A key concern on the horizon for Timo Löyttyniemi, CEO at VER, the €21.6 State Pension Fund of Finland is the impact of higher interest rates on private assets. Investors still haven’t seen the impact of higher borrowing costs on leverage in their illiquid allocations, and he believes a reckoning could be in the pipeline.

In the coming months, it will become apparent how private asset fund managers have handled the impact like the extent they’ve hedged interest rate risk, re-financed, and successfully reduced total leverage levels.

Although he’s confident VER’s managers overseeing allocations including private equity, credit and real estate have prudently managed higher borrowing costs, he says history acts as a warning to investors that things often don’t go to plan.

“There could be negative surprises in some of the fund industry structures. I am eager to see how the impact of interest rate shocks will be passed through to these products.”

Higher interest rates have already exposed weaknesses in individual banks like the tech sector’s favourite lender Silicon Valley Bank. “SVB management had taken excessive risks, while the authorities had allowed reporting that did not require full disclosure,” he says.

As (at the time of writing) Californian lender First Republic scrambles to survive, he says investors “are trying to figure out the next victim,” although he notes the crisis is bank specific, rather than a banking crisis.

VER’s allocation to private assets was recently increased by 3 per cent to include the overweight in the portfolio due to falls in public assets. Just under a quarter of total AUM is invested in illiquid investments spanning private credit (3.3 per cent) private equity (7.4 per cent) infrastructure funds (4.1 per cent) unlisted real estate (4.3 per cent) and hedge funds (4.4 per cent) From now on any increase in the allocation will depend on performance and overall returns.

VER’s allocation to illiquid assets is less than local peers partly because of the fund’s liquidity needs. “We are already paying out more to government for employees’ pensions than we are getting in payments and over the next ten years we expect our negative net outflows to increase and continue. We shall assess the impact to asset allocation, and we won’t continually increase our allocation to illiquidity, there will be a maximum.”

Listed equity

VER’s direct, active allocation to Nordic equities accounts for around a quarter of the 40 per cent allocation to public equity portfolio. The rest of the allocation to public equity is invested globally where VER eschews mandates, with around 75 per cent in index driven funds and ETFs with service providers like BlackRock and StateStreet.

Löyttyniemi counts 59 current investments in funds, including ETFs in the portfolio and says the approach is rooted in VER’s long culture of using mutual funds and ETFs to ensure diversity, flexibility, and low costs.

“Not using mandates works well for us because we can change products if we need, ensuring diversification between products and service providers. We can really execute on the elements we want.”

He adds that the Nordic tilt helps offset the ever-growing allocation to US equity in the world’s equity index. Currently around 60 per cent, it is increasingly on European investors radar. “Even the Norwegian State Pension Fund has set the US weighting at just around 45 per cent,” he says.

Löyttyniemi has a neutral outlook for markets given geopolitical and economic uncertainty and unknowns around central bank policy. The allocation to public equity was pared back by around 5 per cent in August 2021 in a new SAA to allocate less to equities for the first time in the fund’s history. The passive allocation is currently divided between North America (27 per cent,) Europe (21 per cent,) merging markets (22 per cent,) Japan (5 per cent.)

The fixed income allocation follows benchmarks in terms of tracking error, but the portfolio is actively managed (over half by an internal team) and tilts to particular government bonds and money market instruments, credit and emerging markets. Does he see the impact of the war on Nordic sovereigns? “Now Finland is part of NATO, we don’t see this as an issue.”

But he does see geopolitics increasingly impacting corporates. Namely in their supply chains, and increasingly in investor flows. “These flows have an impact in terms of pricing and returns,” he says. “The free flow of capital and globalisation has limits, and in the coming years we’ll see the magnitude of that change in how corporations have acted.”

He notices that more investors are excluding China, and that some are starting to exclude emerging markets from their allocations too.

“We will be held to account on whether we have made good decisions in terms of evaluating what lies ahead. At this stage it is prudent to flag that geopolitics will have an impact in the future, where it lands remains to be seen.”

 

 

A new policy environment is spurring a sense of optimism at Fonds de reserve pour les retraites (FRR), France’s pension reserve fund.

Executive director Olivier Rousseau, a long-time critic of grindingly low bond yields which he has called a “tragedy” for pension funds, particularly those forced to hold them due to regulatory conditions like FRR, can’t hide his enthusiasm for today’s environment of higher interest rates and fiscal tightening after a decade of financial repression.

