A future of rising uncertainty demands investors fundamentally re-think the way they assess risk when building resilient portfolios, argued a panel of experts from MSCI and Singapore sovereign wealth fund GIC.

A joint research paper focussed on building balanced portfolios in a dramatically changed market environment. Its authors outlined five forward-looking scenarios future markets could face, and argued investors should assess the resilience of their portfolios against these scenarios, rather than relying on backward-looking assessments of risk such as mean-variance optimisation.

The paper, Building balanced portfolios for the long run: A new framework for incorporating macro resilience into asset allocation, was co-authored by Grace Qiu and Ding Li, both senior vice presidents, total portfolio policy & allocation, economics and investment strategy, at GIC, and Peter Shepard, managing director and head of analytics research and product development at MSCI.

All three authors spoke with Amanda White, director of international at Conexus Financial, in a panel discussion at Conexus Financial’s Fiduciary Investors Symposium held in Singapore.

The paper argues investors face two major shifts in the investment environment. The first is that private assets have gradually moved from peripheral alternatives to lie at the core of many asset allocations.

The second, more sudden development is the period of heightened macro uncertainty markets are now facing, with higher inflation and interest rates adding to the challenge of secular forces such as climate change, geopolitical tensions and de-globalisation.

Private assets: higher returns, lower risk

Grace Qiu said private assets promise higher returns and lower risk, but they can be hard to evaluate and incorporate into the asset allocation process alongside public markets. Investors need a measure that can be consistently applied across public and private markets.

“We all know that simple statistical-based volatility or drawdown measures will potentially understate private market risk due to accounting smoothing or lagged valuation phenomena,” Qiu said. “Using a public market proxy can be a dirty and quick fix, but it lacks fundamental linkage to private markets, and therefore can be quite difficult to communicate to your private market colleagues and receive buy-in.”

Macro-economic risks that could dominate the coming decades include supply-driven inflation, a less-credible central bank, rising real rates and slowing productivity growth, the paper argues. It uses five potential macro scenarios to test a framework for allocations that is more resilient against long-term risks, at the cost of shorter-term volatility.

Peter Shepard said investors have largely been limited by “two ways of approaching risk,” one being very statistical and short-horizon, and the other a purely qualitative approach to the long-term.

“That’s really unsatisfying,” Shepard said, noting investors either operate “like a casino with known rules, or you give up on a more data-driven process altogether.”

The paper presents a middle ground that models the long horizon and then allows investors to apply judgement to the more uncertain components, he said.

A lot can be predicated about the long term

Investors have long assumed that it is difficult to forecast for the short term, and even harder to forecast for the long term, Shepard said. But the team realised there is actually a lot that can be predicted about the long term.

“It’s hard to say how much it will rain next week, it’s harder to say how much it will rain a year from next week, but it’s actually easiest to say how much it will rain next year,” Shepard said.

Cash flow shocks and discount rate shocks are painful on a short term horizon because prices drop, but “discount rate shocks are less and less painful” on a long horizon because expected returns go up, he said.

Conversely, trend growth shocks to the trajectory of markets are among the biggest risks facing long term investors, Shepard said, unlike macro volatility which is less of a systemic risk and more of a “bump in the road.” These risks cannot be managed by looking in the rear view mirror, he said.

Ding Li said mean-variance optimisation has been key in past decades for portfolio construction because it provides a useful perspective, but it is not the optimal choice for long term investors.

The study shows, for example, that with a ten year horizon, bonds are resilient to only one scenario–a demand shock–but not for other scenarios. Infrastructure, on the other hand, shows balanced resilience across different scenarios. But mean-variance approach will tell investors that bonds are a very good all-round diversifier based on the past 20 years of negative correlation between equities and bonds.

“Our portfolio does show relatively better resilience across different scenarios, but the cost is, if you’re focussed on a short-term volatility risk profile, our portfolio has higher volatility than a traditional mean-variance portfolio,” Li said.

