Asset owners chart route in rough economic waters

Interest rates are rising, inflation is up and as for the markets — volatility is the word of the day, exacerbated by the ongoing war in Ukraine. U.S. equity markets on May 18 had their biggest daily drop in nearly two years. Even so, corporate earnings are mostly strong — with some concerns emerging around retail leaders — and jobs reports are healthy. Given these dynamics and more, Pensions & Investments reached out to long-term investors to ask them what adjustments they're making to portfolios as they navigate these turbulent times in the U.S. and around the world in which many investment executives admitted there was "nowhere to hide." Answers have been edited for space, P&I style and clarity.

"Heading into 2022, with concerns surrounding increasing inflation, rising interest rates, global supply chain issues and a changing economic landscape, we decided to reduce certain risk on a tactical basis," said Mr. Khan, CIO of the $94.7 billion pension fund and director of the division of investment in New Jersey's Department of the Treasury.

"We reduced our holdings in U.S. equities, investment-grade credit and U.S. Treasuries while increasing our cash and cash equivalent holdings," he said in an email.

Although the cash allocation target for the pension fund is 4%, the latest actual allocation is 8%. The pension also recently increased target allocations in high yield and made "slight reductions" in U.S. Treasuries and investment-grade credit, he said.

"We believe shifting to higher cash levels in a rising interest rate environment provides some downside protection during volatile market conditions. It also allows for dry powder to be opportunistically deployed in the future as market conditions stabilize," he said. "We are continuing to hold this posture for now."

Citing market uncertainty, Mr. Khan said that as the Federal Reserve raises interest rates, "cash and cash equivalents are also delivering higher returns."

A higher cash allocation is an example of a tactical allocation decision that is "relatively short term and designed to address near-term market changes without materially impacting the Pension Fund's long term goals," he said.When the global marketplace presents "new and interesting opportunities" for longer term investors, "we will look to decrease our cash holdings," he said.

Ms. Brake said her team in December 2020 outlined three potential scenarios for global markets going forward for the board of the Melbourne-based A$200.7 billion ($141.9 billion) sovereign wealth fund, but only after Russia's invasion of Ukraine did it become clear that the ugliest of the three — dubbed "divided world" — would prevail.

Ms. Brake, who was warning that inflationary pressures could get out of hand well before that became a consensus view, said the Future Fund's portfolio was well positioned for the volatility that's marked 2022 thus far, but "you always wish you had done more."

And especially where equity exposures are concerned, there's lots to do, Ms. Brake said. Trends that had been massive tailwinds for margins have turned into headwinds, ushering in what's likely to prove an extended period where it will be "extremely difficult … to make equity returns," she said.

In this "new regime … you don't want to have too much equity-related risk," Ms. Brake said.

The Future Fund's equity weighting fell to 30.9% as of March 31 from 35.8% nine months earlier, and further declines will become apparent when the next quarterly results are announced, she said.

Meanwhile, for the considerable allocations to listed stocks the fund retains, "we're just much more thoughtful about how we take that equity exposure" — for example, identifying companies that are relatively resilient to higher inflation outcomes or finding alternative private markets exposures, Ms. Brake said.

In an environment with "nowhere to hide," the team is working to identify a broad swath of opportunities where it can squeeze out incremental gains because "equity beta is unlikely to allow us to achieve our mandate — a return of 4% to 5% above consumer price inflation. "We've done a bit of a lot of things," she explained.Among other initiatives, the fund made its first allocation to gold in March 2020, Ms. Brake added.

Strong returns over the past few years have provided the $165.7 billion State of Wisconsin Investment Board, Madison, some cushion to be able to adopt an asset allocation for the $147.2 billion Wisconsin Retirement System "that is expected to run a little on the cool side in terms of return over the next few years," said Mr. Denson, executive director and CIO, in an emailed response to questions.

It also helps that the retirement system is fully funded, he said, which will help the board weather what he expects will be a lower-return environment over the next five to 10 years.

"Right now, it looks like there is nowhere to hide when it comes to finding positive investment returns from an asset class perspective," Mr. Denson said. While the combination of inflation and interest rate hikes have negative consequences for both equity and fixed income, he said, "these scenarios don't last forever and, ultimately, we are long-term investors."

About half the retirement system's core fund is invested in public equities, with the rest divided among fixed income, real estate, private equity and inflation-sensitive assets. He said that while the board does not make changes to the asset allocation based on difficult short-term market conditions, they can adjust certain exposures when they feel the market provides clear market opportunities.

