MN, the €175 billion ($190 billion) Dutch fiduciary manager for pension funds and insurers including the large metal schemes PME and PMT, as well as the pension fund for the Netherland’s merchant navy, is preparing to invest in private corporate debt.

The fixed income portfolio currently accounts for around 60-70 per cent of MN’s total assets under management. It already comprises allocations to sovereign debt (the lion’s share since client funds’ matching portfolios are typically bigger than their return seeking allocations) Dutch mortgages, high yield bonds, bank loans, infrastructure credit and emerging market debt and will shortly include a new mandate to corporate debt, explains Markus Schaen, a senior manager at MN in the fixed income team.

MN’s pension fund clients’ demand for the new allocation – which will comprise three or four new managers over time – derives from a combination of factors and has been two to three years in the making. On one hand, it is a natural extension of a Dutch focused, pre-existing allocation to private corporate debt. This allocation dates from the GFC when Dutch companies were hunting for finance, recalls Schaen.

On the other it is born out of a deliberate ambition to have more diversification in fixed income as their allocation to the asset class has grown.

“Our clients have got more comfortable with illiquid investment,” he says. “They started with infrastructure debt which has also allowed them to incorporate impact into their investments. In the private corporate debt strategy, they want access to companies that they can’t easily find in the public bond portfolio; are too small to come out with a bond or do not have an official rating. They also want to help companies that are struggling to access finance because banks are concentrating on bigger corporates and want to invest structurally in the local economy.”

Alongside the illiquidity premium and impact potential, Schaen traces demand for the allocation to the fact it has a low correlation with other markets and comes with lower transaction costs because it involves long-term, 10 to 15-year investments.

The new allocation will comprise investment grade corporate debt via private placements and bank co-financing and high yield debt via senior loans. Client funds aren’t particularly looking for direct lending exposure, despite the higher returns.

“Our clients have set moderate risk/return targets for private corporate debt and want to have very low probabilities of defaults in their portfolios.”

He is mindful of a few key challenges ahead.

Sourcing is an important factor to watch and means it may take time to build up the allocation. More so in today’s competitive environment which is impacting the spreads available for investors, creating tighter pricing and seeing covenants and documentation spring up.

“It’s something we’ve noticed particularly in renewables,” he explains. “It’s getting to a point where the return is not a good reflection of the risk, and investors are not being adequately compensated.”

He is also aware that changing the composition of the allocation down the line will be difficult – yet MN’s clients’ appetite for ESG exclusions that will force a change in portfolio composition seems to be rising.

“Various sectors are now getting excluded. For example, one of our clients has sold off all their fossil fuel investments,” he says, referencing PME’s 2021 decision to divest all fossil fuels. “Compared to liquid strategies, it will take more time and it is more costly to sell off a sector in an illiquid asset class.”

portfolio impacts of esg

He also points out that ESG exclusions will make the portfolio more concentrated, with a lower number of positions thereby increasing risk.

It leads him to reflect on how ESG is becoming increasingly important across the fixed income allocation. For example, MN recently incorporated MSCI ESG ratings into its custom benchmarks for several strategies so that companies with lower ratings than its threshold won’t make the benchmark. And he notices some investors are poised to go one step further.

In the past, ESG integration was primarily focused on exclusion of sectors and companies, and engagement. Today, he believes the market is evolving whereby more investors only want to invest in “the best” companies. He believes this cohort are increasingly looking at how to build portfolios from ground zero, adding the most sustainable and transition-proof companies one at a time as opposed to starting with an index and benchmark, and knocking out polluters via an exclusion policy.

“More investors are starting to think about hand picking the companies they want to invest in.”

This approach may bring hands-on control for the Netherlands’ ESG-conscious pension funds, but he reminds it also comes with the risks inherent with investing in a small universe and that with every exclusion the remaining eligible positions in the benchmark will get bigger.

In another observation he notes that client funds’ focus on ESG often results in a disconnect with external managers. Another part of his role includes monitoring European and US external managers (he works with around 30 external fixed income managers on behalf of  client funds) who he says sometimes fail to grasp that for some pension funds, ESG integration and impact is more important than out-performance.

“Of course, client funds are looking for decent returns, but sometimes this is not the most important thing, especially if they have ESG considerations. A growing number of funds are comfortable with passive, benchmark-like returns if it is accompanied with ESG integration.”

They don’t want any negative headlines around their investments, and they want transparency around how their asset managers are paid, he continues. “We sometimes see a disconnect between traditional asset managers who continue to strive for financial return only, yet this isn’t what many client funds actually want.”

Schaen, who typically meets with external managers twice a year, concludes with a nod to his pet manager peeve that can also create a disconnet: personnel changes in the management team without any warning.

