Key Takeaways

  • Investors are contending with a lingering late-cycle macro backdrop with latent recession risks for the US economy and most developed markets.
  • Rather than wait for the cycle to turn, the journey toward the destination of eventual growth or recessionary outcomes merits its own consideration.
  • We believe that staying invested, keeping active and diversifying across public and private markets may allow investors to seize late-cycle opportunities.

Economies move in cycles, and each cycle brings its own challenges and opportunities. In many aspects, the current cycle has shown signs of aging and we are likely in late cycle. As investors debate the chances of growth or recession, we think the journey merits its own consideration. Staying on the sidelines could prove costly, while we believe an active, diversified approach across public and private markets may be the best way to navigate near-term uncertainties and seize late-cycle opportunities.

Late Cycle, Not End Cycle

Some Macro Data Has Slowed, But Not Enough For A Recession

For over a year, the Federal Reserve (Fed) has embarked on aggressive rate hikes—along with balance sheet reduction—to combat stubbornly high inflation. Price pressures in the US have started to ease heading into the second half of 2023. Among the key components, core goods inflation has decelerated the most as supply chain pressures eased, shelter inflation has started to level off in recent months, core services ex-shelter inflation has moderated to some degree yet remains the key risk to our inflation outlook.1 Gradual and uneven progress on disinflation suggests to us that humility is required in forecasting future levels from here, even when most of the key drivers appear to be moving in the right direction.

Drags from persistent inflation and cumulative policy tightening have slowed growth to a soft, but non-recessionary pace. The US labor market’s momentum has started to fade—the quits rate has steadily declined since 2022 and dropped to 2.4% in April, just above its 2018-2019 level of around 2.3%. Despite a mild uptick in May, the downtrend over past 12 months indicates that opportunities for switching to better jobs have been diminishing.2 Wage growth has begun to slow, but further deceleration is likely needed to be consistent with the 2% inflation target. At the aggregate level, the US unemployment rate has not risen much beyond its pre-pandemic level of 3.5%. According to the Sahm Rule, which states that we are in the early months of recession when the three-month moving average of the national unemployment rate is 0.5% or more above its low over the prior twelve months, the US economy is not yet in recession as it heads into the second half of 2023.

Sahm Rule Recession Indicator Suggests the US Is Not Yet in Recession

This doesn’t necessarily mean the economy will avoid a downturn altogether. As monetary policy has continued to tighten, shorter-dated interest rates have risen beyond longer-dated ones, leading to an inverted yield-curve—typically an indicator for an impending recession. Heading into the second half of 2023, the spread between 2- and 10-year Treasuries has inverted to the deepest levels since the early 1980s; other measures of yield curve inversion are also pointing to meaningful recession odds. However, yield curve inversion alone is not particularly informative about the timing of an upcoming recession, and there are meaningful downside buffers that may forestall the economy from tipping into a downturn imminently and prolong the duration of the current cycle.

Despite strong headwinds and signs of weakness, the US economy has proven resilient so far in 2023. Many of the upside surprises in the economic activity data have pertained to consumer spending. Goods consumption rebounded quickly in the first quarter to the fastest pace since the second half of 2021, and services consumption remains strong.3 The combination of a strong labor market and solid real disposable income growth could continue to support consumer spending—and therefore economic growth—in the months ahead.

The balance sheets of US households, corporates, and state and local governments also remain solid at the midway point of the year. Moreover, the tail risk of the debt limit crisis has been eliminated and, so far, stress in the US regional banking system is expected to impose a moderate but not recessionary drag on growth. There are signs that bank lending standards have tightened across several types of loans, while the extent of further credit tightening remains uncertain. Fiscal policy bills, such as the CHIPS Act, may further spur manufacturing investments and provide offsets to credit tightening.

Higher Rates for Longer

We believe the outlook for any further hikes will likely depend on whether labor market rebalancing has progressed far enough to solidify disinflation. In June, the Fed dots projected two additional hikes left for this year,4 which was viewed as a hawkish surprise by markets. Yet despite the aggressive pace of hikes, the level of Fed Funds rate has only recently risen to levels comparable to inflation. This contrasts with historical hiking cycles when the Fed hiked rates well above inflation. Therefore, we continue to expect that US monetary policy will stay restrictive for longer. Such an environment is expected to be particularly challenging for business models that rely on higher leverage, lower cost of borrowing and ample liquidity. On the flip side, however, this may also represent an opportune time to be a lender, particularly in private markets.

Seizing Opportunities

Considering the Fed’s hawkish stance, the timeframe for a monetary policy pivot and the duration of the late-cycle phase remains highly uncertain. But rather than sitting on the sidelines and waiting for the cycle to turn, we believe staying invested with an active, diversified approach may be the best way to navigate uncertainty and seize late-cycle opportunities in the meantime.

