Although the Teacher Retirement System of Texas’s $11.2 billion risk parity portfolio has struggled of late, the pension fund remains committed to the strategy that it forecasts could perform better in the economic environment ahead. TRS, which manages around $170 billion, treats risk parity like an asset class and has increased the allocation over time in terms of both the risk level within the different buckets and size with the portfolio currently targeting an 8 per cent trust level allocation. The strategy of balanced risk exposures is designed to perform well in most market environments and is implemented both internally and via external managers.

Speaking at the Risk and Portfolio Management division’s annual update to the board in December, James Nield, chief risk officer, and Mark Telschow, director, RPM Portfolios, reported a difficult year for government bonds and risk parity, although risk parity has performed better in recent months. The problem, Telschow explained, is that virtually all assets apart from energy investments have declined and the strategy suffers when all assets perform badly. Something other investors like Denmark’s PFA say has caused them to lose faith in risk parity.

“When all asset struggle, risk parity is going to struggle,” said Nield. He also noted that risk parity does best when cash is unattractive, yet cash is currently outperforming other asset classes. “Risk parity is going to struggle as it is short cash,” he said.

Looking ahead, falling growth and rising inflation are likely consequences of Federal Reserve tightening. This could create an environment where risk parity does better. Moreover, risk parity tends to compound returns faster than in other allocations, so drawdowns are shorter and the acceleration better.

The team attributed the few bright spots in risk parity’s performance to successful manager selection (TRS uses Bridgewater, AQR and Invesco) and asset mix selection whereby the portfolio held fewer government bonds. TRS actively manages the risk parity tracking error to reduce the range of relative outcomes through both risk level and asset mix. Telschow also noted that cheaper internal management of some of the allocation created a tailwind.

The board heard how risk parity is complicated by the wide range of opinions regarding different risk and design models; what assets to include in the buckets and what risks to balance – whether that balance should be based on risk contributions or economic regimes, for example. Design decisions result in different portfolios and influence the outperformance or underperformance mean reverse over time. However, Telschow and Nield said there is not a huge amount of informational edge in design decisions.

Experimentation

Alongside running the risk parity allocation and a 16 per cent passively managed government bond portfolio, TRS’s 16-person Risk and Portfolio Management team is tasked with research initiatives and experimentation to help expand internal capabilities and reduce fees. The risk parity portfolio initially emerged from this process which has most recently focused on a new diversified and balanced commodities exposure, similar to the approach taken in risk parity. Launched in September 2022 the portfolio particularly aims to balance exposure to rising inflation.

Other tasks assigned to the Risk and Portfolio Management team include financing liquidity and setting liquidity targets, conducting repo activity, managing derivative trading, and finding the best way to source the fund’s cash needs. The team also rebalance the portfolio, optimise balance sheet and oversee securities lending, seeking additional yield where possible. Having these activities housed in one team means a tighter grasp not only on how much liquidity the fund needs, but also the best way to source it.

Asset allocation

The Risk and Portfolio Management team are also responsible for conducting an asset allocation study every five years. The last study, three years ago, led to TRS adding leverage, increasing its allocation to fixed income to add diversification, and boosting investments in private markets where TRS now invests 42 per cent of assets. Recent results show that the additional allocation to leverage has added 63 basis points of positive return, and more money invested in private markets has also been additive. However, adding to the fixed income allocation has had a negative impact.

The risk management team look at around 200 daily risk signals, reporting on macro and portfolio risks and putting in place action plans if needed. Recent action has focused on bubble signals, allocation and counterparty risks. In one example of the process at work, signals flagged risk in the asset allocation limits in the private equity portfolio vs the allocation through time. This ultimately led to raising the policy limit from 19 per cent to 24 per cent. Nield concluded that data is a key contributor to strategy success, enabling “drill through” analysis to enable more useful reporting.

 

One of our defining characteristics, and main objectives, at Top1000funds.com, is to provide behind-the-scenes insight into the strategy and implementation of the world’s largest investors. In 2022 we introduced some new projects aimed at providing a deeper understanding of best practice and driving the industry to produce better outcomes for stakeholders.