“It still surprises me. Some organizations are straightforward and inform us if there is a change in personnel, but others don’t mention it and we find out ourselves. We understand people move on, but not telling us is worse.” As well as being put on watch, these managers can also expect key questions to follow around how they will ensure the rest of their team don’t leave, and inquiries into their culture and team.

Does he think succession planning is a problem in the asset management industry? “I would say only a few of our managers are very good at succession planning,” he concludes.

 

Faced with Thames Water’s financial difficulties, and the potentially very negative consequences for investors with shares in the holding company controlling this business, many stakeholders seemed surprised by the size of the loss in value recognised at the end of 2022, while transactions carried out in recent years were based on high and even rising valuations.

However, careful consideration of trends in both Thames Water’s cost of capital and volatility, calculated using an appropriate risk model, would have made it possible to anticipate the operator’s financial difficulties.

Indeed, Thames Water’s volatility and value-at-risk have always been high in relation to various infraMetrics benchmarks, including its closest peers, namely other regulated utilities companies. However, the risks have doubled over the past 10 years, as shown in Table 1. Meanwhile, logically, this risk was reflected in the value of the cost of capital and therefore in the discount rate of future cash flows. As a result, its true fair market value has fallen sharply over the past 10 years.

Thus, over the period 2013-2017, under Macquarie’s ownership, the price-to-sales ratio of Thames Water dropped by 58 per cent and EV/EBITDA went down by over 25 per cent, while all the other benchmarks improved in value. In other words, the loss that was booked in December 2022 did not happen overnight.

Clearly, the failure to recognise this loss in value in investors’ financial statements at the right time raises the question of how to value this type of asset, and in particular the methodologies used to calculate the fair market value which, in the case of infrastructure, are based on discount rates that take no account of the reality of the risk factors to which the investments are exposed, nor of the market dynamics of the premiums associated with these risks.

 

Table 1: Risk & Valuation Metrics for Thames Water Utilities, UK Water, Global Utilities and the infra300® market index

Date Segment Volatility* Value-at-Risk** Median Price/Sales Median EV/EBITDA
2013 Thames Water 18.9% -33.1% 3.73 10.30
Global Regulated Utilities 13.4% -11.3% 2.22 8.92
infra300 8.3% -1.2% 2.19 9.69
2017 Thames Water 38.6% -68.1% 1.77 8.13
Global Regulated Utilities 13.8% -11.1% 2.44 12.33
infra300 8.8% -3.0% 2.62 11.83
2020 Thames Water 38.0% -63.0% 1.94 8.45
Global Regulated Utilities 13.0% -8.5% 2.42 11.69
infra300 8.6% -1.7% 2.79 12.00
Q1 2023 Thames Water 37.9% -64.5% 1.54 7.69
Global Regulated Utilities 12.9% -12.7% 2.06 12.81
infra300 10.4% -7.0% 2.93 11.66
Source: infraMetrics.
*Standard deviation of monthly returns over a historical 10-year period.
**Gaussian value-at-risk at 97.5% confidence interval.

An anomaly or a poorly measured systematic risk?

Today, the Thames Water event is often presented as a special case. Indeed, a financial structure favouring debt, a dividend policy inconsistent with the economic performance of the business and furthermore constrained by the securitisation of the dividends, and the regulator’s decision to no longer take account of the project’s real cost of capital when setting tariffs, all played a particular role in the risk of this investment.

However, it would be regrettable to limit the risk of investing in unlisted infrastructure to purely idiosyncratic considerations. Thames Water is not an isolated case. Table 2 provides some significant examples of the materialisation of extreme financial risks in the infrastructure investment class. Lessons for the whole unlisted infrastructure asset class should be drawn from the Thames Water event.

 

Table 2: Impairments, Defaults and Related Volatility of Infrastructure Projects

Company Sector Country Event Detail Value Before the Event (USD) Price After the Event (USD) Drop in Price Volatility Before the Event
Company Segment infra300
Bluewaters Power Station Coal-fired power Australia Default
in 2012		 87,929,231 63,280,539 -28% 21.2% 10.9% 10.3%
Line 9 Metro Arganda Urban mass transit Spain Impairment
in 2020		 51,568,739 33,186,324 -36% 21.8% 13.1% 8.9%
A-70 Circunvalacion de Alicante Motorway Spain Default
in 2012		 25,195,207 – -100% 21.6% 9.9% 6.6%
Nottingham Express Transit Urban light rail UK Default
in 2018		 474,227,049 340,903,055 -28% 27.4% 11.2% 8.3%
Robin Hood Airport Doncaster Sheffield Airport UK Impairment
in 2013		 182,580,630 53,902,406 -70% 21.5% 13.8% 10.3%
Source: infraMetrics.
The segments used to qualify the business risk are those determined in the TICCS framework and representative of the sector and operational risk of the infrastructure investment in question.
Volatility is calculated over periods of 2 years prior to the occurrence of the event affecting the infrastructure investment under consideration.