Private Credit: Be a Lender

In a higher-for-longer rate environment, we see opportunities for investors to earn equity-like returns in private credit. Compared to public fixed income, private credit involves directly providing loans to companies in privately negotiated transactions. The strategy can offer incremental income generation and greater resiliency during periods of heightened volatility, serving as a potentially strong complement to traditional fixed income. The current environment is buoying private credit yields—the average new-issue yield across all US leveraged loans reached 10.2% in 2Q 2023, the highest since 2009.5 This is being driven by borrowers willing to pay more for the certainty of execution and custom terms that private lenders offer. Rising rates and market volatility have led to a slowdown in high yield and leveraged loan issuance, as lenders, including smaller domestic banks, curtail their activity. Private credit has stepped in to fill the gap, expanding the strategy’s share of corporate and real asset lending, particularly across segments of commercial real estate facing tighter credit conditions, income pressure and elevated refinancing needs.

Private lenders today have the benefit of being able to focus on high-quality borrowers with attractive coverage ratios and favorable terms to mitigate downside risk. As interest rates have climbed, private credit loans are offering equity-like returns in the double digits and, in general, private credit terms tend to include bespoke protections and provisions not found in the high yield or leveraged loan market.6 Private credit portfolios can also select investments without the need to manage to a benchmark. Selectivity can be a key advantage—and a potential downside mitigant—in an environment of increased dispersion, slowing growth, tightening monetary policy and headwinds to profitability. As the asset class matures, we believe private credit is becoming an increasingly viable replacement for traditional leveraged finance providers, offering increasing scale, customization, and certainty to borrowers that often view these benefits as compensation for the higher cost of capital.

Fixed Income Resilience

One upside of the transition to a higher rate regime is that the forward income and total return potential of core bonds, such as high-quality government bonds, has improved significantly. They have also delivered positive returns in past recessions and may act as an important ballast to portfolios should an adverse scenario materialize in this cycle.7 Further, core bonds have tended to have a low or negative correlation with equities and other risk assets which drives potential diversification benefits. Given the backdrop of late cycle economy, close to peak hiking cycle, and attractive level of real yield, we find long-duration US Treasuries attractive. Overall, we remain cautious on US credit, but continue to believe that there is opportunity for active management in this space. The recent banking crisis is expected to push US banks to tighten lending standards further and we do not believe this tightening is fully reflected in credit spreads, which are only at median levels over the cycle and not yet an attractive point of entry. Nonetheless, investors should continue to be mindful of security-level relative value and market dislocations that may present idiosyncratic opportunities, and active security selection remains crucial.

Equities: Keep Your Options Open

This year, market positioning appears to be cautious on risk assets, and positioning surveys point toward net underweight allocation of global equities at mid-year point. The US equity market currently embeds two different dynamics. On one hand, mega-cap tech stocks are being driven by high growth expectations as equity investors debate the influence generative AI may have on the future revenue growth and profitability of companies, and the valuation of stocks. On the other hand, the rest of the market is inching higher instead of rallying sharpy as inflation outlook and market sentiment improves. Currently, the valuation of tech remains within historical ranges and well below the peaks of early 2000s.8 Besides, with equity volatility at multi-month lows, the cost of downside mitigation has also become attractively cheap. Considering the macro backdrop, equity fundamentals, market pricing and positioning, we prefer to stay invested in equities with some hedged exposures.

AI Disruption May Lead to Active Management Opportunities

The ability and accessibility of generative AI models and their implications for creating well-crafted content, from persuasive rhetoric to code, has accelerated exponentially. We expect the integration of AI within enterprises and wide scale adoption by consumers may have a huge impact on societies and economies over the coming years. As investors, we believe AI is a growth driver with a wide variety of applications and is on a path to disrupting entire industries as we currently know them. In our view, companies that are harnessing generative AI to enhance their business, leveraging predictive AI to make their business smarter, and those manufacturing the hardware to enable the proliferation of AI are set to disproportionately benefit. In our view, each business will need a clear strategy to incorporate AI if they want to remain a market leader. We find this is a particularly exciting time to be evaluating AI opportunities. Finding the next generation of winners will likely require investors to be nimble and look beyond benchmarks.

Diversification Matters in a Dislocated Global Cycle

The beginning of the current monetary tightening cycle featured synchronized deployment of policy measures in most major economies, but the finale may reveal more differentiated responses as growth and inflation trajectories regionally diverge. While the Fed may be approaching the end of its hiking campaign, further tightening may be required by the European Central Bank (ECB) and Bank of England (BoE) to keep a lid on prices. Contrary to the hawkish stance of other G4 central banks, the Bank of Japan (BoJ) has remained accommodative for an extended period of time. Considering strong domestic demand, we continue to see diversification opportunities in Japanese equities. Beyond advanced economies, emerging markets are moving at their own pace, resulting in a desynchronized global cycle. Emerging market growth momentum remains soft but is no longer deteriorating. Inflation has plummeted in some countries, for example Brazil, Chile, and Mexico. Most EM central banks have reached the end of their respective hiking cycles, and the first EM central banks have begun their easing cycles. High real yields, weak currencies, low inflation may support diversification opportunities in local currency government bonds.

China’s cycle is also distinctively dislocated from most developed markets, with the People’s Bank of China (PBoC) in easing mode. China’s economic activity has rebounded following the lifting of mobility restrictions, but the boost from re-opening has been fading, with macro data missing market expectations coming into the second half of 2023.9 In our view, China’s recovery is likely to be non-linear from here. We believe the country remains a large, growing market with a vast opportunity set, though there is also an important shift in foreign direct investments occurring from China to countries such as Vietnam, India, and Mexico. Besides, US-China geopolitical gyrations may also create a more uncertain environment. Overall, we think a diversified, active approach is key to capitalize on investment opportunities in a dislocated global cycle with differentiated drivers at the country level.

