Pension funds around the world have made ambitious net zero commitments but war in Ukraine could blow them off course. Investment in fossil fuels and possibly higher emissions may be the only alternative to generating the kind of energy output lost from Russia following western economies desperate scramble for alternative supply, says Wyn Francis, CIO of the UK’s £57 billion BT Pension Fund, the UK’s largest corporate scheme which is aiming for a net zero portfolio by 2035.

For sure, the decision by western governments to dramatically cut their dependency on Russian fossil fuels is likely to accelerate investment in the transition as part of the solution. But in a counter narrative that Francis says started to bubble at COP26, the spotlight will also turn on the economic cost of the energy transition, resulting in many investors’ paths to net zero being neither a straight line, nor as obvious.

“The landscape has changed because of this war,” he says. “I don’t’ know what the answer is, but I do feel that now we will get some sensible discussions on what the transition actually looks like with associated investment opportunities.”

The pressure on the green transition as western economies pull out of Russia and change their energy sources, already visible in talk of more coal production in Europe and North Sea oil and gas investment, is just one facet of a much broader, seismic shift. Indeed, Francis believes investors face a seminal moment in history that marks a turning point with decades-long reverberations for markets, asset values and life.

Moreover, unlike in the past, it is not an event that central bank policy makers can easily fix.

“I am struggling a little with the market sentiment that seems to be that this is just another event that The Fed and central banks can step into and sort, or that Russia will pull out and we will go back to normal. I expect a decade long impact on lots of structures that we have taken for granted for the last 20 years.”

For now, like many investors, BTPS’s portfolio is largely unscathed. The pension fund had light exposure to Russia with most confined to active managers in the credit space which had been gradually whittled down because of enduring challenges around ownership rights and governance. BTPS began 2022 with £200 million in exposure to Russia which had fallen to under £50 million by the end of February as sentiment soured.

As for unknowns in the months ahead, for now he’s relying on BTPS’s active bias (it only has one semi-passive allocation in the whole portfolio – a relatively small equity mandate with an ESG filter) to navigate complex corporate challenges, supply shocks and inflation coming down the line.

“It will be difficult to control some of these exposures if you are sitting in passive equity and credit mandates,” he predicts.

Modern portfolio approach

BTPS’s won’t know the extent to which the war has blown its ambitious 2035 net zero pledge off course until it is due to review that target in two years. So far that trajectory has been closely intertwined with a de-risking journey which also targets a cashflow matched position by mid 2030s and has gained most momentum in the last five years. Both de-risking and achieving net zero has required a significant churn, selling out of assets and moving from equity to cashflow-aware, net zero allocations.

BTPS’s twin de-risking and net zero objectives are aligned via a modern portfolio approach, adopted in 2021. Portfolio construction eschews traditional asset allocations to consider instead the function each asset plays in the portfolio: de-risking doesn’t necessarily force the pension fund out of an asset class because it no longer fits, instead, assets find different roles and perform a different function.

For example, five years ago, BTPS’s real estate portfolio was equity-like and highly focused on returns to help meet funding targets. Now, rather than chasing capital gains, this portfolio targets steady, secure income over a longer duration than a standard corporate bond. Similarly in infrastructure, assets have been transitioned by changing ownership structures into a lease.

This multi-functional lens is particularly easy to see with an allocation to corporate bonds, explains Francis.

“A corporate bond contributes to returns via a credit element and helps hedge by throwing off duration. If investors select a particular type of bond, it can also help their net zero ambitions.”  Francis gives particular credit to BTPS’s governance and trustee support for the strategy and their preparedness to let go of the guiding ropes of a traditional asset allocation.

“Governance around the investment bit is often underrated,” he notes.

larger, deeper relationships

The only allocation run in-house is a large LDI portfolio. The rest of the portfolio is outsourced to around 25 managers.

“We are not currently re-tendering any part of the portfolio. We tend to stick with our managers and don’t flip them around. We want them to invest in our relationship, understand our objectives, and for them to know they are there for the ride if they deliver on these objectives.”

The current 25 has been arrived at over the last five years in a quest for larger, deeper relationships that through scale benefits, also drive down costs. The main allocations to infrastructure, property and private equity are run by Hermes, which it previously owned.

Part of the rationale to allocate to external managers includes a belief that internal management can imbue a damaging sense of competition that is detrimental to the fund as a whole.

