The Public Employees Retirement Association of New Mexico, (PERA), is in the process of changing its asset allocation, in line with a new strategic allocation put in place in April, that cuts the number of portfolios from eight to four and reclassifies assets as illiquid and liquid, rather than traditional and alternative.

“We’re keeping it simple,” says Jon Grabel, chief investment officer at the $14 billion Santa Fe-based fund, which runs 31 defined benefit retirement plans for state employees.

The new allocation is divided between a 43.5 per cent allocation to global equity, down 10 per cent and comprising low volatility, as well as hedged equity and private equity, a 21.5 per cent allocation to risk reduction and mitigation comprising core and global fixed income and cash, a 15 per cent up allocation to illiquid and liquid credit strategies up 7 per cent, and a 20 per cent allocation to real assets, up from 13 per cent.

Part of the changes in the equity allocation include a new low volatility and other factor-based strategies that will account for 4.4 per cent of the total portfolio. Two thirds of the public equity portfolio is indexed.

“We are a mature pension fund and the benefits we pay exceed contributions, and we are mindful of volatility and holding adequate liquidity,” says Grabel, who joined PERA two years ago, after holding roles in investment banking and private equity in New York.

“We have increased the amount we index. Over the long-term active management for highly efficient assets doesn’t really make sense.”

Best performers over the past year include real estate and private equity, with the private equity allocation returning 14 per cent in 2015, adding to a run of strong performances over the past five years in a strategy that doesn’t include any co-investment.

But in a shift, and despite Grabel’s acknowledgement that private equity “plays an important role within PERA’s diversified investment program,” PERA is adjusting strategy to focus more on the non-US allocation, in emerging markets particularly.

He says the fund is also looking for more diversification in the real assets portfolio, adding more to timber, infrastructure and farmland.

 

Private equity not a ‘silver bullet’

“We are keeping the core US buyouts static. Many LPs believe private equity is a silver bullet, but I don’t believe this is the case. It is important to remember that many investment opportunities are cyclical. I am not stating that we are in a private equity bubble, but we may be in a period of excessive demand, excessive supply and excessive expectations.”

He also questions the fees.

“The average private equity fund in the fundraising market is over $3 billion” and “the average hold time for private equity investment is decreasing,” he says. These two factors result in general partners (GPs) raising more funds in quicker succession pushing up management fees which have become “a source of substantial wealth for GPs, regardless of fund performance.”

Where he favours private equity, is the access it gives to industry verticals that are underweight in the public markets like healthcare and consumer discretionary sectors in emerging markets. He also believes the fund has an advantage in the smaller deals.

“At $14 billion PERA is a sizeable investor, but we are sufficiently small in the context of the $3 trillion private equity industry and the $25 trillion US retirement industry. We can concentrate on subsectors that are immaterial for institutions that are three, 10 or 20 times our size.”

An example of the smaller fund advantage is in early stage venture capital, he says.

“The mega institutions find it harder to allocate because of the administrative burden. We can take advantage of niche or capacity constrained areas like venture capital or lower mid-market private equity – these strategies where it is difficult for larger asset owners to take advantage.”

PERA uses external managers throughout the portfolio, with no plans to bring any allocations in house.

“Very few organisations have the economies of scale for effective internal management of passive strategies. The costs related to internal management are not just to do with an increased headcount, but include the risks and tracking errors associated with mandates. Additionally, active strategies require proprietary information and few public pension funds have that type of unique data,” he argues.

Where Grabel is active is in the asset allocation, tightening the guidelines on managers and clawing back on the tracking error he affords.

“Many active managers have generated alpha by introducing different security types. In fixed income this could be high yield or emerging market debt. But these are really asset allocation decisions and not for managers to make.”

In 2015, the fund returned 1.8 per cent and generated investment gains of approximately $0.3 billion net of investment fees and expenses in a performance below the 7.75 per cent actuarially required annual return hurdle, and which compares to 10 per cent returns for both the three and five-year periods.

Pensions expert, Hidekazu Ishida, talks about the state of corporate pension funds in Japan – from where they’ve been to where they’re going – and discusses some popular investment strategies.

