Page 51 – Top1000funds.com

Key Takeaways

For most of the past decade, the hedge fund industry faced headwinds to generate alpha as subdued volatility led to fewer trading opportunities and a near-zero interest rate environment hindered the process of asset price discovery.
Hedge fund industry performance displays a strong positive relationship between higher inflation and higher interest rate regimes. There are both structural and environmental reasons for the performance pattern of hedge funds in a higher inflation and higher interest rate environment.
The new and evolving macroeconomic environment plays to the advantage of most hedge fund strategies, and we expect it will lead to materially greater expected returns with similar—and potentially lower—levels of risk over the medium term.

In mid-2022, few outside the artificial intelligence (AI) community had heard of a chatbot called ChatGPT. However, by January 2023—only two months after its November 2022 release by OpenAI—ChatGPT was estimated to have reached 100 million monthly active users, making it the fastest-growing consumer application in history.¹ This set off a proverbial AI gold rush; application developers, venture capital-backed startups, and some of the world’s largest corporations are all now scrambling to assess the possibilities of a world heavily influenced by generative AI tools.²

While many hedge fund managers are also incorporating AI into their processes, many are more focused on capitalizing on what is widely viewed as a new and more volatile market regime. As of July 2023, the US Federal Reserve had raised the Federal Funds Rate at 11 out of the last 12 meetings—including four straight 0.75% hikes—marking the fastest and most aggressive pace of rate increases since the early 1980s.³ With the Fed Funds rate jumping roughly 500bps in only 16 months (March 2022 – July 2023), hedge fund managers may also be experiencing a similar strategy-altering evolution of the economic environment.

The new and evolving macroeconomic environment plays to the advantage of most hedge fund strategies, and we expect it will lead to materially greater expected returns with similar—and potentially lower—levels of risk over the medium term.

A Market Environment of Higher Volatility

Following the Global Financial Crisis (GFC) of 2008-2009, both low inflation and meagre economic growth led to dovish global monetary policies and generous fiscal policies. As a result of easy money and ultra-low interest rates, volatility was dampened in most asset classes. Since early 2022, there has been a material increase in inflation that has led to a mostly coordinated attempt by central banks to remove market liquidity and raise interest rates, which has had the expected effect of increasing volatility in most asset classes. While rates and volatility are certainly higher now than in the decade following the GFC, they are reasonable when measured against longer timeframes. Furthermore, despite many economists and market participants believing that the shift to tightening monetary and fiscal policy may ultimately lead to recession, the jobs markets and risk asset performance to date have remained strong. However, despite debate around if and when the economy will have a soft landing or recession, there appears to be market consensus for a prolonged period of elevated macro volatility.⁴

For most of the past decade, the hedge fund industry faced headwinds to generate alpha as subdued volatility led to fewer trading opportunities and a near-zero interest rate environment hindered the asset price discovery process. Following the tightening of monetary policies, we now have a new macro regime characterized by greater volatility—which should also lead to better investing opportunities for hedge funds. Historically, when equity and fixed income volatility has increased, hedge fund alpha generation has also improved; this scenario occurred as recently as the second half of 2022.

In the mid-2000s, hedge fund alpha generation was about 5%—similar to the average Fed Funds Rate during the period. Hedge fund alpha remained strong during the depths of the GFC and the period immediately following; nimble, opportunistic investors were able to find profitable trades in dislocated markets around the globe. It was the long subsequent period of low rates and low volatility that caused and supported an environment in which there was little economic uncertainty, resulting in low dispersion within asset classes from which hedged investors could profit. There are few ways for hedge fund strategies to generate alpha when all securities trade in sync, equity and bond markets trend based on monetary policy, and volatility remains low.

Historically, the hedge fund industry has displayed a strong positive relationship between higher inflation and higher interest rate regimes and better hedge fund performance.⁵ In periods marked by low inflation,⁶ hedge funds have generated absolute returns that are approximately half (52%) of those available to equity investors; in periods of high inflation,⁷ hedge funds have materially exceeded US equity market returns. When inflation has been close to the Fed’s long term target of 2%, we see that hedge fund returns were roughly in-line with equities; however, hedge funds have generated these returns with significantly lower volatility due to the relative value orientation of many hedge fund strategies, resulting in a Sharpe ratio greater than 1.0, as illustrated in the chart below.

How Hedge Funds May Benefit from Higher Volatility

There are both structural and environmental reasons for the performance pattern of hedge funds in a higher inflation and higher interest rate environment. From a structural perspective, many hedge fund strategies maintain high levels of unencumbered cash. Managers typically seek leverage by using financial derivatives that have low margin requirements. Hedge fund strategies such as trend following, global macro, and fixed income relative value (among other strategies), often have cash levels in excess of 50% of the funds’ net asset values. As a result, when short-term cash instruments (e.g., money market funds, short term T-bills etc.) offer materially higher interest rates, it creates a total return tailwind for these investment managers. Additionally, equity long/short managers benefit from the increased interest on the proceeds from shorting stocks (i.e., short rebate). For example, a market neutral hedged equity manager running a 100% long and 100% short portfolio is now able to harvest an annualized positive carry of approximately 5%, compared to near 0% in the prior decade.⁸

Interest rate normalization increases the value add of security selection. Over the last decade, we observed a one-way multiple expansion as the S&P 500 price-to-earnings multiple doubled from 11x to 22x from 2010 to 2021. In this environment, alpha generation from security selection was difficult as stocks all rose together. In our current higher rate environment, we have already seen contraction in price-to-earnings multiples, which will increase the importance of security selection.The evolving market backdrop has increased the opportunity set not only for equity strategies, but also for credit managers. With liquidity being removed from markets and companies refinancing into a higher interest rate environment, corporate defaults are already on the rise. We expect this increase to continue as more companies’ bonds mature and some firms are unable to refinance at the new, higher rates on offer.

Finally, the new macroeconomic regime has been a significant tailwind in the trading environment for tactical trading managers. Trend following and directional macro managers benefited from the coordinated rise in interest rates during 2022 to post one of their strongest return years on record due to the performance of the fixed income portions of their portfolios (for reference, for calendar year 2022, HFRI Macro Index returned 8.8% and SG CTA Index returned 20.15% vs MSCI World -18.5% and Barclays Agg -13%).⁹ Fixed income relative value managers were able to profit not just from the higher level of interest rates, but also from the increased volatility in fixed income markets allowing them to meet their return objectives at lower levels of leverage and risk. We expect the environment to remain attractive for tactical trading funds in the medium term, particularly for global macro managers who may be able to profit from divergence in the monetary and fiscal policies of both developed and emerging economies as inflation normalizes in certain countries while remaining high and problematic in others.

Manager Selection in a Higher Volatility Environment

While a higher volatility market backdrop may benefit a number of hedge strategy types, selecting high-quality hedge fund managers remains the most critical feature of a successful hedge fund program. Unlike traditional long-only equity and fixed-income fund managers who typically risk manage their tracking error versus a benchmark, hedge fund managers are mostly absolute return focused and benchmark agnostic. If one were to place investment managers on a passive-to-active spectrum, hedge fund managers sit on the most active side of the spectrum. As a result, the performance dispersion amongst hedge fund strategies, even across those running similar strategies, is widely distributed.