We now have readers at asset owners from 95 countries, with combined assets of $48 trillion, and we are also pleased to say that our readers are spending more time on our site and there are more people visiting, so thank you to all our interview subjects, readers and supporters over the last year. Below is a look at the most popular stories of 2022.

This year we launched the Asset Owner Directory which is an interactive tool to give readers an insight into the world of global asset owners. It includes key information for the largest asset owners around the world such as key personnel, asset allocation and performance. (All the information collected is from publicly available sources and is accurate as per the fund’s most recent annual report.)
Importantly, for context and depth, the Asset Owner Directory also includes an archive of all the stories that have been written by Top1000funds.com about these investors over a period of more than 12 years, allowing readers to better understand the strategy, governance and investment decisions of these important asset owners. This new initiative was very well received by the industry and is now the most visited part of our site.

In 2022 we were at last back in person hosting our events for the global investor community. Needless to say all our delegates were thrilled to see each other again. It was actually like a big party. We hosted events at Cambridge University, Chicago Booth University, Harvard University and Maastricht University.
Thankyou to all our speakers, spsonsors and delegates that made those events such a massive success, and we truly hope we are doing our bit to prompt the industry to shift to best practice behaviours as they take on their big responsibilities of managing other people’s money. We’re going to do it all again next year and kick off our event calendar with the Fiduciary Investors Symposium in Singapore from March 7-9 which we are very excited about.

In February 2021 we launched the Global Pension Transparency Benchmark which is  a collaboration between Top1000funds.com and Toronto-based CEM Benchmarking. In that first year we ranked 15 countries on public disclosures of key value generation elements for the five largest pension fund organisations within each country. The overall country benchmark scores look at four factors: governance and organisation; performance; costs; and responsible investing; which are measured by assessing hundreds of underlying components. We focused on transparency because we believe transparency and accountability go hand in hand and lead to better decision making, and ultimately better outcomes.

In 2022 we expanded the GPTB and publicly disclosed the individual scores for 75 of the largest funds in the world. The idea is that by publishing the underlying scores of the funds we will show really what best practice looks like and give the industry and individual funds a North Star to aim for in their quest to improve transparency and ultimately improve outcomes for their stakeholders. We’re very proud of this initiative and grateful to CEM for their partnership.

ESG remained a key focus for institutional investors this year (a reminder that ESG is topic du jour for the industry but Top1000funds.com has been reporting on ESG since 2009). An article by Fiona Reynolds, who was long-time CEO of the PRI, responded to the rising denunciation of ESG investing. She claims that over-thinking, over-regulation and over-standardisation is complicating what is actually a very simple investment philosophy.

We can’t look back at 2022 without acknowledging the pain and disruption caused by the war in Ukraine. Our resident academic, Professor Stephen Kotkin, warned us back in February, before the war had broken out, that it is not the war itself between Russia and Ukraine that investors should be concerned about, but the destabilising effects of Russia’s actions that could impact globalisation and harm the west. The energy and living crisis in Europe is testament to his warning and we hope things can improve very quickly.

As always we thank you for your readership, your loyalty and your continued interest in our media and events. Happy holidays and see you in 2023.

The Universities Superannuation Scheme, USS, trustees of the largest private pension scheme in the UK, withstood September’s turmoil in the government bond market for five key reasons. Speaking at USS’s 2022 Institutions’ Meeting, Simon Pilcher, chief executive of USS Investment Management, said the asset manager uses less leverage than most other UK pension funds. “Leverage has not been a problem for us,” he said. At end of September, the Valuation Investment Strategy had 16 per cent in leverage.

Pilcher said USS has also been protected because of diversification. In an important seam to strategy, USS buys US government bonds to hedge inflation and interest rate risk, no relying exclusively on UK government bonds. In a third pillar, the asset manager was also supported by its allocation to private markets which protected the downside and have less volatility than public markets.