“Japan’s corporate pension funds are contracting; they used to have half of their exposure in equity, but now they stick to safe assets,” says Japanese pensions expert Hidekazu Ishida, a former investment officer for the ¥320 billion ($3 billion) Osaka Gas Pension Fund, a defined benefit fund for Japan’s second largest gas utility, serving seven million customers in the Kansai area.

Ishida left to pursue his own career in 2015, but during his decade-long tenure, he oversaw the 1990s’ high of deregulation in the industry – when Japanese corporates were allowed to manage their own pension funds for the first time, and asset managers piled into the sector – to today’s gradual shrinking of Japan’s corporate pension funds.

Something he attributes to the ageing population and pension payments exceeding contributions, long-term low interest rates and the rise of defined contribution schemes.

“DB schemes in Japan are a dying species,” he says.

Assets at Osaka Gas are portioned between a 51 per cent allocation to bonds and deposits, with a significant amount dedicated to cash flow, a 31 per cent allocation to equity, and a 17 per cent allocation to real estate.

Popular strategies among Japan’s corporate pension funds include: multi-asset strategies offering little risk but stable returns, which although low are a preferred alternative to low bond yields – or equity risk.

Ishida says that corporate pension funds’ success with private equity has been “slow”.

Osaka Gas began investing in private equity in 2000, but didn’t make a meaningful return until 2012, he says.

Ishida observes that corporate funds favour hedge funds in their allocations for the liquidity they offer, with typical allocations of between 5-10 per cent of their assets. He also sees growing demand for smart beta strategies in Japan.

“It is possible to manufacture an alpha stream that seems to be stable, and they are relatively cheap,” he says. “Given the rate of sales activity, I think this is a new area.”

Yen a ‘safe harbour currency’

Many pension funds have also been caught out by not sufficiently hedging assets denominated in foreign currencies.

“Funds should have hedged more of their currency exposure last year. The Yen is a safe harbour currency that has been strengthening for the past six months, hurting overseas asset performance and helping to amplify losses. Hedging costs are so expensive – and it limits investors’ ability to go abroad. Going overseas shouldn’t mean that investors take currency risk, but a lot do.”

Ishida also notes another concern among funds since Japan adopted negative rates in January to spur spending and inflation. Some Japanese banks are poised to start imposing charges on the money they hold for clients such as pension funds, in a bid to limit the costs they are incurring from the Bank of Japan’s negative interest rate policy.

“Negative interest rates have forced banks to introduce a surcharge for deposits and short term liquidity. I don’t know what this means for investors yet,” he says. Mandates are typically outsourced, explains Ishida.

“There is no in-house management, because legally pension funds have to outsource all their mandates. Pension funds are not supposed to stock pick, although they can select their managers. Some large funds are allowed to run their own passive strategies, and firms like Panasonic have developed their own investment management subsidiaries, to run theses passive mandates.”

World’s biggest pension fund

Japan’s government recently put off a plan to let its $1.1 trillion public pension fund, the Government Pension Investment Fund (GPIF), buy and sell stocks directly, following criticism that the move could lead to excessive state influence on the market.

The legislation would have allowed the GPIF to directly buy and sell stocks, in a reform that would cut down on fees paid to managers and allow the fund to constructively interact with corporations and improve governance.

The GPIF is also barred from investing directly in assets such as real estate, infrastructure and private equity.

Current asset allocation at the world’s biggest pension fund is 39 per cent in domestic bonds, 4.5 per cent short term assets, 13.5 per cent international bonds, 21.4 per cent domestic stocks and 21.6 per cent international stocks. The GPIF plans to announce its fiscal-year results at the end of July, with market expectations that the fund will report a loss. In 2014 it announced a shift from bonds into equity as it sought higher returns. The fund posted a 12 per cent return in the year through March 2015, but it has been hit since by the downturn in equities.

As interest rates have fallen globally, the search for income has been a prominent narrative driving investment decisions. This has meant income-oriented assets have been “bid up” by the market, compared to other sectors, and are relatively fully priced in Mercer’s view.