Markets are facing an “evolution, not a revolution,” and asset returns are likely to improve over the next ten years, despite a range of challenges facing global markets, argued Wylie Tollette, chief investment officer at Franklin Templeton Investment Solutions.

For 10 to 15 years the traditional balanced investor has seen fixed income delivering “return-free risk,” despite being a significant portion of the portfolio, said Tollette, in a lively panel discussion at Conexus Financial’s Fiduciary Investors Symposium held in Singapore. Tollette’s projections clashed somewhat with those of Craig Thorburn, director, CIO’s office, at Australia’s Future Fund. 

“At a broad level, we see fixed income, because of concerted and coordinated central bank activity, in decent shape for the first time in a long, long while,” Tollette said.

Every year Franklin Templeton Investments holds a formal, forward-looking exercise that brings together asset class experts from across the firm, including quant equity teams, to give a ten-year capital market expectations forecast. The exercise uses a mean variance optimisation framework as a starting point, then brings in expert views to make it more forward-looking and cover variables that are harder to predict, Tollette said.

Despite some “scary” global developments taking place in the geopolitical sphere, Tollette said “over the long term I’m pretty positive on returns, with perhaps even a lower-risk portfolio meeting a lot of investors’ expectations over the next ten years”.

Tolette said that in the 1980s a relatively low-risk public pension portfolio with a 30-70 split of equities and fixed income respectively, was able to achieve its desired rate of return without increasing risk. But for the next 35 years, this portfolio had to add risk to achieve its desired returns, Tollette said.

A cool new normal

Times have again changed, and “for the first time in many years, what I’m seeing, looking at our forward-looking ten years, is many plans are going to be able to achieve that rate of return, 7 or 8 per cent, without adding risk,” Tollette said. “That is a cool new normal.”

Inflation pressures “are likely to continue a little bit” and inflation may move slightly higher, but the firm has a low level of conviction around this because demographics are “pulling in the other direction, there are going to be fewer people buying most of the stuff in this world and driving inflation–at least goods inflation”.

However there could be continued developed market inflation pressure on services, wages and shelter which is proving to be “sticky”, Tolette said.

Asset risk premiums rose in 2022, he said. “It’s just simple math right, when markets fall 25%, forward looking returns look better, and we see that almost across the board.” 

The main difference in the coming years is that policy makers will be more constrained, particularly on the fiscal side. 

“US is nearing its debt levels,” Tolette said.

“It really can’t continue to do that and expect to be the worlds reserve currency, it can’t continue to borrow like it has been.

“And many other countries are in a similar spot. It’s going to be harder for many developed governments to respond [with fiscal levers] in the same way.”

But broadly speaking, markets are predicted to be in better shape, he said. “So a typical 60/40 portfolio from the last several years has returned a heart breaking 3.8%,” Tollette said. “That was our expectation last year. Now that same portfolio is closer to 6%. It’s doing much better.”

Private assets will also see positive returns, but the caveat is “we assume in these returns that you are able to avoid the bottom quartile of managers in private assets”, Tollette said.

“That’s a big assumption,” he said. “If you don’t do that, if you cannot avoid the bottom quartile of private asset managers, you shouldn’t invest in private assets at all.”

Returns much more challenging

Craig Thorburn, director, CIO’s office, at Australia’s Future Fund, was less sanguine. Thorburn said markets are facing a new paradigm which will make returns much more challenging in the years ahead, due to issues such as de-globalisation, demographics moving from a tail to a headwind, policy and political populism, inflation, and the role of bonds in portfolios.

Thorburn said the Future Fund has been increasing its bonds exposure over the last six to nine months, seeing them as a defensive anchor in some scenarios like a “traditional downturn”, but not necessarily in an environment of geopolitical tensions and coordinated fiscal and monetary pressures on the economy, which is forcing investors to “consider aspects that are non-traditional”.