However, "in the current markets, we think those opportunities have been slim," Mr. Denson said.

He also noted the fund has a leverage target of 15%."We are using leverage where it can be combined with other assets in a way that provides the lowest level of risk for a given level of return. Our goal is to leverage low-volatility assets to help manage risk rather than boost returns. The leverage helps reduce risk by supporting a higher allocation to lower-risk fixed income, including (Treasury inflation-protected securities), and a lower allocation to equities at the same overall fund target return. This strategy is a small part of our long-term strategy of greater diversification and risk control," Mr. Denson said.

So far, 2022 is turning out to be a pretty rough year, with inflation levels higher than they have been in 40 years, Mr. Ailman said at the $323.6 billion pension plan's May 4 meeting. What's more, it is hard to make money in a rising interest rate environment, he said.

Stocks do well at the beginning of an interest rate rise but end up struggling later on — and equities are struggling now, Mr. Ailman said.

At the end of 2021, the pension plan was up by about $19 billion but that increase is already gone, he noted. Mr. Ailman added that he doesn't know whether CalSTRS, West Sacramento, will end its fiscal year on June 30 with a positive or negative return for the year.

Pension officials are increasing the plan's exposure to inflation-sensitive assets; CalSTRS had 4.8% in inflation-sensitive assets and 42.9% in public equity as of Feb. 28. The pension plan's long-term target allocation to public equity is 32%, while its target to inflation-sensitive assets is 6%.Increasing exposure to inflation-sensitive will push CalSTRS' equity exposure down, lowering the plan's volatility, Mr. Ailman said.

The $204.7 billion Teacher Retirement System of Texas, Austin, "has a bit more cash than usual with small underweights to public equity and long-dated U.S. Treasury bonds," Mr. Auby said in an email.

"This feels like a good place to be as volatility remains elevated," he said."We are fortunate to have a 6% allocation to our energy, natural resources and infrastructure private portfolio, which we expect to be helpful in inflationary environments."

Venture capital is another area where TRS investment officers are "more focused than usual" since "valuations are starting to come down as they mirror the broader markets," Mr. Auby said.

The system's venture capital portfolio rose to 15% of plan assets as of Dec. 31, driven by strong returns in 2021, compared with a 13.2% allocation as of Dec. 31, 2020.

As for what's on the horizon, Mr. Auby said, "We have been thinking about the length of the equity drawdown. Could it be over a longer time frame, similar to the 2000-2002 dot-com drawdown?"As of Dec. 31, TRS' actual asset allocation was 55.9% global equity, including public equity and private equity/venture capital; 21.3% stable value, including government bonds, stable value hedge funds and absolute return; 18.2% real return, including real estate, energy, natural resources, infrastructure and commodities; 7.8% risk parity; and -3.2% cash and leverage.

"I think it's just going to be a tough environment, probably for some time," said Ms. Miller-May, CIO of the $54.1 billion Oak Brook-based Illinois Municipal Retirement Fund, in a phone interview. "I think we've experienced a lot of quick recoveries and rebounds and ups and downs, but I think this turn is a little different."

"There are so many headwinds," she said. "We have the shutdowns in China, we have the Russia-Ukraine (war), we have inflation, which is probably the biggest headwind. Our stocks are down, our bonds are down, there's really nowhere for us to hide."

Ms. Miller-May, who joined the pension fund as CIO in August, said she and her staff expected some kind of a market correction in the near future, so they worked to revamped the target allocation.

In February, the board approved increasing its targets to fixed income and international equities to 25.5% and 18%, respectively, from a respective 25% and 15%; and decreasing the targets to domestic equities and alternative investments to 35.5% and 9.5%, respectively, from a respective 39% and 10%. Also, the board approved changing the real estate asset class to private real assets and increased the target to 10.5% from 10%, and kept the target to cash at 1%.

Within fixed income, Ms. Miller-May said the pension fund is pulling back on investments in core fixed income and U.S. Treasuries and is looking at bank loans as a short-term "proxy" for private credit."It takes a long time to hire a (private credit) manager, so let's just increase the bank loans, increase the high yield, and pull back the core to get some kind of income from fixed income," Ms. Miller-May said.

"I think the markets are overly discounting the amount of tightening that will be required," said Mr. Van Vleet of Textron, Providence, R.I., in an email. "I am most certainly not a seller of U.S. equities. The peak in rates is not far off."

