The transformation of investment instruments in fixed income has altered traditional 60:40 portfolios. But for some investors, the hunt for yield is a rising cause for concern that could lead to another credit crisis.

The time when investors split their portfolios 60:40 with the debt allocation sunk in government bonds are long over, said David Hunt, president and chief executive of PGIM, the asset management arm of Prudential.

Speaking at FIS Digital 2021, he said that investors now build much more diversified allocations across a wide range of fixed income instruments creating substantially varied and more attractive portfolios.

Hunt called the current climate “punitive” for investors with large cash allocations. It explains why so many now hunt for yield and ensuing huge demand for all kinds of fixed income, and fixed income-like instruments, like structured credit or real estate debt that offer a yield ahead of cash. Investment in all these types of assets has increased as people try to beat a negative return on cash, he said.

However for Richard Williams, chief investment officer of £33 billion ($44 billion) Railpen, who asked a question of the PGIM president, investors’ hunt for yield is a source of concern. He worries that some are becoming complacent about risk in a way that could lead to another credit crisis. Moreover, he noted some investors’ belief that governments will step in in another credit crisis is leading to under-pricing credit risk and a view among some that credit is a less risky asset than it used to be.

“There are a generation of people who haven’t been through a credit cycle,” he warned.

This concern, plus a “hunch” that the market is moving into a higher inflation environment, means Railpen currently holds as little fixed income as possible, alongside reducing credit risk.

Williams told delegates that from a total portfolio level, he was not enthused with credit or fixed income. However, from a liability matching perspective the fund will continue to hold a bit more credit in the future than what it owns today – and will do more in the private markets.

“We try to find assets that prosper regardless of inflation,” he said.

Meanwhile Hunt’s enthusiasm for new investment instruments does not extend to crypto assets. He said that regulation might, over time, reduce the amount of speculation in the crypto space but today his priority is distinguishing between assets that are a store of value and those that are speculative in nature and don’t have a regulatory framework.

“Crypto is in second category,” he said. Sure, regulation and transparency could lead to crypto having predictable features that give it a lack of correlation with asset classes like gold, but it will only have a role in a sophisticated portfolio with this kind of oversight.

Inflation

The inflation debate needs to move on from whether inflation is transitory or not and should be broken down into a more nuanced approach, said Hunt. Many of the price rises visible around the world are not transitory. For example, energy prices and house prices, fuelled by a long-term lack of building. In contrast, some prices are transitory like lumber or used cars.

However, Hunt argued that long-term and powerful deflationary factors that have kept inflation low are still with us like digitisation, accelerated since COVID. He noted how some industries like manufacturing have seen spikes in productivity thanks to digitisation and new technology coming to the fore. Industries struggling with digitisation, and where technological change hasn’t translated into higher productivity, include financial services and healthcare. However, he argued digitisation will increasingly change financial services, already visible in areas like payments with productivity gains.

The demographic challenge and the number of workers choosing to leave the work force and not coming back is also deflationary. Although he did note that a reduction in the work force could also be inflationary if wages rise.

Hunt also said the risk of a policy mistake by the Fed is high given the many unknowns. He said the Fed typically focuses on the forces at play in the labour market which makes it “overly waited in a dovish stance.”

He added that most expansions are killed by a policy mistake by the Fed.

A demand shock is fuelling inflation and the supply chain crisis. Elsewhere, investors need to prepare for lower returns in US equities and diverse economic performance from different regions as individual country’s pandemic response plays out.

Don’t expect another decade of outperformance from US equity while inflation, fuelled by a demand shock, is set to spike foreign exchange volatility impacting total portfolio returns, warned Rebecca Patterson, director of investment research, Bridgewater Associates speaking at FIS Digital 2021.

Perhaps one of Patterson’s more surprising comments was her argument that today’s supply chain crisis is the consequence of a surge in demand rather than a supply shock – and is here to stay for a while yet. Strong demand in both absolute terms and historically has produced a once-in-a-generation shock that hit companies dependent on just-in-time inventories.

The demand shock is evident in Chinese factories scrambling to meet US demand. They are running at maximum capacity (20 per cent higher than pre-COVID industrial production) so much so they have now usurped local energy supply. The demand shock is clogging up shipping lines and ports and the time needed to meet orders is taking longer. It is also spiking labour costs.

