Rebalancing back to asset class strategic ranges after a market rise or fall is one of the most vital seams of strategy at the $70.1 billion Los Angeles County Employees Retirement Association (LACERA). Rebalancing ensures the investment team remain consistent with investment policy statements, don’t try and time the market and avoid behavioural bias.

“Rebalancing really is the best long-term strategy we have,” said chief investment officer, Jonathan Grabel, speaking in a recent board meeting at the fund.

Rebalancing forces the investor to sell when asset prices have gone up and buy when they have gone down to stay within asset class bands in a strategy that has come to the fore in today’s volatile and unpredictable markets. In stark contrast to December 2022, all major asset classes have climbed higher in January in a lock step trajectory that is a source of alarm for Grabel, telling board members that he is instinctively cautious when asset classes move in tandem in either direction.

The rules-based approach removes the temptation to follow trends and media fads – it avoids the tendency to follow strategies that “worked yesterday,” he continued.

It led Grabel to reflect on the importance of avoiding peer comparisons and rankings too. His focus is on LACERA’s actual performance versus the benchmark, for the investor to “run its own race” and focus on its ability to pay benefits to members. “Peer ranking is not really related to our mandate,” he said.

According to its latest annual report, LACERA’s 2022 target asset allocation comprises a 51.1 per cent allocation to to growth (global equity, private equity and non-core private real estate) 11 per cent allocation to credit, 17 per cent allocation to real assets and inflation hedges and a 21 per cent allocation to risk reduction and mitigation.

The pension fund’s cash levels currently sit around $900 million, equivalent to around three months-worth of benefits.

“Any cash above this is used to stay invested and rebalance,” he said.

Risk management

LACERA’s investment team is midway through a review of operational due diligence processes in a bid to improve risk management. Recent horror stories at JPMorgan Chase, now suing executives at recently-acquired startup Frank for creating nearly 4 million fake customer accounts, illustrate what can go wrong and underscores the importance and timely nature of LACERA’s review.

“Diligence is the place even the best investors can fail,” said independent board member Gina Sanchez.

So far, the process has already tightened operational effectiveness. For example, historically LACERA’s investment division was siloed into individual asset class teams. Now two new teams focused on portfolio risk management and asset allocation, and corporate governance and stewardship across the portfolio work alongside the asset class teams.

Elsewhere, new technology is supporting the risk function, developed internal investment committees are helping standardize processes and operational due diligence assessments are included in all investment recommendations.

LACERA also appraises properties in the real estate allocation annually rather than every three years. Other incremental changes include a daily NAV with a custody bank.

“We are focused on trying to have consistent procedures,” said Grabel, who told the board providing relevant material to the consultants is a time-consuming process but wholly in line with the investor’s “mantra of continuous improvement.”

“It will help us be better investors,” he concluded.

 

Despite a challenging few years, countries across the Asia-Pacific region are entering 2023 with some momentum. Easing pandemic conditions and improved mobility have boosted domestic demand and retail sales. The region has also enjoyed strong export growth, most notably across South-East Asia.

The diversification of global supply chains away from an over-reliance on China has seen a number of beneficiaries, particularly in South-East Asia and India. Asia also has a gigantic pool of tech talent leaving countries well poised to tap cutting edge growth industries.

But 2023 will be characterised by stronger headwinds that are predicted to slow growth. With the European Union entering recession and low growth forecast for the United States, countries across the region will no longer enjoy the export boom of recent years.

Inflation and the response of central banks will also cast its shadow, disproportionately hitting balance sheets in countries where households and businesses are highly leveraged.

This year will also see the continuation of geopolitical concerns dampening market enthusiasm. An escalation of the war in Ukraine could deepen the impact on commodity prices. North Korea has rejected overtures from South Korea and is likely to continue with its nuclear development and testing.

China’s domestic economic problems could, conversely, see it adopt a more conciliatory approach to diplomacy and ease geopolitical tensions somewhat.

The Economist Intelligence Unit forecasts regional growth of 3.5 per cent in 2023 which is marginally slower than 2022 and significantly short of the pre-pandemic trend of 4 to 5 per cent.