In particular, managers and investors need to stop thinking that the volatility of this asset class can be measured with a global appraisal-based index calculated from very backward-looking and de facto smoothed valuation data. An annualised volatility of 3-4 per cent and a Sharpe Ratio of more than 3 tell you nothing about the risks in infrastructure investment. Furthermore, as can be seen in Table 1, not only is the volatility of unlisted infrastructure, as represented by the infra300 index, reasonably higher in general, but it can also vary significantly depending on the business segment (in this case, regulated utilities for Thames Water).

This link between observed volatility and default risk is not unique to Thames Water. Table 2 shows that, before they suffered a major impairment or even default, the investment projects under consideration experienced high volatility calculated on the basis of fair market value. This volatility, as with all other asset classes, was predictive of the risk of loss in value. As such, it is much higher than not only the volatility of global equity infrastructure represented by the infra300 index, but also that of the TICCS segment representing the sector and business risk to which each of the projects in question was exposed.

This reality of the risks involved in investing in unlisted infrastructure must be taken into account both when allocating to this asset class and when assessing a specific project.

Measuring risks for what they are represents the first and indispensable step towards good risk management. Moreover, this transparency lends credibility to an asset class with attractive financial characteristics, whether it be comparing its risk-adjusted performance with that of other private or public asset classes, or considering its diversification and, of course, liability management capabilities.

At a time when all stakeholders, including regulators, agree on the importance of increasing the proportion of private assets in pension fund allocations, transparency on the risks of these investments is essential.

Noël Amenc is Associate Professor at EDHEC Business School (Singapore).

 

The discourse around ESG investing may be “messy” but Mercer’s global chief investment strategist, Rich Nuzum, says media and political scrutiny can help sharpen the focus of pensions and sovereigns on their objectives and duties. The comments come amid a debate about the merits of decarbonising portfolios ahead of the COP28 climate change summit in Dubai. 

The increasingly “messy” and “impolite” discourse around environmental, social and governance investing, especially in the US, may have unlikely benefits for fiduciaries, says Mercer’s global chief investment strategist, Rich Nuzum. 

Institutional investors who adopt an ESG objective or overlay have been targeted by high-profile US policymakers, including Florida Governor and Republican presidential candidate Ron De Santis, who has lashed the investing style as reflecting an “ideological agenda” and “left-wing values”. The topic has become a mainstay of conservative critics on cable news and social media platforms, while some state legislatures have sought to restrict or even ban activity by ESG-focused asset managers. The discourse has frustrated industry leaders and governance experts, who argue the politicisation of investment decision-making presents a “systemic risk”. (See The politicisation of investments at US public funds)

But while Nuzum admits the conversation has become “less polite and more pointed”, he says it is the latest incarnation of a meaningful debate being held by boards and investment committees for decades.  

“This is a contrarian view … [but] I think it’s a very constructive dialogue,” the New York-based Nuzum tells Top1000funds.com on the sidelines of last month’s Mercer Global Investment Forum in Sydney. “It is forcing fiduciaries to think deeply about what they want to do and why.” 

Nuzum says the scrutiny placed on US-domiciled pensions in particular, which are increasingly subject to a raft of federal and state restrictions on capital allocation and proxy voting processes, sharpens their focus on the extent to which environmental or social impact should form part of their investment objective, if at all. 

“You can make investments to have an impact … and you can do it for values. But let’s be clear as stakeholders – as the investment committee or board – about what we are doing and why,” he says. “The US dialogue is forcing clarity around that.” 

Beyond ESG 

However, Nuzum, who advises more than a dozen of the world’s largest asset owners, says the term ‘ESG’ can be unhelpful, suggesting fiduciaries really ask themselves whether they should be aiming for impact beyond a return on capital to members, and, if so, in which areas.  

For example, he says diversity, equity and inclusion is often a stated focus of US and South African funds, while decarbonisation is a goal for many Europeans. Endowments and funds associated with religious organisations may also have specific ethical overlays, he points out.  

For many other funds, it will not be appropriate to have impact as an explicit objective. In that case, Nuzum says, any investment in, for example, electric vehicle manufacturers or renewable energy providers should be squarely focused on risk and return, and the “sole interest to participant”, where that legal obligation applies. 

Net-zero nitpicking 

Aside from the heated political and media discourse, Nuzum has detected an active debate within the global asset owner community over the benefits, or otherwise, of net-zero goals.  