“We are seeing the tightest labour market we’ve seen in the US for generations; firms are saying they can’t fill their positions,” she said.

It will continue as US householders with cash in hand and rising disposable incomes (as wages go up) continue to spend with confidence. It will also support inflation into 2022, something she said many investors were not doing enough to integrate into their portfolios.

“Most don’t have protection for very high inflation; we also think they should focus on how to benefit from rising inflation.”

Countries different responses to COVID will also begin to play out in the investment world. While the US, Europe and the UK embarked on massive fiscal stimulus and held down borrowing costs, other governments (like Mexico) did very little. The different policy reaction is resulting in a dispersion of economic conditions across different countries providing a rich seam of investor opportunities. “We are excited,” she said.

US underperformance

Using the US (where there was a strongest monetary and fiscal response to COVID) to illustrate how this dispersion could impact the investment environment, she flagged challenges ahead for portfolios with large US exposure. The stimulus has continued long after households began to recover their finances after the pandemic. Moreover, there is more to come as Congress readies a huge infrastructure bill that will lead to trillions more stimulus.

She noted that investors tend to extrapolate from the past to help explain the future. But in a new investment climate, last decade’s US corporate winners are most likely to be this decade’s losers. Investors are currently allocating more to US stocks and bonds now than at any time since the mid-1980s, and assets will have to grow beyond what is already priced in to attract more money.

But US companies will increasingly feel the pinch from less favourable tax and regulatory regimes compared to the last decade that have supported earnings. Now, new regulatory proposals are set to weigh on margins like taxes on big tech.

“We think the bar is high for the US to be an outperformer over the next decade,” she said, advising investors to expect better equity returns from outside the US, and ensure geographic diversification.

Currency volatility

The dispersion in global economic performance, and inflation levels, will trigger currency volatility. It could have an impact on total portfolio returns, she warned, urging investors to check their hedging position. In the past, a decision to hedge or not to rarely impacted total portfolio returns. Now, higher inflation and more volatile Central Bank reactions to its spike, could have a big impact on total returns, she said.

She warned that China’s renminbi will also get more volatile. She said China’s central bank is increasingly prepared to have a flexible policy as the RMB becomes a bigger, global currency which will trigger volatility.

Moreover inflation will be fuelled by commodity price spikes, heighted by the lack of capex investment by mining groups in recent years which is destined to keep commodity prices supported for now.

Fixed income

She advised investors to seek out bond-like returns that avoid traditional fixed income and said any bond risk premium will remain scarce ahead.

Responding to a question from Jean David Tremblay-Frenette, director of investment strategy research at AIMCo, on what the future holds for fixed income, she said high bond yields are emerging across different economies but from very low levels.

Investors should look at ways to engineer return seams that feel bond like, investing in companies that have stable, bond-like cash flows that provide a similar return seam to government bonds.

She also stressed the importance of diversification and inflation-proofing linkers and commodity baskets, as well as gold.

Finance day at COP26 bought headline grabbing news – including the establishment of Mark Carney’s GFANZ and new accounting standards – but the PRI’s Fiona Reynolds tells FIS delegates more needs to be done.

A swathe of encouraging commitments from the financial world in response to the climate emergency will help make this year’s COP26 a success, said Fiona Reynolds, CEO of the PRI speaking live from Glasgow at FIS 2021 Digital.

She said that in marked contrast to previous meetings she has attended during her nine-year tenure as CEO, finance’s role in trying to solve climate change is now front and centre, on the main agenda and stage with financial leaders making the headlines.

“The investment sector is playing a major role in transitioning the real economy,” she said.

GFANZ

Headline grabbing news came thick and fast during COP’s finance day kicked off with the announcement from a new financial coalition (and a new acronym) Glasgow Financial Alliance for Net Zero (GFANZ) that it has $130 trillion to spend on tackling climate change.

“From humble beginnings they released their first progress report yesterday,” said Reynolds of the organisation, led by Mark Carney, the former Bank of England governor, now a UN special envoy on climate and finance.

“There is now $130 trillion in private capital committed to transforming the economy.”

It wasn’t long before the eye-watering number raised concerns that GFANZ, which comprises 450 banks, insurers and asset managers from around the world of which investment managers account for $57 trillion of the pledged assets, banks $63 trillion and asset owners $10 trillion, may not be able to deliver all it promises.