“Our concern is that in that environment, bonds may not be the anchor that you may have relied upon for last 20 to 30-plus years, particularly when you consider that in that environment there has been the fantastic tail wind of declining nominal yields,” Thorburn said. “We’re just not so sure that is in our future gong forward, even though pricing today is definitely better than it was, say, a year ago.”

The Future Fund has looked to other asset classes like alternatives, in particular hedge funds, which it sees through a defensive lens. If investors can avoid the bottom quartile for hedge fund investments, they can achieve uncorrelated returns, Thorburn said.

“We’ve been fortunate enough to have had that happen to us in the last year or so,” he said.

“There have been incidences where that hasn’t occurred, but over the long horizon, we’ve been very fortunate in our manager selection, that we can say hand on heart, that asset class, alternatives, hedge funds…that’s worked really well for us.”

Private debt is also providing some “interesting alpha opportunities,” and providing a lot of value to portfolios, he said.

“It may not be overly defensive when you look at some of the exposures you may need to have,” he said, “but it’s an important part of what we will consider to be more resilient or stronger allocations.”

“A long-term investor sells when it wants to, not because it has to.” This is an especially clear and succinct definition of long-term investing. Long-term investing is about how the institution behaves, not a fixed time period.

The Silicon Valley Bank collapse provides an object lesson.

We have seen crises arise twice over the past six months in seemingly long-term portions of the market: UK pensions, whose funding levels far exceed those in the US; and now in the SVB-banked private equity community, whose partnership agreements commonly extend to seven years or longer. The same underlying behavior led these ostensibly long-term institutions astray. Each took an uncompensated – perhaps even unknown – bet that public-debt trading would remain within a manageable range of those bonds’ terminal value.

To put it plainly, they may have had strong plans for how to thrive in the long run but overlooked what it would take to survive along the way.

Emergency action by the FDIC is now the only thing standing in the way of businesses backed by private equity being stopped out, which undoubtedly would ripple through GPs’ performance and LPs’ asset allocation. These institutions mean to outperform public markets over decades and catalyze the next generation of innovation, including addressing societal urgencies like mitigating climate change.

But they failed to notice that their banks could not meet their portfolio companies’ withdrawals without a fire sale of public debt holdings if interest rates were to rise – as they have for the past year.

In the same vein, the UK government had to offer emergency accommodations last fall when pension investors neglected to notice something similar. In the interest of smoothing their short-term performance on paper, pensions throughout the UK took derivative positions in the public debt market, but without the liquidity to cover capital calls that would result from the same sorts of interest rate increases.

Paradoxically, focusing only on the long term is one of the most devilish short-term behaviors. It nearly collapsed these institutions, and the regional banking crisis is still unfolding in the US. They missed the first step of long-term behavior: be ready to survive the short term.

Perhaps intuitively, many mistake the short term as merely a piece of the long term and assume that optimizing for the long term means being in a position to succeed in each smaller time period within it. False. The long term is not just a series of short terms.

Think about it like a flight. All else equal – same model airplane, for instance – are you more likely to encounter turbulence on a quick hop between nearby cities or on a transoceanic haul? It’s the latter, of course. The transoceanic flight will cross through a wider variety of atmospheric conditions, just like the long-term investor will encounter a wider variety of market conditions.

Many will claim that these rate-related crises were still unforeseeable. Who could have expected that higher interest rates would hurt pensions, when all the ordinary evidence is that they help – or that these rates would matter at all for short-term liquidity in private markets?

These claims are being made by those who misunderstand the risks being encountered. Rates are merely instrumental. These crises really are about some market participants failing to anticipate or appreciate the foreseeable behavior of other market participants. In other words, it is counterparty risk flavored by specific circumstances.

It is the risk of expecting other people to behave like cold, rational computer models instead of panicked humans who do things like run banks or cover derivative positions by realizing long-term holdings.

Richard Bookstaber writes about this exact dynamic in The End of Theory, drawing on his hard-earned scars from the 2008-09 crisis. The gist is that, when people around you in the market act in ways that surprise you, you can surprise yourself in how you respond. Surprise in this sense is never good and always short-term. It is selling assets when you must, not when you choose.

