New rules that could allow pension fund beneficiaries in South Africa to access their savings ahead of retirement hold important implications for South Africa’s largest pension fund the R2.3 trillion ($0.12 trillion) Government Employees’ Pension Fund, GEPF, and it’s ability to invest in illiquid assets.

Reforms currently going through the legislative process under the Revenue Laws Amendment Bill will enable South Africans to access up to a third of their net retirement savings early, while ringfencing the remainder for retirement over the long-term.

The rationale behind the so-called ‘two-pot’ system is that it will actually encourage members to preserve their pension by making it more flexible to accommodate the unforeseen financial pressures many face in their working life, stalling a trend that sees workers resign from their job to access their retirement fund.

“Instead of waiting until they retire or resign, the regulation will allow people to access annual withdrawal amounts if they choose. The industry is really grappling with these proposals,” explains Sifiso Sibiya, head of investments at GEPF. “It is existential for the entire retirement funds industry and will have an impact on how investment strategies are executed once regulations are finalised within the next six months. If you have to increase the amount of liquidity available there will be less assets for long term investment.”

His chief concern is how the fund will ensure sufficient liquidity on hand to pay beneficiaries seeking an early payout and the implications for long-term investment.

He is also mindful of the amount of liquidity GEPF will need to make available, warning getting it wrong could trigger “a market event.”

Sibiya also predicts that the implications will be keenly felt in GEPF’s administrative department where colleagues will need to deal with new pressures around cash flow management, ensuring the fund can absorb the volume of payments expected, as well as keep track of what has been paid out, accounting for money already withdrawn.

As soon as the legislation is passed, he says the investment team will start putting contingencies in place.

Monitoring the PIC

For now, he continues to spend most of his time focused on governance and enhanced monitoring of GEPF’s primary asset manager the government-owned Public Investment Corporation. The PIC is responsible for investing around R2-trillion on behalf of the GEPF, but the relationship came under strain due to political interference at the PIC during Jacob Zuma’s presidency.

In 2021 GEPF revised its mandate with the PIC, drawing up new conditions that included stipulations around consequence management that leave the PIC liable in the event of inappropriate investment decisions; better disclosure of the PIC’s investment decision making processes and ESG integration, and scrutiny of its fee model in the unlisted portfolio.

Now, mandate compliance and monitoring performance around benchmarks is a crucial element of Sibiya’s role. “We are transitioning into a new mandate [with the PIC] that governs our processes and there are more eyes on what we are doing to enhance the effectiveness of our oversight,” says Sibiya.

Tightening GEPF’s organizational capabilities and oversight structures has involved doubling the internal oversight team to six where the focus is ensuring the PIC implements GEPF’s strategy to the letter.

“Research indicates that at least 80 per cent of investment outcome is attributed to asset allocation and we are intent on ensuring our asset allocations are adhered to in order to achieve our set objectives,” he says, continuing “we have added capacity to the team to enhance our effectiveness when it comes to governance around the application of our strategic asset allocation.”

GEPF sets its asset allocation based on an asset liability model and PIC is responsible for implementation and selecting the securities.

Elsewhere, GEPF continues to fill its target 15 per cent allocation to global equity (and a little fixed income) recently increased from 10 per cent. Mandated to managers including JP Morgan, Goldmans and BlackRock, Sibiya says the allocation is bringing important diversification benefits, particularly acting as a buffer against rand volatility and allowing GEPF to tap into dollar returns, and other geographies, at a time growth in South Africa remains challenged.

“The rand is a volatile, emerging market currency and is expected to devalue over the medium to long term based on purchase power parity measures. As a result when South African investors allocate overseas, the currency depreciation translates into an additional return that may act as a buffer, especially if local assets underperform.” Still, he says GEPF won’t push its global allocation beyond 15 per cent of AUM. “This is our targeted allocation and is not expected to change.”

In another seam of the portfolio GEPF targets 5 per cent in unlisted African investments. Of this, it manages a tiny 1 per cent allocation to private equity across Africa internally and the rest is mandated to PIC which in turn allocates to external managers.