Critics voiced concerns that not all GFANZ signatories will set out credible, near-term decarbonisation plans, and said that it doesn’t represent a new pool of money.

Moreover, banks have signed up to the pledge while continuing to finance fossil fuels.

“None of the GFANZ initiatives require their members to commit to phasing out from fossil fuel finance. The initiative will fortunately be reviewing its guidelines every year – we’ll be keeping our eyes peeled for the entry criteria moving upwards,” wrote advocacy group ShareAction in a twitter post. Comments echoed by Reynolds who said all GFANZ members’ net zero disclosures would be scrutinised annually.

Nigel Topping, high level champion for climate action at COP26, who spoke at FIS Sustainability 2020 on how asset owners should do more to hold their managers to account on climate change, argues that GFANZ’ voluntary commitments will not solve the problem without policy action.

“Financial services firms will play a critical role in the transition to a net zero economy, including mobilising the trillions in investment needed, but greater policy action is needed. Specific policy requests of today’s GFANZ call to action include: the end of fossil fuels subsidies; carbon pricing; and a comprehensive reform of financial regulations to support the net zero transition,” he wrote on LinkedIn.

Accounting standards

Perhaps one of the most exciting developments came with the starting gun sounding on new sustainability accounting rules, destined to put sustainability reporting on the same footing as financial reporting. A breakthrough Professor Stephen Kotkin hailed as possibly the most significant initiative to come out of the conference.

IFRS Foundation trustee chair Erkki Liikanen announced the formation of the International Sustainability Standards Board (ISSB) which, integrating existing, key reporting criteria, aims to develop a comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs.

“The development of a consistent standard on climate, and eventually all ESG issues, marks a hugely significant step for investors. Vitally, the ISSB has committed to develop standards which align with the requirements of specific jurisdictions – namely the EU’s Corporate Sustainability Reporting Directive, the US and Asia-Pacific,” said Reynolds.

Other standout announcements include UK Chancellor Rishi Sunak reaffirming plans announced in October to require British listed companies to publish net zero emissions road maps by 2023 that set out how they plan to decarbonise by 2050. A task force made up of industry representatives, academics, regulators and civil society groups will be established to develop a “gold standard” against which companies must detail their transition plans. “Hopefully others will follow,” said Reynolds.

Elsewhere Reynolds, who hands over the PRI leadership to former Cbus CEO David Atkins in December (and joins Conexus Financial, publisher of Top1000funds.com as CEO) noted that the financial community’s role in protecting biodiversity has been another conference theme.

“Firms need to focus on other areas like deforestation,” she said, referencing how a group of 30 investors announced plans to coalesce around an initiative to eliminate commodity-driven deforestation by 2025.

“It’s a small group, but it will grow.”

Reflecting on other initiatives away from finance day, Reynolds said the announcement that more than 40 countries have pledged to quit coal was marred by the absence of key coal consumers China, US and India.

“It’s good, but not good enough,” she said.

Reynolds said that most asset owners that are PRI signatories won’t invest in new coal projects and Asset Owner Alliance members (PRI signatories that have committed to net zero) have committed to get out of coal by 2030.

“Only a small percentage of world energy comes from renewables. We need investors to invest in solutions,” she concluded.

The climate emergency, China and Federal Reserve policy pose the most systemic investor risk ahead according to Stephen Kotkin, Professor in History and International Affairs, Princeton University, who said a dramatic misstep from the US Federal Reserve could cause a massive dislocation.

Stephen Kotkin, more known for his expertise in geopolitical risk, says a dramatic misstep from the US Federal Reserve could cause a massive dislocation. He said Fed policy is currently being pushe by the bond market, and policy makers do not seem to have an inflation policy. It’s a key risk from an unfamiliar source, he said.

“If the Fed doesn’t understand how the economy works it is a major risk, particularly given the depth of its involvement in markets. The Fed is the most important global institution, and if it starts to cause havoc it will be bigger than the climate crisis or China,” he says.

Moreover, he questioned if inflation was transitory given one seventh of global goods are currently trapped and undeliverable in the supply chain crisis.

“If inflation is caused by supply chain problems; supply chain problems are not transitory.”