“If you build an internal deal team, they want to do deals but very often the opportunity won’t be there; the pricing is not there and saying no to the team could cause problems,” explains Frances. Today’s tight and competitive infrastructure market is a typical example.

“If we had an infrastructure team in house looking to print tickets but the investment process deemed the market too tight, that team would get frustrated. It could create a cultural problem that would be difficult to manage.”

Hedging uncertainty

The internally run £18 billion LDI portfolio is mostly invested in index linked gilts.

“We only run allocations internally if we think we can add value, and the LDI allocation was an obvious one,” says Francis. Following a multi-year build out, the allocation now only requires ongoing management. It has hit a hedge objective of close to 100 per cent hedged on a funding basis.

“Stable funding is really important to us, our Trustee and our sponsor,” he says.

The rates and inflation hedging program is the product of five years work in a strategy crafted to slowly build up the ratio and ensure the fund was never forced to hedge at a particular time. Central tenets to building out the portfolio required “being under the radar” says Francis, who was head of investment risk and implementation before becoming deputy CIO in 2014 ( he made CIO in 2021) and says that leaving little or no market footprint was a priority.

“At the start, the challenge was to be under the radar. We were an obvious candidate to start hedging and it wasn’t difficult to work out which side of the market we were coming in on.”

A key challenge in the hedging portfolio today involves managing the caps and floors in a dynamic process that moves the hedge ratios with inflation depending on how the team feel about prevailing conditions.

“We have a number of 3 and 5 per cent caps on inflation and we can’t just leave them,” he says, describing a process that strives for efficiency and taking opportunities  relative to price moves when they arise.

Against the backdrop of potentially unprecedented challenges ahead, Francis finds comfort in clear objectives to build a low risk, net zero portfolio following a well-worn and repetitive process.

“My main objective is to make things as boring as possible because then I know I am doing a half-decent job,” he concludes.

 

With US inflation hitting its fastest annual pace in 40 years, the “output gap” method central banks use to forecast inflation, using the difference between potential output and actual output over the projection period, appears to have broken down, says Warwick McKibbin, Professor of Public Policy and Director of the Centre for Applied Macroeconomic Analysis in the Crawford School of Public Policy at the Australian National University.

Dealing with inflation while balancing fragile economies will require careful use of monetary policy, balanced with green infrastructure spending and investment in ongoing pandemic prevention measures, McKibbin said.

 Speaking with Top1000funds.com editor Amanda White on the Fiduciary Investors Series podcast, McKibbin said more inflation is likely due to the war in Ukraine, not just from surging gas prices but also in agriculture and food, with Russia and Ukraine making up around 40 per cent of global wheat production. This would be a “very, very significant impulse to inflation,” he said.

“That itself is very bad news for the emerging world, because food is a much larger part of the budget of the poorest people on the planet,” McKibbin, who was a former decade-long board member of the Reserve Bank of Australia.

 Higher inflation expectations in the US could cause a wage price spiral similar to what was seen in the 1970s, leading to ongoing interest rate hikes by the US Fed. But the Fed will “have to be very clear in how they communicate the reason for the increasing interest rate,” he said, with a lot of sensitivity in demand conditions in the US economy due to higher oil prices squeezing household budgets at the pump.

Conditions in Europe are more sensitive, he said, with Europe’s energy systems highly integrated with Russia’s. Europe faces increased uncertainty, which is “bad for investment, bad for demand,” he said.

“If Europe does stop buying gas and other assets, other fuels, from the Russian economy, that will cause a recession almost without doubt,” McKibbin said. This will put pressure on the European Central Bank to ease its ongoing tightening of monetary policy, he said.

 The Fed raising interest rates could also lead to capital flight to the US from other emerging countries, he said, putting downward pressure on exchange rates, increasing import prices and driving inflation.

 “My guess is you’ll see Russia probably default on their debt, the Russian economy being crushed, not by military action but by economic action, and I think you’ll find that that will propagate throughout the world as well,” McKibbin said. “So there’s a risk for increased financial crises in a number of emerging countries, and that’s a very, very delicate point in the world economy the central banks have to manage.”

Dealing with this situation will force governments to look beyond monetary policy, bringing in fiscal and climate policy as well, he said.