When looking at our hedge fund database since 2008, which is comprised of more than 8,000 hedge fund strategies, we found a persistent dispersion of greater than 10% return between the 25^th percentile and 75^th percentile hedge fund managers. This dispersion increased during more volatile market environments (i.e., 2008, 2009, 2020, and 2022), averaging an annual return dispersion of over 20%, as shown in the chart below. Interestingly, when analyzing the sub-strategy level performance on a beta-adjusted basis (e.g., a measure of the skill-based return, or alpha of managers), the Information Ratio dispersion is notably wide across strategies and across various time horizons.

To identify high-quality managers, a robust manager selection and comprehensive diligence process is required. Hedge fund strategies are more complex than traditional long-only equity and fixed income managers. Relative to traditional investment strategies, hedge fund managers will utilize higher balance sheet leverage, make extensive use of derivatives and complex trade structures, add illiquid investments, and typically have more frequent trading tendencies. Hedge fund businesses can also be challenging to assess. Hedge fund managers are generally smaller and less diversified than established traditional asset managers—which introduces an elevated level of organizational risk.

In addition to the challenges of underwriting managers, turnover is high in the hedge fund industry. New fund launches and fund closures amongst a universe of >8,000 hedge funds present a dizzying array of options for investors to track. Based on our analysis, we estimate that on average since 2009, more than 10% of hedge fund strategies exited the industry each year. We estimate new entrants to be approximately 10% per year on average as well representing total industry turnover of approximately 20% in any given year.¹⁰

While underwriting a strategy and assessing the ever-changing hedge fund universe may be difficult, the ability to identify skill can help to compound returns over time. We have historically observed that skill may adapt, and skill may persist. For example, using risk-adjusted returns as a proxy for skill, a manager that achieves a top quartile Sharpe Ratio ranking in one year is likely to be above the median manager the following year as well, as shown in the chart below. Although it is ill-suited to evaluate a hedge fund based on a single year’s performance, it is notable that this persistence of skill is consistent across strategy types, with credit long/short and quant macro the lone exceptions. In the world of hedge fund investing, we believe the persistence of skill translates to alpha. And alpha translates to returns that are diversifying and can meaningfully enhance the risk-adjusted returns of an overall portfolio.

The Only Constant is Change

The adaptability of hedge fund managers is key to survival given the Darwinian nature of financial markets. In fact, adaptability is one of four key criteria we assess when evaluating managers.¹¹ We like to think of a down escalator as a metaphor for the continually changing and highly competitive investment landscape for a skill-based manager: if the manager is standing still on the escalator and not continuously adapting, the manager will likely be taken down. A manager that can successfully adapt is not only able to keep pace with the escalator, but also stays one step ahead. Like the technology companies now seeking to capitalize on the promise of generative AI to upend traditional processes, skill-based managers are also adapting to a new and more volatile market regime.

Important Information

¹ Reuters, “ChatGPT sets record for fastest-growing user base – analyst note.” As of February 2, 2023.

² MIT Technology Review, “ChatGPT is about to revolutionize the economy. We need to decide what that looks like.” As of March 25, 2023.

³ World Economic Forum, “The pace of US interest rate hikes is faster than at any time in recent history. Is this creating a risk of recession?” As of October 12, 2022

⁴ Goldman Sachs Global Investment Research, “First to the Finish: Early Hikers and the Rate Cut Outlook.” As of July 27, 2023.

⁵ Bureau of Labor Statistics, Bloomberg, HFRI. Analysis from 1990-2022.

⁶ Defined as inflation less than 2%.

⁷ Defined as inflation greater than 4%.

⁸ Goldman Sachs Prime Services, Prime Insights, May 2023.

⁹ MSCI, See additional disclosures.

¹⁰ Goldman Sachs Asset Management XIG Hedge Fund Database. As of 2022.

¹¹ The other three criteria as part of the XIG process are Governance, Infrastructure, and Process.

Glossary

Alpha refers to returns in excess of the benchmark return.

Carry is the return obtained by holding an investment for a given period.

Price-to-earnings multiple is the ratio of an asset’s price to earnings.

Price-to-equity is the ratio of the price per share to the book value per share.

S&P 500 index is the Standard & Poor’s 500 Composite Stock Prices Index of 500 stocks, an unmanaged index of common stock prices.

Risk Considerations

All investing involves risk, including loss of principal.

Alternative investments are suitable only for sophisticated investors for whom such investments do not constitute a complete investment program and who fully understand and are willing to assume the risks involved in Alternative Investments. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor’s capital.

Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

Investors should also consider some of the potential risks of alternative investments:

· Alternative Strategies. Alternative strategies often engage in leverage and other investment practices that are speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the entire amount that is invested.

· Manager experience. Manager risk includes those that exist within a manager’s organization, investment process or supporting systems and infrastructure. There is also a potential for fund-level risks that arise from the way in which a manager constructs and manages the fund.

· Leverage. Leverage increases a fund’s sensitivity to market movements. Funds that use leverage can be expected to be more “volatile” than other funds that do not use leverage. This means if the investments a fund buys decrease in market value, the value of the fund’s shares will decrease by even more.

· Counter-party risk. Alternative strategies often make significant use of over- the- counter (OTC) derivatives and therefore are subject to the risk that counter-parties will not perform their obligations under such contracts.

· Liquidity risk. Alternatives strategies may make investments that are illiquid or that may become less liquid in response to market developments. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all.

· Valuation risk. There is risk that the values used by alternative strategies to price investments may be different from those used by other investors to price the same investments.

Alternative Investments – Hedge funds and other private investment funds (collectively, “Alternative Investments”) are subject to less regulation than other types of pooled investment vehicles such as mutual funds. Alternative Investments may impose significant fees, including incentive fees that are based upon a percentage of the realized and unrealized gains and an individual’s net returns may differ significantly from actual returns. Such fees may offset all or a significant portion of such Alternative Investment’s trading profits. Alternative Investments are not required to provide periodic pricing or valuation information. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of such Alternative Investments.

The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.

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Key Takeaways

We believe generative artificial intelligence (GAI) has the potential to significantly alter both the economic and investment landscape—making it more than just hype.
In our view, companies with the infrastructure to integrate AI with their existing platforms and businesses building crucial generative AI components appear well-positioned for early success.
Despite risks ranging from misinformation to labor displacement, we believe that widespread adoption of generative AI could provide immense long-term benefits to society.

The idea behind machines being able to think like humans has been around for nearly a century. In the 1940s and 1950s, computer scientist Alan Turing wrote a paper on machines being able to simulate human beings and created the world’s first “Chess-bot.” The term “artificial intelligence” was first used in 1956 by Stanford Professor John McCarthy, who later defined AI as “the science and engineering of making intelligent machines, especially intelligent computer programs.”¹ To be sure, machine learning and artificial intelligence are not new concepts in investing, and in fact, both have been used in quant strategies for some time.

The renewed excitement around the topic stems from the generative aspect of AI. In November 2022, OpenAI released the first generative artificial intelligence (GAI) chatbot, ChatGPT. Put very simply, ChatGPT is a computer program designed to simulate conversation with human users. It can tell you a joke. It can report on the weather. It can even write this whitepaper. By using generative AI vs. traditional AI, ChatGPT can not only “hold a conversation” much better than chatbots of yesteryear, but also can translate language to code, write a resume for an entirely fabricated position, or create song lyrics about your favorite holiday in the writing style of Edgar Allen Poe. ChatGPT’s popularity soared, and within 5 days of being released, the software had over one million users. Furthermore, it was one the fastest applications to reach 100mn users ever.

HOW DOES IT WORK?

