Factor rebalancing a portfolio is a better way to manage liquidity and leverage implications of illiquid assets compared to traditional rebalancing to a static asset allocation, according to new research presented at the Fiduciary Investors Symposium in Singapore.

A research paper, (Re)Balancing Act: The interplay of private and public assets in dialing the asset allocation, published in the Journal of Portfolio Management in April, proposes a new way to rebalance portfolios that more deliberately considers a more stable risk and leverage profile of a portfolio.

Co-author Redouane Elkamhi (pictured), Professor of Finance at the Rotman School at the University of Toronto, who presented the research in Singapore, said this approach allows investors to rebalance to the same underlying exposures – such as growth, inflation, and real rates – without being forced to rebalance to the fixed allocations.

“Generally, we think if you have come back to the SAA and rebalance, that is an active decision at each point in time that that is the best portfolio you can hold,” he said. “Coming back to that starting point is a big call. We need to be more dynamic in the face of uncertainty and the framework we have worked under for a long time.”

The factor rebalancing approach focuses on addressing a number of problems when it comes to rebalancing illiquid assets. For example, during market downturns, private assets can become significantly overweight due to stale valuations and the depreciation of public assets.

And standard rebalancing strategies can unintentionally introduce leverage due to the illiquid nature and potential stale valuation and lead to a deterioration of the fund’s liquidity position.

“You can’t easily rebalance illiquid assets, but the way people deal with that is by leverage, which means an unintended active decision that has implications on value-add,” Elkamhi said.

“This is a plumbing issue – a serious issue in asset management. As the privates get bigger it creates liquidity and leverage problems.”

Liquidity and leverage

The paper demonstrates how liquidity and leverage changes with a traditional rebalancing approach and using factor rebalancing which is designed to help the portfolio achieve more stable profiles in terms of leverage, risk, and liquidity.

This is done by considering public assets as complements to the illiquid private assets and making adjustments to the allocations of public assets to maintain the desired factor allocation for the overall portfolio.

Elkamhi said the approach gives investors a framework that allows a portfolio to be tilted without unintended active decisions.

Elkamhi said the paper was not a view on the optimal allocation to private versus public assets but a tool to rebalance to desired allocations without the unintended impacts on leverage among other things.

“If you have constraints to come back to the fixed allocations this is giving you a degree of freedom to give you a better liquidity coverage ratio and to better deal with privates in the portfolio,” Elkamhi said.

“We are not advocating for more privates but if that is the aim our methodology allows you to have more private without effecting the liquidity coverage ratio (LCR) level the same way traditional rebalancing will do, with a huge magnitude.

Redouane Elkamhi is part of the faculty of the University of Toronto and will speak at the Fiduciary Investors Symposium on campus from May 29-31. For information click here.

In September 2022, the University of Exeter convened an international meeting titled ‘Tipping Points: from climate crisis to positive transformation’.  Part of the conclusion, and the subject of subsequent work (See USS outlines new climate scenarios for improved decision making), is the idea that ‘positive social tipping points’ are probably the fastest and most powerful way of addressing the climate crisis. That is the origin of this thought piece – how might we tip a social system?

Let’s start by creating a model to represent a generic social system. The model will be in the form of a network that has nodes and connections. The nodes will be entities that are capable of making decisions – so individuals and business (but with scope to go more abstract into algorithms, smart contracts and generative AI). The connections between nodes are flows. As we are considering social systems, these flows can include virtues like friendship, help and love, as well as more typical flows like information, money, goods and services.

Complexity science often refers to systems performing computation (they work out the best allocation of resources – the ‘invisible hand’), so let’s use computers as an analogy. A computer has an operating system and the real world equivalent is the ‘rules of the game’. The ‘rules of the game’ is shorthand for a very large set of layered ‘commands’ which govern the behaviour of individuals and corporations. They include international, national and local laws, as well as unwritten values and norms that govern ‘how we do things in this part of the network’[1]. They therefore encode the prevailing ideology (eg capitalism is the best way to organise an economy), amongst other things.

