In its latest position paper, Australia’s Future Fund outlines its investment approach in a new investment landscape characterised by the end of 60:40 portfolios, inflation, declining corporate earnings and climate change – amongst others.

Australia’s Future Fund, the $245.8 sovereign wealth fund, plans to modestly increase its structural risk profile to better target its 10-year benchmark of 6.1 per cent desired returns while continuing to appropriately moderate risk. In the year to June 30 it raised its risk profile and this will continue [See Future Fund adds risk and generates best ever return.]

In its latest position paper the fund also details plans to develop its models and governance to better combine its long-term investment strategy with the ability to move flexibly. Elsewhere, the fund notes an increased illiquidity tolerance given the current investment environment favouring skill-based returns that are worth the higher fees.

The plan is to also apply additional resources to identify and pursue high conviction value-add exposures particularly in private markets and debt. Private markets provide inflation protection and defensive characteristics, but the fund also sees public markets adding value via strategies that closely manage the use and costs of illiquidity.

Future Fund’s latest analysis of its investment approach is the consequence of significant changes catalysed and accelerated by COVID-19 that are creating a new investment order. Expect lower returns, more inflation risk, more divergence, conflict and market fragility, the fund argues. The current investment environment will also test long held assumptions and question the conventional wisdom that has guided the fund since it was established in 2006.

“We believe that the investment thinking that has delivered strong returns over recent decades needs to be revisited,” writes the fund. “We believe that preparation and monitoring the investment environment and testing our thinking and the assumptions on which it is built, are the best ways we can position our investment program to generate strong returns, with acceptable risk, over the long-term.”

It’s led the fund to consider a variety of plausible scenarios and consider how it can evolve and position the portfolio to be as robust as possible in those scenarios. All the while playing to its key characteristics and advantages of having a long-term investment horizon, a total portfolio approach and the ability to partner with high calibre investment organisations globally.

Paradigm shifts

The paper highlights paradigm shifts that are shaping the investment order in ways that should encourage investors to think afresh about their portfolios.

Deglobalisation is replacing globalisation as the hitherto free movement of goods and services, investment and people across national borders slows and in significant cases reverses. It’s resulted in tensions between the world’s two largest economies while technological developments are more closely guarded as part of national security policy.

Countries have reasserted their national interests, controls over national laws, and put a domestic focus over and above an open international system. National economic policies have moved towards greater state intervention and controls.

Technological innovations have allowed firms to develop operating models based on intangible assets, such as data and software platforms leading to the rise of digital conglomerates. Innovation advantages have led to disruption and dispersion within industries.

Many developed markets face ageing populations and have been reliant on migration to counter population contraction and ageing. Asset inflation has exacerbated wealth inequality between generations. In developed countries younger people may experience disadvantage in security of employment, house prices, higher education debt and record levels of national debt.

Physical climate risk has become more severe over time. Insured losses from natural disasters have increased from around $10 billion per annum in the 1980s to $45 billion in the last decade (inflation adjusted). Direct overall losses have been four times the size of insured losses and have increased approximately threefold in the last 30 years. Companies with carbon-intensive operations and value chains are potentially vulnerable to market repricing. Renewable energy is becoming cost competitive with traditional generation sources.

In the US corporate earnings have increased from around 5 per cent of GDP in 1990 to 8-10 per cent today. This has been driven by the use of technology and innovation to drive productivity improvements from intangible assets, capital friendly tax arrangements, restructuring, offshoring and automation which has reduced costs. If these trends come to an end, or reverse, (perhaps as a result of deglobalisation and populism) and without new sources of growth, expect downward pressure on earnings and equity returns in the decades ahead.

The forces that have brought inflation under control have ebbed or are now in reverse and the response to the financial crisis of 2008 and to the more recent pandemic have added to government debt burdens. Fiscal stimulation has added to burgeoning entitlements which can only be met by pro-inflationary policy.