Many funds around the world have made commitments to reduce carbon emissions by either 2030 or 2050. But in the scramble to decarbonise portfolios other ESG-minded investors have asked whether removing exposures from individual portfolios is really conducive to meaningful climate action setting up a debate between asset owners Nuzum says.  

Making proactive investments in green technologies may not reduce the size of a portfolio’s carbon footprint, but it would assist with the economics of replacing carbon with other forms of energy.  

“Impact oriented investors, [especially] large sophisticated sovereign wealth funds, get really frustrated with the net-zero part of the community, because they say ‘you’re solving your portfolio, not changing the world,” Nuzum says, reflecting sentiments he has heard among his client base and broader network.  

Political pressure 

At the same time, Nuzum says asset owners must resist pressure from governments, which may wish to influence their investment decisions for political reasons.  

He gave examples including UK legislation known as the Mansion House Compact, under which large pensions agreed to increase their allocation to British private equity and start-ups.

But Nuzum says there are both political and investment risks to being pressured into backing such projects.  

“It’s easy in my experience for politicians to target [pension] funds because they’re not very sympathetic. But the moment that voters realise ‘Hey, that’s my money’, it becomes very bad politics.”

Norway’s giant sovereign wealth fund, the Government Pension Fund Global, took out the top spot in this year’s Global Pension Transparency Benchmark. Amanda White talks to CEO of Norges Bank Investment Management, Nicolai Tangen, about why transparency is important and why under his leadership Norges aims to be the best fund in the world.

Transparency has been high on the agenda of Nicolai Tangen since he became chief executive of Norges Bank Investment Management, responsible for the management of the $1.43 trillion Government Pension Fund Global, three years ago.

It’s not just because being transparent is the right thing to do, or that the Norwegian sovereign wealth fund is a ‘fund for the people’ and stakeholder management is crucial. It’s because transparency builds trust and a platform to be more impactful in generating change.

“Knowledge of the fund is linked to the trust that people have in the fund,” Tangen says in an interview with Top1000funds.com about the fund taking top spot in the Global Pension Transparency Benchmark for 2023. “We are really dependent on the trust of the Norwegian people, because this is a democratically-anchored fund it has to do with the trust of the people and the politicians and the whole governance structure here. Norway is a very transparent and democratic society and so we have to reflect that in the way we run the fund.”

But importantly, as an investor, being transparent allows the fund to be more influential when it wants to address change in the portfolio companies it invests in.

“By being more transparent you are more impactful when you try to investigate change,” Tangen says. “We work hard with our portfolio companies to get them to be more transparent, to disclose more on what they do on climate and so on. So we owe to them to be as transparent as we can be.”

A clear emblem of Norges’ transparency leadership can be seen in its approach to proxy voting. The fund’s giant equity portfolio, about 69 per cent of assets, makes it the largest single owner in the world’s stocks, representing about 1 per cent of all listed equities globally. It votes in 12,000 annual general meetings across 63 countries every year. Not only that but five days before each AGM, NBIM reveals how it is going to vote, giving other institutional investors and the companies themselves full transparency on their voting position.

“To have impact and credibility with our voting we have to be transparent in what we think and how we vote, so all this [transparency] goes hand in hand,” Tangen says. “We are the most transparent fund in how we vote, and we announce how we are voting in advance. No other company does that.”

This week the fund will expand that transparency publishing a status report on its voting for the first time. In addition the fund lists every investment holding on its website by name, demonstrating full transparency in its investments.

“Where we are the most transparent in the world is that every single share we have is reported. You can look at everything we do. You can look at every change in our holding, every single company we invest in. That is the most extreme transparency we have,” Tangen says.

The fund has also published “expectations documents” of how companies in its portfolio should address global challenges in their operations including climate, tax-avoidance, child labour and biodiversity.

Top amongst peers

Last year when the Global Pension Transparency Benchmark revealed the individual scores of the 75 underlying pension funds for the first time, Norway’s sovereign wealth fund came in a close second to Canada’s CPP Investments. “Next year we will be number one,” Tweeted Nicolai Tangen, in what would become a promise lived up to.

Fast forward to 2023 and not only has Government Pension Fund Global outranked 74 of its global peers, but it improved its transparency score by 14 points to overtake CPP Investments, last year’s winner. The total score was underpinned by Norges taking out first in transparency of reporting around performance and responsible investment, second spot in cost transparency and 16th of the 75 funds reviewed in governance.

The Global Pension Transparency Benchmark, a collaboration between Top1000funds.com and CEM Benchmarking, is a world first global benchmark measuring the transparency of disclosures of 75 pension funds, and 15 pension systems, across the value generating measures of cost, governance, performance and responsible investments.