Similarly, the ‘software’ describes how the node processes incoming information and makes decisions. Some of the node’s decision-making algorithm may be standard across most local nodes, but some of the lines of code are likely to be bespoke and dependent on individual context. For example, the majority of nodes at the present time are likely to have a component in their algorithm which encodes the following sentiment: “the products of fossil fuel companies are currently required for internal combustion engines; AND immediately cutting off the supply of those products would be more harmful than beneficial”. We can imagine that the algorithm of a climate activist encodes a conflicting, or opposite, sentiment.

Using this mental model, we now have a line of sight to the answer to our question – how might we tip a social system? We can change the information flowing through the network; we can change the individual decision-making algorithms; or we can change the rules of the game that apply to all nodes.

In essence, our desire to tip a social system implies a number of things:

  • The behaviour of the social system is currently suboptimal (against some objective; this is likely to be a value judgement)
  • The behaviour of the components of the system might be suboptimal (against the larger, system objective)
  • We have identified a mechanism by which we can easily change the behaviour of at least some of the components (a tipping point implies we are looking for small changes that can have a large effect)
  • The change in behaviour of those components will propagate through the system, causing other components to change their own behaviour
  • The aggregate result of the changed components, will be significant change at the system level.

Our mental model shows how we might attempt to intervene within the system to bring about the change we desire. Most powerful, but most difficult, is to change the ideology (operating system). For example, we could seek to replace “growth is good” with “growth that damages the ecology or the environment is bad”.

We can also lobby for changes to the law. Many countries have already signed into law net-zero emissions commitments, opening the door for further laws to aid its achievement. This would change the societal incentive structure (the rewards and punishments attaching to behaviours). For example, a law that changes the price structure will trigger multiple behaviour changes.

Next, we can try to change the software. Because we are dealing with social systems, this will include a consideration of values and ethics, not just beliefs about how the world works. For example, does a human life in the global south have the same value as a human life in the global north?

I would argue that our current algorithms imply it has a lower value. If that is an uncomfortable, or even abhorrent, thought, then you are free to adjust your own algorithm accordingly – but the change might not produce as much financial return. To push a social system over a tipping point, we are effectively looking for the equivalent of a computer virus – a change in code that spreads through the network, altering the algorithm of each node it ‘infects’. This is what climate activists believe they are trying to do.

Finally, we can seek to change the information flowing though the network (the inputs to the algorithms). In a sense, this is what climate science has been trying to do.

In this thought piece I have only been able to sketch the initial idea. However, it seems to me that the conversation over social tipping points would be greatly enhanced if it included the change mechanism it was seeking to employ, in order to trigger the system change it would like to see.

Tim Hodgson is co-founder and head of research of the Thinking Ahead Institute at WTW.

[1] In the framing offered by Donella Meadows in Leverage Points: Places to Intervene in a System, our rules of the game relate to her three most significant (and hardest) intervention points – the mindset out of which the system arises; the goals of the system; and the rules of the system (such as incentives, punishments, constraints)

South Africa’s Government Employee Pension Fund, GEPF, the R2.2 trillion ($116 billion) defined benefit fund for the country’s public sector employees, is in the process of readying its investment processes for a new law that will allow people to draw down some of their retirement income early.

The Revenue Laws Amendment Bill and the Pensions Fund Amendment Bill still need to be signed into law by South Africa’s President, but GEPF is busy preparing for a September 2024 kick-off.

Beneficiaries’ pots will be split into two components comprising a savings element (one third of their pensionable service) from which people can tap a capped amount annually, alongside a larger, invested component which can’t be withdrawn until retirement – or death.

“People will only be allowed to make one withdrawal every tax year from the savings component and whatever they withdraw is treated as additional income and taxed,” says Brian Karidza, head of benefit and actuaries at GEPF.

On one hand the legislation has come under fire for using pension funds to solve societal problems. Critics argue that retirement funds should only be used for retirement, not for supporting people through COVID and its aftermath, the cost-of-living crisis or bouts of unemployment, warning the policy will foster a long-term retirement shortfall.