Rising cost of debt

With the exception of China and Japan, central banks across the region increased their policy rates over 2022 to tackle inflation and support local currencies, and the impact of these increases will mostly be felt in 2023.

Countries with high levels of household debt – such as South Korea and Australia – will be hard hit, with the EIU giving below-consensus GDP growth forecasts of 1.3 per cent and 1.5 per cent for Australia and South Korea respectively. The high household debt levels of Malaysia and Thailand will also drag on these economies somewhat.

Higher debt servicing costs will “add to the squeeze caused by the higher consumer and producer prices generated by the war in Ukraine,” EIU said, and hit consumer spending and business investment.

Conversely, the gigantic emerging markets of Indonesia and India both have low household debt levels, as does the advanced economy of Singapore, and these markets are less likely to be impacted by forced household deleveraging.

Uncertainty across South-East Asia

Investors have been keenly watching South-East Asian nations as manufacturers seek alternative destinations to China. The region has seen a boom in physical and digital infrastructure, while mega-regional free trade agreements have helped smooth supply chain linkages.

But political risk will increase uncertainty, and conditions will depend on how countries navigate their own individual challenges. Thailand faces a highly contentious election this year, and if forces loyal to exiled former prime minister Thaksin Shinawatra gain the upper hand, controversy and discord are likely to follow.

Malaysia saw an indecisive outcome to its November 2022 election, with hopes that a “unity” government led by Prime Minister Anwar Ibrahim may bring new energy and reforms, but also fears long-running instability will continue.

The large and diverse country of Indonesia is also gearing up for an election in 2024, and electing leaders in over 270 provincial, district and city governments simultaneously in November 2024 will be no mean feat.

“With negotiations and coalition-building dominating the political agenda, the Jokowi government may become a lame-duck sooner than expected, even though his term continues until October 2024,” writes Hana Satriyo for The Asia Foundation.

India to gain ground

India may be a beneficiary of instability in South-East Asia and investor concerns about China, which may enable it to draw greater numbers of global manufacturers looking to relocate.

India has a large and youthful labour market, and EIU notes “incremental progress in addressing weaknesses in terms of transport infrastructure, taxes and trade regulation.” The EIU now ranks India above China in its global business environment rankings.

Investment has accelerated in India’s electronics sector, which the country has previously struggled to cultivate, aided by government support. Electronics exports rose by around 50 per cent to $14 billion in 2021, and had matched that value over the first nine months of 2022.

Taiwan’s Foxconn, an Apple supplier, is among others planning significant expansion in India. India’s presidency of the G-20 in 2023, and its likely conclusion of bilateral trade agreement negotiations with Australia and the UK, will further strengthen its hand.

China’s long road back from Covid-zero

Continued weakness in China’s property market, and the impact of weak international consumer demand on Chinese exports, will continue to put pressure on China’s economy, according to the Asian Development Bank’s Asian Development Outlook.

While easing pandemic measures have given much of the region a running start into a difficult year, China is only beginning this journey, and a smooth transition back to normality is far from certain.

The EIU cautiously forecasts China’s economy to grow more quickly in 2023, but also notes several significant members of Xi Jinping’s new leadership team, notably the incoming premier Li Qiang, lack experience running the organs of China’s central government.

Challenging domestic circumstances could persuade China to ease its increasingly combative approach to international relations, which has impacted China’s economy due to sanctions, trade tariffs and heightened geopolitical risk, and led to a rising aversion from international firms to expand business operations in China.

“While China is not about to conduct a foreign policy U-turn, especially with Mr Xi still in charge, we believe that it will seek more favourable international conditions in 2023 as it manages domestic challenges,” says the EIU.

The return of big-spending Chinese tourists will be widely welcomed across the region, but so far, numbers have been anecdotally lower than expected even during the lunar new year.

Experts pin hope on technology

Asia has a gigantic pool of tech talent, producing a large proportion of the world’s STEM graduates according to the McKinsey Global Institute. Project Syndicate reports Asia has accounted for 52 per cent of global growth in tech-company ventures, and 87 per cent of patents filed, over the past decade.

