USS’s head of dynamic asset allocation Bruno Serfaty reflects on the inflation risk coming down the track, and suggests ways investors can build alternative liability matching portfolios beyond government bonds.

In recent years, inflation has boosted asset prices and asset owners have benefited disproportionately compared to economic activity. The dark side of inflation however, when wages and costs spike to hit corporate profitability, could be edging closer. Speaking at FIS Digital 2020, Bruno Serfaty, head of dynamic asset allocation at USS Investment Management, the in-house manager for the £68 billion Universities Superannuation Scheme, the United Kingdom’s largest pension fund, warned investors that inflationary dark clouds could soon appear on the horizon.

The shift towards greater state involvement in the economy could lead to higher inflation over the longer-term, while fiscal policy might shift to higher spending and taxing, with a more redistributive tilt to reduce income inequalities. “This may impact, at some point, the profitability of companies,” he said. Elsewhere, he flagged that tariffs on goods courtesy of the China/US trade war and Brexit will also cause prices to rise. “We could be at this cusp where we have moved from the good side of inflation where every asset went up to more of the dark side, and we as asset owners need to be prepared for this.”

Cue recent strategy at the fund like its 2020 £400m investment for a 49 per cent stake in a fuel station portfolio owned by oil major BP.

The annual rent reviews are linked to inflation, providing the scheme with liability-matching cashflows in an investment that will sit in an existing property portfolio of nearly £4 billion and is part of USS’s £18 billion allocation to private markets. Elsewhere, the pension fund has a 6.5 per cent exposure to nominal government bonds and a 26.9 per cent allocation to linkers, increased during the Covid shock to take advantage of the market’s fear of deflation. The fund also believes pricing remains attractive due to lack of inflation hedging demand amongst pension funds.

When the conversation turned to the enduring challenge of rock bottom fixed income yields, Serfaty suggested asset owners reassess why they hold bonds in their portfolio. A similar process has helped inform USS’s construction of a liability matching portfolio based on real assets in private markets and the credit space.

The deconstruction process helps clarify the rationale for holding fixed income. Whether that is based on a belief that bonds are an important source of diversification from growth assets; a belief that inflation will stay low and bonds provide good real returns or if bonds are a store of value because they are the safest instrument, and where money is best saved. “If you decompose the reasons why you own bonds, then you can try and find alternatives to that,” he said.

For example, volatility products or credit opportunities could provide alternatives to bonds as a hedge against an equity drawn down. While asking if bonds really do provide the best store of value has to be seen against the backdrop of vast government issuance. “If governments are printing so much money, I do wonder if they are truly a good hedge. Maybe gold or currency diversification could help – these are different avenues we look at.” Here USS recently took steps to improve the diversification of its foreign exchange exposure and increased allocations to currencies with defensive properties during turbulent times such as the Japanese yen.

It leads him to reflect on the long-term impact of the policy response on the portfolio. Government borrowing, coming on top of already high levels of government debt before COVID, will impact asset prices for many years. Expect a highly liquid environment and stoked competition for real assets, he concluded.

“What is really unprecedented is the scale of the policy response that has taken place. We started with a high level of debt before COVID and we are getting to an unprecedented level post COVID. GDP in 2021/22 is going to bounce, but what is not going to bounce is the level of debt – in fact it is quite the opposite. This year in the US for example, debt is 15 per cent of GDP: that’s a large number.”

Celebrated expert and author on democracy Thomas Carothers speaks to Stephen Kotkin on the reasons why democracy is in crisis. The solutions involve meeting the needs of alienated middle classes, strengthening institutions and policies that foster equality rather than enable elite capture, he said.

The crisis in democracy is linked to three key trends that have emerged over the last 15 years said Thomas Carothers, one of America’s most celebrated experts on the topic. Speaking at FIS Digital, the Harvey V. Fineberg chair for democracy studies at the Carnegie Endowment for International Peace urged investor delegates to reflect on a few important themes rather than make the mistake of slipping into a “broad gloom” about democracy’s long-term survival.

First, he linked threats to democracy in established democracies like the US and in some European countries to troubled middle classes, a group he described as “dislocated and insecure and searching for alternatives.” Their hunt for “something different” has also been fuelled by immigration, sparking a reaction against too much change and leading people to seek to “turn the clock back.”

A second trend threatening democracy comes from the fact once emerging democracies like Turkey, India and Brazil have infact turned authoritarian. He said these countries move away from democracy isn’t linked to their economies struggling. Instead, it is caused by weak institutions. “It turns out that democracy in these countries is doing badly because of weak institutions,” he said.

In another trend he explained to delegates that democracy is struggling because instead of liberalising and converging with the West, China and Russia have gone in different, surprising directions. “Two authoritarian powers are genuinely challenging the West,” he said.

