Affluent small European nations such as Denmark easily count among the world’s most outward-looking places, and DKK 95-billion ($16.4-billion) investor Unipension clearly casts its eyes far and wide from its headquarters in suburban Copenhagen.

While nearly all investors look for some exposure in the world’s key markets, Unipension has enhanced its international focus by actively eliminating home bias in spaces where others dare not. The investor – which controls three labour-related pension funds – recently decided to sell its entire Danish property holdings and invest the proceeds in international real estate funds.

A fully international approach is a bold move in an asset class that most investors are more comfortable in close to home. To Niels Erik Petersen, Unipension’s chief investment officer, it was a logical step for the investor.

“In all our investments we have a core-satellite international diversification strategy, but in real estate we only had Danish exposure so we wanted to diversify here as well,” Petersen says. The move, which will also see real estate allocations harmonised at 5 per cent across the three funds Unipension controls, will concentrate primarily on the United States and Western Europe.

Just 5 per cent of Unipension’s liquid portfolio (incorporating all assets excluding real estate) is invested in Danish equities, and Petersen says the fund has tried to avoid a home bias in this asset class as well.

“Denmark has a very small market, so there are a lot of opportunities outside of our region that help us balance the risk of our portfolio,” he explains. Petersen points out though that the international focus should not be interpreted as an abandonment of the investor’s homeland though, with the smooth functioning of Danish capital markets a key focus of Unipension’s active ownership strategy.

Careful global approach

“Diversification is important on our fixed income side, but what’s also important is that you get your money back,” says Petersen. Danish government bonds and high quality Danish mortgage bonds are therefore a significant part of the 39-per-cent gilt-edge-bond portfolio. Other “core” European government paper from the likes of Germany and Holland occupy the rest of that position.

Despite being an international fund, Unipension naturally has no desire to be impacted by regional pitfalls, and it therefore divested from southern European government bonds in 2009.

Petersen reveals that an unintentionally off-putting research trip led to Unipension moving away from the continent’s more indebted government bonds well before most other European investors followed. He was part of a group that met with a number of figures in Athens a few years ago with the firm intention to increase Unipension’s holding of Greek debt.

Discovering the true extent of the crisis conversely led Unipension to quickly drop its holdings in not only Greek but also Spanish, Italian and Portuguese government debt – a call that looks inspired in hindsight.

A dependence on external managers for Unipension’s vast emerging market portfolio (11 per cent of liquid assets are in emerging market debt and 29 per cent in overseas equities) means no such research is necessary in this space. The emerging market debt holdings have increased in recent years at the expense of gilt-edged bonds, with equity holdings also increasing gradually due to their strong performance.

A 12-per-cent allocation to high yield in the liquid portfolio “has been useful” says Petersen, who indicated Unipension had no doubts about the assets despite high yield investors suffering in this summer’s market turbulence.

Again Unipension appeared to have timed its tactical approach well with a move down from an overweight position on high yield being made in 2012. This was definitely “not a macro call”, Petersen points out though, as the fund simply saw better protection in loans.

Thin pickings lead to alternatives

Petersen explains that implementing a “duration overlay” had been a key strategic change in the recent past in an effort to extend the duration of assets to match liabilities, but this was reversed last year. “

Everything is pointing to a scenario of low returns in the coming years,” he says, betraying an outlook marked by pessimism. The investment head does not expect a “tremendous” performance in equities. Low interest rates also make the prospect poor for bonds in his view.

A natural consequence of that grim view would seemingly be for Unipension to diversify its asset base as much as it has its geographic spread. Petersen confirms this process is well under way with a private equity portfolio being launched in recent years and since increased to 4 per cent of liquid assets.

“We will increase our private equity holdings further, no doubt about it,” he says. The private equity bucket has a US-tilt, while Unipension has discovered a liking for secondary holdings.

The investor could well join other Danish pension funds in making major attempts to develop infrastructure investments, according to Peterson. Unipension’s limited and relatively short liabilities make this less of a pressing need, although it has already looked at various potential projects.

Strong returns in the last few years perhaps make it easier for Petersen to express his fears for the future. Unipension has gained accumulated returns of over 74 per cent since the start of 2009, which is some 14 per cent higher than its benchmark. In 2012 it booked an annual return of over 13 per cent but there has been a noticeable slowdown in 2013, with returns of just under 3 per cent for the first half of the year.