In recent years there has been a flurry of “income” type funds enter the market, targeted primarily at the wealth sector or smaller institutional investors.  These can take various forms, but a common theme is an emphasis on yield-rich assets and an almost complete avoidance of lower yielding assets such as sovereign bonds. Such funds come with their own risks – the narrow pursuit of income in today’s low yield environment can offer as much downside to the unwary as the narrow pursuit of capital growth.

Types of income funds

Income products tend to fall into three categories:

Equity-focussed funds which invest primarily in stable dividend-paying companies but may have flexibility to invest a portion in fixed interest securities. Given they are concentrated in equities, for the most part these funds offer limited downside protection, albeit the defensive stock bias provides some insulation

Bond-focussed funds which are fully invested in corporate-issued fixed interest and cash. To bolster income, an allocation may be made to sub-investment grade or unrated securities

Diversified funds which are exposed to sectors as above but add or amplify asset classes with income-producing characteristics, such as listed property or infrastructure.

A dollar is a dollar

When considering such funds, it is useful to have regard to a wider context: A dollar of return is a dollar of return whether it comes from income or capital gain. Indeed, in countries where there is little or no taxation of capital gains, maximising dividends may not be the most tax-effective manner to generate returns

Investment returns are generally enhanced by tilting exposure toward those assets or sectors which offer better value or growth prospects relative to others

(As previously stated as interest rates have fallen globally, the search for income has been a prominent narrative driving investment decisions. This has meant income-oriented assets have been “bid up” by the market, compared to other sectors, and are relatively fully priced in Mercer’s view.)

The income component of an investment should aim to be sustainable but, equally, investors have to be mindful of the capital component of the total return. Valuation is important which entails not paying too much for the assets that are generating income.

‘Benign’ market environment

Income-oriented funds tend to have exposure to assets which have a relatively high correlation to the movement of interest rates, including a tilt to sectors seen as “bond proxies” such as utilities, property and banks. The fairly benign market environment we have been through over the past six years – low interest rates with moderate credit spreads and volatility – has provided a solid tailwind for income-type funds.

A low interest rate environment may well continue into the medium-term; however, that is only one scenario. A concentration on allocations to yield-rich asset classes may prove problematic in certain market conditions, such as a “flight to quality” where credit spreads widen and equity markets fall (to take one example, overseas higher yielding bonds lost around a quarter of their value in the period August-October 2008).

If valuations are stretched and begin to reverse, the prospect of investors incurring capital losses may become a reality. And in an individual sense, those who are near or at retirement are particularly sensitive to a drop in the value of their savings – they may not have the required investing time frame to recoup any losses.

There is also a risk that company dividend streams prove unsustainable, due to either pay-out ratios being too high, or insufficient revenue growth. An active manager can help by taking all the above factors into account and avoiding the riskiest parts of the market, but balanced attention to growth, as well as income, will limit the scale of the challenge.

The above discussion is not to say that an investor allocation to income-generative assets is unjustified. Especially where there is a view that interest rates will be “lower for longer” or for investors that have very clearly defined cash flow requirements – and limited need for significant upside from capital growth.

However, it raises the question as to to what extent investors should make use of income-oriented funds and whether now, in particular, is a good time to do so. A fund with more-diversified factor exposures helps reduce the likelihood of being severely impacted by a correction in any one segment of the market.

Being pragmatic

From a pragmatic perspective, it cannot be denied that a sizeable portion of investors, particularly in the endowment and wealth sectors, have a bias to receiving a steady stream of income arising from their portfolio. Human behaviour is such that regular pay-outs fill a need for “tangible” evidence of a return on investment, and there is a general aversion to drawing down on principal.

It is also true that income-paying assets fulfil a need of providing cash to cover grants, or spending requirements, in a relatively simple manner (even if the selling of units in a product can fulfil a practical need for liquidity with modest cost implications). The challenge for advisers and fiduciaries is to help ensure natural or embedded tendencies do not unduly compromise long-term investment goals.

Given the primary focus of income funds is to provide yield as opposed to an efficient portfolio in total return terms, and given the strong returns of yield-rich asset classes in recent years, caution should be exercised in allowing income-themes to dominate investment allocations.

A focus on yield should not be to the detriment of effective portfolio diversification. Ultimately, a well-constructed suite of different asset exposures should offer superior long-term outcomes to a fund dominated by corporate bonds and high-yielding shares.

