Expecting the unexpected - How pension plans are adapting to a post-Brexit world Author: Prof. Amin Rajan - e-fundresearch.com
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Expecting the unexpected
How pension plans are adapting to a post-Brexit world
Author: Prof. Amin Rajan
Author: Prof. Amin Rajan First published in 2016 by: CREATE-Research 4 Mayfield Park Wadhurst TN5 6DH United Kingdom Telephone: +44 (0)1892 784 846 Email: amin.rajan@create-research.co.uk © CREATE Limited, 2016. All rights reserved. This report may not be lent, hired out or otherwise disposed of by way of trade in any form, binding or cover other than in which it is published, without prior consent of the author.
Foreword Amundi has a commitment to being your trusted partner. As part of that commitment, we endeavour to help our clients make more-informed investment decisions. That is why we are pleased to again work with Amin Rajan from Create Research to bring you valuable insights for the pensions industry. The need for innovation and new methods of finding return is more important now than ever. After eight years of a low yield environment and market uncertainty, many are realising that traditional asset allocation models may no longer be appropriate. This uncertainty has increasingly become the norm and with major headwinds such as Brexit looming large, it is not expected to end in the near future. Created specifically for pension providers but appropriate for all large institutional investors, Expecting the unexpected: How pension plans are adapting to a post-Brexit world goes into detail on the factors that are influencing return and the drivers of innovation in both investment strategies and asset allocation modelling. Based on a survey of 169 pension plans across Europe and followed up by structured interviews, the report explores topics such as the use of consultants in developing mandates, the increasing importance of ESG strategies and the use of ETFs in portfolios. The report also has several case studies providing an insider view on how your peers across the European pension marketplace are approaching innovation from various perspectives. We hope you find this report both informative and useful in helping you meet your investment goals. Pascal Blanqué Deputy Chief Executive Officer, Global Head of Institutional Business, Group Chief Investment Officer Expecting the unexpected 3
Acknowledgements This report presents the results of the third annual survey of European pension plans launched by Amundi Asset Management and CREATE-Research. Each year, the survey topic is chosen by asset owners in a private poll. Two related topics have been chosen for this year’s survey: first, the likely impact of the rising populist tide marked by Britain’s vote to leave the European Union, followed by the election of a populist president in America; and the innovations needed to survive the resulting turbulent investment landscape. My foremost thanks go to the 167 pension plans across Europe who participated in the survey. Many of them have provided unstinting support over the years, creating an impartial research platform that is now widely used in all the fund jurisdictions around the world. My sincere thanks also go to Amundi Asset Management for sponsoring the publication of this report without influencing its findings in any way. Their arms-length support has helped to canvass all shades of opinion and present the findings in an impartial manner. My grateful thanks also go to IPE for helping to conduct the survey and especially to its editor Liam Kennedy for his wise counsel and constructive support throughout the project. Finally, I would like to thank two colleagues: Lisa Terrett for managing the survey and Dr Elizabeth Goodhew for editorial support. After all the help I have received, if there are any errors and omissions in this report, I’m solely responsible. Amin Rajan Project Leader CREATE-Research 4 Expecting the unexpected
Contents Foreword 3 Acknowledgements 4 1 — Executive summary 6 Introduction and aims 7 Headline findings 8 Theme 1: Brexit has transformed the politics of fragmentation 9 Theme 2: Asset allocation will be a relative value game 10 Theme 3: Distorted markets are hastening innovations 11 Theme 4: Innovations should improve the old as well as create the new 12 Theme 5: It’s time for radical thinking 13 2 — Asset allocation: 14 Stock markets are in the thrall of the central banks Overview 15 Rising populism is yet another headwind for global growth 16 Asset allocation will be about separating signal from noise 18 Today’s market distortions require radical thinking 20 3 — Investment innovations: 22 Recent experience and future imperatives Overview 23 New asset classes are emerging for a new age 24 No dominant product themes have as yet gained momentum 26 Market distortions are promoting new asset allocation tools 28 Asset vehicles are transforming the investment landscape 30 Innovations should focus on alignment of interest 32 Expecting the unexpected 5
1 Executive summary
Introduction and aims Old certainties are gone. What will take their
place is unclear at this stage.
One definition of insanity, Risks are being stacked up like a wedding cake.
according to Albert Einstein, Investors now find themselves on a journey into
the unknown.
is to do the same thing over
Against this background, this survey report
and over again and expect aims to present an assessment from European
different results. pension plans on three pertinent issues:
— how will the new tide of nationalism affect
Pension plans across Europe have taken this financial markets over the rest of this decade?
message to heart. They have realised that they — what asset allocation approaches are likely
have a stark choice in this surreal era of negative to be adopted?
yields: continue doing what they have been
— which investment innovations are likely
doing all this time and march nobly off a cliff, or
to deliver acceptable results in the volatile
adapt and change.
environment of this decade?
Most have chosen the latter in the belief that
These questions were pursued in a pan-European
quantitative easing (QE) by central banks in
survey covering 169 pension plans, with combined
America, Europe and Japan has reset the rules
assets under management of €1.76 trillion. The
of investing, sidelining the conventional wisdom
survey was followed up by structured interviews
of the last 60 years. The past is no longer a guide
with 30 senior executives. The survey provided the
to the future.
breadth, the interviews the depth. Details are given
The outright purchases of bonds by central in Figure 1.0.
banks and the accompanying zero-bound policy
The next page presents our headline findings. It
rates prevented a rout turning into a 1929-style
is followed by five themes that expand on them.
depression after the collapse of Lehman Brothers
in 2008.
Figure 1.0
The greatest danger in times of uncertainty
is not the turbulence; it is to act with What sector does your pension plan cover?
yesterday’s logic. (% of respondents)
Peter Drucker
However, after eight years, they have also Sector
resulted in an unprecedented distortion of asset
values through convictionless trades. Rates on Private — 69%
nearly $15 trillion of sovereign bonds have gone
into negative territory. Yet the global economy Public — 21%
continues to face severe headwinds: growth
remains sub par in all the key regions. Both — 10%
More importantly, although central bank action
was supposed to be exceptional and temporary,
there is little sign of normalisation.