GAI’s functionality can be attributed to three key components: 1) neural networks, 2) deep learning, and 3) natural language processing (NLP). Just like human brains, GAI works on a system of multiple neural nodes that process and filter through information in multiple states. Consider a program that is teaching a computer to recognize paintings, and we show this program Andy Warhol’s Campbell’s Soup Cans.² The initial layer in this artificial neural network is like the optic nerve, feeding raw data from the “eyes” to the “brain.” Data then flows through several neurons, and each has a different function and can communicate with others; perhaps the first is searching for edges and passing information along to the second, which is searching for shapes and passing information along to the third, which is searching for specific features. In this example, each node is an individual knowledge hub that screens and classifies data at each stage, ultimately leading to the model identifying the correct work of art. Taking the analogy one step further, deep learning is a means of machine learning through unstructured data.

Traditional machine learning may have required humans to tell the program specifically what to look for—if a painting contains pop art, the artist may be Andy Warhol or Keith Haring. By showing the program thousands of depictions of pop art, it can draw its own conclusions and further improve its analytic capabilities. Finally, NLP enables computers to interpret speech, gauge interest, read text, and evaluate images, both with syntactic and semantic analysis. By using NLP, a GAI model that is shown Campbell’s Soup Cans may be able to posit conclusions on the meaning behind the painting: perhaps Warhol depicted what he did to show that art should be for everyone, not just cultured curators, or maybe he was just an avid soup consumer! Put very simply, neural networks, deep learning, and NLP are all means of how AI thinks.

Is GAI Just Another Hype Cycle?

One of the key points of skepticism around investing in artificial intelligence is the debate as to whether it is another bubble. We argue that it is not, because AI is already making an important impact in investing, and because funding for GAI has already surpassed that of previous hype cycles at their respective peaks. Artificial intelligence and machine learning have been used in quantitative investment strategies for several years. Anyone who has ever used a trading algorithm has likely taken advantage of AI in investing, as many of these algorithms are making decisions based on large data sets at high speeds or exploiting possible arbitrage opportunities. AI can also be used to optimize asset allocations to construct portfolios that might perform better than those constructed with traditional techniques, aid in pre- and post-trade analysis, and analyze market and credit risk. While less known, some large language models may also be used in both sentiment analysis—e.g., comprehending subtext of corporate earnings calls—and portfolio optimization. Most recently, a GAI model was created to analyze Federal Reserve statements and assign them a “Hawk-Dove score,” with the goal of detecting potential trading signals.³ We expect these links between AI and investing to become even more intertwined as society becomes more familiar with the technology.

“Something else that sets GAI apart from many prior technological advancements is its potentially drastic impact on economies.”

Another indication that AI may persist for some time is the amount of funding that is being deployed. In the first quarter of 2023, GAI companies raised $2.3bn from venture capital firms. Quarterly VC fundraising for the metaverse at its peak in 2021 was only $2.1bn. Large corporations are taking a similar interest; in 4Q 2022, there were only 10 mentions of “generative artificial intelligence” on S&P 500 company correspondences. We believe this stemmed from Microsoft’s purchase of a $10bn stake in OpenAI. In 2Q 2023, this number increased drastically, and even Mark Zuckerberg, who changed the name of his company to Meta in 2021, said, “[Meta’s] single largest investment is in advancing AI.”

Of course, using AI also includes challenges. For instance, increasingly opaque algorithms can make it difficult for humans to monitor, evaluate, and understand how AI models will respond to inputs, anomalous events, or complex tasks. Additionally, AI relies on large amounts of data, especially in the learning phase. The quality and availability of this data can lead to improper calibration, skewing results.

We recognize that there may be growing pains with AI and acknowledge the potential risk of markets getting ahead of themselves. But in our view, GAI is here to stay.

Economic Impact of GAI

Something else that sets GAI apart from many prior technological advancements is its potentially drastic impact on economies. In the long term, we believe that widespread adoption of GAI has the potential to materially change our lives, interactions, and all of human existence. Goldman Sachs Global Investment Research economists have likened the impact of GAI to two milestone inventions in human history: the electric motor in 1890 and the personal computer in 1981. In each of these instances, the productivity “boom” did not begin until roughly 50% of businesses adopted the technology—a threshold that took 20 years to reach. After reaching this threshold, however, labor productivity grew by 1.5 percentage points annually for over a decade, and we believe that widespread adoption of GAI could yield similar effects to the tune of a 7% annual increase in global GDP, which stems from two main channels. First, many workers are employed in occupations that are partially exposed to AI automation. If AI can increase workers’ capacities, then plausibly, said workers may direct some of their newfound time toward more productive activities. Second, if workers do end up being displaced by AI automation, we believe that these workers will eventually become reemployed, and therefore boost total output. The size of GAI’s impact will ultimately depend on its true capabilities and adoption timeline, but we believe that it is possible to begin reaping the economic benefits of GAI sometime in the latter years of the 2020s.

Technological Impacts of GAI

AI has seemingly been the darling topic on company calls across industries. As of the end of June, the phrase was mentioned 3,330 times according to Bloomberg.⁴ The surprising aspect of this viral growth, aside from the broad volume of mentions, has been the range of companies—from Microsoft to Kraft to Moderna to Zoom—that are trying to incorporate AI into their businesses. As previously mentioned, the most widespread use of GAI thus far has been chatbots. Following Microsoft’s substantial investment in OpenAI for the use of ChatGPT, other tech companies have increased efforts in making their own chatbots (Google’s Bard, Snapchat’s “AI”). The functionality of chatbots extends far beyond jokes and weather updates. Chatbots have the potential to revolutionize customer service and improve the efficiency of human searches/research—ask ChatGPT to plan a travel itinerary of a camping trip for proof. Additionally, chatbots are becoming smarter and more sophisticated at incredible rates. Chatbots are not the only notable application of GAI. Through NLP, AI is being used to help programmers write original code. In some instances, according to Goldman Sachs Chief Information Officer Marco Argenti, developers are accepting nearly 40% of code written by AI,⁵ which could boost programming productivity by double digit percentages. Eventually, AI will be used in entertainment, medicine, and nearly every industry.

Investment Impact of GAI

Outside of the question, “is AI going to take over humanity,” investors are most curious as to where they can strategically position their portfolios to take advantage of its new developments. Given the different components of the GAI tech stack—including apps, hardware, cloud platforms, foundation models, and model hubs—companies may want to consider tech investments to capitalize on the benefits of GAI.

“There seems to be a plausible case for gai in just about every industry.”

In our view, the groups who may prosper the most are 1) large companies with infrastructure who can integrate AI with their existing platforms, 2) companies that produce both the components of AI and build/license GAI models, and 3) companies outside of technology who are most willing to scale their own AI adoption. Unsurprisingly perhaps, large tech companies with strong infrastructure stand to gain from the advent of new tech. By implementing AI models into existing productivity tools, workers could benefit from increased efficiency and the ability to leverage multiple sources of data in one application. For example, someone creating a presentation could use GAI to pull notes from a text document and populate a slide in a slideshow, all without leaving the slideshow application. Furthermore, GAI can help employees who are not as well-versed in software to take full advantage of the tools available to them.

