April 13, 2021

Tactical Shifts: How Institutional Investors Are Adjusting Asset Mixes Now

Private credit, real estate, emerging markets. Here are the ways CIOs at HOOPP, the James Irvine Foundation, and two others are solving the allocation puzzle.

Reported by Larry Light

Art by Kiki Ljung, Folio Art

Set it and forget it is a non-starter for institutional investors, especially over the past rollicking, sometimes terrifying, year. Asset allocations have always been in motion, and lots of brainpower is expended on getting the right mix—both for the near-term (aka tactical) and the long-term (strategic).

Not everyone is successful at it. So let’s look at four institutions that have adjusted their asset allocations, both tactically and strategically, to generate good returns and weather turbulence.

Last spring’s unpleasantness could have upended the James Irvine Foundation’s goal of distributing grants to help California’s low-income workers advance economically. Instead, thanks to some wise investment planning, the organization has been able to increase its grants budget.

Tim Recker, CIO and treasurer, increased the fund’s credit line, thus allowing it to keep making grants during the downturn without selling assets. Even more significant were the changes he has made to the foundation’s portfolio, which saw its investment return clock a 31% advance last year.

Those shifts, made after his arrival at the fund more than four years ago “set us up for 2020,” Recker said. In all, he ended up replacing half the portfolio over three years. While the investments had been performing fine before his arrival “and we could’ve stayed put,” he felt that the re-allocation was the best for the long-term.

Smart Moves

One change Recker made was to whittle down the fund’s exposure to energy, to 0.4% from 6%, because “it didn’t fit our ideas.” He also sold stakes in some of the foundation’s hedge and venture capital funds, which were “not earning their cost of capital.” The fund as of 2020 was “US- and China-centric,” he said, and underweight in Europe.

This strategy proved to be prescient, although Recker makes clear he is not a seer, but just someone with a sense of how this particular portfolio could be improved for the coming years. “Why not change if it’s not broken?” he asked rhetorically. “Because then it might be too late.”

Setting up a good allocation and sticking with it can pay off. The San Bernardino County Employees’ Retirement Association (SBCERA) got pummeled in the pandemic market crash, and ended up losing 2.8% for the fiscal year ending last June 30. But then came the recovery: The plan’s mix of small-cap and emerging market stocks, structured credit, and private equity, among other assets, powered it to a 22% return in the current fiscal year through February. The plan, under CIO Don Pierce, now is 78% funded.

The philosophy is different at the Royal Mail Pension Plan in the UK, which is fully funded. The British postal fund, led by CIO Ian McKnight, had steadily been de-risking, and so it wasn’t hurt much from last spring’s market wipe-out. It had positions in macro hedge funds, whose strategy is to play large economic events worldwide—currency swings, interest rate changes, etc. Result: Assets increased 17% for the recent fiscal year.

Heading in a more risk-prone allocation direction is the Healthcare of Ontario Pension Plan (HOOPP). The retirement program has shed a batch of low-yielding bond holdings, moving into stocks, corporate credit, real estate, and infrastructure, which it thinks can bring better returns than traditional fixed income. The plan can afford to take on risk: It is fully funded and then some, at 119%.

HOOPP already is a major landlord in the Toronto region, and one of its key areas of expansion is into developed markets outside Canada, particularly the US and Europe. Last year, it paid C$270 million (US$214 million) for a stake in a Portuguese fiberoptic company.

Like many other Canadian funds, HOOPP puts a big emphasis on direct property ownership. “We have 80% of our real estate portfolio as a direct investment,” as opposed to being in a pool with others, noted CEO Jeff Wendling (he also retains his former job as CIO, until a replacement is found). In an interview, Wendling explained that a big real estate push for some years has been underway into logistics and away from ailing retail. The fund has a large concentration of warehouses devoted to e-commerce order fulfillment.

Why to Worry

Many allocators might still be wondering how to rearrange the game board in 2021 and beyond. A recent survey of global institutional investors by Natixis Investment Managers showed a plethora of concerns over muted returns ahead and not reaching pre-pandemic levels until next year or 2023, and also about handling a lot of volatility along the way.

Respondents expressed a wariness about equities, although they recognized their skyrocketing potential. They displayed low regard for traditional fixed income, except for serving as ballast, and were intent on finding better-paying versions of it, like private credit. They showed enthusiasm about alternative assets, which feature long-term promise (say, from private equity), and, for some alts, shorter-term appreciation from the likes of commodities.

“There is opportunity to be found—if you know where to look,” wrote Dave Goodsell, head of the Natixis research unit.

The search for the right combination to meet each fund’s individual needs can be a mind-bending exercise, involving many moving parts. “You want liquidity and downside protection” and “negative correlation to equities,” said Anne Lundberg, head of the institutional distribution team at Thornburg Investment Management.

