How sovereign funds are dealing with 'lower for longer'

Sovereign funds discussed how asset diversification, particularly into alternative assets, was key to outperforming in times of low returns in conventional markets at their annual meeting.
How sovereign funds are dealing with 'lower for longer'

Sovereign investors from around the globe gathered in New Zealand this week to compare notes on the surrogate investment means they are using to eke out yield in today’s ‘lower for longer’ market environment.

The biggest answer to sourcing better returns? Look to diverse asset allocation, and include alternatives.

At the annual International Forum of Sovereign Wealth Funds (IFSWF) meeting in Auckland, regional investors including Singapore's GIC and China Investment Corporation (CIC), rubbed shoulders with those from other parts of the world such as ADIA from Abu Dhabi and British Columbia Investment Management Corporation (BCIMC).

In the face of what Bob Prince, co-chief investment officer at US fund group Bridgewater, described at the event as the worst return environment for conventional bonds and equities in 100 years, sovereign investors are forging alternative strategies to maintain decent returns while keeping risk exposures manageable.

Tham Chiew Kit, managing director for its total portfolio strategy division at Singapore’s GIC, suggested that most globally balanced funds could only hope to achieve 1.5% to 2% per annum in the next two to three years.

The question GIC asked itself was "Do we raise risk or bring it down?" Tham said many longer-term investors are more likely to pare down risk, given this challenging outlook.

He advised funds to play to their strengths and not seek returns in unfamiliar places. “Locate equity sectors and styles away from expensive to relatively cheaper ones."

In the case of GIC that means looking at equities with a value bias, as stocks with quality earnings are likely to underperform in this environment.

He presented a number of options that GIC has considered, but note that he most favoured ‘bottom up alphas’ – or individual investment opportunities the fund discovers from internal analysis and diversification across active strategies.

Diversification essential

Tham argued that there are big risks associated with not diversifying away from traditional balanced portfolio allocations.

"We don’t know how long the normalisation process will take," he admitted, but estimated that it could take several years. In the meantime central banks and regulators would have "thrown the kitchen sink" at the problem.

"So I don’t think the markets will move much one way or the other. How the volatility in the market will resolve itself is a huge question, so keeping dry powder (and being prepared to act opportunistically) is probably prudent."

New Zealand's prime minister John Key, a former investment banker with Merrill Lynch (before it was acquired by Bank of America), shared similar worries. In a keynote speech, he said the big concern facing the world economy was how the central banks’ impact on markets via high doses of quantitative easing and ultra-low rates would be unwound.

He said that the Federal Reserve chair Janet Yellen and other central bankers expressed confidence in meetings with him that the unwinding of government buying across the world could be managed without hurting markets.

CIC president Li Keping agreed that the low return environment was "really worrying for institutional investors. What puts the most pressure on us is lower returns on a historical basis".

CIC's response has been to improve its asset allocation framework, said Li. Until 2015 CIC followed an endowment model, but in 2015 it has established a reference portfolio, which is a neutral benchmark, a policy portfolio to consider the direction of portfolio construction, and its annual policy portfolio that defines deviation from its benchmark and sets portfolio construction targets based on these deviations, Li noted. This typically includes infrastructure and alternatives allocations.

Li added that CIC is also delegating more power to its portfolio managers, in-house and externally, in each product area. "We want to give them more room where we feel they have the ability to generate more alpha," he said.

Risky business

One advantage sovereign wealth funds have is the ability to stay long-term focused.

Gordon Fyfe, chief executive and CIO of British Columbia IMC, said foreign currency reserve funds don’t require public equity allocations at all. "If you’re Harvard [University’s endowment fund], you need to sell assets to pay your professors and you’ve got to keep the school warm. But if you are a sovereign fund, your horizons are much further away.

“We need to take advantage of the thing we’ve been blessed with, which is this long term outlook,” he added, “so even in this low growth environment there are ways to improve our returns."

Some of the most exciting opportunities lie in distressed areas, he suggested, noting that Brazil offered a good example. "British Columbia recently bought a pipeline there. If it wasn't for the crisis in Brazil, we would never have had access to it."

Shipping is also ripe for investment, after seeing asset values plunge as global trade volumes have fallen.

“A lot of people who had ordered these ships a couple of years ago can’t take delivery, and we’re able to buy them,” said Fyfe. “At those sorts or levels (60c on the dollar) we can lease these boats for three or four years and at least break even. We can hold them on our balance sheet and in the next four or five years we will able to sell them into a much stronger market."

However, Fyfe noted that such investing was not for the faint of heart. “This is not easy, there’s a lot of hard work in this stuff, understanding the assets, the sector and the dynamics.”

He also suggested sovereign investors seek to reduce management fees of 3% to 5% for external management, given that returns have fallen. He suggested there were opportunities within new private equity funds by proven managers "where you’re not going to pay these sorts of fees." 

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