This issue marks the 400th edition of conexust1f.flywheelstaging.com,  which looks at the strategies and views of the world’s largest asset owners. So what were the concerns and opportunities of investors six years ago, and what are they now?

 

Since its launch in 2008, the journalists at conexust1f.flywheelstaging.com have written more than 2,000 stories on the strategies and views of the world’s largest asset owners. Our edge is in our truly global coverage, and our in-depth analysis of these investors’ strategies via our Investor Profiles.

The first fund we ever profiled was ABP, back in September 2008. At that time volatility was spiking to record highs and there were major losses across equity markets. But the profile proved what is still true today, that large, patient investors acting diligently can add value over the long term despite market conditions.

Central to their ideology is the idea that a long-term investment strategy increases the potential for higher returns and enables the fund to take on more risk. It advocates diversification across and within asset classes including alternatives sources of yield, and it prudently manages risk. The same profile could be written today.

Reflective of many of the world’s pension funds, the coverage ratio of ABP, the world’s third largest pension fund, fell to 90 per cent in 2008 from 140 per cent in 2007, due to a drop in the actuarial interest rate at the end of the year to 3.6 per cent, and a return on investments for the year of -20.2 per cent. The investment strategy thus became a focus on meeting liabilities.

In other sectors, such as sovereign wealth funds, growth continued despite the investment losses.

In 2008 sovereign wealth funds collectively grew by 18 per cent, bringing the sum of assets held by the vehicles to $3.9 trillion. Today that is around $5.4 trillion.

In December 2008 CalPERS appointed its first woman chief executive, Anne Stausboll, who remains its captain today.

Later that month the president of China Investment Corporation, Gao Xiqing, warned that markets had not yet bottomed and the US dollar would resume a downward trend. He turned out to be right, with one US dollar buying £1.49 when he made his prediction, but only £1.38 a month later. It’s now around £1.68.

In January 2009, two US pension funds and one UK pension fund fund (the $15 billion New Mexico State Investment Council, the $2.1 billion Baltimore Fire and Police Retirement System, and the $6.4 billion Merseyside Pension Fund) revealed exposure to Madoff through fund-of-hedge funds.

The exposures raised serious questions about the due diligence of large pension funds, and the lack of transparency around the underlying managers in funds-of-hedge fund investments, an investigation which hasn’t dissipated today.

At this time, the effect of huge market losses were seen at asset owners of different types. Harvard Management Company began shedding 25 per cent of its workforce in February 2009, after incurring a 22 per cent loss since the beginning of that financial year.

The $59 billion New Jersey Division of Investment made several changes to its alternatives investment portfolio including a slowdown in new commitments, on the back of a belief that large institutions with high allocations to alternatives would be forced to sell portions of their portfolios in order to raise liquidity and rebalance their overall asset allocations.

Instead its focus shifted to credit-related opportunities within private equity and real estate; and the targeting of potential opportunities to purchase interests in existing alternative investment partnerships in secondary market transactions.

Similarly the then $161 billion California State Teachers’ Retirement System tweaked its allocation seeking to deploy $6 billion tactically in the debt markets, as well as the conception of a new “innovation portfolio”.

Interestingly 2009 marked the first time the largest 20 pension funds globally, underperformed (by 2 per cent) the rest of the Towers Watson top 300 universe.

In 2010 Sweden’s first four buffer funds, with combined assets of $83 billion excluded 10 companies from their investment universe for violating international law; PGGM sought alpha by internally managing illiquid assets and OMERS launched its co-investment entity, OMERS Strategic Investments.

Risk became a focus with funds all over the world, including UniSuper in Australia and PSP in Canada and looking at new and comprehensive risk management systems.

Funds also took risk off the table with equities allocations decreasing and alternatives on the rise – CalSTRS, New Zealand Super and ABP were among those looking for “opportunities amongst the wreckage”, while the Australian Future Fund began its love-affair with debt.