Spread across 50-odd countries Africa’s unlisted market is attracting flows from global investors, drawn to new opportunities like infrastructure as high inflation and interest rates impact their portfolios at home. Investing in Africa also holds compelling SDG and ESG opportunities. US public pension funds (where a government initiative aims to foster trade and investment between Africa and the US) have invested in private equity funds run by African Development Partners, for example.

Does GEPF’s experience offer insights for these investors? Above all, Sibiya counsels on the importance of hard currency revenues wherever possible to protect against a currency squeeze impacting returns.

“African currencies are generally volatile despite some being pegged to hard currencies and sharp devaluations can catch you by surprise. Assets may perform in local currency, but when they are converted into dollars it becomes something different and they may underperform. Measures can be put in place to mitigate against currency risk on portfolio returns like structuring portfolio companies with business models that generate hard currency revenues.”

Korea Investment Corporation (KIC), the country’s $169.3 billion sovereign wealth fund, is increasing its allocation to private assets and accelerating the expansion of the portfolio faster than initially planned.

“KIC plans to raise its allocation to alternative assets to 25 per cent by 2025 from 22.8 per cent ($38.7 billion) at the end of 2022 to enhance its returns while better responding to market volatility amid macroeconomic and geopolitical uncertainties,” confirmed a spokesperson for the fund that was set up in 2005 with $1 billion seed investment.

The move reflects an acknowledgement that the benefits of diversifying into equities and fixed income “are becoming less apparent.” Strategy at KIC is increasingly focused on exploring new investment strategies and expanding alternative investments, diversifying across asset classes to build a long-term investment portfolio that is less susceptible to market volatility.

Despite a “proactive risk hedging” programme and the fast-growing allocation to alternatives (alternatives where 17 per cent of AUM in 2021) sharp falls in bonds and equities meant the fund suffered a -14.36 per cent loss in 2022.

The fixed income allocation (31.6 per cent of AUM) and equity (38.3 per cent of AUM) make up the bulk of KIC’s “traditional” portfolio and has seen an annualized return of 4.06 per cent since 2004.

In contrast, since its launch in 2009 the combined alternatives portfolio of private equity (9.5 per cent) real estate and infrastructure (9.7 per cent) and hedge funds (3.3 per cent) has achieved an annualized investment return of 8.23 per cent.

KIC will focus particularly on investment opportunities in private credit markets, and the spokesperson told Top1000Funds.com the investor will access opportunities both directly and through external fund managers. KIC began making direct private equity investments in 2010 and co-investments with GPs in 2011.

KIC had previously aimed to raise its alternatives target to 25 per cent by 2027.

The decision follows other leaps forward in its approach to alternatives that include last year’s acquisition of private debt manager Golub Capital. In a nod to “the sharp growth of the private debt market where loans to blue-chip companies can generate stable cash flows” KIC strengthened its partnership with Golub by becoming a shareholder.

Elsewhere, KIC opened a new San Francisco office in 2021 to better hunt opportunities for its  venture investment programme KIC Venture Growth (KVG) that seeks “secure high-growth potential opportunities” that will “expand our portfolio.” The KVG fund aims to deal with industry paradigm shifts and identify excellent tech assets early on.

KIC is also setting up an Indian office, following in the footsteps of other investors including Canada’s Ontario Teachers’ Pension Plan (OTTP) and Singapore’s Temasek. CDPQ opened a Delhi office in 2016.

Hedge funds

KIC begun investing in hedge funds in 2010 and runs a diversified strategy using multiple approaches. Going forward, a particular focus will be on absolute return strategies that take advantage of arbitrage opportunities such as equity L/S, event-driven and fixed-income arbitrage, seeking to tap the impact of rising interest rates, increased market volatility and other changes in the financial environment.

Asset allocation decisions are based on KIC’s long term strategic asset allocation; strategic tilting, and tactical decisions. Going forward, KIC plans to strengthen the role and function of asset allocation in consideration of financial market conditions, the characteristics of each asset class and its investment horizon to achieve its investment objective.