Free but prudent

The trio of funds under Unipension’s control run nearly identical asset strategies, Petersen says, with a system of modulised mutual funds ensuring assets are efficiently pooled. Slight liability differences and risk appetite variations at the three respective boards require some fine tuning though, he adds.

As liabilities are guaranteed on a contingent basis (Unipension promises to deliver at least 1 per cent per year but has a get-out clause if returns fall below that), Petersen says the investor “has a large degree of investment freedom and we can really go for long-term returns”. That allows Unipension a bigger risk budget than its Danish counterparts, although in true conservative Scandinavian tradition, Petersen says the fund has actually kept its risk “very low” under its international diversification drive.

The global outlook of Danes has created a problem for Unipension in that it has found itself under fire at home, along with other pension funds, for emerging market debt investments.

They have been criticised on the basis that the investments might support undesirable regimes. Petersen explains that Unipension carefully follows guidelines and is willing to avoid any investment it deems irresponsible.

“We are here to invest and not make foreign policy, but we do like to invest on an ethically sound basis”, says Petersen, who calls for international guidelines to be developed to make sustainable emerging market debt investments easier.

Unipension includes environmental, social and governance experts on its central investment decision-making organs, and Petersen himself is a respected figure of the sustainable investing scene as member of the United Nations-backed Principles for Responsible Investment Advisory Council. He is pleased to have a leading role in a movement that he deems is gaining increasing importance. “Responsible investing is perceived a lot differently than it was 10 years ago,” he points out.

A policy portfolio is a poor reflection of investor preferences, argued Peter Bernstein. This philosophical question has now been empirically tested by MIT’s Mark Kritzman, who shows the inter-temporal disparity of a policy portfolio’s risk profile. He suggests a simple framework for addressing this deficiency.

Kritzman encourages investors to replace rigid policy portfolios with flexible investment policies.

It’s not unlike a dynamic asset allocation idea, except he uses different information or signals as the conduit for any change.

Kritzman, who is a senior lecturer in finance at the MIT Sloan School of Management and the president and chief executive officer of Windham Capital Management, presents empirical evidence, and a potential framework, to the philosophical argument put forward by finance historian Peter Bernstein.

Bernstein argued that a policy portfolio is a poor reflection of an investor’s preferences; instead, it may simply be a benchmark for determining the success or failure of active management.

Selecting a portfolio of asset classes that best meets an investor’s objectives, given the outlook for expected returns, risk and correlations at a point in time, is not desirable because it changes over time.

“The return distribution implied by a particular portfolio at one point in time may be quite different at another point in time – and investors want the distribution, not the portfolio. The portfolio is simply a means to an end. The solution to the problem, therefore, is to revise the portfolio as needed to preserve the desired return distribution or at least to give the next best distribution,” Kritzman argues in his latest paper, Risk Disparity. “Or in other words, to replace a rigid policy portfolio with a flexible investment policy.”

Addressing conflict

He says that investors have two conflicting goals of growing their assets and limiting their exposures to significant drawdowns.

“The policy portfolio is supposed to be a way of balancing those. There is an implicit assumption that a policy portfolio will deliver consistent risk profile, but they are actually highly changeable,” he says, adding that the standard deviation of a broadly diversified portfolio can range from 3 to 25 per cent.

“It is not a valid argument that a reference portfolio is giving you stability,” he says. “I argue that you should replace a rigid portfolio with fluid allocation to get stability.”

Kritzman says that investment strategy defined as a set of fixed weights doesn’t do a good job at all of seeing an investor’s risk preference.

“Fixed asset weights don’t do the job they’re supposed to,” he says. “Further, our two measures of risk, beyond standard deviation and correlation, give a more reliable measure of when markets are dangerous and a portfolio is susceptible to that.”

“Investors can get a more stable risk profile by opportunistically changing their exposure to risky assets,” he says.

While typically dynamic asset allocation is driven by metrics of valuation such as stocks versus bonds, Kritzman suggests a change in allocations by drivers of risk, and he looks in particular at two different types of risk.

Predicting volatility

Predicting portfolio volatility is a tricky science.

Implied volatility and historical volatility are both of limited value according to Kritzman, who instead argues investors use the absorption ratio to anticipate shifts in portfolio volatility.

He says this measure captures the extent to which a set of assets is unified or tightly coupled, which means they will exhibit a unified response to bad news.