Watch For The Next Phase of The Cycle

As cycles turn, investment opportunities shift. We continue to monitor closely the balance of risks between the economy’s strength and vulnerabilities, as they provide more clues on where we are in the journey toward the future stages of the business cycle. The upcoming quarters are likely key in revealing global central banks’ degree of success in bringing down inflation, the future path of monetary policy, as well as to what extent balance sheet resilience and fiscal programs may offset drags from interest rate and credit tightening. But uncertainty and disruption present opportunities for long-term investors. In our view, market participants should remain vigilant to growth and inflation dislocations across economies—as well as trends that transcend cycles—and stay invested, seizing late-cycle opportunities where they can be found.

Important Information

1 US Bureau of Labor Statistics.  As of July 7, 2023.

 

2 US Bureau of Labor Statistics. As of May 31, 2023.

 

3 US Bureau of Economic Analysis. As of June 30, 2023.

 

4 Federal Reserve. As of June 14, 2023.

 

5 LCD, “Amid credit tightening, leveraged loan market revisits Financial Crisis levels” As of June 7, 2023

 

6 Cliffwater Direct Lending Index. Analysis of the unlevered, gross of fees performance of U.S. middle market corporate loans. As of June 30, 2023

 

7 Bloomberg, Datastream and Goldman Sachs Asset Management. Analysis of German, UK, US and Japan government bonds annualized total return in local currency from March 31, 1980 to March 31, 2023.

 

8 I/B/E/S and Datastream. As of July 19, 2023.

 

9 National Bureau of Statistics of China. Bloomberg. As of July 17, 2023.

 

Glossary

 

CHIPS Act establishes and provides funding for the Creating Helpful Incentives to Produce Semiconductors (CHIPS) for America Fund to carry out activities relating to the creation of incentives to produce semiconductors in the United States.

 

Correlation is a measure of the amount to which two investments vary relative to each other.  Past correlations are not indicative of future correlations, which may vary.

 

G4 Central Banks refers to the Bank of England (BoE), the Bank of Japan (BoJ), the Federal Reserve (FED), and the European Central Bank (ECB).

 

Hawkish refers to more aggressive monetary policy, the opposite of Dovish.

 

Mega-cap tech stocks refer to technology companies >$100bn in market cap.

 

Quits rate refers the number of quits during an entire month as a percent of employment. Quits include employees who left voluntarily, with the exception of retirements or transfers to other locations.

 

Recession is defined as two consecutive quarters of negative growth in real GDP.

 

Sahm Rule Indicator, as identified by Claudia Sahm, identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months.

 

Syndicated loans refer to financing, or loans, that are offered by a group of lenders—known as a syndicate—who collaborate to provide funding for a single borrower.

 

Volatility is a measure of variation of a financial instrument’s price.

 

Risk Considerations

 

All investing involves risk, including loss of principal.   

 

Equity investments are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. Different investment styles (e.g., “growth” and “value”) tend to shift in and out of favor, and, at times, the strategy may underperform other strategies that invest in similar asset classes. The market capitalization of a company may also involve greater risks (e.g. “small” or “mid” cap companies) than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements, in addition to lower liquidity. 

 

Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.

 

High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated fixed income securities 

 

Emerging markets investments may be less liquid and are subject to greater risk than developed market investments as a result of, but not limited to, the following: inadequate regulations, volatile securities markets, adverse exchange rates, and social, political, military, regulatory, economic or environmental developments, or natural disasters.

 

The risk of foreign currency exchange rate fluctuations may cause the value of securities denominated in such foreign currency to decline in value. Currency exchange rates may fluctuate significantly over short periods of time. These risks may be more pronounced for investments in securities of issuers located in, or otherwise economically tied to, emerging countries. If applicable, investment techniques used to attempt to reduce the risk of currency movements (hedging), may not be effective. Hedging also involves additional risks associated with derivatives.

 

Alternative investments are suitable only for sophisticated investors for whom such investments do not constitute a complete investment program and who fully understand and are willing to assume the risks involved in Alternative Investments. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor’s capital.  

 

Investments in real estate companies, including REITs or similar structures are subject to volatility and additional risk, including loss in value due to poor management, lowered credit ratings and other factors.  

 

The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered. 

 

Conflicts of Interest 

 

There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. These activities and interests include potential multiple advisory, transactional and other interests in securities and instruments that may be purchased or sold by the Alternative Investment. These are considerations of which investors should be aware and additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment. 

 

General Disclosures 

 

Diversification does not protect an investor from market risk and does not ensure a profit. 

 

Past correlations are not indicative of future correlations, which may vary.

 

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Date of First Use: August 7, 2023 326527-OTU-1841471

The $95.4 billion Oregon Investment Council has established anchor relationships in relative value, event-driven, and global-macro strategies as well as expanded the CTA portfolio, equally weighted managers, and continues to conduct due diligence on additional multi-strategy funds. Meanwhile it is also restructuring its public equity allocation following a review of the portfolio and its managers.

