Institutional investors are turning their attention to Asia, with CalPERS the latest large pension fund to announce a new foray into the region.

America’s biggest public pension fund this week announced it would invest $530 million in two new real-estate funds targeting investments in China.

Despite concerns about a residential property bubble in China, CalPERS’ chief investment officer Joe Dear says that the $238.2-billion fund sees the urbanisation and income-growth trends in the country underpinning the strength of its real estate.

“Income growth and urbanisation remain the key themes for growth in China,” Dear says.

“China’s office and retail sectors offer stable rental income and potential for capital value growth.”

 

Heading east
Faced with a laggard US economy and Europe slipping into a grinding recession, large institutional investors are increasingly looking to the Asian region for returns.

The Canadian Pension Plan Investment Board has a long-term relationship with specialist listed-property fund manager, Goodman Group.

Investments include industrial and logistically focused investment in China, Australia and Hong Kong. The ongoing partnership has recently been expanded to investments in greenfield sites in North America.

The $43-billion industry super fund AustralianSuper has also set its sights on Asia and, in particular, China.

The fund’s chief investment officer, Mark Delaney, says the fund now has 45 per cent of its international equities in emerging markets and more than half of this exposure is in Asia.

The fund has also looked to build on-the-ground expertise in the region, hiring a specialist local investment analyst in China.

This year it also launched an Asian Advisory Committee to look at investment opportunities in the region. The committee is chaired by former reserve bank governor Bernie Fraser.

CalPERS’ latest investment continues to build on its exposure to the Chinese property market.

The Californian fund will invest $480 million in the ARA Long Term Hold Fund sponsored by ARA Asset Management, a member of the Cheung Kong Group.

The pension fund will also invest $50 million in ARA’s Dragon Fund II. CalPERS previously invested $500 million in the ARA Dragon Fund I in 2007.

The ARA Long Term Hold Fund will target investments in high quality office buildings in central business districts and retail malls in well located, densely populated suburbs in first and second-tier cities in China and Hong Kong.

The Dragon Fund will primarily focus on retail, office and residential property investment in key cities of China, Hong Kong, Malaysia and Singapore.

CalPERS’ initial investment in ARA’s Dragon Fund I earned the pension fund a 19.2-per-cent return for the one year period ended March 31, 2012, and an annual 8.4-per-cent return over the last three years through March 31, 2012.

CalPERS aims to increase its total-portfolio risk oversight, as well as move towards more dynamic asset allocation as the fund attempts to overhaul its investment decision-making processes.

This week the fund released a two-year business plan that aims to implement a risk-based dynamic asset-allocation approach by June 2014.

It is the first time the $238.2-billion fund has drawn up a business plan over a two-year time frame, with other such plans typically setting out the fund’s objectives on a year-by-year basis.

The 2012–2014 business plan forms part of the implementation of its five-year strategic plan and also details a push to establish a comprehensive portfolio-risk-management system and practices to measure, manage and communicate investment risks.

Stretching out to 2017, this strategic plan sets out broadly ranging goals for the fund, which covers not only investment objectives but the culture of the organisation and its broader societal engagement.

In the plan CalPERS aims:

  • To cultivate a high-performing, risk-intelligent and innovative organisation
  • To engage in state and national policy development to enhance the long-term sustainability and effectiveness of its programs
  • Focus on improving long-term pension and health benefit sustainability.

Hybrid on the horizon
California’s public pension system is under the spotlight after the state’s governor Jerry Brown announced a wide-ranging reform program that would seek to develop a hybrid defined-benefit/defined-contribution system.

CalPERS has engaged in the preliminary policy discussions around this reform program, presenting to the state legislature but is under pressure to ensure a future system does not disadvantage current members and maintains future flows into the fund.

At the end of last year CalPERS reported that it was near a 75-per-cent-funded status, which would result in unfunded liabilities of between $85 billion and $90 billion.

In its latest strategic plan, the fund aims to hone its investment process so that it considers both the asset and liability sides of CalPERS’ balance sheet.