Long-term investing now sounds a lot harder. No one intends to sell before they want to. But it happens because the only way to avoid it is by anticipating the market behaviors of everyone around you, as well as your own. Long-term investing is realizing that you too can panic – and then putting systems in place beforehand so that you don’t.

Matthew Leatherman is managing director, programs, for FCLTGlobal

It is inaccurate to refer to rising US-China tension as a “new Cold War,” according to a former permanent secretary of Singapore’s Foreign Ministry, as both countries are “vital and irreplaceable components of a single system” with supply chains that are unprecedented in their density, complexity and scope.

In a discussion about the future of capitalism and how the West can adapt to a rising Asia, Bilahari Kausikan, now chair of the Middle East Institute at the National University of Singapore, said the US and China will most likely continue to compete fiercely for advantages while trying not to disrupt the system too much.

Kausikan worked in Singapore’s Foreign Ministry for 37 years in a variety of appointments including ambassador to the Russian Federation, permanent representative to the UN in New York, and permanent secretary to the Ministry.

Speaking with Amanda White, director, international at Conexus Financial, at Conexus’ Fiduciary Investors Symposium held in Singapore, Kausikan began with an anecdote about former Chinese leader Deng Xiaoping–who pioneered China’s opening up to world markets after the devastating era of the Cultural Revolution–meeting Indian Prime Minister Rajiv Gandhi in 1988, when speculation had begun about the 21st Century being the Asian Century. 

Deng said he didn’t believe it, according to Kausikan’s description of notes from the meeting. It could only be the Asian Century if India and China get along and grow together, he reportedly said, before naming a range of other important countries, not all of them in Asia.

“China is rising, but it is not rising in a vacuum,” Kausikan said. “It is rising and becoming increasingly important component of the global economy, and cannot be separated from the global economy.”

The global economy is under stress but Kausikan said he does not think it will fragment or break, despite the world returning to “a relatively normal period of contested order.”

The so-called “rules-based order” has always been contested, and sometimes violently, throughout history, and the period from the Berlin Wall falling in 1989 through to the Financial Crisis in 2008 was a “short, abnormal period…when the overwhelming dominance of the United States made it seem as if its conceptual order was the only possible conception of order.”

The war in Ukraine is likely to be a long war, he said–continuing for several more years at least–but it is a “second order issue” when the first order issue is US-China relations.

He said he gets irritated every time he hears talk of a “new Cold War.” “That’s a very intellectually lazy trope that fundamentally misrepresents the nature of this competition,” Kausikan said. “The US and the former Soviet Union each led two seperate systems which were connected only at their margins. Their main common interest was to avoid mutually assured nuclear destruction.

“By contrast, the US and China are both vital, irreplaceable components of a single system, and they are connected to each other, and the rest of us, by a historically new phenomenon. That phenomenon is supply chains, of a density and complexity and scope never before seen in history.”

While there will be bifurcation in certain domains, particularly high-tech domains with national security implications, this complex web can never bifurcate completely into two seperate systems, he said.

The US and its allies, for example, hold all the crucial nodes in the semi-conductor supply chain. But China is 40% of the global semiconductor market, and “you cannot possibly cut off your own companies and those of your friends and partners from 40% of the market without doing them grievous damage,” Kausikan said.

The US will therefore need to be discriminating in how it applies legislation that limits the transfer of technological goods to China, he said.

And China may be keen to rely more on domestic consumption to drive growth, but “that’s easier said than done, so for the foreseeable future they will have to compete within the same system,” he said.

Both sides will, therefore, be keen to gain advantage over the other competitor “without disrupting the system too much.”

He also said he did not believe China was “eager to use force to re-unify Taiwan.” China “simply doesn’t have the capability either in hardware or software,” he said. It will eventually acquire this ability, but will still be aware that amphibious operations are extremely difficult, and the only country with great experience in these operations is the United States.