Mr. Van Vleet said he and his investment staff, which oversee just under $16 billion in global defined benefit and defined contribution plan assets, are continuing to "lean into areas we already have considerable exposure."He cited real estate in general — completion sectors in particular, which include data centers and life sciences — and leveraged first-lien loans. He also noted Textron continues to "average into China A-shares" and that he finds midstream oil and gas interesting due to "high cash flows, renewed demand (and) trades cheap due to carbon naysayers."

Mr. Folwell, state treasurer and the sole trustee of the Raleigh-based $119.2 billion North Carolina Retirement Systems, said his fund has always been "very conservatively managed," and he expects the fund will weather the current volatility by adhering to its focus on maintaining a "margin of safety" over the long term.

"When the markets entered this downturn earlier this year, we had the highest cash balance in our history and the duration on our bond portfolio was its shortest ever," he said. "The markets had been priced to perfection."

Mr. Folwell noted, however, that the fund has witnessed very good performance from its non-traditional assets. According to the state treasurer's quarterly investment report, for the three months ended March 31, the pension fund lost 3.46% overall but saw increases in private equity of 3.65%, along with returns of 4.78% in core real estate, 5.76% in non-core real estate and 1.03% in opportunistic fixed income. In contrast, the public equities part of the portfolio sank 7.67% in the first quarter.According to the report, the plan had $7.5 billion in private equity (6.3% allocation); $6.59 billion in core real estate (5.5%); $2.66 billion in non-core real estate (2.2%) and $7.24 billion in opportunistic fixed income (6.1%). Public equities accounted for 34.6% of total assets.

The portfolio for each of the five New York City Retirement Systems pension funds, which had total assets of $263.2 billion as of March 31, is "impacted by volatility in the market," said Mr. Haddad, interim chief investment officer. However, as long-term investors with "broadly diversified portfolio across asset classes and geographies," he added, "we live through the euphoria and declines of the markets."

"We study and make changes to our asset allocation in consultation with independent consultants as well as the trustee boards every three to five years, most recently in the first half of 2020," Mr. Haddad said. "Given events in markets, we anticipate discussing with our boards whether to conduct a new asset allocation study."

Some market scenarios are more challenging than others and there are no "silver bullets" that can deliver positive returns all the time, said Mr. Davis, CIO of OPTrust, which manages the assets of the C$25.9 billion ($20.1 billion) Ontario Public Service Employees Union Pension Trust, Toronto.

"Markets so far in 2022 have obviously been difficult to navigate, but it follows several years of very strong returns and some correction is to be expected, even if its timing cannot be predicted," he said.

Mr. Davis noted that OPTrust "continuously re-evaluates" its portfolio allocations in response to changing market conditions. "With higher market volatility, the forward-looking risk-return profile across asset classes is shifting rapidly, and we will seek to take advantage of that," he added.

"While we are currently seeing high inflation. How this plays out will depend on other factors like if central bankers' efforts to engineer a soft landing are successful," he said. "When thinking about the various headwinds, we do not try to take big bets on what the future will hold and adjust our assets accordingly. Rather, our investment strategy involves being agile and resilient in different economic environments."

In response to "large swings in yields," Mr. Davis said they would "naturally reconsider our fixed-income allocation" as they would with its equity allocation in response to a major market downturn.

"Generally, at higher yields, larger allocations to bonds make sense but need to be evaluated against other exposures that compete for scarce liquidity and risk resources," he said. "Our bond portfolio is customized to mitigate the interest rate sensitivity of the plan's liabilities."Mr. Davis noted OPTrust has been "very successful investing in illiquid assets" such as private equity, infrastructure and real estate. "These are core parts of our portfolio and will remain so in the future," he added.

Messrs. Hitchcock and Berg wrote in an email that while the recent turbulence in markets has caused many investors to lose sight of a longer-term investment thesis: Pension funds and endowments have a tremendous advantage because they can focus on the long-term horizon.

The commission, which manages the Columbia-based $41.7 billion South Carolina Retirement Systems' investment portfolio, has seen strong performance in its private markets and hedge fund portfolios this year and has been "slightly underweight" public equity since early 2022, which has helped performance, Messrs. Hitchcock and Berg said.

"We have always believed in diversification, and this has definitely helped us weather the volatility," they added. "It's a bit eye-opening how poorly the 60/40 and 70/30 portfolios have performed."