If anything, the boundaries of the unconventional What is the nature of your plan?
policies are stretched to the extreme with the Nature
arrival of negative interest rates. The resulting
Pure DB — 44%
manipulation of markets and financing of
government deficits is becoming a new orthodoxy.
Pure DC — 30%
As if that is not enough, the risk of sliding into
a world of competitive and angry nationalism Hybrid — 14%
has risen sharply because of two recent events:
Britain’s vote to exit the European Union Mixed — 12%
(Brexit), with far-reaching consequences for
the European Union as an economic power;
and America’s election of an overtly nationalist
administration, with far-reaching consequences Source: Amundi Asset Management /
for global trade and security. CREATE-Research Survey 2016
Expecting the unexpected 7Headline findings In this surreal scenario, the asset choices of
pension plans will rely on four themes deemed
most conducive to value creation.
1. Markets are mispricing the risks from the First, investing will remain an agnostic relative
current tide of nationalism value play, in this era of exponential risks.
Brexit is yet another headwind for global growth. Second, the money in motion will go into asset
Its economic impact will be felt in the UK but it classes with pockets of value opportunities.
could potentially morph into a wider EU problem These include global equities, private equities
reminiscent of the 2011-13 Greek crisis. and emerging market assets. US equities will
The Brexit vote is the canary in the coal mine. It need a strong earnings boost to sustain their
presages the politics of fragmentation. Donald current inflated valuations.
Trump’s victory threatens old certainties about Third, investors will also be drawn into asset
America and its role in the world. For now, classes with pockets of fair value. These
nobody knows what will replace them. All our include off-market bespoke investments such
crystal balls are broken. as infrastructure and alternative credit; and
Will President traditional investment grade corporate bonds.
After these momentous votes, the markets
Trump nose-dived only to recover just as quickly. The
implement Fourth, even if secular stagnation becomes a
rebound confirmed the age-old truism: markets reality in the face of heightened political risks,
what Candidate rarely price in big political outcomes until they negative interest rates are not quite the one-way
Trump are faced with them. bet they seem.
promised? After the sugar highs, populist policies fail under
Or will he be Instead, they imply the ‘greater fool’ theory
their own contradictions. Markets are poor of investing. Much can go wrong – especially
constrained by predictors of their impacts. loss of policy credibility – as central banks go
the traditional
Hence, investors now face an extra layer of on printing money that has no asset anchor to
checks and reduce financial instability and moral hazard.
uncertainty, as investing continues to become
balances once in a high-wire act while asset prices are artificially
office? Theme 2 gives more details (p.10)
inflated by the QE flood.
An interview
quote
Unsurprisingly, therefore, our survey respondents
do not see Brexit as promising anything 3. As investment returns have morphed into
resembling a happy ending: 96% expect a monetary phenomenon, innovation has
increased volatility; 74% expect increased become essential
contagion susceptibility between markets; and The 2008 crisis fast-forwarded the adoption of
68% expect higher funding deficits. investment innovations that emerged in the last
Indeed, the impact on deficits was most decade with varying degrees of success. Some
immediate as the Bank of England lowered its will outlast the crisis that propelled their rise in
policy rate. the first place.
The number of UK pension plans in deficit rose Looking ahead, however, pension plans want
to 4995 from 4854 at the end of May 2016. their asset managers and pension consultants to
Funding ratios fell close to their lowest recorded improve the old as well as create the new.
level, stretching average recovery periods from They want innovations to improve four features
ten to fifteen years. of existing strategies: fees and charges, risk-
Theme 1 gives more details (p.9) return trade off, liquidity and client engagement.
They also want innovations in the investment
process to recognise that investment returns
2. Asset allocation will be driven by an are turning into a monetary phenomenon,
agnostic search for value influenced more by central bank largesse than
QE has brought forward future returns. The economic factors.
dream combination of high returns and low The art of investing has to venture beyond
volatility delivered by QE may soon be history, financial theories so as to develop new insights
as its potency wanes under the structural into how to make money while central banks
influence of ageing demographics, falling and markets remain caught in a tight embrace,
productivity and rising inequalities. while facing new political risks.
The 36-year old bull market in bonds will be There should be a clear line of sight between
ending, as the new US administration embarks asset owners’ needs and innovations.
on its ambitious plans for infrastructure
spending and tax cuts. Themes 3-5 give more details (pp.11-13)
8 Expecting the unexpectedTheme 1
Brexit has transformed the politics of fragmentation in the
European Union and created new risks
It is hard for The immediate aftershock of the Brexit vote replay of the 2011–13 Greek crisis.
investors to saw the MSCI World Index plunge by 7% and According to the European Council of Foreign
distinguish European stocks by 11%. If the fall was steep, Relations, there have been 34 anti-EU
an event that so was the rebound, once the Bank of England referendum demands in 18 countries – the
announced fresh monetary stimulus. Markets
causes periodic ones in France and The Netherlands could be a
were reassured that central banks would be even political minefield. The populist wave in the US
volatility from more dovish. Complacency set in.
the one that is a may well hit Europe.
game changer. However, our survey respondents expect the Who will fund the increased deficit spending
second and third round effects of the vote to be of the new US administration is unclear. China,
highly negative (Figure 1.1): Japan and Saudi Arabia may not be so eager if
— 92% expect increased market volatility new trade barriers are created.
— 76% expect a further disconnect of market In today’s interconnected world, it was hard
prices and their fundamentals enough to connect the dots on all possible
— 74% expect increased contagion susceptibility risks due to the experimental policies of
between global markets central banks.
— 68% expect higher funding deficits Populism has added yet another layer of
uncertainty for pension investors, who are
— 54% expect lower investment returns now braced for more market-moving events.
