A year after the Fed’s most significant rate hike in decades, you might think that investors have already beefed up their portfolio strategies for a higher interest rate world. But some of the biggest investors are making, or first planning, some of their biggest moves right now.
Count the largest county pension plan in the United States among elite investors who plan to increase bond volume as a result of the high interest rate environment. That was the message from Jonathan Grabeel, chief investment officer of the Los Angeles County Employees Retirement Association (LACERA) at CNBC’s Virtual Sustainable Returns event on Wednesday. He says the upcoming portfolio reallocation will have significant implications for the markets and the economy.
“I think the changing market environment with higher rates probably changes everything, it changes the way we think about allocation,” Grabel told CNBC’s Frank Holland. The pension plan — which invests on behalf of 180,000 active and former workers in L.A. County and has nearly $70 billion in assets — will reconsider its strategic asset allocation, said LACERA’s CIO, the pension plan, this summer.
As the pension giant seeks a total yield of 7%, Grabel said the summer review will look at changes in stocks, bonds, real estate and real estate asset allocations. As far as we can go [7%] And more can be obtained with safer fixed income investments, it may change the amount of capital we have in more complex and riskier equity-like investments.”
LACERA isn’t alone among the top investors talking about how higher interest rates are changing portfolio allocation decisions, especially when it comes to private market stocks and alternative investments. Fellow California pension giant CalSTRS is making a bigger bond move, the Wall Street Journal reported earlier this month. “The bonds are back,” said Chris Elleman, chief investment officer at CalSTRS he told the newspaper.
According to LACERA’s 2022 Annual Report, its investments are split between about $24 billion in public equities, $19 billion in bonds, $13 billion in private equity, $6 billion in real estate, $4 billion in hedge funds and 1 billion dollars in real estate assets.
Last year was the first in the previous three fiscal years that the pension fund’s investment portfolio lost money. While it still managed to outperform its benchmark, returns were well below the actuarial assumptions of a 7% return.
The net investment loss for the fiscal year 2022 amounted to approximately $1.5 billion, a decrease of $17.1 billion from the fiscal year 2021, when the net investment gain was $15.6 billion, and attributed this to “difficult market conditions in the first half of 2022, including War in Europe, high inflation and an economic slowdown in China.
By contrast, investment returns of 25.2% in 2021 were much higher than the 7%, which LACERA attributed to strong performance from global equities and private equity assets.
Grable said the shift to more fixed income among large investors would trickle down to the “whole economy”. “We realize that because investors have less risky assets, it changes how capital is allocated to companies,” he said.
“This is really driving the demand, need and requirement for boards that focus on excellence, and where access to capital is,” he added at the CNBC event focused on sustainability and investment.
LACERA was not scheduled to conduct one of its formal three-to-five-year reviews this summer, last completed in 2021, and involved creating new asset allocation groups.
Why pension funds are turning more to bonds now
Major moves by large institutions that manage billions of dollars based on long-term return assumptions take time to take effect, so it should come as no surprise that some of the most significant moves related to rate hikes are happening for the first time now. According to pension consultant Callan, the shift to fixed income is to expect asset allocation plans to come from more pension funds, especially as the annualized capital markets assumptions used by chief investment officers tilt the equation toward more bonds.
Callan’s latest forecast for the decade from 2023-2032 shows greater returns than the underlying bond after a prolonged period of time when spreads and yields were very tight, making the public bond market less attractive. “A lot has changed in the world and AGG [the Bloomberg Aggregate Bond Index] “It looks more attractive,” said Kyle Fichetti, vice president and fixed-income specialist at Callan’s Global Director Research Group.
The risk-return profile of investment grade bonds is a good example. Last year, Callan’s capital market assumptions predicted a 1.75% yield for the underlying bond against a risk profile of 3.75% for the fixed income asset class. This year, the forecast is for a yield of 4.25% against an expected risk of 4.10%.
Callan’s analysis of how a portfolio was structured a decade ago to generate a long-term return on pension obligations versus how it is structured today shows a greater increase in fixed income. “That’s a lot to think about for plan sponsors, and the discussions are all about the investment community,” Fechetti said, with most asset allocation changes to date, which can include investment grade and high yield, on the sidelines.
“It hasn’t happened yet, but it will happen over time,” he said. He added that this will have implications for private market investments and growth investments, as the returns offered on public fixed income improve and do not require the risk of illiquidity.
More stable income does not mean more 40-60 portfolios
This does not necessarily mean a return to the 60-40 stock/bond approach that was left for dead in years of high stock market returns and ultra-low interest rates.
While the traditional investing concept had a better year in 2023, and some investors are now backing it again, some large institutions say it’s time to abandon it, including BlackRock. in a report This week, the BlackRock Investment Institute said that terrible returns last year for a 60-40 portfolio followed by great returns this year should be discounted.
“We don’t see a return to a bull market for common stocks as we saw in the Great Moderation. That was a period of decades of pretty stable activity and inflation when most assets went up and bonds provided diversification when equities fell. We believe strategic allocations five years and beyond built on these old assumptions It doesn’t reflect the new system we’re in – a system where major central banks raise interest rates into recession in an effort to bring down inflation.”
The bonds will not provide the “reliable” diversification they have in previous years, “but higher yields mean that income is finally returning to fixed income,” her team wrote. Overall, BlackRock says focusing on broad portfolio concepts is a misstep for the future, but for now, increased rates mean more focus on income plays.