Strategies in a time of uncertainty

Mark Versey recently took part in a panel discussion organised by Professional Pensions to discuss opportunities and challenges in alternative investments.

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What is the economic and market outlook? What are the key investment challenges over the coming 12 to 18 months?

Mark Versey (MV): Generally, real assets have been very resilient throughout the crisis, but there have been some obvious challenges, notably the impact on sectors that rely on bringing people together.

Over the medium term, sectors such as retail face challenges as the move to e-commerce continues and people continue to question the need for physical retail – it’s not really the right time to be investing in that sector right now.

The office market also faces challenges over the medium term. We very much believe the office market is here to stay, but it will change; offices need to become much more of an experience, much more of a collaboration space. So they will stay, but in a different guise.

One factor that is good for all real assets, however, is low interest rates – which means cheap access to finance. Additionally, the relative value real assets give over government bonds should boost demand. So real assets have got a great underpin generally with interest rates being so low.

In that sense, the outlook is positive longer term, but there are sectors you need to avoid and be careful of right now.

Dr Sushil Wadhwani (SW): I would emphasise the novelty of the Covid-19 virus and how our understanding of it has evolved during the year. Back in March many experts were telling us that a vaccine was very unlikely this year. Certainly, the significant balance of opinion was that it would take a long time for us to vaccinate, say, half the population in the US and Europe. That view has changed very meaningfully over the year and I think this may be one reason why stocks have recovered as much as they did.

A second thing that changed related to whether we would need a second national lockdown – and it now looks less likely we will need a national lockdown again, at least in Europe and the US.

It now looks less likely we will need a national lockdown again, at least in Europe and the US

If we do indeed get a vaccine which confers significant protection – and more than half the people in the US and Europe are vaccinated by the middle of 2021 – then the incomplete v-shaped recover we’ve seen so far becomes more like a proper v.

If the vaccine doesn’t come through, however, you’ve then got very meaningful downside to market levels so it’s going to be very important in terms of looking ahead in terms of markets to be very agile.

What are the indicators and themes you will be looking at over the next 12 to 18 months as being positive for real assets?

MV: Beyond a vaccine, the current indicators we’re looking at are government policies – what infrastructure spending there’s going to be; what’s going to happen to all the guarantees that governments have started giving on loans to corporates; and, particularly in the UK, what’s happening with Brexit and whether this will present opportunities as well as the risks, which are well known.

From a longer-term perspective, we are looking at a number of themes. There is going to be lots of investment in data services, such as fast fibre broadband, for instance. Other areas include the transition to low carbon and the delivery of goods; the logistics infrastructure everyone is relying on to get things delivered at home in one day.

Sushil, you’re looking at things from a more liquid point of view – what sort of opportunities do you see out there currently?

SW: Over the short and medium term, we require enormous agility and I think liquid alternatives can provide that.

Over recent years there have been so many unexpected events. If we look ahead, not only is there a lot of uncertainty around Covid-19 but also considerable uncertainty around the US election and what that might mean for future policy.

Having a portion of your assets in liquid alternatives that can quickly change their mind as events evolve is potentially diversifying for pension funds.

I also think inflation could easily surprise over the coming years – something that could be quite poisonous for conventional assets because we could, having gone through this very benign post-2009 period where equities and bonds have largely gone up together, be entering a scenario where equities and bonds go down together.

How do you incorporate ESG into your strategies?

SW: Everything we do is at the macro level so we don’t currently trade individual equities, for instance, but we certainly trade equity sectors. With that important qualification out of the way, I would say that most of our clients who have ESG-related concerns usually have concerns about exclusions – and we are certainly used to working with our clients in that way.

However, as the world evolves, our thinking has been evolving significantly and we’ve been thinking much more proactively about this area and are now, for instance, actively considering trading carbon futures as part of our portfolio. It’s also affecting our investment process more broadly in terms of, for example, how we think about the long-term fair value for crude oil.

My personal view is that ESG is going to be front and centre of most investment strategies over the coming five to 10 years.

MV: ESG is right in the centre – I totally agree. As we are direct investors into the actual assets themselves, we have to embed ESG into every single asset decision we make. As such, we’re fully integrated in a very bespoke way across real assets.

And just to look at that in more depth, first of all it’s about risk assessment. We look at each asset; what’s the risk as we transition to a low carbon economy, for example? We ask questions around whether there going to be stranded assets, flood risks, insurance risks and so on. That sort of risk assessment is something we’ve done in real assets for a long time.

This process has now been expanded to look at the societal and broader ESG risks.

The hard work now is just pulling all the data together – sourcing, for instance, enough data that we can link back the UN Sustainable Development Goals so we can report it to our customers and show how things have improved over time.

Overall, however, ESG and real assets go really hand in hand. You can change the world by investing in the real assets. You have direct ownership and influence over what happens, rather than just buying shares in a company and then trying to impress on the management team of that company that they need to improve the way they run the business. We actually have to do it ourselves.

Where do you see the opportunities at the moment?

MV: One of the biggest areas is logistics. While that trend has been there for a long while, that whole sector is changing, in particular around where production is going to be. Does it need to be nearer now, and will there be more onshoring? Or are we still going to be doing lots of importing? Where is the supply going to come from?

How we build the cities of the future is also going to be critical. Instead of having your key commodity being iron ore, as it used to be 100 years ago, talent is the new commodity of choice. As such, you need to invest in cities that are going to be there for the long term, those that can attract the talent, grow the talent and retain the talent.

Instead of having your commodity being iron ore as it used to be 100 years ago, now it’s all about talent

From an infra perspective, renewable energy is where a lot of the focus will be; we think energy from waste and onshore and offshore wind are sectors with plenty of room to grow.

