Class of 2020 NextGens

Carol Chan, CFA, is the deputy chief investment officer at EY, where she is responsible for providing guidance for the firm’s $21 billion portfolio. Her day-to-day work includes the design and implementation of investment policy statements, portfolio construction, managing risk and liquidity concerns, manager due diligence, and recommending asset allocation. She joined the firm 10 years ago after working as the youngest divisional CFO at Thomson Financial by the age of 28, earning her CFA there and, subsequently, her MBA at London Business School.

At EY, Chan works with the company’s investment committee to design and alter investment policy statement and has undertaken a series of initiatives intended to encourage the portfolio’s success, optimizing the portfolio’s strategic asset allocation, reducing manager concentration risk by bringing onboard more boutique managers, restructuring return-seeking assets, and helping to transition the open defined benefit plan from a static 70/30 portfolio to a liability-aware dynamic asset allocation.

Chan endeavors to give back to the community by advocating the dissemination of financial literacy and diversity within the industry, as well as communicating laterally across peer groups to share best practices, helping everyone to sustain their fiduciary obligations. As president of Pension Group East, she leverages her position in the $500 billion cohort to share the best insights, knowledge, and news she can use to achieve these goals. Chan earns a ranking in this year’s NextGen series due to her impressive experience and endeavors to make an impact to society through sharing valuable information she’s learned throughout her career.

CIO: What did you think you understood before the COVID-19 crisis … and if, during the crisis you were proven wrong, what did you learn from it?

Chan: I have always understood stocks typically bottom when the economic environment “stops getting worse” as opposed to when economic or earnings data are trending better. Given the scope and speed of the current economic downturn is significantly worse than any recession since World War II, and the uncertainty of when a vaccine or a drug remedy may be available, which is the ultimate solution that would let us return to normal, it’s hard to see when the economic environment may bottom.

Based on the past 10 economic downturns since the 1940s, the time from peak to trough averaged 11 months and the equity market drawdown ranged between approximately -21% and -57%. The current global pandemic, which led to mandated temporary shutdown of major parts of the global economy, coupled with the plummet of oil prices, is expected to be a deep recession. Given the uncertainty on when a vaccine or a therapeutic may be developed, how the re-opening of the global economy may take place, and the lack of visibility of corporate earnings outlook, I am expecting a prolonged market downturn. Between February 19 and March 23 (34 days), the S&P 500 index lost a third of its value. It has since recovered more than half its loss, which is not what I have expected. While I have always understood the market leads the economy, it appears the market has priced in a V-shaped recovery, with a material drop in 2020 earnings that is largely recovered in 2021 in spite of a highly uncertain environment. It also appears the unprecedented commitment from the Fed to buy corporate bonds, including high-yield bonds, have backstopped the cashflow of corporate America, which has spurred optimism among investors. In my view, this is probably over-optimistic—for the rally to be sustained, we would still need growth in the real economy. 

CIO: What took you by surprise? What worked?

Chan: Starting with what worked, during March, the diversification benefit between US Treasuries and risky assets was good. What took me by surprise was the rush to cash in mid-March, which sharply eroded the liquidity of off-the-run Treasuries and led to a sharp surge in trading costs. We had a lot of dialogue with our fixed income managers to understand the liquidity condition of the Treasury market before our rebalancing decisions.

The price of oil future contracts turning negative and the prices of all the big fixed income ETFs trading at large discounts to their NAVs in mid-March also took me by surprise.

CIO: How would you build the portfolio differently now that you have gone through this massive accelerated shift in the market?

Chan: As a steward of capital with a long-term time horizon, we adhere to our playbook for weathering bear markets. We have our strategic asset allocation in our investment policy as our anchor and we rebalance in a methodical manner while retaining enough dry powder to rebalance again if markets sell off further. While we did not make any wholesale change to our portfolios, we made modest allocation to certain tactical opportunities, such as fallen angels.

One thing I would like to change is that the investment team be delegated with more authority to use derivatives for overlay strategies so that we don’t need to trade physicals all the time, especially during times when there is a sharp surge in trading costs.

