity the date on which the principal is to be repaid; Redemption Value the amount repaid on the maturity date; Redemption Yield the return that is expected in respect of both interest and capital appreciation; Duration a measure of the sensitivity of a bond price to changes in interest rates; Default when the borrower has not paid interest or principal on time; Credit rating an independent opinion on the credit worthiness of a bond issuer.

2 Bonds are often classified by the length of time until they mature. The usual categories are: Short Dated under 5 years until redemption Medium Dated 5 15 years until redemption Long Dated over 15 years until redemption Irredeemable with no set redemption date. Bonds issued by companies (Corporate Bonds) are credit rated in accordance to the risk that is attached to them with AAA Bonds at the top end offering low risk (because they are deemed less likely to default) but therefore offer a lower rate of return. The following chart shows how two industry organisations, Standard and Poor's and Moody s classify Corporate Bond ratings: Bond Credit Ratings from Standard and Poor's and Moodys S&P Moody s Explanation Rating Rating AAA Aaa The highest rating. A very creditworthy borrower. AA Aa Borrower has a very strong ability to repay. A A Borrower is strong, but may be vulnerable to changes in circumstances. BBB Baa The credit quality is adequate, but vulnerable to changes in circumstances. BB Ba Borrower can meet obligations in the near term, but faces adverse business and financial conditions. B B Borrower is vulnerable to adverse business conditions. CCC Caa Borrower requires favourable business conditions to meet its obligations. CC Ca Borrower is highly vulnerable. C C Borrower is bankrupt, but still making bond payments. D Borrower has defaulted on financial commitments. Bonds rated from AAA to BBB are considered Investment Grade. Bonds rated BB or below are considered Speculative. Ratings can be further divided, for example + and. Sources of ratings: and

3 Property Property investment generates returns through rental income and through changes in property prices. The rental income element of property can be thought of as similar to the interest from bonds and the price element similar to changes in share prices. Property has a number of characteristics that are different from those of shares and bonds. For example: Illiquidity Property, certainly through direct investment, is illiquid; it takes time to buy or sell a property. Cost of ownership The costs of owning a bond or a share are very low, whereas there are costs to keeping a property in good order and up to date with current requirements. Heterogeneous nature No two properties are exactly the same. Consider two identical houses on opposite sides of a street. You may think they would be worth the same. However, if one house backs onto a railway line then it will probably be worth much less than the house opposite not backing onto the railway line. The same is not true of bonds or shares which are homogeneous. Investment in property can be made in various ways, for example: Directly by buying a property (as far as pension schemes are concerned this will generally mean commercial property) Property funds buying unit trusts, investment trusts and insurance policies which themselves invest in property; Property shares by buying shares in property companies. Cash generally this will be money held on deposit with a financial institution for example where funds are placed with a bank for a predefined period at a set interest rate. The advantage to pension schemes is there is certainty which is useful, for example, to have money available to purchase investments from other asset classes and to pay pensions, cash lump sums, transfer values, etc. Generally cash is readily available and has low dealing costs.

4 Alternative Asset Classes In the world of pension scheme investment Alternative Asset Classes are less traditional investments i.e. not ordinary shares, bonds property or cash. Many of these also use different methods to make the investment. Examples of alternative classes of assets are Hedge Funds Private Equity Derivatives and Swaps Infrastructure Commodities Forestry Emerging Markets Hedge Funds are funds that seek to generate investment returns by using non traditional investment strategies, and a range of investment tools e.g. options, futures, swaps, and forwards, (collectively generally known as derivatives). An example of a common hedge fund strategy is to buy (going long ) investments the investment manager thinks are undervalued, while selling (going short ) investments the manager believes to be overvalued. Private Equity is finance provided in return for shares bought in companies that are not quoted on a stock exchange. Although not the same as Venture Capital the terms are often used as substitutes for each other because often investment is in new businesses. In reality Venture Capital is a type of private equity, as are Growth Capital (finance used by companies to expand their businesses) and Buy Outs (where a firm is taken over by a private equity company). Derivatives are an agreement to exchange a sum of money at a certain point in time. The measure for determining how much money will be exchanged is based on the performance of a particular investment or investment market, during the period of the agreement. The investments on which derivatives are based can come from a wide range of financial instruments e.g. from shares to changes in interest rates and commodities. Since derivatives are about exchanging something of value in the future, the parties involved usually have to provide evidence that they will be able to honour the agreement. The Barnyard Basics of Derivatives is a very helpful article that helps to de mystify Derivatives.

5 Swaps are agreements between two parties to swap future cash flows (and this is cash in its broadest sense i.e. bank deposits). The most common swaps used by pension funds are interest rate swaps (also known as Fixed Swaps). Here the aim is to try and protect the pension fund against unexpected future payments caused by rises in interest rates. The other type of swap frequently used is the inflation swap which is used to try and protect against unexpected rises in the rate of inflation. The NAPF publishes Made Simple guides on a number of investment topics. You may be interested in: Hedge Funds Made Simple When Made Simples are first released, NAPF members receive a free copy. Find out if your colleagues already have copies. Derivatives Made Simple If you don t have a copy and you want to buy one, you can do so online:

