Investment heads at large global funds are reorganising their portfolios as they look to future-proof against global macro risks on the horizon and take advantage of potential opportunities.
Changes in strategies include cutting down on risk, higher allocations to equities and a shift to focusing on absolute returns, the Fiduciary Investors Symposium at Stanford University has heard.
James Davis, chief investment officer at the $25 billion Canadian pension fund OPTrust, says while asset owners are pretty good at managing short-term bouts of volatility, his bigger concern is a period of sustained inflation over the longer term.
“If we have a period where government finances are more problematic, and we know historically, one of the ways you deal with that is for governments to inflate their way out,” he said.
“What is that going to do to asset values over the long term, especially if there’s no real inflation protection built into them. And how is that actually going to impact an overall pension plan.”
Davis said his fear stems from the fact that his pension plans liabilities are fully indexed to inflation, so a scenario where asset values drop but liabilities rise would be “like the worst case”.
Another long term worry is about potential changes in regulatory policy setup that would require financial institutions like pension funds to bear unnecessary inflation risk because they are forced to own long term bonds.
Portfolio Risks
Jay Willoughby, chief investment officer at TIFF Investment Management, says while his fund follows an endowment model and an active management approach, his concerns regarding risks are similar.
One of the issues is on the fiscal side, he said, with a $35 trillion US budget deficit, a $27 trillion off balance sheet liability to the Social Security fund, and a $42 trillion off balance sheet liability to the Medicare Trust fund. Western countries have also used their control of the SWIFT banking system and frozen assets from the east.
“I don’t know what’s going to happen with the value of currencies. That’s one thing that hasn’t been talked about from an investment standpoint. But there’s a number of places in the world that are trying to use fewer dollars in their transactions and trades,” he said.
If artificial intelligence can increase productivity, the US might be able to bail out long-term bond holders and keep inflation down. But that would also result in a significant amount of opportunity in the stock market.
“So my best guess is that that it’s going to be harder to make money,” he said. “Maybe there’s not so much opportunity in bonds. We don’t see any fat pitches in to try to take advantage of and we’re a little late on the bond side.”
Alison Romano, the CEO and chief investment officer of the San Francisco Employees’ Retirement System (SFERS) says her team was extraordinarily successful taking active risk to reach its 7.2% return target and it worked for a long time, until the market shifted.
“So we’re changing. We’re not clamping down on risk, but we’re making sure that where we choose risk that aligns with our skill set,” she said.
That will mean increasing allocation to fixed income, given that the fund has reached a 97% funded status and has the opportunity to not chase returns.
“It’s really making sure that we know why we’re doing what we’re doing, and that the components of the return together will diversify and have each component acting as we’d expect, because I can’t predict what what’s going to happen,” she said.
Absolute Return Focus
With portfolio construction being harder under the current circumstances, the CIOs see advantages in shifting to a focus on absolute returns, rather than simply seeking to outperform benchmarks.
“We’re moving in that direction increasingly. So we’ve got in our portfolio, it’s basically divided into two large components. There’s the illiquid assets, and there’s liquid assets,” OPTrust’s Davis said.
He says historically, he would have used something more akin to a traditional SAA type framework to decide what that liquid mix should be, and then allocate to teams to generate alpha.
“Not sure that’s as effective as it could be. It’s certainly not consistent with our total portfolio approach. And what we find is the teams tend to focus more on alpha than they do on actually generating the best returns for the fund.”
TIFF, meanwhile, is turning to a hedge fund approach to generate portfolio gains regardless of market conditions. It is also betting on a higher allocation to equities.
“In the future, whatever your asset allocation is, push yourself to think about owning more stocks and fewer bonds. If currencies are going to become more important, you might own those stocks overseas,” Willoughby said.
While SPERS has a 10 per cent allocation to absolute return, Romano says the fund will continue to evolve asset allocation, as the markets evolve. That includes looking at how to utilise leverage better, and bringing in more analytics into the decision making.
“We talk a lot about markets, but it is a people business, and so there’s a lot of change management and working with the team and making sure that as we shift that there’s buy in,” Romano says.
“So, it’s both, responding to the markets, but also making sure we have a system where we have really good idea generation.”
