For a decade now, the behaviour of investors appears to have been predicated on the belief that a sustained acceleration in future inflation is unlikely. But if we are now entering an environment in which expectations of inflation begin to rise, the implications for investors are likely to be game-changing. A portfolio that is appropriate for an inflationary world is likely to be vastly different to one which has excelled in the last 40 years of disinflation.

Protecting a bond portfolio

Rising real yields and inflationary pressures are a key concern for bond investors, and conditions are likely to remain challenging for many developed-market government bonds in particular over the coming months. However, these assets may regain a role in portfolio construction as more elevated yield levels create attractive entry points.

There are a number of ways in which investors can seek to protect their bond portfolios in a more inflationary environment. Holding shorter-duration bonds helps to reduce the sensitivity of bond portfolios to rising yields. Other tools include inflation-linked bonds, such as US Treasury Inflation-Protected Securities (TIPS), and floating-rate notes where coupon payments rise with central-bank interest rates. Straightforward derivative strategies can help to protect against heightened rate volatility. Analysing the shape of any changes in the yield curve also provides opportunities to generate returns.

High-yield corporate bonds may also offer attractive characteristics. These bonds tend to be relatively short in duration and have a credit spread, providing a cushion against rising yields. Furthermore, while the economy is in a growth phase, companies are likely to be more profitable, meaning that they can better service their debt, resulting in lower default rates and potentially a tightening of credit spreads.

Finding equity opportunities

In equities, some of the more cyclical areas that have been out of favour in recent years may be set to outperform. Many ‘growth’ businesses, the relative winners of the low-growth, post financial-crisis world, have been trading at high valuation multiples, while those more cyclical areas of the market that traditionally benefit from higher inflation and higher interest rates now appear much cheaper relative to history.

Where can these stocks be found?

We see opportunities within parts of the financial sector; some of the large US banks, for example, have recently grown their dividend payments by 40%, as well as undertaking significant share buybacks. Together with the potential for multiple expansion, this has the potential to deliver a very attractive total return. Elsewhere, for many companies in the energy area, markets appear to be discounting a swift move to cleaner forms of power and the rollout of electric vehicles. Nevertheless, we believe there will be a need for transition fuels for some time, and see opportunities in certain businesses where we are observing a real shift in how management teams are allocating capital.

A different multi-asset toolkit

From a multi-asset perspective, a more inflationary environment over the medium term is likely to have profound implications in terms of how different asset classes behave and are correlated, and this will have repercussions for the way investment strategies are constructed. With bonds not offering the diversification that they have done in the past, it will be important to ensure that portfolios still have liquidity, tail-risk protection and alternative capital-preservation tools. Convex long option and volatility strategies, such as risk-premia strategies with an asymmetric return profile, could help and, if structured effectively, the cost of hedging may not be prohibitive.

Analysis of inflationary episodes and the performance of different asset classes over the last 50 years shows that bonds generated negative real returns during most inflationary episodes, and equities as an asset class also frequently underperformed. Gold performed strongly during the inflationary periods of the 1970s, but appears to have been much less related to inflation since then. On the other hand, commodities that constitute the raw materials of production processes have had a much more reliable relationship to inflation, with a strong positive correlation between broad commodity prices and inflation. Renewable-energy infrastructure assets, whose revenues are often linked to the rate of inflation, could also be well placed to outperform.

Ultimately, we believe an active and flexible approach will be critical in seeking to take advantage of a changing opportunity set, underpinned by a sound risk-management framework.

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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 2021, as the impact of the COVID-induced pandemic continued to be felt, we were on our toes to innovate our media and event offerings in a bid to give you what you needed to navigate a changing world.

We delivered four outstanding digital events and wrote more than 300 investor profiles and other analytical and research-driven pieces on the global institutional investment universe.

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 2021.

In February 2021 we launched the Global Pension Transparency Benchmark, a collaboration between Top1000funds.com and Toronto-based CEM Benchmarking, which ranks 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.

AIMCo, the C$118 billion Canadian fund appointed its first chief investment strategy officer splitting the investment function between the top down strategy and bottom up implementation responsibilities. We spoke to Amit Prakash, as part of our Investor Profile series, about how the new function will add valuable investment insights to clients.

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). As more investors around the world look at how to invest with a diversity lens we examined how investors in Japan, Sweden, the US and Canada are addressing the diversity question as part of their internal organisation and in their investments and the managers they work with.