Others believe it could solve a pervasive trend in the country that sees cash-strapped beneficiaries resigning from their jobs to draw down their pension ahead of retirement. On average, people change jobs seven times in their working life, each time cashing in their pension before they start saving again from scratch in a new job. The problem is most prevalent in private sector pension funds rather than South Africa’s large public sector funds like GEPF, Transnet and the Post Office.

“The only way people will be able to access the retirement element of their saving is by reaching retirement age. The introduction of a savings pot allows people to access their pension without needing to exit the fund, and introduces compulsory preservation for the first time,” says Karidza. “The hope is it will result in the average member being better off because they will actually retire with a larger portion of saving than under the current system.”

Sifiso Sibiya, head of investments at GEPF is confident the changes won’t significantly change investment strategy at South Africa’s biggest pension fund. GEPF doesn’t need to adjust the amount of liquidity it holds because there is a cap on the maximum amount people can withdraw. The fund’s 1.2 million active members could all, potentially, request a drawdown but the fund’s 0- 2 per cent allocation to cash, plus monthly net contributions, would be able to absorb the liquidity calls.

“We won’t need to liquidate any investments, and in the short term it won’t have a significant impact on investment strategy,” he says.

But that doesn’t mean there aren’t other complications to navigate. Sibiya warns that if the government increases the R30,000 cap (the amount has changed several times) things could get a little more complicated. “Until it is settled and acted into law, it becomes hard to get our hands around it. We are trying to plan but there are many moving parts – it is like shooting at a moving target.”

He is also concerned that liquidity calls from other pension funds acting on withdrawal requests at the same time could drain liquidity from the capital markets and create volatility. “GEPF has 80 per cent of its assets invested in South Africa,” he says. “If pension funds sell huge bond tranches it will effect the yield curve.” He believes that smaller funds, with a high number of active members, are most at risk of having to change their asset allocation and hold more liquid assets to meet withdrawal requests.

Some industry protagonists envisage  GEPF running two investment strategies. One for the savings pot and the other for long-term retirement. But Sibiya favours maintaining the current consolidated approach – just  growing the allocation to cash.

“Running a separate strategy for each component will reduce economies of scale by introducing smaller mandates and higher fees,” he says. “It would be better to hold still and just adjust the cash allocation and have larger mandates.”

He is wary of the impact on returns from holding a larger allocation to liquid assets. But hopes that as the new system beds down, beneficiaries’ retirement buckets will ultimately grow bigger because they will be free from the damaging impact of withdrawals that plague the current system. “Our long-term view is that illiquid investments will grow which from a developmental point of view and looking at the needs of South Africa’s infrastructure investment, is positive.”

Preparing for the new system has absorbed huge amounts of time. None more so than readying GEPF’s back-office processes to meet withdrawal requests on time. “The worst-case scenario is if we get 80-90 per cent of our membership coming forward. This would would increase the number of payments that need processing by 10-fold,” says Karidza. “The timing is very tight considering we are still trying to understand the implications.”

 

CalPERS is considering tying the incentive pay of its staff to meeting climate KPIs. For now, the $485.3 billion Californian pension fund continues to monitor trends among peer funds in this area. But in a recent board meeting, members discussed how integrating climate change and environmentally focused performance metrics into CalPERS’ annual incentive plan will likely make board level discussion soon.

Executives from Global Governance Advisors, GGA, CalPERS’ compensation consultant, pointed out that more asset owners are starting to use pay to incentivise staff to hit climate targets. Speaking in a recent board meeting, they said metrics could include climate disclosure and reporting, or allocations to low carbon assets.

“As your advisor we are keeping track of this and when it gets to the point where we can establish what metrics might look like from an operational perspective, we can review it as a committee,” said Brad Kelly, partner, Global Governance Advisors.

CalPERS board members responded to the idea with enthusiasm. “In our proxy voting we hold companies responsible and ask them to report and hold their higher- ups accountable to environmental standards. It’s a good idea,” said Theresa Taylor, president of the board.

Current performance metrics at the pension fund cover investment performance (both from a returns and cost perspective) as well as customer service and stakeholder engagement. However, unusually, CalPERS doesn’t place any weighting on asset class investment performance – investment performance measures remain solely based on total fund results.