“Benchmarking transparency is important initiative, it’s super important, I absolutely love this survey,” Tangen says. “As sovereign wealth funds become more important and a bigger force across the world, it is increasingly important they are transparent. Otherwise people will start to question the whole capitalist model and the secretive powers of these very large pools of capital.”

Tangen says the fund worked quite deliberately to improve transparency and move up the ranks. There is still some room for improvement, especially around governance transparency but the fund’s complicated governance structure – sitting within the central bank and having a mandate from the Minister of Finance – will mean that it will need to engage with broader stakeholders to make changes on that factor.

But Tangen is quick to point out that the fund is not increasing transparency just to win this or any other award. Transparency is something that has been an integral part of the fund’s strategy, and something that he has put particular emphasis on, since he started as CEO in September 2020.

This includes all types of transparency including more openness internally within the organisation and externally to the outside world.

“Now we share everything, for example we share the notes from the leader group meetings across the organisation so everybody in the firm can see what we discussed,” he says. “And we open up to the outside world and have many more people who can talk on behalf of the fund. We have gone from four people three years ago to now 625 people, so everybody can talk about it. It’s a complete change.”

Transparency is a clear indicator of Tangen’s leadership style and he makes no secrets of the fact that Norges has an ambition to be the world’s best fund.

“We want to be the world’s leading fund, full stop. That includes everything from performance, reputation, our people and leading on ESG,” he says. “With ESG that has to do with having clear and intelligent views, being consistent and long term in our views and have our views well anchored in our parliament and so on, so if there is backlash against ESG which we have seen in other parts of the world, we are not going to change our mind and I think that is really important.”

To be the best in the world the leadership team is focused and deliberate in: how it recruits, educates and retains people (it recently hired sports psychologists); how it embraces technology especially the use of AI; its operational robustness and how it weathers volatility; a clear and consistent voice in how it communicates; and performance.

“The way we develop people and create psychological safety and be seen to grow and thrive is important,” Tangen says. “The leadership team has a clear focus to be the best in the world.”

 

MassPRIM credits a crucial element of its investment success to a laser focus on controlling costs. Costs, alongside risk and return, comprise three philosophical pillars that shape investment and in the fiscal year 2024 cost saving measures include no-fee co-investments in private equity and direct investments in real estate.

The $96.6 billion Massachusetts Pension Reserves Investment Management Board (MassPRIM) is budgeting for $520.3 million, equivalent to 52.6 basis points, in costs next year. In a recent administration and audit committee meeting, the board heard how the investor’s slightly higher projected fees and expenses are linked to higher average asset levels and a larger allocation to more complex and costly assets that results in higher costs. Next year’s budget has a modest increase of $2.3 million, or 0.4 per cent from the prior year.

MassPRIM credits a crucial element of its investment success to a laser focus on controlling costs. Costs, alongside risk and return, comprise three philosophical pillars that shape investment of the giant PRIT Fund, the pooled retirement fund for Massachusetts teachers and other state employees.

In a balancing act, the increased allocation to higher performing, higher cost, asset classes has to align with a goal to keep expense ratios consistent year over year. The board heard how the investment team are constantly looking for ways to save money and that the fiscal year 2024 budget reflects many of those cost saving measures, such as no-fee co-investments in private equity and direct investments in real estate.

Still, the investment management fees portion of the budget will increase $1.9 million in line with forecast hikes in private equity, real estate and timber fees, increasing in line with projected increases in commitments and acquisitions in those asset classes.

MassPRIM’s budget comprises three pillars – external investment management fees, third-party service providers and internal operations. Of that, investment management fees account for approximately 90 per cent of the total budget, explained Anthony Falzone, deputy executive director and chief operating officer, presenting the draft operating budget. He said the budget doesn’t include performance fees, incentive fees or carried interest as it is extremely difficult to estimate future performance.

The size of any one asset class does not directly relate to the size of the expense, Falzone continued – private alternatives will have higher fee structures than larger allocations in the public markets. “Historically that has been money well spent, specifically in the case of private equity,” he said.

“No one likes to pay high fees but these alternatives are a critical component of MassPRIM’s asset allocation that historically has allowed the PRIT Fund to exceed that 7 per cent actuarial rate of return.”

The board heard that the budget is not necessarily intuitive in that fees often trend in the same direction as asset levels. If asset levels are up fees will normally increase – and growing assets is a good thing.

The fee budget to third-party service providers is decreasing due to lower budgeted PCS platform provider fees and real estate consulting fees, along with cost savings from internal research as the team build out their own data infrastructure. The board heard that the last section of the budget, operations expenses, has increased mainly due to changes in the compensation section to support new hires.

Falzone mentioned the need to continue to look for ways to add transparency and detail to help communicate where MassPRIM is allocating budget. “Additional transparency helps management perform analytics that can aid in measuring where MassPRIM spends,” he said.

