Asset owners are diversifying, cutting costs and allocating assets to low-volatility strategies in preparation for a market downturn, a high-level panel discussion at the Fiduciary Investors Symposium at the University of Oxford found.

NEST, a workplace pension fund set up by the UK Government, is preparing for lower returns in the coming years, said Mark Fawcett, chief investment officer of the £1.7 billion ($2.4 billion) portfolio.

“We have put the numbers in, and our expected returns are somewhat lower than in earlier years” Fawcett said, in a discussion chaired by Chris Cheetham, global chief investment officer, HSBC Global Asset Management and chair of the UK’s Mineworkers’ Pension Scheme.

Fawcett explained that one option would be to increase risk, but this strategy worries Fawcett.

“Increasing risk at this point in the cycle feels wrong,” he said.

The option that Fawcett has started to pursue, is to incorporate more asset classes as well as looking to add value in asset allocation and manager selection, although he noted that adding some asset classes to diversify further was challenging because of the fund’s cost constraints.

Affordable options that would help weather-proof the portfolio include NEST’s new allocation to commodities, which will soon bring the asset class into the portfolio for the first time. Fawcett is also mulling other strategies that play to the advantage of NEST’s growing assets under management. Although member pots are still small, contribution rates are climbing. The fund is predicting its assets will double next year and again the following year. A market correction could provide an opportunity for it to buy on the lows, backed up by dry powder from its increasing contribution levels.

Another strategy for a bearish market is writing out-of-the-money put options to capitalise on NEST’s steady equity accumulation. The fund invests about £50 million every month in equity, an amount that will double this year and then again next year.

“Why not try to take the insurance premium and benefit from this while we accumulate the equities we would naturally be buying along the way?” Fawcett said.

Railpen, the £25 billion ($34.9 billion) industry scheme for the UK railways, has sought out diversifying elements such as catastrophe insurance. CIO Richard Williams noted that competition for these assets was steep.

“We invested less than would have liked,” he explained. So far, Railpen has kept its equity allocation at “normal” levels, partly because Williams is circumspect about predicting the extent of the downturn that lies ahead.

“Everyone is expecting low returns in the future but how often is it that the markets deliver what experts expect? I am not convinced we are living in a period of low returns.”

He noted, however, that a prolonged downturn for the pension fund would be worrying, given the scheme needs a 6 per cent to 7 per cent return to meet its funding requirement in real terms.

PGGM, the Dutch asset manager of the €189 billion ($230 billion) healthcare scheme PFZW, is limited in its ability to time the market because of its slow-moving investment process. Instead, it has built in diversification and long-term returns with a passive global equity allocation, smart-beta strategies that include quality and low volatility for resilience in market downturns, and a 20 per cent alternatives portfolio that combines private equity, real estate and infrastructure. The fund has also built a nominal bond portfolio that, like the alternatives allocation, helps hedge liabilities; although principal director, investment strategy, Jaap van Dam, said PGGM had scaled back here because of low nominal bond yields.

Investors are also targeting costs to prepare for lower returns. Railpen has bought assets in-house, which has helped alignment and created efficiencies.

“It has given us the opportunity to do better in a low-return world,” Williams said. The fund’s property investment is one example where it has taken on development risk directly; it has also produced its own smart-beta strategies, creating a tailor-made portfolio with a smaller number of stocks than what is available commercially.

Lowering costs

NEST, which has a total expense ratio of just 30 basis points, works with its managers to devise smart, low-cost strategies. One example is the fund’s climate-aware equity portfolio with systematic tilts and a focus on overweighting companies exposed to renewables and clear transition paths to a low carbon economy.

PGGM has also prioritised costs, trimming 20 basis points over the last five years by bringing management in house, investing directly and renegotiating manager fees. Also, van Dam noted new long-term themes that would help trim expenses at the fund, such as more integrated portfolios, owning fewer assets, greater engagement and a renewed emphasis on “where value is created”.

The panel also referred to the importance of governance and robust management when preparing for a downturn – particularly if they have to move quickly. It is something PGGM has navigated by empowering its board to take ownership of just these kinds of decisions. Van Dam used the example of rebalancing to illustrate how an up-to-speed board was crucial.

“If you have a disciplined rebalancing process and you do regular fire drills to test it, when the big hit comes it won’t take two years to discuss,” he explained. “It will just be done.”

Railpen is also talking through strategies with its stakeholders ahead of time, including the possibility of using more leverage in a downturn. Strategies such as tail-risk hedging and a large allocation to cash are difficult at the fund because it has an ambitious return objective, Williams said.

