Pension Funds Letter 4 - The end of “easy money”: at the dawn of a new era for asset owners

Just after the recent market corrections and volatility spikes, important debates are arising again. The stress observed lately in the markets clearly indicates that we are on the verge of a global regime change. We are progressively abandoning the era of zero rates and “easy money”, which has anesthetized investors, pushing them to take more and more risk, and bringing asset values to unprecedented levels.

Such a transition cannot be smooth; it will certainly mean a lot more nervousness and volatility in the markets. Even if most specialists tend to be reassuring, seeing in the recent market turmoil episode a “natural” and even “salutary” correction, institutional investors such as pension funds cannot ignore the shift and will need to reconsider their investment approach in terms of asset allocation and portfolio construction.

Pension funds will have to look for new sources of return, both on the bond and equity sides. In the fixed income universe, in a context of potential rising rates, the flexibility of asset allocation will be key in order to grasp opportunities where they stand, whether they lie in taking advantage of yield curves discrepancies or in seizing liquidity premia from assets at the far end of the liquidity continuum (e.g.: leveraged loan, private debt). When it comes to equity, the new sources of return are likely to be found in active volatility management strategies and factor investing approaches. Transcending the bond and equity boundary, pension funds should also consider strengthening their position in emerging markets, given their performance potential, provided the stock picking is highly selective. Last but not least, in the new era to come, ESG strategies will become essential in a long-term investor’s asset allocation. Not only are they a good way to mitigate long-term risks, such as climate risk, but they also represent a good opportunity to get extra returns. This search for new sources of performance will naturally lead to a re-appropriation by pension funds of fundamental rules regarding portfolio construction to deliver results in accordance with their liabilities and funding constraints, as well as beneficiaries’ expectations. The optimization of portfolio construction is intrinsically linked to an increasing integration of risk management considerations, in particular risk factors, which should help pension funds to select investments with a rewarding risk factor profile.

As pension funds enter this new era of enhanced volatility and unpredictability, they are also likely to increase their holding periods in order to allow risk premia to materialize, as it has been highlighted in the latest edition of the Create survey, interrogating more than 160 pension plans over Europe. The underlying of such a move is the hunt for long-term opportunities as well as a permanent search for efficient diversification and hedging strategies to face long-term challenges. Time horizon is not the only criterion to take into account for pension funds when addressing their beneficiaries’ needs in the current shifting environment. In order to adapt to the growing work flexibility and mobility of their beneficiaries, they also have to integrate the geographic dimension in their set-up. To answer this need, large asset managers have developed cross-border solutions for pan-European pension schemes, enabling them to go beyond physical boundaries and local regulatory constraints.

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