Markets are going to react to what’s not priced in – and analysis of what is currently priced in, doesn’t add up. So warned Bridgewater’s chief investment strategist Rebecca Patterson, speaking at FIS in Maastricht.

Markets are discounting that the Federal Reserve starts easing interest rates next year. But markets have not begun discounting that earnings, and earnings expectations, are expected to decline, and if Central Banks are serious about taming inflation, they will destroy demand which will feed into earning expectations. “In aggregate, and at a high level, equity markets would be up this year if we took out the impact of the discount rate,” she said.

Patterson told FIS delegates that Bridgewater’s views on inflation have evolved. Strategists at the world’s biggest hedge fund, which runs a celebrated pure alpha and all-weather strategy, now believe that although inflation will remain “sticky” and will be slow to fall, a more pressing challenge for investors looms in slow growth. Signposting a meaningful contraction ahead, she said slower growth than expected, combined with high inflation, raises the spectre of stagflation.

Almost every asset class will be impacted by central bank tightening in a process that is already starting to appear. The impact is becoming visible in the housing market, and it is increasingly apparent in consumer and business confidence. She said that data suggests the US will likely face a 2 per cent contraction next year, with Europe’s economy shrinking more. “We see a lot of downside risk on growth,” she reiterated.

Policy misstep

The difficult economic backdrop is leading to the appearance of economic stimulus in some jurisdictions like Germany and California. But the travails of the United Kingdom’s ex-Prime Minster Truss underscore the challenge of introducing fiscal stimulus in the current climate. “She thought the best way to help the UK was to cap energy and give subsidies to business,” said Patterson. “But she did it with high debt levels and while the BofE was trying to get inflation under control. With fiscal stimulus, monetary tightening, and high debt levels, it was no surprise that bond yields shot up.”

Europe faces slow growth and real incomes being hard hit; meanwhile companies are experiencing rising costs caused by high inflation and slower growth. A potential policy misstep could include the ECB using asset purchases to buy Italian bonds to stop spreads widening between Italy and other, stronger, European sovereigns, she warned. “What if some countries don’t want to use [asset purchases] to bail out Italy?” she asked. “The ECB’s job is challenging because the downside to growth is larger than what markets discounting.”

Strategies that worked in the past no longer work. For example, equities and bonds have both performed in a low inflationary world where growth has been mostly positive. Investors have moved into private investments and got paid to take overweight US positions. Moreover, in the past when equities have fallen, Central Banks have stepped in by lowering interest rates and adding stimulus. “Equities turned quickly, even with slowing growth,” she said. Now however, as Central Banks target getting inflation back to between three and two per cent by raising rates, this won’t be possible.

China

Patterson said Chinese growth is being hit on a couple of fronts. Consumer confidence has been hit by the property crisis while enduring lockdowns are crimping the economy. Exports have been hit by the slowdown in Europe. Positively, she said China doesn’t have policy constraints and can put in place fiscal and monetary stimulus. Still, China remains stymied by the absence of demand. “The problem is that even if you create the availability of credit, you still need demand.” China is also battling longer term challenges like its demographics; productivity will also be impacted by China struggling to access the technology it needs, she predicted.

Beta challenge

Investors will struggle to access beta in the current environment, meaning alpha becomes more important now than in years prior. This means country selection; manager selection and geographic diversification will become more important than before. Opportunity will come from looking below the hood, although she warned that Bridgewater remains cautious on European equities given the downside risk to growth is greater than what has been discounted. She said key factors to get capital flowing back into Europe depend on the war ending, and China reopening.

European equites may remain in the doldrums, but Bridgewater’s outlook for commodities is more positive. Many commodities have experienced under investment, particularly energy and metals. When demand picks up, supply may not be there, she warned. Moreover, the transition to a green economy will support commodity prices at the margins.