Outside of just productivity, tech companies may be positioned to quickly adopt GAI in search engines—DevOps and cybersecurity to name a few. Second, there is now a global demand for GAI models, but not all companies have the infrastructure/resources to build their own. For a smaller company looking to increase productivity, it makes sense to subscribe to use an AI model that was created externally. We also believe manufacturers of graphics processing units (GPUs) and other components of AI may be able to succeed. Finally, given that roughly 66% of jobs are exposed to AI automation, we believe that any company that can embrace GAI to improve its efficiency could benefit. Healthcare is just one example of a sector in which GAI tools could be leveraged for patient diagnosis, personalized treatment plans, and novel drug design. There seems to be a plausible case for GAI in just about every industry, and although there are very few jobs in which GAI can automate more than half the work, we believe widespread adoption of GAI could provide a double-digit productivity boost in many fields.

Despite being in the early stages of discovery and adoption, the potential advantages of GAI are hard to ignore. However, the narrowness of the recent market rally may be evidence that the markets may not have fully embraced AI yet. Because it is unclear how exactly the adoption of GAI will impact company fundamentals, it may be too early to tell if GAI companies are overvalued, and it is unclear if traditional valuation methods should be applied in this space. Having said that, some tech valuations are severely stretched. Investors may have difficulty in selecting future GAI winners at the right price. As managers continue to study the space, the markets may dictate new valuation dynamics, potentially with the help of AI.

Key Risks

We see three main risks when it comes to widespread adoption of AI technology: 1) privacy and copyright issues, 2) ethical issues, and 3) labor displacement. The large language learning models upon which AI platforms are built leverage huge amounts of data to train, meaning that a cyber-attack or data breach could potentially cause significant damage. More unique to GAI is the risk of copyright infringement. While still early, notable examples of AI “theft” have come from the music industry, in which sound engineers have been able to use artificial intelligence to create original music with AI versions of famous artists’ voices. In some instances, the replication is uncanny. There is also the matter of ethical issues when it comes to using AI, notably in the forms of plagiarism and misinformation. As mentioned earlier, GAI models are trained on existing available data, so the likelihood of content being plagiarized is higher, and it is the user’s responsibility to sensibly use the content generated. Additionally, GAI tools have been under scrutiny around the accuracy of information being disseminated, which can be dangerous to users like asset managers who are unable to verify them.

Despite the dangerous risk that misinformation poses, the risk that we feel is most impactful is labor displacement. We believe that approximately two-thirds of US occupations are exposed to some degree of AI automation, with particularly high exposures in administrative and legal professions but low exposures in construction and maintenance. An estimated 7% of jobs could be displaced.⁶ However, history shows that worker displacement from automation is mostly offset by the creation of new jobs. Sixty percent of the jobs that exist today did not exist in 1940, and over the last 80 years, the technology-driven creation of new jobs has accounted for 85% of employment growth.⁷ We expect AI to be no different, with new roles being created in data science, AI research, and engineering, to name a few. Additionally, while the future interplay between labor unions and GAI is unclear, we have already seen that unions in industries like airlines, medicine, and entertainment writers are navigating the nuances of emphasizing human involvement in jobs while seeking protections from companies and government regulations against being replaced completely.

We feel that GAI could drastically change both the economic landscape and the investment landscape. As with many new technologies, there are certainly risks, but we believe that the benefits of adoption of GAI far outweigh the costs. Through GAI, humans are given some of the most futuristic “game pieces” the world has ever seen with no gameboard or instructions on how the game should be played. That is where the art and imagination of artificial intelligence takes hold. As civilization starts to learn how to wield these tools, we believe the possibilities for innovation could be truly endless.

Important Information

¹John McCarthy, “What is Artificial Intelligence?” As of November 12, 2007.

² Museum of Modern Art, Andy Warhol’s Campbell’s Soup Cans, 1962.

³ Bloomberg, “JPMorgan Creates AI Model to Analyze 25 Years of Fed Speeches.” As of April 26, 2023.

⁴Bloomberg and Goldman Sachs Asset Management. As of June 30, 2023.

⁵The Wall Street Journal, “Goldman Sachs CIO Tests Generative AI.” As of May 2, 2023.

⁶Goldman Sachs Global Investment Research, “The Potentially Large Effects of Artificial Intelligence on Economic Growth.” As of March 26, 2023.

⁷Goldman Sachs Global Investment Research, “The Potentially Large Effects of Artificial Intelligence on Economic Growth.” As of March 26, 2023.

Glossary

Artificial intelligence is the development of computer systems able to perform tasks that normally require human intelligence.

Generative AI is a type of AI system capable of generating text, images, or other media in response to prompts using a database.

Risk Considerations

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Key Takeaways

Investors are contending with a lingering late-cycle macro backdrop with latent recession risks for the US economy and most developed markets.
Rather than wait for the cycle to turn, the journey toward the destination of eventual growth or recessionary outcomes merits its own consideration.
We believe that staying invested, keeping active and diversifying across public and private markets may allow investors to seize late-cycle opportunities.

Economies move in cycles, and each cycle brings its own challenges and opportunities. In many aspects, the current cycle has shown signs of aging and we are likely in late cycle. As investors debate the chances of growth or recession, we think the journey merits its own consideration. Staying on the sidelines could prove costly, while we believe an active, diversified approach across public and private markets may be the best way to navigate near-term uncertainties and seize late-cycle opportunities.

Late Cycle, Not End Cycle

Some Macro Data Has Slowed, But Not Enough For A Recession

For over a year, the Federal Reserve (Fed) has embarked on aggressive rate hikes—along with balance sheet reduction—to combat stubbornly high inflation. Price pressures in the US have started to ease heading into the second half of 2023. Among the key components, core goods inflation has decelerated the most as supply chain pressures eased, shelter inflation has started to level off in recent months, core services ex-shelter inflation has moderated to some degree yet remains the key risk to our inflation outlook.¹ Gradual and uneven progress on disinflation suggests to us that humility is required in forecasting future levels from here, even when most of the key drivers appear to be moving in the right direction.

Drags from persistent inflation and cumulative policy tightening have slowed growth to a soft, but non-recessionary pace. The US labor market’s momentum has started to fade—the quits rate has steadily declined since 2022 and dropped to 2.4% in April, just above its 2018-2019 level of around 2.3%. Despite a mild uptick in May, the downtrend over past 12 months indicates that opportunities for switching to better jobs have been diminishing.² Wage growth has begun to slow, but further deceleration is likely needed to be consistent with the 2% inflation target. At the aggregate level, the US unemployment rate has not risen much beyond its pre-pandemic level of 3.5%. According to the Sahm Rule, which states that we are in the early months of recession when the three-month moving average of the national unemployment rate is 0.5% or more above its low over the prior twelve months, the US economy is not yet in recession as it heads into the second half of 2023.

Sahm Rule Recession Indicator Suggests the US Is Not Yet in Recession

This doesn’t necessarily mean the economy will avoid a downturn altogether. As monetary policy has continued to tighten, shorter-dated interest rates have risen beyond longer-dated ones, leading to an inverted yield-curve—typically an indicator for an impending recession. Heading into the second half of 2023, the spread between 2- and 10-year Treasuries has inverted to the deepest levels since the early 1980s; other measures of yield curve inversion are also pointing to meaningful recession odds. However, yield curve inversion alone is not particularly informative about the timing of an upcoming recession, and there are meaningful downside buffers that may forestall the economy from tipping into a downturn imminently and prolong the duration of the current cycle.

Despite strong headwinds and signs of weakness, the US economy has proven resilient so far in 2023. Many of the upside surprises in the economic activity data have pertained to consumer spending. Goods consumption rebounded quickly in the first quarter to the fastest pace since the second half of 2021, and services consumption remains strong.³ The combination of a strong labor market and solid real disposable income growth could continue to support consumer spending—and therefore economic growth—in the months ahead.

