As global markets navigate turbulent economic waters, active management is proving once again to be a lifeline for institutional investors to ensure their portfolios ride out the storm.

Pension funds are currently operating amid uncertainty and potential risk, says Ruslan Goyenko, an associate professor of finance at McGill University’s Desautels Faculty of Management. “There are [many] uncertainties that are going to affect financial markets, with the biggest challenge being the impact of interest rates.”

He says the financial world is seeing the immediate impact of increased rates on the Canadian housing market, which will be followed by intermediate adjustments to company valuations.

Interest rates were initially increased to control inflation, especially in the developed world that grew heavily reliant on stimulus applied to offset the effects of the coronavirus pandemic, says Amy Chang, managing director of active global fundamental at the British Columbia Investment Management Corp., noting it will take time for these dynamics to play out.

Read: 2021 IIC coverage: Is inflation here to stay?

“U.S. interest rates have increased the fastest in the last 25 years. We’re really entering unknown territory. If interest rates do stay relatively high, and therefore discount rates, companies that have more cash flow today . . . should fare better.”

The surprise in 2023 was how growth was more resilient than expected, even in Canada amid high household debt, says Hafiz Noordin, vice-president and director for active fixed income portfolio management at TD Asset Management. “There was a lot of expectation that with this rapid rate hike cycle . . . we would see a more protracted decline in growth given that the world was used to very low borrowing rates and suddenly had to adjust to higher rates.”

That unexpected growth has been helping to keep the labour market tight, which he believes will persist. But labour markets are now showing signs of loosening, which may lead to an environment where traditional fixed income can do well, with inflation trending back to target. “Still, risk assets may see a bit of a tougher time compared to this year, given the starting point for valuations.”

An active approach

As institutional investors rebalance their portfolios, they’re seeking ways to better match assets and liabilities and for some, that means putting active management front and centre in their diversification strategies, says Noordin.

In this volatile market environment, a number of scenarios could play out and it’s hard to gauge which one will prevail, he says, noting adopting an active management framework that provides more flexibility and tools is a good value proposition going forward.

Risk by the numbers

60% of global institutional investors view higher inflation as the new normal and 61% expect rates to remain higher for longer, though 51% — including 40% in Canada — expect rate cuts in 2024.

40% of global institutional investors — including 54% in Canada and 52% in Asia — are divesting holdings in China, due to its geopolitical ambitions (73%) and regulatory uncertainties (79%).

56% are actively de-risking their portfolios, while 69% are bullish on the performance of bonds and 62% are calling for longer-duration bonds to outperform short ones.

Source: Natixis Investment Managers’ 2024 outlook survey

Many institutional investors seeking long duration and liquidity in an active management framework gravitate toward a conventional fund structure, he adds.

Read: 2023 Defined Benefit Investment Forum: The value of active management in emerging markets

“Some of the larger [institutional investors] are also looking for more customized solutions and more of their interest recently has been around liability-driven investing frameworks, particularly for more segregated types of mandates that can fit in their risk frameworks.”

Inflation has been a persistent challenge in the post-pandemic market. One way to hedge inflation is to view it as a composite of different parts — unit, labour, cost, consumer price index and producer price index — says Monica Defend, a member of Amundi Asset Management’s executive committee and head of the Amundi Investment Institute.

“Once you detect the single determinant of inflation, . . . your equity allocation [will flow] into sectors that allow you to navigate inflation. So again, looking at inflation, not as a monolith, but in its subcomponents might prove valuable for investors.”

A steady hand

The key to navigating these macroeconomic challenges is to block out the noise and operate from a bottom-up perspective with a heavy long-term outlook, says Chang.

Realizing various market challenges are out of their control, her team stays focused on finding competitive advantages of prospective companies that can provide consistent returns in any economic environment. “That means looking at the individual attributes of companies, including their business models, operations and ability to generate free cash flow. Within the BCI’s internal active global fundamental strategy, we have a mandate that’s focused on quality at a reasonable valuation. So opportunities, such as whether the company is underappreciated by the market, drive our investment decisions.”

Private credit as an asset class is still appealing in this environment, given what was happening in the traditional banking system, says John Wilson, co-chief executive officer and managing partner at Ninepoint Partners. But with increasing regulatory demand for more capital to be held by the banks, he’s seeing borrowers seek out private capital to meet their financing needs, which may lead to a higher quality of borrowers. “With interest rates up . . . the return [that investors] can generate . . . on a private loan are much higher.”

Looking ahead

Among 22 global public pension funds, the top factors impacting their investment approaches over the next 12 to 24 months include:

• Inflation (roughly 20%)

• Climate change (roughly 20%)

• Geopolitics (nearly 10%)

• Technological change (roughly 5%)

Source: Official Monetary and Financial Institutions Forum survey

Canada’s Maple 8 — the country’s largest eight public pension plans that manage a total of about $2 trillion in assets — are famous for being very advanced in their use of alternative assets, particularly private assets, and they saw significant benefit from that class, he says, noting institutional investors are staying the course on alternatives because the class has performed really well over the long term.

