Portfolio Strategy – Yield during lean times
It’s a tricky time to be managing global pension funds. Record low interest rates around the world are challenging fund managers who need higher returns to meet the large pension liabilities on the horizon. Normally they would weigh their assets to include more equity. But equity is no safe haven– particularly now since Central Bank money printing has inflated valuations to bubble territory. Pension fund managers –some of whom are managing assets of funds already facing alarming deficits – are challenged with both yield and security in a market not suited for either. Shamindra Perera heads the UK institutional business for Russell Investments, which manages $30 billion in mostly pension assets across various asset classes invested globally. He has worked with Russell for over 20 years at its Sydney, Singapore and now its London office. Overall Russell Investments manages over $250 billion in assets around the world, which makes it one of the largest in the industry. Shamindra Perera worked with CDIC, Seylan Merchant Bank and Asia Capital in Colombo before he joined Russell. He discussed the Russell pension portfolio strategy and also offered an insight to the workings of global fund management. Excerpts of an interview.
What are those broad investment themes you are focusing on now?
You have to have a view about the current environment as well as what you expect in the future. But the one thing about the capital market is, however good your research is, you’re not going to be right all the time. It’s risky to build a portfolio that only works if the scenario you forecast pans out. Whenever you’re building a portfolio you build it within your central scenario but you also have an eye on the big risks that can derail you. It’s important to act quickly should these risks materialize. To do that you need to have foreseen the risks to your central scenario. You can’t also only rely on acting after or when signs of the risks have clearly emerged. That can be too late.
One of the elements of success in investing is the humility to recognize that we’re doing our best, that we have good people and good insight but that we’re going to be wrong sometimes. On the other hand if you build a one-track portfolio it’s difficult to deal with an alternate scenario. Capital markets are bigger than all of us and frankly if you can foresee all those scenarios then that’ll be priced into assets.
Which of global economic outturns, like the Chinese slowdown, the commodities price slump etc came as a surprise and you had to adjust your portfolio strategy?
The biggest surprise to us after the global financial crisis of 2008 has been the strength of the rebound of capital markets. While we forecast the rebound we didn’t quite forecast how strong that recovery would be. Our central scenario was that we’re going to see economic growth. We foresaw China slowing down, and its inevitable impact on commodity prices. But we didn’t foresee the extent of the impact on oil prices that wasn’t driven entirely by China.
You were not surprised about economies bouncing back but you were surprised by how strongly they did. With the benefit of hindsight what do you think was the reason for that?
The liquidity pumped into the system by Central banks. People in the financial sector are renowned for saying ‘this time is different’. Don’t believe them, because there are certain rules that don’t change. Having said that, this kind of coordination by central banks has never been seen in the world before. It was that coordinated action of pumping money into the system that led to the pace of capital markets recovery outstripping the pace of economic recovery to the extent that today, while we’re not that concerned about the underlying economic fundamentals, we’re concerned that valuations are topping. So markets have gotten ahead of themselves, driven by this liquidity and our blindness to bubbles. So markets are between fairly valued to too expensive pretty much all over the world.
How does this view impact your portfolio strategy?
Our central scenario is that markets are expensive. We think economic fundamentals are reasonable, and economic growth will come through. The way we position for that is to have more growth assets in the portfolio and by that we mean equity, high yield bonds, asset backed securities and so on. We are going to have some safety despite the head wind from rising interest rates.
Large portions of our clients are pension funds. Their liabilities are valued by discounting their future cash flows. They benefit when bond yields decline because their liability values decline even further. So having an asset that mimics the liability in the form of a bond is actually a good thing .So the difficulty in answering your question is, what you do depends on who the investor is. If you are building a portfolio for a pension fund you’re still going to have a significant allocation to bonds particularly long duration ones because that matches the liability profile.
The portfolios you manage, I presume, are largely UK pension funds with UK liabilities?
I manage the UK institutional business that is largely UK pension funds, liabilities are UK and assets are global. There is no reason for UK pension funds to constrain their investment universe. A few stocks and a few sectors; energy and a couple of telecom stocks dominate the UK equity market. So options are limited and why limit yourself to that.
