Return Objective
The onset of the Covid 19 pandemic has triggered instability in the financial markets driving down the value of different asset classes. The VIX index which is a real time volatility index that helps gauging the level of volatility in the markets, exhibited alarmingly high levels of values. The CBOE, the VIX indexes of China, Japan, India and several other countries were on higher levels indicating that the markets experienced extreme volatility amidst the health crisis (Financial Express 2021). According to (JPMorgan 2022), the year 2022 will mark the rebound of the economies around the world as the restrictions related to the pandemic are being lifted and mobility in the economy is being restored. Increase in consumer spending, corporate spending and government spending would be the primary factors triggering the growth in the world economies. The BTA fund follows a traditional approach of keeping debt as the primary asset class for investment with investing 60 percent of the total asset into it and investing the remaining 40 percent in Equities.
The primary goal of the pension fund is to provide a secured retirement investment corpus which is linked with the performance of the fund. The fund is focused towards passively managing the equity portfolio and is expected to earn 5 percent return annually over and above the inflation level in the company. According to (Arends 2022), the long-term inflation forecast will be around 3 to 4 percent per year, hence, the fund requires to earn an annual return of around 8 to 9 percent annually with a total investment corpus of GBP10 billion.
- The fund is restricted from investing into companies contributing to carbon emission.
- The firm cannot invest more than 5 percent of the total capital into and small cap stocks.
- The fund needs to invest in liquid bond and stocks as the fund would need liquidity to meet redemption requests.
- The firm needs to give importance to ESG factors while making a choice of investment.
Blue chips Stocks are screened using a few fundamental parameters which are discussed below:
- EPS growth for the last five years needs to be more than 10 percent.
- Dividend yield for the last five years should average around 2 percent.
- The stock should belong to the high market cap category.
In the recent years it has been noticed that passive funds have gained prominence and has been outperforming active funds by a considerable margin. Active funds around the world are dying and investment managers are looking for more passive investment opportunities. The fund will be following a blend of value and growth investing strategy primarily focusing on dividend paying blue chip stocks belonging to US, Europe and some parts of Asia to incorporate emerging markets in the investment universe. Stocks of companies having projects that exhibit super normal growth potential would be selected for investment. The process would require excessive due diligence as companies in emerging markets are risky due to the issues related to information asymmetry (Khoufi 2020). The monetary policy stance of various countries is expected to shift to hawkish from dovish by raising the interest rates to counter the rising level of inflation around the world (King 2022). Hence, stocks of banking and financial institutions would be given importance as the sector is expected to be immensely beneficial in a high interest rate environment (Salzman 2018). Sectors like real estate and retail industry are to be kept into focus due to the favorable impacts of high interest rates into these sectors (Morgan Stanley 2022).
A major chunk of the capital was invested in the US stocks (large cap) accounting for around 42 percent of the total capital. European stocks take up around 32 percent of the total corpus followed by 10 percent invested into large cap as well as small cap stocks of emerging markets. Diversification is an important aspect in determining the success of an investment strategy, hence 11 percent of the capital was invested in REITS which are investment vehicles investing in real assets like properties and buildings (Cullen 2015). Private equity has been allotted 5 percent of the capital keeping in mind factors like high lock in period and riskiness associated with the asset class. As discussed earlier, investment in small cap stocks is limited to 5 percent, hence the blended cap strategy in emerging markets like India and China would provide the necessary exposure.
Constraints
As we know that two of the most important constraints of the pension fund are liquidity and preservation of capital to honor the obligations of the members included in the pension plan. The fund invests 60 percent of its capital into bonds pays coupons which ensures a stable stream of cash flows enhancing the liquidity of the fund. The fund is expecting to earn around 1 percent of return on an annual basis through its investment in the bond portfolio which would consist domestic as well as international bonds.
- The fund is restricted to invest more than 20 percent its capital into junk grade corporate bonds.
- Keeping in mind the expected rise in the bond portfolio, the duration of the bond portfolio needs to be kept below 7.
- Investment grade bonds issued by companies with a debt-equity ratio more than 3 should be avoided.
Both passive and active strategies can be actively traded upon as both the trends are relevant for the debt markets because of the information asymmetry available in the market between participants. To provide the element of stability and maintain a regular stream of income, a major chunk of the investment capital would be invested into government bonds belonging to various countries. Fear of rising prices and hiking of the interest rates by the US Fed to counter the impacts of inflation, investors are selling short-term bonds resulting in a hike of short-term yields and an inverted yield curve (CNBC 2022). Hence, the low prices of bonds give us an opportunity to invests in investment grade and treasury bonds at lower prices. As the world economy including the US and Europe is expected to rebound and perform well in the years to come, corporate profitability may be enhanced resulting in fall in default rates (UN.org 2022).