“We are moving to a more significant inflation figure than we had in past,” said Eric Nierenberg, chief strategy officer, at US pension fund Mass PRIM in discussion with the professor. Mass PRIM has shaped a resilient portfolio across a mix of assets and uses a variety of quant tools to build in robustness. As well as long duration treasuries, Mass PRIM has real estate and other assets that weather inflation better than others, he said.

Kotkin said economics and monetary policy are in a state of flux and urged investors to make understanding risk a “much bigger part” of their portfolio construction. He said many institutional investors are already putting risk front and centre rather than “at the end of the process,” but added that risk is both an opportunity and problem to be managed. “There are opportunities in dislocation and opportunities in proper risk management. Investors may find new opportunities they didn’t foresee.”

Kotkin also flagged additional risk in America’s political landscape, calling Biden “incompetent.” The withdrawal from Afghanistan and his failure to pass the infrastructure spending plan or reduce emissions are some examples, said Kotkin – although he credited Biden for rolling out the vaccine. He said Biden was “governing from the left” and that recent Republican gains in Virginia show the political terrain is shifting once again. “For those worried about the Biden presidency being over, there is little time to rescue the situation,” he concluded.

Climate risk

Reflecting on COP26 in Glasgow, Professor Stephen Kotkin is pessimistic that it will achieve much, arguing the world’s current approach to managing climate change is broken and won’t deliver a carbon price or green the grid.

Speaking at FIS Digital 2021, he drew delegates’ attention to how the climate chaos and emergency is only getting worse: energy shortages in countries that have done most to green their economies and a refusal to invest in fossil fuels as energy demand rises, a lack of investment in a grid that can’t manage renewables at scale and Australia and China both expanding coal production despite commitments to net zero – to name a few.

Kotkin said that the more activists’ push, the more insurmountable the challenge of limiting global warming becomes. He also noted how investment in commodities that are vital for the transition like copper and aluminium has stalled on misplaced ESG sentiment.

“We need more copper to stop global warming,” he said.

Kotkin said pervasive greenwashing is a consequence of the lack of carbon price, or a pathway to invest in the Grid.

“Greenwashing requires looking in the mirror,” he told delegates.

He said COP26 was destined to produce unintended consequences and expressed an urgency to try something different. The one ray of hope from the conference is globally accepted sustainability accounting standards that will help push back on green washing.

China

Turning the conversation to China, Kotkin said the re-pricing of China-related risk is now underway. China risk comprises the demographic shortfall and the country’s need to transition to a consumer-driven economy to make a leap to a high-income country. Investors in China also face considerable ESG risk and are struggling to align allocations to China with their ESG goals.

“ESG makes investing in China more difficult,” he said. He also touted the possibility of US / China conflict.

Kotkin said China may overcome its demographic shortfall, step over the middle-income trap and sort its current battles between the Communist Party and the private sector. However, he said it was unknow if China would become a source of stability and growth, or a source of global instability.

He said the US was awakening from a long-held delusion that “China would become like the US politically as it grew economically.”

He said China needed to figure out what it needed to do to transition to the next phase of economic growth, and the US needed to figure out how to manage China’s rise without conflict. He said the role of countries like Australia, Japan and India would be vital in managing China; understanding China is part of the world, but also standing up to bullying.

Kotkin’s view is that China can’t be contained. Instead, policy makers have an essential role in stopping tension turning to conflict.

“People need to rise to the occasion to manage tension,” he said, citing the importance of engagement and showing China red lines but also finding common issues in a relationship balanced on deterrence, engagement and ultimately diplomacy.

 

Investors need to prioritise resilience, risk management, digitisation trends and talent to future proof their portfolios says OPTrust CIO James Davis.

Resilience and risk management, exposure to digitisation and climate opportunities and a keen eye on talent management will be key components for investment success in portfolios of the future, said James Davis, chief investment officer of Canada’s C$23 billion OPTrust speaking in the opening session of FIS Digital.

In an era of uncertainty where investors need to prepare for “whatever the future throws” Davis told delegates (some 170 asset owners across 26 countries) that risk management is now as much a source of value creation as a control function.

Investment decisions at OPTrust are framed by beneficiaries’ need for certainty. The mature plan is fully funded and can’t take as much risk as younger pension funds, he said.

“Our members just want to know they can count on their pension.”

Still, this must be balanced against the fact three quarters of plan benefits are funded by investment returns from today’s uncertain world.

