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“Investors used to view their allocations to sovereign debt as rock solid, but growing risk now takes up a lot of our head space,” says Charlotte Vincent, co-head of fixed income at the United Kingdom’s £36 billion ($48 billion) master trust the People’s Pension, which has just under £2 billion ($2.6 billion) allocated to UK and US sovereign debt in its £9 billion ($12 billion) fixed income portfolio.

Three years after former UK premier Liz Truss’s budget catastrophically misjudged demand for her government’s debt, causing gilt yields to spike across maturities and forcing thousands of UK pension funds with LDI strategies to fire sell assets such as bonds and equities to meet collateral calls from banking counterparties, Vincent says the long shadow of the crisis remains.

The People’s Pension doesn’t have an LDI strategy but she is concerned about bond market volatility as the government continues to struggle to balance the books.

It’s still relatively straightforward for investors to forecast moves in the short end, referencing the part of the yield curve that plots interest rates over time and refers to bonds with maturities ranging from 1-3 years.

“The Federal Reserve and the Bank of England effectively control short-term market moves via their base rate policy,” she tells Top1000funds.com in an interview.

However, policymakers have less control over the long end which is subject to ongoing negative pressure, amongst which rising budget deficits is a growing source of volatility as well as long-term fiscal pressure like demographics.

In another negative trend, UK pension fund demand for long-dated bonds which has defined the market for decades is also shifting with the gradual move from defined benefits to defined contribution pension systems, creating less demand for the long end.

“Governments need demand for longer dated debt but there are fewer natural buyers. This is creating bear steepening at the long end – it’s gone up considerably and we are closely monitoring it,” says Vincent.

That monitoring has included creating more optionality to allow the investor to adjust the allocation between short-dated and longer-dated US treasuries and gilts, even though it is a passive strategy.

“We position ourselves within UK gilts and US treasuries to ensure we can move away from the long end if we think there are too many pressures, and then move back in. It is a constant discussion. We have given ourselves optionality so that even though it is a passive allocation tracking the index, we have set it out into maturity buckets.”

The Office of Budget Responsibility (OBR), a UK fiscal watchdog, projects that UK pension fund ownership of gilts will fall from 29.5 per cent of GDP in 2024-25 to 10.9 per cent in the early 2070s. The OBR estimates that private sector DB pension schemes, which are closed to either new entrants or further accruals, collectively own around £556 billion ($745 billion) of gilts, but as the members of these schemes retire or die in the coming years, these pension funds will liquidate their holdings.

And DC pension funds like the People’s Pension won’t be taking up the slack. Although the size of the country’s DC funds are projected to grow, they are unlikely to plough more into gilts and not enough to offset bond sales by DB funds.

For example, Vincent says the most likely fixed income allocation to grow at the People’s Pension is high yield and emerging market debt – currently at 5-10 per cent of the allocation – at the expense of sovereign debt.

“We are currently conservatively positioned in high-yield and emerging market debt, which are fully active parts of our portfolio. At present, we’re not seeing the right entry points, but these areas are under regular review and we could shift to a more risk-on position if the right opportunities arise,” she says.

“If we do make changes, we’d most likely go to trustees to increase high yield and emerging markets and reduce the sovereign allocation.”

The OBR has also warned that the UK government will need to pay a higher interest rate to draw more buyers like domestic DC funds and overseas investors into the UK gilt market if the DB pension sector’s holdings drop away.

Vincent acknowledges that reduced pension fund demand for long dated gilts could mean higher yields for investors, but she says the volatility is still an issue. “Everything has a price and as the long end moves, prices can become attractive. But right now the long end is in a state of flux, and this is where it becomes an issue for investors.”

Invesco manages the entire fixed income portfolio, and the fund has no plans to add managers yet. Vincent says the sole manager risk isn’t an issue because the People’s Pension only accounts for a small percentage of Invesco’s total assets under management of $2 trillion. Still, the pension fund receives an estimated £4.2 billion ($5.6 billion) in annual contributions and as its AUM grows, new satellite fixed income managers could be added over time.

