Dealing with defined benefit liabilities has turned Britain’s USS into a buyside derivatives champion, giving it agility in volatile markets

Anyone who has studied at a UK university is likely to have encountered members of the Universities Superannuation Scheme, the £78 billion defined benefit pension fund for the country’s academics. It is also one of Britain’s biggest and most powerful buyside institutions.

USS’s Head of Fixed Income Treasury and Trading, Ben Clissold is working in a very different type of organisation to his former employer Blackrock, where until 2019 he was head of active liability-driven investment (LDI). Clissold works not for USS itself, but a wholly-owned subsidiary, USS Investment Management Limited, which acts as fiduciary manager for USS. USSIM is effectively an asset owner and manager which serves a single client – the 550,000 USS members. Within USSIM, portfolio managers work with Clissold and his team, but not in a way he was used to at Blackrock.

“We run a centralised dealing desk but some of our PMs also still trade”, Clissold explains. “This is different from how a traditional asset manager will be set up. Any large asset manager like Blackrock works very hard to make sure there’s complete segregation between a PM and a trader, because they have a requirement for TCF – treating clients fairly.”

There are acute conflicts for traders with multiple PM clients, recalls Clissold. “Suppose you have two different clients both wanting to buy the same thing. How do you decide who gets to buy it first? There’s got to be lots of rules there”.

This is not a problem for USSIM. “We don’t have those problems, because we only have one client and we’re never going to have another client. It’s impossible for one of my traders to front run my client with another portfolio.”

Instead, the desk structure is driven by efficiency, falling between two extremes. “It’s much better to have one person who’s all over the FX market and trading all of the FX that USS needs to do”, Clissold says, while for some asset classes, trading is best left to the PMs. “Most of the asset-backed security market is primary issuance. If your ABS PMs are spending three weeks looking at a pool of underlying assets that are going to get securitised, then getting somebody else to trade that is pointless”.

Equities are handled by the centralised desk, with some caveats. “Equity trading in general is all done by my team, because their specialisation is useful”, Clissold explains. “There are conversations that happen between PMs and our equity trading desks. There’s lots of thought put into how we access the market, to make sure we have sources of liquidity and access to brokers that allow us to try and place those trades”.

Quizzing external managers

These conversations include external managers, who serve as a vital source of information. “We manage about three quarters of the assets within USS, and about 25% is managed externally by external managers”, notes Clissold. “Those external managers are really good at managing the assets, but they’re also really good for asking questions of them”.

“A good example would be in emerging market government debt. India entered the JP Morgan index and has gone from a weight of zero to 10% of the index. How do you trade Indian government bonds? We could spend a lot of time doing all the research or I could just ask my emerging market debt managers, and I asked three of them, and they gave me consistent answers: ‘This is how we do it. This is how we’ve set it up. We tried this. It didn’t work so well’. It’s just a hugely valuable source of information for us to not waste time and set things up as efficiently as possible”.

The trading desk’s knowledge can even be useful for the managers of USS’s £9.7 billion private equity holdings, Clissold adds. “When there’s an exit from private equity, we sometimes get the choice whether we’ll take the cash or we’ll take the shares and my team will help provide understanding on market liquidity for the PMs who make that decision”.

For pre- and post-trade analytics, some of USSIM’s vendors include Bloomberg, Tradeweb and BestX. Clissold cautions that like everything else USSIM does, funding costs and derivative overlays are a key part of the transaction cost analysis.

“Recently we exited a relatively sizable equity portfolio, we would normally hedge the transition with S&P futures. But when you look at the borrowing costs implied within the futures in the US, we thought it was actually better for us to move into an ETF. So we delivered a basket of US equities, and the broker created ETF units for us. And that was the most efficient way for us to choose to change that exposure.”

When it comes to brokers, Clissold is more concerned not to miss potential good performance than penalise for weak performance. “We just finished our annual broker review, which we do every year. Those things are useful to look back, but probably more useful to look forwards.

What we’re looking for are areas which banks or market makers think they’re good at, and we’re not using them very much for. The salesperson or the relationship manager is always going, ‘try us in this’, and I think that’s one of the most useful bits. If you haven’t traded Singapore dollar with a bank, how do you know whether or not they’re going to be any good at it?”

Diversifying leverage

But USS is much more than a £78 billion pension fund. It is arguably 30% larger, once derivatives-based leverage is taken into account. This leverage is key to understanding how the fund’s traders think and operate.

The source of the leverage is LDI, the strategy used by defined benefit pension funds to protect retiree obligations from swings in interest rates and inflation. Rather than investing all its assets in inflation-linked gilts, which would be ruinously expensive, USS puts only 42% into this category, allocating the rest into growth assets such as equities or credit.

