The surging turbulence in capital markets is causing no end of headaches to institutional investors, which are already struggling with insufficient annual investment returns.
In a time like this it might seem perverse to consider investing into equities, an asset class that has taken major hits to its market capitalisation across the world. Stock markets have registered their largest falls since the onset of the Great Depression. The S&P 500 index, for example, has dropped 11.09% since the end of February to its close on Monday (March 30).
Yet while the crop has been marked, a level of rebalancing was if anything overdue after over a decade of strong performance by the US stock market. Over the 10 years to the end of 2019 the S&P 500 index had racked up an annualised return of 16%. Indeed, during that period equities were increasingly seen as a favoured defensive play, offering good yield and total return for pensions advancing towards negative cashflow territory.
Ironically, an asset class once perceived as risky had became seen as a safe haven.
That image has suffered some major tarnishing, courtesy of the havoc wrought by the spread of the coronavirus disease. As economies have shut down, so the outlook for corporate revenues has become increasingly grim, leaving stock valuations to fall by major levels.
For institutional investors with an eye on the 20-year or even 50-horizon, even March's market correction could be seen as a blip and an eventual buying opportunity
Yet for institutional investors such as pension funds, with an eye on the 20-year or even 50-horizon, even March's market correction and the likelihood of more coronavirus-linked volatility could be seen as a blip and an eventual buying opportunity.
As UniSuper chief investment officer John Pearce told his superannuation members in a March 23 update, in every crashing market there are some sellers who have no choice but to sell assets.
"Even though they might believe that asset prices are ridiculously low, they are forced to sell because they haven’t got enough liquidity to meet their commitments until the crisis subsides," he wrote.
The purpose of pension funds is not to be among those investors, but instead to have sufficient liquid assets to take advantage of cheap valuations, especially in areas of equity they see as offering long-term value at today's prices. It is certainly a lot cheaper to buy S&P 500 stocks now; the index's PE ratio forward estimate for the end of 2021 is 19.21 times, 6.02% lower than the equivalent figure a year ago.
LOOKING TO ALTERNATIVES
In addition to weighing equity investments, pension funds are increasingly looking to build exposures in private equity, real estate and private debt, accepting illiquidity for the promise of high single digit or double digit returns.
Malaysia’s Employees Provident Fund, for example, has built a 5% allocation to private equity and another 5% to real estate and infrastructure.
Korea’s Public Officials Benefit Association (Poba) is a particular proponent of private market investing, in a sustained effort to close a funding gap that stood at 86% five years ago.
“We analysed our members’ capital duration and concluded that it is around 10 years, so we could increase our private markets investment,” said Jang Dong-hun, chief investment officer of Poba. “This is on the basis that usually private markets investment duration is between seven and 10 years. In some extreme cases, it can be 15 to 20 years.”
Poba has gradually increased its exposure to mainly infrastructure, private debt, mezzanine and real estate debt investments, to the point that private assets make up around 50% of its W14.1 trillion ($11.85 billion) in assets. Its funding ratio is now over 100%.
Taking advantage of the illiquidity premium is a good way for a pension fund to improve its funding ratio over the longer term.
The OECD report on global pensions notes that it can make sense for pension funds to seek higher returns, but added that “pension regulators and supervisors need to continue monitoring these developments closely to avoid damaging increases in the risk portfolio of pension funds in their search for yield”.
There is no silver bullet for pension funds to raise returns, but they can take some fairly straightforward steps. Most immediately, they need to pursue two targets: raising target returns and increasing member contributions.
“Taking advantage of the illiquidity premium is a good way for a pension fund to improve its funding ratio [over the longer term],” said Jang.
Doing so will require more expertise, especially as many global pension funds are becoming keen to shift into private market assets.
Another sensible step is for pension plans to ensure their stakeholders fully grasp the issues, along with the benefits and risks of different investment options. The funds need a deep talent pool among professional staff and a nimble governance structure, explained Jang.
With much of the world’s fixed-income yields sitting so low, pension funds face large funding gaps. To reduce them and meet annual investment targets, their investment teams increasingly have little choice but to lock more money into riskier or more illiquid investments. They had better make their stakeholders understand why it’s required.
Richard Morrow contributed to this article.
This article was adapted and updated from a feature on pension fund investing that originally appeared in AsianInvestor's Spring 2020 edition.