“We hold an asset allocation forum every quarter to integrate top-down and bottom-up views from various investment departments and formulate a house view to ensure a reliable asset allocation process,” states its annual report.

The investor has also strengthened its risk management processes, particularly macroeconomic research capabilities as well as re-examined its investment processes to build a system that can withstand future “black swan” events.

Recruitment

KIC’s expansion into private markets has called for an overhaul of its recruitment practices. Nurturing talent across its 300-plus employees is now a central seam to strategy. “The world’s top financial institutions are all trying to secure and retain the best people. It’s a war for talent,” states the report.

KIC went through six recruitment rounds in 2022 and is giving staff more opportunities to study abroad, actively developing overseas investment training programs in collaboration with top global managers. Management philosophy now includes a commitment to “happiness management” by creating a workplace of “respect, consideration and fun and generating positive synergy among employees.”

In April 2022 KIC launched the International Finance Academy, an educational program that nurtures overseas investment specialists and supports the development of Korea’s finance industry. The fund has also revamped its compensation system “because we know that if KIC wants to grow excellent talent, they need excellent compensation.”

Domestic finance industry

Another critical component of strategy involves developing the domestic finance industry. KIC has strengthened its partnerships with domestic financial institutions by making commitments with two asset managers for overseas equity mandates.

“By entrusting domestic managers with more assets and continuing to diversify our strategies, we will actively help Korea’s financial institutions hone their overseas investment capabilities and become more globally competitive.”

It’s a similar story in hedge funds.  Last year KIC supported the overseas hedge fund investments of domestic financial institutions by participating in more joint ventures with them. “With our diverse hedge fund investing experience, and through showcasing our management capabilities, we are helping lead the development of the domestic finance industry.”

 

 

Geopolitical risk has been overstated and most geopolitical risk is already priced into investments, according to American historian, academic and author Professor Stephen Kotkin. And while some geopolitical risk is un-priceable, such as war, “if you can avoid a war between major powers, you can manage geopolitical risk,” Kotkin said.

Speaking via video link at the Fiduciary Investors Symposium hosted in Sydney, Australia, by Top1000funds.com sister publication Investment Magazine, Kotkin said cold war is not such a bad outcome, and may even be sustainable.

“Cold war, or managing a relationship where there are tremendous differences and you avoid a hot war, is a really good outcome, and that’s where we are right now,” Kotkin said. “And if we stay this way, we’ll be fine.”

Moving first to Ukraine, Kotkin said even if Ukraine’s counter-offensive is highly successful, “winning the peace is a lot harder than winning the war”.

“They are related but one doesn’t follow from the other,” he said, noting the US had failed to win the peace in both Iraq and Afghanistan.

Winning the peace in Ukraine would require accelerated European Union accession for Ukraine, and “some type of security guarantee, not likely NATO at this point”, Kotkin said, but that could look like the US agreement with South Korea – “an armistice that’s not dependent on territory,” which may involve Ukraine not getting back all of its internationally recognised territory.

Kotkin, a senior fellow at Stanford University’s Freeman Spogli Institute for International Studies, said the war is a tragedy but is also an opportunity for the West to re-discover the values on which it is based, to rediscover the importance of relationships, and to discover “that it had not been paying attention to large parts of the world” – which has caused to apathy from a range of countries towards issues of concern to the West. 

Potential futures for Russia

Kotkin ran through a range of futures for Russia. One possibility, albeit an unlikely one, is that Russia ceases to be a threat to its neighbours and becomes institutionally part of the West. An authoritarian leader – “a nasty person potentially” – could recognise the separate existence of Ukraine and cease hostilities. Russia could become a Chinese puppet regime, with outcomes for Ukraine that are hard to predict.

Russia could also continue on the path it is on now towards being a “very, very large North Korea,” persecuting its own people, threatening its neighbours, isolated from the international order with “nothing to lose by causing trouble.” Russia could also go through “chaos, possible semi-disintegration” with troubling repercussions for the region and the globe given Russia’s capabilities. The country could also undergo some other “black swan” even nobody can predict.