CalPERS outlines 11 objectives in its five-year plan, which include funding the system through an integrated view of pension assets and liabilities, and delivering target risk-adjusted returns.

To achieve these particular objectives it will actively manage and assess funding risk through an asset-liability-management framework, which will guide investment strategy and actuarial policy.

The fund also aims to implement programs and initiatives that improve investment performance and ensure effective systems, operations and controls are in place.

CalPERS will also conduct an asset-liability workshop by June 2013, “leading to potential revisions to the asset allocation by applying a new risk framework”.

 

Stakeholders engaged… to no avail
In January the fund initiated the five-year strategic-planning process. As a key part of this development, an engagement plan was designed to inform and seek input from key stakeholders, including CalPERS leadership, staff, members, employers, member and employer organisations, and government representatives.

A series of meetings with those stakeholders revealed some key themes. For the board and executive staff, the investment themes included continued innovation to balance risk and returns, making an effort to bring down investment operating costs, the importance of considering ESG factors, and that there is a risk of significant drawdown impacting the funding level permanently.

At a pension policy level, it was highlighted that the fund should defend defined-benefit funds and that it should prepare to administer hybrid plans.

It was also noted that CalPERS should defend its stance for a variety of important issues.

However, there was no consensus on what those issues should be. Suggestions ranged from the value of defined-benefit plans to benefit adequacy to policy issues that could impact sustainability.

S&P Dow Jones Indices’ researchers take a closer look at the long-term effectiveness of low volatility strategies in this paper.

Aye Soe, S&P’s director of index research and design, analyses the low-volatility effect in the US equity market, with a focus on the common properties of various low-volatility strategies.

Drawing from the extensive academic literature that exists on the topic, researchers examine the two major approaches to constructing low-volatility portfolios and apply them to the US equity market: mean variance optimization-based versus the rankings-based approaches.

The analysis shows that both approaches are equally effective in reducing portfolio volatility over a long-term investment horizon.

The analysis is then extended to international and emerging markets.

The findings confirm that the low-volatility effect is not unique to US equity markets but is present on a global scale.

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The new low-return, high-volatility environment requires broadly diversified portfolios, dynamic decision-making and rigorous due diligence, which is beyond the internal capacity of most small funds under $10 billion, warns Russell Investment’s global chief investment officer Peter Gunning.

He says smaller funds must decide if it is cost effective and even possible to internally manage investment portfolios that can successfully adapt to this new fast-changing environment.

“If you are not on this 24/7, in reality, you are going to miss opportunities,” Gunning says. “If you are waiting for the monthly meeting of the investment committee, markets might have been up and down a lot in between and you may have done nothing.”

Gunning believes the current market conditions are here to stay for at least the medium term and if funds are going to achieve their return objectives, they need to take a comprehensive look at their investment processes.

“I would argue if you are probably under $10 billion, it (insourcing investment management) is probably not worth doing. You can do it but you are doing it in a hybrid model,” he says.

Russell manages more than $150 billion for clients that typically outsource their investment decisions to the global asset manager.

 

Three-pronged approach to volatility
Managing the current environment requires a threefold response, according to Gunning.

The first is to look to greater diversity of assets, both listed and unlisted. This multi-asset solution should be implemented with what he calls an “open architecture”.

This approach ensures that the full suite of options is available in any one asset class to achieve a return objective, with the investment team not locked into any one manager or proprietary product.

Gunning says that dynamic asset allocation should involve a rebalancing back to the strategic asset allocation when valuations change, altering the weight of the particular asset class in the portfolio.

It is an approach that has been championed by the investment teams of such large funds as the $165-billion Canadian Pension Plan (CPP).

Secondly, funds should look to ensure dynamic decision-making that can adapt to fast-changing market conditions, both within an asset class and across asset classes.

“Volatility isn’t necessarily a bad thing. It just means that the investment process may need to adapt to it,” Gunning says.

