In this second article in a new series, Nicholas Lyster and Amin Rajan argue that the evolving diversification favours assets with bond-like features and equity-like returns
Worldwide, as DB plans are entering into their run-off phase, they have begun to chase a number of outcomes other than good returns, according to the 2013 Principal Global Investors-CREATE-Research Survey, Investing in a Debt Fuelled World*.
As alpha has proved illusive and expensive, four new goals have come to the fore: inflation protection, low volatility, high income and regular cash flow.
Against this background, our survey respondents have identified the asset classes that are most likely to deliver these goals. In so doing, they have drawn a distinction between those that would be targeted for short-term opportunism and those for medium-term asset allocation (see graph below). One is about taking advantage of bargains that emerge from time to time, the other about extracting intrinsic value.
For opportunism, six asset classes were singled out: distressed debt (cited by 49%),
ETFs (44%), high-yield bonds (42%), commodities including gold (37%), small cap equities (33%) and currency funds (32%). For asset allocation, a further six were identified: global equities (56%), real estate (55%), traditional indexed funds (53%), emerging market equities (52%), emerging market bonds (44%) and alternative credit (44%).
Our post-survey interviews revealed the thinking behind these numbers.
First, quantitative easing (QE) programmes have lifted all the risky asset classes recently in the belief that their multiplier effects will provide a second wind. This could well see an expansion in earnings multiples. The cult of equities can return at an awesome speed, as evidenced by the bounce this year. However, pension plans that aim to re-risk believe that risky assets are already crowded trades at their current valuations. They are unlikely to be chased simply because they are the only game in town.
Second, those DB investors who are eyeing distressed debt, high-yield bonds and emerging market bonds believe that these will remain attractive only so long as rates remain low and spreads do not narrow further. The recent panic selling of emerging market bonds is overdone.
Third, the demand for real assets – especially real estate, infrastructure and farmland – will continue to grow as ever more pension plans overtly target inflation protection in their diversification. For example, some Canadian and Scandinavian plans have raised allocations up to 25%. This rising interest in real assets is the single biggest change from last year’s survey. As the price of inflation-linked bonds has sky-rocketed, pension plans are looking for substitute assets yielding 4-6%.
Fourth, another big change from last year’s survey concerns alternative credit. It will also attract rising interest as banks offload their assets ahead of Basel III. Instruments such as senior loans, collateralised loan obligations, subordinated corporate debt, mezzanine debt, commercial mortgages and private equity secondaries will attract growing demand. Like real assets, alternative credit has two over-riding virtues – low correlation with traditional equities and bonds and high single-digit yields. Those that use floating rate notes also have an inflation kicker. Thus far, their default rates have been low – around 3.5%.
Overall, because of their bond-like features and equity-like returns, real assets and alternative credit are especially appealing to DB plans that have adopted liability-driven investment glide paths. They sit comfortably between returns enhancing portfolios and hedging portfolios.
Fifth, traditional indexed funds and ETFs will attract rising allocations, far higher than reported in our 2012 survey. Both are seen as avenues of low-cost market exposures. Both are also amenable to tilts towards specific risk factors within a smart beta framework.
To conclude, therefore, with QE, investors are braced for market-moving events that may potentially result in big losses or big opportunities. Hence, their asset allocation will seek to manage risks more than returns, and conserve capital rather than grow it. This shifting emphasis is likely to favour cross-over assets for the foreseeable future.
Nicholas Lyster is CEO of Principal Global Investors (Europe) and Amin Rajan is CEO of CREATE-Research
*Available from firstname.lastname@example.org