Pension funds on the record: Seeking protection in private markets

Developing the asset-allocation toolbox

Within the backdrop of high inflation and continued geopolitical uncertainty, nearly all asset classes are struggling, leaving investors like NEST with few safe havens in which to help deliver the real investment returns our members require.  

In the immediacy we have responded to volatility in markets by temporarily diverting cash to take advantage of falls in asset prices and get back to target weights. NEST’s positive cash flows allows us to react this way, given we’re a constant buyer without the need to sell existing assets.

However, at NEST we are long-term investors so we always try and consider the bigger picture when devising our investment strategy.  

NEST’s youngest member is just 16 years old and could be saving with us for 50 years. We cannot get too focused on short-term performance but instead consider what will offer strong and sustainable returns in the long term.  

That is why we have been preparing our investment strategy for difficult and turbulent market conditions over many years, including the portfolio implications of a shift to a more volatile inflation regime.

Higher inflation and bond yields might mean the stock-bond correlation returns to being positive. Investors have benefitted from a 20-year period in which when stocks fell, bonds were likely to rise. If that changes, investor portfolios would lose that diversification benefit.  

There are other tools which we believe can help deliver real returns in challenging environments. We have continued to expand our investment universe, particularly in private markets, to ensure we have more tools in our toolbox we can utilise.  

A regime shift could mean a greater role for assets like real estate and infrastructure in our portfolio, which have implicit or explicit positive links to inflation. Both these asset classes are, to continue the analogy, in our toolbox. 

Just this month, NEST appointed Schroders Capital to help us deploy money in private equity, opening up an asset class which has previously been out of reach for the vast majority of our 11 million members. Private equity allows us to pick out companies which are ‘winners in the pack’ rather than increase our exposure to a whole index and the overall market performance. If selected carefully, these deals are likely to generate superior returns to most other asset classes. 

Despite all the volatility happening in the markets, our diversified investment approach gives us confidence that we have the toolkit to perform well. We will continue to open up opportunities in asset classes like private credit and expect to have a fifth of our portfolio in private markets within a few years. 

Lower equity exposure and downside protection

We have reduced our overweight to equities, which stood at about 3-4% at the start of this year, to an underweight of the same magnitude. We have executed this mostly by selling part of our position in North American equities.

Our dynamic equity allocation is driven by valuation and momentum. Our indicators had already been showing North American equities were expensive. When the momentum indicator also turned negative, this was a sign for us to sell. Because of our allocation to factor mandates and as a consequence of our reduction of our US equity exposure, we now also have a relative overweight to value equities, which tend to perform better in the current macroeconomic environment.

We currently also have hedged between 10% and 15% of our equity exposure via a put-options strategy. The idea behind this is to slowly build a position in times of relative calm on markets when costs are also relatively low. We have not hedged our entire equity portfolio via put options, but it has been serving its purpose well this time too by reducing the downside.

 

“We now also have a relative overweight to value equities, which tend to perform better in the current macroeconomic environment”

Our dynamic interest rate hedge policy has also led us to increase our interest rate hedge because interest rates have been going up. We have been doing this mostly via the swap market, as the large differential between government bond yields and swap rates means swaps are currently relatively more attractive.

The recent changes in the macroeconomic environment and the increasing likelihood of a longer-lasting stagflation scenario has also led us to execute our ALM study according to the original plan to do it in 2022. 

We had considered postponing the ALM study by 1 to 1.5 years, as we are still waiting for the legislation concerning the pension transition to be finalised, but we eventually decided to stick to the original plan, because of everything that is currently happening in the world, which affects our investments. We expect to finish this exercise around the summer.  

In-depth evaluation in progress

One of Pensioenfonds TNO’s investment beliefs is that tactical portfolio management in response to short-term market developments does not add value over the long run. However, if we conclude that we are facing a regime shift, which has a long-term impact on the portfolio, we may change our investment strategy.

In response to the increase in interest rates and inflation we have done some scenario analyses to check the robustness of the strategic portfolio under a severe stagflation scenario. Although the results in such a scenario are not good, they were assessed as being acceptable. 