For UK pension funds what are those opportunities outside the country now?
Our allocations to equity would be lower than we would expect normally. Within equities, while the US recovery is going well, the market has run ahead of the underlying fundamentals. On the flip side of that we think the strong dollar will continue. When you are investing globally you have to have a currency view.
We are moving our US portfolio to more quality stocks. By that we mean very good balance sheets, good earning cover for liabilities and good earnings coming through.
Then you have the growth stocks where expectations of earnings growth are higher and those are not cheap, but you are paying for that growth. If you are concerned about the market valuation you may not want to participate in those. While we might be underweight equities in total we are also slightly underweight to US equities relative to what we would normally have. Then you are concerned about the interest rates going up. So one of the things that we have significantly increased our allocation over the last year are convertible bonds. A convertible bond is a security issued by a company, which pays you some kind of coupon, but it’s convertible to the price of equity at maturity. So convertible bonds behave like equity when things are going well but give you the protection of a bond if things go wrong.
We also haven’t hedged the exchange risk because we like the strong US dollar. We think its strength will continue. If you want to build a global convertible bond portfolio the largest part of the opportunity is in the US. Within the fixed income universe we’d be looking at investment grade bonds issued by top quality corporates.
Their spreads are low relative to sovereign bonds. If or when there is a rate increase the impact will be immediate because the spread to sovereigns is quite low. High yields, on the other hand, are offering bigger spreads. They’re also cheaper than they’ve been in the past. The higher return is because you’re taking more risk. In fixed income, one of the biggest opportunities we have exploited after the global financial crisis is tightening of bank and insurance regulations and the impact this has had on credit. Banks have stepped out of lending to certain areas, particularly smaller and medium enterprises, due to the higher cost of capital. This is despite the UK and US pumping money in to banks in order to get this lending going. Instead this money pumped in has inflated asset prices. It’s left a void in lending where banks are not pursuing new opportunities, they’re also keen to get rid of their existing books as well. The market for packaged securities consisting of bank loans has also thinned out. That’s another area we’re going into. One of the benefits of these are they are floating rate instruments, because the loans the banks have made are not fixed on rates. The fixed income portfolio we’re restructuring away from investment grade slightly into high yield and also increasing our allocation to bank loans backed securities and other floating instruments.
Aren’t you apprehensive that similar problems to those that existed in sub prime mortgage loans,which came to light after the global financial crisis can surface around small and medium business loans too?
Completely. In the high yield market you also have higher risk. You have to understand where that risk is and then you have to take a view of how likely that risk is. We’re talking here about mortgages backed securities.
These are loans to companies granted to companies to carry out their businesses. They have been packaged. If there is some systemic problem that causes more and more small and medium enterprises to go bust then you’ve got a problem but that’s where our view matters that economic growth will continue even if there’s a shock to capital markets in terms of valuations.
What are yields like now?
You’re looking at a yield of 5 to 7%.
In which parts of the world is your portfolio now invested? How is this different to your own base scenario?
Our client portfolios are about $30 billion and probably $5 to 10 billion would be deployed to hedge liability relative risk because most of our clients are pension funds and most of the liabilities are much greater than the assets. When interest rates have been dropping liabilities have been skyrocketing, even though we have had asset prices increasing, the asset price increase has been on smaller pool than the liabilities, so the gap is widening. We deploy part of the assets always to mimic the liabilities up and down. Because asset size is lower than the liability we use leverage swaps to match the liabilities so that for every dollar of capital that we allocate to hedging liability relative risk we get about four to five dollars of interest rate risk coverage. So even though we’re allocating maybe 20% of the assets to hedge the liabilities we’re hedging 100% of the assets.
Apply this to a real scenario?