A strategy that reduced the portfolio’s exposure to sterling also helped protect the pension fund. The investment team had observed for a while that sterling tends to perform badly in volatile markets. Fearing volatility, strategy centred around increasing the non-UK element of the portfolio, said Pilcher, adding that the team had also ensured plentiful stocks of cash and collateral in preparation for market volatility as yields rose through the year. When this was turbo charged in September, the scheme was prepared.

Finally, Pilcher credited USS’s governance for the scheme’s fortitude during September’s market turmoil. This enabled the investment team to act quickly at a time fast decision-making was critical to protect the downside and exploit opportunities.

Pilcher said the turmoil in the bond market caused UK pension funds such a challenge because of the quantum and speed of the move. “We saw daily moves five times larger than we’ve ever seen before,” he said. However, he noted that the direction of travel – aka higher bond yields – is positive for pension funds because it leads to lower liabilities and a larger surplus/lower deficit.

Hedging in the US

The portfolio is divided between a 60 per cent allocation to growth assets and a 40 per cent hedge ratio whereby USS hedges 40 per cent of the inflation and interest rate risk embedded in its liabilities.

Pilcher explained that USS has increased its liability hedge ratios for both interest rates and inflation over time. However, a large chunk of that hedging has been achieved outside the UK, mostly in US. “As bond yields have risen, it causes our hedge ratios to rise without doing anything to our underlying investments. The rise in hedge ratios is due to the market bringing it to the portfolio,” he said.

Still, he said that the investor has taken a more active approach to hedging inflation risk, seeking to add hedging when the breakeven rate has fallen. For example, USS increased hedging in the UK when breakeven rates were lower last July. “This was a cheap opportunity to acquire inflation in the UK,” he said. Similarly, the team looked for opportunities to hedge inflation exposure via the US market, given US inflation is structurally cheaper to buy than the UK. “Our actions have helped as inflation has grown around the world – hedge ratios have increased but they have been acquired at opportune times,” he said.

USS’s aggregate exposure to growth assets has been constant at 60 per cent of the portfolio. However, Pilcher said that in recent months USS has reduced that exposure given concerns about the outlook for growth assets. USS’s exposure to private markets has grown however, with a particular focus on private equity and real growth – inflation-linked assets like infrastructure. The fund hasn’t invested enormous amounts in private assets through 2022, but private assets have helped protect the portfolio and delivered well for the scheme, he said.

Indeed, Pilcher said that USS has seen a material increase in its exposure to private assets. Not via an increase in net investments but by other factors including the stronger dollar, taking the dollar-denominated private asset percentage up with it.

Stakeholders heard that USS  runs more of its allocation to private markets in-house compared to peers. Internal management has allowed USS to tailor investments more closely to its own needs – for example sourcing long-term infrastructure assets with inflation characteristics that also give an equity premium. Moreover, USS also manages to pay less to external managers than peer funds where it does outsource.

 

Lægernes Pension, Denmark’s DKK100 billion ($14 billion) pension fund founded in 1946 for medical doctors has just completed a series of tech investments to further sharpen its investment processes.

As the complexity of its investment process grows in its active, strategic, and tactical strategy so has its technology spend in a trajectory that is increasingly viewed as pioneering for the little-known pension fund with a small internal headcount.

Lægernes Pension’s latest tech investment is focused on boosting data management in its systematic strategies to improve due diligence, portfolio modelling and reporting. The systemic allocation is part of a liquid overlay designed to improve the risk-adjusted return of the overall portfolio.

The new technology streamlines data coming into the investment team from the fund’s asset managers and banking counterparties, explains Michael Daniel Andersen, head of portfolio construction who has overseen the introduction of the technology with service provider Premialab. All Lægernes Pension’s strategic and tactical asset allocation is managed in-house, apart from security selection which is managed externally bar an allocation to Danish bonds and inflation linked paper.

Granular data is channelled into one, standardized format comprising everything from performance and risk metrics to exposure levels across every position in the fund’s systematic strategies. Everyone in the investment team can see the results of the data and check their risk exposures describes Andersen, who joined Lægernes Pension as an analyst in 2017.