Patterson noted that inflation targeting by central banks has helped anchor expectations. Still, raising rates to tackle inflation will lead to people losing their jobs. “Raising rates isn’t easy,” she said. Moreover, when people start to lose jobs, Central Banks risk rate rises becoming politicised.

She noticed that foreign allocations to US assets are at the highest level since 1980s. Sure, investors may reduce their allocations to US assets when growth in other markets looks better, but she warned that just because another market looks cheap, it doesn’t make it attractive.

The funds management industry “does not look like the society we serve” despite being an industry concerned about talent, said Sarah Maynard, the global senior head of DEI at the CFA Institute, pointing to the importance of measuring and reporting progress on diversity and inclusion.

As with “green washing,” there is also a major issue with “diversity washing,” Maynard, pictured, said in a panel discussion chaired by Amanda White, director of institutional content at Conexus Financial, which is broadly “this sense of organisations making…a commitment that they’re not following through.”

Speaking at Conexus Financial’s Sustainability in Practice forum held at Harvard University, Maynard said there is a marked under-representation of women when looking at labour participation rates by gender in investment teams. The view becomes more stark when adding in race and ethnicity, and other elements of diversity like gender fluidity, she said.

The CFA Institute has a history of producing codes and standards in response to issues, and so in response to this diversity problem in the industry, CFA worked on “developing a code to give the industry the structure to progress and also to lean on that infrastructure that we already have around codes and standards and indeed around aspects of professional conduct and enforcement,” Maynard said.

Released in February this year, and now with more than 50 signatories, CFA’s Diversity, Equity and Inclusion Code for investment professionals provides principles and implementation guidance on the “what and the how” of diversity and inclusion.

“We are collecting data from all of our signatories and essentially we will be reporting outwards on aggregated data, so that folks can actually see how their organisations look relative to their peer group and understand the need for accelerated change,” Maynard said.

While measurement and data collection is critical, there is also a need for a cultural shift that changes practices and people management to produce better outcomes, she said.

“Because one of the interesting things we’re increasingly seeing and hearing in the evidence from the allocators of capital is actually firms that can demonstrate greater diversity, equity, and inclusion are also producing better investment results,” Maynard said. “So I think that’s a point to really focus minds.”

Signatories welcome the fact that there are sanctions for non-performance, she said, and that they will be held to account on their progress.

Also speaking in the panel discussion was Juliette Menga, chair of ESG committee at Aetos Alternatives Management, who said investment professionals should look at the research of Harvard psychologist Dr Mahzarin Banaji, and her work looking at implicit bias around race, gender and sexual orientation.

DEI work needs to be “extremely intentional and actionable,” Menga said. “It’s not something that you can start with: ‘We are in a meritocratic world, let’s find the best people.’ There is a lot of unintentional biases that play out.”

Investors need to track progress, hire the right people and begin by looking at their own firms, she said.

“If you don’t have a diverse group of people doing that investment diligence work, you would likely not come up with a diverse group of managers.”

Aetos has a DEI committee spanning a wide group of people from senior leaders to junior professionals across different groups to think through issues such as hiring and promotion practices and partnering with different organisations on internships, she said.

Organisations need to question how widely they are opening their talent pipeline when they are filling vacancies, she said, noting Aetos has a system that tracks managers by gender and racial diversity, and allows the firm to “do a self audit to really explore some of the reasons why you passed on some of those managers, especially compared to some of the ones that you pick in their place.”

Kate Murtagh, managing director, sustainable investing and chief compliance officer at Harvard Management Company, said investment professionals sometimes “forget how closeted an industry it is.”

Aside from internship programs, outreach to community colleges and first-generation college students is something large and small investment firms can do, she said.

“Some of the big shops will tell me, ‘oh, well, people know how to get a job here.’ It’s like you go to this school and then you go to that business school and then you go to this investment bank. I grew up in Troy, New York. That was all news to me. I had no idea how this industry worked as a first-generation college student.”

