The 2022 annual CIO Sentiment Survey, a collaboration between Top1000funds.com and CaseyQuirk, part of Deloitte Consulting, finds asset owners most concerned about equity valuations and inflation. After three years of fee rises, asset owners are paying less for their investments with external fees coming down, while CIOs in 2022 are also working with a smaller manager roster than previous years.

The survey, which has been running for six years, finds global CIOs notably concerned about elevated equity valuations and inflation. Touted as temporary by most policy makers last year, inflation now looks more engrained and is driving demand for defensive allocations to assets like infrastructure and real estate. For a breakdown of the full results including graphs and analysis click here.

Asset allocation

Investors’ risk perception is informing their planned allocation shifts, most visible in a spike in the number of funds planning “significant increases” to active fixed income in North America and EMEA.

Elsewhere, CIOs continue to de-risk and reduce equity allocations while the majority of respondents said they planned to increase allocations to alternatives, increasingly tilted toward real assets and private debt. Respondents listed the main defensive allocations in their portfolios as core fixed income (61 per cent) and real assets (30 per cent) and said they are venturing into private markets for yield and diversification. For more results click here

Costs

Despite a planned shift towards higher cost strategies like private markets, asset owners reported a reduction in investment costs linked to managers increasingly offering discounts to gain new relationships. 2022 respondents indicate that costs have stabilised after several years of steady increases, indicating total average investment costs relative to assets at 48 basis points in 2022 compared to 50 basis points in 2021. Importantly, cutting investment costs particularly around new products, operations or outsourcing was a key CIO priority in the 2021 survey.

Most respondents (40 per cent) said that their costs had decreased compared to 31 per cent of respondents responding their costs had stayed the same. For more results click here

External managers

When it comes to sourcing new managers, most CIOs surveyed use existing relationships with providers and consultants to introduce new relationships. Introduction requests via consultants, or making direct enquiries to a new manager themselves, are the least-used route.

The data also revealed more CIOs in 2022 are working with a smaller manager roster. Just under two thirds of respondents said they currently work with less than 50 managers, in contrast to last year when just over half of respondents said they worked with less than 50 managers.

But asset owners using a smaller manager cohort, doesn’t mean 2022 heralds a further reduction in the number of managers. Over two thirds of survey respondents noted plans to either moderately increase” (31 per cent) or “maintain” (33.3 per cent) their manager numbers. For more results click here

Operations and technology

Technology produced some of the most emphatic 2022 responses, highlighting asset owners driving ambition to increase technology within their organisations. In notable spikes from 2021 levels, around two-thirds of respondents cited the importance of process automation to improve staff efficiencies; 90 per cent are currently channelling technology to improve analytics tools and services; 94 per cent are investing in performance reporting and attribution tech and 97 per cent are deploying technology to manage risk. For more results click here

Risk

2021’s roaring equity markets have boosted the funded status of many pension funds and reduced their need to add incremental risk with three quarters (76 per cent) of survey respondents saying they had no plans to increase risk to achieve their return target. Elsewhere, 63 per cent of 2022 respondents said they are confident of meeting their return target compared to 51 per cent in 2020.

For another year running, the majority of 2022 respondents (68 per cent) said they have a return target of over 5 per cent in contrast to 2019 when only 31 per cent of respondents cited a return target of over 5 per cent.

For a breakdown of the full results including graphs and analysis click here.

 

Sophisticated investors rely on scenario analysis to select portfolios. We propose a new approach to scenario analysis that enables investors to consider sequential outcomes. We define scenarios not as average values but as paths for the economic variables. And we measure the likelihood of these paths on the basis of the statistical similarity of the paths to historical sequences. We also use a novel forecasting technique called “partial sample regression” to map economic outcomes onto asset class returns. This process allows investors to evaluate portfolios on the basis of the likelihood that the scenario will produce a certain pattern of returns over a specified investment horizon.

Click here to read full article

Incorporating uncertainty into the asset allocation process is a complicated but essential ingredient of building portfolio resilience, something investors are valuing more than ever in an environment where inflation, geopolitical and climate risks dominate. GIC and BlackRock have both developed asset allocation frameworks that incorporate investors’ aversion for uncertainty.