Her company likes bank loans and asset-backed securities (ABS) as fixed-income substitutes for its institutional clients. These instruments generate higher interest payments than Treasury paper. And Lundberg’s firm ensures that at least two-thirds of them have a credit rating of A or better, thus lowering qualms among the risk-averse.

Pension Paradigms

Last spring’s breathtaking stock market decline, as the pandemic shocked the world, rattled many plans. US public pension funds took a hammering that ranged from 20% to 40% losses then, according to asset manager BlackRock’s institutional unit. And that skewed the asset mix to a large overweighting of fixed income, which hadn’t been as badly hurt as equities.

Then the damage self-repaired, and stocks rose to a new peak. HOOPP, for instance, managed to spring back to an impressive 11.4% return for all of 2020. Nonetheless, the early-2020 plunge convinced many money managers that further equity gains may be limited, especially because valuations are far too high for their comfort.

More broadly, BlackRock projected, some 70% of public plans will miss their assumed rates of return over the coming decade. Those with greater exposure to stocks and alternative investments will fare better than funds with higher fixed-income weightings, the firm’s analysts concluded. Current interest rates remain historically low, a circumstance that few predict will change soon in any meaningful way. Meanwhile, BlackRock’s expectations for a continued roaring stock market over the next few years are low.

The allocation story, of course, is somewhat different for corporate defined benefit (DB) plans. The company-sponsored programs tend to be better funded, at 92.9% lately, by consulting firm Milliman’s count, versus 78.6% for public funds.

Corporate DB plans are better off because they cover far fewer people than their public counterparts and often have frozen benefits for retirees and barred entry to new hires. Plus, many company retirement programs these days offload their DB liabilities to insurance companies. One dynamic that drives corporate plans’ asset allocations: They are more into de-risking, known as liability-driven investing or LDI, which means ever-larger bond concentrations despite today’s low rates.

Playing Jenga

When pension funds and other institutions plan for tomorrow, what do they see? Sure, the future always is murky, and investors perennially climb that storied wall of worry. Yet three market crashes this century have upped the pessimism quotient, to hear asset managers tell it.

A January survey of asset managers by Morningstar found that they expect US stocks, the traditional growth engine of most portfolios, to average about 3% annually over the next 10 years. Over the past decade, the S&P 500 averaged about 14% per year.

In many ways, constructing a portfolio is like a game of Jenga, where blocks are removed and added to a tower, in hopes that the whole structure will be stable and not topple. Before the 2020 US election, Northern Trust developed several scenarios for clients, based on the possible outcomes: a Democratic White House and a Republican Capitol Hill, a continued GOP presidency and a split Congress, etc.

Once the Georgia runoffs were over, with both houses under the Dems’ leadership by a smidgen, the firm shifted a segment of its model portfolio into stocks from bonds. In the liquid section of the portfolio, as opposed to the part devoted to long-term investing, the equity-debt breakdown now is 68% to 32%, where before it had been 60% to 40%. “We figured there would be higher government spending” with the Democrats in charge, however narrowly, said Jim McDonald, Northern Trust’s chief investment strategist.

To be sure, the firm’s strategic framework is altered to meet the needs of separate institutional clients. One family office, for example, had just sold a business it owned, and thus had a bunch of cash on hand. The task was how best to distribute this sudden flood of liquidity. In a second example, a defined benefit plan needed more cash to meet an increase in its payments to beneficiaries, as more filed for their pensions. Northern Trust advised taking the money out of fixed income, where prospects for capital appreciation aren’t as bright as elsewhere.

Different Strokes

Institutions have different needs, naturally. A large state pension plan has to meet its obligations to a vast number of retirees. A corporate fund, seeking to do a risk transfer (i.e., move the liabilities to an insurer), needs enough money to make the program fully funded first, since the insurer won’t touch an underfunded plan. A foundation makes grants, a distribution that it can tailor as the situation warrants.

Asset allocating has the virtue of, in most cases, predictability. “You can see liquidity events coming,” said Jared Gross, head of institutional portfolio strategy at JPMorgan Asset Management. Such as an actuarially determined expansion of a pension plan’s retiree rolls as workers call it quits, or a payout from a university endowment to fund scholarships for an incoming freshman class.

True, unexpected things happen, as last spring’s COVID-19 market free-fall made clear. Regardless of the timing for when they need cash, though, institutions typically have a decent amount of flexibility to meet these challenges. Some clients, Gross said, “have more liquidity than they think they do.”

One example, he noted, was what he termed “core real assets,” meaning those that produce income. Think office buildings that collect rent, freighters that charge fees for the cargo they carry, and electric utilities that get rate payments from customers. It’s often possible to raise those payments, Gross said.

To be sure, that usually must take place after a lease or contract expires and is renewed. But it does give a property owner the ability to plan for ever-escalating income. Office rentals may prove to be an exception, given all the talk about companies needed less space, post-virus. But even if an office shake-out removes a lot of these assets from institutional portfolios, some day they will return.

That’s the kind of goal that all asset allocators can get behind.