The United Kingdom’s University Superannuation Scheme, USS, has developed several strategies to protect the portfolio from inflation. These include a comprehensive interest rate and inflation hedging program alongside investing in assets that are sensitive to inflation including infrastructure and emerging market inflation linked bonds. Another source of return this year has come via USS’s active currency allocations, continued Mirko Cardinale, head of investment strategy, USS, speaking at FIS Maastricht.
USS doesn’t set an FX hedging policy, but independently decides its appetite for FX risk and the appropriate mix of currencies. “Having a diversified portfolio of the main, liquid currencies with a focus on more defensive currencies including the euro and yen, has been very helpful,” he said.
At USS, governance is structured to ensure enough flexibility to respond quickly to changes in the environment, an agility that is also enabled by the pension fund’s inhouse team and derivatives expertise, said Cardinale.
USS uses leverage to hedge its interest rate risk, and protecting the portfolio from the recent sharp move in UK interest rates has been challenging. However, the pension fund has remained resilient partly thanks to a framework that provides risk analysis going back to the 1970s. “We are conservative, and took action before things got difficult,” he said. The framework provides a basis on which to balance liquidity and collateral and is operated by the in-house team. “We moved assets to rebalance without a major issue,” he said.
APG: the impact of interest rates
Investment strategy at APG Asset Management, the largest pension provider in the Netherlands, is currently focused on the impact of reform in the Dutch pension sector. Laws, about to be approved in Parliament, could impact asset allocation if regulatory restrictions on taking risk are eased. Reform may also lead to pension portfolios becoming more transparent, allowing individuals to better see the volatility in their pension pot. This could have the effect of making strategies more defensive, predicted Onno Steenbeek, managing director, strategic portfolio advice, APG.
On one hand, rising interest rates might lead to bigger allocations to interest rate swaps and hedges, but on the other, such allocations may not be necessary in a new system.
“If we move the portfolio in one direction, is there a chance we have to reverse that move?” he asked.
IMCO: a focus on inflation
Strategy at Canada’s $79 billion Investment Management Company of Ontario, IMCO, is similarly focused on inflation where fellow panellist Rossitsa Stoyanova, CIO, IMCO, said the investor’s 5-10-year outlook predicts a higher and more volatile role for inflation ahead.
“We do think given what is going on in the world that structurally inflation will be higher or more volatile. There will be cycles where inflation overshoots and needs to be bought down.”
IMCO doesn’t have a tactical or dynamic asset allocation and is focused on long term trends. However, a broad mandate allows the team to move tactically when needed. The investor has increased its allocation to inflation linked bonds and continues to build investments in real estate and infrastructure.
“We are looking for more inflation linked assets in infrastructure,” she said.
Away from inflation, Stoyanova noted how heightened levels of volatility will provide an opportunity for active investment. Indeed, she noted that beta will be increasingly challenged. The fact that integrating ESG and sustainability is increasingly difficult in passive strategies, also builds the case for active investment. IMCO is building its private market capabilities and wants to invest more in the energy transition.
“We are building expertise to invest alongside strategic partners,” she said.
the importance of Modelling
At USS, strategy includes frequent scenario analysis. Rather than hunting for probabilities, analysis focuses on playing out different scenarios and exploring portfolio implications across the main asset classes to reveal resistance in the portfolio.
“This is a better use of time,” said Cardinale.
Similar scenario modelling at APG reveals an ever-widening possibility of outcomes. Steenbeek noted that although risk scenarios are helpful in explaining what could happen, they are difficult to apply to an actual asset allocation.
“What is good in one scenario is bad in another,” he told delegates. “Do we cover the whole spectrum of possible outcomes?” Elsewhere he noted how higher interest rates have led to discussions around higher interest rate hedges and liquidity at APG.
Stoyanova outlined the challenges of designing a long-term portfolio around stagflation. “A portfolio just needs to withstand stagflation,” she said.
She noted the risk of private markets lagging public markets after a sell off. She also said that every time IMCO considers investment opportunities in private markets, the team also compares the risk and return in public markets, discussing if they would do better buying the public market as it may be at a discount.
Private markets must outperform because of the illiquidity factor, and because investments may contain leverage or involve restructuring, she concluded.
“We recognise this, and require a spread over the benchmark,” she concluded.