 “I think the climate policy is a key one that’s not being used or thought about as a macroeconomic instrument, but in fact I think that’s where the potential for strong investment and productivity growth can come from,” McKibbin said.

Climate change is leading to supply-side shocks that could prove to have enormous impacts on the global economy, leading to a growing field of work modelling the shocks that come from climate change.

Persistent increases in temperature could impact agricultural productivity along with labour participation and efficiency, leading more broadly to a negative impact on production and employment, McKibbin said. And this is before speaking about the increased frequency of extreme weather events.

Policy instruments like a carbon tax could drive higher costs in societies that use fossil fuels for electricity generation, leading to supply shocks such as increased cost of transportation.

Green infrastructure spending could provide a short term demand stimulus, and a long term expansion of productivity of the private sector, offsetting this supply shock, McKibbin said.

Climate policy needs to be distinct and predictable with a long term trend in inflation built into the price of a carbon tax, he said, avoiding the volatility that could come from a cap and trade policy.

In terms of how Covid-19 will continue to play out, McKibbin said the pandemic is “nowhere near being over” with continuous emergence of new variants out of large populations in emerging countries who are not immunised.

“This isn’t over until the whole world is vaccinated, and that won’t be happening for quite a few years,” McKibbin said. “So we have to live with the uncertainty.”

This will increase risk, reduce capital investment and cause persistent low economic growth, McKibbin said.

“The key lesson is if you’re going to invest, don’t invest in dealing with the pandemic, invest in prevention,” McKibbin said. “Prevention is all about public health in poor countries, changing animal-human interactions, but also investing in public health systems.”

 

For more on McKibbin’s modelling on the impact of the pandemic on the world economy, see Long COVID for the global economy.

Historical performance and cash flow characteristics differ enormously among infrastructure asset sectors, and even between assets of the same sector, says the vice president of PGIM IAS’ private assets research program. But scarcity of data makes infrastructure performance notoriously hard to study.

As asset owners increasingly look to infrastructure investments for stable cash flow and diversification in a low interest rate environment, they need to better understand the wide variation in performance between sectors and business models, says an expert at PGIM, the global investment management business of Prudential Financial.

Junying Shen, vice president and co-head of the private assets research program in the Institutional Advisory & Solutions (IAS) group at PGIM, said IAS research indeed found infrastructure equity assets show only moderate correlation with public debt and low correlation with public equity. Conversely, infrastructure debt assets are highly correlated with public debt.

Speaking on a podcast for Market Narratives with Amanda White, the editor of Top1000funds.com, Shen said both infrastructure funds and direct infrastructure assets were found to perform resiliently during periods of public market volatility.

While public equity and high-yield credit declined on average around 10 per cent and 5.5 per cent respectively during times of volatility, infrastructure equity assets rose by 2.4 per cent on average, while infrastructure debt assets and infrastructure funds both had only moderate losses of around 1 per cent.

Digging deeper into the pooled performance of infrastructure asset bonds, IAS found a large variation in the risk return profiles of different sectors within infrastructure equity. Annualised total returns for the last 10y ranged from 13 per cent for the mature traditional power generation sector, to 6 per cent for gas pipelines.

There was also a large dispersion of dividend payouts from infrastructure equity investments by sector and development stage. Investors in an established network utilities company could expect to receive dividend payments from the beginning of the investment, while a greenfield solar project may not receive dividends in initial years and may only begin to receive positive and rising cash inflows as the project matures.

Shen advised investors not to assume performance and risk based on an asset class, as there exists significant idiosyncratic risk between individual assets.

“Investing in just one or two infrastructure projects will probably fail to capture the cash flow characteristics of all of the pooled infrastructure, equity and debt sets,” Shen said. “But on the other hand, the closed-end fund vehicle allows investors to at least diversify their infrastructure investment exposure through a full spectrum of strategies, including core, core plus, opportunistic, green energy, region specific and niche strategy.”

Gathering data for this research is time-consuming and cumbersome due to the lack of data around infrastructure investments, Shen said, with assets valued infrequently and most private asset data providers reporting performance measures based on fund manager appraisal valuations which may not reflect fair market value.

Shen has a focus on quantitative research related to traditional and alternative assets, and the development of asset allocation models. Cash flow characteristics are particularly important in modelling infrastructure investments into a portfolio allocation framework that integrates liquidity measurement, she said.