Diverse manager costs set to rise In line with mandates

Elsewhere, the board heard how fees paid to diverse managers will increase as the number of diverse managers in the portfolio grows. MassPRIM deployed more than $2.8 billion to diverse managers in 2022, bringing the total to more than $9 billion in line with its award-winning FUTURE Initiative.

MassPrim launched its FUTURE Initiative to comply with 2021 Investment Equity Legislation, championed by Treasurer Goldberg. The Initiative sets goals for MassPRIM to increase the use of diverse investment managers and vendors to at least 20 per cent of total AUM. Alongside allocating capital to diverse managers, the asset manager has promised to reduce barriers to diverse managers, enhance DEI reporting and develop enhanced contract tracking.

MassPRIM  posted a 6 per cent gain for the fiscal year ending June 30, powered by equities. Fixed income continued to struggle, but private market allocations provided ballast in a “stormy environment”, particularly private debt and timberland. MassPRIM is targeting an increase in the private equity target allocation from 12-18 per cent to 13-19 per cent.

In hedge funds, current strategy includes maintaining the allocation to stable value funds and continuing to identify co-investment opportunities. MassPRIM is expanding its presence in multi-PM platforms and their impact on the hedge fund industry, and is also continuing to explore directional funds and sector, country-specialist funds.

The board heard how market downturns create good buying opportunities, and that the team has been busy evaluating opportunities. It has deployed nearly $6 billion in new investments across all asset classes despite markets remaining in a prolonged, volatile period for now.

As the multitude of macro-economic risks influence market conditions in unpredictable and unprecedented ways, CIOs are facing the most challenging and interesting times in their careers. A group of investors came together in London to share their ideas on how to best assess risk and position their funds for both the challenges and opportunities in this increasingly demanding and puzzling market. 

Better risk and liquidity management alongside regional diversification and a bigger focus on operational excellence are key levers for portfolio resilience according to a group of large asset owners who came together in a London boardroom to share ideas. With geopolitics, liquidity concerns and a “pesky inflationary” environment on their minds, there was no shortage of topics to debate. The group focused on how the global economic pressures are impacting investment opportunities and how to position their portfolios for the best possible outcomes, no matter what the environment. Climate pressures, risk and scenario planning, and liquidity management and flexibility were key areas of sharing.

Chair of Universities Superannuation Scheme (USS) and renowned UK economist Kate Barker said inflation is still a key consideration around the strategy table. Barker, who sat on the Bank of England monetary policy committee from 2001 to 2010, said if participants didn’t remember the importance of better monetary and fiscal coordination, “we are all doomed”.

“Central banks will manage to keep inflation under control but it will be more difficult,” she said, warning that real interest rates are a lot higher than most economists estimate. “One of the things about trying to keep control of inflation is I always ask people: where do you think the neutral real interest rate is?” Barker said. “Economists still think it is zero. I don’t think that can possibly be true. We need to think that the neutral rate for the UK is about 3.5 per cent in real terms. Are we ready for that world? We are now making adjustments for that.”

Railpen head of investment strategy and research John Greaves said the fund had been wrestling with the role of bonds in a portfolio given the macro and market volatility and uncertainty. “We’ve had this pesky inflationary environment that has been difficult for investors and we’ve been looking at how to mitigate that risk in portfolios as well as take advantage of it,” he said.

In terms of portfolio resilience, the group – which also included Barclays Pension Fund chief investment officer Tony Broccardo and Norges Bank Investment Management global head of strategy research Frederik Willumsen – discussed the importance of diversification, hedging unwanted risks, organisational robustness, the sustainability of economic models and technology, liquidity, active management and dynamic asset allocation.

Is diversification still a tool for resilience?

GSAM head of UK fiduciary management Ed Francis began the discussion about diversification by asking participants to question whether diversification has delivered what it promised.

“Fundamentally we would still be of the view from an academic perspective if you can get uncorrelated sources of return working together it is better for risk management outcomes over the long term,” he said. “On the flip-side the industry has a complexity bias, and if you’re an agent in the system you do things that are more complicated. We need to control for that bias. There has been a lot of experimentation with things like alternative beta and certain areas of the credit markets and I feel like some of that hasn’t really delivered. Is there a better way?”

GSAM, which partnered Top1000funds.com on the event, recently published a paper, Investing in a high-risk world, suggesting portfolio construction in the current market environment should focus on risk management, liquidity and optimising across public and private assets simultaneously.

Railpen’s Greaves agreed that risk management needs to be a core part of any conversation around diversification.

“Everyone has different measures of risk they focus on. Principally we try to focus on the medium to long horizon with regard to risk management,” he said. “For example the relationship between emerging market debt and equity in the short term is about liquidity and risk aversion and they are highly correlated. In the long term, is whether I get paid back by Mexico related to whether Tesla has an earnings surprise? Probably not. You have to think through the medium-to long-term structural drivers of the portfolio.”