In the aftermath of the financial crisis, institutional independence has been eroded through the introduction of measures such as Quantitative Easing, yield curve controls and other forms of central bank intervention in government funding markets in an effort to induce or support fiscal spending. The pandemic has further accelerated this shift.

As monetary policy reaches its limits and technological disruption provides scale with its low capital expenditure requirements, the traditional economic cycle is under threat and traditional metrics for assessing fair value are being challenged. There is an argument that the base rate and risk premium component of risk asset discount rates should be structurally lower – and valuations structurally higher than they have been through modern financial history.

Government bonds have been the defensive anchor of investment portfolios for over 30 years with the traditional 60/40 equity bond portfolio relying on negative correlation between the two asset classes. Nominal bond yields are significantly lower so the scope for bonds payoff is reduced. Investors have ended up paying to benefit from bond rallies rather than being paid. If inflation begins to rise the bond-equity correlation may prove much less beneficial going forward.

“I wouldn’t dare tell a company how it should be run, they are the experts. Rather than tell a board how to behave I would rather have them compete,” says Paul Droop, group pensions CIO of the Bank of Ireland who believes regulation is damaging free market competition in a worrying new shift that  poses the single biggest risk for investors.

That old photograph taken in the early 20th century of a horse and cart alongside one of Henry Ford’s first cars is often used today to describe the seismic energy transition ahead as the world moves from petrol and diesel to electric cars. But it belies one crucial difference. The first cars were a consequence of a market-driven change – no one told people to buy them. Today new rules decree that people can’t drive petrol cars for much longer, discouraging investment in the companies that make them.

Leaving aside value judgements and not expressing a view on the climate emergency, it is this emerging and worrying shift from liberal, market-based economies to centrally planned and regulated ones that poses the single biggest risk for investors, argues Paul Droop, group pensions CIO at the Band of Ireland, overseeing the €7 billion Bank of Ireland’s Staff Pension Fund (BSPF).

“There is an increasing shift away from liberal markets, promoted and driven by a growing range of sources. On a spectrum from very open and liberal market economies to another extreme of centrally planned, the world appears to be moving significantly towards central planning and control,” he says in an interview from the fund’s Dublin headquarters.

It’s not just visible in increasingly pervasive climate regulation. The pandemic has hastened the trend, ushering unprecedented rules and restrictions in response to COVID many of which still haven’t been removed.

“Permanent rules have come about regarding what we can and can’t do; how we behave and how we interact with one another.”

And it’s not only governments and regulators driving the shift. Asset owners and managers are hastening the trend too says Droop, particularly concerned about the growing role – and pressure – on shareholders to intervene in corporate governance.

“I wouldn’t dare tell a company how it should be run, they are the experts. Rather than tell a board how to behave I would rather have them compete.”

Only that competition is increasingly stymied in a threatening backdrop for BSPF’s portfolio exposed to the entire market and structured to tap every kind of risk. Droop’s risk management philosophy has virtually no reliance on alpha but emphasises diversity and resilience instead. The listed markets should be a field of competition where every buyer and seller can come together, he argues. That vibrancy and health depends on the best companies securing the most favourable access to capital and the worst falling by the wayside but rules that define what makes a good company distort the field.

“It should be a competition open to all where the best win and those that aren’t as good fail.”

Exposure to everything

Exposure to everything is vital in today’s uncertain world where investors can’t be sure what really lies ahead.

“Information about the past isn’t even that good,” he says. Some investments go wrong, others thrive but that’s competition within the market for capital.

“For every failure, we are on winners as well,” he says. “We don’t filter anything out. If we have diversity, the strategy will naturally benefit from any opportunity, without having to try and predict what it might be and take explicit and specific risk to articulate that view.”

It’s a risk management strategy that is as suitable for ESG as any other source of risk, today and historically.

“A market capitalisation-based exposure to global listed equities would be superior to an approach that screened, tilted, held assets according to some arbitrary rules or was actively managed according to views of the manager. Diversity as a risk management process should still work for any risk presented by ES, or G issues if you believe it does for, say, global monetary policy.”