Anne Westreich, managing director and senior consultant at Verus Investments, talked about teaming up with data firm eVestment for diversity disclosure. Verus helped create the Institutional Investing Diversity Cooperative or IIDC, which now has 26 investment consulting members advising on more than $43 trillion in assets.

“Everything in the light of day is much more clear,” Westreich said. “So we can then talk about progress and then we can see what the progress is with each of the managers and the industry as a whole.”

The Public Employees Retirement Association of New Mexico, PERA, is increasing its allocation to private markets to 40 per cent of its $16.6 billion portfolio in the hunt for illiquidity premiums, despite the spectre of markdowns ahead.

The proposal for a 7 per cent increase to private markets focused on private equity (where the allocation will grow from 12 to 17 per cent of AUM) and credit is about to go to PERA’s full board for approval, explains Michael Shackleford, the pension fund’s new CIO who took the helm in August. In the pipeline before he joined the fund, if approved, the boosted allocation sourced by reducing investments to emerging market debt and core bonds, will mark the first of several changes he plans for the portfolio.

“Relative to peer funds, we are near the bottom in terms of the amount of risk we take. Increasing our investment in private markets will allow us to take incrementally more risk to generate incrementally more return,” he says.

Although darkening economic clouds put the risk of investing in private markets increasingly front of mind, Shackelford says it remains outweighed by the potential returns compared to public markets. “It’s true that investors are driving down the illiquidity premium in private markets – the more you pay, the less the return. At some point that premium will be driven down so much it may not be worth it and we might as well all be in public markets, but this is still a few years down the road.”

Those risks are most prevalent in private credit where Shackleford notes that the illiquidity premium has reduced on the back of higher interest rates. “High yield bonds and leveraged loans are closer to where private loans are at the moment.”

Still, long-term he expects private credit to outperform public credit once interest rates come down again. “Over the long term, we will be paid to own private credit over public debt. We still have a meaningful allocation to core bonds, high yield and leveraged loans but private credit is a good way to add returns.”

New managers

PERA will most likely re-up with existing managers in private equity but in credit the hunt for new managers is underway. A key element of the bigger allocation involves moving away from credit hedge funds and investing instead with direct lending managers focused on middle market companies with a good track record in terms of yield. Strategies could include making loans to solid companies with a private equity sponsor able to step in and provide the capital, he says. “If the business gets into trouble, you can take possession of the assets and pay off the loan.”

The hope is this approach will do better than PERA’s allocations to credit hedge funds where he says success has depended on managers performing in volatile public markets and successfully picking winners and losers, rather than a simplified approach making loans based on the fundamentals of a company. “Credit hedge funds have had a hard time – it’s much harder for a manager to get it right.”

Private credit managers in contention include relationship formed at North Dakota Board of University and School Lands where as director of investments he was involved in seeding funds with a raft of managers. “I am already talking to them,” he says. Elsewhere, Shackelford plans to draw on PERA’s own bench which he has spent his first months vetting and getting to know.

Open ended

Shackleford is a keen proponent of open-end fund structures which, rather than a one-off commitment, allow investors to add money over time. “I want to give money as we have it. This way we also will get distributions back in terms of interest payments, but no principle back until we want it.”

He is also interested in credit managers offering opportunities to seed funds in an approach that allows PERA to influence the structure and model of the investment alongside lower fees. “Say we go into an existing fund paying 75 basis points in a management fee,” he says. “Compare that to seeding a fund and paying 30 basis points in a manager fee – that equates to an increased alpha of 45 basis points. Almost half a percentage point is meaningful over a long period of time.”

There are a few caveats, however. Seed funding requires chunkier sized investments and inhouse skills to evaluate direct investments. It also involves investing in a smaller number of companies with more concentration risk than a pool. “If you have a good staff of people who can review investments and you have faith in the manager, you can make those types of investments.” PERA, which outsources all asset management excluding a cash management piece, has an internal staff of about 13.

