Creating resilient portfolios for the post COVID-19 world
Global Investment Insights
with Amin Rajan, Chief Executive, CREATE-Research and a member of The 300 Club
Amin is the Chief Executive of CREATE-Research, a UK based think tank that specialises in future trends in global funds management. Its network of researchers undertakes research and advisory assignments for governments, global banks, fund managers, multinational companies and international bodies such as the EU, OECD and ILO.
Amin’s current research programme aims to highlight how institutional investors are creating resilient portfolios in the post COVID-19 world, as the global economy struggles to recover from what is the economic equivalent of a massive cardiac arrest.
The extraordinary policy response by central banks and their governments was timely and vital. But it has also inflicted toxic side effects on pension finances via falling asset values from plunging markets and ballooning liabilities from falling interest rates. The latter has also hit the cash-flows essential for regular pay outs.
Thus, asset allocation has come under the spotlight, raising three specific issues:
What shifts are likely in the current macro financial regime in response to the unorthodox policy response from central banks and governments in the key economies?
How will these shifts affect the way investing is done in future?
What will be the key changes in pension plans’ asset allocation?
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Market prices will increasingly reconnect with their fundamentals as key central banks will lose potency in artificially boosting asset values and dampening volatility.
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A razor-sharp focus on resilience marks a back-to-basics approach to investing. This could be an exciting development for the future of investing, in Amin’s view.
It rests on the belief that market prices will increasingly reconnect with their fundamentals as key central banks will lose potency in artificially boosting asset values and dampening volatility. Their debt monetisation policies – including yield curve control – will erode their independence and see the return of inflation.
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Central banks’ debt monetisation policies – including yield curve control – will erode their independence and see the return of inflation.
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Resilience is now being pursued via strategies with strong intrinsic worth that can withstand high volatility and deliver attractive risk-adjusted returns, while pursuing accelerating structural themes that will reshape the key growth points in a post-pandemic world.
Resilience means investing on the side of change. It could be custom built, as is possible in private markets; it could be pursued via specific themes; it could be a strategy’s inherent feature, as with cash-flow compounders that act as shock absorbers in turbulent markets; or, it could have policy backstops, like private debt now being bought by the Federal Reserve.
“Theme investing, targeting selective growth points in the global economy that transcend market fluctuations, will become more popular. It will be spearheaded by ESG, technology and healthcare”, Amin highlighted.
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Quantitative easing has brought forward future returns. Institutional investors now expect to be in a prolonged era of low prospective returns.
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Successive rounds of quantitative easing in the West over the last decade have brought forward future returns, with anaemic growth in the global economy. They set a floor under asset prices and dampened volatility. Institutional investors now expect to be in a prolonged era of low prospective returns, as the fog of uncertainty has descended on the global economy with the subsequent wave of the pandemic. Finding sufficient, consistent returns in this era of low yield is the biggest challenge for institutional investors.
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Finding sufficient, consistent returns in this era of low yield is the biggest challenge for institutional investors.
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COVID-19 could be the last straw for many defined benefit (DB) schemes, in particular. By turning a raging bull market into a savage bear market, the pandemic has dealt a double blow to the finances of DB plans.
Quite apart from inflating the present value of their future liabilities, falling rates also mean lower cash-flows, as plans typically rely on bonds to fund regular payouts to their retirees. To cover the resulting shortfall, they have to invest even more or hold fire sales of their current assets.
Thus, falling rates have proved to be the Achilles heel of DB plans. Worldwide, just over half of them have a hedge against falling rates.
The rest are forced to seek extra contributions from sponsors, make assets sweat harder and prune retirement benefits. On the latter front, serious attempts have been made over the last decade as rates continued to plummet under successive rounds of QE. They included raising the retirement age in line with life expectancy, upping employee contributions, withdrawing the automatic indexation of benefits and linking pension entitlements to an employee’s career average, instead of final year, salary. Being hardwired into employees’ job contracts, these entitlements were difficult to downsize. But lump-sum one-off contributions from plan sponsors paved the way for reforms.
Since the crisis, the spotlight has once again been turned on additional contributions from plan sponsors. Having already made a series of one-off cash injections over the past decade, the sponsor covenant risk is currently at an all-time high. For at least a third of DB plans worldwide, the future looks bleak.
The immediate issue is whether the majority of DB plans can survive without increased contributions and reduced benefits, despite progressive switching to defined contribution plans in the past two decades – even in former rock-solid DB markets like Canada and Japan. While providing financial respite to plan sponsors, that has only shifted the pain to employees.
Risk has been transferred from those who were unable to manage it to those who do not understand it. The problem is much less acute where DC funds are managed by a professional board of trustees. Yet, hardly anyone expects DC plans to deliver better retirement outcomes than DB plans.
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Risk has been transferred from those who were unable to manage it to those who do not understand it. Hardly anyone expects DC plans to deliver better retirement outcomes than DB plans.
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Going forward, facing a prospective, low return environment, asset allocation will target four goals. Along with the supporting asset classes that will underpin them, and they are:
Capital growth: global equities, EM equities, high-quality equities
Income generation: infrastructure, IG bonds and alternative credit
Inflation protection: equities and infrastructure
Capital conservation: sovereign bonds.
Equities are expected to be the engine of capital growth; especially so-called cash flow compounders. Selective EM debt will be another bright spot.
Private equity is also likely to attract interest. Its return dispersions are now widening, with a significant gap between the best and the rest.
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Equities are expected to be the engine of capital growth.
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Infrastructure will benefit from large-scale fiscal stimulus and inflation protection. Renewable energy will likely be the sector with the most investor interest. In turn, the IG space will benefit from two advantages: being high up in the capital structure and enjoying central banks’ protective umbrella.
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Private equity is also likely to attract interest.
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Sovereign bonds will be favoured by a minority who have good funding ratios and who want to fully de-risk their portfolios.
“Our survey results indicate that only 18% will favour the safe haven of US treasuries, for example. Their near-zero yield is a major deterrent from a total return perspective in this era of ‘low for even longer’ rates. Their investors are likely to experience the sort of financial repression last seen in the US in the 1940s when rates were kept low to fund the post-war recovery”, Amin stated.
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Renewable energy will likely be the sector with the most investor interest.
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Amin left us with some interesting revelations from his career that have shaped how he views investment management and how institutional investors’ perceptions have changed over the decades.
“In the late 1970s, I joined the UK Treasury as an economic forecaster at a time when the ‘rational expectations’ revolution pioneered by the ‘Chicago School’ was in full swing.
Successive attempts to incorporate its key tenets into our large-scale econometric model came to nought because of their heroic underlying assumptions about the ultrarationality of economic agents and the markets in which they operate.
Hence, some twenty years later upon entering the world of investment management, imagine my surprise when I discovered that the School’s twin offspring – capital asset pricing model and efficient market hypothesis – were part of the core curriculum for wannabe portfolio managers and their standard toolkit.
It was clear that they provided nothing more than a cloak of respectability to complex mean–variance optimisers based on rear-view mirror modelling. In 2012, I wrote a paper for the newly formed 300 Club, arguing how this form of pseudo-science is short-changing investors. Its ex post outcomes rarely matched ex ante promises.
The paper understandably invoked venomous emails, including one from a Nobel Laureate who then sat on the board of an asset management firm. But widespread comments from readers on a subsequent article I penned for the Financial Times revealed only too well how institutional investors are no longer taken in by the notion of mean-variance optimiser that has long dominated investment thinking”, Amin recalled.
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Sovereign bonds will be favoured by a minority who have good funding ratios and who want to fully de-risk their portfolios.
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Disclaimer
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