Global pension funds are increasingly looking to private assets to build resilience, stress testing various scenarios to manage the liquidity risks that come with increasing private market allocations.

In a panel discussion at Conexus Financial’s Fiduciary Investors’ Symposium held in Singapore, Anne-Marie Fink, chief investment officer, private markets and funds alpha at the State of Wisconsin Investment Board, said SWIB has the advantage over many other US pension plans that its liabilities fluctuate with its assets, with the amount it pays out based on a five-year return with a base level that it cannot go below.

That “gives us a certain amount more flexibility relative to somebody who has got to pay X amount regardless of what’s going on in the markets,” Fink said, in a discussion chaired by Amanda White, director of international at Conexus Financial.

SWIB manages around US$143 billion in assets. The fund has roughly 28% private assets and is debating internally to increase that allocation to 35% or even 40%, Fink said. The fund’s liquidity allowed it to increase its allocation from 20% during 2021.

“Our teams have been really talking to all of our GPs and essentially saying, ‘we have liquidity, and if you have other partners that maybe are over their skis on their private assets, we can provide liquidity.’”

The fund’s hedge fund strategy is “portable alpha” with virtually no beta in its portfolio, Fink said, along with some passive allocations. This is sensitive to the cash rate, so now that the cost of capital has risen, the fund is now “pruning” its portfolio and looking for ways to increase return per dollar committed, potentially using leverage and accepting some extra volatility.

Also on the panel was John Greaves, head of investment strategy and research at Railpen in the United Kingdom, which manages about $50 billion of assets and administers several pension schemes including the UK’s Railways Pension Scheme.

Improved resilience versus governance and liquidity costs

Adding the appropriate amount of liquidity is an important consideration for Railpen, Greaves said, with illiquid assets like real assets potentially improving macro resilience, but at a governance cost and a liquidity cost.

The fund has pensions to pay, so it cannot ignore short-term risk outcomes, he said, and “liquidity risk is one of those reasons where you can become unstuck in the short term.”

“Funding liquidity risk” came to the fore last year in the UK, he said, proving it is critical for funds to think through, and stress test, their expected short term cash flows.

“That was really challenged in the UK in September and October last year with the volatility in the UK Government Bond Market,” Greaves said. “So that was a really good reminder to think what what might happen, what your risk models might say is impossible, and think through the unexpected. But that aside, it’s usually managed very prudently.”

“Market liquidity risk” is also a critical consideration, being the amount of illiquid assets a fund considers appropriate, Greaves said. These assets may take “many months or years to sell, sometimes you have some control, sometimes you don’t,” he said. 

Managing relationships is critical

The fund balances and differentiates among these assets where some assets may be very illiquid, while others may have strong secondary markets or provide significant income. Managing relationships with general partners is critical, and investing one year but not the next can stress these relationships.

“It was mentioned earlier that you want to avoid the bottom quartile managers,” Greaves said. “You better believe that you need to be investing almost every year to kind of do that, and to maintain those relationships in the top quartile managers. That’s just the way it is.”

Stress testing also involves looking at the possibility that illiquid assets may suddenly become cash flow negative, and “you’re not getting that return of capital because your general partners aren’t exiting because the environment isn’t favourable to do that,” Greaves said. 

The fund needs to limit exposure to illiquid assets at about 40%, he said, noting this approach differs from some Canadian schemes that have much higher levels of illiquidity.

“That model, I think, relies on being fairly proactive on secondary sales and exiting assets, and that is a very resource-intensive and quite a different investment process, so it wasn’t a good fit for us,” Greaves said.

Ding Li, senior vice president, total portfolio policy and allocation, economics and investment strategy, at Singapore sovereign wealth fund GIC, said taking a total return perspective, and looking at the total fund outcome, is also critical.

“For the long-term investor, especially for those kinds of pension plans which have some kind of payout liability, I think the total return is actually the focus for the investment outcome rather than alpha only,” Li said. “Because even if you pick out the right Alpha, if you don’t really capture good market beta, then your total outcome still does not meet your client’s objective.”

Muslim consumers comprise a young and enormous population, and there is a growing opportunity for startups that cater to their needs, argues one of Asia’s most impressive venture capitalists, Thomas Tsao.

Tsao, one of Asia’s most well-known venture capitalists, has been increasingly involved with “TaqwaTech” startups, which build products to serve muslim consumers. He co-founded Gobi partners in 2002–a regional platform that supports entrepreneurs from early stage to growth stage–with 13 offices and locations around Asia.

Tsao has invested in nearly 350 companies in Asia including Aerodyne, Airwallex, Animoca, AutoX, Carsome, GoGoX, Kumu, Prenetics, Sandbox VR, Sastaticket.pk and WeLab.

Speaking at Conexus Financial’s Fiduciary Investment Symposium in Singapore, Tsao said Gobi in its early days had a significant focus on the innovation going on in China along with its massive market.

“It’s a huge opportunity, and look at it now, but what’s a bigger opportunity than that?” he said. “It’s focusing on Muslim consumers, and it’s a $2 billion population opportunity. So that’s something we’re very, very excited about.”

Some of Gobi’s TaqwaTech investments include Durioo, which is “trying to become the Disney for Muslim children…creating animation around Muslim values for a younger audience,” Tsao said.

Ratings for Muslim-friendliness

Another, Tripfez, caters to Muslim travellers by providing a rating system for hotels based on Muslim-friendliness, he said, noting hotels in Muslim countries typically provide prayer mats and an arrow pointing in the direction of Mecca, among other Muslim needs. These are often not provided by hotels outside Muslim countries.

The pace of innovation is accelerating, Tsao said, with technological developments allowing emerging markets to learn from each other and the paths of other nations and build tech ecosystems much more quickly than their forbears in Silicon Valley or even China.

Another of Gobi’s investments is Carsome, a South-East Asian e-commerce platform for buying and selling cars. While some high-end cars can be bought online, the majority of brands are sold through auto dealerships, which Carsome wants to disrupt, Tsao said.

“If you talk about it from an ESG standpoint, a car manufacturer should never build a car until it actually has an order,” Tsao said. “But in order to do that, you need perfect information and you need a lot of traffic and we see that as a real breakthrough that’s going to come in and will then also tie into the next big phase of mobility, which will be autonomous driving.”

In the future, consumers will be able to buy an electric vehicle with autonomous facilities, and rent that car to an autonomous network during the times it isn’t being used, so it can pick up passengers from Grab or Uber and generate money for the owner, he said.

Early-stage VC not affected as much

While large tech platforms have seen massive corrections in the past year, Tsao said the early stage universe – where venture capitalists write cheques for $500,000 up to around $25 million – has not been affected as much.

He said “one of the most interesting investment opportunities in China today” is in China’s Greater Bay Area, a megalopolis that will combine Hong Kong, Guangdong and Macao into a super-economic zone of around 70 million people.

“I think this is going to be one of the most interesting opportunities and there’s a lot of tech sectors that people are going to be investing into,” Tsao said. “And again, for all of those who are doubling down on China, you should be looking at the Greater Bay Area.”

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.”