Bridgewater’s head of investment research Karen Karniol-Tambour explained how integrating impact alongside risk and return is a revolution that will see more diversification among investor allocations to asset classes such as commodities. Elsewhere, it requires using multiple data sets to analyse stocks and sovereign bond allocations to see the real-world impact of a company’s product or services, and which governments are heading to net-zero.

And interestingly, research conducted by Scientific Beta looks at the performance of ESG strategies and asks whether non-financial information in ESG scores offers additional performance benefits. The research finds that the effect of risk adjusting the performance of ESG strategies shrinks the apparent alpha to a level where none of the strategies delivers positive alpha.

Earlier in the year we hosted celebrated economist Joseph Stiglitz, University Professor at Columbia Business School at one of our Sustainability events. He said that the slow pace around developing a comprehensive approach to debt in emerging markets and developing countries will result in a weaker global recovery. He urged for a restructuring of debt in a coordinated approach between the public and private sector.

More recently we looked at how the Abu Dhabi Investment Authority, the state-owned investor with an estimated $700 billion assets under management, is introducing more technology in its own internal processes and determined to become a more active – and reactive – investor. The fund’s decision to invest more in its own in-house technology came with the realisation that a slow down in its capacity to generate alpha was linked to a lack of investment in big data and AI.

Perhaps one of the most personal stories I have ever written is one remembering David Villa, the executive director and chief investment officer of the State of Wisconsin Investment Board who passed away this year.

David Villa was a unique thinker and generous with his ideas. It was hard not to be swept away by his passion for change. He had a deep thoughtfulness and desire to improve outcomes for his members and the many other pension fund members around the world for whom his peers managed money. This is worth remembering and anchoring ourselves in as we reflect on the year that was.

Thanks for reading.

 

 

Last year’s SPAC boom which saw 677 SPCAs raise an estimated $200 billion provided an unexpectedly rich seam of returns to the University of Texas Investment Management Co portfolio (UTIMCO). SPACs, or so-called blank check companies without any assets, float on the stock market and raise money from investors at which point they hunt and merge with private companies looking to go public and list.

Some of UTIMCO’s private assets were acquired by SPACSs in a process that achieved both liquidity and good valuations, said Rich Hall, UTIMCO’s new CIO responsible for investment strategy and selection and risk management at the $68 billion portfolio, taking over from Britt Harris who will remain President and CEO. Most recently UTIMCO’s investment team have developed strategies to arbitrage the market where Hall estimates there are still around 500 SPACs looking for acquisition targets.

The SPAC boom is part of the wider listing largesse that characterised 2021 as the capital markets roared back to life coming out of the pandemic. IPO markets have been at all-time highs, raising an estimated dollar value of $500 billion over the last two years, said Hall speaking at UTICMO’s December board meeting. UTIMCO benefited from the boom, particularly when some of the fund’s venture capital managers jumped through the IPO window to distribute significant cash back to the endowment. “It is market wisdom that when the IPO window is open you jump through it because you never know when it will close,” said Hall.

China challenge

In contrast, the growing regulatory crackdown in China has caused a more challenging investment backdrop in the capital markets. The Chinese government’s active regulation and intervention in the market in line with its social stability and political objectives has left the listing plans and investor hopes inherent in fast-growing Chinese corporates like Ant Group, and most recently ride hailing app Didi, in tatters. Elsewhere, investors have got burnt by the Chinese government’s decision to turn tutoring and education businesses into not-for-profit. “Many firms had investments in these sectors, and they’ve suffered significantly,” said Hall, adding that UTIMCO has no intention of allocating more to China. “We are very comfortable where we are.”

Still, uncertainty in China did little to dent UTIMCOs portfolio which grew by $15 billion last year on the back of robust contributions and exceptional investment returns, enabling it to distribute $2 billion to the university and medical systems it serves.

The portfolio is structured to provide diversity across different economic regimes with equity the wealth creator (propelled particularly by private equity), real return providing inflation protection and stable value countering the threat of deflation. For the year ending August 2021 UTICMO achieved a one-year return of over 30 per cent with every portfolio contributing alpha. The fund’s ten-year return sits at 10 per cent, well above a target of 7.5 per cent set to ensure the endowment doesn’t lose purchasing power through inflation.  “We target 100bps of alpha every year and on a 10yr basis, we are running 20 basis points ahead of that,” said Hall.

