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.
Where to now? Try greenfields infrastructure
With equities and bonds both fully priced, investors are increasingly looking at alternative strategies. A new one, although difficult to access, is ‘greenfields infrastructure’.
According to David Neal, the chief executive of IFM Investors and a former CIO and chief executive of the Future Fund, the conundrum for investors was well expressed by Stein’s Law – ‘if something cannot go on forever it will stop’.
Neal was addressing the opening session of AIST’s ASI conference last week (August 31), alongside economists Carol Austin, a trustee of NSW’s State Super and former guardian of the Future Fund, and Shane Oliver, AMP Capital chief economist.
Returns looking forward were lower than most investors needed for their members to meet expectations and for their liabilities in the case of defined benefit, insurance and other fiduciary funds.
Neal said that Bridgewater, the highly regarded value-orientated hedge fund manager, was discounting 10 per cent of current market prices every year for the next 20 years. “That’s pretty extraordinary,” he said.
Just as economist Herbert Stein made his observation in 1986 using rising US debt levels versus GDP as an example, so Shane Oliver said that it was “hard to look past the massive increase in debt levels” caused by the impact of covid-19.
In his mostly upbeat take on markets, Oliver said that while he had been supportive of fiscal policy actions through the pandemic, there had been about US$9 trillion added to the G4 countries’ debt levels alone, making total indebtedness of more than 300 per cent of GDP.
Nevertheless, Oliver said he believed the world was “about half-way up” the cycle and the recovery should continue for “another year or two” despite some hiccups. “But the 40-year decline in inflation and bond yields could be over,” he said.
Neal agreed that inflation felt like it was a lot closer than it had for the past 20 years. So, do you increase your exposure to bonds and increase that risk; do you sit out of the market in cash; do you invest in foreign currency, which was not without its own risks?
“I have a couple of suggestions which won’t surprise you given where I work,” Neal said. “Long-term private markets investing” was one, but he recommended investors “step to the side of the traditional approach” to private equity which often involved egregious fee gouging and non-aligned strategies.
Renewables presented opportunities, with total investments topping “well over US1 trillion a year” by 2030. However, there was an excess of demand for new investments in renewables, he said, which infrastructure did not have.
There was also a broad array of sometimes-complex credit strategies which presented opportunities when provided by “suitably skilled managers”. These strategies could deliver close-to-equity returns.
“You have to come back to the investment discipline of searching long and hard for good opportunities with economic value and don’t overpay for them,” Neal said. “It’s the little bits of incremental returns that add up for the long term.”
The private markets were less efficient where it was about “skilled people doing the work”, he said. “In infrastructure, there is a lot of capital but there are also a lot of new opportunities… The greenfield infrastructure space, itself, is one where infrastructure managers typically don’t invest, but if you have the skills and capabilities to embrace more greenfields risk, there are extremely good opportunities.”
State Super’s Carol Austin, who started her career as an economist with BHP before moving into funds management, was fairly optimistic about inflation, at least in the short term. “It will not happen this month, not in the next 12 months. It’s years out,” she said.
She also didn’t think there would be a ‘crash’ of GFC proportions because of structural differences whereby there are stronger balance sheets now. “I also don’t think the Fed will allow anything to disrupt the flow into equity markets for the next 12-18 months,” she said, “or before the mid-term [US] elections.”