“We are exploring whether to embrace more leverage and borrow money to buy assets,” he divulged. “We are talking to stakeholders now so that when the time comes, and we make that request or effect that strategy, there will hopefully be a high level of understanding.”

“The current pricing is the worst in history in terms of achieving long-term goals,” warned Greg Jensen, co-chief investment officer of Bridgewater Associates, the world’s biggest hedge fund.

“We have seen a fall in yields in all assets that puts 10-year returns for a traditional 60/40 portfolio at 2 per cent to 3 per cent, and for most entities, this won’t cut it,” he said.

Jensen spoke at the Fiduciary Investors Symposium at the University of Oxford. He drew on his two decades at Bridgewater to highlight important trends ahead and dispel any lingering investor hope that a downturn won’t materialise.

The signs of troubles ahead have been masked, he said, by the fact that asset prices have done so well in recent years. Valuations have grown steadily higher, thanks to monetary policy that has pumped liquidity into markets, creating a massive excess of cash relative to assets. Central banks ploughed into bond markets, going “from 5 per cent to 20 per cent of the market”, Jensen said. That liquidity has driven up asset prices to yields that are similar to cash, and squeezed the private sector out of bonds, pushing investors towards riskier assets.

“The private sector has more in illiquid, risky assets than at any point in history,” said Jensen, who pointed to the flat risk curve as another indication of low returns ahead. “Today, people are far out on the risk curve, with very low expected returns.”

The current economic cycle has lasted so long partly because of central bank caution about cutting back on liquidity, but also because inflation for goods has stayed low. Yet Jensen said quantitative easing (QE) had caused massive inflation; it just has occurred in financial assets rather than goods, and its impact has been just as significant.

“You can create money and where it goes [determines] what it drives up,” he said.

Life after QE

QE has worked and central banks are pulling back. Now the impact of the removal of that liquidity, rather than the production of it, will play out. Nowhere more so, in Jensen’s prediction, than in private-sector reluctance to buy the asset issuance that lies around the corner. Governments, particularly in the US, will increasingly call on the private sector to finance large budget deficits, yet investor appetite is muted. Jensen predicted policymakers would struggle to navigate this.

“There used to be enough liquidity to buy into a dip, but everyone is fully allocated, and a big gap is going to be exposed.”

He expects to see investors either lever up to buy these assets or sell out of risky existing holdings and move into safer assets; either way, there would still be a capital shortage that would probably show up in the bond markets first.

“At today’s prices, the private sector has no interest in bonds,” he said. “Yet they are going to need to be [convinced to] buy the budget deficits that are being created.”

Governments face the challenge of drawing up a fiscal and monetary policy to deal with the downturn, when they’ve already used up the tools of low interest rates and QE. Policymakers also face secular trends such as mounting deflationary pressure, accentuated by automation, and changing demographics.

“Today, there is more debt, which will be a draw on future income,” Jensen explained. “But there is also less income because there are fewer workers in terms of paying back that debt. This is a gap we call the big squeeze.”

Rising interest rates would also put financial assets under pressure and Jensen urged slow tightening; he added that the interest rate rises that had already taken place wouldn’t play out for nine months.

“The mistake of being too easy is better than the mistake of tightening too quickly,” he said.

In today’s late cycle, most assets do poorly, bar exceptions such as commodities and inflation-linked bonds. Jensen urged investors to address this reality by lowering expected rates of return to something closer to what is achievable. He also suggested close portfolio analysis to see how different allocations perform in periods of falling and rising growth and “where the environmental bias lies”, to build a portfolio for a downturn.

Investors should seek out passive assets that have a bias different to their current portfolio, Jensen said. Another plan could be finding alpha managers that are more likely to do well when things go poorly.

 

Geographic diversity

He urged diversity not only of assets but also of geography.

“We don’t know which countries will break which ways,” he said, and suggested splitting portfolios more evenly between the emerging world – particularly China – and the US and Europe.

“People aren’t diversified this way and the picture in China and a few other countries is not as dire as the picture in the developed world in terms of expected returns,” Jensen said.

He advised remaining liquid enough to react to circumstances, which could evolve quickly.

Investors need to go much further than carbon footprinting their portfolios to measure environmental risk, a sustainable finance expert has said.

Ben Caldecott, director of the sustainable finance program at the Smith School of Enterprise and the Environment at the University of Oxford, said that although carbon footprinting was the easiest tool to measure exposure to environmental risk, the process didn’t accurately determine exposure because the data was often poor.

