How are pension funds and other institutional investors approaching investments in 2023?

While the coronavirus pandemic, rising geopolitical tensions and high inflation are all contributing to market volatility, diversification remains a constant theme as institutional investors continue to weather economic storms.

Read: Institutional investors considering geopolitical risk, inflation in portfolio construction

The notable events of the past year have led to economic conditions that echo those of the 1970s, says Yusuke Khan, a partner and investments leader for Canada at Mercer. However, he says it’s important to note that institutional investors now have access to a wider range of sophisticated investment strategies than they did 50 years ago.

“Private markets will continue to be important, as will the relevance of considering more dynamic or opportunistic strategies to seek out potential alpha from disruption and dislocation and energy transition, as well as innovation.”

Alternative investments

With high market volatility providing challenges for both equities and fixed income throughout 2022, traditional 60/40 portfolios didn’t perform very well, leading to an increased focus on private markets, says Michael Schnitman, senior vice-president and head of alternative investments at Mackenzie Investments.

Private infrastructure offers significant inflation-fighting characteristics, some of which have contractual pricing that’s indexed to inflation, he adds. “The total return aspect of private infrastructure projects are very attractive and, when compared to listed infrastructure, you have significant differences because listed infrastructure has high inherent equity-like volatility. In private infrastructure, investors have a direct relationship to the stream of cash flows that are generated from these projects.”

Read: Survey finds 44% of institutional investors likely to increase allocations to alternatives

The CAAT’s long-term lens and focus on diversification have led to significant allocations to private assets, particularly real estate and infrastructure, says Haque, noting he expects solid performance and strong diversification benefits over time. The plan is keeping a close eye on agriculture, he adds, as well as opportunities in the energy transition space, including net carbon reduction activities in renewable and transitioning industries.

“Our focus on the long term means that we can look for value and opportunity to further diversify our portfolio in 2023 and beyond. . . . Overall, we’re cognizant of the need to maintain sufficient liquidity to take advantage of opportunities as they arise.”

Inflation and fixed income

As global inflation surged throughout 2022, central banks responded in kind by continually increasing interest rates.

However, there are signs that rate hikes are slowing: in December, the U.S. Federal Reserve raised its interest rate by 50 basis points to between 4.25 per cent and 4.5 per cent, after increasing rates by 75 basis points at its previous four meetings.

In addition, with the Fed projecting that it will cap its benchmark interest rate at 5.1 per cent in 2023, the two-year U.S. Treasury bond rate becomes anchored and dampens interest rate volatility, says Samy Muaddi, portfolio manager for the emerging markets bond strategy at T. Rowe Price Group Inc.

Read: 43% of global institutional investors expect fixed income performance to continue to decline: survey

“It allows fundamental credit views to come back into the fore. In the past, it didn’t matter what your 10-year credit spread was if you couldn’t figure out where the two-year Treasury [rate] is going. It’s setting up a more positive situation for credit markets in the back quarter of 2022 going into 2023. That doesn’t absolve us of the credit cycle or recession, but we’re in a better place with that greater certainty on the path.”

In December, the Bank of Canada raised its interest rate by 50 basis points to 4.25 per cent, noting it’s taking a wait-and-see approach before increasing rates again. It’s a departure from the bank’s previous stance, when, after increasing interest rates by a full percentage point last July, it said rates would need to climb even higher to curtail inflation.

Kristina Hooper, chief global market strategist at Invesco Ltd., says this move is in line with expectations that central banks will “hit the pause button” in the first half of 2023, potentially leading to an economic recovery in the second half of the year.

“It’s hard to envision that today because [central banks] are still relatively fast and furious in their tightening cycle, but I anticipate we’ll see a downshifting and that’s already occurred for the BoC. . . . There are questions around how quickly inflation will moderate, but I think central banks will be comfortable if they see the inflation moderation occurring over the course of several months.”

While Muaddi has seen increasing demand among institutional investors for liquid alternative investments, he also sees opportunities in higher-quality securitized credit, such as AAA, [residential mortgage-backed securities], [agency mortgage-backed securities], high-yield credit and emerging market debt.

