Rest Super has been carefully modifying its equity portfolios in anticipation of more volatility to come. We speak to Kiran Singh about the tools the team has at its disposal to do this.
Superannuation fund Rest has been gradually repositioning its investment portfolio while continuing to seek alpha opportunities in anticipation of a tough investment climate.
The combination of rapidly rising interest rates and still high asset valuations has given the investment team pause for thought as to how they are going to face any potential upheaval.
“I think everyone acknowledges that it’s late at night, the party is coming to an end, but you’re not quite sure if you still keep dancing,” Kiran Singh, Head of Listed Assets at Rest, says in an interview with [i3] Insights.
But there is one thing Singh is sure of: the music is going to stop at some point.
“You cannot have an environment where you have that rapid increase in interest rates – the world is so preconditioned to low inflation and sub-segments of the economy and financial markets continuing to take on large amounts of leverage – and not have something implode somewhere,” he says.
“All these things, whether it’s the UK LDI (liability-driven investment) situation last year, the US regional banks this year, or even the devaluation within parts of the private equity universe, coupled with the derating of the technology sector, are all just symptoms of the underlying driver that interest rates are much higher than they were 18 months ago.”
I think everyone acknowledges that it's late at night, the party is coming to an end, but you're not quite sure if you still keep dancing
He says there are a number of ways to build a more resilient investment portfolio.
“As we’ve gotten later into the investment cycle, with rates going up and earnings growth starting to taper off, we have repositioned the investment portfolio and moved money from riskier to more defensive strategies,” he says.
“The way we think about the construction of the equity portfolios is this core and satellite [approach]. They fulfil different roles: core is around ensuring low cost, liquidity and risk control, while satellite tends to be higher risk and greater alpha [strategies].
“So more has gone into core, which has brought the overall tracking error of the asset class down and we have done that over the last year and a half.”
At a high level, Rest’s Australian equity portfolio now has around 40 per cent of its equity allocations invested in core strategies and 60 per cent in satellite strategies to ensure it can still achieve its alpha targets for the asset class.
The team has further adjusted risk in the equity portfolio by also looking within the satellite strategies and moving towards more defensive investment styles and managers.
“When you look at what you have in your satellite strategies, you can then decide which styles you think are going to perform well in a tough environment and lean more towards quality and defensive-style strategies rather than risky, small-cap and cyclical allocations,” Singh says.
“We are going into what we think is a slightly more challenging investment market for equities. So we have more quality in that satellite portfolio even though as a whole we have reduced the allocation to satellite versus core.”
Together these measures have resulted in halving the tracking error of the equities portfolio compared to 18 months ago.
“We can reduce the overall tracking error through the mix of styles, strategies and managers, and we have done all of that. The tracking error has gone from closer to three per cent to now being below two, so it’s quite a material reduction, whilst ensuring we continue to generate alpha for members,” Singh says.
“We believe Rest is now in a good position to deal with any potential market turmoil that might come its way and is ready to take advantage of any opportunities a sell-off may present.
“I would say that we’re getting closer to the end of the investment cycle and the mindset is shifting towards when and where we can start adding more risk.”
Dynamic Asset Allocation
In addition to the active portfolio management measures described above, Rest does have the ability to make asset allocation calls through its dynamic asset allocation (DAA) process.
Led by Andrew Thomas, Head of Investment Strategy and Asset Allocation at Rest, the DAA program operates within clear delegations.
But Singh says the fund typically avoids taking large positions under this program and favours adding incremental value through more frequent small changes.
We can reduce the overall tracking error through the mix of styles, strategies and managers, and we have done all of that. The tracking error has gone from closer to three per cent to now being below two, so it's quite a material reduction, whilst ensuring we continue to generate alpha for members
“Taking big asset allocation bets are risky and often only pay off once every seven years on average. When markets are really in deep negative territory or extremely exuberant, that’s when you can make some of those big calls,” he says.