Let’s say there’s a pension fund with a 30-year liability. You would deploy some of your assets for risk management purposes. With the rest you can buy a 30 year bond, but that may cover a tiny proportion of your liability, so rather than buying a bond, you buy a swap, so essentially let’s say your liability is 100 and you invest 10 of capital to match that liability and leverage four to five times. You still don’t get 100% coverage, you may get 50 or 60% coverage. If for instance interest rates drop and that liability value goes up from 100 to a 110, you have 50 to 60 percent matching hedging assets. They would have maybe increased from 50 to 55 percent, so you are moving in the same direction whereas if it had not leveraged you only have 10 and it’ll increase to 15 and that isn’t much.
So you’ve deployed about a third of your portfolio for risk management?
I’d say about 20 to 25% for liability matching, and then you are focusing on the rest of the assets to generate growth. Let’s say you are trying to generate something like inflation plus 4% or something like that on a market cycle which is seven to 10 years. Typically with that kind of return profile, you probably would carry about 50% to 60% in equities. Today we’d probably carry 40% to 50% in equities, and in the US within those equities we are moving towards quality names rather than growth or value names.
Right now the European and Japanese allocations will be slightly higher than normally. Emerging markets will be about equal or slightly lower. From a valuation standpoint; emerging markets are far cheaper than developed markets. But there are times when you don’t want to catch a falling knife. Because of those risks we’re not piling into those assets that have declined in value but we’re not exiting either. There’s an allocation to frontier markets as well, and countries like Sri Lanka would come into the frontier market.
Would you invest in a market like Sri Lanka?
Allocation of total return seeking assets to frontier markets would be about half a percent. Allocation in the emerging market would be in the region of 10%. In our allocation of frontier markets one of the large overweights is Sri Lanka. We hold a range of names from John Keells, Distilleries, Commercial Bank and Seylan Bank.
What’s the liquidity threshold you require to hold assets here?
How we manage a portfolio is we allocate at macro level. Then we employ fund managers to manage in the different markets to the overall asset allocation level. So the actual decision to invest in Sri Lanka wouldn’t be made by us, it’ll be made by one of the specialist frontier market managers that we allocate money to. Those managers will have a mandate to outperform a frontier market benchmark and those managers will allocate to the underlying stocks.
These managers are UK based?
No, they’re global. So the Sri Lankan allocation is more than likely coming from a frontier manager. We do allocate to global emerging market managers as well and one of our global emerging market managers has an allocation to Sri Lanka of about five to six percent. That’s an off benchmark allocation for that manager because their benchmark is emerging markets, so they’ve made an off benchmark allocation to a couple of stocks in Sri Lanka including John Keells.
How have frontier markets been doing?
Emerging markets and frontier markets have had a tough time. I’m talking here in relative terms. At the moment our allocation to frontier is neutral to slightly lower than what we would do over the long term.
Clearly your portfolio is allocated based on outlook and how your expectations differ from market expectations. So what’s the outlook?
Our outlook is for a modest rate increase in the US and UK. In fact at the Bank of England meeting there was an equal split between members who were voting for a rate increase and members who were voting for status quo, which hasn’t happened for a long time.
Our central scenario is benign modest growth followed by a small increase, which shouldn’t be mistaken for a trend increase. Over the last several years the risk of inflation and the risk of deflation have both been present simultaneously. Think about how diametrically opposite those two scenarios are but they’ve actually a risk to our central scenario of manageable inflation. Decline in oil prices has had a disinflationary impact, but that’s a onetime effect. For that disinflationary impact to continue oil will have to decline from $50 a barrel to $25. No one is forecasting that. Whether by design or accident coordinated monetary loosening by Central banks has got us to where we are and one of the questions for the future is when will they take the heroin supply away? I don’t think Central Banks are going to completely shut off the taps, so it’s not going to be cold turkey. They will reduce the dose observing how the addict is doing.
The market is aware this will happen but nevertheless there is a risk. We will have to wait and see. What are those benchmarks?
What we care about is that the portfolio is growing faster than the liability. If not we are in trouble. So it’s about outperforming the liability growth from a benchmark. We then need to figure how we do that.
Remember part of the assets have already been allocated to managing risks of the liabilities doing something we don’t like inflation and interest rates risk. Liabilities rise with inflation. Once done, we need to generate some growth and that growth is in order to outperform clients liability by three percent a year, already having allocated 20% of the portfolio to hedge risks, so that’s no longer now available. With the remaining portfolio we might have to generate inflation plus four percent annual return.