“We could get to the point where we are too big for one manager, so we will keep an eye on it.”

Historical tights

The largest part of the fund’s fixed income allocation (65 per cent) is invested in investment-grade credit in a semi-active strategy that seeks “to avoid the losers” in a buy and maintain approach. Vincent explains that this allocation is currently conservatively positioned because strong technical indicators in corporate bonds continue to drive “massive demand,” putting pressure on spreads.

“We are seeing tights we haven’t seen since 1997 – they are in the top percentile across the board,” she says. “The trajectory of rates is heading down so investors are locking in returns now. The market is priced to perfection.”

Investment grade is split into European, US and UK corporate bonds with different maturity buckets, allowing the manager to shift between geographies and duration in a strategy that aims to strike a balance between being strategic and also enabling any opportunity to change those allocations.

Corporates want to talk about responsible investment

The portfolio is fully hedged and has a net zero overlay that includes a bespoke engagement solution with Invesco.

She concludes that responsible investment is now a key seam to strategy.

“Engagement in fixed income is growing, with managers working alongside corporate ESG teams to achieve the best outcomes. To ensure consistency of message, asset managers are increasingly bringing credit, equity, and responsible investment analysts to meetings with corporates,” she says.

“As fixed income investors, we find corporates want to engage with us because we own their debt, and asset managers are able to clearly explain and express their investors’ priorities, helping to bring alignment. For example, we have an exclusion policy and net zero alignment across our investment-grade portfolio.”

Dutch pension giant APG Asset Management has built a three-pronged framework for public infrastructure investments, linking each prong to the government’s level of control and guiding its own ownership and cash flow decisions.

It has become increasingly relevant as global asset owners face pressure to invest domestically, with politicians turning to private capital to fund national priorities amid growing budget deficits.

In the UK, the 17 largest workplace pension providers have pledged to invest at least 10 per cent of their defined contribution assets in private markets (half of that is earmarked for the UK) by 2030, under the Mansion House accord which is touted to release up to £50 billion in capital.

Real assets in particular are under the spotlight due to their connection with key economic and social issues including housing, energy and digitisation. Their importance is exemplified by the Future Fund’s move to partially internalise its direct infrastructure and property investments in Australia this June, opening doors to defence-related investments and other areas of national priorities where there is a lack of manager coverage.

A report by the International Centre for Pension Management (ICPM) found infrastructure investors share a common gripe when dealing with the public sector: they argue governments often struggle to articulate the desired outcomes, investment timelines or exit strategies, which could lead to poorly structured projects or unrealistic expectations.

APG is addressing this ambiguity by segmenting its public infrastructure investments into three models – regulated business, concession and public-private partnership (PPP) – which have different degrees of involvement from the government.

The models assess government requirements on an infrastructure project including the preferred length of investment holdings, degree of control, and types of cash flow.

For example, investors can own the assets indefinitely in the regulatory business model but only for a pre-defined period in the concession model. The government retains asset ownership in the PPP model while allowing private investors to develop or operate the asset, leading to a higher degree of control.

In terms of cash flow, while private investors make an upfront payment to the government and try to recoup the cost via ongoing revenue in the regulated business model (such as consumer energy bills), they receive a fixed remuneration over time from the government under PPP for developing and operating the asset.

One asset owner surveyed by the ICPM report noted the discrepancy between short political cycles and long-term investment horizons as a key challenge.

Aligning the expectations between public and private sectors early would help make sure the project falls inside the “investible window” – defined as a set of sound legal, financial, and governance conditions that must simultaneously exist for an investment to fulfil the fiduciary duty, the report said.

Having institutional investors assess investments in a robust way will only benefit governments and attract investors.

Ultimately, the key to incentivising domestic investments is a structural one, and only if governments acknowledge the institutional constraints that asset owners work with can they design projects that would attract capital, the report said.

“Patriotic appeals and mandates are not the solution. Institutional capital is not deterred by a lack of interest but by a lack of fit,” the ICPM report said.

