Pension funds and asset managers are suffering from a communication breakdown, argues Peter Kraneveld
Pension funds and asset managers famously need each other and complain that the other does not understand them. Here is a case study on different wavelengths.
US interest rates going up is an expected surprise. Most analysts seem to expect an upward move before the end of the year – pretty precise for a prediction. So how should pension funds position their investment portfolios to weather the storm best?
The graph below presents a general case of the relation between economic growth and the investment portfolio. OFI Global Asset Management provided the figures. At present, we are somewhere near the point where expansion turns into slowdown. In the expansion phase, equity and high yield should be preferred. During the slowdown, high yield is to be avoided, and the rest will generally stay where they are or get worse.
To one asset manager, the situation is clear. Pension funds are seeking yield. Yield is in high yield. It can be shown that, over the last 8-10 years, high yield, compared with other forms of fixed income, had an attractive risk/return profile. That’s nice to know, but the period is long enough to cover a complete economic growth cycle, so it does not apply to a situation where we are preparing for an expected surprise, but to a situation where we are considering an ALM outcome.
One thoughtful manager notes that US high yield is inversely correlated with oil prices. That looks like an argument to dump US high yield to me and seek direct exposure in oil if that were the intention. After all, oil doesn’t default.
Another manager recommends credit-linked obligation. It sounds fine. Statisticians have been looking for market imperfections in the bond market for a long time, and packaged unlisted private credit seems a better place to look than many others. But what do we know about the risk and liquidity of that market, especially when markets are turbulent?
Infrastructure financing is another favourite – nice, long term and stable incomes, at least as long as the government can be trusted not to change tariffs unilaterally. Maybe even more important, it is highly illiquid, especially in a disturbed financial environment. In other words, not a defensive move against the expected surprise, but another ALM consideration.
What’s a poor pension fund to do? There are alternatives for present portfolios, but do they offer protection when the US Federal Reserve finally moves? Are pension funds lambs, waiting for their slaughter? To have some idea about how pension funds are positioned, we could do worse than to look at the latest report of af2i, the French organisation of institutional investors. Noting that its members can be pension funds, insurance companies or independent funds, such as the Caisse des Dépôts, French institutional investors are great users of bonds. The members of af2i are typically 70% invested in bonds.
Of their bond portfolios, around 50% are sovereign, and practically all are investment grade. High yield is around 2.5% of the average portfolio, but private credit is on the rise at more than 3%. The average maturity of the portfolios is around seven years. Plans for the future are basically to continue present trends.
This looks like a boring, middle-of-the-road portfolio, not like a preparation for the expected surprise. Are French institutional investors unprepared? Look again at the graph above. The data give hardly any indication on where to be. However, they do not measure another dimension – the quality of the investment. The best defensive portfolio in a downturn is a high-quality portfolio, and that is exactly how the af2i members are positioned.
Now we are ready to analyse the gap between managers and investors. Managers assume investors can time the market: get out of high yields before the going gets rough. At the same time, it is a brave manager that claims to be able to time the market. They assume pension funds are looking for yield first. However, pension funds are so hemmed in by supervisors that bear no responsibility for pension quality that their first priority is risk, not return.
Managers assume pension funds are nimble investors that can turn around portfolios in little time. In reality, big pension funds are often bureaucracies, where following the herd is a safer course than showing initiative and creativity. Small pension funds and those that have completely outsourced the portfolio have a communication problem that slows down decision-making. It pays to think far ahead.
Meanwhile, pension funds are apparently unable or unwilling to communicate their inabilities and restrictions to managers. May both parties realise they have an interest in improving the situation.
Peter Kraneveld is international pensions adviser at PRIME bv