— 46% expect reduced risk appetite. It is hard for them to distinguish an event that
causes periodic volatility from the one that is a
Brexit will impact on asset valuation mostly via
game changer.
political contagion instead of a hit on corporate
profits. Its impact in the UK could potentially
morph into a wider EU problem, bringing about a
Figure 1.1
What impact will Britain's decision to leave the European Union have on financial
markets and your own pension plan over the next three years?
% of survey respondents
Financial markets:
Market volatility 3 2 3 92
Disconnect of market prices
from fundamentals 2 17 5 76
Contagion susceptibility between 8 8 10 74
global markets
Pension plan:
Financial deficits 1 16 15 68
Risk appetite 46 7 41 6
Investment returns 54 18 22 6
Decrease Unsure No impact Increase
Source: Amundi Asset Management / CREATE-Research Survey 2016
Interview quotes
With Brexit, some 55 treaties will have The most powerful country in the
to be renegotiated. The final deal will world may reverse its policy on almost
have to be ratified by 36 national and every key issue.
regional bodies.
Expecting the unexpected 9Theme 2
Asset allocation will be a relative value game while interest
rate normalisation remains a distant prospect
The strong dual rally in bonds and equities includes global equities, private equities, quality
to record levels in July 2016 sent out highly equities and emerging market assets. The second
contradictory signals, as did the mass dual sell- camp includes infrastructure, alternative credit
off that followed in September. real estate and quality bonds.
Declining yield – and even negative yield in Europe In contrast, the least favoured asset classes are
and Japan – presages recession and rising risks. deemed to offer value traps or over-valuation.
The ‘don’t fight Booming equity prices, on the other hand, imply The first camp covers a motley collection of
the Fed’ refrain higher economic growth and rising earnings. long-only and alternative assets. The second one
has pushed In this Alice in Wonderland world, investors are covers sovereign bonds and regional equities.
investors buying bonds for capital appreciation and stocks Much will depend upon the size, shape and
up the risk for income. timing of the likely fiscal stimulus of the new
curve, turning The ‘don’t fight the Fed’ refrain has pushed administration in the US. The resulting rise in
investing into investors up the risk curve in an agnostic search inflation and interest rates may well hit bond
an agnostic for value. Certain classes of equities will be values. Its extent, however, will be moderated
by the prevailing structural changes in the global
search for cheap because bonds remain expensive.
economy due to an ageing population, falling
relative value. Accordingly, Figure 1.2 presents pension plans’ productivity and rising inequalities.
investment preferences over the next three years,
distinguishing between most favoured (top half of Equity markets will be exposed to political risks
the figure) and least favoured (bottom half). arising from nationalism, bringing to an end
the dream combination of high returns and low
The most favoured are deemed to offer either volatility inspired by QE.
value opportunities or fair value. The first camp
Figure 1.2
What asset classes will be most suited to meet your pension plan’s needs over the next three years?
Most favoured
Value opportunities % of respondents Fair value % of respondents
Global equities 57 Infrastructure 50
Private equities 42 Alternative credit 46
High quality equities 38 European investment grade corporate bonds 34
EM equities 30 American investment grade corporate bonds 31
EM government bonds 30
EM corporate bonds 30
Value traps % of respondents Overvalued % of respondents
Domestic equities 22 High yield bonds 28
European equities 20 Real estate (debt) 25
Real estate (equity-based REITs) 20 European government bonds 24
Hedge funds 15 US equities 13
Small cap equities 15 US government bonds 12
Gold 8 Japanese equities 6
Commodities (excluding gold) 7
Currency funds 3
Least favoured
Source: Amundi Asset Management / CREATE-Research Survey 2016
Interview quotes
We start from a position where the Central bank action is generating
best way to make money is not diminishing returns. The days of high
to lose it. returns/low volatility are over.
10 Expecting the unexpectedTheme 3
Distorted markets are hastening innovations
As the old The 2008 crisis was a watershed. Asset class In each case, early adopters report net positive
ways of diversification failed when it was most needed. outcomes. Their future growth prospects
investing lost Risk failed to generate returns. Pension liabilities remain favourable.
their relevance began a relentless rise under the weight of rising Second, going forward, four innovations will be
discount rates and ageing populations.
in the new game changers: they will outlast the crisis that
landscape, As the old ways of investing lost their relevance promoted their rapid rise:
the search in the new landscape, the search for new ways — low-carbon strategies and environmental,
for new ways intensified. They focused on some 30 innovations social and governance (ESG), because
that had emerged gradually in the last decade. markets will be increasingly pricing in the
intensified.
Their adoption gained fresh traction after the effects of climate change initiatives after the
2008 crisis. They fell into four categories: asset COP21 Paris Conference in 2015 and HFCs
classes, product themes, asset allocation tools (hydroflurocarbons) Kigale Conference in 2016
and asset vehicles.
— risk factor investing, because it is proving more
A summary version of their scorecard so far is robust than asset class-based diversification
shown in Figure 1.3, which shows the top three
items in each category. Fuller details are given — multi-asset class funds, because their fees are
in Section 3. Three salient points are worthy based on net performance across all chosen
of note. asset classes, unlike single product mandates
First, there are standouts across the patch. — ETFs, because they allow investors to slice
Private debt is the most obvious one. US-style and dice the universe in pursuit of emerging
credit markets are now emerging in Europe, as opportunities.
banks have withdrawn to repair their damaged Third, as asset values have become distorted,
balance sheets after the 2008 crisis. Other pension plans have been more open to new ideas
standouts include risk factor investing, absolute to enjoy early mover advantage. Innovation is
return investing, multi-asset class funds and ETFs. the key.