IAS research will next delve into portfolio allocation and how performance and risk profiles shift with the inclusion of infrastructure investments.

 

After nearly a year at the helm, Edwin Denson, executive director and chief investment officer at the State of Wisconsin Investment Board talks to Top1000funds.com about changes in investment strategy, noting that active management and the need to take on more risk for the same return, are current guiding principles.

Top1000funds.com: Are you venturing into any new strategies and allocations and if so, what is the rationale?

Edwin Denson: We have made some changes to the sub-asset classes within fixed income. That includes increasing allocations to more credit-spread sensitive assets and less efficient segments of the market as well as adding capital where the strength of our internal team creates alpha opportunities. For example, in 2020, we launched two new internal fixed income strategies, our mortgage-backed securities and high yield bond portfolios. In 2022, we are continuing to add capital and build out those strategies.

Increases to those portfolios as well as a new allocation to leveraged loans are being implemented alongside reductions to US government and US investment grade credit. An increase to long-term Treasuries will offset the loss of duration from allocating to leveraged loans and mostly preserves the overall duration of the asset class.

Within public equities, the 2022 asset allocation is tilting towards sub asset classes that have more expected active return potential to increase the likelihood of meeting the 6.8 per cent target for the core trust fund over the long term, including increases to US small cap, emerging market small cap, and emerging market  ex-China large cap.

Our asset allocation and overall investment strategy allows us to take full advantage of the skill and knowledge of our staff. The confidence we have in the allocation comes because of the highly qualified staff that we have managing risk and generating the necessary returns through active management.

Q: What strategies do you have most confidence in and what is your strategy for a lower return environment?

A: Ultimately, we are long-term investors. The next 10 years will be challenging from a total return perspective as returns on assets are generally expected to be low relative to longer-term expectations, in part because of higher than average realised returns from risk assets over the last few years. The challenges of setting policy are twofold. First, the fund needs to take sufficient levels of total risk over time.

Second, the fund needs to shy away, to the extent possible, from the type of risk that can lead to negative short-term returns that are large enough to exhaust the WRS’ surplus used to increase annuities (the dividend surplus) in a short period of time, which could also put upward pressure on employee/employer contribution rates. To meet those challenges, we have implemented an investment strategy designed to weather various market conditions by allocating our capital to areas we feel the most confident we can generate reasonable returns based on the risk we are taking.

Active management is important to our investment strategy. Over the next 10 years, the policy portfolio is forecasted to return just 5.4 per cent which is below the system’s assumed rate of 6.8 per cent. We are using active management to make up some of that difference.  Since the end of 2018, we have moved from 56 per cent to 69 per cent of the fund being actively managed. In addition, we continue to believe in the value of internal management to drive returns at costs lower than the fees paid to external managers when we can support the strategy with both people and infrastructure.

Using our own staff to actively manage the funds is a key cost-saving measure that helps grow the fully funded WRS. We are currently managing approximately 50 per cent of fund internally. By using internal active management with our current asset allocation, which is tilting towards sub-asset classes that have more expected active return, we increase the likelihood of meeting the 6.8 per cent target for the core fund over the long-term.

In addition, the core fund uses a modest amount of leverage in its investment strategy. SWIB’s independent board of trustees has approved a leverage target of 15 per cent for the core fund. We are using leverage where it can improve portfolio efficiency in terms of return for risk versus alternative choices that do not use leverage. The leverage helps reduce risk by supporting a higher allocation to lower risk fixed income securities and a lower allocation to equities at the same overall target return. This strategy is one part of our overall long-term strategy of greater diversification and risk control.

Q: Could you detail the findings of your recent stress test and what it has told you about the portfolio, particularly around the need to take on more risk to get the same level of returns? How will you do this?

A: First, I should point out that more risk is required in 2022 for any particular core fund return aspiration.  For example, in 2019, when we engaged in our stress testing exercise, in order to achieve a 6 per cent return, there was a 10.7 per cent risk associated with that return. And for a 7 per cent return, there was a risk of 14.7 per cent. Now for those same two returns, 6 per cent and 7 per cent, we have to take almost 50 per cent more risk. We need to have 15.5 per cent risk to get the 6 per cent return and a little bit over 20 per cent risk in order to achieve the 7 per cent return. This is because more exposure to risky assets like public equity is needed in the allocation mix to achieve any particular return.