In 2011 fiduciary capitalism emerged and investors were engaged in the role they could play in the future and stability of the financial and broader economic and social environments. What had they learnt from the crisis was that the future was uncertain and they wanted to play their part in making it more sustainable.

Alpha, beta, and alternative beta emerged as the subject du jour in 2010 and fund’s continued to invest in alternatives. For their part, the Canadians continued their infrastructure and property shopping spree.

The defined benefit/defined contribution design debate hotted up, with most defined benefit funds on the defensive, and the Dutch introduced the complex, but fair, concept of defined ambition.

Water emerged as a theme, with Canadian and European funds the first to realise we are running out of the world’s most precious resource. One of the world’s largest investors, the $576 billion sovereign wealth fund of Norway made water one of its six investment focus areas. How the world will feed China is perhaps the most pressing thematic for 2014.

Investors all over the world changed their approach to asset allocation in 2010 and 2011 and began allocating according to underlying risk factors rather than asset buckets.

In December 2010 CalPERS introduced two hedging portfolios as part of this process, and in its analysis found the portfolio has a 90 per cent exposure to equity risk

The two enduring themes of 2011 were ESG integration and underfunding. Tail risking strategies entered the investor vernacular in a big way, and hot topics for investors were rebalancing criteria, bond allocations and insourcing investments.

The world’s largest fund, the Government Pension Investment Fund, Japan, substantially increased its allocation to international equities, moving more than $31.8 billion of assets into offshore equities in the year to June 2011.

Collectively, investors globally woke up to long-term investing and collaboration towards the end of 2011. They also continued to review their strategic asset allocation with greater regularity and looked at tactical and event-driven investments more often.

Texas Teacher’s strategic partnership program started baring fruit, and other investors started following suit, marking a change in the nature of asset owner/asset manager relationships to one of collaboration and intellectual property exchange.

That same year European funds started slashing equities in the wake of the Eurozone crisis, and reducing fees and finding, the increasing elusive, alpha continued to be a focus

The Kay Review in 2012 renewed British investors focus on long-term investment horizons and the obstacles inherent in the financial system.

Distressed debt was all the rage, and while there was a lot of talk about green bonds not a lot of action. Currencies were unpredictable and emerging markets went in and out of favour.

Many funds started looking at their decision making processes, costs and staffing in house and governance reforms became the norm. In the UK and Australia consolidation of pension funds continued, while on the investment side stranded assets became a consideration.

As volatility continued and investors became hungry for alpha, risk parity and smart beta entered the fray in full force in 2013 and there’s no sign of their retreat. The only marketing jargon that could even come close to pushing smart beta off its mantle would be “big data”.

At the end of 2013 the average global asset allocation of the seven largest pension markets in the world was 52 per cent equities, 28 per cent bonds, 1 per cent cash and 18 per cent other assets.

For the past six months interest rates and the prospect of positive correlations between stocks and bonds is the potential nightmare keeping investors awake at night.

So what will investors be talking about for the next six months?

My predictions are liquidity; proxies for alternatives, particularly private equity; dynamic asset allocation and of course rising interest rates.

 

 

We look forward to the next 2,000 stories about, and for, asset owners.

 

For any editorial enquiries please contact amanda.white@top1000funds.com

 

Implementing the asset allocation changes of a very large portfolio, particularly in private markets, is a conundrum CalPERS is dealing with as it moves its asset allocation and decides how to fill new private market allocations.

 

In February this year the $283 billion CalPERS investment committee approved a new strategic asset allocation which will see the private equity allocation reduce from 14 to 12 per cent.

The fund’s current private equity allocation is 10.9 per cent, and Baggessen said in his presentation to the committee, this meant the exposure was underweight even the reduced target allocation, so more capital would need to be added even to reach 12 per cent even though that represents a decrease in the strategic asset allocation.

“This creates one of the more problematic asset classes with regards to targets,” he said.

