At US pension fund CalPERS’ board meeting next week, the investment team hope to settle on a new discount rate and begin structuring a strategic asset allocation to support it. Interim chief investment officer Dan Bienvenue is due to explain the different risk implications for the giant portfolio, about to surpass $500 billion, if it targets a 6.5 per cent, 6.8 per cent (it’s current discount rate) or a mighty 7 per cent assumed rate of return year after year.

Leverage will be a key discussion topic as the investment staff press again for leverage in the strategic asset allocation to help reduce risk. It’s possible CalPERS could reach its return target via equity, but a leverage element will enable the fund to own more diversifying assets, said Bienvenue speaking at FIS Digital 2021 ahead of the November 15th meeting.

“We are recommending a total exposure of 105 per cent going into this ALM cycle – total assets at 100 per cent with that extra 5 per cent used to purchase diversifying assets. Through this lens, it’s a risk reducer.”

Mindful of board concerns that leverage adds operational risk and brings extra hazard in market environments where both equity and bonds sell off, 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.

“Leverage and private assets make the premium on liquidity even greater,” said Bienvenue who joined CalPERS as a portfolio manager 17 years ago and replaced Ben Meng as interim CIO when Meng stepped down last year.

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.

“We get a higher return per unit of risk in private equity on a modelled and realised basis,” says Bienvenue.

Still, he told FIS delegates that deploying private equity at scale and gaining the cost advantage of co-investment all the while ensuring robust underwriting remains CalPERS’ enduring challenge.

“There is a tension between getting capital deployed and underwriting,” he said. “You can always get someone to take your assets; you just might not like what you get.”

He wants to make more of CalPERS co-investment strengths, shaping a decisive brand and acting quickly when the call to co-invest comes.

“It’s about knowing we don’t have a no risk or low risk option.”

He said CalPERS is a sought-after Limited Partner but needs to ensure it is also a consistent partner of choice; able to move quickly and leverage its strengths.

CalPERS’ bid to build out private equity sits within a wider push into private markets. In a new move it is seeking to add a 5 per cent strategic allocation to private debt – historically seen as an active risk.

“$25 billion is quite a lot of capital for that space,” reflected Bienvenue. Large funds like CalPERS raising their threshold to the asset class has begun to spark concerns amongst other investors with several FIS Digital chief investment officer’s voicing their concerns at the amount of money flowing into private credit.

 

Efficiencies in public equity

Other areas of recent change at fund include narrowing the equity benchmark which used to comprise some 11,000 securities. Many of the companies in the bottom half of the benchmark added complexity in trading and sub custody accounts, but little diversification benefits, said Bienvenue.

Narrowing the benchmark has involved finding a sweet spot between the additive value of additional securities and diminishing marginal returns. The change was part of CalPERS broader ambition to increase efficiencies in how it harvests public market risk premium, both operationally and by instilling cost and risk efficiencies to maximise the return per unit of risk. Elsewhere in public markets, the investment team is looking at adding exposure to emerging market sovereign debt.

“It adds risk but it also adds diversification in public markets.”

He concluded that CalPERS is also spending time integrating sustainability into decision making across public and private markets, aware that sustainability and regulation will affect assets differently.

Lastly, Bienvenue sounded a wary note on investment in China citing “stroke of the pen” unpredictability as a key risk. Despite Chinese economic growth and Chinese assets adding important diversification, he said the accuracy of data, shadow banking, real estate and challenges around finding the right partner make investment challenging. “There are lots of questions; the challenge is finding good answers.”

Investing in mega trends like technology, demographics and sustainability involves abandoning the benchmark in the ultimate active portfolio.

Trend investment offers asset owners exposure to key themes in the world today. Rather than ‘going with the flow,’ investing in trends means ‘anticipating the flow’ and is one of the purest forms of active investment, said Mark van der Kroft, chief investment officer fundamental and quant equity at Robeco speaking at FIS Digital 2021.

“It is the ultimate active portfolio,” he said. “We understand these trends and can see themes being played out.”

Investment in trends involves a long-term view and moving away from the benchmark to look at secular changes and different investment opportunities. It is important to leave the benchmark as this is a representation of the past. Trend investment involves trying to find winners and taking out stocks that won’t benefit from secular changes, he said.

