David Villa, CIO of the $110 billion State of Wisconsin Investment Board is worried about the outlook for returns. As a result he’s significantly underweight sovereign bonds in favour of cash. But he’s also positioning the organisation to do better analytics for more complicated portfolios, another result of a low return environment. The fund is working on at least five data and technology projects and has hired a chief technology and operations officer.

 

David Villa, chief investment officer of the $110 billion State of Wisconsin Investment Board has sold out of sovereign bonds into cash in the belief that cash is, relatively, attractive and a good substitute for bonds.

“I believe we’re late in the credit cycle. Yields on government bonds are low and we are willing to hold cash as a substitute for bonds,” he says.

The core fund strategic allocation to fixed income is 25 per cent, but Villa won’t disclose the current allocation.

“We are underweight duration and sovereign bonds. I don’t want the market to know how much, but it is a meaningful underweight.”

“We are selling duration and holding cash, I don’t want to lend to the US government for 10 years and receive a coupon that’s less than inflation, I’m not being compensated.”

Villa also points out that private assets more expensive than public assets and if there is a correction in equity markets it will add to the portfolio drawdown as private assets are marked down on a lagged basis.

“I prefer to add risk when the compensation is high,” he says. “We have a lot of cash so can be fearless in rebalancing, so we’re waiting.”

The fund’s one year return as of June 30, was 7.62 per cent, net of all fees.

It has a 17 per cent allocation to private assets split between private equity 9 per cent, and real estate 8 per cent. Both have performed well with the one-year return for private equity 14.3 per cent, and real estate 6.95 per cent.

“The real estate is meeting expectations, and private equity is beating expectations over one year.”

But Villa’s expecting it to be disappointing going forward, partly because leverage is high and there is also a lot of capital chasing private equity.  Every dollar of private equity creates 2.5 dollars of debt.

“We are trying to tilt our commitments in a direction of more defensive strategies, in particular less leverage,” he says, noting that 90 per cent of the portfolio is with general partners, 10 per cent is co-invested.

Villa is worried that the asset allocation is going to deliver 5 to 6 per cent, well below the fund’s target.

“I’m not so much worried the return will be that for five or seven years but that there will be a combination of good and bad years and we will average 5 to 6 per cent,” he says. “Asset prices are high so as asset prices normalise returns will below.”

He says because current and prospective cash rates are low, when he builds return expectations with cash rates as a base, expected returns on all asset classes are low going forward.

“If equities return 7 per cent and bonds return 3 per cent, you get weighted returns of 4.2 per cent and 1.2 per cent or a total of 5.4 per cent,” he says. “It’s hard to meet the target.”

 

Technology

In recognition of the fact the portfolio has become more complex, in a bid to chase down alpha, the fund has spent a lot of time and energy on technology.

It currently has five big technology projects underway:

  • Building a data warehouse
  • Improving data governance
  • Upgrading the performance analytics engine
  • Centralising the portfolio engineering function
  • Upgrading technology platform for private equity

“We have been undergoing a tech transformation,” Villa says. “Many institutional funds managers have lots of technologists, data scientists and engineers but the majority of them are keeping the system working and providing analysis and reporting that has to be done in a semi-manual way and not an integrated approach. In the 1980s and 1990s we had equities and bond portfolios that were totally separated. As we create more strategies that are multi-asset and unconstrained, we need more work arounds in the technology. We are trying to move to a very integrated straight through processing environment where we have a data lake and snap technology on top of that and push buttons. Moving to unconstrained portfolios has meant this is a massive challenge.”

“We want to move away from spreadsheets to run the business which is not timely and prone to mistakes. We need a different technology solution to get there and it has proved to be a big challenge to do this.”

The fund has great aspirations and in the past two years has made good progress. It recently hired a chief technology & operations officer, Julia Valentine, who Villa describes as “the real thing”.

“She’s driving us into the future,” he says.

“It used to be an environment where the typical pension portfolio could earn 8 to 9 per cent. Today it’s harder to achieve your target, so we are all trying to use more complicated strategies and solutions and old technology platforms are just not up to scratch. Now we need to manufacture alpha and it’s expensive. That wasn’t necessary in the past but today it’s mission critical and everyone is doing it at the same time.”