In private equity he increasingly favours co-investment but via open-end fund-of-one vehicles rather than bespoke co-investment transactions. Once again, this structure allows him to add capital as he goes, and seed funds without a management fee. “Funds-of-one are open ended so you can add more capital as the manager does more deals,” he explains. “All we do is add capital to the fund of one and then we can co-invest alongside the manager’s second fund. If the manager does a third fund, we add more capital to the fund of one and co-invest in the third fund.”

Risk parity

In another shakeup, Shackelford is cutting back on PERA’s risk parity allocation setup by his predecessor Dominic Garcia in 2018. He plans to pare back the allocation from 10 per cent to 8 per cent of assets under management in the first step of a reduction that is likely to go further still. “It could get cut back more in the future, but 8 per cent is a good start. We will continue to monitor it.”

The decision isn’t just based on the fact risk parity has had a difficult year. He is also questioning the role of risk parity in a multi-asset portfolio – namely the rationale for a meaningful allocation to a substitute multi asset portfolio that mirrors the large portfolio.

“Using futures and derivatives to get exposure to stocks and bonds and commodities and trying to balance those risks is fine, but in this market where all stocks and bonds are down because of high inflation this strategy doesn’t do very well. My view is that we can cut this back and do other things with our risk dollars.”

ESG

Shackleford is steering clear of the ESG debate raging amongst fellow US public pension funds. New Mexico currently views ESG integration by its managers as a nice-to-have, add-on that is not essential. “It’s not required by law and the board haven’t spoken on the issue,” he says. ESG integration only manifests in a tie break between two managers offering the same returns, style and strategy. “There are arguments on either side of the debate. It’s not something we ask our managers to have. It’s a contentious issue; the best thing to do is for the legislature to speak otherwise you are dammed if you do and dammed if you don’t.”

 

Sustainable investing needs to be defended from external attack as questions are raised about how much change it is actually achieving within portfolios and out in the world, argued David Wood, director of the Initiative for Responsible Investment at the Harvard Kennedy School.

Simple stories of “politicised versus non-politicised investment” do not make sense in light of the history of ESG, he said. Rather, ESG has come out of attempts to make sense of the relationship between finance and society, he said.

“I think the point of history we are in right now [shows] a growing consensus that ESG can’t be an end in and of itself,” Wood said.

Speaking with former PRI CEO Fiona Reynolds, now the chief executive of Conexus Financial, at the Sustainability in Practice forum held at Harvard University, Wood said sustainable investing has always been a way for investors to navigate the world and steward their assets according the belief that there is more to risk than simply volatility.

Against a backdrop of anti-ESG discussions in the media and a backlash by politicians, particularly in the United States, Wood said criticisms of “woke capitalism” are “mostly bad faith” and “there’s nothing necessarily politicised about investors addressing the climate crisis or economic equality or racial injustice.”

“These may not fit neatly into the relative valuation of enterprises or deals, but that doesn’t mean they’re not investment issues. I think that’s the whole point of the growth of this field.”

Wood pointed to a tension within the field that had existed from the beginning. A focus on values, not value, led to the social and environmental analysis that is at the heart of what ESG investors do today, he said. This meant sustainable investment has always been both a critique of, and an embrace of finance.

“You’ve got to believe that finance can fix things, and that we need to fix finance,” Wood said. “Everybody in the field of responsible investment believes those two things at the same time,” although the proportion or weighting of these clashing ideals varies from person to person, he said.

The years following the GFC saw an explosion of developments in the field, with asset owners embedding ESG into investment beliefs and strategies, collective action on topics like sustainable palm oil, and the take-up of these ideas in public policy. But this came with a cost.

“The essential tension–at least the critique of finance part–got buried in the public story and the growth of the field. You hear instead that sustainable investment is just investment…it’s not something different. But if it’s not different, what are we doing?”

History has now reached a point where people are asking how much we are getting out of these efforts, how much is changing within portfolios, and how much is changing out in the world, Wood said.