For years, bereft of any returns, government bonds had become a volatility reduction tool or insurance in a risk-off climate, forcing investors to hunt for yields with lower quality fixed income. Elsewhere, it led to strategies that have now been exposed as risky, particularly hedging liabilities via LDI. Late last year many UK pension funds, prevalent users of the strategy, had to sell assets to raise cash to maintain the level of leverage needed to ensure they could hedge their liabilities when yields jumped sharply higher.

“LDI was protecting portfolios from the consequences of a further decline in interest rates when interest rates were already absurdly low and needed to go back into normal territory,” says Rousseau, who oversees a portfolio split roughly 70:30 to performance assets versus investment-grade bonds including French government bonds and other euro- and dollar-denominated bonds, plus unlisted assets.

Elsewhere he flags another risk area revealed by rising rates: “zombie” companies that have borrowed too much and will start to feel the shock of higher borrowing costs.

The long-awaited policy reset (after many false starts) means monetary policy is returning to normal. Interest rates are edging higher and fiscal policy has tightened, preventing governments indulging in binge borrowing because it now costs money to borrow.

The policy reset means that equities and bonds are an important source of diversification once again. “The arbitrage between interest rates and equities is back. We are in a normalised environment in terms of the policy mix,” he continues – although he cautions that a traditional 60:40 portfolio is still vulnerable to inflation.

If inflation surprises on the upside, investors will lose money on both equities (at least in the short term) and bonds.

“60:40 is a portfolio for a stable inflation regime or a modestly deflationary regime,” Rousseau says.

The new policy environment is feeding into strategy tweaks. For example, come the supervisory board’s asset allocation review in June, Rousseau notes a case for somewhat reducing FRR’s equity allocation in favour of high yield bonds, an allocation he calls something of a sweet spot.

High yields bonds are not overly vulnerable to inflation, and give a decent pick up over sovereign bonds, comparing favourably to investment grade credit. “The spread of high yield over investment grade more than pays for expected credit losses,” he says. Moreover, the lower duration of these assets also gives protection if inflation surprises on the upside.

Cashing in

Like many investors, FRR’s 13 per cent allocation to illiquid investments has provided some of the best returns in recent years. The portfolio has a French bias and includes investment in small-and mid-cap companies and French real estate. Built up slowly since 2013, and mindful of FRR’s liquidity constraints, Rousseau says last year the portfolio truly came right.

Recently FRR’s GPs have started to sell some individual stakes in the €1 billion private equity portfolio at significantly higher prices than where they had been valued, suggesting they had marked valuations at reasonable levels.

“It wasn’t a question of barking up the valuations and praying for validation,” he says, attributing success to good cooperation between the investment teams, management, and the governance. Will private equity continue its run? He says a small reversal this year is possible however if it happens, it will be limited.

Elsewhere the infrastructure portfolio has garnered stellar returns, also buoyed by a few sales. FRR’s small allocation to real estate (around €200 million) has also provided a steady return and the unlisted debt portfolio (€1 billion) returned a positive result. “This is good when you compare this to listed bonds which fell by 13 per cent,” he says.

“It would have been even better if we had succeeded in convincing the governance that there was also a strong case for select hedge fund strategies and insurance-linked strategies,” he reflects.

De-coupling

The policy reset may be fanning an easier investment environment, but Rousseau is mindful of key risks of which geopolitics, manifest in the increasingly fractious relationship between China and the west and ongoing war in Europe, is one of the most perilous. Mostly because of the challenge of finding protection and shelter for the portfolio if geopolitical tension snaps higher.

“Our portfolio has been constructed on the basis that all hell doesn’t break lose,” Rousseau says.

“Except, to some extent, holding US Treasuries and of course tail risk protections which are very expensive, there isn’t much you can do to protect equities and bonds if the Hormuz Strait is on fire,” he says, referencing one of the world’s most important trade routes. Adding, “geopolitics does not matter, except when it does. And today it’s not just neutral – not just noise.”

Positively, it is leading to investable trends (witness Apple’s boosted manufacturing operations in India, for example) that he says will bring increasing opportunities.

“Tapping into deglobalisation trends has very good days ahead of it,” Rousseau says.

And deglobalisation doesn’t mean that everything will be re-shored, he adds. Rather it means companies will build supply chains in countries they deem reliable and friendly.