It leaves UTIMCO comfortably within Wilshire Trust’s universe of 13 similarly sized endowments with high allocations to private equity and venture. “We are in the bottom ten percent in terms of risk and the top 20 per cent in terms of return. Relative to a broad peer universe, we feel like we are doing pretty well,” Hall told the board.

Looking ahead

Looking ahead, Hall flagged enduring concentration in the US equity market. However, despite the fact the top ten stocks in the S&P 500 represent 30 per cent of the index; trade at a premium (to the index) and significantly move the market, he said these stocks’ influence was not “unwarranted” given they are the most profitable and fastest growing businesses around and can support higher multiples. Elsewhere, he noticed that although valuations are high, the dispersion of valuation is also high. “Managers still believe they can find good investment opportunities for us.”

A tone that informs his wider macro analysis of the year ahead. The sprint for returns is over and investors should now prepare for a marathon; the easy money has been made in terms of market returns but there is still some gas left in the economic tank – he doesn’t see a bear market ahead and is moderately risk-on.

Inflation (and strong wage gains) are risks and he warns supply chain disruption will continue to thwart business performance, observing how UTIMCO hears much more mention of both in earnings calls. Reflecting on the supply chain crisis, Harris stressed the dangers and damaging impact of the energy Transition going so quick it triggers spikes in energy prices and fuel shortages, recently visible in Europe.

However, above all that lies a still greater risk. If central banks turn suddenly hawkish and increase the frequency and magnitude of rate rises compared to what is already priced into the market, Hall warned that investors will face a far more challenging 2022.

 

 

The CIOs of two of Australia’s largest asset owners, Aware Super and UniSuper are looking to enhance their competitive advantage in an increasingly concentrated superannuation market.

The chief investment officers of two of Australia’s largest super funds have contrasting strategies to tackle regulation, investment strategy and performance in 2022.

Aware Super – the result of a merger of First State, VicSuper and WA Super – aims to continue growing through mergers which will create complexity for its investment management team, says CIO Damian Graham.

The fund engaged consultancy McKinsey to develop a five-year strategy which found some complexity was a competitive advantage in a crowded market, Graham says.

“The way we’re investing – internalisation as part of the portfolio, infrastructure and property, an internal macro strategy-style offering – those sorts of things are slightly more at the complex end but that’s a better way to apply risk where you want to be different,’’ he says.

The fund is investing in greenfield infrastructure and social housing, less in retail, with its property portfolio makeup of 35 per cent industrial, 30 per cent residential and less than 12 per cent in retail and some in office.

“That’s an active position for us. Do you think we can add value? Yes we’re happy to build greenfields assets rather than buy,’’ he says.

“ What we’re trying to do is reduce where we don’t want to be different or we don’t have a conviction – we are trying to close down those areas.”

Aware’s aim is to grow from A$160 billion to A$250 billion funds under management in four years, energized by mergers, with private market investment managers around the world in different locations, Graham says.

Aware expects to double its portfolio manager workforce to 200 as it increases its areas of excellence around real income and growth assets and supporting teams on property infrastructure, cash and trading.

Meanwhile, award-winning fund UniSuper has inhouse management experience that is a competitive point of difference, says its CIO John Pearce.

With industry heavyweights Chris Cuffe, Mark Armour and Felicity Gates among its investment committee, the fund runs a significant inhouse asset management business, Pearce says.

“It’s not simply a case of a board saying: ’we better pay higher remuneration and get the best people and away we go’. It’s governance structures and governance mindset that’s what’s really important,’’ Pearce says.

The fund has more than 450,000 members and A$100 billion in funds under management, while significant fallout expected for its university sector members was not as bad as predicted. Opening up to the public this year meant inflows have been “really strong”, Pearce says.

Yet to announce a merger, UniSuper is talking to seven funds and in due diligence with two, Pearce says.

Macroeconomic views

On a macroeconomic view, Pearce says bonds have become irrelevant for funds to match pension liabilities.

“If you started matching liability you would guarantee insolvency down the track,’’ Pearce says.

“There was no other option but to risk it. That’s what we’ve done and that’s what the central banks want us to do – to take more risk.”

In terms of digital and cryptocurrency strategies, Pearce says there is no “crypto seeping into UniSuper portfolios”.

“We’ve now got a $3 trillion market with no adult supervision and its definitely in need of that. The fundamental basis of crypto is flawed,’’ Pearce says.