Over the last 16 months, $95.4 billion Oregon Public Employees Retirement Fund, OPERF, has approved eight new hedge fund strategies totalling $2.45 billion in commitments in its diversifying strategies portfolio.

Moreover, the team at Oregon Investment Council (OIC) have established anchor relationships in relative value, event-driven, and global-macro strategies; expanded the CTA portfolio to four, equally weighted managers, and continues to conduct due diligence on additional multi-strategy anchors in the $4.6 billion portfolio. Of the new relationships, seven are brand new while one was a conversion of an existing fund investment.

The latest changes are steps on the road to overhauling the portfolio, centred around diversifying managers and strategies to escape a legacy of concentration in the portfolio and overlapping exposures. Today, top 10 hedge fund managers at the fund include names like AQR Capital Management (which has three mandates) Hudson Bay Capital Management and Davidson Kempner Capital Management.

“I think the team has done an amazing job over last couple of years [building the allocation] from seven firms and nine strategies to 22 and 25. That’s a tremendous amount of travel; a tremendous amount of writing of these 350-page documents we use to review all the different details, in addition to their other job in real assets,” said CIO Rex Kim in a recent OIC meeting. He added that building out the portfolio has relied heavily on consultant Albourne, providing support around manager selection and due diligence particularly.

OPERF launched its alternatives portfolio comprising real assets (7.5 per cent of AUM) and diversifying strategies (7.5 per cent of AUM) in 2011. Diversifying strategies returned 16.5 per cent in 2022, outperforming the HFRI FOF Conservative benchmark and a 70/30 Reference Portfolio, led primarily by GAA and CTA legacy exposures.  On the heels of strong 2021 and 2022 performance, the portfolio is now outperforming its benchmark on a three-year basis.

The OIC board heard how the collapse of SVB triggered a negative impact on some hedge fund strategies including short bonds, CTAs and macro. Positively, strategies like long short and relative value have done better.

Other recent trends include investors rebalancing because hedge funds have outperformed, moving assets from hedge funds into private credit.  Still, hedge funds offer attractive opportunities relative to prior years due to higher cash yields. Elsewhere absolute return strategies with a low correlation to equity are providing valuable diversification.

Going forward, the team will continue to increase the number of managers and strategy diversification, including relative value (which has a 26 per cent strategy weight vs a 34 per cent target) and equity long short. Strategy will also continue to focus on rebalancing GAA and CTA managers while researching areas of interest including quantitative equity market neutral strategies and fixed income arbitrage strategies.

Restructuring in public equity

OPERF is also restructuring its public equity allocation following a review of the portfolio’s construction and managers.

The portfolio reset, embarked on over a year ago, seeks to address key issues including bringing the tracking error within range; maintaining and adding core passive exposure to the developed market sleeve, revisiting Oregon’s factor selection in the risk premia portfolios and focusing on alpha generation from high conviction active managers.

The restructure is a response to analysis that revealed that the portfolio’s largest factor exposure was to value, and that it was underweight growth – particularly large growth on a benchmark relative basis. The majority of active risk was coming via style factors, and the tracking error was high at 2 per cent, explained Louise Howard who became senior investment officer for the allocation in January 2022.

Since January, in phase one of the strategy, Oregon has targeted the low hanging fruit in the restructuring process in the form of benchmark misfits, taking down over-weights to smaller-and mid-sized value exposures and re-purposing those assets to more benchmark orientated strategies. The team have also reduced the underweight to large cap growth equity and ensured stock selection becomes a larger contributor to active risk. The tracking error has also come down significantly to 1.2 per cent.

From now until year end the focus will be on adding passive exposure to the international allocation, and further diversifying the factor exposure. From 2024, the focus will be on rebalancing manager exposure to reduce active risk and adding exposure to neutralize existing style biases.

OPERF’s portfolio is divided between public equity (27.5 per cent) diversifying strategies (7.5 per cent) real assets (7.5 per cent) fixed income (25 per cent) private equity (20 per cent) and real estate  (12.5 per cent)

New Zealand Super has revamped its multi-factor equities portfolios, working with its three external managers to integrate sustainability. Amanda White spoke to head of external investments, Del Hart, about the fine balance of meeting sustainability goals and finding factor alpha, and the next phase of the fund’s sustainability strategy: measuring investments for impact. 

New Zealand Super’s active global equities is managed by three managers in various concentrations of multi-factor portfolios across value, low volatility, momentum, and quality. 

As part of the fund’s bid to integrate sustainability across its whole portfolio, it recently engaged with Northern Trust, AQR and Robeco, which manage the portfolios, on how to best integrate its sustainability objectives without compromising the integrity of the factor exposures. 

“The multi-factor mandates make up 19 per cent of the portfolio so if we couldn’t do something with that, it was a gap in the portfolio in terms of sustainability goals,” NZ Super head of external investments and partnerships Del Hart tells Top1000funds.com in an interview. 

“If we restricted it too much we wouldn’t find the scope for factor alpha we were looking for, but we found we couldn’t simply give the factor managers the Paris-aligned benchmark we used for the passive portfolio as their universe for stock selection.” [See NZ Super culls equities, focuses on impact] 

The balancing act meant ensuring the managers had a large enough investable universe and weren’t restricted in their approach to creating the alpha expected from the portfolios, whilst still meeting certain ESG outcomes. 