Over the years Kritzman and various co-authors have used this measure to predict broad market fragility and among other uses the US Treasury Department’s Office of Financial Research used it in the analysis of early warning signals of financial crises.

Kritzman says it can be applied to measuring the fragility of any set of assets, including the components of an individual portfolio.

“It’s a measure of the fragility in external markets. For example, if US stock markets are tightly coupled then they are more susceptible to shocks. We have taken the same methodology and applied it to a portfolio. We end up having a measure of risk that gives external danger measures.”

He also looks at the intrinsic fragility of a portfolio, which is dependent on the assets in that particular portfolio.

What this means in practical sense, he says, is investors can start with a policy portfolio and if there is no external or intrinsic fragility, then stay with the status quo.

“In the paper I show that if there is a measure of one of these, then there is heightened fragility and the equities portfolio should be cut in half. If both show fragility, then cut back virtually all equities. This is a pretty extreme move and in reality it would probably mean cutting equities by 25 to 50 per cent,” he says.

Such a dynamic approach is possible because of the use of exchange traded funds or futures exposures and, as such, avoiding implementation costs.

 

 

 

From a strategic asset allocation point of view, AustralianSuper is one of the most aggressive investors in emerging markets, particularly Asia.

About a quarter of the $43-billion fund is in international equities, and nearly half of that is in emerging markets.

Equities is the vehicle for AustralianSuper’s emerging market exposure because growth remains the reason for its allocation.

“And equities are the main beneficiaries of growth,” says chief investment officer, Mark Delaney (pictured right).DELANEY_Mark-120x

Specifically the fund wants direct consumer exposure in Asia, and to do this has looked beyond a passive approach with major indexes – such as the MSCI All Country World Index – that have greater exposure to the financial and energy sectors in emerging markets.

It’s a valid strategy to look beyond passive investing in emerging markets, particularly given the mixed performance of equity markets that make up the index, and also the dominance of state-owned enterprises.

Conrad Saldanha, managing director and portfolio manager of emerging market equity at Neuberger Berman, says benchmarks are not reflective of the underlying economy – and that is true for both developed and emerging markets. But emerging markets have a number of unique characteristics which means active management is even more of an obvious choice.

Benchmarks in emerging markets capture the dominant drivers – commodities, financials and state ownership – which in some countries such as China are 90 per cent of the benchmark.

“You get the biggest capitalisation companies but it is not necessarily representative,” he says.

Where active management rules

Managing director and head of investment strategy and risk at Neuberger Berman, Alan Dorsey, agrees the beta story is not working well in emerging markets.

“It is a particularly good environment for active management. When the tide is going up and all the ships are going up, or the tide is going down and all the ships are going down, then the beta story is better. But there is mixed performance of emerging markets equities. Security selection is paramount,” he says

Phil Edwards, principal at Mercer in London, agrees there are a lot of opportunities for skilled active managers in emerging markets.

“Active managers make sense because of the risk management perspective as well, so using active managers is useful for that.”

Saldanha, pictured right, says his stock picking involves looking for quality businesses with secular growth opportunities, higher returns, lower debt with strong cash flows.Saldhana_Conrad-120x

“We want to identify, evaluate and predict cash flow for those companies with a domestic focus,” he says.

He says there are good bottom-up opportunities in emerging markets, including in mid-cap companies and frontier markets.

According to Dorsey investors should consider the MSCI ACWI index as the starting point of their overall equities asset allocation, and then have manager tilts into various countries, some of which are emerging.

But he believes the tilts should be done on a security-selection basis – not on a country basis, which requires corporate and also global analysis.

“Asset allocation generally depends on the client’s objectives and their guidelines on absolute returns and relative returns. Many investors think of the question of whether to include emerging markets in a wider international equities exposure in terms of the index,” he says. “The weighting of the allocation to emerging markets is clearly centre stage. While not all emerging markets companies are stellar, neither are all developed market companies less attractive. You need to look at company selection globally.”

Finding your ideal weight

In Europe the reduction in allocations to domestic equities has seen a subsequent uptake in international allocations, including emerging markets.

Mercer’s Edwards says there has been a more global approach and funds are awarding global active equities strategies and, as part of that, emerging markets.