Robeco isolates three main mega trends. Transforming technology and digitization; demographic changes and the emergence of new middle classes and what van der Kroft calls “preserving earth,” – picking winners in a deep and expansive sustainability trend.

Preserving earth does not just equate to finding opportunities in climate change; it includes investments that anticipate regulatory change and how the scarcity of resources will play out as well as changes in health. Mega trends are removing barriers to entry, disruptive, creating new products and changing our, and industry, behaviour.

Positive for equity

Trend investing is buoyed by Robeco’s positive outlook for equities in the coming five years. Investors will be rewarded for taking risk, although it will be less skewed to the upside, said van der Kroft. Despite a highly uncertain macro environment characterised by policy unknowns, and the challenge of governments maintaining economic growth whilst crimping personal freedoms to hold down the pandemic, the outlook is supported by technology boosting productivity.

“The environment for the economy is solid,” said van der Kroft, who added that tightening will arrive in response to inflation, but won’t derail the current liquidity in the market.

The long-term nature of trend investment does not make portfolios static. Instead, portfolios are dynamically tilted to benefit as trends evolve and change. For example, smart phones, invented 15 years ago, went on to change the world of advertising, gaming and banking to name a few.

“It is about staying on top of trends and understanding how mega trends can split into sub trends,” he said. Importantly, investors shouldn’t bet on small, thematic risks.

Avoiding losers is a critical element of the jigsaw. Investing in a benchmark already has losers, but by choosing a trend, investors exclude corporates outside trends and narrow their universe. It requires deep research and an analytical edge, alongside outspoken positions, he said. Many investors underestimate long term trends and under-utilise long-term information, not extrapolating its true significance for businesses. It requires the right tools in the box, of which one is sustainability analysis.

“We try to have a very independent analysis from a sustainability perspective,” he says.

Investing in sustainability mega trends requires looking through the noise of the current ESG landscape. It also involves avoiding short term quarterly reports which blur trend investors’ view.

“Stick to your guns and believe in what you do,” he said.

Trend investment is different to factor investment. In response to a question from Fred Nieuwland, chief investment officer, Mars Incorporated, van der Kroft explained that factor investing is tied to looking backwards to see how value, momentum or size trends determine premia that lead to out- performance. Most factor investment is based on past results, but trend investment doesn’t take the benchmark as the starting point and is more focused on quality and growth.

Nieuwland said trend investment can be somtimes difficult because mega trends conflict with each other. For example, demographic trends titled towards consumption by emerging middle classes in developing economies conflicts with sustainable world trends.

As the demise of the office component in real estate allocations continues investors are favouring data centres, warehousing and low cost accommodation.

Office and bricks and mortar retail have suffered most at the hands of the pandemic. However, the pandemic-triggered impact on real estate from working from home and buying online varies across regions. For example, UK department stores and malls have been hit harder than their German counterpart, typically characterised by a grocery anchor.

Offices able to offer sought-after locations which help companies showcase their brand will thrive most. Moreover, offices in cities like Tokyo, where many employees’ preference is to come into work rather than work from home, will also thrive. In contrast, demand from office space in city’s like San Francisco, where most workers are now fully remote will stay weak. London offers opportunities for office investors. The pricing is much softer on a Brexit discount compared to other European capitals.

“The GFC offered an opportunity to get into London, now we are seeing the same thing,” said Tony Brown, global head of real estate at M&G Real Estate. Speaking at FIS Digital, he argued that investors should distinguish between offices that are magnetic and able to draw employees back with a better offering, from those that are mandatory.

It is important to view the current challenges in real estate in the context of the asset class’s evolution. For example, data centres and logistics overtook bricks and mortar retail a while back just as the listed equity giants of old like oil groups and big banks have also lost their crown.

“We haven’t been that positive on office for a while,” said Jon Cheigh, chief investment officer and head of real estate at Cohen & Steers, who estimates a fall in demand for office space of between -2 per cent to -10-15 per cent.

This was a sentiment echoed by fellow panellist Andrew Palmer, chief investment officer at Maryland State Retirement and Pension System. Overseeing a $7 billion allocation to real estate – $1 billion of which has been committed to managers over the last 12 months – he told delegates that the pension fund has been underweight office for while.

“It’s a difficult asset to release; it’s very expensive to make changes.”