While some people in Washington have been hoping to “break Russia off from China in order to contain China”, the real game should be “engaging with the Chinese to help us manage the problem of Russia”, and stave off some of the worst possible scenarios, Kotkin said.

The Ukraine invasion has revealed a lot of lessons relevant to China, Kotkin said. “The West is not in decline, is not decadent, is not going away and is, on the contrary, unified, powerful, resilient and large – very large and substantial,” he said.

The West also has technology China relies on and has consolidated alliances around the world. The greatest protagonist on behalf of the West is Xi Jinping, Kotkin said, as “without him, we wouldn’t have this kind of consolidation”.

And Ukraine demonstrates that “if you militarily try to take a country like Ukraine or a self-governing island like Taiwan, you cannot have it”.

“You get a smoking pile of rubble, Kotkin said, and a Chinese invasion of Taiwan “would be an act of total desperation on their part”. Continuation of the status quo is the best option for all involved, he said.

But the biggest threat to global order is not China. Rather, it is “American fiscal insanity and the fiscal insanity of many of our friends and partners”, Kotkin said. Whether the West manages to get its house in order remains a big variable.

Every generation throughout history believes it has lived in innovative times, and yet, every generation brings its own innovation and change. The reality is that defining what innovation looks like can be quite hard.  Steve Jobs described it as “putting a ding in the universe”; Thomas Edison as “finding a better way to do things”; and science fiction writer, Arthur C Clarke as “going beyond the limits of the possible”.

For the asset management industry, innovation has been driven by the proliferation of data; advances in technology, including the widespread adoption of artificial intelligence (AI); and commitments to ambitious sustainability goals – all of which have caused significant disruption to the business, people and investment models of organisations.

Economist and Santa Fe Institute external professor, W. Brian Arthur, maps this digital and data revolution over the last 50 years – from integrated circuits, processors and memory chips in the 1970s/80s; to the connection of digital processes and computers via the internet; to the development of magnetic, gyroscopic, radar and other sensors. The latter is critical as these sensors brought us oceans of data and it is estimated that the asset management industry has nearly tripled its spending on data since 2017.  The challenge for our industry today is how to make sense of it all, while providing benefits for its stakeholders, with the use of artificial intelligence playing a leading role.

Benefits can’t be understated

The benefits of artificial intelligence to our industry cannot be understated and we see investors trying to harness its power through the use of natural language processing, image recognition and machine learning.

From processing unstructured ESG data from alternative sources with the aim of assessing company risk; to using AI in private markets to source deals and conduct due diligence on businesses; to improved customisation of products and client experiences. We also see its benefits in improved trade-execution algorithms; searches for new sources of alpha through alternative data and the generation of synthetic data points and scenarios; and reduced costs for data management.

Indeed, around 63 per cent of banks and investment firms surveyed confirmed that they are currently deploying or already using AI, with a further 28% intending to deploy it over the next 1-3 years (Gartner Data and Analytics Transformation Survey, 2022).

However, it is the development of generative AI – where machine learning models are trained to generate new content and data by training on existing data sets – that has caused divisions: the optimists who see the significant opportunities to drive work efficiency, allowing our workforce to do different, higher-value tasks (the National Bureau of Economic Research (NBER) recent working paper, Generative AI at Work, which points to a 14 per cent productivity improvement, with the greatest impact on novice and low-skilled workers); the pessimists who emphasise AI’s potential to propagate misinformation and create widespread disruption to jobs or even existential risk to human life; and those in-between who see lots of opportunities for AI’s use but strongly highlight the need to mitigate and manage its risks.

Social technology generally lags behind the development of physical technology and, as such, we need to be aware of the risks and put in place guardrails, while embracing its benefits.

We also need to not underplay the roles of human intelligence (HI) as a complement to rapid advances in AI use cases. Indeed, the combination of AI + HI will be especially powerful if we are to learn the intrinsic limitations of this technology and adjust our part in this combination.