Effective risk management has to refer to the price of assets and securities, he adds. Yet if managing risk simply means, say, “buying windmills and selling coal miners” without reference to the price, investors aren’t effectively managing risk. Especially in an environment like today when he says everyone seems to be tilting the same way. “From a risk management perspective, this type of behaviour leads people to buy overpriced assets and sell under priced ones – which isn’t very good risk management.”

Diversity wins

Since he joined the fund in 2011, Droop has transformed the asset allocation. He’s increased liability hedging, diversified across asset classes and boosted coverage of private markets with the BSPF allocation currently split between equity (13 per cent) credit (23 per cent) secured income (7 per cent) real estate, infrastructure and absolute return (5 per cent each) and liability hedging (42 per cent)

A risk management philosophy that eschews alpha and champions diversity and resilience to mitigate uncertainty means he avoids all managers with highly concentrated or opportunistic approaches. He also spends less on fees.

“We tend to employ managers at the more ‘boring’ end of the scale. Total management fees across the portfolio are about 30 basis points, which includes some very expensive private and hedge fund strategies.”

Droop, who runs the portfolio with one assistant and is responsible for the thought leadership and idea generation, links the fund’s success to this clear delineation of duties and a willingness to do new things. In the six years to December 2020 the BSPF’s return seeking assets have returned 7.6 per cent. He also credits the trustees and governors for not chasing fads but remaining faithful to a core belief and philosophy. And he has no plans to change anything.

The fund’s liabilities are hedged enough – if he was to hedge anymore he worries he would lose benefits or risk diversification on the margins – and he added two new credit strategies last year. Investment themes like China, or new technologies, are already captured in the diverse approach that doesn’t try to pick winners.

It leads the conversation back to his central argument. A portfolio built to tap all parts of the economic value creation chain in a market-based economy where every investment behaves differently but each individual asset has a role in the play, doesn’t require much maintenance. Or at least until governments start interfering.

“Moving economies to central planning and control amounts to a net loss for everyone. The market should be allowed to sort it out.”

Being ready for anything, a focus on risk management, using more leverage and opportunities in technology are key characteristics of the portfolio of the future according to investors who spoke at the Fiduciary Investors Symposium recently.

Resilience and risk management, exposure to digitization and climate opportunities, and a keen eye on talent management will be some of the most important elements in portfolios of the future, according to James Davis, chief investment officer of OPTrust.

Davis says that risk management is now as much a source of value creation as a control function and his focus is on building a portfolio that is as resilient as possible which means only allocating risk – a scarce resource – with purpose.

OPTrust is also establishing relationships to better understand crypto and blockchain innovations and he said blockchain and tokenisation are significant, with a need for investors to understand them to know which opportunities to tap and which parts of the economy to avoid because of approaching disruption. This was a view echoed by David Veal, chief investment officer of the Employees Retirement System of Texas who said “I’m excited by tokenisation”.

“I think you could add a whole new layer of liquidity to existing assets and potentially open up new investments to investors,” Veal said.

Other speakers at the conference said investors should be preparing for a new tokenised economy where assets are fractionalised, divided up amongst potentially millions of investors into tiny portions of ownership on a blockchain. Jenny Johnson, president of Franklin Templeton said this will enhance liquidity, price discovery and accessibility to high value, illiquid assets like real estate at a fraction of current transaction costs.

Meanwhile the Abu Dhabi Investment Authority is thinking about technology across all its investment functions with director of the strategy department, Jean Paul Villain, saying a decision to invest more in in-house technology came with the realisation that a slowdown in its capacity to generate alpha was linked to a lack of investment in big data and AI.

ADIA is making up for lost ground investing in different kinds of quantitative approaches, collecting, cleaning and testing data to apply across the portfolio from long-short equity allocations to tactical positions and facilitate access to the best managers.

The fund is also pushing more actively into private assets, especially private equity and infrastructure where it first invested in 1992 and 2005 respectively.