Read: Institutional investors increasing allocations to real assets amid inflation, sustainability challenges: survey

“The latter two [categories] have eight to nine per cent yields with the ability to actively manage around impairment risk. In most periods, that’s in line with long-term capital market assumptions on equities. It’s not a wholesale endorsement, but you can actively manage around the risks we see on the horizon.”

While a stronger U.S. dollar can lead to tightening financial conditions, for the weakest pockets of the credit market, such as emerging market debt, it’s preferable to lower asset prices or higher interest rates, he adds.

“We’d much rather see financial conditions tightening for a stronger dollar than through the other choices. There’s still tight financial conditions and credit risk and a potential U.S. recession, but it’s not really the recession that gets you as an investor; it’s the deleveraging of financial risk that tends to happen in recessions. Our view is that a lot of that has been frontloaded.”

Khan agrees, noting that, while the market is pricing in inflation, institutional investors will have to think about a wider range of stress scenarios when constructing their portfolios. “Much of that is a consequence of what we call the end of free money — interest rates are now positive, but it wasn’t too long ago that investors were worried about negative interest rates.”

Crypto in question

While cryptocurrency has been on institutional investors’ radars for several years, it remains a relatively niche sector.

However, with the recent bankruptcy of crypto exchange FTX Trading Ltd., the hype may die down even further. The Ontario Teachers’ Pension Plan is among the institutional investors that lost money as a result of FTX’s bankruptcy, after investing a total of US$95 million in the exchange.

Read: Ontario Teachers’ facing losses from crypto exchange collapse, Caisse financing Quebec EV manufacturer

Amir Akbari, assistant professor of finance at McMaster University, says while most institutions are invested in the blockchain technology underlying crypto as opposed to direct exposure to cryptocurrency itself, the entire sector is coming under increasing scrutiny.

“A lot of investors, including many institutional investors, thought this was the future of investing. Most institutional investors are rebalancing their portfolios away from cryptocurrency. . . . There’s a cash flow with [blockchain] technology and, if you’re a long-term investor, you’re thinking about dividends. But the technology is also being hammered right now — people are casting doubt on it because it’s unregulated and very few people understand what they’re investing in.”

As with any emerging asset class, the CAAT is paying careful attention to the evolution of the cryptocurrency market, says Haque, adding the plan doesn’t have any direct ownership of cryptocurrency and doesn’t expect that to change in the near term.

ESG integration

In addition to inflation and the lingering pandemic, the impacts of climate change and an increased focus on social justice issues are widening the spotlight on the role of environmental, social and governance factors in investment decisions.

While it isn’t a new trend, ESG is becoming fundamental to all considerations when looking at investment opportunities, says Schnitman, adding private credit offers some unique opportunities tied to ESG.

“Five to 10 years from now, ESG won’t be a separate set of products or asset class, but will be germane to all asset classes. As you look to mitigate risk, evaluation of ESG principles will be key to evaluation of all investment opportunities. There are opportunities in the private credit space to make loans and have an ESG ratchet, where the interest rate would be reduced by a certain number of basis points if ESG criteria are met and sustained over a period of time.”

Read: A look at the latest legal issues around ESG investing

With regards to environmental factors, a warming planet will also require innovations that bring investment opportunities. Khan suggests institutional investors will have to develop a more robust investment approach based on engagement and stewardship beyond just a box-ticking exercise. “[Climate change] will be a consideration for investors beyond 2023 and will have huge consequences for livelihoods, going [further than] the physical costs that we’re seeing more frequently. What are the policy and technological consequences and solutions around that?”

For the CAAT, a focus on sustainable investment is key to maximizing long-term, risk-adjusted returns, says Haque. The plan is increasingly focused on its external investment partners’ ESG capabilities and practices, as well as implementing recommendations from the Financial Stability Board’s task force on climate-related financial disclosures. “We are committed to integrating climate change considerations into our investment processes and upholding the ‘S’ and ‘G’ pillars.”

Blake Wolfe is the managing editor of Benefits Canada.