Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Lessons for nation-building from Canada’s pension fund debate
Last year, Australia was briefly gripped by nation-building fever as the government suggested that some of the capital managed on behalf of the country’s budding retirees could be put to use in, say, social housing or renewable energy assets. The idea received a mixed reception, with super funds variously pointing out that they already owned a significant chunk of Australia’s infrastructure assets and that they were trying to move away from their home country bias – not to mention the risk/reward tradeoff of investing in
Aside from cardboard king Anthony Pratt’s annual debt funding roundtables, the nation-building idea is mostly dead, though it would be foolish to think that it couldn’t be reanimated at a moment’s notice should politics require it. It would also be foolish to think that it does not come with any tradeoffs. But while the idea of incentivising (or compelling) pension funds to invest in their domestic economies is poked and prodded at, it’s rarely examined in any depth. Enter a paper by Keith Ambachtsheer, one of the architects of the modern Canadian pension system, McGill University’s Sebastien Betermier, and Chris Flynn from CEM Benchmarking.,
Canada, for those who haven’t been paying attention, is having its own nation-building debate. Recently, a consortium of businesspeople called on the government to mandate its pension funds invest more in the domestic economy to help meet a growing productivity gap, a call that received some support from the government – and substantial resistance from the pension funds themselves.
Canadian funds, like most pension funds, have a home country bias that is gradually giving way to global diversification in the search for returns. That’s not just a function of their size, but the unavailability of attractive investment opportunities at home.
“When we consider the factors limiting domestic investment in Canada, we identify one major friction that deters Canadian pension funds from increasing their domestic share,” says the paper, titled Should Canada require its pension funds to invest more domestically? “The lack of strategic assets. By these we mean specific asset classes that demonstrate distinct strategic benefits to a pension fund portfolio so that pension funds can meet their mandate to deliver regular, cost-efficient income for pensioners and sustain a healthy pension system.”
One example is Canadian Real Return Bonds, which Canadian funds use to hedge against inflation risk and which the Canadian Ministry of Finance has recently stopped issuing. Another is infrastructure, which provides steady and inflation-indexed income streams, but the Canadian government largely retains ownership of assets like airports and power stations. Without access to those assets, more investment in the domestic economy would “undermine careful risk-return calibrations, compromise existing governance functions and expose pension plan members to potential financial losses”.
Of course, Canada and Australia are not the same country, nor do they have the same pension system. A strategic asset in the defined contribution environment will often be very different to one in the defined benefit environment. And as the paper points out, Australia has been much more successful in encouraging investment in its economy by both international and domestic institutions by “proactively monetising” large infrastructure assets, such that new toll roads and tunnels are sought after by institutions from around the world.
But Ambachtsheer Et al. make a pertinent point that requires only minor extrapolation: if Australia does want its super funds to invest more in the domestic economy, it will effectively have to give them opportunities they cannot find anywhere else. That point was made by the super funds themselves in a whitepaper released last year where the likes of Cbus, AustralianSuper, Rest and IFM warned that “the Australian energy transition still risks falling behind as investors find more compelling opportunities overseas”.
“Capital is flowing to places with more attractive investment opportunities, strong climate and energy policies and growing demand for clean energy and low carbon goods and services,” the funds wrote in a paper titled Super-powering the energy transition in Australia: A policy blueprint to facilitate superannuation investment. “Australia can’t afford to be left behind.”
While super funds love toll roads, it’s clear that they’re being attracted to the more exotic energy transition opportunities on offer as a result of the US’ Inflation Reduction Act. But when it comes to producing a pipeline of these more exotic opportunities, there’s significant risk: trying to pick winners in untested technologies or industries, essentially intervening in – and competing with – the market. Still, without those projects for super funds to diligence, nation-building will continue to “languish in the landscape of rhetoric”.