The outsized returns we’ve seen over the last three years have detracted from the forward-looking expectations. However, the good news is that higher returns over the last three years have built up the dividend reserve for annuitants. These returns have yet to fully flow through the system, given the five-year smoothing mechanism that is in place. And they do provide us a cushion to utilise an asset allocation that is expected to run a little on the cool side in terms of return over the next few years and avoid taking undue risk.

Q: Has the market regime shifted? Also, could you talk a little about the dangers of de-risking too soon and its impact on long term returns?

A: It is very hard to know in real time whether there has been a shift in the existing economic or market environment that will be persistent as opposed to transitory. The result is that at SWIB we have implemented an asset allocation that can help weather changes in market conditions without having to predict precisely when they will occur or if they are occurring. The structure of the plan also makes a huge difference.

The fact that the WRS is fully funded and operates on a unique risk sharing model means that we don’t have to chase every dollar of return as the risk climbs higher and higher. Instead, maintaining a disciplined long-term asset allocation allows us to take generate reasonable returns that help keep contribution rates for employers and employees stable and avoid large swings in annuity adjustments for retirees.

Q: How does technology support your active, in-house strategies? What is the fund doing specifically, and how is it changing how you invest?

A: We continue building out the technology to support internal management and new strategies. For example, we selected the SimCorp Dimension platform to serve as an integrated portfolio management and accounting system for our public markets portfolios. Ultimately, SimCorp will house a full view of our assets and will allow us to move away from using a third-party service provider for the investment book of record and middle office services. In conjunction with this new platform, we are also onboarding our first prime broker relationships.

SWIB uses eFront as a its software platform for private markets. This creates efficiencies in reporting, data warehousing and maintenance of the systems used for private equity, venture capital, co-investment, real estate, and hedge funds. As a result, we have automated transmission of transactional data and wire instructions, created consistent processing of transactions and valuations, and implemented key metric reporting.

Making enhancements to our data management to support the increasingly complex internal strategies and tools we are using remains a focus given the anticipated low return environment.

Q: What is your leadership style and why is enabling and supporting colleagues so important?

A: I think in the investment industry, it is easy to have tunnel vision and become focused solely on the investment strategy. My entire career has been concentrated on the investment side, but now, in the combined role of executive director and CIO, I find myself spending a meaningful amount of time focused on the culture at SWIB and my overall approach to leadership. My leadership style is to be less directing, other than reinforcing our mission and values and our vision and articulating the agreed upon objectives that help us get there.

And I apply that style consistently across the agency. I see myself as more of an enabler and a supporter setting folks up for success. I think that if we all live up to our organizational values – Excellence, Innovation, Integrity, Collaboration and People — that dovetails nicely with an environment where leadership enables and supports our employees rather than micromanage them. We need everybody to contribute, to be set up to win, and to be able to work together for us to achieve those objectives.

Q: What is the most important thing you’ve learnt since taking the helm?

A: The clear lesson from the past year is that you can’t be a good executive director/CIO by focusing only on the investment strategy. There is an impulse that pushes you toward what you know best, and it makes sense that if you can get the investment strategy right, everything else will work out. But there is a whole other skillset, and an entire list of non-investment challenges, that are just as critical to our success. So I am focusing on recruiting and retaining top talent across the agency, developing a culture that motivates employees, ensuring that we have the technology, systems, data and infrastructure to support our long-term goals, and engaging with our stakeholders around the state.

And, I’m also working on the investment strategy. The core fund returned 16.9 per cent in 2021, bringing the five-year return to 12.5 per cent and the 10-year to 10.10 per cent. Those returns exceeded the return of the core fund benchmark by 0.64 per cent, 0.43 per cent and 0.36 per cent, respectively, and continue to exceed the long-term WRS investment target of 6.8 per cent. We have a really solid foundation to build on, but we can never be complacent.

 

The move by  legendary US corporate raider Carl Icahn to force the board of McDonalds to change its policy on cruelty in pig farming has highlighted a risk to investors that is not going away.

His nomination of two directors to the restaurant chain’s board, in protest at the continuing use of gestation crates to confine pregnant sows, is a chance for the fast-food chain to get ahead of a flow of regulation before it inflicts escalating costs and reputational damage.