However in amongst all these trends lies another that Carothers, whose work includes democracy assistance projects for many organizations alongside extensive field research on aid efforts around the world, warned delegates promises more disruption still. Citizens have rising expectations of improvements in their education and wealth, and ask more of the people governing them. However, in many cases people are unable to better their lives, leading to protest. People feel excluded and marginalised and increasingly angry about corruption, he said. “Corruption is the single biggest driver of political change.”

He also said political overreach is threatening democracy as Presidents steal elections, visible in countries like Belarus. “Protest waves are the thermostat that measures the fever,” he said. “It’s not a problem with democracy; the problem is that citizens want more, and governments are struggling to provide.”

Moreover, democracy also flounders when flawed systems choose bad leaders. Instead of elections processes being open and fair, often leaders are not representative; elsewhere leaders are constrained by law, or fail to show basic competence. He said the West has been complacent about rising angst amongst the population, and overestimated the health of institutions in striving and nascent democracies back in the 1990s. “All shiny, new democracies have weaknesses; there isn’t a mysterious crisis in democracy – these are tangible things,” he said.

Next the conversation turned to the US election. Despite the high turnout (the highest in 100 years) US democracy remains troubled because of a series of challening problems. On one hand the polarization between the US Republican and Democratic political parties is extreme. “There is very little common ground; the right is much further right than the centre right,” he said citing extreme Republican views like the elimination of taxes as difficult to square with liberalism.

US democracy is also under threat because of elite capture. The high concentration of wealth by people with a strong influence over aspects of policy is testing democracy. If you have money you can penetrate the political system, he said. This ignores the middle classes, while attempts to change the status quo are met with cries of class war. “The idea that America’s democracy is a democracy for all is not true,” he said. Finally, Carothers warned that America’s democracy is imperilled by “a very old constitution” with structural problems that allow entrenched minority interests. “Constitutional amendments are a heavy lift,” he said.

That said, solutions are to hand. He urged Biden to push ahead with “broad-based” wins for the population like healthcare, infrastructure and broadband investment. He also urged to begin fixing the electoral system by ensuring it is no longer run by bipartisan officials, requiring a new policy overseen by central guidance as well as significant investment. “Take small issues one at a time rather than a big bang approach,” he said.

However, Carothers concluded that one of the dilemmas of polarization is that it makes reform to alleviate it difficult. “Consensual systemic reform in a polarized country is difficult; big reforms are also difficult with elite capture.” As for America’s ability to preach democracy overseas, he urged a neutral and humble, “quiet and serious,” approach that wins back credit for the US overseas.

A cohort of ESG experts argued that the current data and research available for investors is lacking. Elsewhere they urged investors to engage with corporate boards to encourage change.

Much of the current ESG research and data is not fit for purpose because it doesn’t integrate big data or the sentiment analysis that really gages what companies are doing rather than saying. Following an in-depth study into corporate purpose that assessed 800 publicly traded companies on their response to the pandemic and inequality crisis, Mark Tulay, founder and chief executive of the Test of Corporate Purpose (TCP) initiative and chief executive of Sustainability Risk Advisors, said that investors urgently need new models to help them assess and integrate ESG risk.

Speaking at FIS Digital 2020, Tulay outlined how the TCP initiative, which partnered with ESG data providers Truvalue Labs and Morgan Stanley, explored the extent to which purposeful companies, including signatories to last year’s Business Roundtable pledge to re-define corporate purpose away from shareholder primacy, performed during the pandemic.

“We did something that would be impossible with traditional ESG research. We need a new model to integrate ESG and I hope more investors push the frontier in encouraging this,” Tulay told delegates.

Alongside ratings agencies producing conflicting corporate data, an “alphabet soup” of organisations and NGOs produce different guidelines, said fellow panellist and co-chair of the TCP initiative Robert Eccles, visiting professor of management practice at Oxford University’s Saïd Business School and a leader in how companies and investors can create sustainable strategies.

Although these organizations have developed standards and are increasingly working together, he flagged investor confusion. Imagine how impossible financial analysis would be without accounting standards, he said.

“This is the situation ESG is in today.” Calling for a global body and “basic plumbing” to enable investors to integrate ESG and facilitate corporate reporting, he espoused the urgency to get behind a sustainability standard board.

Alongside the stark absence of informative data guiding ESG investment, the initiative had another key take-home – companies that performed well on ESG metrics also performed better through the crisis. However, companies that have a declared purpose to represent all their stakeholders (rather than just their shareholders) did not necessarily perform well through the crisis.

Purpose

Eccles urged investors to do more to encourage portfolio companies to adopt purpose. He said purpose should be integrated at board level and that investors should hold their fund managers accountable for pushing companies on the subject.

“Tell your portfolio companies you want a company-specific statement of purpose signed by the board,” he urged.