The balance sheets of US households, corporates, and state and local governments also remain solid at the midway point of the year. Moreover, the tail risk of the debt limit crisis has been eliminated and, so far, stress in the US regional banking system is expected to impose a moderate but not recessionary drag on growth. There are signs that bank lending standards have tightened across several types of loans, while the extent of further credit tightening remains uncertain. Fiscal policy bills, such as the CHIPS Act, may further spur manufacturing investments and provide offsets to credit tightening.

Higher Rates for Longer

We believe the outlook for any further hikes will likely depend on whether labor market rebalancing has progressed far enough to solidify disinflation. In June, the Fed dots projected two additional hikes left for this year,⁴ which was viewed as a hawkish surprise by markets. Yet despite the aggressive pace of hikes, the level of Fed Funds rate has only recently risen to levels comparable to inflation. This contrasts with historical hiking cycles when the Fed hiked rates well above inflation. Therefore, we continue to expect that US monetary policy will stay restrictive for longer. Such an environment is expected to be particularly challenging for business models that rely on higher leverage, lower cost of borrowing and ample liquidity. On the flip side, however, this may also represent an opportune time to be a lender, particularly in private markets.

Seizing Opportunities

Considering the Fed’s hawkish stance, the timeframe for a monetary policy pivot and the duration of the late-cycle phase remains highly uncertain. But rather than sitting on the sidelines and waiting for the cycle to turn, we believe staying invested with an active, diversified approach may be the best way to navigate uncertainty and seize late-cycle opportunities in the meantime.

Private Credit: Be a Lender

In a higher-for-longer rate environment, we see opportunities for investors to earn equity-like returns in private credit. Compared to public fixed income, private credit involves directly providing loans to companies in privately negotiated transactions. The strategy can offer incremental income generation and greater resiliency during periods of heightened volatility, serving as a potentially strong complement to traditional fixed income. The current environment is buoying private credit yields—the average new-issue yield across all US leveraged loans reached 10.2% in 2Q 2023, the highest since 2009.⁵ This is being driven by borrowers willing to pay more for the certainty of execution and custom terms that private lenders offer. Rising rates and market volatility have led to a slowdown in high yield and leveraged loan issuance, as lenders, including smaller domestic banks, curtail their activity. Private credit has stepped in to fill the gap, expanding the strategy’s share of corporate and real asset lending, particularly across segments of commercial real estate facing tighter credit conditions, income pressure and elevated refinancing needs.

Private lenders today have the benefit of being able to focus on high-quality borrowers with attractive coverage ratios and favorable terms to mitigate downside risk. As interest rates have climbed, private credit loans are offering equity-like returns in the double digits and, in general, private credit terms tend to include bespoke protections and provisions not found in the high yield or leveraged loan market.⁶ Private credit portfolios can also select investments without the need to manage to a benchmark. Selectivity can be a key advantage—and a potential downside mitigant—in an environment of increased dispersion, slowing growth, tightening monetary policy and headwinds to profitability. As the asset class matures, we believe private credit is becoming an increasingly viable replacement for traditional leveraged finance providers, offering increasing scale, customization, and certainty to borrowers that often view these benefits as compensation for the higher cost of capital.

Fixed Income Resilience

One upside of the transition to a higher rate regime is that the forward income and total return potential of core bonds, such as high-quality government bonds, has improved significantly. They have also delivered positive returns in past recessions and may act as an important ballast to portfolios should an adverse scenario materialize in this cycle.⁷ Further, core bonds have tended to have a low or negative correlation with equities and other risk assets which drives potential diversification benefits. Given the backdrop of late cycle economy, close to peak hiking cycle, and attractive level of real yield, we find long-duration US Treasuries attractive. Overall, we remain cautious on US credit, but continue to believe that there is opportunity for active management in this space. The recent banking crisis is expected to push US banks to tighten lending standards further and we do not believe this tightening is fully reflected in credit spreads, which are only at median levels over the cycle and not yet an attractive point of entry. Nonetheless, investors should continue to be mindful of security-level relative value and market dislocations that may present idiosyncratic opportunities, and active security selection remains crucial.

Equities: Keep Your Options Open

This year, market positioning appears to be cautious on risk assets, and positioning surveys point toward net underweight allocation of global equities at mid-year point. The US equity market currently embeds two different dynamics. On one hand, mega-cap tech stocks are being driven by high growth expectations as equity investors debate the influence generative AI may have on the future revenue growth and profitability of companies, and the valuation of stocks. On the other hand, the rest of the market is inching higher instead of rallying sharpy as inflation outlook and market sentiment improves. Currently, the valuation of tech remains within historical ranges and well below the peaks of early 2000s.⁸ Besides, with equity volatility at multi-month lows, the cost of downside mitigation has also become attractively cheap. Considering the macro backdrop, equity fundamentals, market pricing and positioning, we prefer to stay invested in equities with some hedged exposures.

AI Disruption May Lead to Active Management Opportunities

The ability and accessibility of generative AI models and their implications for creating well-crafted content, from persuasive rhetoric to code, has accelerated exponentially. We expect the integration of AI within enterprises and wide scale adoption by consumers may have a huge impact on societies and economies over the coming years. As investors, we believe AI is a growth driver with a wide variety of applications and is on a path to disrupting entire industries as we currently know them. In our view, companies that are harnessing generative AI to enhance their business, leveraging predictive AI to make their business smarter, and those manufacturing the hardware to enable the proliferation of AI are set to disproportionately benefit. In our view, each business will need a clear strategy to incorporate AI if they want to remain a market leader. We find this is a particularly exciting time to be evaluating AI opportunities. Finding the next generation of winners will likely require investors to be nimble and look beyond benchmarks.

Diversification Matters in a Dislocated Global Cycle

The beginning of the current monetary tightening cycle featured synchronized deployment of policy measures in most major economies, but the finale may reveal more differentiated responses as growth and inflation trajectories regionally diverge. While the Fed may be approaching the end of its hiking campaign, further tightening may be required by the European Central Bank (ECB) and Bank of England (BoE) to keep a lid on prices. Contrary to the hawkish stance of other G4 central banks, the Bank of Japan (BoJ) has remained accommodative for an extended period of time. Considering strong domestic demand, we continue to see diversification opportunities in Japanese equities. Beyond advanced economies, emerging markets are moving at their own pace, resulting in a desynchronized global cycle. Emerging market growth momentum remains soft but is no longer deteriorating. Inflation has plummeted in some countries, for example Brazil, Chile, and Mexico. Most EM central banks have reached the end of their respective hiking cycles, and the first EM central banks have begun their easing cycles. High real yields, weak currencies, low inflation may support diversification opportunities in local currency government bonds.

China’s cycle is also distinctively dislocated from most developed markets, with the People’s Bank of China (PBoC) in easing mode. China’s economic activity has rebounded following the lifting of mobility restrictions, but the boost from re-opening has been fading, with macro data missing market expectations coming into the second half of 2023.⁹ In our view, China’s recovery is likely to be non-linear from here. We believe the country remains a large, growing market with a vast opportunity set, though there is also an important shift in foreign direct investments occurring from China to countries such as Vietnam, India, and Mexico. Besides, US-China geopolitical gyrations may also create a more uncertain environment. Overall, we think a diversified, active approach is key to capitalize on investment opportunities in a dislocated global cycle with differentiated drivers at the country level.