In addition, I am re-evaluating the factor exposure among our active fundamental equity managers to ensure we don’t have unintended bias.

CIO: ESG has been a tidal wave force behind recent innovative investment framework in our industry. How do you see the ESG framework and effort be influenced by the recent event?

Chan: As ESG strategies have held up quite well in the current market and global health crisis, it may spur more interest/adoption among US asset owners. According to Morningstar, during Q12020, 24 of its 26 ESG-tilted index funds outperformed their conventional counterparts. The returns of 70% of sustainable equity funds ranked in the top halves of their Morningstar Categories.

Historically, governance issues and fighting climate change have been the top priorities in the ESG arena. With the pandemic, I expect there would be greater emphasis on social issues going forward. Apart from gender parity and workplace diversity, I expect social issues, such as how companies manage relationships with workers, including contract workers, the well-being and safety of employees, especially in the delivery services, grocery stores, manufacturing and health care sector, would be part of the ESG evaluation framework. George Serafeim, Harvard Business School Professor, in his paper titled “Corporate Resilience and Response During COVID-19,” argues that “companies responding in a way that protects employees (avoiding lay-offs, paying sick leave), manages supply chain risk (safety to avoid disruptions), and re-purposing operations to provide solutions (producing masks, ventilators) had higher institutional money flows and less negative returns.”

With environmental and social factors increasingly impacting the long-term valuation of companies, I also expect these non-financial metrics to be progressively integrated into executive compensation structures.

CIO: What’s your view on the “perfect storm” that is currently impacting the oil markets, and how will that change how you invest in upstream energy?

Chan: While we do not have direct private investment in the energy sector, the decline in oil prices has been a supportive influence on the growth rates for some countries, such as Thailand, Philippines, India, Korea, South Africa, China, and detrimental to the oil producing countries, such as Saudi Arabia, Venezuela, Russia, Ecuador, and Norway. This has impacted our allocation in emerging markets debt, high yield, and equities, especially among our value managers who tend to overweight energy.

Although the secular bear market in oil is expected to persist over the long term, I expect crude oil prices to remain volatile in the short run and could present cyclical investment opportunities. On one hand, there could be further downside due to storage risks. On the other hand, the OPEC+ agreement with production cut through 2022 should provide some near-term floor. Considering this is the second time oil prices have collapsed within 5 years, I expect the capital markets to be less inclined to provide a backstop this time. Hence management of energy companies have to be more disciplined in their capital allocation. The cut in capex by US producers are expected to lead to a decline in US oil production. This should result in a more balanced mix of supply and free cash flow. Share buybacks are likely to be suspended and maybe replaced by special dividends going forward. Industry consolidation is also likely. The gradual re-opening of the global economy could help to draw down oil inventories and eventually boost demand. 

CIO: What’s your view on the fate of the Euro and the EU?

Chan: My view is dependent on how long the time horizon, how BREXIT may be implemented, and who may be Angela Merkel’s successor.

In the short run, I think the Euro will remain weak relative to the US dollar and the EU breakup risk will remain low given Greece demonstrated years ago that the cost of even thinking about leaving the EU could be very expensive. Most of the EU nations understand they are very dependent on trade and need to work together in order to exert their influence and not be caught out between the US and China. The ECB has also provided the backstop through its asset purchase programs.

However, in the long run, it is very challenging to keep the union together. Europe has been struggling with anemic growth rates, with GDP well below a decade ago. This was due to a variety of factors, including demographic structure, lack of investment, and R&D, which has been persistently below the growth rate of nominal output.

Within the union, there are big differences among the countries. For example, Germany is differentiated from Italy and Spain in terms of industrial structure, i.e., Germany is strong in goods production and manufacturing while Italy and Spain are more dependent on tourism, which has been greatly disrupted by the pandemic. With the pandemic, economic activity in many places in Europe was down by almost one-third, with Italy and Spain being hit harder than France and Germany. Germany’s fiscal position is also very different from Italy and Spain. Germany has been able to afford an aggressive fiscal response with guarantees and income support. Spain and Italy, on the other hand, have had persistent deficits and have very large debt burdens, and hence have been more fiscal constrained and are essentially looking for a fiscal transfer.