Staying vigilant

The report also outlined that even when contractual frameworks and governance mechanisms appear sound, success is never guaranteed with the shadow of troubled projects like the UK’s Thames Water still looming large.

On paper, Thames Water counts typical infrastructure traits including stable and predictable cash flows that are attractive to investors, but its practice of using an over-leveraged balance sheet to pay dividends pushed the company to the edge of insolvency. Canada’s OMERS wrote off its entire 31.7 per cent stake, which was valued at £990 million ($1.32 billion) at the end of 2021, among other investors who took significant losses including BCI and PGGM.

The ICPM report emphasised the importance of having a sound governance structure when managing operationally complex infrastructure projects, which means establishing a special purpose entity (SPE). It protects investor rights by overseeing significant corporate actions such as material asset dispositions, ensuring clear exit pathways and mitigating equity dilution risks.

Investors should also rigorously self-assess their alignment with different domestic investment projects, starting with aligning their fund types with project briefs, the report said.

For example, large corporate pension funds tend to be more compatible with risk-averse projects due to liability needs and should look for briefs with clear return prospects and liquidity, while avoiding “early-stage or politically sensitive investments”.

Large public pension and sovereign wealth funds can be early investors in commercially viable projects provided they have strong governance, while development and infrastructure banks have a crucial role in de-risking projects and providing institutional guarantees.

A revitalised approach that prioritises active management, value-add strategies and the hunt for alpha in CalPERS $168.6 billion global fixed income portfolio is starting to pay off. Speaking during the pension fund’s annual review of the asset class, which accounts for around 30 per cent of the $556 billion portfolio, investment staff said fixed income has garnered around $600 million in value-add over the last five years despite a honed-down team.

The wholly active and internally managed allocation to investment-grade corporate debt has been one of the star performers amongst the five strategy seams in the portfolio that also spans sovereign bonds, high-yield, mortgage-backed securities and emerging market debt.

Investment-grade credit has posted a one-year absolute return of 6.5 per cent, amounting to an excess return of 31 basis points on an active basis, equivalent to $100 million in value-add driven by strong income from elevated bond yields.

Active value has come from overweighting and underweighting strong and weak companies in the index in an approach that came into its own during April’s Liberation Day volatility, when the team added risk at attractive valuations as the dispersion between corporate winners and losers widened.

Moreover, the performance of investment-grade credit particularly stands out given CalPERS has been underweight and defensively positioned the entire fiscal year, investment manager Brian Parks told the board.

ESG integration within investment-grade fixed income has also given the allocation a valuable edge.

For example, CalPERS profited after fundamental ESG analysis drawn from sister teams in sustainability and governance led by Peter Cashion and Drew Hambly informed the belief that last year’s strike action at defence giant Boeing would end, and production at the company would get back on stream.

CalPERS positioned accordingly, overweighting the company on the basis that it would get compensated for governance risk and there was an advantage in adopting a larger position because Boeing’s bonds were “trading cheap.”

“Once we came to that conclusion, [Boeing] became overweight in the portfolio,” said Parks.

ESG analysis in investment-grade credit explores ESG scores and the relevance of any downgrades to CalPERS underwriting processes. Parks said the team are currently focused on about 15 companies. Engagement is led by the CalPERS corporate governance team, which acts on behalf of both the credit and equity teams.

High-yield strategy in action

A similar active strategy of positive security selection also boosted returns in emerging market debt, an allocation that CalPERS only began two and a half years ago. Since then, it has added around $240 million to performance in a strategy where expert external managers still play a central role. Only 10 per cent of the allocation is internally managed.

In another step change, the high yield allocation has shifted from mostly passive to mostly active. Like investment-grade, the approach paid off during this year’s April volatility. More recently, CalPERS seeded $2 billion to J.P. Morgan Asset Management’s active high-yield ETF, drawn from an existing high-yield mandate.

“This is the first active high yield ETF – they tend to be passive [but it] fits with our active high yield strategy [and] it ultimately adds the ability to capture volatility going forward in the world and we are looking for more active opportunities,” said board president Theresa Taylor.