GGA suggested that CalPERS new chief investment officer, Stephen Gilmore, who joins the fund this July from New Zealand Super, may want to review the current structure and consider the addition of an asset class investment performance weighting in the annual incentive formula for investment staff. Not only will this put CalPERS more in-line with its public pension fund peers. It will also create alignment between pay and performance within the investment team.

“Over time, CalPERS should look to phase in more weighting towards asset class performance with a corresponding decrease in total fund performance for these team members,” GGA suggested.  “A lack of weighting on asset class investment performance within the annual incentive formula for investment professionals working within a specific asset class is the biggest misalignment we see to current best practices.”

CalPERS moved toward a total fund approach in fiscal year 2019-2020 in a bid to break down silos and encourage the investment office to work together. CalPERS also focuses less on alpha generation than typical pension funds in the marketplace. But it has led to a misalignment in today’s competitive hunt for talent which notably includes funds such as CalSTRS.

“Incentives should always retain a strong link between performance expectations and elements that participants have connections and influence in enhancing,” said GGA. “If all investment professionals are rewarded solely on total fund performance, there is much less ability to differentiate between higher and lower performers on the team or recognize and reward certain asset classes that have materially or disproportionately contributed toward the positive performance of the fund.”

Another way to introduce a total fund metric could be via Long-Term Incentive Plans (LTIPs), they suggested. Focused on forward-looking total fund investment performance over three to four years, typically, this model helps align investment and executive staff toward earning a meaningful LTIP payout at the end of each extended performance period.

“Our opinion is that CalPERS’ LTIP will have this impact going forward as it begins to annually complete the associated long-term performance cycles and provide the potential to generate additional payout opportunities for eligible plan participants.”

Quantitative v qualitative

GGA also suggested CalPERS consider linking incentive pay to more quantitative factors.

“Since the commencement of our engagement with CalPERS, GGA has fielded concerns that too much weighting is placed on qualitative performance within the CalPERS incentive plan, which is tougher to measure, and reward, realized performance. As well, truly qualitative measures can possibly increase headline risk because it is often associated with subjective judgments which can also open the fund up to criticism and increased levels of scrutiny.”

Typically, market practice sees incentive pay in investment positions weighted 70- 75 per cent to quantitative performance with no more than 25- 30 percent weighting allocated to the qualitative performance of the individual in their role.

“An adjustment to increase the weighting on quantitative performance would better align these positions with the market, including CalSTRS,” they concluded.

For the team at the administrative office of Dutch asset owner PWRI, the €10 billion pension fund for people with disabilities, the country’s transition from defined benefit to a new defined contribution pension system is all-consuming. PWRI will transition at the start of 2025, although the deadline for the €1.45 trillion ($1.6 trillion) industry to transition  isn’t until January 2028.

Imke Hollander, senior advisor to the board’s investment committee, lists a complex process ahead of the deadline that includes frequent modelling of how the new portfolio will look; time-consuming board approvals for every change to ensure everyone understands, and long meetings with different stakeholders including unions and employers.

“Communication is the really hard part,” she says.

Political uncertainty has also been injected into the process following last year’s elections, and Hollander believes there is now a chance that policy makers might change course. Another element of jeopardy includes service providers readying their systems by the deadline. Like APG, PWRI’s pension administrator, which must provide changes to its software and administrative systems in time, ensuring this side of the process, including all data and formatting, connects to their investment managers.

One reason for the transition to a new DC system is to encourage the country’s pension funds to invest more in risk assets. Retirement income promises under the DB system will be replaced by a new system tied to contributions and investment returns.

While many funds are preparing to invest more in equity, Hollander says PWRI’s asset allocation will not change much. Mostly because the fund is on a de-risking trajectory because it doesn’t have many young participants joining (although it is still open) plus the fact it already has a 50 per cent allocation to equity and real estate.

Although she expects a deeper division between the portfolios serving PWRI’s different demographics, she is not expecting much change. “We won’t be investing more in equity and other more risky assets. Having half the portfolio in those assets, is already pretty risky,” she says.