Hence, some portion of the total investment corpus is to be invested in junk grade bonds of big corporations belonging to US and Europe to capture the default premium. Other corporate bond will include investment grade bonds belonging to companies operating in the banking and financial sector as this sector would be the most beneficial. Sectors like energy, building materials and retail would also be taken into considerations while choosing investment grade corporate bonds to invest (Business Insider 2022). Lower rating bonds with higher maturity belonging to sectors which are highly impacted by a high interest rate environment, would be avoided (Fisher and Weil 2017). The fund would keep the total duration of the bond portfolio less than equal to 7 as high duration portfolio would underperform the market in a high interest environment.
As discussed earlier, the US government bonds have been given the highest weightage in the bond portfolio with a total investment capital of $15 billion. Government bonds belonging to countries in Europe would account for around 20 percent of the total capital. Investment grade corporate bonds issued by reputable companies in the US and Europe are allocated 10 percent each of the total capital. To capture the default premium 20 percent of the total capital would be invested in junk grade bonds of companies belonging to US, Europe and Emerging markets (EM).
The fund should have a considerable exposure to both equities and bonds of different countries which would help the fund to enhance the return potential while keeping the risk of the portfolio at acceptable levels. Stocks and bonds have multiple benefits and costs associated with them and the primary purpose of the investment management team of the fund is to strike a balance between both. Risks associated with stocks can be controlled by investing in stocks having negative or low correlation with each other which would help stabilize the portfolio and reduce the risks. Although stocks can be volatile and result in capital losses, the dividend income from stocks can support the coupon payments from bonds and would help the fund achieve redemption requests from the fund participants (Cieslak and Pang 2021). To manage the equity portfolio the fund should portfolio asset allocation methods like mean-variance optimization and risk-based asset allocation which would make the portfolio optimal and less risky (Zhang, Li and Guo 2018). A dynamic asset allocation approach needs to be adopted to invest capital into particular bonds to incorporate the ever-changing economic circumstances (Brocas et.al 2019). The proposed asset allocation between equity and bonds should yield benefits and allow the fund to meet its obligations without any fail.
Strategy
Conclusion
The Covid 19 pandemic has had a severe influence on the pension business, limiting the capacity of funds to make contributions. Funds that are fully funded rely on investment revenue, whereas underfunded plans rely on contributions from the funds. The funds have been exposed to high volatility in contributions and investment income because to the financial market effects of Covid-19. The BTA pension fund is also at danger from market risk as a result of the covid-19 epidemic. Because the pension fund invests abroad, it must employ a diversification strategy in order to navigate through this turbulent period. The primary purpose of this report was to formulate and investment strategy for the BTA group pension investment management with a total investment corpus of GBP 25 billion. The equity portfolio was constructed using large cap stocks belonging to US, Europe and Emerging market countries like India and China. A portion of capital should also be invested in small cap risky stocks belonging to emerging markets. To diversify the equity portfolio, alternate investment categories like Private equity and REITS were also chosen for the purpose of investment. The US bond portfolio was concentrated in bonds issued by US and European governments. Junk grade bonds were also included in the portfolio to capture default premium. The fund would be able to achieve its objectives and meet obligations if the above-mentioned investment strategy is followed.
References
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Arends, B. (2022) Look out — this inflation forecast is now flashing red, MarketWatch. Available at: https://www.marketwatch.com/story/uh-oh-this-inflation-forecast-is-now-flashing-red-11646923258 (Accessed: 12 April 2022).
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Cnbc.com. 2022. 10-year Treasury yield hits 2.82% — its highest point since December 2018. [online] Available at: <https://www.cnbc.com/2022/04/12/us-bonds-treasury-yields-rise-ahead-of-key-inflation-report.html> [Accessed 12 April 2022].
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Khoufi, N., 2020. Accounting information quality and investment decisions in the emerging markets. Frontiers in Management and Business, 1(1), pp.16-23.
King, B. (2022). Interest rates rise again to counter higher prices. BBC News. Retrieved 19 March 2022, from https://www.bbc.com/news/business-60763740#:~:text=Interest%20rates%20have%20increased%20for,2020%2C%20when%20Covid%20lockdowns%20began.
Salzman, A. (2018) Banks Will Benefit from Rising Rates. Other Sectors, Not So Much, Barrons.com. Available at: https://www.barrons.com/articles/banks-will-benefit-from-rising-rates-other-sectors-not-so-much-1539384188 (Accessed: 12 April 2022).
Business Insider. 2022. The energy sector is outperforming the S&P 500 by the widest margin on record amid war in Ukraine, investment research firm says. [online] Available at: <https://www.businessinsider.in/stock-market/news/the-energy-sector-is-outperforming-the-sp-500-by-the-widest-margin-on-record-amid-war-in-ukraine-investment-research-firm-says/articleshow/90143931.cms#:~:text=research%20firm%20says-,The%20energy%20sector%20is%20outperforming%20the%20S%26P%20500%20by%20the,Ukraine%2C%20investment%20research%20firm%20says&text=The%20energy%20sector%20is%20far,the%20last%2050%20trading%20days> [Accessed 17 April 2022].
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Zhang, Y., Li, X. and Guo, S., 2018. Portfolio selection problems with Markowitz’s mean–variance framework: a review of literature. Fuzzy Optimization and Decision Making, 17(2), pp.125-158.
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