However blockchain, the basis of cryptocurrencies, was “the real deal” and a reason why UniSuper is the largest shareholder in the ASX, a blockchain pioneer, Pearce says.

The direction of inflation is also front of mind at UniSuper.

“The questions that investment managers have to address will be the bond market and the central banks’ response to different scenarios. That’s the debate we’re having at UniSuper,” Pearce says.

“I find it hard, being an old timer that’s lived through inflationary periods, to hold bonds at two per cent and inflation’s travelling at four. What I’m saying is we’ll be a lot wiser by the end of the second quarter next year, but at the moment we’re playing things from the short side.”

 

Institutional investors are seeing their investment period with some private equity managers shorten. The time the GP invests in a company until the time they exit is reducing, meaning that investors are getting more cash coming back than forecast in their pacing models.

“For several quarters we’ve been net cash back for our private equity portfolio,” says Vince Smith, chief investment officer and deputy state investment officer at $31 billion New Mexico State Investment Council for the last eleven years. More cash coming back than forecast makes it difficult to hold up the sovereign wealth fund’s recently extended 13 per cent allocation to private equity and keep its weight to the asset class steady. “We are trying to increase our allocation, and in this environment it’s difficult,” he says.

Smith links the trend to the availability of liquidity meaning companies can go public and investors exit quicker than normal. Private equity teams are also turning companies around at a faster pace. “In some cases, they are just fixing the capital structure rather than overhauling company operations.”

Ideally the fund would have raised its private equity allocation to 15 per cent in its latest asset allocation study, but Smith and the team reasoned this would not be achievable in the study’s three-year timeline. The largest component in the private equity allocation is to growth and buy outs.

Venture Capital

Within private equity, venture capital has been the best performer but the allocation is not without its challenges, and Smith expects a tougher climate on the horizon as Central Banks pare back on their liquidity. “VC could run into some trouble,” he predicts. Getting into small VC funds, the best of which are usually closed to new investors  is an enduring challenge. New Mexico’s sovereign fund status has helped open doors that might be closed to underfunded US public pension funds. “Managers seem to favour our perpetual structure; our hand is a bit stronger. We’ve gotten into a couple of good funds,” he says.

Still, he notes that SWFs “the world over” face increasing pressure on their distribution rates. A factor he believes is contributing to SWFs increasingly aggressive growth allocations. “In the past, SWFs tended to have bond portfolios and maybe some real estate. The pressure on distribution rates had led to them wanting more expected returns.”

The State Investment Council also uses consultants to help access private equity funds and Smith observes enduringly tough fee negotiations as demand for the asset class continues. Elsewhere he says the fund still needs to pare back on the number of private equity managers and strategies in the portfolio which escaped a fund-wide manager pruning and restructuring in 2015.

New Mexico is also building out its private credit allocation, especially focused on the allocation for two new funds – the Tax Stabilisation Fund and Early Child Education and Care Fund. It has led to a hunt for private credit managers and strategies in an asset class he expects to grow in line with his broader anticipation of an inflection point ahead as central banks withdraw liquidity and reduce bond purchases. “If Central Banks withdraw, liquidity will have to come from the banks. They will have less capital to lend which will require more private capital to step in.”

The private credit allocation will be diversified across geographies and sectors, and he notes that the asset class is not as illiquid as often perceived. “We’ve found more liquidity than we expected when we moved into these markets. You can invest for shorter lock ups and there are quicker turnover periods.” Still, for an investor able to tie up money long- term this can be a double-edged sword. “We can’t always get the illiquidity premium.”

Macro perspective

The entire portfolio is externally managed, leaving New Mexico’s internal investment team of 12 primarily concerned with developing the outlook, strategy, and asset allocation in line with macro views. “Our manager selection is a tool to express those views,” says Smith. He has created a portfolio of standard investments allocated to well-known managers that shies away from complexity. He did away with a 10 per cent allocation to hedge funds and hasn’t integrated a global tactical asset allocation or related products. “Managers are always approaching us with new things, but our acceptance rate is pretty low,” he says.

Crypto: Not even close

He expects low returns going forward but sees light at the end of the tunnel, buoyed particularly by shifting demographics and the growing buying power of Millennials as they move to peak earnings. A tick up in productivity will help fuel growth but could also trigger deflation. It’s why he favours investments that throw off cash like infrastructure and real estate. He has no interest in crypto. “We are not even close yet,” he says, noting with surprise some US public pension fund investment. Houston Firefighters’ Relief and Retirement Fund recently announced that it had made its first investment in Bitcoin and Ethereum.