Among European asset owners, Mercer’s asset allocation survey shows the average allocation to emerging markets in 2013 is 5 per cent of total assets or about 10 per cent of equities, which is underweight compared to the proportion of emerging markets within the global equities universe.

The Finnish State Pension Fund, the €15.8-billion ($20.8-billion), VER is one European fund that has been quite aggressive in its emerging market allocations, and is currently overweight its strategic benchmark.

Timo Löyttyniemi, (pictured right) chief executive of VER, says the fund was a net buyer of emerging market equities during the crisis.Timo-Löyttyniemi-WEB

“We have had a benchmark structure for a few years where half of emerging market equity exposure is in a diversified emerging market portion and the other half is in an Asian emerging market portion. We tend to have an Asian tilt as a result of that. From time to time Russia has been a key performer for us, but performance has not been that good in the last two-to-three years so it has no special prominence in our strategy at the moment. Russia used to give us a major performance bonus but other than that there are no major country picks, but more of an Asian bias in a diversified strategy.”

Edwards is advising that funds look at increasing their allocations to emerging markets to be in line with the benchmark weight. The MSCI ACWI includes 24 developed markets and 21 emerging markets.

“Increasing to the benchmark weight seems sensible, and we suggest considering allocating above the market-cap weight,” Edwards says, advocating about 20 per cent to emerging markets.

In addition, he says there is an expanding opportunity set in frontier markets.

They have the characteristics that today’s emerging markets had in the 1980s, but there are limited capacity, risks and liquidity issues.”

Opening the world’s second largest economy

The changing nature and openness of emerging market financial systems mean that constant assessment of the environment is necessary.

MSCI is currently considering whether to increase the allocation of China’s weight in the emerging market index to include the nation’s A shares.

(Concurrently MSCI Korea and MSCI Taiwan Indices remain under review for a potential reclassification to developed markets).

The MSCI emerging market index currently only includes Hong Kong-listed H shares, and some China B shares.

Including the A shares in the index would dramatically change the nature of the benchmark, potentially increasing China’s allocation from around 18 per cent to 30 per cent.

China is already the largest single country weight in the index and this potential change would give it more impact. This obviously has implications for investors.

The Shanghai and Shenzhen stock exchanges have more than 2400 stocks, with a total market capitalisation of about $3.5 trillion.

Foreign ownership is only about 1 per cent of that, due for the most part to the stringent requirements of the Qualified Foreign Institutional Investor system and the slow deployment of its quota.

However MSCI is seeing enough change to conduct consultation on the country’s allocation.

Chin Ping Chia, managing director of MSCI (pictured right), says a series of developments have caused the review, including an increase in the quote of A shares available to foreigners from $30 billion to $80 billion. Chia-Chin-Ping-120x

“We see this as a signal to expand the system and allow more investors to participate.”

In addition the high qualification criteria has been amended.

It used to be that to get a licence you needed $5 billion in assets and a five-year track record. That was lowered in July last year to $500 million in assets and a two-year track record.

“This is a significant change and broadens the set of investors, which is a positive thing.”

China’s Renminbi Qualified Foreign Institutional Investor system has also been expanded from RMB70 billion to RMB270 billion.

“This is a positive message saying there is regulatory momentum to open the markets.”

However MSCI identifies a number of key obstacles that need to be overcome, including capital mobility restrictions, the small allocation associated with licences and the imposition of capital gains tax.

“China is the second largest economy in the world. It is very close to opening to international investment and we think this is the right time to be starting this conversation. But it depends entirely on the progress of the regulatory system. MSCI does not have a time frame, but we are engaging with the regulators so they consider the investment processes and needs of investors,” he says.

“It is also for investors to digest and think about the consequences. Only a small handful of investors – 200 – have QFIIs. A large number of investors haven’t taken action, so what does it mean to take action?

“In the context of every market, when they open and increase foreign institution participation it is a good thing. It mainstreams investment ideas and the market gets more efficient.”

Frank Yao, managing director of Neuberger Berman Asia, says it is a huge positive to include the A shares in the index.

“It is positive for international investors to access China. It is the second largest economy in the world, but international investors have no direct way to access it. It is also positive for domestic investors: if foreign investors come, the market becomes more institutionalised.”

In particular, he says, that would mean improvements in technology, corporate governance and transparency.

Yao says the government influence and management of the corporate sector has diminished over the years.