The region shows strong development in next-generation electric-vehicle batteries, innovation in consumer electronics, 5G development, and digital information-technology services. Vulnerability to the effects of climate change is also driving an enormous push in technological solutions and renewable energy.

But technology gaps in the region remain significant and intra-regional collaboration and investment will be critical. The just-signed Regional Comprehensive Economic Partnership is likely to foster closer ties.

Global market researcher Forrester argues wise technology selection may help investors in the region build resilience and set the stage for future growth, pointing to digital industrial platforms, industrial metaverse initiatives, process intelligence, and automation and robotics as key areas to watch.

And with organisations in Australia, Singapore and India investing, supporting and championing cybersecurity startups and investment, there will be strong growth in cybersecurity startups which have previously been notoriously scarce in the APAC region, Forrester says.

The Fiduciary Investors Symposium in Singapore from March 7-9 will explore the importance of Asia in the global economy and the risks and opportunities in the region. To view the stellar lineup of speakers and to register click here.

If inflation subsides this year, 2023 could be a strong year for growth equities, according to Raj Shant, London-based managing director and equity portfolio specialist at Jennison Associates, a fundamental equities manager owned by PGIM.

Shant said 2022 has been “a terrible year for growth equity investing, probably the worst in absolute and relative terms for a couple of decades,” in a conversation with Conexus Financial managing editor Julia Newbould on the ‘Market Narratives’ podcast.

This was because an upward drift in inflation expectations through the year was bad for growth equity valuations, with a sharp downward adjustment in prices despite earnings for most growth equities continuing to come through, Shant said.

Consequently, growth equities have lost the valuation premium gained during the pandemic in 2020 as well as during outperformance in 2018 and 2019, and returned to relative valuations that were below the long-term average, he said.

Last year was a very difficult year, but it does mean that we are now going into 2023 at a lower than long-term, average valuation, Shant said, “an environment where the expectations for inflation and interest rates globally may have peaked.”

Companies that show the fastest sales and profits growth will be strong contenders to generate the best returns for investors in 2023, he said, if interest rates stabilise or start to be reduced. Whether that will happen is “up to each individual listener or reader to decide for themselves,” he said.

Investing successfully in growth equities requires active investment with strong bottom-up research, Shant said, pointing to Jennison Associates research which shows market expectations for which companies will be the fastest growing companies over the next five years are wrong 80 per cent of the time, when compared with the fastest growing companies in the market over five year rolling time periods.

“You don’t have to be exactly right, you just have to be more right than the market,” Shant said.

Different growth companies can have different characteristics that lead to different risk and reward profiles, Shant said.

What he termed “emerging growers” are younger companies that typically have more upside potential but also more risk and volatility in their growth. These could include cloud-based applications companies which invest in products, R&D and marketing at the expense of short-term profits.

“Stable growth compounders,” on the other hand, are larger companies with more mature growth rates that offer lower volatility and less risk. Examples of these companies are famous global luxury brands, and healthcare companies, Shant said.

In periods where interest rates and inflation expectations are relatively stable, emerging growers will often outperform. But in periods like 2022 where interest rates are rising or the backdrop is more risk-averse, stable growth compounders tend to outperform emerging growers.

Fintech in emerging markets is one of the biggest growth opportunities in the world at present, Shant said, owing to the incumbent banks tending to be more bureaucratic and cumbersome with less investment in consumer experience on their websites, apps and customer service.

Luxury goods also have strong growth prospects owing to emerging middle classes in major markets like India and China, and a desire among younger consumers to get “entry-level luxury goods” promoted by celebrities and influencers on social media.

Electric vehicles are also promising, Shant said, with huge growth over recent years, superior safety and driving experiences and strong environmental credentials, but still extremely low penetration in terms of the global fleet of vehicles.

Norges Bank Investment Management has established a new climate advisory board. Carine Smith Ihenacho, chief governance and compliance  officer, spoke to Top1000funds.com and explains the task at hand.

What is the role of the climate advisory board?