Figure 1.3
Investment innovations that delivered most value since the 2008 crisis: their current
adoption and future growth Current Future
% of adopters reporting an impact adoption growth
Asset classes: rate
Private debt 13 61 52 High
Low-carbon strategies 12 35 32 High
Wind farms 20 32 32 High
Product themes:
Global growth 16 36 42 High
Bank restructuring 18 35 39 High
ESG 12 33 37 Medium
Asset allocation tools:
Risk factor based investing 16 51 51 High
Absolute return investing 36 47 68 High
Dynamic investing 13 40 45 Medium
Asset vehicles:
Multi-asset class funds 13 45
29 High
Exchange traded funds (ETFs) 21 42
35 High
Smart beta funds 24 40
32 High
Delivered least value Delivered most value
Source: Amundi Asset Management / CREATE-Research Survey 2016
Interview quotes
Large pension plans have jettisoned ETFs allow us dynamic asset allocation
the tick-box approach to climate at low cost and full liquidity.
change and are now seeking early
mover advantage.
Expecting the unexpected 11Theme 4
Investment innovations should seek to improve the old
as well as create the new
Against the backdrop of their relatively favourable shelf life. Most of them are about customisation
experience of innovations in this decade, our that meets clients’ needs. Results depend on their
survey respondents were asked whether further intrinsic merits as much as on how clients use them.
innovations could deliver value (Figure 1.4, left- Hence, client engagement is becoming critical.
hand chart). Nearly two thirds responded ‘yes’. When asked how often their asset managers have
But the endorsement is not unqualified. Pension involved their clients when innovating the products
plans want asset managers to improve various that clients buy from them, the responses were:
design features of their existing offerings in order — invariably (12%)
to improve their outcomes (Figure 1.4, right-
The rapid — frequently (19%)
hand chart). Fees and returns top the list.
ascendancy of — occasionally (42%)
asset vehicles This emphasis on improving the old rests on
– like ETFs and a simple imperative: around 75% of pension — rarely (27%).
assets in Europe currently rely on active asset
smart beta – Current engagement models need a big
managers. But earning market-beating returns
underscores the has proved hard while asset prices remain
makeover to create a direct line of sight between
need for active client needs and innovations.
distorted by unconventional monetary policies.
managers to up The changes should enable asset managers to
The rapid ascendancy of low-cost vehicles – like
their game. understand their clients’ specific needs, solicit
ETFs and smart beta – underscores the need for new ideas by tapping into their expertise,
active managers to up their game in a changing manage expectations of what can and can’t be
landscape (as we argue in Theme 5). delivered in markets driven more by politics
For now, it is worth emphasising that unlike their than economics, minimise ‘wrong time’ risks in
physical counterparts, investment innovations buying and selling, highlight proactive buying
do not have predictable outcomes or a definable opportunities and deliver bespoke research.
Figure 1.4
Overall, do you think that further investment In which areas do asset managers and pension
innovations can deliver value to your plan over consultants need to make significant
the next 3 years? improvements if they are to receive mandates
from your plan in future?
% of survey % of survey respondents
respondents
Fees and charges 65
Yes — 67%
Risk-return trade-off 55
Don’t know — 15%
Liquidity 52
No — 18%
Client communication 50
and engagement
Transparency 40
Source: Amundi Asset Management / CREATE-Research Survey 2016
Interview quotes
Markets are adaptive and self The best innovations minimise
correcting. Active management seems investor foibles and choose the right
out of fashion while markets are time. Success is as much about ‘when’
distorted. But it’ll come back. as ‘what’.
12 Expecting the unexpectedTheme 5
As investment returns have morphed into a monetary
phenomenon, it’s time for radical thinking
When asked to rate the contribution of asset by the regular largesse of central banks than
managers and pension consultants in the economic fundamentals.
challenging environment since 2008, the Asset prices are both the result of monetary
majority of pension plans rate it as ‘excellent’ action and a factor influencing it. This implied
or ‘good’ – with asset managers scoring notably circularity is great when markets are doing
higher (Figure 1.5). Asset managers also score well but disastrous when they reverse – unless
higher than pension consultants in specific global growth picks up dramatically. Evidently,
activities, as shown on p.20 in Section 2. central banks will continue to support markets
However, our post-survey interviews unearthed in today’s highly indebted financial environment,
Crisis is often two salient points. where a big market correction can wipe out a
the mother of First, despite higher scores, examples of large chunk of the supporting collateral.
innovation. ‘groupthink’ and rear-view investing are In this complex dynamic, the art of investing has
widespread – mostly due to heightened to go beyond financial theories and develop new
uncertainty. insights into how to make money when politics
Second, any assessment needs to make a more than economics drives the markets.
distinction between qualifiers and differentiators. Newer lenses are needed to study markets from
Qualifiers are the basics that an organisation needs perspectives as diverse as politics, psychology
to get right in order to survive. Differentiators, and philosophy.
on the other hand, are what give it a competitive It is not enough to blame central banks for the
edge. The positive scores in the survey largely sorry state of investing today. The best that
relate to qualifiers. asset managers and pension consultants can do
Few asset managers and pension consultants is to turn the challenges into opportunities.
have yet to differentiate themselves with Crisis is often the mother of innovation.
strategies that seek to capitalise on the fact
that investment returns today are mostly a
monetary phenomenon: influenced far more
Figure 1.5
As a pension plan, how would you rate the contribution of your asset managers and
pension consultants in helping to meet your investment goals since the 2008 crisis?
Asset managers Pension consultants
Excellent — 9% Excellent — 12%
Good — 50% Good — 39%
Mediocre — 20% Mediocre — 35%
Poor — 21% Poor — 3%
Source: Amundi Asset Management / CREATE-Research Survey 2016
Interview quotes
Loose monetary policies will last Investing is heavily nuanced, as
for years. They require new ways of markets evolve like a biological
thinking and investing. organism. Ideas based on finance
theory are not enough.
Expecting the unexpected 13Asset allocation:
2 Stock markets are
in the thrall of the
central banksOverview
Aims Union. The process is unlikely to have a happy
ending for investors. There is also a lot of
Taking a three-year forward look, this section uncertainty around the policies of the new
explores the following questions: administration in America.