“There is new leadership, economic reforms and now China is being opened to the rest of the world. China will become more market driven. In many areas, like the housing and auto sectors, China is more capitalist than the US,” he says. “Last week the government announced it would open the banking sector. Five or even three years ago you couldn’t even imagine this would happen.”

While China will continue to grow, Yao says it is still an emerging market and is very inefficient.

“Investors need to have a long-term investment horizon and emerging markets are volatile. There are still significant alpha opportunities.”

The changing nature and openness of emerging market financial systems mean that constant assessment of the environment is necessary.

MSCI is currently considering whether to increase the allocation of China’s weight in the emerging market index to include the nation’s A shares.

(Concurrently MSCI Korea and MSCI Taiwan Indices remain under review for a potential reclassification to developed markets).

The MSCI emerging market index currently only includes Hong Kong-listed H shares, and some China B shares.

Including the A shares in the index would dramatically change the nature of the benchmark, potentially increasing China’s allocation from around 18 per cent to 30 per cent.

China is already the largest single country weight in the index and this potential change would give it more impact. This obviously has implications for investors.

The Shanghai and Shenzhen stock exchanges have more than 2400 stocks, with a total market capitalisation of about $3.5 trillion.

Foreign ownership is only about 1 per cent of that, due for the most part to the stringent requirements of the Qualified Foreign Institutional Investor system and the slow deployment of its quota.

However MSCI is seeing enough change to conduct consultation on the country’s allocation.

Chin Ping Chia, managing director of MSCI, says a series of developments have caused the review, including an increase in the quote of A shares available to foreigners from $30 billion to $80 billion.

“We see this as a signal to expand the system and allow more investors to participate.”

In addition the high qualification criteria has been amended.

It used to be that to get a licence you needed $5 billion in assets and a five-year track record. That was lowered in July last year to $500 million in assets and a two-year track record.

“This is a significant change and broadens the set of investors, which is a positive thing.”

China’s Renminbi Qualified Foreign Institutional Investor system has also been expanded from RMB70 billion to RMB270 billion.

“This is a positive message saying there is regulatory momentum to open the markets.”

However MSCI identifies a number of key obstacles that need to be overcome, including capital mobility restrictions, the small allocation associated with licences and the imposition of capital gains tax.

“China is the second largest economy in the world. It is very close to opening to international investment and we think this is the right time to be starting this conversation. But it depends entirely on the progress of the regulatory system. MSCI does not have a time frame, but we are engaging with the regulators so they consider the investment processes and needs of investors,” he says.

“It is also for investors to digest and think about the consequences. Only a small handful of investors – 200 – have QFIIs. A large number of investors haven’t taken action, so what does it mean to take action?

“In the context of every market, when they open and increase foreign institution participation it is a good thing. It mainstreams investment ideas and the market gets more efficient.”

Frank Yao, managing director of Neuberger Berman Asia, says it is a huge positive to include the A shares in the index.

“It is positive for international investors to access China. It is the second largest economy in the world, but international investors have no direct way to access it. It is also positive for domestic investors: if foreign investors come, the market becomes more institutionalised.”

In particular, he says, that would mean improvements in technology, corporate governance and transparency.

Yao says the government influence and management of the corporate sector has diminished over the years.

“There is new leadership, economic reforms and now China is being opened to the rest of the world. China will become more market driven. In many areas, like the housing and auto sectors, China is more capitalist than the US,” he says. “Last week the government announced it would open the banking sector. Five or even three years ago you couldn’t even imagine this would happen.”

While China will continue to grow, Yao says it is still an emerging market and is very inefficient.

“Investors need to have a long-term investment horizon and emerging markets are volatile. There are still significant alpha opportunities.”

For more on China in the broader context of emerging markets, read the full story.

Hershel Harper received an early education in finance when he used to read Business Week in High School. The 43-year old now at the helm of the $27-billion South Carolina Retirement Systems, investing on behalf of South Carolina’s 350,000 public sector workers, says he knew back then he wanted to manage money: “I really am one of the most blessed people; I am doing what I always wanted to do.”