A health pandemic, war, inflation, fiscal and monetary policy divergence and climate change impacts have all contributed to an ongoing uncertain economic environment for investors in the 2020s. But for traditional asset allocation models like mean variance optimisation to work they rely on inputs including economic certainty to produce the one optimal portfolio. Perhaps this is no longer best practice.

Many institutional investors are recognising there is not one optimal portfolio and are focusing instead on portfolio resilience. However, asset allocation modelling has been slow to keep up with the need to think differently about modelling the future. Until now.

Singapore’s sovereign wealth fund, GIC, and BlackRock have both come up with asset allocation models that factor in uncertainty and have produced a joint paper to showcase the models and how they could potentially be used together.

GIC uses an explicit scenario-based approach while BlackRock’s approach is predominantly simulation-based, while also allowing for scenario analysis.  Both, however, allow for uncertainty and recognise there can be no perfect portfolio.

Grace Qiu, senior vice president, total portfolio strategy at GIC explains to Top1000funds.com that the fund is using a scenario-based approach to minimise opportunity cost, or ‘regret risk’, of any difference from the baseline scenario.

“We construct different scenarios and apply probabilities, and then design the portfolio such that it stays resilient under different macro regimes.” she says.

The BlackRock methodology, meanwhile, uses simulations and return forecast uncertainty incorporated into its capital market assumptions, and then simulates multiple pathways of portfolio return and portfolio resilience.

“They are different in design and good at handling different types of uncertainties. Both share the same core philosophy that helps produce more robust and resilient outcomes,” Qiu says.

Ding Li, Qiu’s colleague who is also senior vice president of total portfolio strategy, says the objective of incorporating uncertainty is not to produce one best outcome in the future.

“The key principle for this technique in asset allocation is to prepare the plausible scenario and possible outcomes in different scenarios so we can find the more conservative but more resilient solution to handle the outcome,” he says. “In reality we never know the scenario that will happen. The best outcome and predictor most likely is not the objective. It is to account for uncertainty and estimation and risk dispersion in portfolio construction. It’s a key difference from traditional mean variance which relies on point estimation.”

Li says GIC’s research shows there are multiple methodologies to incorporate uncertainty into account and the paper compares the pros and cons.

“You don’t have to rely on a single methodology. You can combine the two together to improve the efficiency of the robust portfolio construction.”

Senior portfolio strategist and  UK Chief Investment Strategist at BlackRock Investment Institute, Vivek Paul, says the approach allows investors to have consistency.

At BlackRock there are many investors across the entirety of the firm who may all have different qualitative overlays on top of the quantitative models, he says. To begin with, incorporating uncertainty into the models can improve the consistency of the firm-wide approach.

“When thinking about mean variance or traditional modelling, the trouble is that investors have known for a long time the limitations of those approaches and have biased a problem in a certain way to get a believable outcome. So they’ve been putting so many constraints around the process that in the end,the actual approach isn’t telling you much,” Paul says. “If you have 100 investors and they are all putting on overlays or constraints then you might not get consistency. By explicitly allowing uncertainty at a systemic level, the starting point is a more believable and consistent approach – albeit one that can still subsequently be enhanced by investor judgment.”

 

Uncertainty in practice

BlackRock’s Paul says the unique environment of the past couple of years is evidence of uncertainty becoming more of an issue now.

“No one was forecasting what would happen in 2020 with the pandemic and no one thought war would be on the doorstep of Europe in 2022. These are examples of why factoring in uncertainty is so crucial,” he says. “We should not pretend we know with certainty what will happen.”

Incorporating climate outcomes into the model is one example of uncertainty in practice, says Paul.

“Having uncertainty in the framework that we have is exactly why we can do what we’ve done when it comes to climate,” he says. “Leading scientists have different predictions for the outcome and how it will pan out. All of our capital market assumptions take into account our best prediction of the climate transition but we are allowing for uncertainty because our best guess might be wrong. Uncertainty is a direct part of the process.”

GIC’s policy portfolio has a 20-year time horizon so by nature asset allocation over the long term does not change materially.