The board will advise on NBIM’s approach to managing climate-related risks and opportunities, including the implementation of its climate action plan. It will advise on sustainable finance and climate risk developments, review and contribute to NBIM’s policies on climate risk and advise on the exercise of NBIM’s ownership rights and the appropriate approach to companies, including on voting and dialogue, related to climate risk. It will advise on NBIM initiatives to develop market standards on climate risk, including approaches to regulators and other standard setters. The board will also be responsible for assessing and evaluating NBIM’s climate-related activities, results and reporting against NBIM governing documents and international best practice.

What is the rationale for setting up this advisory board now?

Setting up a Climate Advisory Board is part of the steps we outlined in our Climate Action Plan 2025 last September to be a leader in manging climate-related financial risks and opportunities. As a long-term and globally diversified financial investor, our return depends on sustainable development in economic, environmental and social terms. We will be a global leader in managing the financial risks and opportunities arising from climate change.

The Climate Action Plan sets out the actions we aim to take over the period 2022-2025. These actions are targeted at improving market standards, increasing portfolio resilience, and effectively engaging with our portfolio companies. At the heart of our efforts is driving portfolio companies to net zero emissions by 2050 through credible targets and transition plans for reducing their scope 1, scope 2 and material scope 3 emissions.

This is an ambitious plan with a focus on engaging our investee companies to change. We are convinced that we will benefit from the reflections by the board members and their support helping us implement the plan. Climate change is a fast moving-field, and insights from the board members can help us respond to new developments and refine our approach over time so we maintain leadership.

How did you select the board?

We believe that managing climate-related risks as an owner of companies through the climate transition requires a holistic and evolving understanding of how climate affects the global economy and financial markets. We therefore focused in the selection process on identifying candidates with complementary knowledge and insights relating to climate change developments.

The chosen candidates together provide a wide breath of relevant climate expertise spanning academia, business, sustainable finance and civil society with insights into the US, Europe and the specific Norwegian context.

NIMB has appointed Professor Jody Freeman, Jennifer Morris, Huw van Steenis and Bjørn Otto Sverdrup as external members to the board. Jody is Professor of Law at Harvard Law School and an independent director on the board of directors of ConocoPhillips. Jennifer is the chief executive at The Nature Conservancy. Huw is vice chair at Oliver Wyman and was previously chair of the Sustainable Finance Committee at UBS. Bjørn Otto is the chair of the executive committee for the Oil and Gas Climate Initiative.

How will the board challenge NBIM, and how do you envisage the board influencing investment strategy?

The four board members all have a deep and complementing climate expertise. They pick up new developments relating to climate change and their different perspectives can help us evaluate when and in what way we should further develop our approach. Our investment strategy is set out in our mandate issued by the Ministry of Finance. The role of the board is to support us in further developing our approach to managing climate-related risks and opportunities as an owner of companies through the climate transition within the limits of our mandate.

 

For years, private equity investment has been relatively straightforward. Buy a company, turn it around and sell it at a profit. Today there’s blood on the streets in a changed market. Aggregate headline US private equity valuations may still be elevated, but the information is lagged and doesn’t tell the whole story, warned the Massachusetts Pension Reserves Investment Management Board (MassPRIM) investment team, speaking in a recent board meeting at the $92 billion asset owner.

IPO activity has slowed (only 74 companies listed in the US in 2022) and proceeds have fallen, resulting in a collapse in the exit market turning cashflows negative and leaving contributions outpacing GP distributions. Valuations have crashed, and financing has got more expensive for private equity buyers.

As the cost of capital has increased, bank lending has shut down for new LBOs: leverage loan volume is lower, spreads are wider, and the approval process is taking longer, doubling the cost of debt. It’s slowed the pace GP’s are investing; slowed fundraising and left many LPs with unfunded commitments (money committed but not invested) now reconsidering the amount they commit going forward.

“Many investors are finding themselves over allocated to private equity. Combined with the slowdown in distributions and reversal of performance, investors are going to be forced to make tough choices in 2023 and beyond,” said Michael McGirr, director of private equity at MassPRIM.