As the new fiscal year begins Harper, promoted internally to chief investment officer of the South Carolina Retirement System Investment Commission (RSIC) a year ago, is overseeing two shifts in strategy at the fund, both designed to simplify investment and pare down the number of managers it uses. South Carolina’s equity allocation, comprising 31 per cent to public equity and a 9 per cent to private equity, hasn’t really changed over the past year. However the US and non-US equity assets are being combined to track a single global equity benchmark, the MSCI ACWI, instead of separate active allocations to US small and large-cap stocks, non-US developed and emerging markets equity. “We are moving to a global benchmark for a straightforward approach to manage and track our largest factor exposure. I expect our global equity allocation to become increasingly more benchmark-centric, with large portions of the allocation to modest tracking error strategies, or to be passive,” says Harper.

Trimming the hedge funds

In another effort to simplify its domestic equity portfolio, South Carolina is in the process of dropping a $3.9-billion portable alpha hedge-fund allocation.

Harper,HershelEnthusiasm for portable alpha, a strategy that allows exposure to an index providing beta returns, as well as investments in uncorrelated sources of alpha, has chilled at the fund. “Portable alpha has been successful overall, however the volatility in the short term is no longer a risk we wish to maintain.We are simplifying our implementation for alpha and beta,” says Harper. Dropping the program is also part of a broader strategy to shave South Carolina’s $5.5-billion hedge fund allocation from 20 per cent to an 8-per-cent policy target of assets under management. (There is a 15-per-cent maximum allocation to hedge funds across the plan.) Part of the reorganisation of its hedge funds includes creating a smaller, dedicated hedge fund portfolio investing only in funds that have a low correlation to other asset classes including global macro, market-neutral or managed-futures strategies. Harper is also looking to better integrate hedge fund investments across the entire portfolio. “Hedge funds aren’t so much an asset class as they are an implementation strategy,” he explains.

The potential in house

Despite the potential to manage a simplified equity allocation in house, any move to boost South Carolina’s internal team of three has stalled for now. RSIC is still weighing up the cost of technology and recruiting its own expertise rather than continuing to pay outside managers, says Harper. “Managing more of the portfolio internally will save millions of dollars, which could remain in the Trust rather than paying manager fees to firms in New York or London, but we must weigh those benefits against the potential of increasing operational risk,” he says. Any move to manage funds inhouse would start with US equities, he adds. The only internal asset management is for short duration securities (3 per cent) and the cash allocation (2 per cent).

Inhouse management would provide a saving that could help plug the fund’s $15-billion deficit, another factor increasingly weighing on investment strategy. “We are only responsible for managing the asset component but we are aware of, and understand, our liabilities,” says Harper. The deficit makes holding liquid assets now more of a priority and was one of the reasons behind reducing the hedge fund allocation. Each month South Carolina pays out more in retirement benefits than it receives in contributions, amounting to about a $1-billion shortfall every year. “This gap has to be filled by the Trust and it is our job to make sure there is enough liquidity on hand to meet the benefit payments,” says Harper. It means South Carolina holds more cash than other public funds; a “cash drag” he says he is “prepared to live with in order to mitigate the risk of not meeting a benefit payment.”

Taking on risk, mitigating volatility

Neither does Harper believe a liability-driven investment strategy is necessarily the answer. South Carolina still looks at strategy from a performance perspective, locked into a legislature-set 7.5-per-cent assumed rate of return. Nor could the fund – only 60 per cent funded – perfectly use the strategy that matches assets to liabilities anyway. “We have fewer assets than liabilities, so a pure asset-liability matching strategy doesn’t make sense for us,” he says. “In a zero-rate environment, we must take on a reasonable level of risk in order to meet or exceed that mandate. We try to do that with a strategy that simultaneously includes elements of mitigation against volatility. Our primary goal is the soundness of the plan to ensure the payment of earned benefits. All of our decisions revolve around that fact.”

South Carolina’s 8-per-cent real-asset allocation is divided between real estate (5 per cent) and commodities (3 per cent). Harper sees opportunity in real estate on the debt side, lending on underperforming “good assets in good markets”. Target markets include the UK, Germany and Ireland but also peripheral Europe. “We have $1 billion in the ground, but we are underweight; our target is 5 per cent of assets,” he says. The fund’s private equity strategy, begun in 2007, has borne fruit with an estimated 14-per-cent return in the fiscal year that includes lag, although he believes the greatest bounty is still to come. “We have capital in the ground but we’re still feeling the J-curve affect,” he says. South Carolina also co-invests in private equity, portioning some funds to its private equity managers but also investing directly in the same projects. “We have several co-investments right now,” he says. “Some haven’t worked out but others have been very successful.” Harper would like to push co-investment to account for a third of South Carolina’s private equity portfolio, although he will need a budget and additional staff to do so.