“A lot of carbon reporting information used to drive analysis is disclosed inaccurately,” Caldecott said, speaking at the Fiduciary Investors Symposium at Oxford. “Carbon footprinting provides moderately interesting insights but can’t measure everything, and the data is not great.”

Instead, he urged the gathered delegates to ask what environmental risks they want to measure, and what impact they care about as investors. In this bottom-up approach, investors would look at the risk of individual assets, and the exposures to which they could be vulnerable.

“Measure each individual asset against the measure of risk you are interested in,” he said, listing environmental and regulatory risk, changing social norms, resource scarcity and litigation as examples. “In the future, there is a real possibility that fiduciaries will be sued over their management and reporting of climate-related risk. The law is a mirror on society and social norms change rapidly.”

New risk modelling

A new type of modelling should first involve determining how assets would perform in years to come, balanced against the risks to which they are exposed. Then, investors should assess a company’s ability and preparedness to navigate environmental risk. The final step would be “plugging into” valuation risks or economic models. Caldecott used the example of Thailand’s power sector to illustrate how this future risk could be measured within a research model to calculate the future emissions of individual power stations over each asset’s lifetime.

Measuring risk this way was getting easier, he said. The current process began with mapping carbon budgets onto listed fossil fuel reserves back in 2011. Next, experts started looking at individual assets and how they depreciated based on carbon budgets. Today, this has progressed to measuring a whole variety of environmental impacts on an asset and aggregating them.

 

A rethink for disclosure

Caldecott questioned the current focus on disclosure.

“Disclosure isn’t the answer to the data problem,” he argued. He said many of the details revealed in the disclosure process were not relevant to fundamental analysis of a company. Although disclosure has a role, particularly in asking questions that help companies think about key environmental issues, he argued that a new, ambitious disclosure framework should look at environmental risk through a lens that includes impact. This would provide the data and disclosure that investors need to deploy their capital.

“The focus on disclosure has come at the cost of having an impact,” Caldecott said. “It lulls people into a false sense of security. We need to be realistic about what disclosure can achieve. Will we get decent disclosure from around the world? There are lots of issues that will prevent disclosure frameworks from working.”

He acknowledged that measuring impact was challenging and asked investors to look at what they could measure “with a degree of certainty” in their portfolios or investee companies; he also advised singling out specific SDGs as measure of impact, rather than looking at them all.

He urged investors to focus on “risk first and foremost” and to begin by shifting their capital so it wouldn’t flow into high-risk environmentally damaging assets.

Caldecott called engagement an important part of the story but suggested asset owners target sectors of the economy that offer the most opportunity to change corporate behaviour.

“Don’t focus on sectors where companies and management don’t have choices,” he said, citing upstream fossil fuel producers as an example. Instead, he recommended engagement in downstream sectors, such as the car industry and power companies.

Far-reaching innovation and technology would soon help investors access the data they need to measure environmental risk, Caldecott said. Remote sensing already allows people to see what is going on around the world via high-quality images; the European Commission provides environmental data to the public via its satellites and private satellites are also important sources of this information. The cost of capturing and storing data is falling and computers can identify trends in new and important ways. It was previously difficult to measure global solar deployment because much of it isn’t registered, particularly in developing countries. Now technology can identify solar installations around the world.

Caldecott said satellite imagery and remote sensory data were allowing new feasibility studies to measure assets’ greenhouse-gas emissions.

“We will soon have the ability to measure greenhouse-gas emissions from individual facilities,” he told delegates. “It has significant implications on how we measure an asset’s exposure to risk.”

He also said natural language processing would allow investors to extract information quickly – important for reputational risk and finding out who owns certain assets.

Finally, he urged investors to understand what they need and to invest in data capabilities or work with providers.

“There is no excuse not to manage these risks,” Caldecott said. “You can measure and manage them.”

Australia’s A$44 billion ($34 billion) Cbus Super, a pension fund for the construction and building industry, is bringing up to 40 per cent of its asset management in-house. It’s a response to the fund’s growing assets under management, which have doubled in the last five years and are forecast to hit $60 billion soon. Pressure on alpha, linked to a declining capacity to pick successful external manager strategies, also influenced the decision.

It’s a brave move. The fund’s existing model has worked well, Cbus chief investment officer Kristian Fok said, speaking at the Fiduciary Investors Symposium at the University of Oxford.