“We have a large exposure to systematic strategies relative to other European pension funds and are quite pioneering in how we view the allocation,” he says, predicting that one of the most important new data sets about to come down the pipe will be natural language processing revealing what people are reading and researching to offer valuable new investment signals. “It could provide a new way to invest. It’s early days, but I think it will be one of the most exciting developments.”

Risk

Lægernes Pension’s systematic strategies comprise more than 1000 different underlying positions that are too extensive for the internal team to oversee. Risk modelling is based not only on asset classes but also risk factors like liquidity, growth, inflation and interest rates. The new technology has allowed the fund to reduce volatility in the overall portfolio and has helped avoid some of the most severe drawdowns of 2022.

It allows the investment team to see into exposures, offering granular detail on which allocations are doing well and which are doing badly, he says. It also flags the risk of overlapping exposures in a strategy that aims to have exposure to every factor – but avoid the duplication that typically spike during large market moves.

“Risk exposures in complex strategies change all the time, and during large market movements some of the systematic strategies could end up with the same positions,” he says. “This technology helps us identify what the risk exposures are and reduces the amount of time we spend monitoring the process providing us with the broadest amount of data to make decisions.”

The technology is also supporting Lægernes Pension’s portfolio construction which is also set according to risk exposures and factors. “We use the technology to outline what the main risk exposures are and this helps us perform quicker analysis when we need to change things. We are now able to implement at a much faster pace, despite being a small firm. We would have a hard time taking on the risk if we didn’t have this – we would have difficulties handling it internally on the ground.”

Tactical

Away from the overlay portfolio, a tactical asset allocation is also a key driver of returns and shaped according to the business cycle and monetary policy taking a 6 – 12-month view. The investment team also run an equity sector selection model in house which goes long or short some equities as part of the strategic process – also driven by the business cycle. The strategic asset allocation includes bonds, listed and private equity and real assets with around 28 per cent of the portfolio in illiquid assets. An infrastructure allocation comprises mostly renewables and digital infrastructure.

Andersen’s key advice to others is to ensure robust governance so the investment team always know where they are invested and have access to the best tools to make the most informed decision. “Work with counterparties to help,” he says, concluding that technology will increasingly shape the investment process. “You will still need people to point the technology in the right direction. But investment teams will change how they operate and how people use their time,” he predicts.

In a positive stock-bond correlation world, balanced portfolios will be more volatile without the natural hedge that bonds provide to stocks in a negative correlation world. Nevertheless, diversification will remain a powerful tool to protect portfolios, according to Dr. Noah Weisberger, Managing Director in the Institutional Advisory & Solutions (IAS) group at PGIM.

The “free lunch” provided by 20 years of negative correlation between stocks and bonds is over, balanced portfolios will become more volatile, and there are few options for investors to engineer portfolios away from this new paradigm, according to an expert at PGIM (the global investment management business of Prudential Financial).

Noah Weisberger, Managing Director in the Institutional Advisory & Solutions group at PGIM, said the “efficient frontier” of optimal portfolios will shrink, and in this new regime“ there are some combinations of risk and reward that just are no longer attainable as you build a portfolio of stocks and bonds.”

Weisberger previously authored two papers that analysed the drivers behind negative and positive cycles of stock and bond correlation. Having concluded that the current macroeconomic environment seems supportive of an extended period of positive correlation, a newly released third paper looked at how investors should adjust their portfolios in response.

The answer is that optimal portfolios in a positive correlation world will not be very different from optimal allocations in a negative correlation world, Weisberger admitted he was surprised by this finding.

Critically, he added, performance of balanced portfolios will be worse on several metrics, and investors will be “stuck with the facts on the ground.” “Within the narrow context of a balanced portfolio of stocks and bonds,” Weisberger continued, “there’s not a whole lot you can do to mitigate that performance deficit.”