Villa and the team have high aspirations for getting work done, but he admits they are “a little short handed” and will probably have to decrease the list of projects to match with staffing levels.

The fund has hired 34 new staff since the beginning of the year, with a turnover generally of about 8 per cent, but the staffing level is below target.

Villa attributes this to the robustness of the economy adding it takes 30 per cent longer to recruit people.

Added to this is the fact a lot of investment managers are trying to do the same thing in technology and Wisconsin is hiring deep domain expertise with more than 70 per cent of hires being relocations from LA, Chicago or New York.

One of the reasons for spending time and money on the technology platforms is to have a more robust inhouse functionality, and the fund has plans to bring a further $2 to $4 billion in house in global equities and bonds plus enhanced.

Admittedly these are assets that were internal but were outsourced temporarily about four years ago because of the technology transformation, and are now being brought back in house.

It currently manages around $55 billion in house but that is nudging closer to $60 billion.

Villa admits there has been a cost in moving around that management of assets but says it is not so much about disruption but a mismatch of cost and benefit.

“The managers we had the money with are very idiosyncratic, who have resources and technology we don’t have, so they can do things we can’t do – we have been renting their infrastructure while we build our own,” he says. “We still have about two years of work on our technology to be as good as the external fund managers, it’s a big transformation.”

The fund estimates it saves around $75 million a year due to its internal management.

 

 

Institutional investors should consider factor investing as a strategic decision.

Recent academic papers identify factors that deliver abnormal returns across asset classes and markets. Consequently, implementing factor investing as an integral part of top-down strategic investment decision-making becomes a key asset and risk management decision for institutional investors that invest in global equity and bond markets. Institutional investors should explain this strategy in a clear and transparent way to their stakeholders.

In a novel academic paper, Do Institutional Investors Manage Factor Exposures Strategically?, Dirk Broeders from Maastricht University and Kristy Jansen from Tilburg University study how institutional investors incorporate factor investing in their investment strategies.

Although factor investing receives a lot of attention, the traditional approach for institutional investors, such as pension funds, is to focus on the optimal stock-bond allocation and, in some cases, alternative asset classes such as real estate, private equity, and hedge funds. Broeders and Jansen assess the factor exposures of institutional investors in the Netherlands, i.c., occupational defined benefit pension funds. The Dutch occupational pension system is economically important because assets under management equal approximately 1.6 trillion and represent 54 percent of total pension funds’ assets in the euro area. Next to the market and credit risk factors, the authors focus on value, momentum, carry, and low beta for both equities and fixed income portfolios. The latter four are constructed as zero cost, long-short factors and have a significant positive mean return for both equities and fixed income.

Broeders and Jansen find a striking difference between factor investing in equity and fixed income portfolios. Based on two key findings the authors claim that pension funds manage equity factor exposures strategically. First, value, momentum, carry, and low beta factors explain differences in expected equity returns between pension funds to a large extend. Second, the factor exposures for equity portfolios are stable over time. By contrast, support for strategic decision-making in fixed income factor exposures cannot be found. Differences in expected fixed income portfolio returns across pension funds are mainly driven by market exposures. The impact of long-short factor exposures on return differences is negligible. In addition, over time the fixed income factor exposures vary much more than strategic decision-making would suggest. The average fixed income factor exposures can get as low as -0.6 and as high as 0.8.

The authors go further and analyse what drives factor exposures. They document that pension fund characteristics, delegated asset managers and exogenous events drive factor exposures. Amongst others, Broeders and Jansen report the following interesting results. Size, measured as assets under management, does not have an impact on the exposures to long-short factors. This observation means that contrary to common belief, large pension funds are not constrained in implementing factor strategies. Further, for both equity and fixed income, asset managers play a non-trivial role. The five most often contracted delegated asset managers amplify factor exposures in either direction. The effect of asset managers on factor exposures may be driven by differences in beliefs about factor investing. Finally, it is shown that momentum, carry, and low beta factor exposures increased sharply following the start of the Global Financial Crisis in 2008 and then reversed sharply around the peak of the euro sovereign debt crisis in 2012. The euro sovereign debt crisis has moved Dutch pension funds away from government bonds in southern Europe to ‘safe haven bonds’ with lower carry ranks, such as German and Dutch government bonds.