Fellow panellist Anthony Eames, vice president and director of responsible investment strategy at Calvert Research and Management, a wholly owned subsidiary of Eaton Vance Management, noted that more companies are rising to the challenge of stakeholder capitalism. He also said that companies’ navigation of the pandemic will have a lasting impact on their brand and reputation.

“Different corporate responses have shortened or lengthened the impact of pandemic,” he said, citing paid leave, nurturing key supplier relationships and cutting back on executive compensation as drivers of success.

Eames also reflected on the challenges inherent in current ESG data but noted important milestones around disclosure and measuring financial materiality. He urged asset managers to adopt an evolved approach that keeps up with learnings.

“We are developing as investors, finding new ways to assess companies’ performance,” he said. It led him to reference a new Corporate Resilience KPI the manager now uses to measure the governance strength of a company as a consequence of the pandemic based on its financial capacity to execute strategy in a crisis.

“This COVID KPI is under the governance pillar and underpins the strategy and competence of the management team of a company,” he said.

Next, the conversation turned to the extent to which investors are engaging with corporate boards. Eames said it was incumbent on managers, and should be written into the mandate, to communicate with client investors on how they are monitoring and engaging with investee company boards. “We are seeing more progress on the engagement front,” he said.

As for Calvert’s own progress in the area, he cited a recent initiative to measure diversity levels in investee companies, many of which don’t disclose workplace diversity. The manager contacted the companies and argued the business case for diversity, triggering some change. “It is encouraging, but we need to keep after it,” he said. “We are gaining more information to make better decisions and helping these companies with their agenda.”

Tulay concluded that corporate laggards needed to be called out, while investors should also highlight corporate success stories. “If companies are underperforming, we should shine a light, while those doing well should be recognised,” he said.

One of our defining characteristics, and main objectives, at Top1000funds.com, is to provide behind-the-scenes insight into the strategy and implementation of the world’s largest investors. In 2020, as the world and global economies changed so dramatically, we were on our toes to innovate our media and event offerings in a bid to give you what you needed to navigate a changing world. We pivoted to a digital event offering, introduced podcast series and created a COVID-19 research hub. All of this in addition to our regular insights into global investors’ asset allocation, industry innovation on fees, new investment opportunities and organisational design.

This year, we have delivered more than 300 investor profiles and other analytical and research-driven pieces on the global institutional investment universe, and we now have readers at asset owners from 95 countries, with combined assets of $48 trillion.

We are also pleased to say that our readers, are spending more time on our site and there are more people visiting, so thank you to all our interview subjects, readers and supporters over the last year. Below is a look at the most popular stories of 2020.

As the second quarter of this year brought with it a flurry of information around COVID-19, we did the hard work for investors in sifting through the noise and launched a COVID-19 research hub which brought together thought-leadership and reports on the impact of the crisis on the global economy and investments.

COVID-19 is changing our understanding of the world and challenged many of ideologies: from capitalism to neo-liberalism, from the over-significance of work to realising work-life balance, and from globalization to nationalisation. In this article the authors argue the COVID-19 pandemic is an inevitable result of globalisation and that the pandemic, in turn, has seriously threatened the world’s globalisation. Disrupted the international world order: legally, socially, politically, and economically. It does however conclude that the pandemic’s adverse effects on globalization is temporary.

We also turned our attention to how large institutional investors were allocating as the equity market gathered pace on its rollercoaster. A series of interviews with CIOs looked at how investors were weathering the storm, and in one of those we went on the journey with the State of Wisconsin Investment Board which in the space of February to April moved its portfolio from “defensive” to “offensive” as it “leans into the opportunities” presented by the coronavirus crisis.

For the first time we also launched two podcast series: Sustainability in a time of crisis, in conjunction with the PRI and Robeco; and the Fiduciary Investors Series, which is an extension of our event series.

In one of the more popular discussions, Professor Cameron Hepburn,  Professor of Environmental Economics, and the director of the economics sustainability programme, at the University of Oxford discussed some of the more recent energy innovations; and the ideal price on carbon; as well as what is needed to move to a net-zero carbon economy. Importantly he looked at the role of finance and the need to recognise that both the finance and climate environments are complex adaptive systems, and that backward-looking analysis is not appropriate for adequate risk management.

“We need to get out of the old paradigms,” he says. “Even the concept of the Black Swan, doesn’t really help us to capture the fact these distributions are not bell shaped, or fat tailed or non-normal distributions. These are interactions between parts of the economy that are shifting the distribution altogether. So these things that are supposed to be a 1 in 10,000 event become the mean because you’ve shifted the distribution.”

He ends by offering some advice to institutional investors on how they should be including climate risks and opportunities into their investment decision-making, and the best way of doing that.

Our digital events also delivered plenty of incredible content with speakers this year including: Ray Dalio, Larry Summers, Esther Duflo, William Nordhaus and the CIOs from CalPERS, APG, TCorp, and many others.