In response to this new investing environment, risk-averse investors may respond by slightly reducing their exposure to stocks. However, perhaps counterintuitively, investors that are less risk-averse may decide to lean more heavily into stocks, with the understanding that “their portfolio is slightly more volatile, bonds are slightly less valuable as a hedge, and the way to compensate for that incremental risk is actually to increase the portfolio’s expected return by owning more stocks,” Weisberger said.

There may also be more room for additional asset classes that bring greater risk, such as commodities, aimed at compensating for greater volatility, he said.

Weisberger warned against using 2022 as a paradigm for markets going forward. The wholesale re-rating of both stocks and bonds in tandem was highly unusual, he said, and investors should not assume the continuation of persistently negative returns for both asset classes.

“In 2022, the performance of a balanced portfolio was less about the shift in correlation from negative to positive,” Weisberger said. “It was much more about really bad realised returns.”

He noted stocks and bonds will likely not be very highly correlated even in a regime of positive correlation, and “there’s plenty of room even within that positive co-movement for the two assets to be diversifiers.” Moreover, with history as a guide, even in the context of a positive correlation regime, bonds could still outperform when equities underperform during crisis periods due to a “flight to quality,” he said.

Unless the terrible returns of 2022 continue, which is doubtful, we are unlikely to witness the death of the 60/40 portfolio, he said. “A portfolio with multiple assets that are moderately correlated still is the right place to go for a risk averse investor.”

Weisberger’s previous research found stock bond correlation regimes are very long lasting, with the current 20-year period of negative correlation following almost 30 years of positive correlation from the late 60s. They are also very similar across developed markets, which typically move together.

Those papers concluded that periods of positive correlation tended to coincide with concerns about fiscal policy sustainability, concerns about monetary policy independence where monetary policy “seems to be driving the cycle as opposed to responding to the business cycle,” and where “investors are re-rating risk in tandem across asset classes.”

A world of positive correlation between stocks and bonds leads to more volatile portfolios, impacting the performance of a balanced portfolio, Weisberger said. This is not because stocks or bonds are more volatile themselves, but because portfolios will no longer be benefitting from the stronger built-in hedge provided by the negative correlation between these two asset classes.

In a world of positive stock-bond correlation, “portfolio managers and CIOs should expect their balanced portfolio to have higher per period volatility, they should expect their portfolio to have a wider range of risk-adjusted returns–even over long periods of time, a wider dispersion of terminal wealth outcomes, deeper drawdowns, and greater probability of ending a given period of time…in the negative,” Weisberger said.

Like many UK pension funds, Belgium’s KBC Pensioenfonds, the pension fund for the banking and insurance group, runs a large LDI programme. Introduced in 2007 to protect against falling real interest rates and rising inflation, around 30 per cent of the €2.9 billion portfolio is invested in LDI and the fund has a leverage level of 200 per cent.

But unlike the thousands of UK pension funds with LDI strategies that had to fire-sell assets during the recent gilt crisis, KBC doesn’t have to post cash as collateral. Instead, it can post government and covered bonds and doesn’t risk having to sell assets if embroiled in a similar market turmoil.

“We don’t have the same issue with collateral as UK funds because we can post bonds – we don’t have to post cash and wouldn’t ever have to sell high quality assets as collateral,” explains CIO Luc Vanbriel, who estimates it would take an additional 3-5 per cent jump in bond yields to force the pension fund to sell corporate bonds or decrease the swap notional values to meet margin calls.

In September’s gilt market crisis, yields spiked across maturities (some up around 1.5 per cent at the height of the crisis) following former prime minister Liz Truss’s mini budget. It forced thousands of UK pension funds to fire sell assets such as bonds and equities to meet collateral calls from banking counterparties.

One of the hardest hit, the BT pension scheme, BTPSM, revealed in its October annual report that the value of its assets fell by £11 billion during the market turmoil.  In a recent written submission to British MPs investigating the gilt market turmoil which has focused attention on the risks of hidden leverage, BTPSM said it had made changes to its LDI strategy in response to the crisis.