 

Australia’s largest industry super fund has looked to India to boost returns, as it ramps up its allocation in offshore private markets to further diversify its portfolio.

The strategy has seen AustralianSuper join Ontario Teachers’ Pension Plan to invest a combined $500 million in India’s National Investment and Infrastructure Fund (NIIF) with plans to double that allocation in the future.

India’s sovereign wealth fund had previously struggled to attract foreign investment into a sector beset by corruption, red tape and a weak legal system. Further, the pension funds’ investment follows a crisis in India’s shadow banking sector which threatened NIIF’s ability to finance infrastructure projects.

But AustralianSuper chief investment officer, Mark Delaney, who helps oversee some $165 billion in assets, insists that there have been improvements over the years. He also said that it is noteworthy that Ontario Teachers is investing in the NIIF too. “Given there is heightened regulatory risk globally, it is not enough to simply say that India has high risk where OECD countries are low,” he says. “Different sectors will have different regulatory risks.”

Delaney also said India looks relatively benign compared to other countries currently, adding that the regulatory risk in developed markets infrastructure is high and increasing.“It’s important to remember that this can change quickly and no country is immune,” he concedes.

The investment chief pointed to the nationalist threat in the UK and numerous examples of regulatory risk in Australia.  “There is a question that in developed markets, investors are not getting the returns for the regulatory risks that exist there,” he said. “While India also has these risks, the returns appear to be priced better is some sectors.”

Delaney likes India’s high GDP growth, largely driven by a growing middle-class. This thematic is what makes India interesting. “It is because of this growth we believe that over the medium to long term, there will continue to be opportunities to invest in the region and hence the potential to invest more there at attractive risk/return profiles,” he says.

Further, he cites structural reforms undertaken by the Indian government such as a national GST, time bound insolvency processes and privatisation processes that split the pricing and assessment criteria. “These will make India’s growth more sustainable, and while risks are still present, they are reducing and likely to trend in that direction going forward.”

Currently, around 5.90 per cent of the fund’s assets are allocated to emerging markets with exposure to India running at 0.58 per cent and China at 1.83 per cent.

Structural forces at play

The super fund currently has 25 per cent allocated to private markets, 11.7 per cent of which is invested in infrastructure. Delaney plans to boost that allocation to 15 per cent.

While his longer-term strategy is to increase investment in offshore private markets, in the shorter term, Delaney says he is not looking to ‘move up the risk spectrum’ but will tilt the portfolio towards infrastructure assets. “The trick is to balance the structurally lower interest rates against being late in the cycle and private markets being in strong demand,” he says.

Delaney expects the ‘lower for longer’ theme will play out over the next 12 months. Further, he anticipates the desire for pension plans to have greater weight in private market assets will play out over the next three to four years. “And then we have the equities cycle which is overlapping on top of that,” he says.

He remains cautious about private equity given the amount of dry powder in the sector, the level of entry multiples and given his view of listed markets. Private markets always lag listed markets in the cycle, he went on to say, so if listed markets come off, unlisted markets will also come off. These are conflicting forces,” he says. “We’re late in the cycle, interest rates are low and we get this conflict because the central banks are seeking to extend the cycle by lowering rates further. On that basis, we are carefully monitoring our capital deployment in private equity and expect to remain cautious for at least the next 12 months.”

Delaney says there are three big global structural forces at play – low interest rates, a swing away from multilateralism to regionalism and governments playing a bigger role in supporting economies’ fiscal stimulus, determining infrastructure spend and increased regulation.

“These things affect every asset; some will benefit from these forces while others will be penalised by them,’ he says. In terms of infrastructure assets, he continues, some will be subject to more regulatory risk while others will benefit from sitting outside of the regulatory regime. “If you look at each asset through those three windows, you can work out their relative attractiveness as and how it changes.”

As he sees it, the world has moved towards multilateralism for the last 40 years as evidenced by the small number of free trade agreements signed in the last few years compared to the much bigger number of pacts forged five or six years ago. Pointing to the geopolitical rifts and schisms around the world  – between US and China, the UK and Europe, Europe and the US – Delaney says these are examples of this shift.