Retail opportunities will shift to residential areas. Similarly, people are moving further away from their places of work, triggering a decentralisation in GDP and creating opportunities around major cities.

Maryland has structured a concentrated portfolio to core managers with allocations including storage and properties with lower price points like multi-family and workforce housing. Single family rentals and senior housing are also in the portfolio, and the allocation to industrials was recently ramped up.

However, investing in real estate alternatives like student accommodation or multi-family units requires investor patience and local knowledge.

“It’s difficult to invest in markets where you don’t have local experience,” said Palmer. “There are sectors we want to emphasise in the portfolio but we are not taking advantage of distressed assets; we are not sure they will return to peaks.”

Investors have flocked to warehousing and cloud computing facilities – both sectors that were initially found in the listed market. It’s behind the current trend of big money investors pivoting their sector composition and using the listed market to access real estate segments like large data centres and healthcare companies, said Cheigh.

“We are seeing investors selling billion dollar office buildings and shopping malls and deploying into self-storage facilities They are going from big assets to aggregate in a bunch of small assets.”

Logistics low yield

Money has poured into logistics and yields are now notably lower. Although panellists noted some opportunities exist globally in logistics, appetite for logistics has waned.

Instead, investors should focus on healthcare, self-storage, data centres and towers and selective office and retail opportunities.

Real estate and infrastructure investors are often competing for the same assets with assets like data centres and cell towers crossing between the two buckets. It is a symptom of more money chasing fewer opportunities and investors becoming more active and flexible. It’s also a symptom or real estate’s evolution from just being viewed as “shiny” buildings, concluded Cheigh.

“Ultimately, investors want a physical asset with positive supply and demand trends. It doesn’t have to be shiny and beautiful.”

More investors are moving into private credit. Opportunities from the pandemic are far from over and the asset class is proving an important allocation in a wider, simplified fixed income portfolio. Investors at FIS Digital discuss their allocations and approaches.

Prevailing wisdom has it that the opportunities that characterised private credit in 2020 are fading with the recovery. Not so says credit solutions investment manager SVP Global with deep roots in distressed investing.

“We have never seen more opportunities. We are extraordinarily busy,” says Ranji Nagaswami who is chief strategy and chief commercial officer and co-head of the ESG committee at the firm.

SVP Global has made $9 billion of new investment in the last two years, $5 billion of which has been made in 2021 in an evolving opportunity that began with rescue financing and corporate restructuring and is now focused on private debt. Investments include restructuring a mall business and investing in aviation debt where the sources of recovery are linked to the underlying aircraft and a claim against the airline, Nagaswami told delegates at FIS 2021.

“We’ve got two to three years of this opportunity still to run,” she said.

Opportunities in the US outpace those in Europe, but investors should expect more opportunities in Europe through 2022. For example, the ECB estimates bad debt on European banks’ balance sheets could grow to trillions in 2022.

Correlation with equity and widespread leverage bring risk to private credit allocations.

“In a crisis, high yield and equity are correlated,” she warned. She also noted investors should understand the dangers of leverage both in the underlying investment, and another layer in the underlying fund. Although this “bumps up the yield,” she said the additional layer is worrying for investors particularly in a protracted crisis.

Leverage and correlations makes manager selection – and only working with managers who have experience through credit cyles – crucial, said fellow panellist Michael Hitchcock, executive director of South Carolina Retirement System.

“We look for mature programs to see how the manager has performed through different scenarios,” he said, warning investors that once they are in funds, they can’t get out since the premium comes from the illiquidity.

At peer fund Ohio School Employees Retirement System private credit accounts for a 5 per cent target allocation and generates a 7 per cent cash yield. The portfolio has generated nearly 9 per cent total return in the history of the private credit portfolio, set up seven years ago in an original opportunistic portfolio. Today strategy is focused on providing better terms to borrowing firms and using less leverage, said Farouki Majeed, chief investment officer at the fund.

In dislocation-orientated direct lending strategies, the pandemic provided opportunities to provide liquidity to cash-strapped companies in the small to mid market, he said. Ohio’s allocation is divided between structured credit, distressed and dislocation opportunities and the fund also co-invests in private credit with long standing partners.

Today Majeed is particularly concerned at the amount of money flowing into private credit as large funds like CalPERS seek to allocate more, raising their thresholds to the asset class.

