By Ndabe Mkhize
The Eskom Pension and Provident Fund (“EPPF”) is a defined benefit pension whose long-term investment strategy is set through an asset-liability modelling (“ALM”) process, which leads to formulation of the strategic asset allocation (“SAA”) of the Fund. The EPPF ALM process is a very robust process that involves three groups of actuaries (ALM actuaries, peer review actuaries, and the Fund actuary or valuator, the investment team, and the Strategic Investment Committee
(“SIC”) of the Fund. The ALM process begins with a Capital Markets Assumptions workshop where the long-term expected real (i.e., inflation-adjusted) returns of each of the major asset classes are set. Concomitantly, the correlations of one asset classes against the other asset classes are also presented in a covariance matrix. The expected real returns and the covariance matrix serve as major inputs into the process of setting the long-term investment strategy – the SAA – of the Fund. The other important consideration is the shape of the cash flows of the liabilities of (i.e., the expected future benefits to be paid by) the Fund.
Hence the decision to invest in Onshore China equities, also known as China A equities, was based on a comprehensive and robust ALM process. The expected future returns of China A equities were sufficiently high to provide return enhancement benefit and the correlation to other asset classes was low enough to provide diversification benefit. The size of the China A equities market is very large by both market capitalisation and turnover. It is second only to that of the United States of America. By turnover, it is larger than the combined magnitude of the UK, Europe, Japan, and Hong Kong equities markets. Please see the chart below. However, the China A market is not yet fully represented in popular equity market indices like the MSCI All Country World Index (MSCI ACWI) or the MSCI Emerging Markets index (MSCI EM). Therefore, it was necessary to have a specific allocation to this large and under-represented equities market. The initial EPPF allocation was set at 2% and was subsequently increased to 3% in the SAA of the Fund. The actual allocation to China A has increased to circa 4.5% (versus the weight of 3% in the SAA benchmark) as at 30 June 2021 because the China A market fared much better than all the major asset equity markets during the COVID-19 market crash of March 2020. Furthermore, the managers chosen by the Fund to invest this allocation to China A performed well and managed to outperform the China A benchmark. However, the Fund’s allocation to Developed Market (DM) Equities was slightly underweight (18.5% versus the strategic weight of 21%) while the allocation Emerging Markets (EM) Equities was almost neutral weight. According to our most recent capital markets assumptions workshop, there was unanimity that the expected real returns of DM equities are lower than those of China A or EM equities.
Ultimately, the long-term investment strategy of the Fund is approved by the Board of Trustees on an annual basis and is included in the Investment Policy Statement (“IPS”), which is reviewed by the Board and the financial regulators (i.e., Financial Sector Conduct Authority) on an annual basis. This IPS is also reviewed by a totally independent actuary – who is independent of the three sets of actuarial firms that are involved in the ALM process. None of the experts who review the long-term investment strategy of the Fund found the allocation to China A to be inappropriate. Furthermore, after the approval of the inclusion of the China A into the SAA benchmark – but prior to the approval of the specific implementation plan thereof – the chief investment officer (“CIO”) of the Fund together with the then chairperson of the SIC, attended the conference of the European Pension Fund Investment Forum (EPFIF) where some of the large European pension funds expressed that they were investing directly into China Onshore markets (China A) as early as 2018.
Secondly, the performance of China A Equities benchmark was higher than Developed Markets (Global) Equities over 1-year and the 3-year period to 30 June 2021, delivering 15.5% and 19.9% per annum over the respective periods (while Global Equities returned 15.1% and 16.6%, respectively). Furthermore, our China A asset managers have outperformed the China A benchmark over the corresponding periods.
We have included a link from Mercer, which is one of the largest global asset consultants, entitled ‘Mercer – The Case for a Dedicated China Equity Allocation'. The conclusion of Mercer is that “many investors are underexposed to the diversification and return enhancing benefits provided by onshore China exposure at the total portfolio level. China is significantly underrepresented in standard benchmarks and many investors’ equity portfolios. We acknowledge specific ESG and geopolitical risks with China equity exposure but believe many of these can be mitigated with active management and are outweighed by the potential enhancement of portfolio efficiency. Within equity portfolios, we recommend EM allocations of at least market weight but, in pursuit of portfolio efficiency, we strongly prefer higher allocations up to 25% driven to a large degree by a much bigger allocation to China A-shares”.
We have included the link to slide deck (‘202108 – EPPF China Information’) that was compiled by one of the Fund’s ALM actuaries, RisCura. This presentation encompasses the rationale for investing into China A, China market statistics, the inclusion of Onshore China into the MSCI indices, and performance.