Because FRR delegates to managers, the investor has no bearing on the day-to-day translation of these concerns on portfolio composition.

“I hope most of our managers are reducing their vulnerability to de-globalisation trends and adapting their portfolios to more recognised supply chains,” Rousseau says.

By law, all FRR’s allocations are managed externally either via mandates (around 80 per cent) or a subscription into collective open, or closed end funds.

Decarbonization

Rousseau’s other enduring concern is the lack of policy action around climate change.

“Governments must stop procrastinating. Policy action is coming, but it is coming too slowly,” Rousseau says, calling for regulation and carbon pricing that means it costs money for investors to hold polluting assets.

Rousseau says he is most encouraged by European disclosure regulation that will require European companies publish their climate exposure at a comparable level to financial disclosure.

“I hope there will be more similar initiatives in the rest of the world,” he says.

“This disclosure will reveal the big losers when the price of carbon finally goes up for real.”

Bad ESG premium

So far, 40 per cent of the equity and bonds allocation has been decarbonised and FRR puts additional demands on its managers every time it renews its mandates.

“It will keep coming down,” Rousseau says. However, like many other investors, he is concerned that divestment (without regulation) is leading to less responsible investors profiting from holding polluting assets.

Responsible investors, he says, are selling polluting assets only for them to be snapped up by other investors (hedge funds, family offices, some private equity, for example) not subject to the same regulation or stakeholder pressure.

This cohort of buyers only see carbon assets through a risk lens – and in the current environment “could have a nice run ahead” in what amounts to, in factor-speak, “a bad ESG premium”.

Only disclosure will reveal the true risk of holding these dirty assets, Rousseau continues.

“As long as carbon pricing remains too low, these investors can continue to hold these assets,” he says.

“What they are doing is mostly rational.

“Disclosure to the susceptibility of a hike in the carbon price is so important because these investors will react to this element. Everybody will see the risk picture more clearly.”

Since joining the Connecticut Retirement Plans and Trust Funds (CRPTF) as CIO just under two years ago, Ted Wright has developed a new strategic asset allocation that has bumped up the allocation to private assets, particularly private equity (up from a 10 per cent target allocation to 15 per cent) as well as private credit, infrastructure, and natural resources.

“One of the things that really stood out was that we were chronically underweight risk assets and private assets,” Wright says, reflecting on what he’s changed at the $60 billion portfolio since moving there from the Los Angeles County Employees Retirement Association.

“We have a risk budget to spend, and now we are spending it.

Public equity has been pared back a little, to around 38 per cent of total AUM. Wright has also rewritten CRPTF’s investment policy statement, articulating the key priorities of the investment management office in one, holistic document.

In a nod to his first career in the military (a self-confessed late bloomer, he didn’t enter the investment world until his late 20s) Wright hopes his approach brings as much rigour and certainty to uncertain situations as possible.

“The military’s discipline, rigour, and work ethic taught me invaluable life lessons,” he says.

“It wasn’t a stretch to go from the military to investment.”

Risk mitigation

In another change, CRPTF’s fixed income portfolio now includes an allocation to risk mitigating strategies that comprises investments that focus on volatility, changes in volatility and different parts of the volatility curve as well as other flight-to-quality strategies to provide downside protection. The allocation – still being built out – is designed to provide stability and to have a negative correlation to markets during equity downturns.

“We want to generate outsize returns when equity markets drawdown, but also design the portfolio in such a way that we can be reactive and proactive depending on market conditions,” says Wright.

“Our risk mitigation portfolio is more complex, but the purpose is to have something that punches above its weight class and doesn’t cost us lots of money while we wait for challenging periods. It is a question of us putting money to work in assets that have greater potential for the upside while reducing the downside during turbulent market periods.”

Manager shakeup

The new strategic asset allocation has led to a shakeup in CRPTF’s 156 (as of June 2022) manager relationships. For example, five to seven managers have gone from the public markets allocation as Wright seeks to consolidate exposures and not double-up.

“It may be difficult to outperform in US public equities ahead,” he says.

“Having six managers carry out one strategy may not be the most efficient use of capital.

“We don’t want to take on more manager risk than we need to, and we don’t want to add managers or have managers in the portfolio just for the sake of having another exposure that is identical to something we already have.”