More investment in private equity is a key component of CalPERS’ portfolio of the future as it builds out its private equity allocation from 8 per cent to around 13 per cent.

The fund’s new asset allocation also includes global equity, reduced from 50 to 42 per cent, fixed income from 28-30 per cent, real assets moving from 13 to 15 per cent, and an allocation to private debt of 5 per cent marking its first foray into this asset class from an SAA level.

It will also include a 5 per cent allocation to leverage for the first time.

Mindful of board concerns that leverage adds operational risk and brings extra hazard in market environments where both equity and bonds sell off, interim chief investment officer, Dan Bienvenue, said the investment team have spent months exploring the fund’s ability to manage leverage – and liquidity.

It has involved centralising the strategy at a total fund level rather than at an asset class level, running scenarios around what the portfolio would look like and modelling diversified pathways to liquidity during times of market stress when the pressure of leverage makes finding liquidity harder.

Into the future CalPERS is wary of investing in China. Despite being a contributor to economic growth and important diversifier, investing in China comes with challenges like the accuracy of data, shadow banking and finding the right partner, Bienvenue said.

Related, Professor Stephen Kotkin says that the climate emergency, China and Fed policy pose the most systemic investor risk ahead.

He said investors in China now face considerable ESG risk and are struggling to align allocations to China with their ESG goals.

He said another key risk comes from an unfamiliar source: a dramatic misstep from the Fed.

The Fed is the most important global institution and if it starts to cause havoc by a policy misstep it will be bigger than the climate crisis or China, Kotkin said.

 

The rising popularity of private assets has made liquidity risk a growing concern for institutional investors, who need to carry enough liquidity for possible downturns, but avoid the opportunity cost of carrying too much, says Michelle Teng, vice president of the Institutional Advisory and Solutions group at PGIM.

Private assets are appealing for their attractive risk-return properties and diversification potential which is not available to investors limited to public markets. But as demand rises for private assets in the search for alpha, liquidity risk has become a growing concern for investors.

While funds that closely manage volatility risk in their portfolios can generally survive periods of short-term volatility, sustained liquid asset drawdowns are a greater concern and can cause lasting damage to portfolios, according to Michelle Teng, vice president of the Institutional Advisory and Solutions (IAS) group at PGIM – the global investment management business of Prudential Financial.

With funds facing lower inflows at the same time as there was a capital flight to safer asset classes – all the while marking to market their FX hedging positions – funds with large private asset allocations faced difficulty with liquidity management, Teng pointed to the experience of institutional investors in March 2020 during a conversation in a Market Narratives podcast interview.

CIOs need to emphasise liquidity risk measurement in order to manage liquidity during these times, which involves ensuring they have enough liquidity to meet their liquidity demands over more than just the immediate term, Teng said.

“In March 2020, some funds experienced heavy liquidity demands that they were able to meet, however, these heavy liquidity demands continued well into April,” Teng said. “At that point, CIOs started to have liquidity worries. Fortunately…government intervention came to the rescue and liquidity demands quickly tapered off after only a couple of months. But what would have happened if help didn’t arrive for six months or longer?”

 

 

Teng said the growth of private capital markets has seen a range of up-and-coming companies stay private longer without going public, making their gains unavailable to investors who don’t invest in private markets.

With general partners (GPs) of private equity funds deciding when they call the capital and make distributions back to limited partners (LPs) who are investors, this creates uncertainty around the timing and amount of cash flows of private equity investments.

Further complicating the matter, when a fund doubles its private equity allocation from, say, 15 to 30 percent, the portfolio’s liquidity risk is not simply doubled. There may be a point where liquidity risk suddenly jumps much higher, Teng said.

“So if liquidity is not managed properly, the CIO may end up in a situation that they are forced to sell illiquid assets with a big haircut to raise cash, or they may have to sell assets that are hard to reacquire later.”