Elsewhere, the fund has a 19-per-cent allocation to diversified credit comprising a mix of high-yield bank loans, structured products, emerging market debt and private debt, and a 15-per-cent allocation to fixed income. Here the allocation is divided between core fixed income, managed by Blackrock and Pimco and recently scaled down to 7 per cent from 10 per cent, and global fixed income. An allocation to opportunistic investments includes low-beta hedge funds and risk-parity strategies.

Harper believes one of the biggest dilemmas for US public pension funds in today’s low-rate environment is balancing venturing out onto the risk spectrum with staying comfortable, in turn risking increased contributions or cut benefits. South Carolina “pushed double-digit returns” last fiscal year, coming in 150 basis points ahead of the benchmark. It’s not surprising he is confident he’s got the strategy right. “We can achieve 7.5 per cent with high confidence and without taking undue risk.”

While commodities are a controversial and problematic asset class to some investors, for others they are an ideal diversifier looking more attractive than ever. A mini-revival in commodity investing among US pension funds suggests the asset class may be enjoying a resurgence. The Los Angeles Fire and Police Pension System, Municipal Retirement System of Michigan and Arizona State Retirement System have all recently upped their commodity holdings.

Don Steinbrugge, (pictured right) managing partner of Virginia-based Agecroft Partners and investment advisory committee member of the $461-million Steinbrugge,-Don-120xCity of Richmond Retirement System, says renewed interest in commodities is part of wider investment trends. “Investors are using commodities as part of a real asset bucket including such things as real estate, as an inflation hedge and also to diversify the portfolio”, he says. “Real assets stand to benefit from increased inflation, should that ensue from the world’s budget deficit troubles.”

That argument is acknowledged by the Ontario Teachers Pension Plan (OTPP), one of the earliest funds to have placed its faith in commodity investing, which is currently investing 5 per cent of its $129-billion portfolio in the asset class. Spokesperson Deborah Allan says in addition to functioning as a hedge against “unexpected” inflation, it believes that “commodities typically have low correlation to other asset classes”.

David Hemming, commodities portfolio manager for Hermes, says many pension funds are moving towards strategic asset allocations of between 2 to 4 per cent after dipping their toes in the asset class with less than that. A 2012 Mercer survey found European funds that invest in commodities indeed allocate around 3 per cent on average – a mere 8.9 per cent of European and 2.1 per cent of UK funds reported having commodity investments at the time of the survey though.

Tough times

The continued reluctance from many pension funds to invest in commodities perhaps stems from a relationship with investors has been best characterised as up and down. Money initially flocked into commodities in post-crisis diversification efforts, but sentiment then appeared to turn with some investors – most notably Illinois Teachers Retirement System – dropping investments. Returns at funds using the asset class have not always made other investors envious either, with CalPERS losing 7.2 per cent on its commodity exposure over the five years to January 2013. The Dow Jones UBS Commodity Index provides graphic evidence of a sluggish few years – the index has failed to come close to its mid-2008 peak and started 2013 at roughly the same level it started 2004.

OTPP has shrugged off a below-benchmark minus-1.2-per cent performance over the past four years in its commodity portfolio with a faith in the asset class’s ability to perform over longer time horizons, according to Allan.

Should other investors be equally optimistic? That may depend on whether they accept the reasoning for commodities’ key selling points misfiring in the recent past.

“Unfortunately we haven’t seen commodity returns keep pace with equity returns since 2008,” concedes Hemming, although he characterises this as a small period. “We saw asset classes come down across the board after the extreme events of 2008 and 2009,” says the manager, who argues a high growth and high inflation environment is one in which commodities would really flourish. “That is what you would expect to see at the tail end of an economic recovery,” he adds, “as you would expect equities to rally first and then commodities to follow through as the expectations of higher growth and inflation are realised.” He argues that the presence of this ideal environment in China in recent years has buoyed commodity markets there.

Hemming (pictured right) adds that the historically low correlations between commodities and other asset classes also broke down during the financial Hemming,David-120xcrisis and remained prevalent after with “risk-on risk-off taking hold against the backdrop of central bank interventions”. Steinbrugge feels there is ample evidence of commodities defying equity cycles though, saying that commodity-trading advisers have enjoyed negative correlation to equity-down markets over the past 15 years.