“So, it is all about being more dynamic in terms of the asset allocation decisions across that diverse set of building blocks.”

Finally, Gunning says, due diligence has moved well beyond the sphere of manager selection and now demands ongoing oversight of operations to minimise risk.

In a low-return environment, part of this is due diligence to ensure efficient execution across a diversified portfolio so there is not what he calls “implementation leakage” because every basis point is crucial.

‘It is a whole lot of small things, particularly when returns are low, but they all add up,” he says.

 

Equities are not dead
Looking ahead, Gunning says that the fund is cautiously optimistic about equities that “may surprise on the upside”.

“We think that on a relative basis equities are a fairly good place to put your money,” he says.

Gunning has previously warned about the need for investors to actively manage their fixed income portfolios, saying that typical indexes expose investors to the biggest debtors.

In addition, he notes that fixed income investors should look carefully at their sovereign exposure, raising concerns that a bubble is emerging in some segments of the sovereign debt universe.

“There is definitely on the sovereign side a bond bubble developing. When you think about 10-year treasuries at 1.5 per cent and two-year government auctions going off at negative, TIPS – five-year and ten-year – are very low.”

“Interest rates can only go so far, we wouldn’t say that equities will come roaring back, but on a relative basis we are more positively disposed to equities than sovereign bonds. We do think there is a reasonable case to maintain positions in high quality corporates and high yield.”

In its fixed income portfolio, Russell currently has what Gunning describes as a “systematic overweight to credit”.

Regionally, Gunning sees that the US may provide better outcomes than Europe, which will be “difficult at best”, and, predicts a soft landing for China.

“On a relative basis, North America is probably providing the best opportunities, followed by Asia and then Europe, on the equity side.”

Asia will be a growing part of investors’ portfolios, predicts the chief investment officer of AustralianSuper, Mark Delaney. He is steering the $43-billion fund towards the Asian century with up to 45 per cent of its international equities now in emerging markets.

Asia represents about half of this emerging market exposure and, despite the flight from risk assets in light of recent market uncertainty, Delaney says that the fund has maintained its allocation to emerging markets.

“We still think that equities will be the main game, because growth is one of the key reasons we are going into these markets and equities are the main beneficiaries of economic growth.”

In addition to a growing focus on emerging markets and Asia, Delaney is starting a long journey towards moving Australia’s biggest industry super fund from an outsourced investment model to gradually building internal management capacity across asset classes.

Delaney describes the process as a long-term goal, which will begin with the investment team internally managing part of its Australian equity allocation.

Small cap Australian equities will continue to be externally managed, but the team will focus on the broader market.

Currently, half of its Australian equities are passively managed.

There are 40 members in the investment team, with half in operations and half in the policy part of the portfolio.

The fund is aiming to add an additional 10 to 20 additional staff members.

Moving into Asia
Along with looking at its internal capacity, Delaney says the fund has also rethought its approach to credit, recently investing in direct-credit opportunities in infrastructure and property.

The investment team has also kept to its longstanding policy of not investing in hedge funds, with the one exception of maintaining its lengthy relationship with Bridgewater.

The approach to hedge funds is to “keep things simple” and it is a method the fund has extended to its push into Asia.

AustralianSuper has limited its foray into emerging markets to predominately equity exposures. Delaney notes that low yields on emerging-market sovereign debt don’t make it a compelling opportunity and he is cautious about the execution risk of investing in unlisted assets.

Candid about the fund’s capabilities in Asia, Delaney says the fund is seeking the advice of experienced operators in the region, recently hired a fulltime member of the investment team in China and is launching an Asian advisory board.

The board, chaired by former Reserve Bank governor Bernie Fraser, will advise the fund as it looks to increase the breadth and depth of its exposures to the region in the coming years.

Delaney says the advisory board is there to add to the knowledge of the investment team, and help “avoid some of the mistakes” other investors have made when putting capital to work in Asia.

Beyond passive
For Australian funds, the question of emerging market exposures always comes with the concern that these funds may be doubling down or duplicating exposures already gained through domestic holdings.