Empathy, judgement and the ability to inspire

The reality is that AI cannot yet fully replicate human behaviour in all its dimensions. Traits such as creativity, empathy judgement and the ability to inspire others are very much the reserves of humans. We are also reminded that the skills of the future (The investment professional of the future, CFA Institute, 2019) are not just technical, but also include soft skills such as relationship and building social capital; leadership skills such as crisis management and instilling an ethical culture; and T-shaped skills including situational fluency and adaptability. And we also need judgement and inference skills to consider data in its full context where simple causality is not present in a complex system and where trade-offs need to be made between highly objective/valid hard data and softer more subjective data that may be more material.

Data science and analytics have become a vital part of the investment business. But the ultimate test of quality in data and technology will be related to the quality of decision-useful information and the connected insights, judgements, processes and algorithms applied to it.

AI can indeed be a game changer for our industry – it is a systemic opportunity – but only if we are able to mitigate the risks that have and will come from multiple sources. It is the powerful combination of AI + HI that will truly deliver long-term value – enabling us to make better decisions quickly and more consistently, with the human touch.

Marisa Hall is head of the Thinking Ahead Institute at WTW, an innovation network of asset owners and asset managers committed to mobilising capital for a sustainable future. 

Bank runs bought down three regional lenders in the US earlier this year and the sector is poised for more consolidation ahead, warns Steven Meier, CIO and Deputy Comptroller for Asset Management at $233.5 billion New York City Retirement Systems (NYCRS).

Ever since the failure of Silicon Valley Bank, Signature Bank and First Republic, a growing number of other regional lenders are facing mounting risk from falling deposit rates and costly regulation. They are also unlikely and unwilling to make new loans, with profound implications for businesses.

A key reason behind mounting risk at regional US banks is the growing divergence between the Fed funds rate and interest rates on checking accounts, increasing the risk of bank deposit outflows. As interest rates track higher, saving account holders are moving their deposits out of banks to higher yielding T-bills.

“Any individual with money sitting in a checking account can move it to T-bills or a money market mutual fund for a 500-basis point pick up in yield. It is challenging for these banks as these deposits flow out,” said Meier speaking in a recent investment committee meeting.

“These banks are at risk of increased regulatory costs and increased deposit costs which equate to a lower net interest margin and lower profitability on the part of regional banks,” continued Meier. He highlighted the probability of around 30-odd banks including names like Western Alliance, Zion and First Horizon as likely candidates to “reorganize their balance sheets.”

Alongside questioning the ability of struggling regional banks’ ability to make money in the longer term, Meier flagged that the US economy is still “overbanked” indicative that further consolidation is coming down the line. In 1997 the US had around 13,000 banks compared to around 4000 today. “This is still high compared to global standards.”

Recession risk

Along with the likelihood of more regional bank failures, Meier warned that the US economy remains at risk of recession. Although the slope of the US yield curve has been inverted since 2022 and the economy still hasn’t dipped into recession, the warning signs that have predicted every downturn since 1969 continue to flash red.

“The 10-year treasury yield should trade at a premium, but two-year yields are above 10-year yields and this tells us that the market is pricing in a recession at some point in the future.”

Monetary policy acts with a long and variable lag, he warned. The most aggressive rate hiking in 40 years has tightened financial conditions that are still not fully felt through the economy.

He warned that the prospect of recession and tightening credit conditions will cause spreads to widen further .“We will see this in the coming months,” he said, adding that if the economy moves closer to recession, the number of defaults will spike.

Inflation in the US is still strong, primarily supported by resilient consumer spending and China reopening. And the signs that it will remain strong abound. Geopolitical trends around re-shoring, inflationary pressure in the transition and shortfalls in the labour market (although he noted signs that the US job market is slowing) all point to enduring inflation.

Positively, the board heard that for many investors cash is currently “a free lunch” that is both low risk and offers a high return. As such it is a meaningful contributor to active risk.

Factors to watch

Meier warned that in the aftermath of resolved US debt ceiling negotiations, trillions of treasury issuance will put pressure on bill rates, repo rates and other allocations. and said that although equity markets have had a healthy spate of late, the strong dollar is impacting returns on non-US equities. Private markets have seen excess returns at NYCERS although non-core real estate has underperformed.