Gestation crates are small metal cages which prevent pregnant pigs from moving or even turning around, and bans on pig producers using them have slowly emerged across the world. The first was imposed in Sweden in 1994 and many western countries including the UK, New Zealand and nine US states have since followed suit.

But the scale and depth of legislation against the crates shifted when voters in California, Massachusetts and the European Union backed bans to prevent the retail sale of imported pork reared using gestation crates from outside their jurisdictions, not just their own farms.

California consumes 14 per cent of US production, so the impact will be significant when the regulation, which was due to come into force in January, but is currently held up in the courts, takes effect.

Opposition, and costs, ramps up

The escalation marks a dramatic shift in the landscape. The European Union is planning to introduce restrictions on imports of meat from caged animals from 2027.

There’s dispute over how much costs will rise as companies make the necessary changes to their production, but those that are unprepared risk being hit harder – both materially and in terms of reputation – than those that get ahead of the new rules.

For example, gestation crates have a lifespan of approximately 25 years, and any installed today are unlikely to be in use for anything like that long, leaving farmers with pig housing they have paid for but can’t use because it breaches new regulations.

Opportunities for investors

Consumers are also increasingly aware of the caging of animals, and campaigners and activists will not stop publicising the practice – and exposing those who continue to use it – until there’s wholesale change.

Sales of brands that cite animal welfare in their labelling increased by 27 per cent between 2019 and 2021, showing the opportunities available for investors. Whole Foods, which is already compliant, expects not to have to increase prices after the California crate ban comes into force, while shoppers in other stores face paying up to 7.7 per cent more for uncooked cuts of pork.

Investors and companies tempted to dig in to fight the new rules need only to look at how quickly egg production has evolved to see how fast the consumer tide can turn, and how quickly they could be left with dramatically devalued assets – facing high costs just to catch up.

More to come

Cage-free eggs represented just 2 per cent of the US market in 2010, but this increased to 28 per cent by 2020 and is expected to hit 70 per cent by 2026. The rapid growth has prompted Cal-Maine Foods, the country’s largest producer, to invest over $500 million since 2008 to expand the company’s cage-free egg production capacity.

In 2011, UK farmers lost £400 million in stranded assets in the form of recently purchased cages. UK farmers complained to government that they had budgeted for the cages to last for as long as 50 years, but those plans had to be scrapped long before then.

Many investors, including those in FAIRR’s $48 trillion network, will welcome Carl Icahn’s attempt to force McDonalds to live up to its promises on welfare grounds, but it’s evident that slow movement on gestation crates is as much an investment risk as it is an issue of animal welfare.

The financial, reputational and regulatory threats from continuing to cage pregnant pigs need to be addressed by the development of facilities that future proof farms by meeting and exceeding the coming requirements.

If the industry fails to prepare, it will risk falling behind regulation, ever-increasing costs and continued exposure to shareholder action – until it is forced to fall into line.

For investors managing ESG risks, the case for swift action is clear.

 

Jeremy Coller is founder and chair of the FAIRR Initiative, an ESG focused investor network, and Chief Investment Officer of Coller Capital. 

 

“When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbours get envious,” wrote Warren Buffett in his 2010 shareholder letter in one of his frequent criticisms of the strategy where investors borrow to invest more. “But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices.”

Buffet’s comments contrast with other investors who are equally convinced leverage provides a vital ingredient to their portfolios, either reducing risk by borrowing to invest more in low-risk assets and boost diversification, protecting their funding levels, or for a bolder cohort, allowing them to increase investments in risk assets.

Through the noise of protagonist assurances and critic warnings, one thing rings true. Against the backdrop of rising rates, market turmoil and pension funds’ ever-growing illiquid allocations, leverage is going to increasingly come under the spotlight.

Different strategies

Last year board members at CalPERS, America’s biggest pension fund, voted in favour of borrowing to invest an amount equivalent to 5 per cent of the fund’s value, around $25 billion, to help it meet its 6.8 per cent return target.

In the Netherlands, pension funds don’t lever their overall balance sheet but new laws being drawn up to support the country’s moves to a DC-based system are exploring how leverage could be applied between different lifecycle funds.

