Home / Analysis / Smart money shifts away from listed, developed markets

Smart money shifts away from listed, developed markets

Analysis

State Street Associates, the academic research arm of the big custodian bank and fund manager, has published two studies on the behaviour of sovereign wealth funds with asset allocation and their thinking behind a shift towards private markets.

The asset allocation study shows a big move towards alternatives and unlisted investments and increased exposure to emerging markets and Asia. However, most SWFs now seem comfortable with the geographical spread within their portfolios.

Half of those surveyed had lifted their exposures to emerging markets in the past three-to-five years and none intended to reduce this in the near future. With Asia, 20 per cent had increased their exposures and 70 per cent expected no change in the near future.

  • The white papers followed surveys of large SWFs, including Australia’s Future Fund (IFSWF) and the NZ Super Fund, and were produced in conjunction with one of the firm’s two research partners, the International Forum of Sovereign Wealth Funds. The other research partner is the fund manager Bridgewater.

    The asset allocation paper follows a survey of 10 member SWFs of the IFSWF and shows how the have responded to the global financial crisis. Largely because of their already-high exposures to unlisted markets, most fared better than smaller investors and investors which require greater portfolio liquidity.

    The paper comparing their experiences in listed and private markets followed a survey of eight SWFs shows they wanted to take advantage of the illiquidity premium in private markets and also that they thought they could add more value du to the relative inefficiency of those markets.

    Will Kinlaw, senior managing director and global head of State Street Associates, said: “Much like all investors in today’s economic climate, SWFs are balancing traditional financial theory with the complexities presented by today’s real-world circumstances.

    “They recognise that, in many cases, their long investment horizons represent an advantage, and they are seeking investments that will provide attractive long-term return, risk, and diversification properties. What looks appealing based on monthly returns may look much less so when the horizon is measured over multiple years.”

    From the asset allocation study, 90 per cent of funds had exposures to listed equities in the Asia Pacific region, 70 per cent to sovereign bonds and 60 per cent to corporate debt. Allocations to corporate debt in the region are a lot less common among other fiduciary investors such as pension funds.

    Key findings from the listed versus private markets study included:

    • Even though SWFs have been successful in private markets, many reported ongoing internal debate as to whether the return premium is fair compensation for the risks these types of investments add to the portfolio.
    • SWFs cited a wide range of factors that led to success in private markets, including fostering a culture of long-term investing, attracting and retaining qualified staff, partnering with other SWFs, assigning multi-disciplinary due diligence teams, and proceeding slowly to keep pace with developing in-house capabilities.
    • Of the SWFs interviewed, 50 per cent said they had to make changes to their governance process to overcome challenges related to the speed of decision-making regarding private market opportunities.

    The asset allocation paper includes an interesting interview with Mark Kritzman, a senior finance lecturer at the MIT Sloan School of Management, in which he points out that 75 per cent of the premium obtained from private market investments comes from the industry sectors in which they invest and only 25 per cent from their illiquidity. Therefore investors can get much of the premium by investing in ETFs, say, which also invest in those sectors.

    Kritzman, who is a leading research on asset allocation methods, says dealing with illiquid asset classes is tricky for a variety of reasons.

    “One is that, in many cases, the managers are paid performance fees. This has two effects. One is that the measured or the observed volatility of the returns net of fees is lower than the returns gross of fees. So the volatility that you observe actually understates risk. The reason for that is that performance fees cut off the upside. Reducing upside volatility, which is what performance fees do, is not lowering risk. When a manager outperforms and you give some of that outperformance back to managers you are reducing the upside you get…you are not lowering risk. It lowers volatility but it doesn’t lower risk. The first thing you need to do is reverse engineer the fee calculation so that you get a proper measure of downside volatility,” he says.

    “The other problem with some of these asset classes, such as private equity and real estate and, in some cases, hedge funds, is that the values are based on fair value pricing. These prices are typically anchored to prior period prices so they are smoothed and there is a positive auto-correlation. That also understates the true risk of these investments. So what you ought to do is de-smooth the returns. If you do that you get estimates of risk that make much more sense.

    “On the return side, performance fees also cause you problems. For example, it turns out that if you have many managers who charge performance fees, the expected returns of those managers as a group will be less than the average of their individual expected returns. The reason for this is that when a manager outperforms, they collect a performance fee. When a manager underperforms, they do not reimburse you for that underperformance. So the actual average return of the managers is lower than the average of the individual expected returns of the managers.

    “Now, you might argue that there are clawbacks that would prevent that from happening. That is true in principle but, in fact, that is hardly ever the case. It is typically the case that the manager either gets terminated, if the manager underperforms significantly over some period of time or, if you really like the manager, you are going to reset the high-water mark. I would say a good rule of thumb is that the expected return of a group of managers who charge performance fees is about 80 basis points less than the average of their expected returns.”

    – Greg Bright

    Investor Strategy News




    Print Article

    Related
    How the Future Fund (and others) think about the total portfolio approach

    TPA is an “uncommon and demanding” approach to running an investment organisation, according to the Future Fund, but a rewarding one – as long as institutions that take it up know that it’s not a transformation that should be embarked upon lightly.

    Lachlan Maddock | 22nd Mar 2024 | More
    How this global giant plans to become a go-to manager for super

    The AUD$660 billion M&G has been a “sleeping beauty” down under, and it wants more than the mandate it already runs for the Future Fund. Thinking like an asset owner is part of the equation.

    Staff Writer | 22nd Mar 2024 | More
    How big investors are getting more bang for their RI buck

    More and more of the global institutional investor set is turning to thematic strategies even as they resist the use of ESG benchmarks amidst questions about the methodologies that underpin them.

    Lachlan Maddock | 13th Mar 2024 | More
    Popular