Greaves said regional diversification had probably been under-emphasised by institutional investors and would be more important going forward, as highlighted at the Fiduciary Investors Symposium in Singapore in March.

“We are entering a multi polar world. Regional diversification is a lever that many institutional investors don’t pull very hard,” he said. “A lot of western investors are pulling out of Asia, it feels like that is the wrong way around. I think that regional diversification will be much more important in the future.”

Newly appointed NEST chief investment officer Liz Fernando has been actively building out the fund’s private markets portfolio. “When we think about private markets it’s so we can get access to return streams not available in public markets and to industries and sectors which aren’t coming to public markets until later in their maturity,” Fernando said.

NEST, the £30 billion and fast-growing UK defined contribution fund, first started investing in private credit focusing on middle market lending as a complement to the high yield portfolio. It then moved into infrastructure and renewables as “an amazing opportunity to get capital in the ground and benefit from the energy transition”, Fernando said.

It’s been investing in private equity investing for about a year, with the fund now looking at natural capital, particularly timber, as the next private investment opportunity. “Natural capital is extremely uncorrelated with other asset classes and low volatility, and it fits in with our ESG goals,” she said.

The Church Commissioners for England fund was ahead of the curve in investing in natural capital with a 5 per cent allocation to forestry added to the portfolio in 2011 and producing 15 per cent per annum ever since. It also has a separate 5 per cent allocation to farmland. Church Commissioners chief investment officer Tom Joy told the roundtable his team asks two questions when considering diversification in the portfolio.

“We try to define a role an asset class should play, and then ask if it is reasonable to assume that asset class will be able to fulfil that role,” he said. “They are two different questions. We actually felt we were struggling to talk about resilience back in 2018 when the whole of fixed income, including private credit, was not offering anything like what we needed. So we started a program of building an internal dynamic hedging capability which went completely against the grain of what most people would think. We found it to be a very useful tool. We are not using it much at all now, other than removing foreign exchange hedging.”

We need to think that the neutral rate for the UK is about 3.5 per cent in real terms. Are we ready for that world?

Chris Rule has been involved in building the Local Pension Partnership from inception since becoming inaugural CIO in 2016. He’s now chief executive, and LPPI has been an important player in infrastructure in the UK as the designated manager for GLIL Infrastructure. One of the benefits of infrastructure is its cashflow, and its utility in the context of meeting the pension promise.

“We have embraced infrastructure particularly private infrastructure and harvest the income from that,” Rule said. “We look at 50 per cent of the return to come from yield.”

However, Rule said he is concerned about an emerging gap between the buyer and seller and the impact of that on capital deployment.

“What has been relatively easy to do is to deploy capital into secondary assets,” he said. “That is more challenging today because there is a big gap between seller and buyer. We have significant unallocated capital we are looking to take advantage of. Addressing the demand side of that and bringing efficiency is interesting for us. Double-digit returns and good income is positive, but capital deployment will be the question over the next few years.”

LLPI has benefited from a top down total portfolio view in its asset allocation approach which is something CPP Investments has been doing for some time and is constantly tweaking.

Managing director, public markets in the active investment management group, Romy Shioda, said the fund looks to have a strategic allocation as a collective portfolio and then considers relative value across public and private to achieve the exposures.

“We are now trying to move towards a more centralised approach and have more guidance from the top, as there are lot more correlations and macro factors that drive it. So things like inflation hedging from infrastructure is important,” she said. “We are trying to think of it at a high level and then whether we have a unique edge in public or private to invest, and the bottom-up specialty to deliver the exposures.”

But the risk with a top-down framework, according to Railpen’s Greaves, is the potential introduction of pro-cyclical behaviour.

“We have completely revamped the approach we have for managing illiquid exposures,” he said. “You’ve got to be careful chasing allocations to illiquid assets as markets are rising – particularly if you are a slightly cashflow negative fund like ours. We are telling our illiquid teams we want them to be slightly below target most of the time because we want to have dry powder if markets turn,” he says. “Investing is as much about creating the processes and frameworks to be successful through time as it is coming up with perfect SAA.”

Operational excellence

The worlds of risk, liquidity and operational excellence collided in September 2021 in the UK with the gilts crisis. GSAM’s Francis said the “LDI crisis” highlighted the impact of operational failure and inferior assessments and execution, which may have led to very poor decisions,” he said.

“There were other situations where, for structural reasons, people didn’t have visibility on their positions and had to take action as a result of that. We understand some schemes cut hedges at inopportune times. As time goes by, we are seeing more and more bad stories in the market impacting schemes’ funding levels. High-quality investment operations in that one period [were] really important, perhaps for the first time in history.”