Lower for longer

Asked about this long-term view on interest rates, he wavers. Delaney doesn’t think that there is a lot of value in very long-term forecasts, and largely manages the portfolio to shorter-term horizons.

“We do note, however, that a lot of the structural factors that have helped drive down rates over the past few years – demographics, high levels of global debt, technology, and globalisation largely remain in place,” he argues.

Regarding the fund’s listed-equities exposure, Delaney manages via a tactical asset allocation process which seeks to balance both valuation metrics with the macro environment.  Around 55 per cent of AustralianSuper’s portfolio is allocated to equities.

Given the current high prices, are lower risk assets that generate lower returns still attractive on a risk-adjusted return basis?

“It’s unclear whether the risks of now lower returning assets, for example bonds and property, have actually reduced,” says Delaney. “We’re focused on identifying the investments that are going to generate us the strongest return, while being adequately compensated for the risk.”

AustralianSuper will probably lift its private market’s allocation in response to lower rates and reduce its listed equities and fixed interest weighting, the CIO said.

In terms of risk premia and liquid alts, Delaney is still trying to determine whether it has a role in the fund’s portfolio.  “It’s not an immediate priority for us.”

Despite AustralianSuper being the nation’s largest superannuation fund, Delaney says $165 billion is a “pretty small number” relative to the total pool of retirement savings and a drop in the ocean for global capital markets. “We talk about Australia being the third or fourth biggest retirement market in the world with $3 trillion dollars, or US$2 trillion. The US pension market is worth US 41 trillion so Australia is less than a tenth of the US market and that’s not even the whole globe,” he adds.

The fund is projected to double in size to $300 billion over the next five years.

 

 

At Complementa we have been collecting data on Swiss pension funds for the last 25 years. Our latest 25th annual risk check-up study draws on information from 437 Swiss pension providers with an aggregated balance sheet total of CHF 649.1 billion ($250 billion). Our findings show that Swiss pension funds had a successful first eight months of 2019. Moreover, although the Swiss pension sector has always been characterised by a balanced investment mix an important trend is emerging: funds are increasing their allocations to alternatives.

The asset structure of Swiss pension funds has traditionally been equally balanced between fixed income, equities and real estate. Today some changes in the choice of investment instruments are starting to emerge.

Most striking is the emergence of alternative investments. Swiss pension funds have begun to give a higher weight to alternative investments with alternatives now accounting for on average 10 per cent of a typical pension fund’s total assets putting alternative allocations in the double digit range for the first time. The proportion of pension funds with an alternatives quota above 10 per cent has risen from 13 to 25 per cent in the last four years. Around 9 per cent of all pension funds currently exceed the BVV2 category limit of 15 per cent in alternatives.

Swiss pension funds are also increasingly investing abroad, even though there was a slight decline in 2018 – something we attribute to lower valuations in equities. Nevertheless, the share of foreign investments has more than doubled since 1995 from 19.8 per cent to 48.9 per cent. The reduction of a “home bias” is particularly pronounced in equities. Whereas in 1995 domestic Swiss equity typically accounted for 63 per cent of a pension funds’ equity allocation, today this stands at 32 per cent.

Although foreign investment is increasing, Swiss funds are not increasing their foreign currency exposure. On the contrary, foreign currency ratios have been gradually reduced from 28.7 per cent to 14.6 per cent since 2006, thus reaching a new low.

Widening definition
In Switzerland the term “alternative investments” has long been a synonym for the three categories: hedge funds, commodities and private equity. However this is no longer the case. While the three categories covered more than 90 per cent of alternative investments by 2010, the figure is now only 55 per cent.
Alternative categories have increased to span private debt, insurance-linked securities and infrastructure.

In these categories, the increase in total investment is attributable to both funds’ increasing their allocations and and initial investments for the first time. In the case of commodities and private equity, the amount of pension funds allocating remains constant at on average 34 per cent. In the case of hedge funds, less pension funds are allocating with the ratio continuing to decline slightly. Whereas until 2012 every second fund was invested in hedge funds, six years later it was only 37 per cent

Hedge funds experienced a real boom after the equity crash in 2001 and 2002, in which they proved to be extremely crisis-resistant. In the last few years however, many Swiss funds started to avoid hedge funds. Nevertheless, hedge funds remain by far the largest category among alternative investments, particularly popular with larger funds.