MassPRIM, however, is staying the course and continuing to commit to its best performing asset class. In line with a multi-year effort to slowly increase the allocation to private equity, it is adding an additional 1 per cent to its range (13-19 per cent) and continuing with current pacing, ploughing $2.2 to $3billion into new funds and co-investment opportunities this calendar year, convinced that opportunities lie beneath the market’s uncertain and volatile surface: valuations are becoming less expensive (particularly for tech companies) offering buying opportunities, and history shows that the best performance in private equity originates when other investors are cutting back.

But success will depend on a few key strategies. Vintage year diversification is essential, as is sticking to consistent pacing models that avoid increasing the allocation all at once.

Unlike many peers, MassPRIM can maintain pacing because its current allocation to private equity has remained comfortably within range. The average actual private equity weight from a sample of ten peer funds is 18.1 per cent versus an average weight of 15 per cent – based on available records, six out of nine pension plans are above their target weight.

As more LPs rethink their strategy, GP’s will increasingly seek capital outside their traditional asset bases. The tougher fundraising environment gives MassPRIM a chance to pressure GP partners on economic and governance contractual issues too. “We’ll be fighting these fights in the trenches. We will have successes to share, but don’t predict wholesale change in the structure of the industry,” McGirr told the board.

In a new strategy, the team will also focus on opportunities in secondaries, buying and selling fund positions from and to others for the first time in a bid to benefit from the change in the market. Elsewhere, co-investment alongside approved co-investment managers will remain a key strategy, a part of the allocation founded in 2015 that continues to grow in maturity and scale. “I expect to see deal flow in 2023,” said McGirr.

Risks

Widening the range holds risks, however. MassPRIM’s global equity and private equity allocation account for most of the risk in the portfolio which in private equity manifest particularly in write downs in valuations (growth private equity has been hit particularly hard) while distributions are also down because of weakness in the IPO market.

It’s left a heightened focus on the weight of private equity cash flow, and the liquidity profile, making the benefits of vintage year diversification particularly apparent. Combined, both private and public equity portfolios account for about 56 per cent of the market value of MassPRIM’s largest PRIT Fund and 80 per cent of the total risk. The investment team will look to cut the allocation to global equity if private equity goes outside the range.

Performance

The board heard how allocations to alternatives, hedge funds, private equity, real estate and timber have helped anchor the fund in the stormy environment. Looking ahead, risk adjusted, forward-looking returns appear more favourable given the welcome recovery in public equity and bond markets.

The investment team flagged the first signs of a reversal with data pointing to a cooling economy and moderation in inflation. Risks on the horizon include another spike in inflation and weak corporate earnings.

The economic picture is not deteriorating, and there is no expectation that the stock market will discount more than it has already. Other topics discussed include a mooted increase to US active public equity managers alongside growth managers in developed and international markets. Elsewhere the investment team have an eye out for credit opportunities and unique fixed income.

A market taker and unable to control geopolitics, pandemics or slowing economic growth, the only thing the fund can control is the design and composition of the portfolio. Diversification and low costs are key with risk, return and cost comprising the three essential pillars of MassPRIM’s investment programme.

MassPRIM is also poised to schedule the first board meeting of its newly convened ESG Committee. The pension fund has been working with partners at MIT Sloan on the Aggregate Confusion Project, an initiative to improve ESG measurement in the financial sector.

MassPRIM, which prides itself on having one of the leanest headcounts in the country compared to the size of the investment programme, is adding a deeper bench of talent. Staff will be added to help build the diverse manager programme, enhance reporting and oversee the ESG initiative, amongst other things.

Global trends are leading asset owners towards a new era of investing, argues the Investment Management Corporation of Ontario, IMCO, in a new research paper. One where it becomes increasingly difficult to rely on the past as a predictor of the future.

Primary themes that IMCO expects to play a significant role in driving returns over the coming decade represent an “inflection point” or reversal of previously entrenched trends. Examples include the end of “low for long”, a shift away from globalization towards on-/friend-shoring and increased reliance on the fiscal policy lever relative to monetary policy tools.