To achieve the liability hedge it wants, USS uses a £19 billion overlay of interest rate and inflation swaps with maturities up to 50 years. Effectively, this synthetically enlarges the hedge beyond the physical gilts USS holds, allowing the fund to stay invested in equities and other riskier assets that deliver the long-term growth to sustain it as an open DB fund without government backing.

The source of the leverage is not just LDI, but is more diversified using leverage in equity, rates, and inflation, while also diversifying its currency of leverage outside the UK into Euros, USD and Yen. This diversification allows USS to better manage its leverage and cash and collateral management.

The flipside of this strategy is that mark-to-market swings in the derivative hedges involve a collateral operation as the fund pays and receives collateral from counterparties daily. This colours every aspect of USS traders’ thinking.

This is why, if Clissold plans to trade some equities, he instinctively reaches for his derivatives toolkit, considering a futures or total-return swap overlay or perhaps an exchange-traded fund, simply because the capacity is always there. And this capacity provides USS with remarkable agility when confronted with bouts of volatility, as recently seen in March and April.

“Any bounce of volatility depends what you’ve done to prepare, and we work very hard on having full access to as many brokers as possible” Clissold says. “So we’ve got about 30 ISDAs and Global Master Repurchase Agreements in place. Those are the bilateral legal docs and USS has three clearing members at LCH”.

The numbers speak for themselves. In addition to its linchpin LDI trades, USS reported £12.6 billion notional of futures contracts, and £8.2 billion notional of total return swaps, as of March 2024. The fund also had pledged £2.2 billion of bonds to counterparties, according to its annual report.

“What’s unusual about USS in the UK sense is that we’re funding dollars and euros as well as in sterling. I spent eight years at Blackrock, looking after hundreds of LDI accounts. The UK ones would do UK repo, the European based ones would use Euro-based repo, but they’re very rarely funded in multiple currencies. That’s a huge advantage that we have, and allows us to make sure we have cash available when we need it and also minimises some of the costs of that.”

Weathering the LDI crisis

A cautionary tale for many UK DB funds was the so-called LDI crisis of October 2022, when then-prime minister Liz Truss’s budget triggered a sell-off in gilts. As swaps lost value, pension schemes and their LDI managers were forced to sell bonds to meet margin calls, exacerbating declines in the market. USS was insulated from that turmoil as a result of Clissold’s multi-currency funding model and USS was not forced to sell any assets through that period.

“During the LDI crisis when there was lots of stress in the Sterling market, it was much cheaper to fund in dollars, relative to Sterling funding, which blew out to Sonia plus 30bps. It was extremely beneficial for us, not just because we had cheaper funding, but also better liquidity than others in those circumstances”.

The governance of the fund also played a crucial role in 2022, adds Clissold. “While USSIM has guard rails that it has to work within, it doesn’t have to go and seek a fresh mandate or permission from the trustee. Other trustees were faced with having to make having to go back and ask for permission to do what they need to do. We were able to move very, very swiftly through that, because of the way that the structure works”.

Such flexibility stood USS in good stead during the recent tariff turmoil when equity markets declined by more than 15% before subsequently rebounding. While Clissold is hesitant to provide full details, he highlights the remarkable amount of autonomy that USSIM receives from its parent.

“We have discretion to do pretty much what we want, within the risk boundaries that we’re set as part of the IMAA (Investment Management & Advisory Agreement)”.

“We have an allocation to global equities. And as things move, there is a rebalancing requirement within that. So if equities go down and bonds go up, you need to sell some bonds and buy some equities. And so that sort of rebalancing is necessary.”

A crude calculation based on USS published disclosures indicates the kind of trading that might have taken place. Starting with its most recent March 2024 numbers, USS held £22.5 billion in public equities with an asset allocation of 30%. Using the MSCI World index as a proxy, between year-end and mid-April, USS’s equity holdings would have declined to £20 billion. Assuming other assets in the portfolio stayed the same, then USS’s equity allocation would have shrunk to 28%.

In order to rebalance the fund back to 30% of equities, USS would have had to purchase £1.4 billion of stocks close to the bottom of the market, and sold an equivalent amount of bonds, leaving it with £21 billion of equities. When markets rebounded, this portfolio would have increased in value by £3 billion, leaving the fund overweight in equities. To rebalance, USS would have to sell £1.5 billion of stocks – which would have been pure profit for the fund.

“You sell it when it’s expensive and everyone’s happy”, Clissold says. “The difference with March and April is that the market moves happened in the space of two months, whereas you might expect that move to normally happen in the space of two years”.

A £1.5 billion profit over two months would have most traders boasting about their alpha. Clissold and the USS press team shy away from that, and will neither confirm nor deny that such a trade took place. It’s all very English and academic, as befits the pension fund for the country’s university lecturers.