Funds in investing more in private equity
The investment volume in private equity is much more constant than in other alternative investments and has remained above one percent since 2007. In the last three years, however, the ratio has risen significantly and reached 2.0 per cent for the first time in 2018. Investing in private equity is often linked to minimal investment volumes, which make it more difficult for smaller pension funds to be invested.

Parallel to the rising commodity prices until 2008, numerous pensions funds built up their commitments. As a result of the sharp drop in prices, the weight has fallen again in recent years. Additional divestments are pushing the ratio down from 2.3 per cent in 2010 to 1.3 per cent today.

Four years ago private debt was still of secondary importance with an investment weight of around 0.3 per cent. Now the average allocation has since risen significantly to 1.2 per cent making private debt the fourth largest subcategory within alternative investments. However, the high demand for these products and the general interest rate situation has put pressure on yields in the recent past, which is likely to hamper further growth.

In the meantime, more than one per cent of pension fund assets are invested in infrastructure. Similar to private equity investments, access to this category is difficult for small funds. Small and medium-sized funds have investment ratios of 0.3 per cent and 0.7 per cent respectively.

Around 30 per cent of Swiss funds now hold investments in Insurance Linked Securities (ILS) in a growth trajectory fuelled by the low level of interest rates. ILS are also very popular with small pension funds, as access is comparatively easy. Among small pension funds, ILS are now the most popular subcategory among alternative investments.

Real estate
One notable trend is within real estate. Twenty-five years ago, Swiss pension funds’ real estate investments consisted almost exclusively of direct real estate holdings. Gradually, funds increased their indirect allocations and now the share of indirect real estate investment has grown from 0.7 per cent in 1995 to 11.8 per cent of real estate allocations. By contrast, the share of direct investments has more than halved in the same period from 20.3 per cent to 8.6 per cent. Pension funds are also increasing their allocations to foreign real estate in a trend that is gaining some momentum. Over the past two years, the share of foreign real estate has risen from 2.1 per cent to 3.0 per cent. However, pension funds’ domestic bias in this asset class remains high compared with their equity and fixed income investments with the bulk of their property investments in Switzerland.

Heinz Rothacher is chief executive of Complementa AG.

CalPERS traded $55 billion in fixed income securites last financial year as it implemented its new internal structure apportioning fixed income assets across three groups: treasuries, spread and high yield.

Each of the new segments in the board-approved structure has defined purpose and role.

More than half the income allocation ($56.7 billion) is in long spread, which seeks to provide a reliable source of income and an additional source of liquidity; $11.7 billion is in high yield which provides exposure to economic growth and acts as a reliable source of income; and $37.8 billion is in long treasury which seeks to serve as an ecnomic diversifier to equity and is a reliable source of liquidity.

The idea is that this level of granularity allows for a higher level of flexibility in the asset allocation process to help the fund achieve its objectives.

Speaking at the September investment committee meeting managing investment director global fixed income, Arnold Phillips, said the fixed income group had assisted in the set up of a more centralised capital allocation framework to manage plan level, total fund, leverage and liquidity in a cost effective, transparent and risk aware manner

“Trust level liquidity is [CIO of CalPERS] Ben’s highest priority,” Phillips said. “The balance between too much and too little is important. As we try to reposition the portfolio from a top down perspective, it is paramount we know where we stand. I’m not sure we have a more important project, alongside our work on private equity, as a launching point for what we want to do. We are in a strong liquidity position now, the point is what we want to do with it.”

Over the year to the end of June, the net return for fixed income was 9.6 per cent with an excess return of 31 basis points. The portfolio benefited from its duration exposure, and provided a “meaningful ballast when equity risk markets sold off sharply in the fourth quarter of 2018” according to Wilshire.

For the five years to June 30 it returned 4.08 per cent, adding an excess return of 56 basis points.

The fund manages 96 per cent of fixed income internally, and has 31 full time employees with about seven vacant positions.