— what factors will drive the investment returns
of pension plans? C. Asset choices
Global equities and high quality equities will be
— how has Britain’s vote to exit the European
favoured for their excess yield over bonds.
Union unleashed a new tide of nationalism?
Off-market illiquid assets such as infrastructure,
— what asset classes are likely to be most
private equity, real estate and private debt will
favoured against a background of the resulting
be favoured, as the search for uncorrelated
top-down risks?
absolute returns intensifies.
— which areas of investing need improvements
Corporate bonds and emerging market assets
to cope with today’s market distortions
will continue to attract fresh inflows, as
caused by central bank action?
investing increasingly becomes a relative
value game.
Sovereign bonds will become less attractive,
as the potency of monetary action diminishes,
The ripple effects of the Brexit vote will be forcing governments to adopt more muscular
more evident when the ‘divorce’ negotiations fiscal policies, as promised by the incoming
kick off in earnest. administration in the US.
An interview quote
D. Areas needing improvement
The art of investing needs to go beyond financial
Key findings theory. A dual rally in bonds and equities in
July 2016 followed by a mass dual sell-off in
A. Return drivers September showed the severity of market
As central bank action delivers diminishing distortions currently.
impacts, markets will remain in an era of low
returns and high volatility. Key drivers of returns They highlighted the need for improvements
will be: that asset managers and pension consultants
need to make in two specific areas:
— the outlook of the global economy
— risk management: to take account of the subtle
— central bank policies nuances in the evolving investment scene
— Britain’s exit from the EU — tactical investing: to single out value
— geopolitical risks opportunities from value traps in today’s
— fears of a hard landing in China after its risk-on/risk-off cycles.
explosive credit growth.
Investors will be enjoined to continue their
delicate balancing act. On the one side,
recognising that QE has brought forward future
returns for most asset classes; and on the other
side, knowing that central banks are unlikely to
allow big market corrections that would wipe
out the financial leverage that supports today’s
valuations.
B. Impact of Brexit
Brexit has crystallised pension investors’
deeper fears that the anti-globalisation policies
will hurt the global economy and create new
political risks.
A cloud of uncertainty hangs over the new
trading arrangements, as Brexit reshapes the
politics of fragmentation in the European
Expecting the unexpected 15Rising populism is yet another headwind for global growth
Debt is future Since the 2008 crisis, the conventional unlikely to stimulate demand soon to a level
demand brought investment wisdom has been increasingly that will stoke up inflation, which central banks
forward. Its sidelined by central bank action in the West. so keenly want. Despite firing on all cylinders,
current size With the latest negative interest rates on 50- even US growth remains sub par, with a collapse
year Swiss sovereign bonds, investors are pushed in productivity and subdued inflationary
is unlikely
to the extremities of asset price distortion. expectations.
to stimulate
demand soon With fresh rounds of quantitative easing Second, ultra-loose monetary policies have
to a level that announced recently by the Bank of Japan and undermined price discovery for all assets. The
the Bank of England, pension plans see little parallel regulatory changes under the Dodd-
will stoke up
prospect of normalisation for the foreseeable Frank Act in the US and MiFID in Europe have
inflation, which future, while growth in the global economy undermined liquidity in bond markets. Investors
central banks so remains sub par. now find it hard to distinguish a market event
keenly want. that causes periodic volatility from one that is a
So when asked to identify the drivers of
investment returns over the next three years, game changer.
at least one in every two survey respondents This will continue, since central banks want to
identified the same five: growth in the global avoid a recession in today’s highly indebted and
economy, unconventional monetary policies of overleveraged financial environment, where a
central banks, populism marked by Britain’s exit big market correction can wipe out a big chunk
from the European Union, geopolitical risks and of the underpinning collateral.
a hard landing in China (Figure 2.1). Third, Brexit will impact on asset valuations
A number of salient points emerged from our mostly via political contagion rather than
follow-up interviews with senior executives in via immediate impact on corporate earnings
the pension plans covered by the survey. (see INSIGHTS on the next page). Initially, its
First, with successive rounds of QE since the economic impact will be felt in the UK but it
2008 crisis, diminishing return has set in. could potentially morph into a wider EU problem
Growth remains anaemic. In the meantime, that brings about a replay of the 2011-13 Euro
global debt has ballooned from $147 trillion in crisis. The campaign promises made by the new
2008 to $205 trillion in 2015. Debt is future US president carry major risks for the global
demand brought forward. Its current size is economy and security. Brexit has already caused
Figure 2.1
What factors will drive the investment returns of your pension plan over the next 3 years?
% of survey respondents
Growth outlook for the global economy 76
Monetary action by central banks 63
Britain’s decision to exit from the European Union 54
Geopolitical risks 52
Fears of a hard landing in China 50
Growth outlook for the European economy 30
Ageing demographics of your plan members 21
Fears of ‘currency wars’ among trading nations 9
Fallout from new regulations (e.g. Solvency II) 11
Source: Amundi Asset Management / CREATE-Research Survey 2016
Interview quotes
The current level of gilt yield implies The Fed is walking a slippery
30 years of stagnation, if history is any tightrope, after over-inflating the
guide. asset values. Its exit strategy is
fraught with danger.
16 Expecting the unexpecteda flight to safety, driving yields even lower. The as shown by the authorities’ futile attempts to
process is not promising anything resembling boost stock markets in the summer of 2015.
a happy ending on current reckoning (see China will continue to remain a wild card with a
INSIGHTS box below). lot in its favour and a lot against it.
Fourth, emerging markets are witnessing The European economy will continue to recover.
another credit explosion. Their debt:GDP ratio But, as in the US and Japan, its growth will
has risen from 150% to 195% since 2010. In the remain sub par over the next three years.
past four years alone, China’s ratio has shot up No one knows the end game of QE, with the
by 50 percentage points. countless convictionless trades it has generated.