Teng said a fund’s overall liquidity is a consequence of independent decisions being made by different teams, such as the asset allocation group which makes decisions at the portfolio level, and the private equity team which sources deals and makes decisions on a deal-by-deal basis.

It is the CIO’s challenge and responsibility to understand the interaction of these decisions, and how they may affect the portfolio’s overall liquidity risk over time, Teng said, but a lot of CIOs lack tools to measure liquidity risk over the entire investment horizon. Some only forecast liquidity for short periods and lack a total portfolio view on liquidity risk over a multi-year horizon, she said.

Teng said it is not always a problem of having insufficient liquidity. Some funds who were chastened by the GFC may carry too much liquidity, leading to an opportunity cost that drags down performance.

As a result, PGIM IAS has been focused on tracking cash flows from different asset classes over varying investment horizons, with an asset allocation framework that helps CIOs think through the consequences of changing asset allocations between liquid and illiquid assets.

This framework brings together various moving parts   to help CIOs evaluate their portfolio’s liquidity and performance under different scenarios in a consistent way, Teng said.

 

Power prices will not fall to zero in a world of renewables and renewable energy generation ebbs and flows require smoothing and investment in new technologies according to experts on renewable energy. Gas will be in the system longer as a bridge fuel, and investors should also explore opportunities in construction-ready or operational fixed-price renewable energy assets.

Power prices will not crash in a world of renewables, said Richard Howard, research director at Aurora Energy Research speaking at FIS Digital 2021, responding to one of the most frequently asked questions by investors and utility groups.

Renewables’ low marginal costs won’t gradually push the price of power to zero because renewables can’t offer a complete solution. Periods of no wind or sun will lead to renewable doldrums that require smoothing.

Looking ahead to 2050, Europe’s renewable power supply will be supplemented by nuclear (particularly in France and the UK) hydro (popular in the Nordics) or hydrogen generation and carbon capture and storage.

Investors should anticipate weeks or months where renewables can’t meet demand, requiring a flexibility in countries’ energy strategies. Power prices won’t collapse because countries will rely on expensive new technologies. It offers a huge investment opportunity, but involves understanding the risk of how flexible technologies will play their part in a new renewables world.

European countries began the transition to net zero 20 years ago and that early move is now starting to bear fruit with subsidised wind and solar driving down the cost of renewables that now compete with energy production from coal and gas.

“Wind and solar will form the backbone of global energy markets and solve the carbon challenge,” said fellow panellist Alex Brierley, co-head, Octopus Renewables. Renewables are also produced in country, solving the risk of dependency European energy consumers have on producers like Russia.

The transition to renewables will have a profound impact on legacy investments in coal, gas and oil. According to Aurora Energy Research, to keep warming within two degrees by 2050, coal emissions need to be reduced by 85 per cent; oil emissions by 60 per cent and gas emissions by 40 per cent.

“Gas will be in the system for longer as a bridge fuel; gas has a more favourable outlook over decades,” said Howard.

The cut in fossil fuel use will result in massive downward pressure on prices, and downside risk for investors. Moreover, much of the current oil, gas and coal discoveries will need to stay in the ground to limit warming, ending the need for more exploration. Panellists noted that China’s motivation to cut coal use is propelled by the need to cut air pollution.

The risks ahead are not fully priced into commodity markets where prices have recovered from their pandemic lows. “If you believe we are going to get to 2 degrees, you need to believe fossil fuel use will go down, and at some point, there will be a correction,” said Howard. Oil producers will likely pump harder when the reality hits that oil will be worth less in the future, causing prices to crash harder still. The pace of change will depend on how quickly reality builds behind a 2-degree target, and government action to rein in emissions.

As coal, oil and gas are phased down, renewables will form the backbone of the future energy system the panellists said. But investors need to understand the risks they are taking investing in renewables. It involves a grasp of the makeup of the power sector and how the future could evolve around price floors and negative prices particularly.

Harvard Management Company, which manages the university’s $53.2 billion endowment, is not making any new investments in the oil and gas industry, said Michael Cappucci, managing director, sustainable investing at Harvard Management Company.