An invasion of Taiwan would be “a tremendous gamble for the CCP,” he said. If it failed, Chinese leader Xi Jinping would be unlikely to survive in power, and the foundation of the legitimacy of the Chinese Communist Party would be shaken. 

Some of the biggest tailwinds of recent decades are now turning against global economies, forcing funds to find new ways to adapt, according to a panel of investment heads of sovereign and pension funds. 

Speaking at Conexus Financial’s Fiduciary Investors Symposium held in Singapore, leaders from sovereign wealth funds in Singapore and Malaysia, along with United States pension giant CalSTRS, discussed how investors are viewing global macro risks and opportunities, and strategies they are considering to future-proof their portfolios.

Bernard Wee (pictured), group head of markets and investment at the Monetary Authority of Singapore – one of Singapore’s three sovereign wealth funds – said that in the last 30 to 40 years, the global economy had benefited from “three very big tail winds,” all of which are now turning into headwinds. 

In the 1980s it was demographics, but population growth is now slowing. After reaching a global population of 8 billion last year, the next billionth person on Earth will take longer to arrive than the last billionth, for the first time in history, Wee said.

In the 1990s there was the peace dividend after the Berlin Wall came down, but now geopolitical tensions are rising again. And in the early 2000s increased trade and globalisation spurred economies, but trade volumes as a share of global GDP have fallen over the past decade.

Portfolios need to adapt to this new reality, Wee said, with a higher allocation to inflation protection that is “more customised” in terms of its composition of assets. 

For example, inflation-linked bonds (ILBs) performed worse than nominal bonds last year, which was partly due to “the unintended duration exposure you had in ILBs which tended to be much longer bonds than your nominal index.” Investors could also consider adding more gold as a tail-risk hedge.

Investors also need greater “granularity” within each asset class, he said. For example, a commodities benchmark gives a significant exposure to energy, but the details count.

“Energy has done well in the last two years, but you need to think about–with the green transition coming–do you really want such a large exposure to fossil fuels?” Wee said. “Or do you think that industrial metals, for instance, which has typically not been a larger part of the index, could be a bigger part of energy storage or energy transportation?”

There will also be a “redistribution of trade” as trade falls, and there will be winners and losers in emerging markets that were “the winners of growth in the past 20 years,” Wee said.

Scott Chan, deputy chief investment officer at CalSTRS, said inflation could wipe out the four percent earnings yield of the US equity market in the coming few years. “If 40% of the CalSTRS portfolio is starting right now in a negative real yield on earnings–possibly zero over a period of time…that’s sort of a bad setup,” Chan said. 

In response, the fund had been seeking opportunities in other asset classes like real estate, infrastructure and fixed income, and also increasing the amount of private credit. CalSTRS would likely double its allocation to direct corporate private lending over the next four years, he said.

“Probably the largest area that’s scalable for us, which we’re going to be really following into, is direct corporate private lending,” Chan said. “I think a lot of people in the crowd are seeing the same thing. Mid-teens returns, lower default rates, and the opportunity to select high quality companies.”

And with investment opportunities not always fitting neatly into categories, the fund also planned to increase its opportunistic portfolio from the current 0 to 2.5% of the fund, to 0 to 5% of the fund, “to give us more flexibility to pursue those opportunities,” Chan said.

Some of the funds in the opportunistic portfolio would be used to scale existing investments, he said, due to a shortage of new opportunities. “We’re not finding a ton of opportunities because we think prices are going to go south from here,” Chan said.

Having reduced fixed income in recent years, the fund is also considering tilting back in as yields have improved. 

“Right now we’re not doing that, we’re actually just raising cash because we’re getting a fair amount of yield on the short-term piece of it, but I think in the long term we might decide to flow a little bit more back into fixed income,” Chan said.

