Advice for Pension Funds Who May Have Lost Their Way

handsClear Path analysis, a think tank that seeks to “create industry debate and educate finance professionals,” is out with a panel discussion on the renewed volatility in world markets today, and what that means for asset managers.

Noel Hillman, CPA Managing Director, kicks off the discussion by asking whether the U.S. Federal Reserve, with its prolonged maintenance of near-zero interest rates, is “causing more harm than good to the world economy?”

Laura Kodres, division chief for Asia at the Institute for Capacity Development, International Monetary Fund, replies: [A]t some point the elevated financial risks will have to be dealt with, either through macro-prudential policies or through a gradual and well anticipated increase in rates.”

A Prolonged Period of Low Yields

Another participant, Ian Coulman, chief investment officer, Pool Reinsurance, is more explicit about what the costs and risks are. Many investors have been forced during this prolonged period of low yields “to seek out additional, riskier, assets in order to try and enhance returns. This causes a number of problems, in particular that some of the asset classes that investors are going into wouldn’t have been on the radar screen 45 years ago.”

Eventually there will be a rush to the exits of some of those asset classes, “and I am not sure to what extent there will be sufficient liquidity” when that happens. At the worst of the post-crisis recession the Fed policy was understandable and probably better than the alternatives, but the Fed has missed opportunities in more recent months to begin normalization, and has thus created “greater uncertainty within the market.”

Hillman then turned the discussion to institutional investors, especially pension plans and insurers. He asked how they can “position their portfolios for prolonged volatility and uncertain rate changes?”

Coulman said that insurers and re-insurers will do what they’ve always done, they will maintain a portfolio that is “predominately a mixture of government debt, investment grade corporate debt and securitized instruments” with a smaller slice of equity. But they’ll have to consider other risk assets as well, including “hedge funds, real estate, infrastructure and even areas like catastrophe bonds.”

He also observed that insurance companies have to give thought to “the impending Solvency II requirements that will require them to consider return opportunities relative to the capital charge that will be incurred for those different asset classes.”

Pension Funds Under Pressure

Carl Tannenbaum, executive vice president and chief economist, Northern Trust, said that pension funds are under pressure because many of them at some point in the recent past “lost their way and went to asset allocation instead of focusing on their underlying obligations; so they are struggling, to a greater or lesser degree, with funded ratios that may not be where they would like them or without the ability to index where their beneficiaries are expecting it.”

Binql Liu, portfolio manager, emerging market desk, for HSBC Global Asset management, said that emerging market fixed income “as an asset class does have value to offer, particularly given the yield.” Wise institutional investors will adopt a total return strategy to capture the upside potential of EM through the most valuable subEM indexes.

Total return strategies, Liu continued, allow an investor to choose its duration exposure. This is an alpha play, she said, not a beta play. It is necessary to work to pick the winners.

Colm McDonagh, head of emerging market fixed income for Insight Investment, said that investors, especially pensions, are under pressure to go down the liquidity curve and to increase leverage.

A More Granular Look

Talk then turned to a more granular look at the globe. Tannenbaum said that NT is “watching countries which borrowed in currencies other than their own, both in the public and private sector. We are [also] looking at countries which became over-reliant on one client, in some cases China and, of course, we are looking at corruption.” Malaysia is an example of a country that has over-relied in China as an export market, and Brazil is an example of a “terrible corruption scandal.”

Coulman introduced a note of qualified optimism about China, and by implication about countries that rely on their ability to export to China. “I don’t think that China is going into any kind of recession,” he said, “there is the reported 7-8% growth and even if it falls to 5% it is still positive growth.”

But there is a need to pick one’s spots in terms of EM investments, favoring ”those who have put in place the right kind of infrastructure and structural changes that are going to be better for their economies in the long-term.”

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