In his summary of the history of ESG, Wood also took aim at other misleading arguments such as the “simple division between divestment and engagement.” The two have always been inherently interlinked, he said.

The anti-apartheid movement drove divestment discussion into the institutional world by linking retail and institutional investors in the United States, and catalysing the development of engagement networks starting with the Interfaith Center on Corporate Responsibility, and feeding into later developments like the PRI Collaboration Platform and Climate Action 100+.

“There’s no simple division between divestment and engagement,” Wood said. “The divestment movement built the infrastructure for engagement.”

He also praised the UN’s PRI as offering “a master class in institution building and organising,” as it got the world’s biggest asset owners to sign first, who then leaned on asset managers to sign on.

“The principles were aspirational so they were non-threatening,” Wood said. “And you know, lo and behold the Great Financial Crisis comes along and responsible investment was seen as a response from investors: how to think maybe more broadly about the role of finance in the world.”

The Abu Dhabi Investment Authority, the 46-year-old state-owned investor with an estimated $800 billion assets under management, is planning to set up a specialist independent research unit. ADIA Lab will operate as a standalone entity with broad research goals to explore the latest trends and technologies in data and computer sciences.

Projects and research programmes will not be designed specifically to enhance and support ADIA’s investment programme, which already has its own 50-person in-house team of quantitative researchers and developers. ADIA Lab’s research agenda will be set by an advisory board of scientists, independent of ADIA, and a key rationale for the new unit is to nurture an innovative IT ecosystem in Abu Dhabi as the economy diversifies from fossil fuels.

Still, that won’t rule out the research, which will span data science, AI, machine learning and quantum computing, all highly applicable to the global trends set to drive returns in the future like the transition, blockchain, financial inclusion, cybersecurity or space, informing ADIA’s investment processes.

Next step

ADIA Lab marks another step in the giant investor determinedly boosting its technical prowess and application of technology. Speaking to Top1000Funds.com last year Jean-Paul Villain, ADIA’s director of strategy and planning, said ADIA had missed out on opportunities to generate alpha because of a lack of investment in big data and AI.

Over the last 18 months ADIA has begun investing in different kinds of quantitative approaches staffed by an in-house team of quants, physicists, AI and computer experts drawn from hedge funds and academia. They collect, clean and test data to apply across the portfolio from long short equity allocations to tactical positions and facilitate access to the best managers – around 55 per cent of the portfolio is externally managed.

Collaboration

Perhaps one of the most important benefits to ADIA will come from the investor’s proximity to ADIA Lab. ADIA Lab may not be housed in the same high rise building as ADIA, but investment staff will be able to interact and collaborate with researchers, academics and global experts in data and computer science and further embed a scientific mindset through the organization.

Start-ups

ADIA Lab will also focus on projects that could lead to the creation of start-ups. This doesn’t mark the beginning of ADIA investing in start-ups like some other state-owned investors, however. For example, in a pioneering strategy, Singapore’s Temasek creates and seeds its own innovative companies from scratch, effectively building its own strategic capabilities rather than investing in entrepreneurs in the space. ADIA does invest in start-ups of a certain scale through a venture capital allocation in its private equity portfolio, but doesn’t tend to invest in the UAE.

In school, children are first taught to master the basics – what we used to call the “Three Rs” – “reading, writing, and ‘rithmetic”. These areas are widely understood to be the fundamentals of education, and without them a student cannot progress to higher levels of learning or reasoning.

The same can be said of investors. Many of today’s investors have been drilled in the basics of return and risk – or volatility, the traditional definition of “risk.” We know that there is no return without some risk, and we evaluate how much risk is palatable given our objectives. In years past, these two “Rs” were sufficient to succeed. But today’s investors know that isn’t the case anymore, and a third area is necessary to outperform in the future. The third R is resilience.