Elsewhere, the allocation to mortgage-backed securities tapped alpha in active, relative value trades and by increasing exposure to securitised credit.

Concerns about Fed independence

CalPERS staff said the current fixed income market is characterised by attractive yields. However, because credit spreads relative to US treasuries are historically “on the richer side,” the investor has a cautious outlook.

“We take more risk when assets are cheap – that may not be today,” said managing investment director Arnie Phillips, who also reflected on looming risks.

Federal Reserve independence and the size of the US budget deficit are front of minds.

“A world that loses faith that the Federal Reserve is independent will have a potential impact on the portfolio,” he said.

He said that a large deficit comes with large sovereign issuance which can crowd out other forms of financing, and he warned that the government will have to pay more to sell its bonds.

In another alarm bell, CalPERS investment advisor also warned that history shows indebted governments often resort to printing money in a short-term strategy that specifically benefits assets with a limited supply.

Alignment with TPA

The fixed income allocation is beginning to shift in line with CalPERS’ progress towards a total portfolio approach (TPA) that requires cultural and structural changes as the investor puts more emphasis on total performance and team effort, rather than individual asset classes.

For example, cross asset class collaboration is visible in investment director Justin Scripps crossing the floor to temporarily join the private debt teams working in insurance-linked securities and investment grade corporates, blurring the lines between public and private fixed income.

Moreover, the fixed income team already closely collaborates with the CalPERS treasury team on liquidity and leverage strategies, pushing the envelope on cultural, and staff, development.

The board heard that TPA will likely lead to higher correlations between equity and credit risk in global fixed income, requiring monitoring in the overall portfolio construction process and leveraging the ability TPA gives to invest anywhere in the capital structure.

Chief investment officer Stephen Gilmore has formally recommended adopting TPA with a 75/25 equity-bond reference portfolio and a 400-basis-point active risk limit whereby management has the discretion to pursue value-add and risk-mitigating strategies. TPA will replace 11 different benchmarks with a single view to evaluate management decisions.

There will be no change to CalPERS’ 6.8 per cent discount rate.

If TPA is adopted at the November board meeting, the strategy will go live from July 2026. The months in between will be spent on priming governance, reporting and collaboration strategies ahead of the off.

The introduction of TPA has been supported by nine board education sessions so far.

Condoleezza Rice, the 66^th US Secretary of State and current director of Stanford University’s Hoover Institution, said that the new world order is likely to have several characteristics, of which there are already signs: countries will be more protectionist in their trade policies; the world will see a redistribution of security burdens; and those who fail to receive the benefits of globalisation will become louder voices.

At the Top1000funds.com Fiduciary Investors Symposium, Rice highlighted that some of these systemic shifts are not dictated by short-term events such as the Liberation Day tariffs (although they contributed to the overall momentum of change).

But what is certain is that the borderless economic cooperation between countries which the world has thrived under is being dismantled.

“Some of what we’re sensing and feeling are long-term, secular trends that have been developing for some time, and so a change in administration, one way or the other, will not change the international economic and security picture,” she told delegates at Stanford University.

“They [the rules] are not going to come from other great powers – Russia in particular is a disruptive power, and China thinks about an alternative system. So in some sense, it has to come from the United States and other like-minded players.

“Of course, floating over all of it is what is going to happen to the job anyway when we’re looking at technological progress like AI or robots, which already make it more difficult.”

As the US heads into its 250^th anniversary next year, Rice said it’s a good opportunity to retrace early challenges in its history and how democracy guided it through periods of turbulence.

“When people ask ‘why do democracies fail’, they really ought to be asking ‘why did democracy succeed?’,” she said.

“It’s hard to get hundreds of millions of Americans to use these institutions, which are to channel – as the founders would have said – the passions, the values and the interests of human beings into something which we just don’t fight about… [but into] everything we actually agree.

“I would then make a case that for all of our problems, this is an extraordinary success.

“But this idea that because I disagree with you politically, somehow you’re not just my political opponent, you’re my political enemy; and the sense that you don’t have the best interest of the country or the people at heart if you disagree with me… I do think that rhetoric needs to calm down.”