The reluctance to do fiscal transfer, coupled with lots of political pressure from populist movements and the prospect of BREXIT certainly create a great challenge for the EU in the long run.

CIO: What do you think will be the impact of COVID-19 on developing economies?

Chan: A big drop in domestic and foreign demand amid of lockdowns around the world has pushed EM into recession. I expect the recovery to be uneven across EMs, depending on the starting point, the policy response in limiting economic dislocation, and the adaptability of the private sector.

EM central banks have adopted monetary easing across the board, with Turkey and South Africa standing out with 325 bps and 225 bps in easing. This has pushed real interest rates to negative territory in countries, such as Chile, Colombia, China, India, Poland, South Africa, and Turkey. In addition to rate cuts, several central banks have also introduced bond purchases in secondary markets, such as in Brazil, Chile, Colombia, Indonesia, Poland, South Africa, and Turkey.

EMs are also stepping up their fiscal response to the pandemic. Most countries have announced varying degrees of government support to labor markets, corporate sectors, and in some cases, direct cash transfers to households, such as Hong Kong. In this aspect, I expect EM Asia to do better than Latin America. Countries like Malaysia have already announced fiscal packages that equates to 17% of GDP, although its actual fiscal deficit will rise by only a small amount as a percentage of GDP. Latin America, on the other hand, comes into the COVID crisis with limited fiscal space as it already runs significant fiscal deficit.

In addition, although there will be spillovers effect from China’s low growth to EM Asia, a number of EM Asian countries, such as Thailand, Philippines, and Korea, should benefit from lower commodity prices. Latin America, on the other hand, have many commodity exporters in the region. Coupled with poor productivity growth, I expect the negative impact of the COVID-19 shock to be significant in Latin America.

CIO: What are the new creative/innovative strategies that you are researching right now?

Chan: We are evaluating new opportunities, such as TALF 2.0. But I would not consider them as new creative/innovative strategies.

I am interested in researching the following topics:

• With the current low rate environment, there is diminishing effectiveness for US Treasuries to hedge against risk-off environment. Therefore, I am researching alternative risk mitigation strategies
• With the US-China trade war last year and the COVID crisis, it has revealed the weaknesses in the supply chain. The pandemic has also added momentum to protectionism and de-globalization. I am interested in learning the impact of de-globalization, which may change the landscape of many industries and the growth prospects of many companies
• Since the 2008 Great Financial Crisis, companies have issued record levels of bonds amid historically low interest rates. Now, with the unprecedented fiscal response to the COVID crisis, the Congressional Budget Office (CBO) estimates total public debt to exceed the size of the economy in 2020, the first time since the 1940s. I would be interested to learn how it may impact interest rate, inflation, currencies, and tax policy going forward
• As seen in the Great Financial Crisis and this COVID crisis, the US government has stepped in to provide backstop on the downside. I would be interested to learn how it may regulate on the upside and change capitalism and therefore impact how managers may value securities

CIO: With the shakeout of industries currently going on—where do you see the most exciting opportunities over the coming years?

Chan: I believe the COVID crisis has accelerated some of the structural trends that we are seeing before the crisis, such as migration from brick and mortar retail to e-commerce, switch to digital in communication, entertainment, health care and education, acceleration of enterprise system to the cloud, and the development of new diagnostic testing solutions and therapeutics.

Some of the most exciting opportunities over the coming years are in health care with the focus on self-care, in-home diagnostics, and telemedicine. With restrictions on accessing in-person care, consumers are resorting to other means by which they can self-diagnose themselves in the home using apps and services as a first line approach. This is also accelerating the use and familiarity of telemedicine in order to access providers. The result is an explosion of innovation from academia, government institutions, startups, and enterprises in addressing these trends. 

CIO: And professionally, where do you see the most exciting areas to specialize further over the coming years?