Resilience isn’t taught as a core principle of investing, but it should be. Investors today, particularly institutional investors that manage others’ money over longer horizons, must meet expectations that go well beyond hitting a target rate of return with a given level of volatility. Meeting these expectations means being able to adapt to unforeseen events or paradigm shifts, and incorporate objectives beyond return. These objectives may be related to targets on climate, progress on diversity and inclusion practices, limitations due to geopolitics, and many other issues.

When investors ignore these other objectives, disruption often occurs – usually enough to cause the investor to make costly changes at the worst time. Building portfolios that are resilient to changing expectations or guideline for how return is earned is critical, especially for investors with very long-term horizons.

Modern Portfolio Theory, as introduced by Harry Markowitz in 1952, taught us about risk and return and the “efficient frontier.”

This was the start of “two dimensional” investing. Prudent investors seek to build efficient portfolios – those that maximize expected return for a given level of expected risk. A portfolio with scope to target a higher return with the same level of risk – or the same return with lower risk – is considered “inefficient” it lies below the efficient frontier. Prudent investors could choose different combinations of risk and return along that line, but never below it.

During the second half of the 20th century, before Modern Portfolio Theory was fully incorporated into investment decision-making, there were likely many inefficient portfolios. But as tools improved, fiduciaries recognized that targeting efficient portfolios was both more beneficial and their duty. There are some drawbacks to such an approach, but the goal of building an efficient portfolio along return and risk targets is now universally accepted.

Today, in light of changing expectations and aided by new information, we are now considering how to build efficient portfolios on three dimensions: risk, return and now resilience. Rather than a simple two-dimensional curve, think of a building with a large, curved roof. Points along the axis are efficient combinations of risk, return, and resilience. As in Modern Portfolio Theory, prudent investors could choose different combinations of risk, return and resilience along this line. However, choosing a portfolio inside it – one in which risk, return, or resilience could be improved without affecting any of the others – would be inefficient and imprudent.

A three-pronged optimization of a portfolio isn’t a new idea. Investors have long been aware of a “3-D framework”.

In fact, a 2019 study from AQR Capital Management proposed a theory in which each stock’s ESG score both (1) provides information about firm fundamentals and (2) affects investor preferences. The solution to the investor’s portfolio problem is an “ESG-efficient frontier”, showing the highest attainable Sharpe ratio for each ESG level. Roger Urwin has called 3-D portfolio frameworks that incorporate impact “a game changer”.

For fiduciaries, it may be more intuitive to consider resilience than ESG or impact. If an investor has made a net-zero commitment, for example, then perhaps their measure of resilience is their carbon footprint, as they will be unable to hold investments with high carbon outputs over time. If the investor could meet the same risk/return targets with better resilience, why wouldn’t they do so?

Similarly, an investor may be concerned about being able to hold investments in certain countries over time due to geopolitical implications. If there were similar investments in countries without such risks, it would make sense to adjust their portfolio.

There is a lot of discussion today about whether sustainable, “ESG”, or net-zero portfolios entail trade-offs. The answer is that it depends on where the portfolio starts. Given how new this line of thinking still is, it is likely that the portfolio is inefficient by the standards of our three-dimensional frontier. In that case, there is no trade-off at all, and there may in fact be Markowitz’s “free lunch” of investing – building resilience by moving towards the “resilient frontier”. Of course, if the portfolio is already on the frontier, there will be trade-offs to increase resilience, just like there would be trade-offs to add return or reduce risk.

Given that the role of a fiduciary is to optimize the portfolio for their beneficiaries over time, a prudent investor must try to be on that new frontier to fulfill their fiduciary duty – to maximize return with a given level of risk in a resilient manner. Even under US law, “risk-return ESG” is permissible in contrast to “collateral benefits ESG”.

Some may say that this is simply good investing. But as prior work in this area has shown, there is indeed a method to considering changing environmental, social, or geopolitical factors in the investment process. And it is necessary to build portfolios that are well-positioned to adapt to a changing world and prosper in the long term.