David Scobie is a principal at Mercer in New Zealand

Britain’s vote on June 23, 2016 to leave the European Union (EU) has been salutary, exposing the political, economic, and cultural divide between the Davos elites (to use shorthand) and the majority population. This gap has widened not just in the United Kingdom, of course, and this was not the first such vote. (When the EU-Brussels has been put to national votes, it has tended to be repudiated, only to be subjected to re-votes or just ignored.) A squeaker remain vote in the UK would have enabled the Davos elites to continue papering over the divide. So whatever the mendacity and irresponsibility of the “leavers”, or the ultimate outcome of any Brexit process, balloting was a victory for democracy.

The vote did not appreciably increase the risk of an unravelling of the EU, which was already high. Europe today is a remarkably prosperous and peaceful place, with degrees of cross-border cooperation that are stunning by any historical standard. And this followed the most horrible wars in recorded history and required decades of painstaking effort and painful compromise. All this has been undermined, though, not by the 52-48 vote in the UK but by the integration process itself.

Europe’s deep, and perhaps insurmountable challenges, are rooted in a shift from the European Economic Community, a zone of free trade in goods, to the European Union. Aspirations for such a leap can be appreciated, but it has proved fateful in practice. Monetary union came first not because it was most desired, but because it was the least difficult. Political union lagged not because it was less desired, but because it was too difficult (cultural union, still more so). But as some critics warned at the time, and has become evident to many more people since, is that monetary union without fiscal, and ultimately political union, does not advance prosperity and peace.

Either fiscal-political union happens or monetary union ends

Amid the manifest devastation of the economies of southern member countries by the single currency, the so-called five presidents of the EU – of the Commission, Council, Central Bank, group of finance ministers, and Parliament – issued a report back in 2015 on advancing financial, fiscal and political union. Their summons died on arrival. But either fiscal-political union happens (good luck) or the monetary union ends – or the EU continues to serve as a mechanism for creating mass unemployment, because of the vast differences in the economic makeup of euro member countries.

This self-inflicted predicament is a much bigger threat to Europe than any posed by Russia, even if one holds a jaundiced view of Kremlin intentions and behavior. (The possible impact of Brexit on NATO is beyond the scope of this essay.)

Europe’s fundamental structural dilemma is often obscured by passionate ideological tilting. In left-wing critiques, the EU is increasingly identified with “neoliberalism,” an epithet taken to mean wrongheaded liberalisation of every aspect of the economy, from capital (finance) to labor (immigration), which is viewed as advantaging the few and disadvantaging the middle and working classes. At the same time, much of the actual work of the various European bodies involves extensive regulation to “harmonise” laws, practices, and institutions across borders – which produces absurd rules governing minutia, and fodder for right-wing critiques. In both guises – hyper-liberalisation/hyper-regulation – Europe is more easily bashed than loved.

NAFTA a bit like the old EEC

But this is not a matter of better public relations. The North American Free Trade Agreement, or NAFTA, resembles the old European Economic Community. But if NAFTA had been “deepened” to include a supranational court, housed, say, in Mexico City, whose rulings were mandatory for every United States jurisdiction. And then if every single citizen of Mexico possessed the right, not by flouting the law but precisely according to the law, to settle in the US and draw upon US government benefits, then Americans would better understand much of the popular mood in Europe. The refugee crisis resulting from the catastrophes in Libya and especially Syria added combustible Islamic terrorist fears to the mix, but the underlying principle of unlimited migration was already politically problematic.

Transnationalism has built-in limits. Nationalism often gets a bad name, but it is, by definition, majoritarian and therefore compatible with democracy. Transnational sentiments remain decidedly minoritarian and therefore, in important ways, incompatible with democracy. To put the matter another way, transnationalism can succeed if it is made compatible with strong national sentiment. (Most hardnosed analyses of the creation of the EU, by the way, have proven that countries joined only because the union was seen to further national self-interest.)