In April 2020, the commission approved a simplified policy portfolio consisting of five asset classes: public equity, with a 46% target; bonds, 26%; real assets, 12%; private equity, 9%; and private debt, 7%.

The commission is "remaining patient and have not yet added risk but are evaluating ways in which we may do so," the pension fund leaders said.As the Federal Reserve continues to raise interest rates, Messrs. Hitchcock and Berg said they're prepared for additional volatility. "We always believed that the path back to 'normal' interest rates would be a challenge," they wrote. "We're going to have to get used to higher volatility. Higher volatility environments reward investors who have liquidity and discipline."

Mr. Hyde credited the Auckland-based NZ$56.2 billion ($36 billion) sovereign wealth fund's far-ranging strategic tilting overlay program with effectively minimizing pressure on New Zealand's investment team to tweak the underlying portfolio in response to the latest market volatility.

"Like everybody else, we've been impacted by falling equity markets and bond markets as well … but that's something that we expect," Mr. Hyde said. "There'll be periods when they're up strongly, as they have been over the last decade, and there'll be times when they come off quite sharply. That's part of the territory," he said.

"Our portfolio has been negatively impacted by developments over the past five or six months," he conceded.

That said, the fund's active portfolio — including meaningful allocations to global macro strategies and large allocations to equity factor strategies, and value in particular — "has performed very, very well over that period," helping to limit those losses, he said.

The single biggest allocation in New Zealand Super's active portfolio is the positions "that we're taking in strategic tilting — the value-driven, systematic program which consumes the largest amount of our active risk budget," Mr. Hyde said.

The strategic tilting team buys country-level indexes for equity markets, sovereign bond markets, currencies, real estate, credit and commodities when prices fall below its estimates of fair value. It shorts indexes when valuations exceed those fair value estimates.

Coming into this year's sell-off of equities and sovereign bonds, "we've been universally short in bond markets" but both long and short equity markets, with U.S. stocks standing out as trading at expensive valuations, Mr. Hyde said."As bond markets have sold off, we've reduced our position sizes in our bonds and taken profits along the way," he said. "For equities, we've reduced some short positions in some countries; in other countries we've increased our existing long positions because we thought that they were actually cheap," he said. On balance, the strategic tilting program has taken on more risk in recent months, Mr. Hyde said.

Mr. Edmundson said the only adjustment he's made to the $59.9 billion pension fund was in the spring of 2020, when Nevada PERS reduced the duration of its entire fixed-income allocation to less than two years from six years, a move he said helped alleviate some of the pain from rising interest rates. Aside from that, he doesn't anticipate any dramatic changes to the system's asset allocation due to the market turmoil going on right now.

"We continue to feel pretty good about our positioning from a long-term perspective," he said.

Against the backdrop of elevated inflation and the Federal Reserve looking to potentially raise interest rates aggressively, he said "additional volatility wouldn't be surprising."

His biggest concern is juggling a long-term time horizon with the ramifications of short-term volatility. "Public pensions should be among the longest time-horizon investors in the marketplace. However, I worry at times that the short-term implications of market volatility can derail that longer-term viewpoint," he said.Mr. Edmundson said that while he doesn't see any "screaming deals in the market," he does see a silver lining amid all the market pain. "Cheaper stock markets and higher interest rates equal better prospective returns looking forward," he said. "On a forward-looking basis, I think prospective returns are starting to look better for all the pension funds, particularly due to rising interest rates."

Mr. Tillberg doesn't anticipate any changes to the $13.9 billion system's asset allocation. "We strive to build a durable portfolio that can withstand periods of volatility. We rely on long-term market returns to meet those objectives and strive to maintain persistent exposure to the markets in which we invest," he said.

Mr. Tillberg said that it's difficult to predict what the markets will do. "The future is impossibly hard to predict, which is why the durability of the policy portfolio is paramount," he said.

Mr. Tillberg frowned on "opportunistic investing," saying it's tempting and always looks good in hindsight.

"I do try to resist the natural tendency to do something in favor of staying disciplined to the policy portfolio, which is far more important in meeting the objectives of the system. Beyond taking advantage of volatility through our rebalancing policy, we leave it to our few active managers to find attractive pockets of the market as defined by their respective processes."

Douglas Appell, Margarida Correia, Brian Croce, Palash Ghosh, Arleen Jacobius, Rob Kozlowski, Robert Steyer and Christine Williamson contributed to this story.