Watch For The Next Phase of The Cycle

As cycles turn, investment opportunities shift. We continue to monitor closely the balance of risks between the economy’s strength and vulnerabilities, as they provide more clues on where we are in the journey toward the future stages of the business cycle. The upcoming quarters are likely key in revealing global central banks’ degree of success in bringing down inflation, the future path of monetary policy, as well as to what extent balance sheet resilience and fiscal programs may offset drags from interest rate and credit tightening. But uncertainty and disruption present opportunities for long-term investors. In our view, market participants should remain vigilant to growth and inflation dislocations across economies—as well as trends that transcend cycles—and stay invested, seizing late-cycle opportunities where they can be found.

Important Information

¹US Bureau of Labor Statistics. As of July 7, 2023.

² US Bureau of Labor Statistics. As of May 31, 2023.

³ US Bureau of Economic Analysis. As of June 30, 2023.

⁴ Federal Reserve. As of June 14, 2023.

⁵ LCD, “Amid credit tightening, leveraged loan market revisits Financial Crisis levels” As of June 7, 2023

⁶ Cliffwater Direct Lending Index. Analysis of the unlevered, gross of fees performance of U.S. middle market corporate loans. As of June 30, 2023

⁷ Bloomberg, Datastream and Goldman Sachs Asset Management. Analysis of German, UK, US and Japan government bonds annualized total return in local currency from March 31, 1980 to March 31, 2023.

⁸ I/B/E/S and Datastream. As of July 19, 2023.

⁹ National Bureau of Statistics of China. Bloomberg. As of July 17, 2023.

Glossary

CHIPS Act establishes and provides funding for the Creating Helpful Incentives to Produce Semiconductors (CHIPS) for America Fund to carry out activities relating to the creation of incentives to produce semiconductors in the United States.

Correlation is a measure of the amount to which two investments vary relative to each other. Past correlations are not indicative of future correlations, which may vary.

G4 Central Banks refers to the Bank of England (BoE), the Bank of Japan (BoJ), the Federal Reserve (FED), and the European Central Bank (ECB).

Hawkish refers to more aggressive monetary policy, the opposite of Dovish.

Mega-cap tech stocks refer to technology companies >$100bn in market cap.

Quits rate refers the number of quits during an entire month as a percent of employment. Quits include employees who left voluntarily, with the exception of retirements or transfers to other locations.

Recession is defined as two consecutive quarters of negative growth in real GDP.

Sahm Rule Indicator, as identified by Claudia Sahm, identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months.

Syndicated loans refer to financing, or loans, that are offered by a group of lenders—known as a syndicate—who collaborate to provide funding for a single borrower.

Volatility is a measure of variation of a financial instrument’s price.

Risk Considerations

All investing involves risk, including loss of principal.

Equity investments are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. Different investment styles (e.g., “growth” and “value”) tend to shift in and out of favor, and, at times, the strategy may underperform other strategies that invest in similar asset classes. The market capitalization of a company may also involve greater risks (e.g. “small” or “mid” cap companies) than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements, in addition to lower liquidity.

Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.

High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated fixed income securities

Emerging markets investments may be less liquid and are subject to greater risk than developed market investments as a result of, but not limited to, the following: inadequate regulations, volatile securities markets, adverse exchange rates, and social, political, military, regulatory, economic or environmental developments, or natural disasters.

The risk of foreign currency exchange rate fluctuations may cause the value of securities denominated in such foreign currency to decline in value. Currency exchange rates may fluctuate significantly over short periods of time. These risks may be more pronounced for investments in securities of issuers located in, or otherwise economically tied to, emerging countries. If applicable, investment techniques used to attempt to reduce the risk of currency movements (hedging), may not be effective. Hedging also involves additional risks associated with derivatives.

Investments in real estate companies, including REITs or similar structures are subject to volatility and additional risk, including loss in value due to poor management, lowered credit ratings and other factors. 

The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.

Conflicts of Interest 

There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. These activities and interests include potential multiple advisory, transactional and other interests in securities and instruments that may be purchased or sold by the Alternative Investment. These are considerations of which investors should be aware and additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment.

General Disclosures

Diversification does not protect an investor from market risk and does not ensure a profit.

Past correlations are not indicative of future correlations, which may vary.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.

The website links provided are for your convenience only and are not an endorsement or recommendation by Goldman Sachs Asset Management of any of these websites or the products or services offered. Goldman Sachs Asset Management is not responsible for the accuracy and validity of the content of these websites.

Examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.

Goldman Sachs Asset Management, LP (GSAMLP), Goldman Sachs & Co. LLC (GSCo), pursuant ASIC Class Order 03/1100; regulated by the US Securities and Exchange Commission under US laws.

Goldman Sachs Asset Management International (GSAMI), Goldman Sachs International (GSI), pursuant to ASIC Class Order 03/1099; regulated by the Financial Conduct Authority; GSI is also authorized by the Prudential Regulation Authority, and both entities are under UK laws.
Goldman Sachs Asset Management (Singapore) Pte. Ltd. (GSAMS), pursuant to ASIC Class Order 03/1102; regulated by the Monetary Authority of Singapore under Singaporean laws
Goldman Sachs Asset Management (Hong Kong) Limited (GSAMHK), pursuant to ASIC Class Order 03/1103 and Goldman Sachs (Asia) LLC (GSALLC), pursuant to ASIC Instrument 04/0250; regulated by the Securities and Futures Commission of Hong Kong under Hong Kong laws.

South Africa: Goldman Sachs Asset Management International is authorised by the Financial Services Board of South Africa as a financial services provider.

Esta presentación es estrictamente privada y confidencial, y no podrá ser reproducida o utilizada para cualquier propósito diferente a la evaluación de una inversión potencial en los productos de Goldman Sachs Asset Management o la contratación de sus servicios por parte del destinatario de esta presentación, no podrá ser proporcionada a una persona diferente del destinatario de esta presentación.

Jordan: The document has not been presented to, or approved by, the Jordanian Securities Commission or the Board for Regulating Transactions in Foreign Exchanges.

Date of First Use: August 7, 2023 326527-OTU-1841471

The $95.4 billion Oregon Investment Council has established anchor relationships in relative value, event-driven, and global-macro strategies as well as expanded the CTA portfolio, equally weighted managers, and continues to conduct due diligence on additional multi-strategy funds. Meanwhile it is also restructuring its public equity allocation following a review of the portfolio and its managers.

Over the last 16 months, $95.4 billion Oregon Public Employees Retirement Fund, OPERF, has approved eight new hedge fund strategies totalling $2.45 billion in commitments in its diversifying strategies portfolio.

Moreover, the team at Oregon Investment Council (OIC) have established anchor relationships in relative value, event-driven, and global-macro strategies; expanded the CTA portfolio to four, equally weighted managers, and continues to conduct due diligence on additional multi-strategy anchors in the $4.6 billion portfolio. Of the new relationships, seven are brand new while one was a conversion of an existing fund investment.

The latest changes are steps on the road to overhauling the portfolio, centred around diversifying managers and strategies to escape a legacy of concentration in the portfolio and overlapping exposures. Today, top 10 hedge fund managers at the fund include names like AQR Capital Management (which has three mandates) Hudson Bay Capital Management and Davidson Kempner Capital Management.

“I think the team has done an amazing job over last couple of years [building the allocation] from seven firms and nine strategies to 22 and 25. That’s a tremendous amount of travel; a tremendous amount of writing of these 350-page documents we use to review all the different details, in addition to their other job in real assets,” said CIO Rex Kim in a recent OIC meeting. He added that building out the portfolio has relied heavily on consultant Albourne, providing support around manager selection and due diligence particularly.