“The tides are now shifting, as politicians prioritize domestic employment as a means of addressing inequality. After decades of relative wage gains, emerging markets’ labour cost advantage has waned making the decision to move production to domestic shores easier for global businesses,” says the report.

That resulting disruption will likely be more severe for China than for the US, as China relies more heavily on the US for imports and external demand than the US. Globalization drove the steady decline in costs and prices worldwide over the past several decades, and its reversal, or slowing, could impart inflationary tailwinds as the world heads into a new macroeconomic regime.

In this new world, investors could stand to benefit from a greater exposure to inflation-sensitive assets such as regulated infrastructure, inflation-linked bonds, and commodities. Other economic and market implications include greater volatility, an expected capital-intensive investment “boom” and a growing scope for unintended or undesired passive exposures – all of which can shape investors’ decision-making at the strategic and/or active levels.

Elsewhere, fiscal levers and real economic priorities will take growing precedence over monetary policy and its financial variables of focus, predicts the report. Europe has the potential for the greatest change, as it wrestles with the challenges of a shared currency.

ESG

The potential for “stranded assets” will rise as governments, companies and consumers increasingly adopt cleaner technologies and energy sources at the expense of legacy ones. For example, new environmental rules and/or changing societal preferences could put conventional oil production at greater risk. The notion of climate-related winners and losers is also likely to arise in terms of geographies, with some locations better able to withstand and/or adapt to changing temperatures and weather patterns. As an example, some agricultural activities might shift to relatively cooler areas, or real estate along coastal areas could face elevated risks from rising sea levels relative to those located further inland.

Governments’ push to decarbonize economies as part of climate change mitigation efforts will be expensive, requiring significant capital investments as well as new technologies. Government interventions such as carbon pricing and other policy measures are also likely to drive up energy prices, adding further tailwinds to the global inflationary trend.

Technology

Advances in computing, automation, and other technologies have continued to accelerate. The increase in innovation has become global in nature, with advanced and emerging countries pushing technological frontiers.

This technological disruption is no longer confined to a limited number of market segments such as the software, hardware, and pharmaceutical industries, however. Industries that were not prone to disruption have also been affected. For example, the increase in on-line shopping and home delivery over the last decade has pushed established retail companies into bankruptcy and weighed heavily on retail real estate valuations. The world is only just starting to witness some of the disruption that these developments will bring to large segments of the global economy.

More generally, these technological advancements have coincided with the concentration of gains amongst a narrowing group of firms, consistent with the rise in importance of network effects within many emerging – often digital – sectors and the increased prevalence of winner-take-all competitive dynamics. When such economics are at play, the related value creation tends to flow to first movers and/or those who manage to become the “standard” setters, states the report.

Growth in private markets

Attracted by the resulting potential for superior risk-adjusted returns, a growing number of institutional investors are dedicating resources to private markets. At the same time, demand for/supply of such financing is growing as post GFC regulations have encouraged a move towards private market-based financing over traditional bank-based sources. The net result has been an expanding pool of investment capital seeking a similarly expanding set of private market opportunities. This trend is expected to continue as suggested by estimates from Preqin – a firm specializing in alternative assets data and insights – which foresee private capital assets under management (AUM) increasing at a rate of nearly 15% per year to approximately $18 trillion by 2026.

However, index investing’s growing popularity among retail and institutional investors masks the growing risks associated with these passive exposures, flags the report. It is prudent to continue to build the ability to provide index-based exposures in ways that align with investors’ ESG beliefs and limit the potential for undue concentration risk.

Finally, the report argues that idiosyncratic country drivers highlight the need to look beyond broad, relative economic growth rates – both past and prospective – when evaluating potential investments. History suggests countries’ GDP growth rates and domestic equity market performance exhibit only a very loose relationship over the past couple of decades. Clearly, other factors also matter and point to the need for a thorough assessment of potential returns, risks, diversification benefits and investors’ own abilities to outperform.

For these reasons, a research-driven investment process that allows investors to monitor and respond to the changing world around them is imperative.