Due, in part to competition to purchase assets, private markets have high valuations and CalPERS, and its consultants Wilshire and PCA, believe it doesn’t make sense to fill an asset allocation bucket just to meet a long term goal, especially in the most illiquid and expensive asset classes.

So where does that leave them?

 

Private equity pacing model

Baggessen and his team have suggested a private equity pacing model.

They recommend using an interim weight of 10 per cent this year, and increasing that target by 1 per cent each year, with a corresponding decrease in the global equity target, moving to the 12 per cent target by 2015-16.

Private market proxies are also a consideration, and Baggessen said that achieving the target weight to assets possessing the capital market assumptions of private equity may require some alternatives, such as private market proxies, and the team is currently assessing those.

But the fund’s consultant Michael Schlachter, managing director and principal at Wilshire Associates, doesn’t agree with the proposal.

“Sometimes a simple solution is best,” he said at the investment committee meeting.

“Rebalancing from A to B is best practice, you don’t go from A to B via W,” he said referring to the proposal to move the private equity allocation from 14 to 12 per cent via 10 per cent.

Similarly Allan Emkin from Pension Consulting Alliance said the board, and staff, of CalPERS needed to use common sense.

“The run up in equity markets that increased the market value of the portfolio is good news. But it doesn’t mean it’s an opportunity to put more money in private markets,” he said. “It doesn’t mean a higher allocation to illiquid asset classes that are overpriced. It’s time to use common sense. Real estate and private equity are not cheap, it makes more sense to take a deep breath and go slow.”

Some members of the investment committee were concerned that the overall CalPERS’ portfolio was still exposed to the same risks as it was in 2008, with John Chiang asking “what do we do in advance so we don’t go along for the ride if market falls?”

Baggessen said there were no investments the fund could invest in that supported the fund’s discount rate and return target of 7.5 per cent.

“There’s no place to hide from that,” he said. “What we can shift is on the margin but there is not a panacea. We can’t hedge or remove that tail risk because of the size of the portfolio, even if we were smaller it’s not clear we’d pay the cost for the hedge and if a counter party could take it on.”

Baggessen said tail risk hedging would expose the fund to other types of risk such, as leverage.

 

Size constraints

The actual allocation of private equity at the moment is around 10.9 per cent, which represents around $6 billion capital to be allocated this year.

It’s a commitment the CalPERS investment team agrees is potentially executable given the market conditions and the size of the portfolio. A 14 per cent allocation, would require capital allocations of $8 or $9 billion, depending on the year, and be much more difficult to execute.

The relativity of the fund’s private equity allocation within the industry is an important perspective. A $6 billion capital commitment represents about 2 per cent of the total private equity market. By contrast, CalPERS’s ownership of publicly traded equity, at a 47 per cent allocation of the total portfolio, represents about 0.47 per cent of the FTSE All World total capitalisation.

CalPERS’ activity within the market can thus not only impact its own ability to buy and sell, but it can impact the overall market.

Senior investment officer for asset allocation and risk management, Eric Baggessen, said this impact is even more rarefied when the fund is trying to concentrate allocations in the top performing managers.

“This is a big footprint,” he said, emphasising it as an example of the constraint of the size of the portfolio. “We are too large to accommodate any allocation to any market segment.”

One of the discussions at the investment committee was the impact of size. Board member, Priya Mathur, suggested the allocation to private markets should not be driven by CalPERS’ portfolio size but the size of the market and its capacity.

“The upper limit can’t be based on our own portfolio size,” she said. “We need to build that into how we do asset allocation.”

 

CalPERS strategic asset allocation

Asset class New target    Current actual
global equity 47% 53.7%
private equity 12 10.9
global fixed income 19 15.3
real estate 11 8.5
infrastructure and forestland 3 1.3
inflation sensitive 6 3.3
liquidity 2 4.7
ARS 0 2.2

 

With the advent of smart beta it was only a matter of time before the appropriate use of “smart” was analysed and questioned. A paper to be published in the forthcoming summer 2014 issue of The Journal of Portfolio Management looks at the active choices of smart beta strategies and how and when they can be labelled “smart”.