I’ve mentioned data; again, that is a big theme with lots of investment happening in that area.

SW: If I think about the long-term outlook for the alternative strategies, we run then I’m actually hugely optimistic in terms of the outlook over the next decade.

If you go back to 2009, the expectation for what the US 10-year bond yield would be in 2020 was a little over 4%. Today the US 10-year bond yield is less than 1%. Since the global financial crisis, we have had a period where bond yields have continuously surprised on the downside and that’s provided a huge tailwind to conventional assets. Bond yields have come down, earnings have gone up, equities have done well, and it hasn’t been that difficult to make money with conventional assets.

If I look ahead to the next 10 years, the 10-year ahead bond yield projection in the US is just a little over 1% – it’s projecting hardly any rise. And if I’m even half right about my pessimism about inflation – i.e. that inflation is going to be the next big surprise – then it seems the outlook for conventional asses will be challenging. But the sorts of alternative strategies we run do best when the world is surprised.

Thinking about geography – and more about the shorter-term period over the next year – then the vaccine is going to be an important driver of sectoral and geographical return. The beaten-up sectors should do best on a vaccine coming through and that then plays into country weights.

So you get a market like the US that has meaningfully outperformed over many years in part because of its high tech weighting, I think it’s now due for some underperformance under this vaccine scenario because other equity indices that have a much lower tech weighting, are likely to do rather better than the US as you get this rotation into the beaten-up sectors.

So it argues for Europe versus the US. It actually also argues for Europe versus Asia, because Asia was able to control the virus rather better through having a formidable testing and tracing system. Europe lagged behind there. I’d also put in a plug for emerging markets – as long as the vaccine is distributed fairly, it will also provide great relief to emerging market assets, both currencies and equities.

To what extent are issues such as liquidity, the speed of deployment, market overcrowding and complexity concerns for investors, and how are you mitigating some of these challenges in your strategies?

MV: All our assets, almost by definition, are long-term investments and must be considered so. Having said that, a secondary market is certainly growing and a lot of the offerings that we and others have are open-ended or semi-open-ended in style, so there is the ability to redeem units or take income after a lock-in period. Additionally, income streams can be created to match pension liabilities.

With regards to speed of deployment, it takes time to build a portfolio – up to two years for a bespoke portfolio. If you want fast deployment, there are two routes. One is to allocate to a pooled fund that doesn’t have a massive queue. The second way is to look at multi-asset or multi-sector investment strategies that can invest across a range of assets, potentially giving managers a lot of opportunities to invest over a shorter period of time. It can take a very long time to deploy capital if you have a single strategy with a very narrow investment case.

Regarding the issue of market overcrowding – the supply versus demand question for illiquid assets –I would say that some of markets have only just opened up and, while things like real estate debt are now firing on all cylinders, things like infrastructure debt are really just beginning to pick up again. As such, there’s quite a lot of supply and demand is actually relatively low at the moment.

While areas like real estate debt are now firing on all cylinders, others like infrastructure debt are really just beginning to pick up again

This is mainly because banks have pulled back from lending. They have also been involved in government lending programmes, which has taken up a lot of their focus.

In terms of what is crowded right now, the private equity area is going to be quite crowded and there are a lot of people looking for distressed opportunities, but that’s not an area we focus on.

SW: I’ll take the three challenges you outlined. We tend to focus very much on the more liquid instruments because some of our vehicles provide daily liquidity, others provide weekly liquidity. As such, we’re very anxious to ensure that the instruments we choose are sufficiently liquid to be compatible with the liquidity promise we make to our clients. And we regularly review the portfolio for that.

In terms of speed of deployment for clients, given it’s a liquid portfolio, we can deploy relatively quickly.

The third challenge you referred to was market overcrowding. That is a real challenge for some of our strategies in the sense that some of them can become too popular. And we are very cognisant of that risk.

We do two things here. The first is to have a philosophy of continuous improvement – whatever strategy we were using two or three years ago will look somewhat different today. That, I think, provides some important protection against the market overcrowding phenomenon you were talking about, because we gradually evolve our strategies and they begin to look less and less like what is commonly being deployed in the marketplace.

The second thing we do is when we’re using a strategy that is more commonly deployed, we tend to time our capital allocation to it. My favourite example here is interest rate carry. So back in the 1980s, interest rate carry was deemed to be a strategy that didn’t work. And that was a time when certainly in my view it was a most profitable period for that strategy.

What are your key takeaways following our discussion?

SW: The key points to make are that we are in an environment where there is more uncertainty than normal. There are more known unknowns and more unknown unknowns. Therefore agility is very important. Liquid alternative strategies can play an important role in terms of providing the necessary agility to pension fund investment portfolios and can for that reason be diversifying.

There is more uncertainty than normal. There are more known unknowns and more unknown unknowns
Sushil Wadhwani, QMA Wadhwani

My argument about the medium – to long – term would be that bonds are right towards the top of their valuation ranges and equities, in absolute terms, are also towards the top of their valuation ranges. Equity valuations only make sense because of how low bond yields are, and if bond yields go up, then equities are going to be in trouble.

If like me you believe there is a significant risk that over a three – to 10-year period inflation meaningfully surprises on the upside, then conventional pension portfolios are in trouble and need a much bigger allocation to alternatives – I do see the next decade as being particularly dangerous for conventional pension fund portfolios.

MV: In traditional listed markets, credit spreads have come in and equities have rallied. As such, we can see potential for strong relative outperformance with real asset portfolios.

The outlook is good in many sectors and, while there are areas to avoid, there are also many opportunities and strong supply at the moment.

Finally, ESG is critical for real assets and embedded in everything we do. In this area, I think we’ll see huge improvements in reporting on real asset portfolios, which will be of great benefit to pension schemes.

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