As asset owners consider that long-term return expectations will be more muted, and in a long-term rate environment that may persist, how should they be thinking about asset allocation? “In the current environment of the Covid pandemic, one of the surprising features is that we've seen an appreciation of both equities and fixed income assets over the course of the last year, not only in total return terms, but in the valuation sense. So, all these markets are now more expensive, and that is what's driving that reduction in long-term return estimates,” said Jeff Palma, Managing Director and Head of Public Investments, Global Fiduciary Solutions at State Street Global Advisors, speaking at Pensions & Investments’ virtual conference series ‘The Evolution of OCIO.’
Crafting Asset Allocation for a Low Return Environment
“Not only do we expect lower equity returns, over a five-year period, we have negative returns forecast in some government fixed income. That's driven by the fact that coupons are very low and interest rates may well rise. That's not true in credit, where you can get a little bit of extra return, but it certainly has implications for lower returns there also,” added Palma, who is part of the firm’s OCIO team that manages $130 billion in OCIO assets across defined benefit and endowments & foundations. “At the same time you have these higher valuations, volatility hasn't come down and, in that sense, Sharpe ratios aren't nearly as attractive. Where you want to take risk in your portfolio becomes more challenging,” noted Palma, at the session titled ‘The New Normal for Investment Returns and Allocations.’
In considering ways to improve risk-adjusted returns, asset owners can consider alternatives but, Palma cautioned, “It certainly is an attractive space, but I don't think it's a silver bullet. We need to be careful and acknowledge where some of the risks are with liquidity, depending on where you are in the glidepath for a defined benefit plan versus an E&F.” Another way is to bring down the correlation of asset classes in the portfolio, he said. “You do not need to have everything so highly correlated just to equity markets. Finding different ways to do that can reduce your funded status volatility and can improve your risk-adjusted returns, and it can insulate you a little bit from potential shocks because again, we still see that correlations are fairly high,” he said.
Plan sponsors should ask themselves how much cushion bonds are going to give their portfolio going forward. “Personally, I think there's some opportunity still to get that cushion, but it's clearly more limited than it was. So we need to think about strategic asset allocation in a substantially different way than has historically been the case and try to use tactics to your advantage,” Palma said.
Private equity and real estate both have attractive characteristics in returns in terms of volatility, Palma said. “If you can bring down the average volatility of your portfolio in a risk-adjusted sense, you're moving the ball forward”. While the private equity space lends itself well to providing those
higher returns at a lower rate of volatility, the trade-off is time frame, he said. “The average investment in the private equity space being a 10-year investment, unless you're doing the secondary market, means that you don't want to have too much of your portfolio there if you think you're going to be moving down a de-risking glide path. So it’s a key consideration in terms of how much liquidity you need in your book to make your regular benefits payments or your PBGC premiums, whatever those might be.”
Real estate is attractive as the investment time horizon can be shorter at three- to five years, he said. “You might even argue that aspects of the real estate market correlate fairly well to some of the LDI characteristics that you want, especially with real estate debt and as you go into private credit and some of those areas that are opportunistically attractive and also provide a bit more liquidity than your traditional locked-up private equity investment,” Palma said. Hedge funds can offer opportunities as well, with fairly low beta and lower correlation, he noted.
“For defined benefit plans in particular, the short-term changes in the liability are still driven by changes in interest rates. And so, we're still believers in building an LDI portfolio, particularly as plans become better funded, want to match their assets to their liabilities, and take down funded status volatility over time,” Palma said. “However, the further you are away from the end of the glide path, that is, the lower your funded status, you need—and probably want—more growth assets in your portfolio. So part of your LDI portfolio should probably be focused on the Treasury space rather than in credit, and that is because the credit spread component is still pretty highly correlated to your equity book.”
The merits of an LDI portfolio persist for endowments and foundations as well, Palma said, adding “What is a bit different now than it has been, is what role do Treasuries play in insulating a portfolio from draw-downs in risk assets? There’s still room for that to happen; if we see sharp declines in equities, we'd expect to see Treasuries rally .” He noted that, in the very recent time period, there has been high volatility in the Treasury markets, and there are concerns about the Fed’s ability to continue to stimulate growth and uncertainty about upcoming fiscal policy. “Our view would be, while interest rates are pretty low, at some point they're going to rise, and that's one aspect of the total return structure to keep in mind. For E&Fs, that role of Treasury allocations has to change a bit, and getting diversification and volatility protection may need to come from different directions.”
The current very short-term risks of COVID and uncertain economic growth are known and, in many ways, reflected in where volatility is being priced in markets today, Palma said. “The longer-term risk of a potential stagflation scenario would be a materially worse world for most investors. If you're a DB plan, you might be pretty happy to see a sharp rise in interest rates as your funded status rises, but your asset returns might not be as strong. There’s a tipping point of what's called ‘good’ higher inflation and ‘less good’ higher inflation. While Fed policy has really suppressed volatility in most markets, particularly fixed income, if that comes unglued in some way, that potential loss of control will almost certainly spill into other asset markets. It will make for a very tough return environment and it will make it hard for DB plans to hedge in that scenario.”
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