Wai-Seng Wong, head of strategy and asset allocation at Khazanah Nasional Berhad–Malaysia’s sovereign wealth fund–said Khazanah was set up in the 1990s as a vehicle to hold privatised government entities, which had since evolved into listed companies. The fund changed its approach around 2004 with a greater focus on growing value across the portfolio – not just preserving value – by actively managing the portfolio companies as a major shareholder, and working on mergers and restructuring.

“That’s really how we view building portfolio resilience, because the reality is, close to half of what we have in our portfolio are these kinds of assets–domestic or regional assets that perhaps require a bit more intervention–where we hold substantial stakes, whether it’s 10%, 20%, sometimes 60%,” Wong said.

There are some “bright sparks,” but also some “old-economy companies in various sectors,” and the fund has a critical role in driving reform and performance, refreshing boards, holding management accountable, and pushing for capital expenditure and strategies to future-proof industries, he said.

It is critical for stakeholders in all nations to find nuanced ways to navigate rising tension between the US and China, with 80% of the world’s population living outside these two nations, argued Danny Quah, Dean and Li Ka Shing Professor in Economics at Lee Kuan Yew School of Public Policy at the National University of Singapore.

If the future moves towards two bifurcated realms where the only choice for smaller powers is to decide whose sphere of influence they fall into, the third nations of the world “will have surrendered our agency to the interests of great powers who are much more interested in a zero sum game of ascendancy,” Quah said, in a talk examining the future of the global economy and the role of Asia. 

Speaking with Amanda White, director of international at Conexus Financial, at Conexus’ Fiduciary Investors Symposium held in Singapore, Quah said “the great powers will not figure it out well without us getting involved.”

“Unless we get into the thick of that and help determine the way forward based on cold, hard-nosed, grim analysis of economic circumstances, if we leave it only to a political narrative of confrontation between democracy and freedom versus tyranny and authoritarianism, the solution won’t be a happy one,” Quah said.

In a provocative talk containing hard truths for both major powers, Quah began by looking at a news headline in local finance wires which talked about Singapore investors needing to “walk a fine line” amidst rising tensions between the US and China. How did things change so quickly from an “age of innocence and healthy optimism [where] we all thought Asia was the future?” he asked.

He presented a global map plotted with the “economic centre of gravity,” which was the average location of the planet’s economic activity, measured by GDP generated across hundreds of locations on the Earth’s surface. Beginning in the 1980s, it began shifting east, away from London and New York, crossing the Arabian Peninsula and ultimately after 2010 settling roughly on the GMT+8 timezone of Beijing (and Singapore).

But optimism began to morph into tension as the political situation shifted alongside the economic landscape, with the growing sense in Asia that the region did not have global decision-making power commensurate with its size.

“The smallest circle that can be drawn on the Earth that contains half the world’s people is this circle centred on GMT+8,” Quah said. 

“If you think peoples’ awareness, choices, political decisions matter, then grew the idea that if the world were truly a democracy, this is where it would begin to make decisions of global significance,” but this was clearly not where global decisions were being made.

China’s increasing aggression and “bullying attitude” has not helped its case, Quah said, pointing to the “Wolf Warrior diplomacy” famous among its diplomats and spokespeople, and its cross-border territorial aggressiveness in the South China Sea.

This undermined trust in Beijing’s narrative that it respected national sovereignty, to the point that when Russia invaded Ukraine, and China sent humanitarian aid to Ukraine without sending military aid to Russia, the United States was still able to easily spin a narrative about China being on Russia’s side, he said.

There is a lot “in play” over the next few years and governments and investors should avoid “sudden moves,” Quah said. 

It is still “up in the air” whether the US or China will lead on the key technologies for the future, with some analysts finding China is leading the US on most key future technologies. And China manufactures a large proportion of the world’s wind turbines, solar panels and lithium ion batteries critical for the green transition, and cutting off China will pose major challenges for the global zero-carbon transition.

“In the midst of this great power rivalry, we need all the help we can get to carve out a future that works well for all of us,” Quah said.