He warned that public equity returns (NYCERS has around $21 billion invested in US equity) remain driven by a handful of big tech stocks including Apple, Meta, Microsoft and Tesla. This also means that NCYERS’ allocation to large cap stocks has outperformed small caps. “Apple’s market cap exceeds that of the entire Russell 2000 index – it’s quite remarkable.”

NYCERS portfolio has a low active risk level, and most of the fund’s performance comes from the market.

Following an amendment to New York state’s so-called basket clause legislation, NYCERS can increase its allocations to private markets to 35 per cent of assets under management, up 10 per cent. A scheduled review of its large and complex asset allocation across the five different plans with trustees and consultants will set new allocations.

 

Defined benefit schemes in the United Kingdom have put aside much larger collateral buffers since the LDI crisis last year with implications for how they invest. Pension funds typically stress tested their portfolios around a 3 per cent increase in gilt yields, but after last year’s gilt crisis, many funds now scenario-plan for an 8 per cent increase in yields.

“Since the gilt crisis last year, my role has focused particularly on making pension fund portfolios more resilient,” says Tegs Harding, professional trustee with Independent Governance Group.

“DB funds have put in place more prudent collateral buffers than what they had during the crisis. We haven’t been sat on our hands. We’ve got much better collateral defaults in place and we can deal with yield increases.”

Harding is chair of the investment committee at £20 billion ($25.3 billion) Legal & General DC Mastertrust and also looks after a book of seven other pension schemes including the £5 billion Diageo Pension Scheme, where she is also chair. The Mastertrust provides pensions for  around 200 employers from around the UK and has around 1.9 million members.

The large yield increases in gilts last year had a huge impact on DB and DC funds in the UK. DB funds with large LDI exposure and an illiquid book had large and rapid calls for capital and needed to implement contingency plans quickly. To shore up collateral, they divested some assets and organized loans from sponsors to ensure they could maintain their hedge.

Investment strategies revisited

Harding says her role includes working with pension funds to revisit their investment strategies.

“Some DB schemes with, say, a 15 per cent allocation to illiquid investments going into the crisis, will now find themselves with a much bigger allocation (up to 30-40 per cent) to alternatives because of changes in the valuations in their portfolio,” she says.

“We work with them on how to change this.”

UK DC funds have larger collateral pools in place and are much better able to deal with yield increases that DB funds, says Harding.

However, DC funds are still navigating the impact of last year’s correlation between equities and bonds.

“On the DC side, we are focused on making sure funds have invested enough in illiquid assets,” Harding says.

“Investing in alternatives through the growth stage of a DC fund leads to better member outcomes. We look closely at Australia’s DC model where assets are made to work harder with more investment in illiquids and the local economy,” she says.

Harding says governance is getting more complex as regulation comes thick and fast, with trustees required to respond to it.

“Much of a trustee’s job is around policy setting and setting the overall ambition and objectives of a pension fund. And geopolitical risk is increasingly impacting the investment climate,” she says.

“My role is to help pension funds deal with these challenges and keep up with the big systematic risks that need managing.”

Integrating biodiversity

A growing element of her role involves working with pension funds on how to integrate biodiversity. She notes many pension funds began to integrate ESG with a focus on climate and TCFD reporting, but this is evolving. “Now there is a realisation that we can’t just focus on climate in the transition,” she says.

“Many companies won’t do well if we don’t tackle biodiversity too, and we must look at things holistically.”

She notes that diversity amongst UK trustees is increasing because the older generation of trustees is retiring and new, younger people are stepping in.

“Professional trustees are more diversified than member-nominated trustees,” she says. “Pension funds take diversity seriously and want trustees from different backgrounds.”

“My primary role is to make sure that people get the benefits they are entitled to. I provide support on how to invest the assets and value the liabilities; check they are administered correctly and make sure employers are contributing the right amount. We also advise on investment and cyber and operational risk.”