The decision on which managers to axe was made by looking at tracking errors and managers’ ability to generate returns above the benchmark. Elsewhere, he says investment staff assessed mandates based on the extent returns would increase if CRPTF paid less in fees. Bywords shaping the shakeup were simple, intentional and deliberate, balanced by the need to maintain manager diversity.

Wright has also brought an urgency to the process. Approved last year, most of the do-able shift and downsizing in public markets was completed by the end of 2022.

“I’ve seen situations where a fund completes an SAA and three years later, they still haven’t reached their targets and then they are about to begin another SAA,” he says.

“To be effective, you need to be deliberate with some measure of haste.”

That said, new allocations to private markets are more difficult because they involve pacing up over time. Here Wright is focusing on re-ups in private equity as opposed to looking for new relationships. Bigger allocations to infrastructure and natural resources are nearly wrapped up.

“In private markets, if it’s not a relationship we want to maintain, we don’t re-up and just let the allocation roll off the books,” he says.

“We have a good stable of private equity relationships and hence we are more likely to re-up than add new relationships.”

Diversity

Connecticut runs an emerging and diverse manager program under which it targets placing 5- 10 per cent of total CRPFT assets across public and private markets with diverse managers. Under its so-called Connecticut Inclusive Investment Initiative (Ci3) the investor works with emerging and diverse managers according to a structured, tiered framework which allows promising managers to transition to full sized, direct allocations.

But Wright, one of the few black CIOs heading up a public pension fund, reflects on the enduring challenges in this corner of the portfolio: the idea that investors that allocate to diverse managers sacrifice returns – and the availability of quality, diverse managers.

“Public pension funds’ North Star is a fiduciary duty to pay the promised benefits. My take is, we don’t want diversity for the sake of diversity and investors shouldn’t sacrifice quality in the hunt for diversity. We should have more gender and racial diversity, yes, but this does not mean we have to sacrifice quality.”

“Diversity will only improve if we allocate to the women, black or Hispanic-led investment firms that are as good as the other firms we invest in.”

He concludes that the number of diverse portfolio managers setting up shop on their own is an encouraging sign of more high quality firms emerging.  “Diverse portfolio managers are starting their own firms and new managers are bubbling up. It is getting easier, and it will continue to get easier to find those high-quality firms,” he says.

The United Nations Joint Staff Pension Fund, UNJSPF, is clawing back 2022 losses with assets under management currently valued at $82 billion and the fund experiencing a positive return of 5 per cent so far this year.

Robust returns between 2019 and 2021 had swelled the UNJSPF portfolio by 30 per cent to a record high in its 75-year history to over $91.5 billion by the end of 2021. Come 2022, and the ravages of high inflation and ensuing high interest rates impacting the long-term value of bonds and equity, and assets under management had fallen 14 per cent by the end of the year, said Pedro Guazo, representative of the Secretary-General for the investments of the assets of the fund, speaking in a recent UNJSPF Global Town Hall.

Guazo predicted the fund would be back up to $90 billion assets under management in the next two to three years. UNJSPF targets a long- term return of 3.5 per cent and has a 20-year return of 5.35 per cent. Despite the plunge in AUM last year, Guazo said UNJSPF had retained its fully funded status.

“The market value of the assets is way higher than the liabilities,” he said.

Low costs and efficiency compared to peer funds are an important contributor to the portfolio’s health.

“We manage to get the same returns with costs 30 per cent lower than comparable peers,” Guazo said, attributing low costs to the fact around 82 per cent of the portfolio is managed internally.

Around 50 per cent of the portfolio is invested in public equity versus 30 per cent in fixed income. The bulk of the public market portfolios are managed internally apart from an externally managed small cap equity portfolio and a new allocation to corporate bonds.

The global equity allocation is divided into four teams – North America, Europe, Asia Pacific, and Global Emerging Markets – that follow a disciplined investment process, centred on equity screening, fundamental analysis, and frequent dialogue with corporate management teams. The focus is on high-quality companies able to generate stable cash flows, a return on investment above their cost of capital, and the ability to achieve sustainable and profitable growth.

In a recent change of strategy, UNJSPF introduced a new benchmark for fixed income that incorporates a corporate bond component, broadening the pension fund’s asset mix. UNJSPF uses external managers in the allocation as it continues to develop and strengthen in-house capabilities. Over time it expects that the internal fixed income team will progressively assume a larger management of the portfolio as resources and capabilities are added.