Chan: As a generalist, I cover all asset classes in our portfolios. However, there is one area that I would like to spend more time on—ESG investing, which has not been prominent in the US pension arena. Research has shown that during market downturns in 2015-2016, 2018, and Q12020, sustainable indices tended to outperform conventional indices by having a smaller drawdown. I view ESG factors as tools to evaluate the quality of business and management, and quality is a widely accepted investment concept. There are different approaches to ESG investing, such as negative screening, ESG integration, thematic investing, and impact investing. I believe where managers who have embedded the ESG framework in their investment process in a holistic manner, coupled with the right portfolio construction, ESG could add value. This is because such an approach allows managers to engage with companies on material ESG issues that could potentially unlock value on a forward-looking basis without relying on backward-looking ESG scores and ratings, which could be inconsistent across vendors.

CIO: How is the quarantine affecting the way you view teams and working environments, such as work from home, meetings, etc.?

Chan: Working from home has not impacted our team interaction much, as we now have doubled our team meetings via Microsoft Teams per week so that we could keep in touch with each other. We also have virtual happy hours via Zoom from time to time although it is not the same as spontaneous discussions at the water cooler in the office. I have increased the frequency of my 1:1 meeting with my direct report to provide support and guidance, with a focus on well-being check-in.

Although working from home has its convenience, I find it difficult in some aspects as an asset allocator. For example, on-site manager due diligence is not a possibility at this point. We typically include an office tour where we visit the trading desk and the compliance department as part of our operational due diligence. These cannot be assessed in virtual due diligence meetings.

In terms of industry conferences, although presentations and panel discussion can be conducted virtually, the lack of opportunity for one-on-one conversation with my peers in virtual meetings is something that I miss.

CIO: What exercises have you found useful?

Chan: Last year, we were evaluating a derivative overlay strategy. As part of the strategy assessment, we included some stress testing and scenario analysis for the portfolios, which has been helpful to our liquidity management and rebalancing process during the market drawdown in March.

CIO: Who is the manager you don’t currently work with whose brain you’d most like to pick for an hour?

Chan: I would like to meet with Howard Marks from Oaktree Capital Management. Howard is a very experienced, patient investor with intellectual humility. He is astute – he is good at framing the questions and logically weighing pros and cons. I would be fascinated to hear what he thinks the opportunities are in credit.

CIO: And in a fantasy scenario, if money was no obstacle, where in the world would that meeting take place?

Chan: Beijing—I believe Oaktree has an office there. Howard may be inclined to travel there. I think it would be good to observe first-hand how China re-opens itself and to look at the credit opportunities close up.

CIO: What asset class or investment troubles you most right now—and why?

Chan: Given the uncertainty on when a vaccine or a therapeutic may be developed, how the re-opening of the global economy may take place, and the lack of visibility of corporate earnings outlook, I am puzzled by the valuation of US large cap equities.

CIO: Describe the weirdest interaction you’ve had with an asset manager. 

Chan: Many years ago, at an on-site manager due diligence meeting, I was interviewing the founder/CIO of a boutique manager, who was in his 60s. I asked him about succession planning. He got very upset about the question and kept on saying he was not that old. Succession planning is an important element of manager due diligence, especially in relation to evaluating key man risk.

CIO: What should be an investment trend, but isn’t (yet)?

Chan: With more innovation in investment vehicles, I believe alternatives assets in defined contribution plans should be an investment trend. An example would be infrastructure investing.

Governments are increasingly hard-pressed to obtain the capital required to maintain and expand their infrastructure. Private sector capital, such as defined contribution plans, can be used to satisfy those infrastructure needs. Conversely, defined contribution plan participants are generally looking for steady retirement income and inflation protection.

As most infrastructure assets have monopolistic positions and provide essential services to the markets they serve, they can provide stable cash flows which could be attractive to plan participants who are looking for steady retirement income. In addition, the inflation protection characteristics and the low correlation to traditional asset classes should make infrastructure assets attractive investments for defined contribution plan participants, who are looking for diversification from traditional stocks and bonds.

I would like to see more innovation in investment vehicles, where private infrastructure would be combined with a sleeve of listed infrastructure to provide daily liquidity, so that infrastructure investing could be an investment trend for defined contribution plans.