OPERF launched its alternatives portfolio comprising real assets (7.5 per cent of AUM) and diversifying strategies (7.5 per cent of AUM) in 2011. Diversifying strategies returned 16.5 per cent in 2022, outperforming the HFRI FOF Conservative benchmark and a 70/30 Reference Portfolio, led primarily by GAA and CTA legacy exposures. On the heels of strong 2021 and 2022 performance, the portfolio is now outperforming its benchmark on a three-year basis.

The OIC board heard how the collapse of SVB triggered a negative impact on some hedge fund strategies including short bonds, CTAs and macro. Positively, strategies like long short and relative value have done better.

Other recent trends include investors rebalancing because hedge funds have outperformed, moving assets from hedge funds into private credit. Still, hedge funds offer attractive opportunities relative to prior years due to higher cash yields. Elsewhere absolute return strategies with a low correlation to equity are providing valuable diversification.

Going forward, the team will continue to increase the number of managers and strategy diversification, including relative value (which has a 26 per cent strategy weight vs a 34 per cent target) and equity long short. Strategy will also continue to focus on rebalancing GAA and CTA managers while researching areas of interest including quantitative equity market neutral strategies and fixed income arbitrage strategies.

Restructuring in public equity

OPERF is also restructuring its public equity allocation following a review of the portfolio’s construction and managers.

The portfolio reset, embarked on over a year ago, seeks to address key issues including bringing the tracking error within range; maintaining and adding core passive exposure to the developed market sleeve, revisiting Oregon’s factor selection in the risk premia portfolios and focusing on alpha generation from high conviction active managers.

The restructure is a response to analysis that revealed that the portfolio’s largest factor exposure was to value, and that it was underweight growth – particularly large growth on a benchmark relative basis. The majority of active risk was coming via style factors, and the tracking error was high at 2 per cent, explained Louise Howard who became senior investment officer for the allocation in January 2022.

Since January, in phase one of the strategy, Oregon has targeted the low hanging fruit in the restructuring process in the form of benchmark misfits, taking down over-weights to smaller-and mid-sized value exposures and re-purposing those assets to more benchmark orientated strategies. The team have also reduced the underweight to large cap growth equity and ensured stock selection becomes a larger contributor to active risk. The tracking error has also come down significantly to 1.2 per cent.

From now until year end the focus will be on adding passive exposure to the international allocation, and further diversifying the factor exposure. From 2024, the focus will be on rebalancing manager exposure to reduce active risk and adding exposure to neutralize existing style biases.

OPERF’s portfolio is divided between public equity (27.5 per cent) diversifying strategies (7.5 per cent) real assets (7.5 per cent) fixed income (25 per cent) private equity (20 per cent) and real estate (12.5 per cent)

New Zealand Super has revamped its multi-factor equities portfolios, working with its three external managers to integrate sustainability. Amanda White spoke to head of external investments, Del Hart, about the fine balance of meeting sustainability goals and finding factor alpha, and the next phase of the fund’s sustainability strategy: measuring investments for impact.

New Zealand Super’s active global equities is managed by three managers in various concentrations of multi-factor portfolios across value, low volatility, momentum, and quality.

As part of the fund’s bid to integrate sustainability across its whole portfolio, it recently engaged with Northern Trust, AQR and Robeco, which manage the portfolios, on how to best integrate its sustainability objectives without compromising the integrity of the factor exposures.

“The multi-factor mandates make up 19 per cent of the portfolio so if we couldn’t do something with that, it was a gap in the portfolio in terms of sustainability goals,” NZ Super head of external investments and partnerships Del Hart tells Top1000funds.com in an interview.

“If we restricted it too much we wouldn’t find the scope for factor alpha we were looking for, but we found we couldn’t simply give the factor managers the Paris-aligned benchmark we used for the passive portfolio as their universe for stock selection.” [See NZ Super culls equities, focuses on impact]

The balancing act meant ensuring the managers had a large enough investable universe and weren’t restricted in their approach to creating the alpha expected from the portfolios, whilst still meeting certain ESG outcomes.

The NZ Super team did a lot of research and spoke to peers as well as a range of fund managers, both incumbent and others, to canvass the financial effects of integrating ESG into multifactor equities.

“There was a range of views, but the prevalent view was the impact was uncertain,” Hart says. “If we can incorporate ESG considerations without compromising the exposure then there is no reason to believe it will reduce returns. Our goal is not to generate alpha from the ESG integration but to have justifiable confidence it won’t detract from returns.”

Three changes to the factor strategies ensued. The investable universe was moved away from the MSCI ACWI IMI to the MSCI World index, effectively removing small caps and reducing the number of stocks from 4,500, to 1,500.

“That’s the level we think there won’t be a negative performance impact. It was still possible at that level to achieve a strong exposure to our desired factors,” Hart says.

From that universe, managers were given freedom to choose their exposures to manage the portfolios but their benchmark was changed to the MSCI World Climate Paris-Aligned index, which is the same as used for the reference portfolio and passive global equities.

“So they need to manage to the ESG characteristics of that index but can do it in a way they choose for generating the returns,” Hart says.

Managers can design a portfolio that gives the ESG desired outcomes, as per the benchmark, but doesn’t require them to meet specific targets in terms of ESG metrics.

“It gives them flexibility. And the important thing is we will use MSCI ESG metrics to report their performance and require them to explain any consistent underperformance, that’s our way of checking in a consistent way that our three managers are adopting an appropriate solution to achieve the goal,” Hart says.

The fund is now working with the managers to implement the new changes which may include some amending their investment management agreements.

With ESG considerations further integrated across equities, the fund will turn its attention to the fixed income portfolio.

Impact measurement

It’s all part of a move by the fund to sustainable finance which followed a two-year review of its responsible investment position, with ‘sustainable finance’ referring to the consideration of the impact of investments on society and environment, as well as thinking about the ESG risks on investments.

There are few large asset owners globally which measure the impact of their investments, but it is attracting growing attention. New Zealand Super will do an initial portfolio assessment due by the end of September.

In developing an appropriate framework, the first part of the process was to define impact, and the framework for qualification, measurement and management.

New Zealand Super’s definition of impact is: Investments made with intent to deliver measurable positive social and/or environmental impacts, and the fund’s required financial return. Importantly it has the four factors of intent, measurability, impact and returns.

And questions it asks to assess investments around impact include: Does the investment meet the return hurdle; have positive social or environmental impacts been identified as a core component; can those impacts be measured; and are there any significant adverse impacts associated with the investments?

Hart says developments in the past few years including the growing use of taxonomies has given the fund confidence they can invest in scale, measure impact and meet the financial return goal.

“A few years ago we were interested in impact but our mandate to meet returns and with our fund growing we couldn’t get sufficient comfort in scale in a meaningful way,” she says.

“We couldn’t invest in size and be able to measure what we were getting out of that.

“There has been an evolution happening in the industry that has helped us get comfort that we can find managers that have that intent, and we needed those manager to report ideally on a comparable basis.”

The fund has developed an impact investment framework with a five-step process covering qualification, measurement, reporting, analysis and management.

The fund’s preference was to adopt, and if needed adapt, an off-the-shelf solution, given the progress and convergence of existing frameworks, and it decided on the IMP 5 dimensions of impact as the most appropriate approach.

“In terms of measurement we wanted to have a consistent approach so we are using the five dimensions of impact for working through our existing portfolio and to invest in new sustainability solutions. We are at the stage where we are putting the new framework through any relevant new investment that we do, and taking time to go through the existing portfolio for which investments qualify for impact.”