 

In the abstract the paper’s authors, Bruce Jacobs and Kenneth Levy say:

Smart beta strategies aim to outperform the capitalization-weighted market through relatively simple alternative weighting methods that emphasize a handful of factors such as size, value, momentum, or low volatility.

Because of their simplicity, smart beta strategies bear a resemblance to passive investments. Yet, smart beta strategies are the product of active choices and can be compared with active multi-factor strategies (“smart alpha”).

When considering any active strategy, investors should have a clear understanding of the sources of expected returns, the stability and sustainability of those returns, the risk exposures and risk controls, the liquidity demands of the strategy, and whether the management costs are commensurate with expected results.

Only then can investors determine which strategies are deserving of the “smart” label.

 To access the paper by Bruce I. Jacobs and Kenneth N. Levy, click here

 

 

US public pension funds are ignoring their liabilities in managing their pension assets, a situation that needs a paradigm shift in thinking and asset allocation to ensure benefits can be paid to beneficiaries.

The dialogue about the US public pension funds’ underfunding position continued at the CFA Institute’s annual conference this week, with Ronald Ryan calling for pension funds to tell the “financial truth”.

Ryan, who is chief executive and founder at Ryan ALM, Inc., which specialises in custom liability indices and liability beta portfolios, says the accounting rules governing US corporate and public funds are distorting the real underfunding position, which is much worse than reported.

Further, he says pension funds tend not to manage to liabilities, a situation which means “you don’t know the enemy”.

“Given the enormity of the pension crisis, investment consultants and those managing the pension assets need to say what we have been doing doesn’t work. It’s simple – tell the financial truth,” he says. “Imagine a doctor getting an X-ray or blood test wrong, well that’s what’s happening in pensions, it’s getting the wrong diagnosis. Without a customised liability index you don‘t know the enemy, you don’t know what liabilities look like. But they are big and they are very interest rate sensitive.”

Ryan says there needs to be a paradigm shift in the asset allocation of the US pension system so that liabilities can be funded in a stable and low cost way.

He advocates for each fund to have a custom-liability index, which sets out the benefit schedule which can be priced at market rates and the size, shape, duration and interest rate sensitivity of liabilities can be managed.

“At every investment meeting of a pension fund you would think there would be a discussion of the funded ratio to gauge if they are on track and how to make sure the asset allocation responsive to liabilities. But this doesn’t happen,” he says.

Ryan, who was also formerly director of fixed-income research at Lehman Brothers and has received a number of awards, including the Bernstein Fabozzi/Jacobs Levy outstanding article award from the Journal of Portfolio Management and the William F. Sharpe Indexing Achievement Award for lifetime achievement from the Information Management Network, also advocates for a change in the language around pension management.

“Once liabilities are defined as the true objective, we have to redefine the language used. For example alpha will no longer be excess asset growth, but the amount above liabilities growth.”

One of the problems he identifies is that change will involve the players in the industry recognising they got it wrong.

“Consultants find it hard to say all these years we’ve been doing it wrong and now I want to do it differently,” he says.

 

The evolution of the $43 billion QSuper’s offer to all members is definitely not at an end.

In fact, Rosemary Vilgan, chief executive of QSuper, sitting in the board room of QSuper’s on the top floor of its Brisbane office, archly states: “I keep saying to people you should not work here if you do not like change.”

The continued innovation is driven by the events of 2008 when some members saw their account balances drop by 30 per cent  – an arguably more traumatic, or atleast dramatic, event for QSuper than other funds.

Higher than average member balances, around $140,000 currently, means QSuper members lost more, its members having built up contributions long before most other plans came into existence in  Australia in 1993. QSuper celebrated its 100th birthday in 2013.

The GFC forced some to delay their retirement and QSuper staff were on the end of a certain amount of bitterness and awkward conversations, a moment etched in Vilgan’s memory. So much so, that she riles at those who look sunnily on the return to more healthy investment markets of late.

