Interest rates are headed higher, trade tensions are mounting, and both Tesla and Facebook shares are sliding. In normal times, these developments – as well as the looming threat of a no-deal Brexit and new ructions in Italy – would fray investors’ nerves.
But not these days. Buoyed by strong earnings, robust economic growth, low unemployment – and maybe some pot stocks, too – market benchmarks in Canada and the United States have remained remarkably unruffled in recent months.
So long as massive U.S. tax cuts continue to fuel North American growth and there’s no nasty conclusion to the Canada-U.S. trade talks, it’s easy to sympathize with the prevailing complacency. But it may also be a fine time to ask whether there are structural reasons for the market’s high level of risk tolerance – reasons that could go into reverse at whatever point storm clouds begin to gather.
One of the generally underappreciated forces behind the market’s what-me-worry attitude is the shifting attitudes of big institutional investors in a low-return world. Pension funds, in particular, have had little choice but to embrace risk.
The transformation of a once dowdy profession has been striking. Intech, a U.S. equity manager, calculates that pension funds in that country have had to nearly triple their level of risk over the past 20 years to hit their targeted returns.
Back in 1995, even the dimmest of pension fund managers could have generated 7.5 per cent a year simply by stuffing a portfolio full of boring old bonds and other fixed-income investments. By 2005, the game had become more challenging – a manager would have had to split her holdings roughly half and half between bonds and other investments, mostly stocks, to have a reasonable hope of hitting the same target.
These days? It’s rocket science. To create an efficient portfolio with a 7.5-per-cent expected return, a manager has to devote nearly nine of out every 10 dollars to volatile non-bond investments, ranging from large-cap and small-cap stocks to real estate and private equity.
As you might expect, returns have become far less predictable. Intech calculates that portfolio risk, a measure of how much returns vary from one year to another, has shot upward from 6 per cent in 1995 to 17.2 per cent in 2015.
There are other potentially worrisome side effects from the scramble for yield. Many of the newfangled asset classes, such as infrastructure investments, private debt, private equity and real estate, are not particularly liquid – in other words, you can’t easily turn them into cash. While a pension fund can usually sell its stocks in a matter of minutes or even seconds, it might require months, especially in an economic downturn, to find a buyer for a stake in a private corporation or a toll highway or an office building.
This sets the stage for what could be a vicious feedback loop if the economy ever does sour. In a declining market, pension funds would still have to generate cash to pay pensioners and the only way they may be able to generate that cash is by selling stocks.
“With trillions of dollars in pension plans on the table, this situation could be self-perpetuating,” a recent Intech report argues. “As more plans are forced to sell equities to raise cash, it could lead to still lower security prices – all the while paving the way for even greater funding gaps down the road.”
To be sure, these waves of sell-offs may be muted by pension plans’ tendency to buy areas that have recently fallen. Also, the problems are likely to be most acute in the United States, where return assumptions on pension plans tend to be particularly lofty. But Intech does make a sound point about the potential for disruption in a world where asset managers reach for yield using assets that they might not be able to tap as easily as they hope. At some point, today’s nonchalance will be tested.
PENSION PLAN PORTFOLIOS REQUIRE more
risk for a 7.5% expected return
Fixed
income
Private
equity
Real
estate
Non-U.S.
equity
U.S.
small-cap
U.S.
large-cap
7.5%
Return
100%
1995
6%
4%
5%
14%
52%
5%
2005
8.9%
20%
12%
12%
13%
33%
17.2%
2015
22%
8%
Risk
JOHN SOPINSKI/THE GLOBE AND MAIL
SOURCE: intech investments
PENSION PLAN PORTFOLIOS REQUIRE more
risk for a 7.5% expected return
Fixed
income
Private
equity
Real
estate
Non-U.S.
equity
U.S.
small-cap
U.S.
large-cap
7.5%
Return
100%
1995
6%
4%
5%
14%
52%
5%
2005
8.9%
20%
12%
12%
13%
33%
2015
17.2%
22%
8%
Risk
JOHN SOPINSKI/THE GLOBE AND MAIL
SOURCE: intech investments
PENSION PLAN PORTFOLIOS REQUIRE more risk
for a 7.5% expected return
Fixed
income
Private
equity
Real
estate
Non-U.S.
equity
U.S.
small-cap
U.S.
large-cap
Return
4%
5%
12%
12%
14%
13%
100%
52%
33%
5%
7.5%
20%
22%
8%
1995
2005
2015
Risk
6%
8.9%
17.2%
JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: intech investments