Nonperforming loans in excess-capacity In today’s interconnected world, it is hard to join
overleveraged sectors such as steel and energy the dots on all possible risks.
will intensify pressure to recapitalise the banking Many improbables may occur given that the
system. So large is the credit injection that much entire global monetary system is influenced
of it cannot be absorbed efficiently. by the experimental policies of central banks.
Evidently, most new debt goes to pay off old Pension plans are braced for market-moving
obligations rather than invest in value-creating events that may result in big gains or big losses.
activities. China’s rebalancing from exports to Their search for better ways of investing has
consumption also carries risks of policy errors, intensified.
Neither the EU
Interview quotes
nor the euro
zone are likely
to disintegrate China continues to kick the credit can The tide of globalisation is turning, as
anytime soon. down the road. Its sugar highs don’t growth has faltered and inequalities
The risks from last long. have widened.
Brexit are on a
slow fuse and
could potentially Insights
roil the markets,
as did the Greek Stock markets are too complacent about the Brexit aftermath
crises in 2011–14.
In the immediate aftermath of the Brexit vote, Neither the EU nor the eurozone are likely
European stocks fell by 11% and the MSCI to disintegrate anytime soon. The risks are
World Index by 7%. If the fall was massive, so on a slow fuse and could potentially roil the
was the rebound – once the Bank of England markets, like the Greek crises in 2011–14.
announced a monetary stimulus. Markets The real significance of the Brexit vote and
rallied in the belief that major central banks the subsequent result of the US presidential
around the world would be even more dovish. election is that they show how nationalism
But the fallout from Brexit is simply postponed. now triumphs over globalism. Populism is on
To start with, sterling’s stunning decline to the rise in Europe. Global trade and growth
168-year lows will push up inflation without are at risk. The lacklustre growth in the
boosting the UK exports, since these are much global economy faces yet more headwinds.
less price sensitive. As businesses reassess their The Bank of England’s timely monetary
prospects, the UK may well sink into recession, action has calmed the markets at the
especially if the prospect of trade deals proves expense of hitting pension plans. The total
illusory and constitutional hurdles proliferate. deficits of the UK plans in the Pension
Currently, there is a cloud of uncertainty Protection Fund 7800 Index fell to 78% after
hanging over the terms of the ‘divorce’ and the Brexit vote – close to the lowest level
the new trade deals. As the UK has turned ever recorded of 76.5% in May 2012. The
migration into a ‘red line’ issue, negotiations number of plans in deficit rose to 4995 after
could turn protracted and acrimonious. Why the vote, from 4864 before the vote.
would the EU accommodate deluded Brexiters? Our recovery period is now extended from
EU leaders are naturally keen to prevent ten to fifteen years, so big is our plan deficit.
other member states from leaving. Political
minefields lie ahead with the upcoming
A UK Pension Plan
elections or referenda in Austria, Hungary and
Italy, and demands for outright exit from the
EU in France and Holland.
Expecting the unexpected: how pension plans are adapting in the post-Brexit world 17Asset allocation will be about separating signal from noise
in an agnostic search for relative value
Asset prices have been rising faster than the real expansion in earning multiples will be acceptable
economy everywhere. QE has brought forward because these asset classes remain the biggest
future returns. Rates will remain even lower for beneficiary of fresh stimulus from central banks
even longer. Ageing bull markets are on bumpy in China, Europe and Japan. In contrast, markets
terrain with sky-high valuations. Unknown in Europe, Japan and the US have narrowed: their
unknowns dominate the risk scene, especially momentum has weakened with fewer – mainly
after the US presidential election. Normalisation tech – stocks now powering their rise. The likely
remains a distant prospect. But pension fiscal stimulus in the US could change that.
investors also know that times of high risk are The second theme favours off-market bespoke
also times of big opportunity. investments such as infrastructure, alternative
Against this sombre background, our survey credit, private equity and real estate – all
Normalisation identified eleven asset classes that are likely delivering uncorrelated absolute returns in excess
remains a to be favoured over the next three years by at of equities. They are also perceived as being less
distant prospect. least 25% of respondents (Figure 2.2). Their sensitive to rate rises on account of their in-built
preferences reflect four investment themes floating rate structure. Alternative credit is likely
But pension
that would be most conducive to value creation to see the biggest increases in allocations. Real
investors also at a time when financial markets remain estate allocations will be directed towards value-
know that times disconnected from the fundamentals (see added and opportunistic categories, since prime
of high risk are INSIGHTS box on the next page). and core assets are deemed overvalued.
also times of big
The first theme reflects the search for yield. The third theme treats investing as a relative value
opportunity. Global equities and high-quality equities will be game, while the QE tide continues to lift all boats.
favoured for their excess yield over bonds. Further This will favour under-valued, under-researched
Figure 2.2
Which asset classes will be most suited to meet your plan’s investment goals over
the next 3 years?
% of survey respondents
Global equities 57
Infrastructure 50
Alternative credit 46
Private equity 42
High quality equities 38
European investment-grade corporate bonds 34
American investment-grade corporate bonds 31
Emerging market equities 30
Emerging market government bonds 30
Emerging market corporate bonds 30
High yield bonds 28
Real estate (debt) 25
European government bonds 24
Domestic equities 22
European equities 20
Real estate (equity-based REITs) 20
Hedge funds 15
Small cap equities 15
US equities 13
US government bonds 12
Gold 8
Commodities (excluding gold) 7
Japanese equities 6
Currency funds 3
Source: Amundi Asset Management / CREATE-Research Survey 2016
Interview quotes
Bond markets are dysfunctional, like Investors are buying bonds for capital
a barometer that gives inaccurate appreciation and stocks for income.
readings. How odd!