Importantly the fund will continue to apply its standard sustainable investment framework to all investments, including those that don’t qualify as Impact investments.

“It doesn’t mean we won’t invest in something but we are making sure we are giving thought to if an investment creates impact or not and having the lens and giving sufficient consideration to impact investing.”

Hart says the impact measurement is a work in progress with the first step to get really clear on what the fund was trying to achieve and ensuring a consistent methodology, criteria and expectations in measuring impact.

“The external managers’ team, the internal team and our direct team all need a consistent approach,” she says, adding the fund has engaged some of its managers, including Generation Investment Management which it appointed only this year, and are leveraging some of their expertise.

“We have leveraged our network to help us form our solution and that has helped us,” she says. “We are on the cusp of having a lot more clarity and visibility.”

Other tools are also being created for the investment team, including a dashboard, to provide visibility to the team internally and to help educate them.

The predominant themes that are being measured are positive environmental impacts, with Hart acknowledging the social aspects are much harder to measure.

“The next stage is to think more about where the opportunities are, where we can focus our effort to get impact and map that against the SDGs,” she says. “We will get more sophisticated.”

South Africa’s EPPF wants to increase its allocation to private equity and venture capital to help ride out volatility at home in a strategy where governance and stakeholder engagement is central. CEO Shafeeq Abrahams explains.

South Africa’s R190 billion ($10 billion) Eskom Pension and Provident Fund (EPPF) the retirement plan for employees of the country’s electricity utility, is currently building resilience into the portfolio, seeking greater diversification through an increased allocation to alternatives and overseas investments. Elsewhere, EPPF is reviewing its approach to passive investment, preparing to bring more systematic strategies in-house.

The increased overseas allocation to alternatives is most focused on global private equity and venture investment. The team have just returned from meeting US managers, and EPPF hopes to issue an RFP in the next 12 months.

“We have been looking at what is out there, and the risk as well,” says Shaafeq Abrahams, promoted to chief executive and principal officer at the fund in 2021.

Although Abrahams plans to build the international allocation to private equity, venture capital and infrastructure, he won’t push the allocation much above current levels. A new regulatory ceiling allows the fund to invest up to 45 per cent of assets outside South Africa. EPPF currently invests 36 per cent of assets overseas, which he says is about right.

“Changes to regulation allowing for an increased foreign allocation will be inputs into our upcoming asset-liability modelling exercise and we will see the outcome. But in terms of our modelling, and given our liabilities are in rand and we would have to manage the currency risk, we will probably stay at current levels unless there are very compelling investment opportunities.”

The bulk of the overseas allocation is invested in international equity, with smaller portions (5.7 per cent) in emerging market equity (3 per cent) African assets and (2.8 per cent) China A Shares.

Alongside a quest for diversification, the decision to invest more in illiquid assets is also a bid to smooth volatility. Higher interest rates and inflation promise more volatility ahead, he warns. “Over the long run volatility sorts itself out, but we’ve found greater diversification helps weather the storms.”

Rand volatility particularly is a constant consideration in portfolio construction. “We take a view on currency risk, and it does influence our allocations,” he says. Although the fund never hedges long term because it is too expensive, it will hedge short term currency risk. “If market conditions indicate currency volatility, we will hedge during a specific period on a tactical basis to give us comfort.”

An appetite for South African infrastructure

A larger allocation to alternatives will also include more investment in South African infrastructure where he likes the long term, stable cash flows that provide insulation against inflation. South African infrastructure assets also chime with EPPF’s sustainability and impact targets. “If we get infrastructure right, we can drive the sustainability agenda and outcome, help grow the economy and address inequality.”

Existing exposure includes renewable energy and economic and social infrastructure assets but he’d like to expand this to opportunities in toll roads and bridges. The challenge is finding bankable projects with the right returns and partners. “The regulatory framework needs to encourage more public private projects and we are working with peers to frame the conversation to see how we can unlock this. We have room to invest on a long-term basis and a lot of appetite, but we also need a big push from public policy makers and regulators too.”

Doing more in-house

Although most assets will remain externally managed, Abrahams wants to do more in-house and expand the current 35 per cent of assets EPPF runs internally. Not only will this reduce the cost, he also wants to the team to manage systematic strategies internally and beef up their internal capabilities in private markets in anticipation of more co-investments and direct investments.

EPPF has an internal investment team of 50 (part of a large total headcount at the pension fund of 150) and he says this could grow by 55-60. The internal team is largely South African focused across a mixture of passive and active strategies, dictated by differentiated risk budgets.

Wider changes in the pension industry

Abrahams is also bracing for wider changes at the pension fund, which was founded in the 1950s. Much of his time since taking the helm has been spent building better communication with EPPF’s 80,000 members, which he says is particularly important given Eskom’s enduring corporate challenges.

“It’s critical that we inspire confidence through our behaviour, decision making and governance. All decisions must be made in line with member interest, independent of the employer. We are very mindful of the 80,000 families that depend on us. Our loyalty and allegiance to our members is paramount. One of my biggest challenges is instilling confidence in our members that the fund is well regulated and well governed at the executive level,” he continues.

Now, as South Africa inches towards a two-pot system which will allow beneficiaries to access some of their savings early, member experience, communication and stakeholder engagement are more important than ever.

Unlike executives at peer fund GEPF, Abrahams doesn’t predict the new regulation will result in significant drawdowns in the portfolio, or liquidity issues. He is more concerned about the complexity of implementation and administration, particularly for a defined benefit fund. “Numerous requests for drawdowns will carry an administrative cost and is a significant shift in the way pension funds have traditionally operated.”

He is also concerned about the long-term impact on members if they access their retirement fund early, and warns the policy change needs to run alongside an extensive education programme. “Our members need to understand the impact of the loss of compound interest over time. Accessing their pension may provide short term relief, but it could create long term retirement shortfalls.”

South Africa’s unfolding electricity industry also heralds change for EPPF. Plans to unbundle the giant utility into different segments are now back on the political agenda. If corporate divisions are separated into separate independent companies, EPPF, currently one fund for all Eskom employees, would have to change to take on a broader set of employers. “We have just started to have discussions about how we respond to the Eskom unbundling. It’s very early days, but also quite exciting,” he concludes.

Adapting To Change: How Hedge Funds May Benefit In A New Volatility Regime

Key Takeaways

A Market Environment of Higher Volatility

How Hedge Funds May Benefit from Higher Volatility

Manager Selection in a Higher Volatility Environment

The Only Constant is Change

Important Information

Key Takeaways

HOW DOES IT WORK?

Is GAI Just Another Hype Cycle?

Economic Impact of GAI

Technological Impacts of GAI

Investment Impact of GAI

Key Risks

Important Information

Key Takeaways

Late Cycle, Not End Cycle

Some Macro Data Has Slowed, But Not Enough For A Recession

Higher Rates for Longer

Seizing Opportunities

Private Credit: Be a Lender

Fixed Income Resilience

Equities: Keep Your Options Open

AI Disruption May Lead to Active Management Opportunities

Diversification Matters in a Dislocated Global Cycle

Watch For The Next Phase of The Cycle

Important Information

Restructuring in public equity

Impact measurement

An appetite for South African infrastructure

Doing more in-house

Wider changes in the pension industry

California Public Employees Retirement System (CalPERS)

ABP/APG Asset Management

California State Teachers Retirement System (CalSTRS)

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