It leaves OPTrust having to earn the returns it needs (to keep the plan fully funded) incurring the lowest possible risk. Davis is focused on building a portfolio that is as resilient as possible, only allocating risk – “a scarce resource” – with purpose. The fund also hedges all unrewarded risk. It has a liability hedge portfolio that holds long maturity bonds, and the fund uses leverage to reduce its funded risk.

Returns

The return seeking portfolio is primarily focused on alternative assets comprising real estate, infrastructure and private equity.

Davis doesn’t see much value creation potential in public markets. Although the fund does have some actively managed portfolios, his preference is to allocate risk to public markets only to get the desired risk exposure for the overall portfolio and benefit from a dynamic public markets allocation that can “mitigate drawdowns in the wider return seeking portfolio.”

Beyond diversification

For true resilience, investors need to think beyond diversification and focus instead on resilience no matter what the economic environment.

“We can’t always count on diversification; correlations change,” he warned.

The macro environment is simply too unknown to make diversification a fail-safe. For example, it was impossible to predict COVID or the policy response. The Fed could make a policy mistake; inflation is increasing but deflation is as much of a possibility, and investors shouldn’t rule out stagflation either.

Resilience also comes via cost effective risk mitigation strategies like machine learning, providing insight to help reduce equity drawdowns.

“It allows us to dial up and dial down the equity allocation in the portfolio more effectively than we can do using our own predictions,” he said.

 

 

Digitisation and climate

Although Davis noted the challenges inherent in identifying digitisation winners and losers, the pension plan is drawing on external expertise to better understand crypto and blockchain innovations – an example of how OPTrust, which manages assets in-house where it has the expertise, also works with partners when needed.

Davis said that digital assets are poised to gain traction, changing “the way markets look at how we access investment opportunities” as the virtual economy evolves.

Blockchain and tokenisation are significant, and investors need to understand them to know which opportunities to tap and which parts of the economy to avoid because of approaching disruption.

Internally it is also using AI to improve investment outcomes.

A portfolio of the future needs a firm grip on the implications of climate change. A risk that has accelerated compared to “a decade ago” when Davis noted investors deemed the implications of climate change a “risk down the road”. He said climate change is happening quickly and markets are pricing it in.

Convinced of the opportunity ahead, OPTrust has set up a new team tasked with helping colleagues across the pension fund integrate climate into their decision-making processes, and seeking out investment opportunities in its own right.

“We have given them investment capital,” said Davis, saying the focus for opportunities lies at the intersection between innovation and sustainability. “We believe capital will flow to where solutions are being created to solve challenges: we want to identify where the opportunities are and we want to participate. It is not just about risk.”

OPTrust is currently shaping a new climate strategy it hopes to launch mid next year that will outline the fund’s view on fiduciary responsibility in the context of climate change.

Portfolios of the future also need to pay particular attention to talent and governance. Davis said investors need to think more about how to bring new people into their organisations.

“People are our greatest asset,” he said, detailing OPTrust’s rotational internship programme where young, cognitively diverse talent spend time across the plan.

“Young people bring fresh ideas and innovation.”

Another, central tenet to future proofing portfolios for the years ahead is governance.

“In a changing world, you need to bring your board along,” he concluded.

More so given today’s climate where risk management is not just about control but also about value creation.

“If you don’t know what harbour you are seeking, no lighthouse will guide you.”

The world in which pension organizations operate is undoubtedly becoming more complex.  Not only have organizations needed to adapt to low interest rates and changes in capital markets since the financial crisis, but also the need to navigate within the framework of climate change and sustainability. That is before we even consider the impact of the COVID-19 pandemic.

Pension organizations must continuously adapt to these changing conditions to be successful over long time horizons. Stakeholders are right to be concerned about an organization’s ability to innovate and succeed long-term.  These concerns can be addressed through transparent communication.

Reviewing the disclosures of 75 global pension organizations for the Global Pension Transparency Benchmark (GPTB) found that only 36 per cent of organizations made public disclosures regarding their organizational strategy that went beyond disclosures of economic and market conditions and the impact on the performance of their investments. Clearly there is room for improvement in communicating key corporate activities to stakeholders.  This article explores some of the ways that funds may go about doing so.