In an endorsement of its hard work over the last year, Sweden’s Fund Selection Agency (FTN), the government agency charged with procuring and monitoring the funds on offer on the country’s premium pension platform, is already starting to see improved returns and lower fees from the wave of new equity funds it mandated last year.

“Comparing the new universe of equity funds to the old universe reveals a 150 basis point improvement,” Erik Fransson, executive director at FTN tells Top1000funds.com. In keeping with the organisation’s stated aims, the main contributor to that added value is higher performance, accounting for 125 basis points. The remainder of the benefit (25 basis points) comes from more favourable pricing or lower fees.

“It is a case of so far so good: we have come a long way and we are really satisfied with the work so far,” says Fransson.

Working Swedes have paid into the mandatory defined contribution state pension fund ever since it was established in 2000 and assets on the platform are forecast to double to $451 billion by 2040. Today, the entire “premium pension system” accounts for around $232 billion split between the FTN and default fund AP7 which manages a default option for savers who did not make an active investment choice. Members of the system can choose the level of risk and strategies for their savings.

The ongoing overhaul was rooted in a handful of fraudulent and other poorly performing funds on the platform in the past, a consequence of lax requirements on the funds offering their wares. In recent years, the number of funds on the platform has dropped from 900 to around 450 in a drive for quality that resulted in many falling away. The FTN will procure funds worth around $116 billion between 2024 and 2027.

Tier 1 institutional pricing

FTN’s latest mandates to both passive and active large and mid-cap Swedish equity fund managers show the direction of travel.

In passive, three fund managers have been awarded SEK 65 billion ($6.8 billion) across five funds. The average charges were 3.9 basis points, reduced from a “rich” 12.9 basis points and mandates were won by managers with more sophisticated risk mitigating strategies including how they handle changes in the index and the different index constituents, as well as experience with strategies like security lending.

“This is really close to Tier 1 institutional pricing and will add a great deal of value in the long run. It’s very exciting and we are satisfied with this especially as we are doing this in a fund format. Contrary to popular belief, not all index funds are created equal – the selected funds show strong value creation potential,” says Fransson.

The SEK 92 billion ($9.7 billion) allocation to seven active fund managers was awarded across ten funds and also achieved a “big reduction” in fees, down from an average of 30 basis points to 15 basis points.

In another endorsement of the jump in the quality of fund managers bidding for mandates, Fransson says that none of the managers were disqualified due to mistakes or poor responses. The value of assets under management in the categories won’t change under new management so managers have a clear idea of the amount of assets they will be able to manage from day one if successful, helping the agency secure the best price.

Managers pay a tender fee and if they are successful, a platform fee based on assets under management. These requirements have successfully deterred managers without a good chance of success from going through the lengthy RFP process. All FTN’s costs are financed by an annual fee of 0.5-1.5 bps of assets under management on the platform.

Tech funds and fixed income up next

In the next step, the organisation will announce the $11 billion allocation mandates for a series of new tech-focused funds. Once funds are selected to manage these assets, some 55 per cent of the total capital on the platform will either have been mandated or in process, equivalent to 90 per cent of the equity category.

The team is also working on $23 billion global equities mandate divided between European small-cap and Swedish small-cap.

Work to secure successful procurement of next year’s mandates to new fixed income and target date funds, balanced funds and liquid alternatives is already underway with a focus on adjusting the RFPs and designing the search. All funds have a daily NAV, and most will be UCITS compliant. There is no plan to add private markets to the mix.

Rolling out a total portfolio approach is rarely a linear process, as even its most experienced practitioners have warned that without careful resistance to old language, culture and structure, asset owners can easily slide back into the “comfort” of strategic asset allocation.

Despite having adopted a TPA mindset since it was established in 2006, Australia’s Future Fund is still constantly resisting a “gravitational pull” back towards SAA-like tendencies, according to its former chief investment officer, Ben Samild, who was interviewed for a TPA report published on Tuesday.

