Faith in the long term
A notable feature of the institutional investors’ panel at the Milken Global Conference in Los Angeles at the end of April was a faith in the ability of investors to reap long-term risk premia and a determination to do so.
Institutional investors’ problems are well known and articulated: the need to find returns in a world of deleveraging; low and sluggish growth coupled with high debt in developed markets - the “battle of the uglies” as Alexander Friedman, CIO of UBS’ wealth management division put it; the danger that governments will inflate their way out of the debt problem.
And while the mission and objective of some of the investors on the panel is straightforward, perhaps deceptively so - “maximising return in hard currency given an acceptable risk horizon” of 10 years in the case of China Investment Corporation, or achieving a 7.5% annualised return in the case of CalPERS - the road to getting there is certainly not.
Broadly, the threat of inflation loomed larger, at least in the longer run, than the shorter-run threat of deflation due to deleveraging, and inflation-generating assets came in for discussion. Accordingly, CalPERS has for some years had a dedicated allocation to real assets. But recognising the attractiveness of infrastructure for institutional investors, and also the political pressure to invest, CalPERS CIO Joseph Dear was unhappy about the lack of realistic opportunities in the asset class either in terms of sector, geography or investment structure.
Since it is domiciled in a resource-rich country, Canada Pension Plan Investment Board (CPPIB) regards itself as being long commodities but is looking for a new strategy, according to Mark Wiseman, executive vice-president, investments, at Canada Pension Plan Investment Board. He said the fund is “thinking about building an investment programme where we are buying reserves literally in the ground that will be extracted in decades to come. It is the advantage of being a very long investor and it’s the advantage of having a 75-year time horizon and no need of near-term liquidity.”
In Europe, the Canadian government fund owns a Norwegian gas pipeline but no government bonds. Wiseman: “The beauty of that asset is that if we buy a German Bund all we are buying at the end of the day is the full faith in credit of the German government and what we have learned is that ain’t worth much.” Or more starkly put: “I’d rather buy a gas pipe than a promise from Angela Merkel.”
Nevertheless, timing is crucial with inflation assets, according to Dear: “You don’t want to be too early, even if you are right, because the portfolio choices you make to protect yourself against that could really diminish your returns.”
Some of the investors said they were working to overcome traditional asset-allocation labels. In the words of Wiseman: “A bond could be a US government bond or a bond could be a corporate distressed bond that is essentially equity waiting to happen” and to put that in your fixed income allocation is “nonsensical”.
By the same token, equity is the residual claim on the assets and cashflow of a firm after all other creditors have been paid. So CPPIB does not distinguish between public and private equity with a 65% allocation straddling both.
Instead, investors should allocate to risk factors. “It amazes me that people are still talking about asset allocation,” Wiseman added. “If there’s one thing we learned during the financial crisis its that assets, when you least expect it, all tend to behave the same way or all tend to behave differently. We’ve been trying to get away from asset labels.”
CPPIB and CalPERS agreed about the opportunity that lies in equity of US companies that dominate their industries and which are able to maintain pricing over time. As Wiseman put it, “if you don’t believe in the long run that equities are going to outperform bonds then you don’t believe in the capital markets.”
But sponsors and members are understandably unwilling to increase contributions if equity volatility gets too high and underfunding kicks in, which puts pressure on the short term. As Xi-Qing Gao, vice-chairman and president of China Investment Corporation (CIC) said, even the Chinese government is less long-term in mentality than might be thought: “Theoretically we are long term because our risk horizon is 10 years.… but at the same time.… every government agency will try to tell us, ‘why did you make these bad deals?’.”