The NZ Super team did a lot of research and spoke to peers as well as a range of fund managers, both incumbent and others, to canvass the financial effects of integrating ESG into multifactor equities. 

“There was a range of views, but the prevalent view was the impact was uncertain,” Hart says. “If we can incorporate ESG considerations without compromising the exposure then there is no reason to believe it will reduce returns. Our goal is not to generate alpha from the ESG integration but to have justifiable confidence it won’t detract from returns.” 

Three changes to the factor strategies ensued. The investable universe was moved away from the MSCI ACWI IMI to the MSCI World index, effectively removing small caps and reducing the number of stocks from 4,500, to 1,500. 

“That’s the level we think there won’t be a negative performance impact. It was still possible at that level to achieve a strong exposure to our desired factors,” Hart says.  

From that universe, managers were given freedom to choose their exposures to manage the portfolios but their benchmark was changed to the MSCI World Climate Paris-Aligned index, which is the same as used for the reference portfolio and passive global equities.  

“So they need to manage to the ESG characteristics of that index but can do it in a way they choose for generating the returns,” Hart says. 

Managers can design a portfolio that gives the ESG desired outcomes, as per the benchmark, but doesn’t require them to meet specific targets in terms of ESG metrics. 

“It gives them flexibility. And the important thing is we will use MSCI ESG metrics to report their performance and require them to explain any consistent underperformance, that’s our way of checking in a consistent way that our three managers are adopting an appropriate solution to achieve the goal,” Hart says. 

The fund is now working with the managers to implement the new changes which may include some amending their investment management agreements. 

With ESG considerations further integrated across equities, the fund will turn its attention to the fixed income portfolio. 

Impact measurement 

It’s all part of a move by the fund to sustainable finance which followed a two-year review of its responsible investment position, with ‘sustainable finance’ referring to the consideration of the impact of investments on society and environment, as well as thinking about the ESG risks on investments. 

There are few large asset owners globally which measure the impact of their investments, but it is attracting growing attention. New Zealand Super will do an initial portfolio assessment due by the end of September.

In developing an appropriate framework, the first part of the process was to define impact, and the framework for qualification, measurement and management. 

New Zealand Super’s definition of impact is: Investments made with intent to deliver measurable positive social and/or environmental impacts, and the fund’s required financial return. Importantly it has the four factors of intent, measurability, impact and returns. 

And questions it asks to assess investments around impact include: Does the investment meet the return hurdle; have positive social or environmental impacts been identified as a core component; can those impacts be measured; and are there any significant adverse impacts associated with the investments? 

Hart says developments in the past few years including the growing use of taxonomies has given the fund confidence they can invest in scale, measure impact and meet the financial return goal. 

“A few years ago we were interested in impact but our mandate to meet returns and with our fund growing we couldn’t get sufficient comfort in scale in a meaningful way,” she says. 

“We couldn’t invest in size and be able to measure what we were getting out of that. 

“There has been an evolution happening in the industry that has helped us get comfort that we can find managers that have that intent, and we needed those manager to report ideally on a comparable basis.” 

The fund has developed an impact investment framework with a five-step process covering qualification, measurement, reporting, analysis and management. 

The fund’s preference was to adopt, and if needed adapt, an off-the-shelf solution, given the progress and convergence of existing frameworks, and it decided on the IMP 5 dimensions of impact as the most appropriate approach.  

“In terms of measurement we wanted to have a consistent approach so we are using the five dimensions of impact for working through our existing portfolio and to invest in new sustainability solutions. We are at the stage where we are putting the new framework through any relevant new investment that we do, and taking time to go through the existing portfolio for which investments qualify for impact.” 

Importantly the fund will continue to apply its standard sustainable investment framework to all investments, including those that don’t qualify as Impact investments.

“It doesn’t mean we won’t invest in something but we are making sure we are giving thought to if an investment creates impact or not and having the lens and giving sufficient consideration to impact investing.” 

Hart says the impact measurement is a work in progress with the first step to get really clear on what the fund was trying to achieve and ensuring a consistent methodology, criteria and expectations in measuring impact. 

“The external managers’ team, the internal team and our direct team all need a consistent approach,” she says, adding the fund has engaged some of its managers, including Generation Investment Management which it appointed only this year, and are leveraging some of their expertise. 

“We have leveraged our network to help us form our solution and that has helped us,” she says. “We are on the cusp of having a lot more clarity and visibility.” 

Other tools are also being created for the investment team, including a dashboard, to provide visibility to the team internally and to help educate them. 

The predominant themes that are being measured are positive environmental impacts, with Hart acknowledging the social aspects are much harder to measure. 

“The next stage is to think more about where the opportunities are, where we can focus our effort to get impact and map that against the SDGs,” she says. “We will get more sophisticated.” 

South Africa’s EPPF wants to increase its allocation to private equity and venture capital to help ride out volatility at home in a strategy where governance and stakeholder engagement is central. CEO Shafeeq Abrahams explains.