Read: 2022 GIC coverage: Fixed income markets keeping calm, carrying on amid global uncertainty

While Canadian pension funds have invested strongly in Canadian commercial real estate, many found they were over-allocated in this area when the pandemic began, says Wilson, noting they’re now right-sizing their allocations to include more infrastructure, warehouses and data centres or other alternative asset classes, including in international markets. “When we talk to small- and mid-sized pension plans, real estate was generally their only significant exposure to alternative assets and they’re seeking to grow their allocations to other alternatives . . . for better diversification and/or inflation protection.”

Chang also sees opportunities in the industrials market, particularly in the U.S. Due to a huge backlog of projects, there will be a lot of investment in vital infrastructure, such as airports, roads and bridges that will largely be supported by bipartisan legislation.

“We think there’s probably upwards of $1 trillion of spend that needs to occur over the next decade in the U.S. There’s been a huge amount of under-investment and just a very small number of projects have been started in terms of shovels in the ground.”

She notes another area that’s gaining traction in the market is health-care innovation, such as glucagon-like peptide-1 agonists, a diabetes treatment that has also been indicated for weight loss. Because these drugs can help individuals realize substantial weight loss, they’re increasingly being covered under medical plans and, as a result, they’re in high demand.

Global disorder

Geopolitical disorder is causing even more uncertainty for institutional investors, says Defend, noting this may call for a pivot back to the 60/40 balanced approach.

“For the first time, after 20 to 30 years, we are living in a supply shortage, [as a] result of the various crises and wars we have [endured]. This will leave us with winners and losers, particularly in the emerging markets where the . . . supply chain [is shifting] from China to India, Indonesia, Vietnam, Brazil and Mexico.”

In addition, discussion surrounding on-shoring versus nearshoring will continue, particularly when it comes to the climate transition sector. In the U.S., tax incentives and infrastructure bills will provide further momentum in this sector. “Any investments related to the clean transition are opening up investment opportunities,” she adds.

Read: Which frontier markets are on institutional investors’ radars amid geopolitical churn?

Indeed, a recent survey by the Official Monetary and Financial Institutions Forum found more than a third (35 per cent) of pension funds said they expect to increase their allocations to green bonds and green real assets over the next 12 to 24 months and most expect to increase investments in renewables.

Global markets will see fragmented growth, with emerging markets growing faster than advanced economies, Defend says, citing data that shows gross domestic product slowing in developed markets, particularly in the U.S., where many economists are predicting a recession in 2024. Over the longer term, more growth will take place in emerging markets. “It is true that China is slowing, but it is slowing because they are targeting a more balanced and sustainable growth rate. But there are other countries such as India or Indonesia, that eventually will have to contribute, so we estimate the growth will likely be there. These are the asset classes [pension funds] should have in [their] portfolios.”

Key takeaways

• Interest rate volatility will continue to be a main challenge for institutional investors in 2024.

• Pension funds are staying the course in fixed income, though private credit investments that can provide long-term duration are becoming more appealing.

• A geopolitical reorder is underway, with a focus on emerging markets and regions that will benefit from a shift in supply chains.

The OMFIF survey also found 40 per cent of institutional investors selected India as the most attractive emerging market due to its government’s investment in infrastructure. Investments in the country’s digital infrastructure may boost its productivity level, but this is contingent on it being socially well managed, says Defend, noting education will be critical.

The next Industrial Revolution

While the world is bracing for a global recession, there’s also optimism that a Second Industrial Revolution — the rise of artificial intelligence — will increase the productivity lost during the pandemic, says Goyenko, noting this will spur growth and lead to high valuations.

“It will create a lot of jobs and a lot of opportunities. In all sectors, AI brings improvement because it will replace manual work to increase efficiency and reduce delays and, therefore, costs. It will optimize the supply chain, which is a very important part of any business model. Basically, the technology will allow companies to cut a lot of production costs.”

In finance, he says AI will help investors produce better forecasts.

Read: 2023 Investment Innovation Conference: How institutional investors are using data, technology to generate alpha

“It’s the most powerful tool I’ve ever seen applicable to investments. . . . It makes the current investment book obsolete. It’s excellent at anticipating crises and increases in volatility. A couple years ago AI was a good solution, but now it’s really a salvation.”

The BCI is exploring AI tools to help with day-to-day functions and it’s also being used to decipher unstructured data. “We have a quantitative team within active equities and they found it very useful to write Pythoncode, for example, in terms of their systematic strategies,” says Chang.

“We’re probably [in an] early stage at this point, but I definitely see the day-to-day benefits [with] just the sheer amount of volume of information that we have to process [in our decision-making] for our clients.”

AI isn’t a crystal ball, but it’s better than a human, in terms of the amount of data it can analyze at once, says Goyenko. “However, in volatile times like now, where there is so much uncertainty, it would be socially irresponsible for pension funds to not use AI in their investment strategies.”

Lauren Bailey is the interim managing editor of Benefits Canada and the Canadian Investment Review.