This is Part 1 of our DB Summit Coverage. Part 2 will be published next week.

In the current low-yielding fixed income market, fund managers and plan sponsors are desperately looking for alternative strategies to wring the most they can from their investments simply to meet funding objectives.

Speakers at last month’s Benefits Canada Defined Benefit Summit noted that the global economic and investment markets have moved into a more volatile phase. All of which raises the old axiom of whether to “de-risk or up-risk.” And, for that matter, adopt an illiquid versus liquid approach. For those fund managers staunchly clinging to traditional indexing as an investment strategy, an environment of low-yielding fixed income assets, coupled with lacklustre economic outlook, represents a nightmare.

Cash is going to keep losing money every day simply because fund managers will not achieve a rate of investment return above the rising rate of inflation, said Craig Alexander, senior vice-president and chief economist at TD Bank Group. “Bond yields are likely to rise only modestly, with the yield on 10-year U.S. bonds likely to clock in around 2.2% to 2.8% for [2015], which means that fixed income yields will still be below the 3% seen at the beginning of 2014,” he adds.

Read: 7 forecasts for 2015

There is only one asset class that offers select investment growth possibilities, Alexander noted, which would be equity markets—albeit with higher risk and volatility.

Not all fund managers see greater market volatility as an obstacle, but rather an opportunity to exploit market inefficiencies to gain just a little extra beta return. “Going forward, it’s safe to say that we’re going to be in a lower [investment] growth environment, which is going to put pressure on pension fund sponsors and fund managers to achieve their long-term return requirements,” said Eugene Lundrigan, COO of Sun Life Investment Management Inc.

He doesn’t see DB plan fund managers wandering too far from their traditional investments; namely, fixed income assets. But Lundrigan believes there will be an uptick in interest by Canadian fund managers in non-public sector debt, such as high-yielding corporate bonds and commercial mortgages. Naturally, these bonds have greater inherent risk, but in weighing the risk factor against return, there are opportunities to exploit.

Fund managers “are going to look at working their assets harder to achieve plan objectives,” he added. In terms of the liquidity versus illiquidity debate, Lundrigan concurs that cash will produce negative gains. “You need some liquidity in your plan, but not too much of it—you need to find the right middle band.”

Liquid and non-liquid asset returns in the same investment class are today more similar than has historically has been the case in investment models, observed Wayne Wilson, vice-president of Lincluden Investment Management. Illiquidity and liquidity in achieving the right portfolio balance is a risk that has to be managed, he conceded, adding that a highly illiquid position may mean losing out on market opportunities in terms of portfolio rebalancing.

Travis Bagley, director of transition management (Americas) at Russell Investments Canada, pointed out that an illiquid or liquid position as part of a plan’s investment strategy in today’s investment environment is not as simple as it sounds.

The present market in high-grade fixed income assets is definitely tighter than before. The challenge is how to reduce illiquidity when market makers are not facilitating the supply and demand to move large parcels of fixed income assets. “Reduced liquidity in the markets means moving a large block of bonds is a lot harder,” he explained.

As a result, Bagley doesn’t foresee a change in liquidity in the fixed income markets in the short term. Specifically, he notes that the “liquid-type” bond market will continue to face liquidity challenges in the future.

Read: A fresh look at alternatives and illiquidity

Get smart
Smart beta has also become an important tool in the investment palette, said Alexander Davey, director, senior product specialist, alternative beta strategies, at HSBC Global Asset Management (U.K.) Ltd.

But when it comes down to the nuts and bolts of investment strategies, what exactly is smart beta? Davey conceded that it’s something of an industry buzzword, representing alternative investment strategies to traditional market capitalization price indexing—and, in fact, many of these strategies have been around for quite some time.

Essentially, smart beta strategies are designed to offer a margin of extra return that can be derived from selecting a different passive index instead of one based on market capitalization and by utilizing asset selection styles, stock market metrics or reweighting strategies to construct your index. In this regard, capturing smart beta depends on a belief that investment market reactions are not always efficient and prices of equities are more volatile than they should be.

Capitalizing on these market inefficiencies through management, a smart beta strategy could provide a two- to three-percentage-point return above the passive price-based index, which in the current sluggish investment environment can be substantial in achieving a DB pension plan’s growth objectives, Davey said. “I believe there is an equity risk premium worth catching through a smart beta strategy.”

Smart beta is definitely not based on a market cap-weighted index, he explained, but rather is an adoption of another form of investment strategy methodology. “We’re coming out of the most hated bull investment market, so investors are looking at individual factors that drive markets,” he added. “Smart beta is part of this demand-driven market.”

Read: Appetite for smart beta growing among institutional investors

Active versus passive
“It’s important to be aware of how investment market dynamics are changing, as plan sponsors now have less financial flexibility than before in terms of lower returns relative to higher costs associated with DB plans,” said Jim Cole, vice-president at Phillips, Hager & North Investment Management.

As such, he emphasized the need to adopt a risk management approach to portfolio management as the environment becomes increasingly volatile.

However, Cole believes there are new investment opportunities opening in the global fixed income market as a result of this increased volatility. He, too, subscribes to the theory that markets do not always react efficiently in pricing and thus provide unique investment opportunities through active portfolio management.

“It’s important to understand how tools are being used to increase returns relative to risk…the last three years has seen increased volatility in the investment markets with investors focusing on headline risk and thus overreacting,” he said.

This broad-brush market reaction creates upside risk opportunities for fund managers who truly understand the fundamental risk components inherent in the different markets, Cole said. “Today, there are more investment return opportunities through active investment management than in recent years.”

Read: Why don’t Canadian plan sponsors like passive management?

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