With the Australian Stock Exchange dominated by resource giants and the country’s four big banks – many of which are rolling out their own Asian growth strategies – concentrations of risk must be carefully managed.

Delaney turns this argument on its head, looking beyond blunt geographic exposures to underlying sector exposures.

He argues that Australian investors must adapt their portfolios to Asia as it matures if they are to maintain and potentially grow their exposure to the future engine room of the world’s economy.

“We think in the medium term, as Asia matures and becomes less resource-intensive, we will have to substitute indirect resource exposure for more direct consumer exposure,” he points out.

To do this the fund 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.

Delaney explains that all its international equities, including emerging markets, are actively managed.

Biding its time
However, the fund is prepared to be patient in executing its strategy; Delaney notes it avoided increasing its emerging-market equities holdings in last year’s volatility.

Emerging market equities were one of the worst performing asset classes last year and were caught up in the selling off of risk assets.

But Delaney says that moments of market pessimism can be a potential opportunity for those investors with a longer term perspective.

“Always, falling prices should make stocks more attractive in a world of relative equity allocations between emerging markets and markets elsewhere. A lot of markets have fallen,” he says.

“Emerging markets are now at a discount to developed markets, which is where they have historically traded, and the investor optimism has disappeared from emerging markets. Probably, it makes it a better time to invest than 12 to 18 months ago. We haven’t done anything yet but the preconditions are falling into place.”

Delaney says the fund has done extensive work investigating the relative merits of different ways to access the growth story of emerging markets.

One potential strategy is to look for large multinational companies listed in developed markets that generate revenue from emerging markets, in particular Asia.

The fund’s investment team looked at this option but its research revealed that the theory didn’t stack up to the reality of where the sources of revenue for these companies were coming from.

The fund’s research focused on both European and US-listed companies and revealed that between 20 and 30 per cent of revenues are derived from Asia, Delaney explains.

“For stocks listed in the US and Europe, the vast majority of their revenues come from activities in their region,” he says.

The fund has gradually increased its holdings of emerging markets equity by reinvesting income from its developed markets segment of the equities portfolio, Delaney explains.

Managing risk: in or out?

The fund has also developed an in-house risk management system that manages risk across asset classes.

“We have our own risk model that we run, and it is based predominately at the asset-class level rather than the stock-selection level,” Delaney says.

“We are not trying to add each individual stock to the total; we are trying to work on the broad asset classes and what the major risks are. We will look at the level of absolute risk we take and the amount of relative risk we take, and the components thereof.”

As part of its risk management the fund does liquidity testing, modeling how the portfolio will perform in a market downturn.

The fund has a broad objective to have only about one-third of its assets in the balanced fund, its default option, in illiquid assets.

Delaney says that liquidity is generally understood to be an asset that can be liquidated in less than three months.

In addition to its internal risk management system, the investment team looks at asset allocation and sector tilts are also decided internally.

Investment staff also set broad sector strategies, while specific stock selection is left to external managers.

“All asset classes are currently external, but we are looking to bring part of Aussie equities internal and we will look to diversify that over the next three to four years,” he says.

Delaney says that the decision to move to internal management is driven by the capacity for internal management to access a better portfolio of assets, whether it can be done cheaper and whether the strategy can be effectively executed.

“We will start carefully and if [internal management] proves to be successful, it will attract more capital, like any other manager works,” he says.

Nuts and bolts
The current strategic asset allocation in its default balanced fund is as follows:

Strategic Asset Allocation


The fund has adopted a dynamic asset allocation approach for more than 10 years, and looks at its holdings on a monthly basis.

As of June 30, the fund’s balanced option achieved a 1 per cent return for the financial year, compared to an Australian superannuation industry median return of 0.5 per cent. This followed two consecutive years of strong returns of 10.3 per cent and 10.1 per cent. The balanced option has averaged 9.3 per cent a year since inception in August 1985 and over a 10-year period has achieved an annual return of 6.4 per cent.