“That is the thing that is making me angriest at the moment is when you hear the popular media say it is great, we are out of the GFC, long term returns are back.  Real people actually experienced that dip.”

QSuper has rejigged its members, and subsequent investments, into eight cohorts with different levels of investment risk, which come into effect this month, but will evolve as the fund gathers more information about its members.

The groupings of members are currently based on what data the fund already has on file; their age, account balances and salaries. As the fund learns more about its members’ personal wealth and planned retirement dates then more groupings may emerge.

In theory, QSuper would like to offer tailored solutions for all its 500,000 members in the manner of the theory espoused by Professor Robert Merton through the firm Dimensional Fund Advisors, but says it is impractical to employ for 500,000 people. Vilgan says she admires Merton’s ideas and muses that it could be put into the “suite” of member options.

In the meantime, the eight cohorts will be updated and adjusted in reaction to changes in the cost of living for pensioners, the age pension, Centrelink benefits, interest rates and the prices of staple items.

“People with lower investment balances got a lot out of Centrelink. So if budget changes Centrelink benefits we will change calculations,” says Vilgan, who along with chief investment officer Brad Holzberger shares the distaste with the fascination some hold with funds’ asset allocation decisions, believing such cost of living measures are often neglected.

A new retirement income product

While these changes are in train, QSuper is already thinking further ahead by exploring how to build new retirement products, particularly in those that pay out if a member lives until 80 or beyond.

One idea that appeals to Vilgan is a form of long life insurance for which members pay a premium from age 50 onwards. This would build up an investment that might be held in CPI linked infrastructure –  at the very least it would be less conservatively invested than an annuity.

Unlike an annuity, the eventual payout would be a lot freer from the vagaries of markets on the day it was paid out. In this model members would live off savings and Centrelink benefits between the ages of 65-80, before receiving their payment.

“One of the advantages is that you know how long that money has to last,” says Vilgan who believes members probably underspend to budget for the eventuality of living beyond 80.

The product she proposes would pool investments and would pay back a member’s estate if they died before 80, a sum equal to their contributions. If they live long enough to draw on it they would get the pooled investment returns that have accrued.

Part of the reason for the interest in such products is the aversion many savers have, in particular QSuper members, to purchasing annuities.

“One of the biggest downfalls in normal annuity purchase is giving up $50,000 in one hit and the fear of not living long enough to get that money back,” says Vilgan.

The take up of the white-labelled Challenger lifetime annuities has been “very quiet” admits Vilgan, who does not state a figure of purchases, but says it is less than 100 and at best in the 10s. It has not been an ideal time to purchase as market conditions have led to falling annuity rates, though she thinks members behaviours need to change too.

“We probably need to think of ways to guide members to a deferred annuity or a pooled product into income stream accounts.” She muses on whether part of the projected 12 per cent contribution into super could be allocated towards an income bearing product in retirement.

A super insurer?

In the above model of a long life ‘insurance’, a fund is not taking any balance sheet risk due to the lack of a guarantee, so it would not need an insurance licence, but Vilgan sees no reasons why a fund or a collection of funds could not do that.

“Super funds are now big enough institutions that either singly or collectively, some of us might get life insurance licences,” she says. “It has certainly been put out there in the industry, that if we want some of these products why wouldn’t we use a collective to organise them. There are a few funds who are saying ‘how can we create retirement?’ and ‘what moves are we prepared to make?’.”

She cites the example of the ME Bank as one such a model, but also describes the giant US teachers retirement fund TIAA CREF as “inspirational”, for being a defined contribution accumulation plan which also holds an insurance licence for issuing lifetime and deferred annuities.

One of the reasons QSuper is so gung-ho on change is that it controls its own administration, but this is not true of many other big funds who are often struggling with the cost or the limitations of their administrator.

“We have had some of those funds talk to us, they want to innovate as we are doing, but you have to administer it,” she says.