Remembering back to the pre-COVID days at the beginning of the year, before the crisis changed everything, readers were interested in the pace of technological change and advances in machine learning, which Campbell Harvey, Professor of Finance at Duke University said will result in a “shake out” in investment management.

We also looked at the rising influence of the sovereign wealth fund with a look around the world of their influence and the spate of new funds setting up.

And in an area that has been an ongoing investigation for Top1000funds.com we revealed new research that showed the Canadian model, revered world over for its supreme pension management, is not low cost despite that being one of its oft-described traits, rather these funds are cost efficient, rather than being low cost.

Lastly, but certainly not least, investors were interested to learn about the specific climate activities of some of the world’s leading asset owners, with only a handful of pension funds committing to achieving net-zero emissions by 2050 and developing an approach to achieve that goal.

Protected by furlough schemes and mortgage holidays and saving money working from home, many consumers have come through the pandemic in better financial health than they were before. It could pose an exciting investment opportunity, say a panel of FIS 2020 Digital experts.

Investors are eyeing opportunities in the consumer sector as many people emerge from the pandemic with spending power at the ready and in better financial health than before. FIS Digital 2020 delegates heard from Matt Hammerstein, chief executive at Barclays, how UK consumers are emerging from the crisis in stronger financial positions than going into it.

He said that although some consumers have been hard hit by the pandemic, typically those on lower incomes, with young children and working in the hospitality sector, others have saved because of restrictions on their ability to spend and some have changed their financial behaviour.

“There has been an unprecedented amount of people paying off debt,” he said, adding that many of the bank’s more affluent customers are preparing to spend once the vaccine has been rolled out.

So-called consumer risk is typically held by banks, rather than investors, observed fellow panellist William Nicoll, chief investment officer, private and alternative assets at M&G Investments. But the relative financial strength of many consumers is causing him to reflect on whether investors might move into consumer risk. I wonder if consumer risk will move out of banks to investors and if investors might, for example, see returns on mortgages attractive, he asked.

“Consumers are underweight in many portfolios; consumer risk might be interesting.”

He said investors we will never compete with banks in terms of their reach and depth of consumer understanding, but he said if banks offload risk, investors might “be happy to take it.” Adding: “It is the current thing we are most interested in.”

Nicoll explained how consumers have been supported by government helicopter money, furlough schemes and mortgage holidays.

“In a normal crisis, we’d see unemployment going up, a mortgage crisis and other impacts, but there is no big housing crisis coming through as people have been protected.”

Moreover, the end of government furlough and mortgage holidays is unlikely to have a big impact on the robust health of many consumers.

Other important changes in consumer behaviour triggered by the crisis include the move away from cash, said Hammerstein.

“We are unlikely to go back to cash,” he said.

Elsewhere he also noted a move from credit card use to debit cards, and people refocusing on their surroundings, either by buying locally, or spending more on their homes.

“People are refocusing their energy and spend on supporting local businesses,” he said, noting how retailers focused on the home and hobbies have done well through the pandemic. “People are thinking differently about how they use their home,” he said, referencing “a tale of two halves” in the retail space reflected by Barclay’s own staff where around 40% of employees now work from home.

Expanding on the WFH trend, M&G’s Nicoll noted how investors in real estate will increasingly favour environmentally-friendly buildings. Old office blocs requiring full refurbishments will struggle. “We have seen accelerated moves towards the office of the future,” he said. That said, although office space has been hard hit by the pandemic, Nicoll argued that companies will still want office space. “The desire for offices and central spaces has changed but not gone away; quality will do well.”

In contrast, retail property is in difficulty he said, noting how the market is writing down the value of retail property. As for aviation, he said the desire to travel hadn’t gone away although factors around carbon emissions will impact aviation.

Accelerated trends

The pandemic has accelerated trends already underway like digitalisation, investment in efforts to counter climate change and Chinese growth, reflected fellow panellist Peter Branner, chief investment officer, APG. Referencing the fund manager’s 2019 stake in Brussels Airport, bought with Australian alternatives fund manager QIC, Branner said “flying with come back,” although he noted that with “hindsight we could have waited longer.”

Elsewhere, the recently acquired stake in a Portuguese toll road operator has also struggled to perform given people are driving less. Here he reflected “people will continue to drive; maybe not the same cars but they will drive.”

Now the fund is looking at opportunities in electrification and the grid and wind investment in France and Portugal, allocations he described as some of “the most important part of our private portfolio” seeing “the strongest price moves.”

Investors’ inability to carry out due diligence on the ground because of the travel ban is a key concern, he concluded. “It’s a big worry.” As for a decline in the popularity of city living, he said that city centres are still expensive. “City living will always be attractive so I don’t expect that to change too much,” he said.