High volatility in commodities has proven another stumbling block, and was cited as a reason by the Illinois fund to ditch its commodities exposure in 2012. Hemming says there is no doubt that commodity volatility “can be a turn off for some investors and trustees”, although he argues that “with the funding levels of some pension schemes, commodity volatility could be a necessary ingredient in closing that gap”.

Steinbrugge also reasons that as a key diversifier, commodities can actually reduce a fund’s overall volatility. That is particularly the case in the US with pension funds typically running 60 to 70-per-cent equity allocations, he says, and that another flipside to the volatility is that “you don’t need much in commodity investments to get the benefits to the portfolio’s risk and return side”.

On top of sluggish returns, uncertain correlation and high volatility, even the supposed inflation-hedging properties of commodities have attracted doubts from some investors. Anton van Nunen, director of strategic pension management at Syntrus Achmea, says in his experience as an investor he has not found a “strong relationship between general inflation and commodity prices”. Hemming argues, though, that on a historical basis, spikes in energy or food prices have been clearly behind most “surprise inflation” events. Allan states that OTPP is confident too in the ability of commodity prices to “hedge against inflation over long-term investment horizons”, while acknowledging that imbalances in supply and demand can have a distorting short-term impact.

Answering the green lobby

Even if investors are sure of commodities’ investment appeal, there are further doubts about their credentials for sustainability. Commodity futures in particular have come under fire from the sustainable investing world. Murat Ünal, founder of German investment consultancy Funds@Work, says futures in so-called soft commodities – primary food products – are subject to harmful speculative investments, with liquidity often rushing to given areas to push up prices.

That argument has its opponents but “even the largest players in Germany are very hesitant to look at soft commodities” as a consequence, according to Murat_Uenal_120xÜnal (pictured right). He reckons that the reputational risk is too great for investors to be attracted to a sub-asset class, while the potential destabilisation of soft commodity markets can in any case have a knock-on effect on emerging-market equity returns via food inflation.

Legislation that effectively prioritises bond investing has also played a major part in making commodity investing usually “well below 1 per cent” among German pension investors though, he adds.

Simon Fox, director of commodity research at Mercer UK, says that investing in farm land, a commodity allocation can actually boost a fund’s sustainability credentials by playing a part in boosting global food production. Ünal agrees this can be a case, but purely in long-term commodity investments, rather than futures. He would like to see more done in social entrepreneurship funds to facilitate this.

The place for commodities

A period of performance problems arguably presents a huge opportunity for investors. “It’s better to invest in commodities when they’re not performing rather than getting involved after they have performed,” Hemming says. Talk of an end to a commodities “super cycle” as Chinese growth slows is, however, off the mark, he argues: metal prices look sustainable and energy prices remain low in the US, while agricultural prices can swing up at anytime as they are heavily dependent on weather-influenced annual crops. Should energy prices go even lower, he suggests, they would also be able to buoy other commodities by propelling economic growth.

OTPP made commodity investing part of its alpha-seeking “tactical allocation” bucket earlier this year. It invests to the Stand and Poor’s Goldman Sachs Commodity Index benchmark, which has a 70-per cent energy tilt. Allan justifies this by arguing that energy “has historically been the best hedge against unexpected inflation”.

Across the institutional investing world, a trend towards active commodity investing has been noticed as funds shy away from the volatility of indices. “The case for a passive allocation to commodities has always been relatively weak compared to other alternative asset classes,” Fox says. As a result he thinks “there is much more interest in illiquid plays in assets such as timberland and farm land”.

The expertise of an active manager can also count in the complex asset class. Negative roll yields – the dreaded ‘contango’ – remain a challenge that can only be mitigated with skill, Hemming says. While there are active managers looking to generate alpha from commodities such as OTPP, Hermes and others focus on risk-reducing beta strategies.

The Los Angeles Fire and Police Pension System reportedly decided to split a commodity-derivate portfolio in order to carry out both an enhanced-index strategy and an “active-constrained” approach when deciding to enter the asset class.

Steinbrugge adds that commodity exposure is also being picked up in global macro and hedge funds strategies. Clearly the ways into the asset class are every bit as divergent as the views on it but there is no doubting the faith commodities proponents place in its value as part of a sophisticated asset strategy.