18 Expecting the unexpectedNegative rates and under-loved assets in four areas: investment reflecting desperation on the part of central banks.
sound like a grade bonds, high yield bonds, and emerging They cannot go on defying market gravity with
one-way bet market equities and bonds. Arguably, emerging paper money that has no asset anchor to reduce
but they rely markets are coming into favour not because of financial instability and moral hazard caused
their renewed dynamism but because they offer
on the ‘greater by cheap money policies. Central banks are no
better relative returns – in the near term. longer viewed as omnipotent institutions. They
fool’ theory of
investing The final theme cautions against overcapitalising may well be reaching the limits of what they can
on negative interest rates on sovereign bonds in achieve with QE. Hence, net new money into
parts of Europe. Yes, the rates may sink even further sovereign debt is likely to be limited.
into negative territory and generate windfall gains. Another reason is that rates are likely to rise in
Negative rates sound like a one-way bet but they the US to fund the new deficit spending. The
rely on the ‘greater fool’ theory of investing. A lot longest bull market in bonds in history may be
can go wrong on this journey into the unknown, coming to an end.
Interview quotes
New allocations will end up in unlisted Making money in the surreal
illiquid markets with good return environment of negative rates requires
expectations. exceptional skills or exceptional
luck.
Insights
Perverse messages from bond and equity markets
The strong dual rally in bonds and equities investors up the risk curve. The buyback
to record levels in July 2016 was a rare boom on both sides of the Atlantic, fuelling
phenomenon, as was the mass dual sell-off in stock markets, is mostly the bi-product of
September; both telling contradictory stories. ultra-low rates. High stock prices are not
Declining yield – and even negative yield in evidence of a healthy economy. Rather,
Europe and Japan – presage recession, rising they reflect the fact that there are too few
risks and a fall in capital expenditure, if the opportunities for productive investment
history of the past 50 years is any guide. The as companies grapple with the secular
current yield on a US 10-year Treasury note stagnation scenario, while the global debt
implies a 60% probability of recession in 2017 mountain shows no sign of shrinking.
and inflation at 1.4% a year through 2021. The question uppermost in the minds of
On the other hand, booming equity markets investors worldwide is whether corporate
imply higher growth, rising earnings and strong earnings can rise in a modest growth
corporate spending. This seeming disconnect world. While improvements in economic
is explained by two idiosyncrasies in today’s fundamentals have been slow, top-down
financial markets. factors such as loose monetary policies,
political concerns in Europe, the Chinese
First, many of the purchasers of sovereign bonds
credit boom and oil prices have taken centre
are compelled by regulators to buy them at any
stage in driving up equity prices. The process
price. Pension plans in many EU jurisdictions
will receive fresh impetus with the proposed
are obliged to offset long-term liabilities with
stimulus package in the US.
assets of similar duration. Likewise, banks buy
bonds to comply with the new rules that govern The resulting expansion in the earnings
their risk profile. Most of all, central banks multiple is mostly justified by the fact that
themselves have become the biggest buyers of equities now deliver better yield than bonds
bonds as part of the QE programmes. On the in most markets – contrary to conventional
supply side, governments have not been issuing wisdom – while their respective valuations
bonds in large volumes. In the face of artificial remain distorted. In this Alice in Wonderland
excess demand, bond markets are like broken scenario, we have to remain invested as our
crystal balls with little predictive powers. liabilities are maturing rapidly due to ageing
demographics and our coverage ratio remains
Second, on the equities side, unconventional
below 100 due to ultra-low discount rates.
monetary policies have taken valuations to
heights well above their historical norms.
The “don’t fight the Fed” refrain has pushed A Dutch Pension Plan
Expecting the unexpected 19Today’s market distortions require radical thinking on the
part of asset managers and pension consultants
Our survey asked pension plans to assess the a nascent phenomenon outside the Netherlands
value added by asset managers and pension because of seeming conflicts of interest. Tactical
consultants via their eight core activities since asset allocation has gained ascendancy with
the crisis. risk-on/risk-off cycles that characterise markets
Taken as line items, asset managers were today. But it requires enhanced investment
rated as ‘good’ or ‘excellent’ in five of them capabilities that can turn volatility into
by at least 50% of respondents (Figure 2.3). opportunity. These are scarce currently.
They include investment returns, strategic In the wake of the crisis, pension plans have
asset allocation, stock selection and portfolio taken on board a number of innovations, as we
construction, risk management and access to shall see in Section 3. But that does not detract
new investment insights. from an over-riding message from our post-
The corresponding figure for consultants is three. survey interviews: while new asset classes and
They include listening and understanding their asset allocation tools are needed, there is also
clients’ unique needs, strategic asset allocation plenty of scope to improve the old approaches
and risk management. while the bulk of old money is tied up in old
asset classes.
In both cases, the scores for fiduciary
management and tactical asset allocation are Risk management and tactical investing were
notably low. Taking them in turn, fiduciary widely singled out as areas that need big
management has gained traction but it remains improvements.
While new asset Figure 2.3
classes and
asset allocation How do you rate the contribution of the following activities of your asset managers
tools are needed, and pension consultants in helping you to meet your plan's investment goals since
there is also the 2008 crisis?
plenty of scope Contribution by asset managers: % of survey respondents
to improve the Returns on your investments 12 24 51 13
old approaches Strategic asset allocation 10 22 54 14
while the bulk of Portfolio construction and stock selection 4 31 41 24
the old money is Risk management
Access to new investment insights
11 24 53 12
13 27 52 8
tied in old asset Listening and understanding your plan’s unique needs 26 28 30 16
classes. Tactical asset allocation 20 34 40 6
Fiduciary management 26 28 30 16
Contribution by pension consultants:
Listening and understanding your plan’s unique needs 12 17 49 22
Strategic asset allocation 14 26 37 23
Risk management 12 29 42 17
Manager selection 15 36 38 11
Returns on your investment 15 39 35 11
Access to new investment insights 20 35 37 8
Fiduciary management 14 40 28 18
Tactical asset allocation 27 45 20 8
Poor Mediocre Good Excellent
Source: Amundi Asset Management / CREATE-Research Survey 2016
Interview quotes
We want to pick the bandwagon Where else is opportunity, if not in
premium when momentum is volatility? How many asset managers
working. know how to capitalise on it?