He believes extracting alpha from manager selection is preferable, sustainable and adds value over time.
“I always refer to selection alpha versus allocation alpha. I think selection alpha can be earned incrementally through time, while asset allocation alpha is lumpy and infrequent,” he says.
“Philosophically, I would say that alpha is harvested more frequently and is more consistent from underlying asset classes than it is from asset allocation.”
Internalisation
All of Rest’s satellite strategies are run by external, active managers. But as the fund recalibrated the portfolio, more money moved to its internal team, which in combination with a number of enhanced passive strategies covers Rest’s core allocations.
Internalisation has been a gradual and thoughtful process and with the migration of Super Investment Management, Rest now runs about 13 per cent of its non-cash assets internally. The team also has board approval to increase this to 25 per cent in the future.
Rest manages nearly every asset class in-house, from cash to equities to infrastructure. Around five years ago, it developed an Australian equity capability, which is currently run by a team of five individuals, led by Phillip Baré, who is the Head of Internal Australian Equities.
The strategy is a core, broad-cap strategy with a portfolio of around 45 to 55 ASX stocks and a moderate tracking error of between two to three per cent.
And it has been growing its assets rapidly in the past two years.
“When I first started, the internal strategy was less than two per cent of the asset class, but now it is close to 14 per cent of the asset class. We expect it to rise further over time, partly because the performance of that portfolio has been very strong over the medium and long term. It is probably one of our best-performing strategies,” Singh says.
We don't set specific numbers around how much internal/external we have in Australian equities. We don't see there being a natural cap because it's quite a large-cap-focused strategy. So with the size of the fund, we can keep growing. The only hard constraint we have is given to us by the investment committee, which is that an internal strategy cannot be more than a prescribed per cent of the overall asset class
“We don’t set specific numbers around how much internal/external we have in Australian equities. We don’t see there being a natural cap because it’s quite a large-cap-focused strategy. So with the size of the fund, we can keep growing.
“The only hard constraint we have is given to us by the investment committee, which is that an internal strategy cannot be more than a prescribed per cent of the overall asset class. We always want to ensure contestability in our manager line-up and we don’t want to have a disproportionate dominance of an individual manager driving the asset class returns.”
Asked whether the fund is looking to add further capabilities in this area, he answers that this relies for a large part on the available talent in the market.
“We are always looking at additional strategies. We keep an open mind because sometimes there is an opportunistic angle where a team becomes available or a group of individuals become available that might want to come and run money internally for us,” he says.
“But the first-order decision is always around fit-for-purpose. Bringing anything internal will save you costs because asset management is a fixed-cost business, so knowing there are clear economic benefits, the consideration also looks to the strategic benefits that we believe can be derived from having an internal team running a strategy for us.
“And it is always predicated on us being convinced that at a minimum they can preserve the returns as well as any other external manager would.”
Although most funds see the internalisation of Australian equities as relatively straightforward, many argue it is harder to run international equities from Australia because it is too far away from the financial centres of New York and London and is located in an inconvenient time zone.
But Singh questions whether this holds true for all international equity strategies.
“I actually think this concept that global equity teams cannot be based out of Australia is a little bit flawed because it does very much depend on the type of strategy,” he says.
“When we think about internalising, a lot of it has to do with finding a strategy or a style that can be done from Australia. So, in thinking about the international equity strategy that we run, the first question we’ve asked ourselves is: ‘How niche a strategy is this?’
“If it is an Indian small-caps strategy, then we will never do it out of Australia because there is a benefit of location. You need to be in the weeds and on the ground. But if you’re running a global large-cap, blue-chip-type franchise, then we believe you can strike an effective balance between desktop research and travel.”
Besides, most companies are not domiciled in London or New York, he says.
“The investor relations team could be in Atlanta, it could be in Seattle, they could be in parts of Silicon Valley. So I will always question [the need to be] based in London or New York,” he says.
__________
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.