Investors are increasingly allocating to private credit as the role of fixed income changes within portfolios. South Carolina used to have an overly complex portfolio with 18 different asset classes, explained Hitchcock.

Now the portfolio has been remodelled to five asset classes based on a philosophy of simplicity rather than an “always on complexity” so that any complexity must prove it offers risk reduction or additional returns. Private credit is focused (75 per cent) on direct lending and (25 per cent) on opportunistic allocations and tasked with providing a persistent source of income with downside protection. The wider fixed income allocation is tasked with providing diversification and liquidity.

Simplicity is also a watchword at Ohio where the portfolio is structured to have the minimum possible number of asset classes.

“What you can do with less there is no point trying to do with more,” said Majeed.

In one recent evolution, hedge funds have been dropped from the strategic asset allocation. The fund has migrated from hedge funds into real assets and private credit after the realisation that hedge fund returns had not been as strong in recent years. The allocation to real assets has risen to 17 per cent from 10 per cent.

Elsewhere, Ohio has worked with one of its tech-focused private equity managers to tap private credit. The asking price for a few companies was “too high” and not a viable equity investment, recalled Majeed. But by providing a structured capital solution, the asset owner and manager were able to create a new avenue for the firm.

Blockchain technology will open up illiquid assets, like real estate, to new investors in what could be the greatest disruption ahead. Franklin Templeton’s Jenny Johnson explains how the asset manager is ensuring it taps the new opportunity.

Prepare for a new tokenised economy where assets are fractionalised, divided up amongst potentially millions of investors into tiny portions of ownership on a blockchain. It will enhance liquidity, price discovery and accessibility to high value, illiquid assets like real estate at a fraction of current transaction costs. For example, it could lead to multiple owners of a single piece of prime real estate via tokens and programmed smart contracts that allow every single investor to safely collect their one-millionth of the rent.

Speaking at FIS Digital Jenny Johnson president of Franklin Templeton explained that it was this belief in a blockchain-led disruption ahead that is driving the firm’s keen focus on how distributed ledger technology will impact asset management and private markets in the future.

Blockchain is already well known for transforming companies’ back-office data reconciliation. Now investors should prepare for further change ahead.

“Real estate is an obvious one. It makes me excited about the opportunities in the industry,” she said.

Franklin Templeton’s investment in the tokenisation space includes incubator investment in a tech-enabled farmland platform that fractionalises ownership, helping farmers sell off portions of their business. Elsewhere, the firm is working on an AI project to value art.

“We are trying to understand the space,” she said. “It is quickly evolving and there are lots of dead ends, but if we are not focused, we will miss out.”

Johnson voiced her determination to bring creativity, innovation and the entrepreneurial spirit to Franklin Templeton as the 4th industrial revolution gathers steam. She warned investors that incumbents rarely fair well during periods of innovation since they have to focus on doing their day-to-day job alongside keeping up with the future. Her strategy is to cultivate small groups of expert teams, carved out of existing teams where their focus on innovation was often seen as distracting.

Johnson urged delegates not to confuse Ethereum, the decentralized blockchain network powered by Ether coins, with Bitcoin which she called “niche”.

She said the programming language on the blockchain will lead to proliferation of other applications in financial services and gaming.

Acquisition

Franklin Templeton recently announced its purchase of private equity investment specialist Lexington Partners for $1.75 billion building its presence in private equity secondary funds and co-investments. The announcement follows on from other recent acquisitions of private credit manager Benefit Street Partners, real estate investor Clarion Partners and hedge fund K2 Advisors. Franklin Templeton’s highest-profile acquisition came in February 2020 when it bought rival Legg Mason for $6.5 billion

Johnson told delegates that the acquisitions fill product gaps at the firm and enable Franklin Templeton to provide asset owners with solutions, not just products.

“We want to partner with thought leadership,” she said.

It’s led the firm to establish an Academy to help train and educate partners and an Institute that draws on expertise across the business. In-house experts offer insights on how investors should position for the evolution of the vaccines, to expertise on water risk. She said that acquisitions have also been shaped to fill specific niche capabilities at the firm. For example, it now aims to offer Separately Managed Accounts to institutional and retail clients that overlay quant data analysis.

Johnson, renown for her championing of diversity, pleaded with asset owners to view diversity in their employees as importantly as they do in the portfolios.