The portfolio is divided between stocks and bonds (50 per cent) and alternatives (50 per cent) where Smith is still filling out allocations to non-core fixed income and real return, both well below target. Building out the renewable allocation in the real return portfolio has been challenging because of competition, he says.

The allocation to core fixed income amounts to just 10 per cent in a reflection of traditional fixed income’s declining use in the portfolio. “Fixed income should provide income, liquidity and downside protection to stock investments, but it only does one of these things.” Unless there is a big sell off in the stock market, he doesn’t envisage any shift back into public markets.

 

 

A recent webinar hosted by FCLTGlobal, the not-for profit that aims to focus capital on the long-term to support a sustainable economy, urged investors to allocate more to emerging markets to solve the climate emergency and consider climate risk in every transaction.  Investors should include climate impact and a just transition into their traditional risk and return framework, said panellist David Blood, founding partner and senior partner at Generation Investment Management.

Dow, the global materials science company, has introduced a range of measures to achieve climate neutrality by 2050, said Jim Fitterling, chairman and CEO of the company. Dow has reduced its emissions by 15 per cent over the last decade and is targeting another 15 per cent reduction by 2030 driven by a sweeping investment program, he said. The company is increasing renewables in its power mix, as well as focusing on carbon capture, advanced nuclear and hydrogen strategies.

Most importantly, Dow’s decarbonisation strategy also allows the company to grow. “Investors understand you can grow and get your footprint down,” he said. “Investors want us to succeed and see us as part of the solution.” He noted how investors increasingly dig down into the company’s climate strategy details and like to see commitments and results.

Fellow panellist Kim Thomassin, executive vice president and head of investments in Quebec and stewardship investing at Caisse de dépôt et placement du Québec, said CDPQ uses engagement as a key lever of influence. The asset owner considers the ambition and potential of each investee company to reduce its carbon footprint, negotiates governance rights when it invests and measures progress.

For example, since CDPQ invested in India’s Apraava Energy in 2018 with the ambition to support the company’s transition, Apraava’s renewable energy mix has increased by 25 per cent. She said that CDPQ plans to exit oil investments by 2022. “Our capital remains available to energy companies that have a transition project.”

Giant asset manager Fidelity Investments’ fiduciary duty to maximise returns sits within the company’s sustainable strategy, said Pam Holding, co-head of equity and asset management lead on sustainable investing at Fidelity. Assessing corporate climate strategies is critical to understanding the long-term return profile of Fidelity’s investment. The asset manager determines where the risks are most material, and rank orders companies using a proprietary evaluation process drawing on quantitative and fundamental insights. Fidelity also actively engages with companies. “Every company is on a journey,” she said, adding that tomorrow’s climate winners maybe only just starting out. “Assessing climate strategies and risk is good business, and the right thing to do.”

ISSB

Panellists also noted progress on disclosure, namely the COP26 announcement from the IFRS Foundation that it would form the International Sustainability Standards Board (ISSB), tasked with creating a single set of standards to meet investors’ information needs. However, disclosure in private markets is a growing concern. “How we manage disclosure in private markets is critical,” said Blood.

Thomassin noted that although public companies are in the spotlight, investors also scrutinise private companies; the same ESG rules apply to public and private companies, she said outlining how CDPQ works closely with private companies and that private companies increasingly “ask for help” to adapt and transition. She added that CDPQ  now ties a portion of its own variable compensation to climate change targets.

Challenges accessing corporate data risks investors making the wrong judgements. It also introduces the risk of greenwashing in the asset owner and manager community. Companies and investors need to demonstrate they are not just talking about net zero commitments, but put in place actions to prove it, said panellists.

Fidelity is constantly trying to find new ways to access data, working with industry peers. “There are instances where data is sparse and not comparable from company to company,” said Holding. She spoke about the consequences of getting climate analysis wrong; incorrectly assessing the impact of climate change could mean investing in a company that fails to change or understand climate risk, she warned.  Investors need to be wary of double counting and additionality.

Fitterling said that a carbon price is preferable to government taxes. Taxes raise revenue for the government, but it’s not clear if they are redistributed to reduce emissions. Holding added that because data and comparability is still low, investors need confidence that credits are offsetting environmental damage.