Sovereign wealth funds, central banks feel pull of partnerships

082012 keeley
Moving: Terrence Keeley said low yields are forcing institutions to look at other asset classes.

Poor return prospects are pushing more official institutions into the arms of strategic partnerships with money managers running multiasset mandates.

In July, the Beijing-based National Council for Social Security Fund announced the appointment of J.P. Morgan Asset Management (JPM), Neuberger Berman Group LLC, Lombard Odier Investment Managers and Schroders PLC to manage such multiasset portfolios. Officials at the $136 billion fund did not say how much each firm got.

Many other official institutions — which comprise central banks, sovereign wealth funds, sovereign pension funds and similar government-controlled investment organizations — are considering adding multiasset strategies, including the $32 billion State Oil Fund of Azerbaijan, Baku, sources said.

While managers declined to talk about specific clients, they said in general, the trend is accelerated by low nominal yields and sovereign credit concerns combined with higher overall volatility in global markets. As a result, competition is rising sharply among those providing multiasset portfolios with a strategic partnership element for sovereign wealth funds and other official institutions.

“In many ways, official institutions are pushing the envelope to bring about the next generation of money management,” said Robert Prince, co-chief investment officer at Bridgewater Associates LP, Westport, Conn.

Interest rates that are straddling a subzero yield environment in some developed economies have hurt official institutions disproportionately because of the institutions' typically high reliance on investments in debt issued by the U.S., eurozone, Japan and U.K. governments, sources said. Official institutions, with an aggregate $24 trillion in assets, have witnessed a steep decline in annualized returns from their government bond holdings in particular, sources said.

From 1998 to 2008, a typical portfolio of high-quality government bonds with an average duration of two to three years returned about 3.5% on an annualized basis in Special Drawing Rights terms, according to estimates by BlackRock (BLK) Inc. (BLK) The same portfolio now would generate an annualized return of less than 0.5%. The impact is estimated to have cost central bank reserve managers alone about $300 billion a year compared to pre-crisis levels, according to BlackRock.

New confrontation

Official institutions “have not been confronted by such events before,” said Terrence Keeley, managing director and global head of the official institutions group at BlackRock (BLK), New York. “Low nominal yields have forced them to look at other asset classes in a new light.”

The trend toward greater diversification has been pushing official institutions toward higher risk/return investments; new asset classes, including alternatives; and new currencies. In total, BlackRock managed about $195 billion on behalf of central banks and SWFs as of year-end 2011, according to Pensions & Investments data.

Daniel Farley, Boston-based senior managing director and chief investment officer of State Street Global Advisors' investment solutions group, said implementing multiasset strategies is one way for official institutions “not only to generate returns, but also to promptly move between asset classes” while gaining insights into how those asset classes operate. SSgA managed $325 billion on behalf of central banks and SWFs as of Dec. 31.

Strategic partnerships involving multiasset strategies still attract a relatively tiny fraction of overall SWF asset inflows, but they play a crucial role in SWF asset allocation because the best ideas garnered from these portfolios are often used to implement the rest of portfolio, said Charles Baillie, managing director and head of global portfolio solutions at Goldman Sachs Asset Management, London. He declined to name the clients GSAM is advising on such mandates. As of Dec. 31, the group managed $61 billion on behalf of central banks and sovereign wealth funds, according to P&I data.

“We're living simultaneously with inflation and deflation, because of the fiscal imbalances around the world. We've got negative interest rates in (certain) developed economies, and higher growth with higher inflation in some emerging markets,” said Cynthia Steer, head of manager research and investment solutions at BNY Mellon Investment Management, New York.

As a result, money managers are being pushed beyond the constraints of traditional asset modeling “to better function in this broader macro environment,” Ms. Steer said. BNY Mellon managed about $50.5 billion on behalf of central banks and SWFs as of Dec. 31, according to data provided by the firm.

Varied appetites

Clients vary in terms of risk appetite, with SWFs usually clustered at the higher end of the risk spectrum and more willing to invest in alternatives. Central banks, on the other hand, might be more focused on capital preservation and are inclined toward fewer subasset classes confined within fixed income, sources said.

For some official institutions, the problem with their strategic asset allocation isn't from too much equities, but too much government bonds. “For any given asset class, there exists a susceptibility to perform poorly for a long period of time,” Bridgewater's Mr. Prince added. “For (government) bonds, that might be a sustained rise in inflation. On the other hand, equities might perform poorly in a sustained weak-growth environment. Different portfolios tend to be out of balance in their own way.”

Traditionally, managers are hired because they have a certain expertise such as large-cap European equities, GSAM's Mr. Baillie said. In the case of multiasset strategies managed on behalf of sovereign wealth funds, these strategic partnerships represent “a full transformation in which managers are asked to think exactly in the same way with the same concerns” as the client, Mr. Baillie added. “It fundamentally changes the way that a manager operates.”

The strategies are tailored to individual clients and vary accordingly, but there are some similarities. For example, they usually employ factor-based analysis to manage risk at the overall portfolio level. Compared to a typical global tactical asset allocation strategy, these multiasset portfolios go beyond a search for the best opportunities and look for investments that combine to meet or exceed an absolute-return benchmark “with the greatest certainty over the long term,” Mr. Baillie said.

Institutional investors are realizing that within the traditional pre-defined strategic asset-allocation framework, “returns are pretty much directed toward the most volatile asset class — mainly equities,” said Stephane Monier, global head of fixed income and currencies at Geneva-based Lombard Odier Investment Managers.

Lombard Odier spent the past nine months tailoring a risk-parity strategy for large institutional clients to include inflation protection among five equally-weighted risk allocations. In addition, a passive fundamental fixed-income benchmark is implemented to further improve risk-adjusted returns, Mr. Monier said. Lombard Odier manages a total of about $3.1 billion across all risk-parity strategies. Since inception in September 2009, Lombard Odier's risk-parity strategy returned an annualized 3% net of fees in terms of Swiss francs with a Sharpe ratio, or a measure of excess return per unit of risk taken, of 1.3.

A pioneer in risk-parity strategies, Bridgewater has about $130 billion in total assets under management, about a third of which is managed on behalf of official institutions such as central banks and SWFs. “Almost all of the official institutions we're working with are moving in the direction of risk parity,” although at different stages, Mr. Prince said. Since 1996, Bridgewater's risk-parity strategy has returned an annualized 9.5% net of fees in U.S. dollar terms with a Sharpe ratio of 0.6.

“Competition in this field is defined by who can generate excess return over an absolute-return target measured over a rolling period of time, and provide additional strategic partnership benefits,” said Alan Dorsey, managing director and head of investment strategy and risk at Neuberger Berman, New York. “It's simply a new evolution in asset management.”

In addition to tactical asset-allocation skills, clients also look for returns from actively managing the underlying investments and more rigorous risk management from an overall portfolio perspective. The level of transparency is also higher compared to the typical GTAA mandate and an emphasis on performance-based fees stresses “a keen alignment of interest,” Mr. Dorsey said.

In some cases, particularly among newly established funds, the intent of multiasset strategies might be to gain exposures to new asset classes and also to better understand how those asset classes fit into the overall portfolio. In others, SWF executives are working with managers to assist in broad basic asset-allocation decisions — for example, where to overweight and underweight asset classes, Mr. Dorsey said.

Mr. Farley of SSgA added: “They're looking for dynamic flexibility in order to take advantage of return opportunities.”

This article originally appeared in the August 20, 2012 print issue as, "Institutions eyeing greener pastures".