6 Infrastructure as the name suggests this is investment in a wide range of projects ranging from economic infrastructure e.g. railways roads, schools, water pipes to social projects like hospitals. Growing demand from developed and developing economies. Commodities Investments in natural resources including gold, base metals, wheat, grain, coffee etc and in livestock. Commodities may also include works of art and antiques. Forestry while obvious from the title, pension fund investment in forestry will generally involve commercial forests or woodlands where timber is actively being marketed and sold. Emerging Markets Generally this involves investment in corporate bonds issued by less developed countries. Risk, return and liquidity Return What the investor expects to gain (although there is also the possibility of loss)) from the investment both in terms of income over the time it is held and via repayment of the capital sum made to secure the investment at the outset. Risk What are the chances the investor will gain or lose on their investment? For example, if you throw a dice we know there is a onein six chance that a particular number, for instance 4, will come up on a given throw of the dice. We cannot, however, predict which number will come up. This is the concept of risk. In investment terms, the investor might expect the investment to provide a return of 10%, but it is important to consider the likelihood of other outcomes. For instance what is the chance of a 10% loss or more are they one in a hundred or one inten? The latter indicates a riskier investment than the former.

7 Liquidity An investment is said to have good liquidity if it is easily converted into cash. In ordinary circumstances mainstream shares and bonds can be sold to raise cash very quickly. Of course there may be individual shares and bonds where this is not the case. In times of extreme events, it may be difficult or impossible to sell a whole class of investments. For instance, after 11 September 2001, the New York Stock Exchange was closed for four business days making it impossible to trade many US equities. Asset classes with the lowest return will typically have the lowest risk, and vice versa. This is one of the fundamentals of finance extra return demands extra risk. The following chart shows the expected return, risk and liquidity for the four main asset classes. Asset Class Expected Risk Expected Return Expected Liquidity Shares (Equities) High High High Bonds Low Low High Property Medium Medium Low Cash Lowest* Lowest High Alternative Investments Varies Varies Varies * In terms of pension scheme liabilities, however, bonds are generally considered a lower risk than cash. Risk/Return Shares The price of individual shares goes up and down every day. This is known as volatility and is often thought of as a measure of risk. The volatility of individual share prices is usually higher than that of individual bonds. And the volatility of equity markets as a whole is usually higher than that of bond markets. Volatility is a disadvantage if an investor needs to sell shares at a time when the price is low. Low in this context, however, is a subjective term. In practice it is difficult to tell in advance whether the price is low now, and will recover in the future, or whether it will fall further. The prices of shares change for a number of reasons, for example: the company good news, for example, improved sales figures can make prices rise and bad news for example, poor management or stiff competition can lead to a fall in prices; the economy rate of inflation, changes in interest rates and exchange rates can also affect equity prices. In general, equities are likely to do better when an economy is growing than when it is slowing down; the market Investors can feel positive or negative about companies, sectors of the economy, or even whole countries. Companies do not necessarily pay dividends and the share price may fall. However, there is the potential to receive dividends and for the share price to rise. Over long periods of time, equities have performed well in relation to most other asset classes and to inflation.

8 Risk/Return Bonds Risk from bonds arises in a number of ways, for example: Interest rate risk a rise in interest rates will mean that the yield element of a bond's return will need to rise accordingly, and so its price will fall. Credit risk there is always a risk that the issuer of a bond will default. if the outlook for a borrower worsens, it will be considered more likely to default and the prices of its bonds will fall. Inflation risk high inflation erodes the worth of the future payments from a bond so an upward move in inflation or expectations of inflation will usually make bond prices fall. Longdated bond prices are heavily influenced by inflation and expectations of inflation. Volatility, similarly to shares, is a measure of a bond's risk. Investment in bonds produces a near certain return, provided the bond is held to maturity and then issuer does not default. In most cases, the return is by way of the interest or 'coupon' payments and the repayment of the principal at maturity. Many bonds, however, are not held until maturity and in any case their price fluctuates over time. So the return from the bond is usually not certain. Over long periods of time, the return from bonds has been lower than that for shares but with lower risk. Property Risk /Return Property fits somewhere between bonds and shares in terms of its risk/return characteristics. Some of the main risks of property investment arise from: Variable income property income used to be set under long term leases, but now more flexibility is demanded, making the income less certain. Obsolescence property requirements change through advances in technology or changes in business requirements. The owner will need to spend money to bring the property up to date. Lack of liquidity it takes time to buy and sell property and there are large transaction costs involved, in particular tax ('stamp duty').

9 Cash Risk/Return Cash is a relatively low risk asset. In ordinary circumstances the main risk relates to the credit worthiness of the institution to which the cash has been lent. It is quite rare for a bank to default on its obligations, but not impossible. The key, therefore, is to be aware of the credit quality of the bank and, as with most areas of investment, to diversify the investment so that not all of the risk lies with one institution. Diversification will not help cash investments in extreme environments. The worth of cash is eroded by inflation. High interest rates can offer some compensation for this but not always especially if inflation turns into hyper inflation. The most extreme example of hyper inflation was in Germany in the 1920s but it has occurred more recently, for instance in Argentina in For UK pension funds hyperinflation hopefully will not be a worry but it is still worth noting that extreme events have occurred and may from time to time happen again. Cash is usually expected to deliver a lower return than other asset classes, reflecting the low level of risk. Over the longer term cash returns tend to exceed inflation, but to lag the returns on shares, property and bonds. Of course, there are periods when shares, property and bonds do badly, and in these periods cash may be the best performing investment. Alternative Asset Classes Risk/Return Alternative investments offer the potential for enhanced returns or increased diversification or both. However consideration needs to be given to the fact that they may be Unfamiliar to investors; More costly to use; More time consuming to manage; and More volatile than shares, bonds property and cash.