The endowment is now looking for investments to replace this exposure but finding the opportunities that provide equity-like returns that will meet the fund’s long-term goals is challenging.

Biotech, green energy and climate solutions are now front of mind.

“We are seeing opportunities that weren’t around two to three years ago,” he said. Still, he noted these opportunities are in the millions rather than the billions.

Long-term, yield-seeking investors should hunt for construction ready or operational fixed price renewable energy assets. Higher returns come from assets going into development, in the land or planning stage in property-like investment. Other opportunities include network infrastructure, vehicle charging, and partnering with the hydrogen industry. Investors should think what they are trying to achieve and see the energy transition as a system change rather than discreet pockets, concluded panellists.

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. The fund’s early installation of new technology like Bloomberg terminals and other small data banks in its investment office 25 years back had bred a complacency that meant it was late to adopt and build a critical mass around new technology, said Jean-Paul Villain, ADIA’s director of the strategy and planning department, speaking at FIS Digital 2021.

ADIA only reports two performance numbers, for 20 years and 30 years annualized. As of December 31 2020, the figure was 6 per cent for 20 years and 7.2 per cent for 30 years.

Now ADIA is making up for lost ground investing in different kinds of quantitative approaches, collecting, cleaning and testing 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.

“We were seeing technology everywhere, but not very much in our own strategies,” said Villain. “We realised we had to start again.”

In another new seam, the fund is pushing more actively into private assets, especially private equity and infrastructure where it first invested in 1992 and 2005 respectively. The new focus is on building partnerships and targeting specific strategies; rather than invest much directly ADIA seeks co-investment opportunities in a new active and concentrated approach.

“We started years ago, so we have some experience,” he said.

The strategy was recently visible in ADIA joining a private equity led group that includes Canadian pension plan CPP Investment Board and Singapore sovereign wealth fund GIC behind the purchase of antivirus software company McAfee, in advanced talks to go private in a deal worth more than $14 billion.

More active means being more reactive. Like many institutional investors ADIA had fallen into the habit of waiting for change, said Villain. Now, the giant fund plans to be more granular in its approach, better able to react to increasingly apparent correlations between geographies and asset classes. “There is more correlation between buckets and countries than what we had twenty years ago.”

Fixed income

ADIA’s fixed income allocation (15-30 per cent) is a particular focus. Villain, who has been at the fund since 1982 bar a five-year absence well remembers years of stellar 7 per cent annual returns in liquid sovereign debt allocations in stark contrast to today.

ADIA invests in fixed income for returns but mostly to ensure liquidity on hand, needed to manage inflows and outflows in open ended activities, rebalance the portfolio following investment in opportunities and reduce volatility.

“Fixed income has different functions; we work out how much we need for each function and try to reduce it,” he says, describing fixed income’s role as bringing structure to the whole portfolio.

ADIA’s large asset allocation bands comprise equity (43-67 per cent) fixed income (15-30 per cent) alternatives and real assets (17-30 per cent) and cash (0-10 per cent cash)

Inflation’s impact on the fixed income allocation and valuations in real assets is another key focus. For sure, an inflation level of 3-4 per cent, especially as it is associated with higher economic growth, isn’t all bad. Moreover, its negative impact on fixed income is offset by its positive impact on other parts of the portfolio. The inflationary push pull on the portfolio plus questions around whether it is transitory or here-to-stay leave him reluctant to take a single view on its arrival on the economic landscape.

The economic bounce back in the wake of COVID accounts for one inflationary cause.

“We had a politically induced recession followed by politically induced recovery,” he says, adding that many companies have been shocked by the speed of the recovery and demand outstripping supply. “This maybe transitory.”

Another, longer-term, inflation cause is coming via societal shock and change particularly captured in the real estate market. People value a larger house, balcony or garden more than their short commute, he says.

The structure of the housing market can’t respond quickly and is taking much longer to adjust, he concluded.