South Africa’s R190 billion ($10 billion) Eskom Pension and Provident Fund (EPPF) the retirement plan for employees of the country’s electricity utility, is currently building resilience into the portfolio, seeking greater diversification through an increased allocation to alternatives and overseas investments. Elsewhere, EPPF is reviewing its approach to passive investment, preparing to bring more systematic strategies in-house.

The increased overseas allocation to alternatives is most focused on global private equity and venture investment. The team have just returned from meeting US managers, and EPPF hopes to issue an RFP in the next 12 months.

“We have been looking at what is out there, and the risk as well,” says Shaafeq Abrahams, promoted to chief executive and principal officer at the fund in 2021.

Although Abrahams plans to build the international allocation to private equity, venture capital and infrastructure, he won’t push the allocation much above current levels. A new regulatory ceiling allows the fund to invest up to 45 per cent of assets outside South Africa. EPPF currently invests 36 per cent of assets overseas, which he says is about right.

“Changes to regulation allowing for an increased foreign allocation will be inputs into our upcoming asset-liability modelling exercise and we will see the outcome. But in terms of our modelling, and given our liabilities are in rand and we would have to manage the currency risk, we will probably stay at current levels unless there are very compelling investment opportunities.”

The bulk of the overseas allocation is invested in international equity, with smaller portions (5.7 per cent) in emerging market equity (3 per cent) African assets and (2.8 per cent) China A Shares.

Alongside a quest for diversification, the decision to invest more in illiquid assets is also a bid to smooth volatility. Higher interest rates and inflation promise more volatility ahead, he warns. “Over the long run volatility sorts itself out, but we’ve found greater diversification helps weather the storms.”

Rand volatility particularly is a constant consideration in portfolio construction. “We take a view on currency risk, and it does influence our allocations,” he says. Although the fund never hedges long term because it is too expensive, it will hedge short term currency risk. “If market conditions indicate currency volatility, we will hedge during a specific period on a tactical basis to give us comfort.”

An appetite for South African infrastructure

A larger allocation to alternatives will also include more investment in South African infrastructure where he likes the long term, stable cash flows that provide insulation against inflation. South African infrastructure assets also chime with EPPF’s sustainability and impact targets. “If we get infrastructure right, we can drive the sustainability agenda and outcome, help grow the economy and address inequality.”

Existing exposure includes renewable energy and economic and social infrastructure assets but he’d like to expand this to opportunities in toll roads and bridges. The challenge is finding bankable projects with the right returns and partners. “The regulatory framework needs to encourage more public private projects and we are working with peers to frame the conversation to see how we can unlock this. We have room to invest on a long-term basis and a lot of appetite, but we also need a big push from public policy makers and regulators too.”

Doing more in-house

Although most assets will remain externally managed, Abrahams wants to do more in-house and expand the current 35 per cent of assets EPPF runs internally. Not only will this reduce the cost, he also wants to the team to manage systematic strategies internally and beef up their internal capabilities in private markets in anticipation of more co-investments and direct investments.

EPPF has an internal investment team of 50 (part of a large total headcount at the pension fund of 150) and he says this could grow by 55-60. The internal team is largely South African focused across a mixture of passive and active strategies, dictated by differentiated risk budgets.

Wider changes in the pension industry

Abrahams is also bracing for wider changes at the pension fund, which was founded in the 1950s. Much of his time since taking the helm has been spent building better communication with EPPF’s 80,000 members, which he says is particularly important given Eskom’s enduring corporate challenges.

“It’s critical that we inspire confidence through our behaviour, decision making and governance. All decisions must be made in line with member interest, independent of the employer. We are very mindful of the 80,000 families that depend on us. Our loyalty and allegiance to our members is paramount. One of my biggest challenges is instilling confidence in our members that the fund is well regulated and well governed at the executive level,” he continues.

Now, as South Africa inches towards a two-pot system which will allow beneficiaries to access some of their savings early, member experience, communication and stakeholder engagement are more important than ever.

Unlike executives at peer fund GEPF, Abrahams doesn’t predict the new regulation will result in significant drawdowns in the portfolio, or liquidity issues. He is more concerned about the complexity of implementation and administration, particularly for a defined benefit fund. “Numerous requests for drawdowns will carry an administrative cost and is a significant shift in the way pension funds have traditionally operated.”

He is also concerned about the long-term impact on members if they access their retirement fund early, and warns the policy change needs to run alongside an extensive education programme. “Our members need to understand the impact of the loss of compound interest over time. Accessing their pension may provide short term relief, but it could create long term retirement shortfalls.”

South Africa’s unfolding electricity industry also heralds change for EPPF. Plans to unbundle the giant utility into different segments are now back on the political agenda. If corporate divisions are separated into separate independent companies, EPPF, currently  one fund for all Eskom employees, would have to change to take on a broader set of employers. “We have just started to have discussions about how we respond to the Eskom unbundling. It’s very early days, but also quite exciting,” he concludes.

 

Canada’s TTCPP Pension Plan became a stand-alone entity only three years ago. Top1000funds.com discusses the fund’s journey to independence and the evolution of the hedge-fund heavy investment portfolio with CIO Andrew Greene.