Canadian funds have been applying leverage for over a decade. The C$541.5 billion Canada Pension Plan Investments applies 22 per cent leverage to the portfolio, borrowing money to increase exposure to less risky assets and boost diversification without further increasing its already above average 85 per cent equity risk target. CPPI’s use of leverage leaves its risk tolerance unchanged, says Edwin Cass, chief investment officer at CPPI.

America’s State of Wisconsin Investment Board (SWIB) which manages $144 billion of state retirement and investment funds and has used leverage since 2010, approved an increase in the Core Fund leverage from 10 per cent to 15 per cent in its 2021 asset allocation in a strategy that involves reducing equity exposure by leveraging low-volatility assets like fixed income.

“The leverage helps reduce risk by supporting a higher allocation to lower risk fixed income securities and a lower allocation to equities at the same overall target return. This strategy is one part of our overall long-term strategy of greater diversification and risk control,” says Edwin Denson, executive director and CIO at SWIB. Elsewhere US funds like Texas Teachers introduced leverage in 2019.

In another approach, Sweden’s SEK849 billion ($90 billion) AP7 has a riskier strategy, borrowing up to 15 per cent of its portfolio value to allocate more to global equity.

“We can take on a bit of risk, and to get that additional risk we use leverage on our global equity exposure,” says chief investment officer Ingrid Albinsson. Sister fund AP1 has also been using leverage for a long time, motivated by diversification.

Other pension funds have a different approach. “Leverage can help increase fixed income exposure and reduce the total risk to a fund’s surplus,” explains Roman Kosarenko, senior director, pensions, at $2 billion listed Canadian corporate Loblaw Companies Limited who studies leverage use in pension funds. He says that once leverage is viewed through the lens of protecting the surplus – rather than focusing on asset returns – it is much better understood by pension funds.

“Every dollar of incremental returns you earn via leverage provides you with a surplus cushion to protect against a possible hit to your surplus, including from rising interest rates.”

Sources of finance

Over the years, Canadian funds’ expansion and sophistication in tapping leverage reflects how central the strategy has become with almost all Canada’s big funds running sizeable commercial paper programs and borrowing billions via the repo markets. CPPI issues commercial paper in the domestic, US and UK markets for terms out to 30 years. Elsewhere, it borrows in the repo market while around one third of its leverage comes through short selling derivative contracts.

The $227.7 billion Ontario Teachers’ Pension Plan has developed a sophisticated investment funding strategy designed to diversify the maturity, market-sources and cost of its borrowing run out of the Ontario Teachers’ Finance Trust (OTFT), set up in 2015 to sell debt to international institutional investors. Canadian funds have also jumped on green issuance as another source of finance, issuing around $6 billion of green debt to date.

Interest rates

Leverage strategies have been fuelled by low interest rates and rock bottom borrowing costs. Canadian pension funds with a AAA rating can borrow for peanuts, says Alex Beath, senior research analyst at CEM Benchmarking in Toronto who argues for them not to do so, is actually imprudent.

“In a low interest rate environment, not to consider how a fund might be able to use leverage is imprudent. It is so cheap to borrow, funds almost have to look at leverage as being part of a good fiduciary.”

Unlike Beath’s cheerleading however Malcolm Hamilton, senior fellow at the C.D. Howe Institute in Toronto, is a fierce critic of leverage. Still, he charts its origins from the same source. As interest rates dropped, real returns from bonds fell away. Pension funds found that increasing risk by leverage was a convenient way to meet their return objectives.

“What they’ve done is just as risky as reducing the bond allocation and increasing the allocation to public equity. Had interest rates not dropped, I suspect Canadian pension funds would have little leverage today.”

It means today’s changing macro picture of increasing interest rates and rising borrowing costs will put pressure on pension funds to ensure financing costs are adequately compensated with expected returns.

Investors using leverage and borrowing to invest by expanding their fixed income exposure in a rising rates environment, could end up buying into an overpriced asset that will steadily depreciate as rates rise. Today’s climate opens the door to operational unpredictability, making a fund’s liquidity profile and confidence in its decision makers crucial, says Kosarenko.

“Unexpected increases in interest rates devalue the bond holdings and substantially reduce the actual (as opposed to expected) rate of return on assets.”

It leads him to reflect that now might not be the time to embark on the strategy – and pension funds that have never used leverage may have missed the boat.