“We have become more cautious in how we manage the scheme’s liquidity and have increased the collateral buffer to which we operate,” it said. “This will position the scheme to better weather any further volatility in the gilt market but will also reduce the expected returns from our assets.”

Inverse yield curve

Posting collateral may not be as risky for KBC, but Vanbriel is mindful of other risks, particularly an inverse yield curve, the harbinger of an economic downturn.

“On the swaps, we pay a short-term floating rate and receive a long-term fixed nominal or inflation linked payment. An inverse yield curve is a risk because we would pay more than we receive.” KBC swaps the coupons on a diversified pool of highly rated bonds, and to limit the risk of an inverted yield curve, caps leverage at 200 per cent.

The LDI allocation is managed in an institutional mutual fund run by KBC Asset Management which also manages most of the pension fund assets although private assets are outsourced to specialist managers.

“We review the leverage level twice a year but in extreme circumstances we can adapt the level quickly,” he says.

In a dynamic approach, KBC can increase matching assets if the real interest rate increases. Elsewhere, if the funding ratio moves higher the level of hedging is also increased – although the leverage would always remain below 200%.

“We have a de-risking plan in case real interest rates rise or the funding ratio increases, whereby we will hedge more using swaps and linkers,” he says.

Vanbriel, who positioned the portfolio for higher inflation back in 2019, says the pension fund has been well protected thanks to an allocation to inflation linked swaps and an increased (to 15 per cent) allocation to real assets comprising infrastructure and real estate.

“You cannot eliminate the risk of inflation staying high for a couple of years,” he predicts.

Exposure

In another contrast between European and UK schemes, Vanbriel also flags the worrying exposure of UK pension funds to the government bond market. He estimates European pension funds only own around 20 per cent of the European bond market in contrast to much larger gilts exposure amongst UK pension funds, particularly to longer-term gilts, which helped create a vicious circle during the crisis.

“It’s a completely different picture,” he says. The UK’s Investment Association estimates that over the last decade, total assets in LDI strategies have quadrupled, rising from £400 billion in 2011 to almost £1.6 trillion in 2021.

Equity weights

In another strategy, Vanbriel is increasing the equity weights in the DC portfolio. KBC’s portfolio is currently split between a €2 billion defined benefit fund and two much smaller defined contribution schemes. The decision follows the latest ALM study (conducted every three years) and is based on a reworking of forecasted returns. Employers running DC schemes in Belgium must provide a minimum guaranteed return of 1.75 per cent at the end of an employee’s career.

“It is not really a typical DC plan due to this guaranteed return,” he reflects. The ALM study revealed that if the fund increases its allocation to risky assets, it increases its forecasted return without significantly increasing the risk to employers.

European angst

The increased allocation to equity will be global. KBC reduced its home bias two years ago following observations that the European allocation was more volatile and drawdowns in Europe had more of an impact and recovery took longer.  “We didn’t reduce it because we were negative on Europe,” he says.

Still, today concerns about the economic health of the continent are mounting. The euro has fallen in value along with valuations in European equity markets, down more than falls in the US. The pain is most acute in the KBC’s exposure to central European equities, he says.

Global diversification is also echoed in the private equity allocation. KBC has added a 2 per cent allocation to private equity in the DB portfolio to sit alongside a 34.5 per cent allocation to listed equity. Vanbriel likes the private equity allocation for its diversification from IT and pharmaceuticals in the listed space and ensures vintage and manger diversity.

“In private equity we don’t have a particular niche or concentrate in one sector. Each of the funds we invest in is global and sector diverse.” Currently overweight at 3 per cent because of performance, he has no plans to increase the allocation in the future.

ESG

KBC has also developed its ESG policy in recent months. The investor already limits its investment universe to the best performing ESG companies. For example, rather than investing across the entire MSCI North American index in its US equity allocation, it only invests in the top 40 per cent of ESG rated corporates in each sector. In a new seam, KBC now invests according to specific criteria based on corporate greenhouse gas emissions and sustainable development goals. The fund excludes all fossil fuels – but will invest in green bonds from the fossil fuel industry.