The EU has every incentive to punish Britain for its nationalist leave vote as a deterrent, but even beyond business people, large numbers of European passport holders, not least EU elites, want continued, unfettered access to London. Large numbers of influential UK passport holders do not want to lose openness to Europe either. Still, no state has ever been granted full access to the EU while refusing to be governed by all its rules, including open EU borders, a key factor in the leave vote. Negotiations should, perhaps, be held in a Kabuki theater.

Still, if Brexit takes place in some form – which remains to be seen – it would have little or no appreciable effect on Europe’s fundamental structural dilemma. Europe’s status quo is detrimental and ultimately untenable, but its replacement could take different forms. Upheaval remains an option.

Euro not ‘one for all and all for one’ 

To point out that right-wing populists have no viable economic program to solve the deep problems from which they gain votes is not a persuasive argument for holding onto the euro. If the euro is so dear, for economic as well as symbolic reasons, a stable way out could be via introduction of a northern euro, which only select countries would join.  The current euro would then become a de facto southern euro, and its uncertain prospects would be independent of the survival of the euro (in a sustainable, northern guise). Just such a northern-southern double currency was the original plan of some European dreamers in the second half of the 19th century. Instead, Germany unified in a series of wars and introduced the mark.

The Brexit vote’s most immediate consequence, for better or worse, has been to scuttle the “small government” austerity of the Tory government. More long-term, it seems to have placed in question the survival of the United Kingdom. In fact, Scotland, Wales, and Northern Ireland have been developing different political cultures from that of England. If the UK is worth saving, and if it can be saved, it will be. If not, the Brexit vote would have at most accelerated something that would have happened anyway.

Powerful underlying interests have a way of asserting themselves through the cut and thrust of events and the predictable political opportunists. It is possible to imagine a face-saving salvation of Britain’s EU association and of Britain itself. It is harder to imagine survival of the EU over the long term. 

Stephen Kotkin is an adviser to conexust1f.flywheelstaging.com 

He is the Birkelund Professor in History and International Affairs at Princeton University, where he has taught since 1989. He is also a fellow at the Hoover Institution at Stanford University. He is the author of Stalin, vol. I: Paradoxes of Power, among other books. For several years he was the book reviewer for the New York Times Sunday Business section (2006-2009), and today writes reviews for the Wall Street Journal and TLS. Kotkin earned a PhD from University of California Berkeley (1988).

Creating a low-carbon index was a practical way for the New York State Common Retirement Fund, the third largest pension fund in the United States with $178 billion in assets, to put its beliefs into action.

Vicki Fuller, chief investment officer of the fund, says that environmental, social and governance (ESG) considerations are integral to the investment philosophy of the fund.

“We live by them, they are firmly mentioned in our investment philosophy as a source of return and risk, this is not new for us,” she says.

“It is not new for us to be invested in renewables, solar, wind, and active managers who execute sustainable strategies.”

Now $2 billion of US equities is passively tracked to this low-emission index, which excludes or reduces investments in companies that are large contributors to carbon emissions, like the coal mining industry; and increases investments in companies that are low emitters.

The portfolio is managed by the international equities portfolio management team internally, which also manages the rest of the US passive portfolio.

In total the fund has around $50 billion in US equities, and over time plans to increase the amount in this index.

Other investors have also established low-carbon indexes to use internally.

In 2013 PGGM developed an index in house, which measures the 2800 companies in the FTSE All World Index for their environmental and social policy and good governance.

The index re-ranks the companies based on these criteria, which also include a minimum threshold. As a consequence of this, about 200 companies that don’t make it into the index have been sold by PGGM, which amounts to about 1 per cent of the portfolio.

At New York Common, the low emission index, which was created in partnership with Goldman Sachs Asset Management (GSAM), is modelled after the fund’s existing indices, which are passive investments in US companies with returns that match broad market performance.

 

Climate change one of the biggest risks

The low emission index eliminates or underweights stocks in some of the worst greenhouse gas emitters, based on independent emissions data reported to the carbon disclosure project, and will reduce the emissions profile within the index by up to 70 per cent.

Fuller says the focus of a long-term investor is on the strategies that manage risk, and that climate change is one of the biggest risks facing global investors across multiple sectors.

“By shifting our capital to companies with lower emissions and comparable returns, we are sending the message that our investment dollars will follow businesses with strong environmental practices,” she says.