For pension plans exploring how to step out from under their sponsor and set up an autonomous organization, Canada’s TTC Pension Plan (TTCPP), the $7.8 billion defined benefit fund for employees of Toronto’s public transport network, offers a case study in the journey to independence.

Early pivotal decisions on route to creating a separate entity included TTCPP’s board deciding not to fold the plan into OMERS, the $124 billion fund for employees of Ontario government municipalities in an endorsement of its own well-established governance and financial health. In a next step, the leadership team (TTCPP hired its first independent CEO in 2016) worked with sponsors Toronto Transit Commission and the Amalgamated Transit Union (ATU) on the structure and transition of the spin off entity. It took until January 2019 for the new fund to launch.

In the early days, a skeleton team oversaw mostly fund of fund investments with the support of consultants, recalls chief investment officer Andrew Greene, who joined in 2017 from OPTrust as the first dedicated investment person.

Today, TTCPP continues to reduce its dependency on consultants and is growing its internal expertise. The investment team guard a healthy funded status and oversee a growth-orientated strategy that includes leverage and hedge funds in a model that has all the hallmarks of  Canada’s much larger Maple Eight.

Greene, who estimates the fund will hit around $10 billion assets under management by 2030 in line with its 6 per cent discount rate, is also pushing into private assets, growing the allocation to 16 per cent of AUM from 10 per cent as per the latest asset liability study.

Elsewhere the focus is on building a new level of transparency, control, and securing better fees with managers. In charge of its own destiny, more resources are also flowing into pension management for the first-time including communication, member outreach and IT, which were a lower priority when the fund was managed by the TTC.

“At first, I relied heavily on the CEO and consultants. We were only able to hire people after two years and the team is now six. The plan is to hire another two to three people over the next 18 months,” says Greene, a Chicago native who moved to Toronto 17 years ago. “Plans that outsource everything to consultants are not as satisfying for staff.”

leaning into Hedge funds

For him one corner of the portfolio that provides particular satisfaction is hedge funds, an 8 per cent allocation that holds a mirror to TTCPP’s evolution. Until recently, the strategy consisted of two fund of funds, but when one fund merged with another, and the other went out of business, Greene changed tack.

He hired a consultant and built a direct hedge fund portfolio that was cheaper and more concentrated, and is managed on a discretionary basis as the team has evolved and grown. The allocation targets high single digit returns, but what Greene particularly likes is the diversification benefits across asset class and geography, allowing TTCPP to invest across the capital structure, take a view on different time horizons and short investments that the team doesn’t like when the rest of the portfolio is long only.

The allocation’s maturity, plus new internal resources, mean restructuring the portfolio is ongoing and Greene is reappraising certain strategies. For example, he is increasingly circumspect of long short equity.

“Long short equity is the biggest part of the hedge fund market, but I find it difficult to navigate as often one is paying alpha fees for beta returns,” he says.

Instead, he wants to lean the other way, favouring fixed income, relative value, and convertible strategies, as well as strategies that can work across the capital structure to find dislocations or take advantage of equities and bonds no longer being in sync.

Restructuring will also involve reducing the number of managers. When Greene took the helm TTCPP invested small parcels of around $5 million across 20-odd funds in an approach designed to open the door with managers, providing the opportunity to top up when a space appeared with sought after partners. It took a number of years, but now TTCPP has a full position with several top tier funds. “By the end of this year we will be down to 14 hedge funds, using fewer managers in a more concentrated portfolio.”

TTCPP typically writes cheques of $20-40 million while the consultant leans on funds to get a discount where ever possible – although Greene says the only managers that really offer a discount are smaller and starting out. Still, he notes some openings to reduce fees. For example, one of the macro managers that was underperforming has lowered its fee until they get back to the high watermark.

It’s a slightly different story away from hedge funds. Greene observes that the investment climate means more managers are open to renegotiating fees.  The denominator effect, whereby many investors (particularly endowments and foundations) are pulling back on investing more in alternatives because these portfolios have not been marked down as much as public assets, is creating opportunities to invest with sought-after GPs.

“Names that we had trouble getting in with before are now more open to discussions. It is a good opportunity, and we are buying at better prices. Prices in private markets are still going down and we have better access to GPs and terms than we would normally have.”

Leverage and higher yields

TTCPP uses leverage at a total fund level and can lever up to 10 per cent of the fund. Today the higher cost of borrowing means Greene is paring this back to around 5 per cent. “Leverage is costing me 5 per cent instead of 1 per cent and given our funded status is better because yields have gone up significantly, there is less need to take the incremental risk.”

Leverage is primarily used to invest more in market-neutral, low-beta hedge fund strategies. However, Greene says he doesn’t directly map where the leverage is applied – rather it is an extra 5 per cent to invest across the fund wherever the opportunities arise.

The funded ratio and higher yields are also driving other strategies. For example, he is trimming the public equity allocation to 20 per cent of AUM and in its place, Greene will bump up the allocation to private equity and put more assets to work in public credit, including investment grade, multi asset, high yield and bank loans, where he says it’s possible to tap equity like returns without the volatility.

Growing the allocation is timed around opportunities, he continues. “We are moving into credit, but credit spreads remain tight. When the spreads start to widen, we will increase the high yield allocation, but we will pull it back as the spreads come back in.”