A bigger impact from the transition will be felt in PWRI’s hedging policy. Like many other Dutch funds, PWRI has seen its solvency ratio improve off the back of higher interest rates and is now seeking to lock in those benefits before the transition. Increasing the hedging position in the short term protects against a reduction in the solvency ratio if rates go down, she explains.

PWRI currently hedges over 60 per cent of its liabilities, up from 30 per cent a few years ago. “Now interest rates look steadier we’ve decided to increase our hedging levels and de-risk to make for a smoother transition,” she says, adding additional hedging will be done via swaps. In January 2024 PWRI had a coverage ratio of 123.3 per cent

The transition is also adding a layer of complexity to decisions to invest more in illiquid assets. PWRI has room to invest more in assets like infrastructure, but she says the board is wary of doing so at this juncture. These types of assets will be more difficult to value in a new DC world where participants will want to know what they own, and how much they can expect in retirement, she says.

Moreover, the team is too busy to consider partnerships with other investors, something that could help PWRI, a relatively small fund, access these types of investment and build on successful allocations that resonate with beneficiaries. “I don’t know if we are large enough to expand our investment in infrastructure. You need to make large investments in these types of assets. There are ways to do it with others, but this is not the time.”

Preparing for the climate transition

PWRI is also focused on the other transition shaping institutional investment. The climate transition continues to push the portfolio in particular directions. For example, the board are reconsidering the role of convertibles because they haven’t done as expected. Sitting between equity and fixed income, this allocation was not as much of a downside buffer as hoped, and it has been difficult to integrate ESG into the convertibles portfolio.

“It’s hard to get the ESG scores right and have enough performance.  I’m sure people out there can do it, but in the last couple of years, convertible bonds haven’t worked as expected for us.”

Hollander is currently helping the board to explore how best to reduce emissions in PWRI’s high yield allocation in line with a recent commitment to achieve net zero across asset classes. The team have made progress in global credit and equity where it uses discretionary mandates to ensure ESG integration. But integrating net zero in high yield is complicated by the lack of data and the fact reducing emissions in the portfolio directly impacts performance. “We only have data on a very limited amount of the portfolio, and engagement is difficult,” she says.

And PWRI isn’t just worried about climate scores in high yield. It also needs the social scores of the underlying companies in the allocation to improve. It has developed its own restrictions on which companies it invests in, which it implements helped by fiduciary manager Columbia Threadneedle in a decades-long relationship. “As the biggest customer in a number of their funds, we have been able to introduce bespoke restrictions,” she says.

PWRI’s investment beliefs, reduced to five from ten in 2022, seek to guide the team on how best to balance costs, performance, and sustainability so that ESG doesn’t cost too much, or dent returns. The team hope it has hit this sweet spot in the move from active to semi-passive in equities. Using two managers across developed and emerging markets PWRI has given up some upside potential because the strategy isn’t wholly active, but the approach follows a benchmark which the fund developed with ESG-restrictions and only costs a few basis points in fees.

Still, beliefs do come at a cost. PWRI has wound down its private equity allocation because of a lack of transparency in the asset class and double fee layers. Although it still has around 1 per cent of the portfolio in private equity, it won’t invest more.

As the conversation draws to a close, Hollander reflects on the biggest winners of the Netherland’s transition to a new pension system so far. It might turn out the new system is cheaper, but the costs are mounting up, mostly in fees to consultants. For a pension fund enduringly mindful of fees and the impact they have on beneficiary returns, advisor fees is a growing source of angst. “Consultants are doing very well out of this,” she concludes.

 

LACERA, Los Angeles County Employees Retirement Association, is reducing its allocation to growth and real assets – namely global equity and real estate – and titling to allocations with a more moderate return potential and stronger downside protection comprising investment grade bonds and hedge funds particularly.

The latest changes at the $77 billion pension fund reflect a shift in thinking from previous asset allocation reviews. In recent years, LACERA has steadily put more assets to work in illiquid private credit and private equity in the hunt for returns during decades of historically low interest rates.

Now the focus is on reacting to higher interest rates and downside protection, with CIO Jonathan Grabel warning the board that the relentless climb in equity markets in recent quarters is “unsustainable.”

