Higher rates and inflation
After extraordinarily low interest rates for much of the post-Global Financial Crisis period, equally extraordinary fiscal and monetary support during the COVID-19 pandemic fuelled higher inflation. Central banks have since embarked on an interest rate-hiking cycle to bring it back under control. As rates edged higher, new challenges and opportunities have emerged for investors.
“The period of really low interest rates was a meaningful challenge if you were running an insurance portfolio with a fixed income allocation of 80%,” said Nick Martowski, CIO at medical professional liability insurer MAGMUTUAL. “But, as rates have risen, insurers are [now] trying to book as much income as they can, and lock it up, having been through the desert.
“The problem is that inflation is high and that can be problematic for insurance companies. There aren’t a lot of great hedges to protect them.”
Jason Bull, CIO of the University of Georgia Foundation, said for investors with inflation-plus real return targets it has been a challenging time, as prices have continued to rise since the end of the pandemic.
“Perhaps over the long run you can achieve those inflation-plus returns,” he said. “With a CPI+5% target, an equity-centric portfolio historically would have given you a fighting chance for delivering inflation-beating returns. But can you absorb the volatility with that type of allocation?”
A place for private markets
One way that CIOs have been offsetting the impact of inflation is through greater diversification, which has been evident in their allocations to private markets. Private markets exposure has increased in recent years as investors have sought higher yields and rates of return outside public markets. But, as monetary stimulus has been withdrawn and interest rates have started to rise, many of the conditions that drove the trend, in a sector that often uses leverage, are no longer in place.
However, greater familiarity with the asset class and its versatility means that it will remain a key part of portfolios in the coming years.
“Private markets play a significant role in our portfolio, and they have played an even bigger role in the overall endowments and foundations community,” said Jason. “It isn’t uncommon to see some endowments and foundations with highly illiquid structures. The reason is that many partnered with great managers early on and the returns have been very strong.”
Private markets strategies could help boost returns, but there can be great dispersion of returns, depending on the asset class and manager selection, said Nick.
“One of the guideposts we use is to determine is the odds of success for active management in certain asset classes,” he explained. “For example, I don’t want an asset allocation model that tells me we need X% in venture capital, because the return is going to be highly contingent on our ability to source and partner with the best VC funds in the world.”
Although private markets have become a key allocation for some asset owners and institutional investors, it is important to make sure investors are protected should things turn south.
“We are almost always 20-30% in private assets and 40-45% in market-neutral hedge funds, so manager selection is very important in a portfolio with such a high allocation to alternatives,” added Jonathan. “We have a derivative overlay around those exposures that will change depending on the funded status and risk tolerance of the plan sponsor.
“Generally, we try to run a Sharpe-balanced beta exposure, which has trailed equity-centric portfolios for the last decade, but hopefully it will pay more benefits in the future. We believe that diversification will pay off going forward.”
The role of ESG in portfolio design
One of the biggest investment trends of recent years has been the growing awareness of factors around environmental, social and governance (ESG). Alongside the greater adoption of ESG-friendly policies by the asset management industry and companies more broadly, there clearly remain voices asking how and why implementation should take place in many portfolios.
It is becoming easier to gain access to sustainability themes, said Nick, as more fund managers have incorporated screens and processes that improve their ESG credentials, without asset owners having to explicitly implement a strategy.
“We are an allocator, so we don’t do any in-house bond or stock picking but, when we evaluate managers, we are looking carefully at how they are using ESG or DEI [Diversity Equity & Inclusion] principles to influence their decisions,” he said. “On the whole, we believe more integration is better and more progressive. We want sophisticated fund managers and we want to be ahead of trends.”
DEI could be another important driver of returns, says Jonathan, so it is important to get it right.
“A more diverse range of life experiences around a table leads to better decision-making, more robust processes, better risk management, and less groupthink. [We believe] the result is better performance,” he said. “We want to see our group of managers become more diverse and we would like to see the investment industry trend toward the representations in the overall US labour force. That will take time and a lot of progress.
“But, if it doesn’t, that means there will be a lot of underutilised and underdeveloped talent. As well as being a tragedy for the industry, it would also be bad for growth, productivity, quality of life and, ultimately, returns.”
One of the key opportunities in the coming years will come from the transition to a net-zero carbon economy, as companies, industries and governments around the world act to reduce their carbon emissions and help tackle climate change.
Jonathan said evaluating direct investments in areas such as sustainable aviation fuel companies and next generation aviation technology are just some ways that his airline is taking a more proactive stance towards a more sustainable future.
“Sustainability is a critical issue for Delta. The aviation industry is carbon-intensive and we are working hard to decarbonise,” he said. “But it’s going to take a lot of capital to transition to a more energy-efficient future and a tremendous amount of innovation. Some of that capital will come from Delta’s balance sheet, but some of it could come from institutional investors as well.”
He added: “This is something Delta needs to get right, there are win-win opportunities where we can look at pension assets and pension relationships to generate strong investment performance while helping to drive the company’s goals forward and reduce its carbon footprint.”
As markets continue to evolve and the macroeconomic outlook changes, there will be many challenges and opportunities. By remaining flexible and taking the advice and approaches from their peers and rivals, CIOs will be able to adapt their portfolios, potentially enhance returns and preserve capital.