Qiu says the process that models different macro economic scenarios, however, and assigns probabilities to them based on the likely path, has brought inflation into the fore in the portfolio construction process and highlights more than ever the need for diversification.

“For a naïve mean variance portfolio you go for  higher return, higher risk assets like equities, and rely on bonds to diversify. But both of those are financial assets and under inflation could get impacted. This process definitely brings out the importance of diversification and the need for more inflation resilient real assets in the portfolio,” she says.

“By explicitly modelling the need for diversification under an inflationary environment you can understand the need for real assets which may not have the same return as equities or private equity. This need to have more inflation resilient diversifying assets in the portfolio is one concrete practical example of the framework in practice.”

Paul also says the biggest risk to investors is inflation and Blackrock has already incorporated it as part of its core macro narrative.

“We believe inflation is under appreciated in market dynamics in the medium to long term, so our approach is already heavily tilted to inflation-sensitive assets, this means the inflationary impact of the war in Ukraine on the global economy has already been taken into account.”

GIC’s Li also emphasises the usefulness of the uncertainty framework across different time horizons, with GIC using long-term modelling as well in the short term across its dynamic and tactical asset allocation.

“For GIC and our peer group this framework is very flexible in terms of the different level of applications, it can be at the top down strategic level for a very long horizon and also applied to near-term uncertainty.”

Becoming a sustainable organisation is one of three pillars in CalSTRS’ new five-year strategic plan, as it also reveals progress on its net zero plan.
Presented to the board in March, the $312 billion fund’s 2022-25 strategic plan includes 10-year vision for the future broken down into three, three-yearly strategic plan cycles, kicking off in July 2022.
The plan is centred around three core pillars: being trusted stewards to ensure a well-governed, financially sound trust fund; leading innovation and managing change, including innovation to grow resiliency and efficiency; and focus on a sustainable organisation, including fully integrating a unified ESG ethos in everything it does. The latter includes investments but also a focus on internal diversity, equity and inclusion to drive organisational outperformance.
Many of the new priorities are a continuation and advancement of the current strategic plan including operationalising sustainable investment beliefs to create long-term value, execute on the CalSTRS Collaborative Model 2.0 and a focus on advanced technology for business agility and to increase efficiency while transforming business processes and digital adoption. The Collaborative Model focuses on managing more assets internally to reduce costs, control risks, increase expected returns and leverage external partnerships. Since 2017 this has saved the fund more than $780 million.
Some of the objectives of the previous strategic plan, which finishes at the end of June this year, will be carried over into the new plan including achieving full funding of the defined benefit program by June 30, 2046; integrating the fund’s sustainable investment and stewardship strategies; implementing the collaborative model leveraging all of CalSTRS resources; and a focus on technology to reduce costs.
In September 2021 the fund pledged to a net zero portfolio by 2050 or sooner but has invested in climate-oriented solutions and integrated climate risk considerations into its investment and stewardship activities since 2004.
When it made the pledge it also outlined that it would take a year to figure out the plan for implementation.
In February CalSTRS released its eighth annual Sustainability Report which shows it is evaluating its internal policies and practices for greenhouse gas emissions in line with its portfolio commitment. This includes business travel, remote work and onsite energy use.
The fund is expanding its West Sacramento headquarters with a new 10-story tower. The project is being financed through tax-exempt, lease-revenue green bonds issued through the California Infrastructure and Economic Development Bank.

CalSTRS head of sustainability, Kirsty Jenkinson, is one of the speakers at the Sustainability in Practice event to be held at the University of Cambridge from April 19-21. If you are an asset owner and would like more information on attending visit us here.

Canada’s $25 billion OPTrust has maintained its fully funded status for the 13th consecutive year while the $114.4 billion Healthcare of Ontario Pension Plan (HOOPP) has just reported 2021 returns of 11.2 per cent and a funded status of 120 per cent – meaning that for every dollar owed in pensions it has $1.20 in assets.

In its 2021 Funded Status Report, OPTrust highlighted ongoing concerns to maintaining its funded status including the investment environment, plan maturity, longevity risk and low interest rates affecting the funding valuation. OPTrust returned 15.3 per cent led by return-seeking assets however noted that its liability hedging and risk mitigating assets did not perform as well.