“Environmental, social and governance is an important part of our long term strategies. Businesses which focus on the health of their companies are better to invest in. We want companies to generate long term returns into perpetuity; if there are issues causing them to be unattractive with long term returns, we want to know about it,” she says.

The fund participated in the landmark Mercer study, Investing in a Time of Climate Change, which identified the impacts that various scenarios of climate change could have on global investors. That report showed that New York Common had significant exposure to climate policy action, with almost 60 per cent of its allocation to public and private equities.

One of the recommendations of the report was re-allocating a portion of passive equity holdings into low-carbon alternatives.

“Mercer showed us how vulnerable our portfolio was,” Fuller says.

“We have a large exposure to developed countries and if there was aggressive mitigation we would be vulnerable.”

GSAM, which is one of the fund’s strategic partners, helped measure the carbon footprint of the global equities exposure.

 

Reducing its carbon footprint

“Our carbon footprint was 15 per cent less than the benchmark, with 75 per cent US equities and 25 per cent non-US equities in the portfolio. It set us on a quest to see what we could find,” says Fuller.

The low-carbon index was an outcome of a number of conversations with GSAM that centred around reducing the carbon footprint, which was largely determined by a subset of companies.

“Could we create a parallel index that didn’t take significant tracking error, was not different from a sector and industry perspective, but that had a lower or zero exposure to high carbon companies? We have been working on this a long time.”

Importantly, she says the focus is not just on fossil fuel companies, but on materials and industrials that also have a significant carbon footprint.

“This is why we were looking for a holistic approach. For us the approach we are taking is about the shared responsibility, it’s a problem across all industries.”

The index, Fuller says, is firmly within 25 basis points tracking error.

“That is gratifying for us because of the volatility relative to fossil fuels. We hope to increase investments in that index. We have $50 billion in US equities, about $2 billion is in the index, which is a meaningful number.”

The fund is now conducting research to determine the efficacy in applying this methodology to non-US developed equities markets. About 13 per cent of the portfolio is in non-US equities.

Engagement remains an important part of the success of the strategy to decrease the carbon footprint.

“It is very important to our success for companies to report. It is early days, but it will continue to be a big initiative to engage companies to report data to companies like the Carbon Disclosure Project.”

In addition to the low emission index, the fund recently committed an additional $1.5 billion to its sustainable investment program, bringing the total commitment to sustainable investments to more than $5 billion. Investments in this program include a wind farm in New York state and alternative energy production across the globe.

In an announcing the index, the New York State Comptroller, Thomas P DiNapoli said: “Low-carbon, sustainable investments are key to our future. Our pension fund has long supported climate aware strategies, and this expansion of our commitment offers a sensible solution that will protect the fund’s investments. It’s an approach to low-carbon investment that we can expand across all asset classes, and help spur the kind of innovation and ideas that will assist in the transition to a low-carbon economy.”

Norges Bank Investment Management would like to see an increase in the number of company listings and in a new research paper suggests more flexibility from exchanges and index providers could facilitate this.

The paper, The listings ecosystem – aligning incentives , examines the decline in the number of company listings and the concern this presents for investors.

It says that unintended consequences of regulations, lower capital needs, expansion of alternative funding sources, and changing market structure have been suggested as possible causes for this systematic decline.

The paper, which reflects Norges Bank Investment Management’s views, provides a framework that attempts to address this decline and proposes possible remedies that could be taken by the various stakeholders to encourage more listings.

The paper argues that at its core, the listing ecosystem needs to establish a new equilibrium to address the evolving conflicts of interest between founders, early investors, underwriters and future shareholders.

It proposes some practical steps that could be taken by brokers, exchanges and index providers.

One of the key findings is that given the demand from investors to access smaller and start-up companies, that exchanges develop new solutions in the form of new listing classes or alternative trading platforms, to enable smaller firms to go public at an earlier stage of their life cycle.

NBIM welcomes the idea of junior or secondary exchanges that aim to reduce barriers of entry for smaller firms. And that eligibility criteria, like trading liquidity and reporting frequency, could be relaxed at the early stages of new company’s listed life cycle.

It suggests that index providers could also be more relaxed and revisit their rules for inclusion.