What we have planned though, for the coming months, is a more in-depth evaluation of our investment strategy with regard to inflation risk. We think that inflation, going forward, will be higher and more volatile. 

In response to that, we will evaluate our allocation to real assets. At the moment we have a 5% allocation to real estate and no allocation to infrastructure. We want to evaluate how a higher allocation to those asset categories could improve the strategic portfolio. 

Finally, we will also evaluate our dynamic interest rate hedge policy. At the moment, our dynamic interest rate hedge policy runs from 40% to 100%, and at the current interest rate we are 60% hedged. In view of the new pension contract it seems unlikely that we will have a higher interest rate hedge than 60%. Therefore, we are evaluating whether we should cap the hedge ratio at 60%. 

An interesting by-product of a lower interest rate hedge is that you have a bigger implicit inflation risk hedge, assuming a positive correlation between inflation and interest rates. That is helpful in the current stagflation environment.

Relentless focus on real, inflation-linked assets

Our strategic benchmark is generally revised in conjunction with our triennial actuarial valuation but we have scope to implement tactical positions according to market conditions.

From our perspective, markets are at a challenging juncture. Investors are caught between the pull of low unemployment and firm underlying economic growth and the push of high inflation, rising interest rates and concerns of an impending recession.  

We try not to predict but our expectation is that, despite high inflation, central bankers will be slow to raise interest rates and although the consumer will feel the pinch of the higher cost of living, spending will hold up and economic growth will not be as affected as markets seem to be pricing.

Consequently, we have not yet expressed any market views  although, as a sterling investor, we are waiting for an opportunity to hedge against sterling appreciation after its sharp decline, particularly relative to the dollar. Also, we feel there may be near-term opportunities to buy UK government bonds tactically.

Our long-term objectives of increasing real assets or inflation-linked assets remain intact and we continue to identify and acquire suitable assets. A recent example is the acquisition of a UK data centre last year, providing a long lease and inflation-linked income.

Good access to liquidity is key

Current market conditions have not led to strategic changes but some tactical changes have been made. We have increased our underweight position in foreign equities and the overweight position in domestic equities has decreased. Investment in indexed-linked bonds has increased, and although there is uncertainty regarding the Icelandic krona, we believe that it will appreciate against other currencies, which is why we keep an underweight exposure to foreign currencies. Due to the great uncertainty in markets, the focus is on having good access to liquidity, in order to be able to seize opportunities when they arise. 

The economic outlook for Iceland has not changed as much as it has for Europe, and the effects of rising commodity prices have not yet materialised in domestic prices. The impact of external factors on the Icelandic economy is limited.

“Due to the great uncertainty in markets, the focus is on having good access to liquidity, in order to be able to seize opportunities when they arise”

Icelandic households are not as sensitive to rising energy prices as in Europe, due to the large domestic use of renewable sources for the production of electricity and for central heating. Rising commodity prices have had a positive effect on Iceland’s terms of trade, particularly with regard to fish and aluminium prices. The country’s competitive position regarding exports is strong. We expect a good summer for the tourism sector and therefore we are positive in the local economy. Analytica’s leading local economic indicator has been rising since the autumn of 2020 and in April it was as high as it has ever been since 2007.

Inflation is certainly high, but Iceland is in a similar place as its neighbouring countries. The main explanation so far is rising house prices, which are partly due to a shortage of housing, lower interest rates and incentives for first-time buyers. At the same time, there is a growing need for imported labour, due to the low unemployment and the ramp up in tourism. Both factors put upward pressure on the demand for housing.

The Central Bank of Iceland began its process of raising interest rates in May 2021 and currently the interest rate stands at 3.75%. Further rate hikes are expected this year.

However, the real policy rate, which is the main interest rate, taking into account the annual rate of inflation, is now -3.25% and is expected to remain negative in coming months.

Equities in Iceland have fallen this year but relatively less than most neighbouring countries. The Icelandic market will be upgraded from FTSE Frontier to Secondary Emerging Markets in September, which is expected to increase interest from abroad. At the same time, the global market conditions are affecting the domestic securities market and the correlation between foreign movements are growing.

Interviews by Tjibbe Hoekstra, Susanna Rust and Carlo Svaluto Moreolo