Financial markets have become rather unsettled since May. Fast ‘de-risking' led to sharp falls in stock markets and a ‘flight into quality'. After a three-year period of strong runs for most assets - the riskier the more - a correction was overdue. However, more clouds have been moving into the picture, raising fundamental concerns with investors.
The first factor is the squeeze on liquidity available in financial markets, as discussed in this column in the IPE June edition. It has spread more widely since the ECB is trying to catch up on lost ground while the Bank of Japan finally setting the first step towards a more normal monetary policy.
As a second concern, inflation has become more visible in recent months. Price increases reach beyond energy-related products. Reports of increasing production costs in China, the core engine of global product deflation in recent years, only add to such fears.
Thirdly, some investors feel the end of a long and strong profit cycle is in sight. While analysts are, overall, still content with the incoming earnings reports, some strategists warn of a monetary overkill in the US.
Finally, the tick list for political risks has not become shorter, in the face of events in Lebanon/Israel in addition to Iraq, Iran, Afghanistan, North Korea, etc. At the same time, several oil-exporting countries are trying to increase their spheres of political influence.
Despite official rate hikes and inflation fears, government bond yields have remained relatively stable at around 5% (US) and 4% (Euro-zone). This is a result not only of defensive portfolio shifts but also of the predominant view (in mid-summer) of an orderly cooling of the US, and the Chinese economy, into 2007. With stock market volatility somewhat higher, not surprisingly, defensive sectors and assets are back in favour. Nonetheless, M&A activity seems to continue relentlessly, while private equity funds, full of cash, continue their search for new targets.
Many pension funds make efforts to diversify more into real assets like property. This is despite more compressed yield levels in the aftermath of strong performance in recent years and the ongoing slowdown in this sector in the US.
Commodities have become a more two-sided bet in recent weeks, but this does not seem to stop people (yet) from planning or implementing further strategic investments.
When things move so fast on the markets, timing of asset allocation shifts is crucial, and the distinction of strategic and tactical decisions easily becomes academic. Suggestions for key questions to your fund managers and advisers this quarter:
1. Revised expectations for monetary policies?
2. How will the windfall revenues of commodity producers be spent or invested?
3. Risk of a hard landing in the US, and globally?
4. How to time strategic moves into alternative assets.
5. Recent up and down provides a good reality test of your hedge funds and other alpha managers!
Current strategic issues: cash investment
It may be surprising to put cash management on the asset allocation agenda these days, but why not consider contrarian ideas? Cash is indeed often seen as inferior, if an investment at all. Furthermore, cash management may have been delegated to a bond manager or custodian, without any urgent need to change arrangements.
Cash has never really found a comfortable role in pensions investment. In pensions, unlike corporate treasury, cash management used to be seen more of an administration exercise rather than an investment activity.
Also, the long term return statistics show cash behind most other asset classes. Furthermore, there is a massive duration mismatch between the money market and pension liabilities which are typically long term.
Notwithstanding, this may not be a bad time to review ‘cash'. Why?
1. Cash has the good old virtue of (nominal) capital preservation. Rising short term rates make returns on the money market more competitive against other asset classes (see chart).
2. The money market is hardly correlated with other markets. Cash is a proven and reliable diversifier in portfolios, unlike some other products and instruments that make such claim, as investors found out in recent months.
3. Higher rates also imply that more money (in absolute terms) is wasted by inefficient cash management. Many pension funds can still learn a lot from good corporate treasury management.
4. Most pension funds are increasing foreign investments. How well are foreign currency positions managed?
5. Finally, new investment trends in pensions make good cash management essential, eg, the use of swaps and derivatives (whether for LDI, overlay or other strategies).
Whether cash is "king" or "trash", it can't be good practice for pension plans to treat it as a residual. Key issues in any review include the following:
❑ Should there be a strategic allocation to money market? In which form should it be implemented?
❑ At what level is tactical allocation to cash undertaken: delegate fund managers and/or overall pension fund?
❑ Scope for "enhanced" cash funds?
❑ Is there clarity about cash investment accounts and operational accounts (eg for pension payments and administration)? Who consolidates cash positions?
❑ How is cash management performance benchmarked, and reported?
❑ Cash is not riskless. Are there appropriate controls in place, eg for counterparty risk?
❑ Who is in charge? As one commentator said, "money will not manage itself".
Breakout session: investing in infrastructure
This section gives quarterly suggestions for "special sessions" with pension trustees and investment officers, outside the routine business of pensions investing. One area worth a "teach-in" is infrastructure investment.
Potential investors are already facing a dilemma. In recent months, infrastructure deals have reached the media headlines as takeover battles are being fought around airport and motorway companies. All sorts of players are getting involved in heated bidding processes. At the same time, infrastructure investments are hardly represented in pension fund portfolios yet, with the exception of Australia and a few bigger Canadian and European plans.
How the world has changed: Gone are the days when infrastructure was considered boring, at best. Post World War II, it used to be mostly in the domain of the state, and outside the reach of private capital.
This is not the place to discuss the reasons for privatisations or public-private-partnerships, nor the question what exactly should count as economic (eg transport or utility networks) and social infrastructure (eg schools and hospitals). In any case, the private sector comes in as financier and manager of infrastructure, obviously expecting an attractive return.
Such private finance initiatives are now under way in one form another in most countries, most advanced in Australia and the UK, and increasingly in developing economies. The infrastructure transaction value in Europe is reported at €140bn over the last three years, and rising. The estimates for the global infrastructure market potential run into the trillions.
Proponents highlight the economic and legal characteristics of infrastructure projects, such as natural monopolies, high barriers to entry, economies of scale, regulated fees or long-dating government concessions.
Ideally, this should translate into good long term investment characteristics with stable and predictable cash flows (often inflation-linked), and low correlations of returns with other assets.
This is, of course, music to the ears of pension plan trustees faced with a lasting stream of (indexed) pension payments. Infrastructure feels more tangible and real than a lot of other alternative products and strategies presented to trustee these days, where they find it difficult to detect the underlying value. However, it is less clear how trustees can and should go about it in practice.
For most pension plans, it would be impractical to get directly involved in infrastructure projects. At the same time, the range of commingled funds is still limited.
As the market develops, one can expect more products to cover different sectors and regions. Some plans may be more attracted by the defensive income characteristics of mature projects while others may well be interested in the more risky growth potential of earlier-stage developments.
The figure-work available for risks and returns of infrastructure investments is still very limited, and to be taken with some caution. Currently, target returns for infrastructure equity funds are being put at 7-15%, with yield targets at 4-9%. Like real estate, infrastructure is not a homogenous asset class.
Pension fund directors ought to be made aware of the different nature of risks connected with infrastructure projects, including the (often high) financial gearing risk, regulatory risk (eg fee rises fall behind schedule) and political risk (politicians may change their mind). Among the other issues to tackle before going ahead:
❑ Liquidity. How important for the pension fund?
❑ Potential conflicts of interest. Investment groups are often involved in different roles (financing, transactions, management).
❑ Fees. Active management of infrastructure assets does not come cheap.
❑ Resources. Is there adequate time and expertise available?
For many people, infrastructure holds strong social, political, ecological and ideological connotations. Good debates are guaranteed in this breakout session.
Georg Inderst is an independent consultant based in London. email@example.com. Comments and suggestions for future Agendas are welcome