Elsewhere he has lengthened the duration on some of the bond portfolio (from mid to long-term) in response to higher yields. “You can get a 4.5 per cent return sitting on nominal bonds and we like the liquidity too,” he says.

The strategy is a marked change in direction from an earlier decision to reduce the long bonds allocation to zero. As it was, the allocation never got to zero, was only reduced by 5 per cent, and is now being built back up again as interest rates climb higher.

For all his focus on building internal expertise and reducing input from consultants Greene only applies the approach when it fits and doesn’t envisage TTCPP running a large pool of direct investments. Direct allocations comprise a small portion of private equity, a quarter of the private credit portfolio (although he notes the bulk of this comprises one large deal) and some co-investment in infrastructure. In the real estate allocation, where TTCPP invests around 80 per cent of the portfolio directly in Canadian assets, he wants to turn the portfolio on its head.

He plans to transform the real estate allocation into fund of funds or SMA structures and select co-investments with GPs in an 80:20 split respectively. A complete reversal from the current approach where co-investment make up the bulk, and funds the minority. “We have two people working in private markets covering four asset classes and we simply don’t have the capacity to approve every new tenant or budget item. With a small team there are only so many line items we can keep track of.”

But it is a challenge restructuring real estate in the current environment when industrials are white hot, but office is struggling. “We are very hesitant to sell office assets right now. Nobody will buy them unless we sell for a deep discount which we do not think is prudent.”

It speaks of a pragmatic strategy and overarching priority to keep things simple. Greene refuses to chase new asset classes and strategy – he was cynical of Bitcoin from the get-go and TTCPP only has a tiny exposure to crypto though a sleeve in one of the macro managers. The fund has no plans to run other assets or amalgamate with others like the tie up between College of Family Physicians of Canada (CFPC) pension plan and the College of Applied Arts and Technology (CAAT) Pension Plan.

“We are just focused on getting our own ship in order,” Greene concludes.

 

Border to Coast, the UK’s LGPS pool for 11 partner funds, is planning to launch a new UK opportunities strategy that will invest in private markets opportunities in-country, including venture and growth. The allocation will sit in Border to Coast’s existing £12 billion private markets allocation that includes £4.3 billion in infrastructure and £3 billion in private equity.

The multi-asset UK strategy will target areas such as corporate financing, housing, property, infrastructure, renewables, and social bonds. The nature of underlying investments will also result in a range of positive impacts, including jobs created, new housing units delivered (residential, affordable, social, assisted), new commercial floor space, delivery of local infrastructure, renewable energy capacity and the provision of training including apprenticeships.

Subject to ongoing engagement with its partner funds the UK opportunities strategy will launch in April 2024.

“I am particularly pleased with the team’s work with partner funds on our innovative ‘UK opportunities’ strategy, which will facilitate investment leading to the generation of a range of positive local impacts, such as new jobs, infrastructure, and economic growth across the regions of the UK, while providing returns to fund pension obligations,” said chief executive Rachel Elwell, who has overseen the build out of the organisation to 130 employees and £47 billion of pooled assets (of the £60 billion in total funds between the underlying partners) since it was set up five years ago.

The move comes as the British government puts pressure on pension funds to invest more at home to support economic growth. Today, UK pension funds invest almost £1 trillion in the UK through a mixture of UK shares, corporate bonds, government debt, and other asset classes.

Investing more in the UK for growing LGPS and DC funds like NEST may make sense, but for many DB funds it’s not that simple. Many are still reeling from last year’s gilt crisis when the market froze over, and it was impossible to trade. The unprecedented volatility in gilts has seen these funds build new risk models into their portfolios that incorporate much bigger moves in gilts prices. This in turn has implications for how much they are prepared to invest in illiquid assets, running counter to the government push.

In a recent paper, industry body PLSA identified 10 ways to encourage UK pension funds to invest more at home. ‘Pensions & Growth: A Paper by the PLSA on Supporting Pension Investment in UK Growth’ suggests fiscal incentives, policy certainties and increased automatic enrolment contribution levels would help.

Border to Coast is midway through designing two global and two UK real estate propositions. They will lead to further increases in the level of assets under management and are expected to launch later this year. Other new strategies on the horizon include the development of a second climate opportunities portfolio. The investor currently has £1.4 billion invested in climate opportunities.

efficiency gains of Pooling

Border to Coast has pooled 83 per cent of assets owned by its 11 LGPS partner funds, with pooling on target to deliver savings of £340 million by 2030. Meanwhile, research by asset management data company ClearGlass Analytics into value for money, ranked Border to Coast number one in its efficiency scheme index of over 1,000 pension schemes.  The analysis showed its leading position is due to its scale, governance and its blend of internal and external management.

About a third of assets are managed internally, a third externally and a third in a hybrid model for private markets where Border to Coast is selecting funds but acting as a fund of funds managers.

“Five years into our journey, we are exceeding the original ambitions for pooling,” said Chris Hitchen, chair of Border to Coast. “With 83 per cent of our partner funds’ assets pooled we have been able to deliver over £65 million of savings net of set up costs with more to come.  But perhaps more importantly, we have built a sustainable centre of expertise in Leeds delivering innovative and effective investment solutions for our partner funds.”