 Private markets

Externally managed private market allocations comprise private equity, real estate, and real assets. Strategy in real estate – the portfolio dates from 1971 – is focused on manager selection. UNJSPF invests in over 128 externally managed funds globally.

The allocation target is approximately 50 per cent core “open ended” funds and 50 per cent non-core “closed end” funds. Core funds are diversified by geography and property type, and non-core funds are diversified by vintage year, geography, property type and risk profile.

Real assets, primarily infrastructure but also timber, agriculture, and commodities, are also managed externally.

Infrastructure investment, first begun in 2011, is focused on moderate leverage, strong cash flow yield and a demonstrated track record of profitable realizations.

Private equity, launched in 2010, consists of a select number of externally managed funds and co-investments diversified by vintage year, private equity substrategy, sector and geography.

Democratic erosion, protectionism, inter-country rivalry and economic decoupling will have implications for economic growth and financial returns ahead, warns a recent White Paper from Norway’s Ministry of Finance, guardian of the giant $1.3 trillion Government Pension Fund Global (GPFG).

Both financial and non-financial risk will increase as the economic centre of gravity increasingly shifts towards emerging markets, a trend that is likely to make management of the GPFG by asset manager Norges Bank Investment Management (NBIM) more demanding, warns the paper.

The warning is based on a review, overseen by director of the Norwegian Institute of International Affairs Ulf Sverdrup, who was appointed to assess how international political and economic developments may affect the GPFG.

ESG fallout

Although the report doesn’t suggest making changes to GPFG’s investment strategy it flags implications ahead, particularly around ESG. The paper authors warn that responsible investment may become more demanding in the years to come and flags against creating ESG expectations that will be impossible to deliver.

NBIM invests on the basis that favourable, long-term returns depend on sustainable development in economic, environmental, and social terms, in addition to well-functioning, legitimate and efficient markets. Strategy at the fund excludes individual products (tobacco, cannabis, coal, and certain types of weapons, for example) as well as conduct-based exclusions that encompass systematic human rights violations and severe environmental damage.

Because the fund is invested in several thousand companies, including in countries and regions with different norms and values “it is neither feasible, nor appropriate, to organise the investment management in such a way that the fund can never be exposed to unwanted situations”, the report says.

Still, it warns that the scope for responsible investment may be weakened if an increasing share of financial markets are in states with less democracy, transparency, and freedom of the press. “Expectations, ambitions, and requirements need to be considered from the perspective of such a setting,” it states.

Pushing values

Although responsible investment is important for the legitimacy and reputation of the fund in Norway, it could weaken its reputation abroad, the white paper continues. “Responsible investment activities may be perceived as an attempt at imposing Norwegian values and interests on companies and states,” the report says.

The paper says an increased awareness that the fund may be perceived differently abroad than in Norway is important, calling for “a realistic level of ambition for the ethical framework”.

The authors write that the giant fund must not be used as a foreign policy tool, arguing that caution needs to be exercised to avert any impression that it is. “Other foreign policy channels are more suitable for promoting Norwegian political interests abroad,” they say.

Using GPFG assets as a policy tool would complicate both the foreign policy and the management of the fund, with a high probability of weakening both areas. At the same time, the paper notes that foreign policy decisions may affect the fund, and that decisions in the management of the GPFG may have foreign policy implications even if such decisions are financially motivated.

Oil price

Although GPFG recently reported a return of -14.1 percent, revenues from petroleum activities and the depreciation of the Norwegian krone contributed to an overall increase of NOK 89 billion ($8.6 billion) in the fund’s value last year. However, this is a benefit that is unlikely to continue. “In the years ahead, we must be prepared for the fund value to not increase at the same rate as has been registered so far, and for a potential decline in fund value,” the report says.

The report said that over time, the GPFG has become an ever more important source of funding for government spending. In recent years, around 20 percent of the fiscal budget has been funded by the GPFG, and the share was even higher in 2020 and 2021 due to extraordinary measures during the coronavirus pandemic.

GPFG invests around 70 per cent of its assets in equity, and is able to withstand more risk than an investor with ongoing payment obligations and consequently a shorter investment horizon. The fund can weather stock market downturns without having to divest at an unfavourable time.

Partnering for Impact: Institutional Investors and the Net-Zero Transition

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