Working with consultancy Meketa Investment Group, LACERA staff outlined to the board how the “modest” changes (implemented within the next two years) are projected to reduce potential losses while continuing to meet LACERA’s 7 per cent target return. Modelling of the new allocation revealed a slightly higher Sharpe ratio expectation (0.42) when compared to the current policy allocation (0.41) representing a modest improvement in risk-adjusted return expectations.

The team modelled the new allocation on historic and theoretical scenarios including the GFC and COVID recovery; 10-year Treasury bond rates rising 300 bps and US equities declining by 40 per cent, as well as different climate scenarios. The process highlighted the key risks to the new allocation remain equity market decline and any widening of credit spreads.

Risk mitigation becomes a priority

LACERA’s risk mitigation portfolio, tasked with reducing risk by providing liquidity, diversification, and downside protection, comprises cash, investment grade bonds, long term treasuries and hedge funds. It has the lowest risk and lowest return target of all the portfolios in the fund – accounting for around 19 per cent of total AUM but just 3 per cent of total risk.

Grabel explained that diversification has becoming increasingly important as the pension fund has matured and benefit payments exceed contributions. “Losing money has consequences when you are cash flow negative,” he said.

The hedge fund allocation (set to grow from 6 per cent to 8 per cent) comprises diverse strategies across all asset classes, and is tasked with reducing total fund risk with low to moderate volatility and zero correlation to stocks and bonds: neither interest rates nor growth drive returns. The absolute return approach is less risky and less directional compared to many hedge fund portfolios, and the focus is on risk metrics rather than a single return number, the board heard.

Recent results show an equity beta reading of 0.00 and positive up/down capture, explained Chad Timko, senior investment officer.

LACERA currently invests with eight direct managers and each manager has several sub strategies. An emerging manager programme, launched in 2021 and with a net asset value of $539 million is managed under a separate account and part of a reserve manager pipeline.

The emerging manager programme has underperformed its benchmark but preserved its capital while outperforming investment grade bonds.  Revenue sharing is structured into most mandates and Timko observed how several managers stand out as potential future graduation prospects to the main portfolio based on early positive performance.

“Manager graduation are goals of the programme,” he said. LACERA will continue to increase the size of its emerging manager program towards the board-approved target of 15 per cent of the total hedge fund portfolio.

LACERA currently has around $1 billion in cash, used primarily to pay benefits and rebalance; invested in a separate account that is managed by State Street. The board heard that levels are slightly up on target on account of rebalancing and recent capital calls.

A cash overlay programme, put in place in 2019, has contributed to nearly $500 million in gains. “Better managing cash and adhering to our SAA and rebalancing the portfolio, paid for one year’s operating budget and one month’s worth of benefit payments,” said Grabel.

Other allocations in the risk mitigation portfolio comprise investment grade bonds, set to grow to 13 per cent from 7 per cent under the new asset allocation reflecting their value and return. The low risk, low expected alpha investment grade bond allocation is split between passive (70 per cent) and active (30 per cent.) Two active managers follow a core bond strategy, take low active risk and don’t’ invest in any sectors not included in the benchmark.

An allocation to long-term treasury bonds was added three years ago to hedge the growth portfolio and negatively correlate with stocks. The allocation is wholly passive, managed by BlackRock and comprises 80 bonds with maturities between 10-30 years.

“The rise of interest rates in 2022 had a material negative impact on long term government bond returns,” said Vache Mahseredjian, principal investment officer.

China Risk rises up the agenda

LACERA’s new asset allocation also modelled the impact of removing the fund’s exposure to China in response to rising geopolitical and regulatory risk. China exposure is mostly found in the passive global equity allocation, and excluding China from the emerging market category doesn’t change the risk return characteristics of the portfolio.

The board voiced concerns regarding the speed with which it will be possible to divest from China – and the fact the analysis is based on companies domiciled in China, and doesn’t take into account the risk of holding companies with China-based supply chains, or sales derived from China.

“It’s easier for us to adjust our portfolio than for [say] Apple to change how it manufactures and sells [it’s products],” concluded Grabel.