QSuper’s thinking extends to a belief that as much uncertainty and volatility on retirement income should be stripped out as possible. And that they more important than a skewed focus on achieving industry beating returns.

“You should really be measured on what fund got me to a more predictable outcome, not on which fund outperformed on a particular year,” she says.  “Funds will definitely move down that path, which will definitely mean ratings agencies will have to change how we are measured.”

This is a popular theme of Vilgan’s who is convinced members instinctively distrust the volatility inherent in defined contribution plans currently and would settle for a loss of some upside if they could have more predictable returns. Indeed, a tiny proportion of members (around 0.5 per cent) that have opted out of the eight cohort strategies created for them this month, has given her greater confidence to move in this direction.

“Huge numbers actually say you are the expert, I trust you. It is really quite interesting that this industry has not taken on that mantle more. You should not underestimate the number of people for whom this is such a complicated world. That they are relying on us to do a job and they do not enquire into the detail. We have underestimated how much people think are doing the best by them. If this industry was doing the perfect job, you would not have to worry about your account, you would just know there was an income waiting for you in retirement.”

 

 

Australian fund, QSuper’s creation of eight different investment cohorts for its 440,000 default fund members this month has sparked curiosity and admiration from defined contribution experts in the US, the UK and New Zealand.

The investment strategies for each group will be focussed on an estimated retirement outcome for that segment, taking into account the median projected retirement income including age pension entitlements, salary and contribution rates and retirement date.

Rosemary Vilgan, chief executive of QSuper, said the rise in contributions from 3 per cent to 9.25 per cent and the impact of the GFC presented an obligation to adapt and that QSuper’s move would pose a challenge for other Australian super funds to change too.

 

Federal Retirement Thrift Investment Board, Washington D.C. USA

Kim Weaver, director, external affairs for the Federal Retirement Thrift Investment Board, which manages US $358 billion for close to five million Americans, described QSuper’s developments as interesting, not least because the Thrift Savings Plan kept an eye out for ideas used overseas that they could draw upon.

The Thrift Savings Plan offers five lifecycle funds that are custom designed to take the same factors being used by QSuper into account, she said.

“Our L Funds are reviewed annually and updated demographic information is taken into account, along with other market factors. The L Funds’ asset allocation is updated as appropriate.”

 

Mercer, Leeds, England

In the UK, one of largest advisors of corporate plans is seeing a trend towards multiple lifecycle funds.

Paul Macro, UK DC & savings client leader at Mercer, said he knew of a few plans that offered three lifestyle strategies and following recent budget changes which have ended compulsory annuitisation more would follow.

“There has been lots of talk about having multiple default options and to do this, recognition of the types of members that are in the scheme will be necessary.”

He added: “I suspect many trustees will be nervous of making different assumptions for different people – but that as the experience of member behaviour in the ‘new world’ develops over time, this may change.”

 

NZ Superfund, Auckland, New Zealand

David Iverson, head of asset allocation at NZ Super saw the move as logical but was worried about the communication challenge.

“Even though the approach is a step in the right direction, it has the potential to not be seen that way,” he said. “In other words, individuals may not know how to articulate an investment plan that matches what they need/want. But they do know how to compare – with cash, with other funds, with other options. While this behaviour already exists, it can become heightened if a provider is doing something different, and may not be well understood.”

 

Professor Robert Merton, MIT Sloan School of Management, Cambridge, Massachusetts, USA (also resident scientist at Dimensional Fund Advisors Holdings Inc.

“Like Dimensional’s Managed DC, QSuper understands that the goal for superannuation should be providing retirement income and they’ve made a great start on framing it in terms of the needs of the individual member.

“The solution we’ve developed at Dimensional, though, goes further than just two factors in terms of personalisation of the investment process. In addition to age and existing account balance, Dimensional includes other important factors such as current salary, contribution rates, gender and time to retirement.

“Obviously, the system needs a well-designed default strategy to be effective for the majority of people who do not engage with super.”