Traditional fixed income has always provided protection in down equity markets, but it is less effective when rates are rising like today. Still, the $250 billion Florida State Board of Administration’s 18 per cent allocation to fixed income primarily comprising U.S. investment grade bonds remains the best way to protect the portfolio in today’s challenging macro environment, said Alison Romano, deputy CIO, Florida State Board of Administration.
Speaking in a recent meeting of the Investment Advisory Council, Romano explained how the fund is exploring a range of strategies to boost incremental yields across fixed income. Around 64 per cent of the fixed income portfolio is actively managed – less than peers. Romano noted the opportunity to take on more risk via expanding core plus and adding exposures to out of benchmark strategies like structured credit, bank loans, mortgage derivative strategies and short duration credit in a flexible and dynamic approach.
Elsewhere she outlined how the fund will continue to explore diversifying strategies that have the same “liquid diversifying” characteristics as fixed income to generate yield. These could include increasing leverage in real estate and allocating to insurance linked securities and managed futures. “These types of assets add an alternative risk premium and can kick-in in different types of market,” she said.
Since 2007, Florida has steadily pared its fixed income allocation from 29 per cent to 19 per cent (including cash) reallocating to diversifying strategies like strategic investments and real estate. Relative to peers, the retirement fund has a smaller allocation to fixed income than most, and Romano warned Council members that this involves a trade-off between risk and return. The higher allocation to equities and lower allocation to fixed income means the pension plan has experienced higher volatility than many peers: fixed income plays an important role countering risk on many levels, she said listing volatility, tracking error, downside deviation and correlation as a few.
Romano reiterated the benefits of fixed income as a vital source of liquidity, ensuring the fund can rebalance when stocks fall, pay capital calls and benefits. “If we can’t rebalance, we give up millions in capital gains,” she said. For example, fixed income played a key role rebalancing and providing liquidity in March 2020 when the pandemic broke. The fund rebalanced a total of $1.34 billion from fixed income to global equity in March 2020 when bonds also provided $634 million for benefit payments and capital calls needed at that time.
Strategy during the pandemic was the result of lessons learnt during the GFC. Back then the fund had a much higher risk budget and active exposures, and less liquidity which made rebalancing more difficult. After the GFC the fund reduced active exposure and the risk budget, building in more certainty around volatility and contributions.
She also discussed the pros and cons of other strategies away from fixed income to add diversification including increasing value exposure, non-US exposure and dividend yield strategies in equities. Yet she noted this approach increases volatility and tracking error and wouldn’t necessarily provide the protection the fund needs. She warned against increasing the REIT exposure – an alternative liquid allocation – due to its equity risk. Reallocating fixed income assets to liquid public markets will increase risk, she warned. “Without a change in asset allocation targets, reallocation of 5 per cent of the total fund increases risk approximately 50 per cent.”
Elsewhere, she said that putting on meaningful tail risk hedging strategies for the giant portfolio was challenging and expensive. It would require a willingness to pay the cost year after year to keep a hedge in place that might never be used.
The investment team has modelled the different risks ahead including rising inflation and equity volatility’s impact on annual liquidity needs. The models proved that fixed income gives the fund the flexibility to meet liquidity needs. “It did historically and will ahead,” she says. The models also showed that over long periods, fixed income is expected to have the lowest correlation to global equities relative to other asset classes and that fixed income will be a diversifier in negative market scenarios.
Turning to the performance of the wider portfolio, Romano said that over the last three years private equity fuelled by record deal volume, fund raising and distributions, has led returns followed by real estate where high performing investments include industrial and multi-family units. Romano also stressed the importance of not being over tactical, despite the darkening macro picture. For example, European investments recently looked like “good value” but a tactical call would have seen investments subsequently hit by the war in Ukraine.