“We are taking a successful model and changing it,” Fok said. “But it’s time for us to think about our future growth and model going forward.”

Fok said the business case for “doing things differently” was compelling.

“It has made it much easier to have fee structure conversations with managers,” he said.

The process began 20 months ago, when the Cbus board approved a comprehensive plan, beginning with active equity. Cbus has a 55 per cent allocation to equity, split between passive and active.

“We believe in active management and look for a contribution of alpha in excess of 1 per cent,” Fok said. The fund has also set up a direct-lending arm, through which it partners with fund managers.

Handling more infrastructure assets in-house was “a logical extension”, Fok said, and Cbus now directly invests in smaller infrastructure assets, such as a recently completed investment in solar and wind energy in Western Australia. It still uses fund managers for the bigger infrastructure deals, and has good relationships with two global funds, Fok said. He also noted that doing more deals directly has resonated with the fund’s beneficiaries in a meaningful way.

“We are supporting investment activities that are aligned to our membership base,” he said. “It is a nice parallel to say to our members that we invest in the same way.”

Now the focus will turn to building an in-house team to manage small-cap equities. Cbus also wants to develop an Australian corporate opportunities portfolio, which will invest alongside several local companies, either underwriting deals or lending to entities that want to raise private capital rather than equity.

“We will put this to our investment community over the next months,” Fok said.

In the long term, the fund wants to apply its own research to its Asian equity and fixed-income allocations, too.

Three guiding principles shaped the thought process behind the move in-house, Fok said: a long-term approach, Cbus’ reputation among beneficiaries and wider society, and how best to reflect the fund’s positive cash flows. Bringing assets in-house has also freed the fund from a strict mandate that confined assets to single buckets. The interdependency between infrastructure and property assets via Cbus’ airport investments is one example of the benefit, he said.

“Airport services involve customers taking flights, but also retail and car parking. Assets can have characteristics that represent more than one traditional allocation,” Fok explained.

The decision to internalise management has also been driven by the fund’s experience managing a direct property portfolio via its subsidiary Cbus Property, which manages a $3.2 billion ($2.5 billion) portfolio invested in Australia’s commercial, retail and residential sectors. Investments focus on high-quality, sustainable assets, and “there is no compromise” incorporating sustainability, Fok said. It’s an important driver of the business that brings returns of up to 20 per cent annually.

“If you have a reputation for the way you invest, it attracts customers – anchor tenants are an example.”

Challenges with the move in-house have included expanding an internal team from 25 to 80, with plans to grow to 100.

“Attracting the right people, building the right culture and dealing with that growth are challenges,” Fok said. “We are also specific about what type of team we want.”

He stressed the importance of diversity in Cbus’ investment team, 40 per cent of whose members are women. He also raised the importance of cognitive diversity and referred to exploring it in a recent study by the fund.

“Seeing how people make decisions is fascinating,” Fok said. “People have very different approaches.”

More than 1000 people died in Bangladesh’s worst industrial accident when the eight-storey Rana Plaza garment factory near Dhaka collapsed in 2013. Many of the workers, aware that the factory was unsafe, had gone on strike in protest but had returned to the ill-fated building because they had been given an ultimatum to come back to work or lose their jobs.

Since the disaster, worldwide labour federation UNI Global Union, based in Switzerland, has successfully campaigned for independent inspections of factories in Bangladesh. For Philip Jennings, general secretary of UNI, the incident was a tragic example of why investors need to do more to protect workers’ rights by putting pressure on investee companies to safeguard their supply chains.

“Take a stand and be active,” Jennings said, during a rousing speech at the Fiduciary Investors Symposium at the University of Oxford. “Say, ‘No, we are not accepting this.’ ”

Jennings asked delegates to give non-government organisations and unions a fair hearing and improve on their governance.

“Very often, we feel we are being nudged aside,” he said. “Take us seriously. You’ve got a voice, use it.”

After the Rana Plaza tragedy, a powerful coalition of global investors called for big clothing retailers to help the victims and families of factory workers. The move was led by the Interfaith Center on Corporate Responsibility, a group of 275 institutional investors, with more than $4 trillion in assets under management, seeking social change.

It’s the kind of thing Jennings wants to see more of. He argued that investors share with unions a common interest in protecting workers’ welfare.

“My members are your members,” he said.