The A$318 billion ($209 billion) fund avoids words such as “my portfolio”, “benchmarks”, “sleeves” or “asset classes” in its institutional language and promotes “growth”, “income”, “portfolio impact” and other whole-of-fund focused terms. But old ways of thinking often re-emerge especially during times of stress.

Externally, peer comparison, consultant inputs, board renewal and media narratives can impact the sentiment of investment teams.

“When most of your peers are using SAA, it’s hard to be the odd one out,” read the report published by the CAIA Association and the Thinking Ahead Institute.

“No TPA shop has actually ‘made it.’ For these organisations, it’s not about achieving or arriving at TPA status, it’s about resisting regression.”

The TPA framework can also become less effective following a change in organisational structure resulting from a rapid expansion of mandate, assets or team headcount, but solutions to this problem can look different for various asset owners depending on their set-up.

Some, like Australian state sovereign wealth fund TCorp, facilitate TPA collaboration by intentionally keeping a localised office and leveraging the proximity of its investment team.

But Canada’s CPP Investments addresses the problem by expanding the usage of its completion portfolio, which was originally a “quasi-balancing/overlay portfolio” and has evolved to amplify or offset views from positions held by its bottom-up team. This maintains the flexibility allowed by a top-down view while benefitting from inputs from its on-the-ground, geographically diverse investment professionals, the report said.

Asset allocation impacts

In shifting away from SAA to TPA, asset owners are switching from a tracking error-driven to an opportunity cost-focused mindset, and one of its biggest manifestations is the way assets tend to be funded.

For example, CPP Investments coordinates capital allocation decisions through a central investment committee which helps avoid “rigid deal-by-deal trade-offs” among bottom-up teams. Singapore’s GIC manages an overlay portfolio from the CIO’s office which addresses short-term funding needs or thematic exposures without disrupting long-term allocations.

The report points out that this leads to a difference between tactical asset allocation in SAA and its equivalent in TPA: while the former is always in a mindset of “deviating from the constraints set forth by the governing body”, which are the policy benchmarks, the latter can act without them and identify what’s truly beneficial for the portfolio.

Another asset allocation impact of TPA is that it gives funds ways to embrace more “esoteric” asset classes, such as insurance-linked securities and volatility-linked strategies.

It also allows for more creative allocation decisions. Australia’s Future Fund combines defensive hedge funds with zero-to-negative beta and “substantial” venture capital exposure, for example.

“While Future Fund didn’t go through a transition from SAA, this is a great example of how a TPA portfolio deviates meaningfully from peer portfolios that maintain more long-only beta benchmarks and exposures,” the report said.

“These diversifying positions, while unconventional by SAA standards, were integrated for their utility in improving resilience and achieving objectives like inflation protection or return asymmetry.”

Total view of risk

The report observes that under TPA, funds tend to be willing to tolerate higher tracking errors relative to a reference portfolio, which is a low-cost, index notional portfolio that aligns with an investor’s risk appetite and investment horizon.

This could be a result of TPA practitioners focusing more on the total fund objectives, rather than prescriptive measures in risk management, the report said. TPA funds can focus on a variety of key risk indicators including shortfall risk, surplus variability, or drawdown and recovery resilience rather than “measuring volatility for its own sake”.

Canada’s University Superannuation Scheme (USS) focuses on funding gap volatility as a key risk indicator to manage its liabilities and responsibilities to beneficiaries.

GIC, meanwhile, keeps a close track of long-horizon strategic risks and short-term market dislocations by managing risk across three layers: long-term policy portfolio, 10-year strategy buckets, and 3-5-year overlays.

There is a lot of creative room afforded by TPA for investment problem-solving, but the report highlights that one of its drawbacks is complex governance.

“Boards must trust management to make judgment-based decisions that align with long-term goals. Management must trust teams to collaborate rather than compete. And investment professionals must trust that their value is measured beyond a benchmark,” it said.

“As Geoffrey Rubin, senior managing director and chief investment strategist of total portfolio management framed it: The role of the governing body is to set the problem up very clearly. Then the question is: how much latitude does management have to solve it?”