The Capital Markets Research Group conducts strategic planning projects, education sessions and general research for our clients. The Group’s discussions are often very big picture–in what should we invest, and why? These discussions are on the front end of potential changes to strategy, to plan design, to portfolio implementation, and to plan sponsors’ expectations for the future.
One common thread running through much of the group’s work in the first half of 2017 was that all types of fund sponsors are coming to grips with lower capital market return expectations. Sponsors have been hearing “lower return expectations” for some time, but the realization is truly sinking in.
Pension funds have been gradually bringing down assumed rates of return, and resistance to lowering their discount rate has dropped in light of another year with lower consensus capital market projections. Many fund sponsors feel even more compelled to take on substantial market risk to close a funding gap, as in 80%-85% in risky assets. Discussions have then focused on a second round of diversification within the large growth allocation. Sponsors want to know if there’s something–anything–more that they can do to tamp down the risk within the growth allocation, short of actually reducing the allocation to growth assets.
In some sense, these discussions turn the diversification topic on its head: investors are looking for investments with similar underlying return factors (in this case equity) while seeking at least some diversification to smooth the ride within that large growth allocation. A broader growth allocation can then consider investments like high yield, convertibles, low volatility equity, hedge funds, MACs, and option-based strategies. This broadening of growth assets also leads to a sharper focus on refining fixed income exposure to gain a “purer” exposure to interest rates.
E&F Focus
The group’s work with endowments, foundations and permanent school funds during the first half of the year saw an increasing focus on developing a sustainable distribution rate. These funds are typically focused on intergenerational equity, or equalizing spending in real terms over generations. The asset/spending analysis suggests that a 5% distribution rate, once considered standard, will erode the purchasing power of most endowments or foundations over time, absent the ability to raise funds or a steady source of outside income, such as a royalty stream. As a result, similar to pension funds lowering their assumed return, endowment funds are bringing down their long-term spending rates.
Recent Discussions
Callan completed seven asset class structure studies during the second quarter: three domestic equity, two non-U.S. equity, one high yield fixed income structure, and one for real assets. In addition to these formal studies, Callan has engaged in numerous discussions to tweak asset class structures, built around common themes: a passive component in all asset classes, controlling active management costs, seeking out “true” sources of active management value-added, and disappointment with diversification in general.
Diversification efforts, while important in the long term, are sometimes met with disappointment in the short term. Callan directly addressed this issue in our June Regional Workshop, entitled “Why Diversify?” U.S. equity has been the primary source of funding for diversifiers such as non-U.S. equity, real assets, and alternatives. While this result is what one should expect–diversifiers should not perform in line with equity–the disappointment has led many fund sponsors to at least ask the question.