To him, it means investors should help improve workers’ rights in countries that have denied collective bargaining and union membership – part of what he called a rise of anti-democratic forces. The issue is not limited to emerging economies; investor influence on investee companies’ treatment of unions is just as important in developed nations. In the US, Walmart, the country’s largest private-sector employer, has a long history of stopping union membership amongst its 1.3 million employees.

Jennings set out the scale of the problem facing today’s workers. He estimated that about 3.2 billion people were in the global workforce, 1 billion in vulnerable contracts with no certainty of earnings. He cited 150 million children in work and 40 million in slave labour. Also, the number of people in vulnerable jobs is set to grow, he said; 192 million are unemployed, and extreme poverty in emerging economies without social safety nets has left millions without.

“People are living in poverty,” he said. “No wonder people are angry. The [proportion of] working poor in Europe is 1 in 10.”

Jennings also said many workers had been misclassified as freelancers or self-employed, in what he called a slide to the bottom for rights and earnings. In the US, 16 per cent of workers are self-employed.

He urged investment in companies that have a social purpose and encouraged robust due diligence on issues such as human rights, child labour and gender parity. Investors also had a role to play in boosting employment in infrastructure and new, green economies, where employment opportunities run into tens of millions, he said.

Jennings warned that workers felt angry and forgotten, and were insecure about wages and threats such as technology taking their jobs. He called for an end to what he called an assault on the institutions aiming to help workers and warned of the consequences for economies, social cohesion and democracy if unions’ role in the global economy were to be diminished.

“It is up to us to decide what future we want,” he said.

The impact of artificial intelligence on employment has tended to focus on blue-collar workers in sectors like agriculture and manufacturing. But its impact will be just as keenly felt by white-collar workers in professions like medicine, law, journalism and investment, where many decisions are made according to judgement, empathy and creativity, argued Daniel Susskind, career development fellow in economics, Balliol College at the University of Oxford.

It has already started to happen. AI can tell from a photograph whether a freckle is cancerous; newswires and media outlets are using algorithms, rather than journalists, to produce content; disputes are being mediated and resolved without lawyers. In Japan, an insurance firm is using algorithms to generate premiums and in architecture, algorithms are designing new buildings that look just like they have been conceived by a human hand. AI is even taking on tasks usually assigned to clergy – preparing people for confession, complete with a tool for tracking sin.

“That caused such a stir the Vatican has said it shouldn’t substitute the real thing,” said Susskind, who spoke at the Fiduciary Investors Symposium at Oxford.

AI is being driven by the exponential growth in the technologies that underpin it, namely computer processing power, bandwidth and data storage.

“By 2020, the average computer will have the same processing power as the human brain,” said Susskind, who adds that data accumulation is growing as more and more aspects of our daily lives become digitised.

“Every decision we make leaves behind a data exhaust,” he noted.

The ability of computers to solve problems was celebrated back in 2011 when IBM’s Watson wowed the tech industry by winning at the game show Jeopardy against two of its greatest human champions. Since then, the popularity of Alexa and Siri has made systems that can answer questions increasingly commonplace. And more big changes are on the horizon; for example, you have only to look at the forecast growth in driverless cars to see how robotics will change our lives, Susskind asserted.

“As recently as 2004, few people believed cars could ever be automated,” he said.

White-collar workers should be on notice because even areas long thought of as the preserve of human beings, such as judgement, creativity and intuition, are under threat. In fact, Susskind argued that machines already can replicate human emotions. Effective computing, a term that refers to computers’ increasing ability to interpret complicated human emotions – such as distinguishing between different types of smiles – has implications for professions where humans are thought to have an edge due to personal interaction.

To help explain why, Susskind said that whether machines could execute judgement was the wrong question. The right one, he argued, was: For what problem is judgement the solution? The answer is uncertainty.

“A machine can deal with uncertainty better than a human,” he surmised.

Susskind said machines wouldn’t take over entire professions. Instead, he predicted, they would take over specific tasks within a profession, performing them in a different way to humans by using their processing power and data storage.

“Machines will operate in terms of tasks, not jobs,” he said, and explained that AI would cause professions to be broken down into constituent parts. Machines will do some of those tasks, leaving others for people. Professionals face two options. Either they can try to compete with machines or they can try to build the machines themselves.

AI presents important questions, some of which Susskind highlighted. How do we train young people and retrain older people? Who should own and control tomorrow’s practical expertise and intellectual property? Moral questions about what tasks machines shouldn’t control needed to be addressed, too, he said.

“Are we comfy with machines informing parole decisions?” he asked. “How would we feel about a machine making a decision about turning off a life support machine?”