At a high level what are those numbers that you need to broadly reach those client expectations?
Today everything starts with bond yields, they give you a good indication of the implied economic growth. Today bond yields and global economic growth aren’t that good. Having been used to high teens to low 20s returns over the last eight years or so it’s now going to be a bit of a shock. We’re expecting over the next five to seven years only mid to high single digit returns from equity markets and low economic growth.
Little bit of inflation and high teen sort of growth?
I think the global capital markets require a bit of inflation. That’s why Central Banks acted so aggressively because the deflation risk is high now. I’ve been asked a question often, why is deflation so bad, because with deflation people’s cost of living declines and they can spend more? It’s bad because people then wait to spend. If you know that something you want to buy is going to be cheaper tomorrow you won’t buy it today. Our whole capital market system is based on consumer led growth and spending which feeds in to the economic growth. If this stalls – we’ve seen the case study of Japan over two decades – then it’s a problem.
In order to generate economic growth you need low inflation of around two percent globally. Now what we’ve had is not deflation, but disinflation. Even with all this money printing – or dropping money from helicopters, which essentially is quantitative easing – we’re not that concerned about hyper inflation because, there’s still a lot of spare capacity in the world. So spare capacity means as demand increases there is capacity to supply it without impacting on prices. In developed markets like the US and UK one of the reasons for low inflation is that people are working less (fewer hours), so effectively their take home wages are lower. So wage inflation is also not a huge risk. Currently deflation is the bigger worry.
What other asset classes besides the ones we discussed so far do you invest in?
Because our investors, mostly pension funds – are very long term investors with liability going to 30, 40 or even 50 years, we are increasing allocations to somewhat illiquid investments. Pensions have the ability to take on illiquidity and in a low interest rate and low return environment you want to pick up whatever premium you can get. In a higher interest rate return and growth environment you may think I don’t need to take on the illiquidity implicit in these other asset classes because I’m getting enough from my liquid portfolio.
Allocations to illiquid assets include real estate, real estate debt and even some distress debt. The thing that most people forget is even in distress debt you rarely lose 100 percent. Your are taking a risk but there’s someone who’s forced to sell that, usually a bank or an insurance company for whom the capital cost of holding that asset is too high.
Do you invest in Hedge Funds?
Yes we do. We believe that if you have the research capability, you can find skill-based returns as well.But it is very difficult and not as reliable as market based returns. The skills required to find skill-based returns is enormous. Past performance is a very poor indicator of what you can expect in the future when it comes to an active manager’s return. In fact there is fairly strong evidence that it’s the opposite; that it’s a mean reversion effect – fund managers who have done well in the past two or three years then losing money. Skill-based return is the uncertain element that you are hoping to gather, but then there’s a certain element – the fee that you pay, that is certain, for an uncertain return. Yes we invest in active management, provided it’s a long only investment for security selection or hedge funds which are long only, or long-short and for macro strategies. But it’s incredibly important to pick the right fund managers and to make sure that you are getting paid enough in return for the risk you take.
Has private equity (PE) disappointed?
When public markets are doing 25% per annum of course people are going to say why bother with PE. But we’re not forecasting 25% per annum return from public markets going forward, so when you’re forecasting mid to high single digit returns PE has a place in the portfolio.
When I joined Russell as a manager my job was to research private equity managers. This is not a game that you can play at the average. The average manager will disappoint. You have to have the skill to find second quartile or top quartile managers.
Whether it’s private equity or hedge funds, people grossly underestimate the skill that is required to select active managers in each of those areas. People rely firstly on past performance and track record and they rely on brand name. Is it a name they recognize, a name they’ve seen on television, billboard advertisements? Then that’s the strength of someone’s marketing budget and not an indication of the skill set. In an environment when we expect low market returns I think you have to look for enhancement from active management but the caveat is that picking active managers is not easy. It requires skill and a lot of resources.