Roundtable participants agreed that it’s not just when a liquidity event happens that operational management is important, it’s important all the time. “Operations matter even outside of a crisis,” said USS’s Barker, with GSAM head of EMEA institutional business Chloe Kipling emphasising the right governance and delegation allows for flexibility and quick decision making.

Participants agreed that investment operations within asset owners was probably under-developed compared to the investment process, with one participant noting that “everyone has a strategy until they get punched in the face”.

“If you got punched in the face last September all bets are off, it didn’t matter what great ideas you had, or new asset classes, you wouldn’t be able to do any of that good stuff because you made a fundamental mistake,” the participant said.

We are entering a multi polar world. Regional diversification is a lever that many institutional investors don’t pull very hard

Creating first-class enterprise risk frameworks is an area of improvement for asset owners, the delegates continued. The back-end and front-end systems should be brought together in a way that allows for smooth execution in the case of the escalation of a crisis.

Liquidity management is as much a discipline as picking stocks or managing a credit portfolio and should be given more priority within pension funds, the roundtable participants heard. Railpen, for example, tries to constantly think about different liquidity scenarios.

“In my experience risk systems are not great at liquidity management, they are only good as the inputs they get,” Greaves said. “With short-term liquidity management you try to model the worst scenarios for your liquidity and make sure have good coverage of those scenarios with cash-like assets, constant monitoring and nimble governance. But then it is thinking about how you top that liquidity back up and from where – the collateral ladder. That’s the more challenging bit. We try and maintain a view on sources of liquidity at all times, so we know exactly what we would do in different scenarios and it all just flows through.

“You can also engineer the strategy itself to put less strain on the liquidity of the assets and that’s a very sensible reaction to the environment we are in. But it comes at a cost to expected risk and return.”

The fundamentals of risk management and other tools used by investors may become even more relevant, but there was a belief around the table that there is a need to think more deeply about scenarios. Scenario analysis done well can give investors insights into behaviour and preferences of their stakeholders. LPPI’s Rule gave an example of a recent exercise with the fund’s investment committee.

“Scenario analysis can feel a little bit theoretical,” he said. “We wanted to give our IC something more tangible, so we did a red-team and blue-team exercise where we had our investment team gradually feed in the outcome of scenario analysis into the IC and they then discussed the information and what decisions they wanted to take.

“That was quite interesting, seeing the habits the IC developed as they started living through those scenarios, and what we saw was every single time they reached for liquidity.”

“Every time, they wanted more flexibility and agility to have a bit more liquid assets. It was interesting for the IC to live through a scenario rather than just be presented with the outcome, and it showed how they might behave differently.”

As a result of the exercise the fund has made a slight tweak and allocated a bit more into traditional fixed income. “We found in that exercise what habits the IC would form and how we could make sure we are a position to give them options they wanted in that scenario,” Rule said. “There was a tendency for them to say we want to be able to change our mind, so liquidity is important.”

Liquidity management is as much a discipline as picking stocks or managing a credit portfolio and should be given more priority within pension funds

DAA as a tool for portfolio resilience

The role of active management, and in particular dynamic asset allocation, was also on the table, with participants acknowledging that downside protection can afford a fund a bit more “budget to focus on scenarios”.

Investors at the roundtable, including CPP Investments and Barclays, focus on long term strategic asset allocation but also think about dynamic asset allocation in the context of where exposures might be impacted by negative shocks and what hedges can be put in place.

Investors were perplexed by the energy transition and whether intermediate or long-term asset allocation better deals with the disruption. Other investors such as LPPI continue to have conversations around tactical tilts, but rarely act.

“On the occasions we have done it we try to be pro-cyclical, so try to think that we have liquidity, dry powder and can take advantage,” Rule said. “We haven’t found any managers who are good at timing markets, and we know we are not. My view is that we can exert a lot of time and effort into thinking about how we can be smart, but it hasn’t really paid dividends from doing that.”

Meanwhile, Church Commissioners built a big capability for dynamic asset allocation in-house in 2018. Joy said first-line defence – things like puts and foreign exchange – is done in-house for efficient portfolio management; then a second-line defence – which is tail risk hedging – has been developed with some banks.

“The main reason we developed it inhouse is to be time-variant and counter-cyclical. We only use it when we feel really stretched and want to add defence to the portfolio,” Joy said. “It was an enormous journey to get our trustees comfortable with putting the effort into basically building a derivatives capability inhouse. It became live in 2020 and the first thing we actually did was add risk because it was the summer of 2020. But we used it a lot last year and it proved very valuable and will continue with it. The biggest change has been on the internal operation capability.”