20 Expecting the unexpectedThe art of Taking them in turn, the prevailing risk models In an era where politics more than economics
investing needs came unhinged in the last decade when asset drives the markets, the art of investing needs to
to go beyond managers and pension consultants could not go beyond financial theory and develop deeper
financial theory foresee the two vicious equity bear markets; expertise in anticipating price distortions thrown
nor did they detect the time bomb concealed in up by wild periodic risk-on/risk-off cycles in
cheap money; nor did they anticipate asset class which value traps and value opportunities are
correlations going through the roof; nor did they hard to distinguish.
imagine the unintended consequences of the Investment ideas and their embedded risks
mark-to-market rules that turned the US sub- need to be stress-tested under extreme macro-
prime crisis into a global disaster. economic and geopolitical scenarios via personal
Evidently, they missed the subtle nuances of the judgement based on insights and foresights gained
newly evolving investment scene that was far by deploying a multiplicity of lenses. Descriptions
removed from conventional wisdom. based solely on finance theories are not enough to
Much the same observation applies to tactical understand the behaviours of markets.
investing. Rarely have the markets been so
wild; nor is there a precedence of so many asset
classes fluctuating so uniformly.
Interview quotes
There is a need for fresh thinking on In hindsight, periods of market stress
how to generate returns while central have been good entry points.
banks dominate the markets.
Insights
Time to avoid groupthink and rear-view mirror investing
Our funding level has dropped from 104% to Peer risk, agency risk and market risk have
74% since 2007. Falling discount rates have been given rise to excessive herding.
the main reason – but not the only one. Investing Specifically, groupthink and rear-view
has become complex: the old investment investing no longer work in today’s
assumptions on risk, returns, correlation and environment. Standing out from the crowd
mean reversion do not seem to work. is often a precursor to being right. The past
The main reason is that investment is a poor guide to the future while markets
returns have been turned into a monetary remain distorted. For our contrarian style of
phenomenon. They are influenced far more by investing, two basics need to be enhanced.
the regular stimulus of monetary authorities To start with, the investment process needs
than by corporate earnings from the real additional lenses that look at markets
economy. The perception that the US Federal from perspectives as diverse as politics,
Reserve would always intervene if markets psychology and philosophy. Financial
tumbled has now been deeply ingrained in theories alone can no longer be relied upon.
investor psyche. Anticipating central banks’ next move may
As a result, the price of financial assets is thus be hard. But it is vital to stress-test portfolios
both the result of monetary action and a factor under different policy regimes.
influencing it. The implied circularity is great Additionally, our asset managers and
when markets are doing well, but disastrous pension consultants must have an open,
when they reverse. Thus, while central bank honest dialogue with us on what can
action continues to override fundamental and can’t be delivered while markets
value drivers, fat-tail events may well become are behaving so irrationally. As part of
the norm. expectations management, asset managers
Asset managers have responded with numerous must avoid making exaggerated claims
innovations. We have adopted some of them, about future returns.
like risk-factor diversification and multi-asset
funds – with varying degrees of success. They
A German Pension Plan
have been necessary but not sufficient.
Expecting the unexpected 213
Investment innovations:
Recent experience and
future imperativesOverview
Aims Key findings
The 2008 crisis was a watershed. Asset class- A. Current adoption rates
based diversification failed when it was most
needed. Risk failed to generate return. Pension a. New asset classes
investors’ liabilities began a relentless rise. A Out of nine newcomers, private debt has had
lethal combination of rising discount rates and the highest adoption rate, followed by low-
ageing demographics made it harder to honour carbon strategies and wind farms. On balance,
the pension promise. they have also delivered most value. Their
That required trying out new approaches popularity will increase strongly as late adopters
hitherto not tested by time or events. Since the begin to make allocations.
2000-02 equity bear market, many investment Looking ahead, renewable energy is set to
innovations have emerged. But their substantive be a disruptive catalyst after the 2015 Paris
adoption has occurred since the 2008 crisis, as conference on climate change and the 2016
old ways of investing no longer worked and end- Kigale HFC (hydrofluorocarbons) conference.
investors sought out new ways of earning decent
returns. b. New product themes
Some involve new asset classes, some involve Out of seven newcomers, four have had a
new product themes, some involve new asset moderate adoption rate: global growth, bank
allocation tools and some involve new asset restructuring, ESG and technology. They have
vehicles. also delivered most value so far.
This section provides an assessment of their past Looking ahead, ESG and global growth (centred
track record and future prospects. It highlights: on emerging markets) will continue to attract
fresh inflows.
— their current adoption rate amongst European
pension plans c. New asset allocation tools
— their impacts so far in the unusual Of the seven newcomers, absolute return
environment since the crisis investing has had the highest adoption rate,
— their future adoption rates, as Brexit adds followed by factor-based investing, dynamic
another layer of uncertainty over the next investing and liability-driven investing. They
three years have also delivered most value.
— the new areas at which the main thrust of Each has risen to the challenges thrown up by
innovation should be directed over the rest of ultra-loose monetary policies and will continue
this decade. to transform the art of asset allocation.
Below, we highlight the innovations that have d. New asset vehicles
attracted a significant number of early adopters Of the eight newcomers, four have had the
and their outcomes so far. highest adoption rate so far and have also
delivered most value to their investors: multi-
asset class funds, exchange traded funds, smart
beta and diversified growth funds. Together they
are transforming the investment landscape.
e. Future innovations
Pension plans want the next wave of innovation
There should be to improve the old while creating the new.
a clear line of Improvements need to focus on: fees and
sight between charges, risk-return trade off, liquidity, client
the needs of engagement and transparency.
end-investors They also need to adopt multi-disciplinary
and innovation. lenses in the investment process.
An interview
quote
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