“We don’t put together portfolios that aren’t diverse,” she said. “Different views to solve a problem produce better outcomes.”

Asset owners with long term investment horizons, coupled with legislation, will increasingly hold asset managers accountable. Asset owners are demanding more of their managers and asset managers should be driven by what their clients are looking for, said Johnson, the fourth member of the family over three generations to lead the fund manager since it was founded by her grandfather in 1947.

“My father always used to say, take care of the client and the business will takes care of itself.”

A company’s ability to sell direct-to-consumer, cloud computing and digitisation in payments are key areas for investors to focus. Investors should invest in companies that have a business model aligned to how people want to buy goods and prepare for a separation whereby companies with the technology to adapt streak ahead.

Investors are questioning if index exposure to the tech sector will continue to be a source of future growth. The capital markets used to be a catalyst for growth, but more companies are staying private for longer, forcing investors to explore new approaches.

It means some investors are pondering more venture allocations to get exposure, said fellow panellist David Veal, chief investment officer, Employees Retirement System of Texas.

Alongside exploring technology winners, his eye is on those companies left behind. There is a risk that companies that don’t make the transformation will experience value destruction and should be excluded from portfolios at the risk they will be stranded, he said.

At ERS investment strategy is particularly focused on watching corporate margins in the US compared to overseas allocations. In the US, wage pressures are building and creating headwinds for companies. It makes emerging markets more of a focus, where ERS has had a signification allocation for years.

Both panellists stressed the importance of not just having a US centric view but adopting a global perspective noting that blockchain could revolutionise what is happening.

Still, Veal said the enduring belief that population growth and earnings growth would flow through to investor gains is challenged in emerging markets. He noted geopolitical risk and globalisation trends reversing with implications for multinationals.

“We need to recognise we live in a different world to one where globalisation was in full force,” he said.

Investors should remember there is no such thing as a mean reversion in technology – the genie can’t be put back in the bottle. For example, the Amazon-led e-commerce revolution might mature and slow, but it can’t be undone; bricks and mortar won’t suddenly replace online shopping.

“You want to be focused on the future,” said Mark Baribeau, head of global equity at Jennison Associates, who said that a new generation of companies are fighting against the big giants. For example, the next generation of insurgents don’t want to be beholden to the likes of Alibaba or Amazon to sell their goods and are using different systems (like Shopify) to sell direct to consumers.

Direct to consumer movement

One of the most important investor opportunities and key sources of disruption ahead lies in the direct-to-consumer movement. New technology is enabling entrepreneurs starting their own businesses to eliminate the middle person and directly reach out to their customers.

It is evident in the auto industry where the ability to market direct to consumers means manufacturers of new electric cars can sell online, avoiding dealer networks.

“They can keep the margin for themselves,” said Baribeau.

Moreover, innovation in the car industry is now focused on software.

“You don’t need to know how an engine works,” said Baribeau.

This different skill set means new producers’ biggest challenges will be scaling manufacturing to meet demand. Investors should avoid tilting to old incumbents since these companies’ electric vehicle production and sales comes at the expense of not selling traditional cars.

“I would focus on the upstarts,” said Baribeau.

Elsewhere, retailers like LuluLemon and Nike that have physical stores and an online presence have expanded their online sales and gained more control of their inventory. It means they can respond more quickly to changes in consumer tastes and move inventory to where demand is strongest in a new, flexible strategy wholly enabled by technology. Investors should choose companies that have a business model aligned to how people want to buy goods today, and prepare for a separation whereby companies with the technology to adapt streak ahead.

Digital payments

Financial services is another fast-changing industry. China has led the revolution in digital payments via new payment methods like WeChatPay and AliPay, helping transform China into a cashless society and providing end-to-end digital solutions as people use their mobile to transact. The next Fintech boom will occur in the wider Asian region and Latin America where technology will fill the gap traditionally underserved by banks providing convenient, cost-effective solutions that disrupt the market.

Other investor opportunities exist in cloud-based applications poised to replace mobile internet and allowing companies to move to state-of-the-art platforms rather than lumber on under legacy systems. Cloud solutions provide new security and infrastructure management cheaply that is also quickly and easily deployed and upgraded.

“It’s where we see more incremental spending going,” said Baribeau. “And investors just follow the incremental spending.”