The report notes that despite the challenges of the pandemic the last year also held investment opportunities. The pension fund has invested in innovative companies and real estate assets, and 2021 proved generally favourable for investment risk taking. Equities in developed markets did exceptionally well – although emerging markets were flat. Bond values declined drastically as yields jumped as much as 80 basis points for Canadian long-term bonds, highlighting the benefit of a diversified portfolio.

Strategy at OPTrust is structured around a total portfolio approach whereby total fund assets are divided into four sub-portfolios, each with a specific purpose: Liability Hedging Portfolio (LHP), Return Seeking Portfolio (RSP), Risk Mitigation Portfolio (RMP) and Funding Portfolio (FP).

The LHP helped keep the funded status stable in 2021 but was a drag on returns as interest rates increased from very low levels, notes the report. This movement coincided with the Bank of Canada beginning to normalize its monetary policy.

“Bond yields are highly correlated to the Plan’s discount rate over time; therefore, we would expect changes in the value of our bond portfolio to be offset by changes in our liabilities, helping to keep the funded status stable,” it states.

The return seeking portfolio is composed of a diversified mix of risky assets and is the main return driver for the total fund. It includes public equity, private equity, credit, public market multi-strategy investments, real estate, and infrastructure. OPTrust obtains public equity exposure through internally managed cash and derivative positions, as well as using external managers. The public equity portfolio is diversified across developed and emerging markets.

Private equity does best

OPTrust’s $4 billion private equity allocation generated a net return of 52.2 per cent in 2021. Strategy is focused on buyout investments and lower-risk private equity and debt investments. The fund invests directly into private companies, typically alongside partners and indirectly, through private equity funds. It committed $809 million of capital in 2021, including $775 million to 14 new investments despite “ongoing challenges” in developing new relationships and completing new transactions because of the pandemic.

Credit exposure is primarily implemented through external strategies complemented by passive internally managed strategies. Credit spreads narrowed meaningfully over the course of the year. Elsewhere 2021 saw a significant ramp-up in OPTrust’s real estate investment transactions globally as the fund sought to reposition and optimize portfolio exposures. At the same time, investment returns between the best and worst performing property types remain at unprecedented levels.

“As a long-term investor, we remain focused on building resilience in our real estate portfolio by targeting defensive sectors driven by consumer, demographic and technological changes, and by actively modernizing and improving the functionality of our properties, including their environmental performance.”

The real estate portfolio generated a net return of 18.5 per cent in 2021. The infrastructure portfolio, where investment is centred on a platform approach, generated a net return of 33.0 per cent in 2021.

HOOPP: low costs and sustainability wins

Meanwhile at HOOP’s Toronto headquarters, President & CEO Jeff Wendling attributes much of the success to the in-house team.

“HOOPP’s in-house investment team successfully navigated another year of challenges in the economy related to the ongoing effects of the pandemic,” says Wendling. “The result is a strong return and funded status that help make the Plan secure for the long-term benefit of the healthcare workers of Ontario.”

HOOPP delivered strong returns across many asset classes, including public equities (20.11 per cent) real estate (12.52 per cent) and where roughly 60 per cent of the assets are in Canada, and private equity (23.65 per cent). Those returns offset modest declines in its bond portfolio (-1.89 per cent) At the same time, HOOPP continued to evolve its investment strategies with more investment in infrastructure – a fairly new asset class at HOOPP,  and the innovation economy.

Elsewhere, HOOPP expanded its commitment to sustainable investing including introducing a $1 billion allocation to climate change equities and becoming a founding member of Climate Engagement Canada, a collaborative engagement initiative focused on driving action at Canadian companies to deliver emissions reductions.

Notably, operating costs for the year represented just 0.32 per cent of assets, helping keep contribution rates low and affordable for members and employers.

 

 

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

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

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

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

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

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

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

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

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

Modern portfolio approach

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

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

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

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

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

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

larger, deeper relationships

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

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

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

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

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

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

Hedging uncertainty

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

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

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

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

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

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

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

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

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