“The global fixed income five years excess return $1.7 billion, which is about $40 million per fixed income employee,” he said.

Internal management has been a cost effective way to manage the portfolio, with the internal fees coming in at $10.1 million for the year, or about 1 basis point. External management fees were $14 million or about 23 basis points on the 4 per cent of assets managed externally. The fund spent a further 1 basis point on technology and operating expenses.

Phillips was appointed managing investment director global fixed income in July, a position he was acting in from May 2018. He’s been part of the team since 2001. The fund invests 28.7 per cent of the portfolio, or $106.3 billion, in income, making it the fund’s second largest allocation. Global equities is around $185 billion and it returned 6.1 per cent for the year.

“We have shifted to a total portfolio view and away from a siloed approach. We continue to focus on the total fund and how global fixed income fits in. Its purpose is to provide income, as a steady source of liquidity and as a shock absorber to global equities.”

He said the performance for the year was strong due to the interest rate sensitivity in the portfolio, which was a deliberate design by Phillips and the asset allocation and risk management group, headed by Eric Baggesen, to “ward off equities”.

On reviewing the global fixed income results, one of the investment committee mmbers Stacie Olivares asked “as we move into darker times where do we move?”.

“There is $13-17 trillion trading on negative rates, that doesn’t sound like investing, paying someone to hold your cash. As we shift closer to zero rates we may have to rethink the assumptions that go into asset allocation, everyone will,” Phillips said.

“This is a legitimate concern. The creation of our centralised research group helps to look at this from a top down asset allocation and portfolio construction view and will be extremely important as we get into these unchartered waters.”

The fund’s consultant Wilshire gave the global fixed income program a B ranking, putting in the third decile, saying it believes the global fixed income program is managed in an effective and risk-conscious manner, leveraging the deep expertise of the senior management team.

The consultant said the permanent appointment of Phillips added to the score indicating the organisation can cultivate and retain talent.

There has been widespread adoption and more board engagement since the launch of the Task Force on Climate-related Financial Disclosures recommendations in 2017 but more work is needed to get a uniform and comparable approach to climate change disclosure across the investment community.

The $201 billion Ontario Teachers’ Pension Plan said consultants and advisers need to educate themselves on climate change to help the smaller funds integrate the risks into their investment process.

Barbara Zvan, chief risk and strategy officer at OTPP, said the challenge facing the pension industry was no longer about raising awareness but rather how to implement climate change into their organisation. She said it was easier for the bigger plans with more resources to get access to the climate data they need to make investment decisions.

The smaller organisations “can’t always afford to do that,” she said in a telephone interview. “The ecosystems of consultants and advisers need to improve their knowledge on climate change. Bringing groups together will help build the tools needed.”

Canada’s second-largest pension fund was a contributor on a report by the Investor Leadership Network that shows how some of the world’s biggest institutions have implemented the recommendations from the Task Force on Climate-related Financial Disclosures, or TCFD.

It found that while there has been widespread adoption and more board engagement since the recommendations were launched in 2017, more work is needed to get a uniform and comparable approach to climate change disclosure across the investment community.

“Traditional risk management is usually a lesson in history, but there is no history in climate change,” said Zvan. “It’s a complicated topic and there are so many scenarios to take into account – that’s the hardest part.”

The report, which coincides with the United Nation’s climate action summit in New York this week, also showed which asset owners were more ahead than others in embedding climate change into their investment process. Canadian funds particularly fared well.

These include Caisse de dépôt et placement du Québec, which has made climate change part of the mandates of board sub-committees, and OTPP, whose investment committee has formalised climate change as part of its mandate for investment strategy and risk. The report also cited CPP Investment Board, which last year set up a formal climate change program that is being overseen by a dedicated steering committee made up of almost half of their senior executive team.

Zvan says by showing how the bigger plans have tackled climate change, it may help drive momentum among the smaller players. She said while a lot of leadership will also come from the private sector in bringing about change, investors played a key role as they were the ones that ultimately own the risk.

“We have to make 4 per cent real every year so we are looking for opportunities to steer the big ship,” she said. “And at the end of the day,  (we) can just pull their capital.”