Pension funds that haven’t used fixed income leverage, missed years of opportunity to improve their surplus in an environment of secularly falling interest rates, he says.

“If CalPERS is just about to start using leverage, they’ve missed a lot. With interest rates about to go up, it’s probably not the best time to start using it,” says Kosarenko.

Pension funds that have never used leverage may have missed the boat.

Looking ahead he is also concerned with the proliferation of leverage strategies now offered to smaller pension funds via institutional pooled vehicles. These strategies are subject to more pronounced settlement impact, he warns. Leverage is best managed via separately managed, segregated, accounts which give essential operational flexibility which pooled funds, governed by fixed policies around rebalancing, lack.

“If there is a sharp rise in interest rates, pooled funds may still be forced to de-lever at a time bonds are temporarily cheap, selling out at prices they really don’t want to sell out at.”

Liquidity

Leverage depends on ample liquidity. Pension funds that use leverage need to have enough on hand to ensure interest rate payments on their borrowing on top of all the regular calls on their liquidity like paying benefits and cash on hand to meet capital calls. Getting a grip on liquidity was a fundamental pillar of CalPERS former CIO Ben Meng’s ambition to introduce leverage at the fund. Meng’s first step was developing a liquidity framework that identified the pension funds calls on liquidity as well as liquidity sources like dividends, turning assets to liquidity and borrowing capacity via repo markets.

At CPPI strategy is shaped around floors to its liquidity coverage ratios, below which the organisation is put at risk. Cass adds his priority is to target a level of liquidity that does more than simply allow the fund to meet its liabilities.  He wants money on hand through cycles to re-up with private equity funds while the variation margin in derivative contracts requires capital on hand.

But things can go wrong for investors re-financing repo arrangements on a regular basis, warns Serguei Zernov, formerly of OMERS Capital who is now an independent investment manager and researcher based in Toronto.

Acute illiquidity in the short-term lending market on the eve of the pandemic in March 2020 caused the repo market to become suddenly illiquid, making it costly, or impossible, to roll positions. Now investors are watching how current stresses in global markets linked to the economic fallout of Russia’s invasion of Ukraine impact.

“Without other recourses to liquidity, pension funds could be forced to liquidate investments and close positions at the worst time,” says Zernov.

For Hamilton, a key concern is Canadian pension funds ever-growing illiquid allocations, difficult to sell in a hurry. A prolonged downturn like the 1970s could have a significant impact on levered pension funds with a focus on illiquid investments, he warns. CalPERS’ board is as familiar with the investment team’s argument for a larger private equity allocation as they are its support of leverage. Building out the current 8 per cent allocation to around 13 per cent is a critical part of the return seeking allocation and central to the new strategic allocation.

the importance of Governance

Leverage fills many investors with trepidation but it’s worth remembering it will already exist in many of their investments. For example, private equity allocations to LBO funds will be highly levered, says Beath.

Elsewhere he notes how pension funds got burnt in the GFC with highly leveraged real estate exposure.

“A year before the GFC, if you’d asked them how much leverage exposure they had, they would have said none,” he says.

“Hidden” leverage on top of new strategies makes the need for governance even more important. Zernov stresses the importance of centralising the strategy beyond just an asset class level, aggregating and reporting all leverage instruments at the total fund level.

“There needs to be a clear understanding by custodians and board members what kind of leverage is used, and if risk is consistent with objectives and risk profile of the plan.”

At CPPI layers of robust governance include a special committee that came into play to control capital going out the door and ensure liquidity levels through the 2020 crisis. It was stood down nine months later.

Still, Hamilton argues that even Canada’s professional boards with their finance backgrounds and familiarity with the strategy, have governance gaps. Many public Canadian pension plans offer members guaranteed benefits with no link to fund performance, he explains.

“Members may bear part, or none, of the risk while the public bears all, or most, of the risk depending on the plan.”

He says that because members don’t bear the risk, the funds feel they can take more risk, free from ultimate responsibility.

“From my perspective, we have a governance failure – the public bears most of the risk while the plan members receive the expected reward for risk taking. No one represents the public interest in the decision-making process.”

No strategy, leverage included,  works under all conditions,  concludes Kosarenko.

“Pension funds using leverage should monitor market conditions and have policies on scaling down the leverage if there is a rising likelihood of deteriorating conditions.”