Despite several bumps in the decade since the 2008/09 financial crisis, the swift and brutal crash in global equity prices when the coronavirus was declared a pandemic sent pension investors reaching for their playbooks to implement defensive strategies to mitigate the damage.
“People have worked very hard at just acting on the set strategies that they’ve had for years and that have worked in the past,” says René Beaudry, partner at Normandin Beaudry Consulting Actuaries Inc.
For one, the OPSEU Pension Trust takes a segmented portfolio approach, building in sections specifically designed to act as fortification against dramatic transformations in market conditions. “We believe risk, first and foremost, has to begin at the portfolio construction level when selecting assets,” says James Davis, the pension fund’s chief investment officer.
The five portfolio segments include: one for liability hedging, made up of government bonds to account for the interest rate sensitivity associated with pension liabilities; another for return-seeking allocations; one specifically designed for risk mitigation, aimed at hedging the bets made in the return-seeking portfolio; a funding portfolio using leverage; and an incubation portfolio to try new ideas and foster innovation.
During the crash, the risk mitigation portfolio, chock full of allocations chosen for their potential to outperform in risk-on markets, did what it was designed to do, posting more than a 30 per cent return by early autumn, says Davis. The liability hedging portfolio, because of its long-duration bond holdings, also weathered the storm nicely, to the tune of 11 per cent. And the plan’s risk mitigation portfolio provided exposure to currencies that typically do well during market drawdowns, such as the U.S. dollar, the Swiss franc and the Japanese yen, as well as real return and long-term nominal bonds.
As the smoke clears
These built-in portfolio segments performed their intended functions, but there was also room to get tactical, says Davis.
“We remained fully funded throughout that period and we had an abundance of liquidity. That is by design and that liquidity was very helpful in cases like this because it allows you to be opportunistic . . . in challenging markets.”
The liquidity allowed the OPTrust to seek out additional investments in credit, public equities and a number of private assets. “Our deal teams are active,” he says. “We’ve done a number of different infrastructure investments, some private equity and also some real estate investments since the bottom in March.”
While it’s impossible to predict how far markets will fall in a crisis scenario, valuations were suddenly cheaper across equity markets, says Ian Riach, senior vice-president in Franklin Templeton’s multi-asset solutions business.
For long-term investors, this meant it was time to buy, but cautiously. “We’re never smart enough to catch the bottom and we don’t know how long these drawdowns are going to last, but valuations did a very significant reset,” he says. “Bond yields dropped like a stone, they plumbed new levels. And we just felt that 12 months from the start of the drawdown, equity prices would probably be higher and there was a good chance that bond prices would be lower.”
Heading into 2020, equity valuations seemed rich, prompting many money managers, including Franklin Templeton, to take some profits here and there, says Riach. Coincidentally, this meant it also had ample cash on hand to start rebalancing, buying into stocks at newly lower levels.
“We started methodically taking some of that cash right down, selling some of our bonds that had done well and started adding back to equities. We obviously wish we’d done more, sooner, because of the abrupt rebound. But I think being able to have a discipline where you can rebalance among asset classes, based on valuations and what the market is presenting you is important. A lot of institutional managers did this and I think stood investors well during that volatile period.”
Putting diversification to the test
What pension plans are able to do as the world addresses the virus and markets continue to roil depends, in part, on how well they weathered the initial blow.
“We manage a bunch of small and medium-sized pension plans, foundations and endowments and I don’t think it was different for any of them,” says Riach. “Any institutional investor that had a balanced, well-diversified portfolio with high quality securities obviously fared a lot better than the headline indexes did on the drawdown.”
Diversifying into alternatives like real estate, infrastructure and private equity has been a long-term trend for larger plans with more scale to play with, says Beaudry, noting interest in these asset classes is only likely to strengthen.
And while this move may seem attractive, Riach advises pension investors, especially those on the smaller side, not to rush into new positions. “All of a sudden, people are thinking about alternatives now because of what’s going on. And I’d hate to see investors just make a snap decision, there has to be some work that goes into it.
“We still feel bonds have not lost their diversification benefits completely. We just think the magnitude of that diversification or protection may not be the same as it’s been for a number of years. So all of these decisions have to be made after very thorough analysis and investors have to understand their objectives and constraints.”
Back to the land
As for one alternative investment option, there’s an old saying about real estate: they ain’t making any more of it.
Of course, land across the globe can be developed and redeveloped in infinite ways, but the amount of arable farmland the world has to offer is a relatively fixed resource, says Marcus Mitchell, chief investment officer at Bonnefield Financial Inc.
In addition, he notes institutional capital has shifted toward real assets over the past decade, with a particular interest in commercial real estate. The pandemic’s financial ramifications have demonstrated that the typical advantages of these investments, namely their diminished correlation with other assets frequently found in institutional portfolios, aren’t as solid as some would have anticipated.
On the other hand, farmland is a strong defensive play for institutional portfolios, with its own growth potential, he says, noting technological developments have enabled real production advances, meaning more food can be grown on the same land.
The pandemic and the resulting monetary and fiscal policy enacted by central banks has put inflation back on investors’ minds, adds Mitchell. “The spectre of inflation is rising for the first time in a long time with what we believe to be a set up that could produce inflation to a degree we haven’t seen over the last decade.”
Also during this time, many households and businesses have received an influx of cash through government support programs, says Erik Weisman, chief economist at MFS Investment Management. But ongoing uncertainty is causing them to hold onto those capital reserves in an attempt to remain prepared for a worsening economic outlook, which creates a decline in the speed with which money changes hands. In a recovery scenario, the loosening of the world’s collective purse strings would mean a sudden surge in money velocity, just one phenomenon that could cause inflation.
“As money velocity starts to pick up and the amount of money chasing the same amount of goods increases, this bodes well for assets that have a relatively fixed supply,” says Mitchell.
The increasingly real — if not immediate — threat of inflation is a factor institutional investors need to start thinking about from a total portfolio perspective, says Davis.
Long-term bonds, in the context of rock-bottom interest rates, just don’t have the oomph they used to, he adds, noting investors must recalibrate their past strategies, especially the ones focused on dealing with the risks posed by a deflationary environment.
“The kinds of risks we’ve faced in the past and the COVID risk, they tended to be deflationary in nature. That’s not to say those risks don’t exist going forward, but I think we need to broaden our horizons and look at other kinds of scenarios that may come to pass. . . . With interest rates so low, there’s a lot less risk mitigation potential from bonds now than there was in the past. . . . While I don’t think real interest rates are going up any time soon, inflation expectations could be and that would wreak havoc on a bond portfolio.”