About the Global Pension Transparency Benchmark

The Global Pension Transparency Benchmark (GPTB), a collaboration between Top1000funds.com and CEM Benchmarking, was launched in 2021.  The GPTB is a world first for pension fund disclosure, bringing a focus to transparency in a bid to improve pension outcomes for members. The public disclosures of key value generating elements for the five largest pension organisations across 15 countries were reviewed in the inaugural annual assessment.

The GPTB framework examines four high-impact value-driving factors: governance and organisation, performance, costs, and responsible investing, which are scored by assessing almost 200 specific components.

The reviews cover fund websites, annual reports, financial statements, and various other published documents. Disclosures are scored objectively, mainly using yes/no answers related to what is disclosed/not disclosed.

Disclosures related to performance results are scored but the relative outcomes themselves are not scored. Clearly, outcomes are important. However, it is not useful to compare them across funds globally because of differences in plan types, organisational mandates, and regulatory frameworks.

In developing the GPTB framework, we recognised that disclosure quality cannot be completely captured by simple objective questions.  Communication quality – clarity, cohesiveness, brevity, plain language, use of infographics – is difficult to measure objectively, but it is vital to ensure that key information is read and understood by stakeholders. Therefore, we decided to highlight communication quality through our selection of best practice examples.

Communication quality ranged widely across funds.  Some reviews were frankly painful to do because of poor communication quality, even when disclosures and transparency scores were reasonable.  In contrast, the communication quality of some of the material we reviewed was outstanding.  We found that the small group of funds that prepared Integrated Annual Reports were among the very best.

Disclosing organizational strategy: Moving beyond investment performance

Organizations are generally quite forthcoming about their fund performance and how it was impacted by external economic factors.  The review of funds for the GPTB revealed that:

  • 95 per cent of organizations reviewed provided commentary on economic and market conditions; and
  • close to two thirds of organizations provided forward looking statements on how they saw economic and market conditions impacting their fund in the future.

Although undoubtedly important, how a pension organization navigates economic and market conditions is only one piece of the puzzle.

Pension organizations, especially large globally focused pension organization, are better viewed as corporate entities who must effectively manage more than just their stock of financial capital to be successful over long time horizons.  The Integrated Reporting, or <IR> framework provides a guide as to what pension organizations should be disclosing to stakeholders and defines the following capitals:

Financial capital – The pool of funds that is available to the organization for use in the provision of pensions and available to generate returns to meet future obligations. Pension organizations currently focus most or all of the disclosures on this capital.

Manufactured capital –In the context of pension organizations, this capital represents the buildings and more importantly the IT infrastructure and systems used to create value.  Organizations must ensure that its IT systems are fit for purpose of managing risks and that such systems innovate as new risks emerge or gain in importance.  This capital also encompasses the operation of satellite offices to enhance value creation in foreign assets.

Intellectual capital – Not only must organizations ensure adequate physical infrastructure, but they must also ensure that proprietary economic, risk and reporting models remain relevant and reflect both current realities and anticipated changes.

Human Capital – Pension organizations must ensure that they possess the requisite human capital to enact their investment strategy.  This is especially pertinent when organizations choose to insource investment management, risk and other functions.

Social and relationship capital – This category of capital would include not just disclosure and communications to stakeholders but also how the organization navigates the political realities in both their home jurisdiction as well as globally.  By virtue of their size and importance in the provision of pensions on a national level, pension organizations will often have to work with both governments and NGOs to ensure that they are able to create value both for their direct stakeholders and society as a whole.

Natural capital – Similar to social and relationship capital there are two lenses with which to view this capital.  First from the lens of the organization’s own natural footprint.  Although often viewed as relatively minor, communication in this regard can help foster better social and relationship capital.  More important is how funds deal with natural capital through their stewardship and active ownership endeavours, ensuring that financial capital continues to generate value over the long-term.

How leading organizations are communicating corporate strategy

The example below from Canada’s PSP Investment Board shows that effective disclosures on corporate strategy don’t have to be long and complex.  In a single page they effectively distill the major items of their organizational strategy, covering topics such as:

  • The management of their human capital through discussion of development and retention of staff; and
  • The growth of their stock of intellectual and manufactured capital by increasing their global footprint and investment in new systems to increase operational efficiency.

Michael Reid is vice president, relationship management at CEM Benchmarking.