Markets remain highly volatile. The recent invasion of Ukraine by Russia has elevated the uncertainty to another level. As many of our latest round of OCIO interviews occurred prior to these recent developments, stay tuned for updates on this topic in the near future. For our latest OCIO Focus, discussions with OCIO managers focused on how they were positioned heading into 2022 and what trends they are observing. For this series we spoke with the teams at Bank of America, Callan, and J.P. Morgan.
A favorable part of the OCIO model is the flexibility for the manager to respond to market conditions more dynamically than traditional governance models. Given the current context (equity sector rotation, Fed tightening in light of escalating inflation, and the more recent conflict in Eastern Europe), it is one of the features that we would make extra efforts to highlight.
The Great Rotation
While the broad equity indices performed extremely well last year, there was a noticeable dispersion underneath the surface. Energy, real estate, and financials were the top performing sectors in 2021, all with a “value” bias, as well as typically being the beneficiaries of an expanding inflationary cycle. That outperformance (energy, in particular) has accelerated year-to-date in 2022 with the conflict in Eastern Europe beginning to have impact.
We also saw a continuation of U.S. equity outperformance versus non-U.S. markets, and large cap equities outpacing their smaller counterparts. Particularly violent has been the drawdown in small and mid-cap growth equities, pandemic “winners,” SPACs, etc. We asked the OCIOs to comment on some of these trends and how they were positioning.
Mark Andersen, Senior Vice President at Callan, shared their perspective: “We aim for style neutrality over the long term. As we look at active managers in the U.S., generally they have been leaning towards the value side of the spectrum. We don’t try to correct for that in the short term, which has been a tailwind lately.”
While discussing the markets, the team at J.P. Morgan Asset Management cited inflation, and the inevitable reaction from the Federal Reserve as the main driver of recent dislocations. On the equity side, they are focused on allocating to active managers who have a focus on sectors with the ability to absorb and pass on higher input costs. “Due to inflation we’ve started to lower equity exposure, an example of our tactical tilt process. Another example would have been in March 2020, adding risk as government support materialized. This is what we do on a day-to-day basis – thinking about ways of going over/underweight equities in a certain period,” said Zack Page, Managing Director, Multi-Asset Solutions at J.P. Morgan Asset Management.
At Bank of America, the Chief Investment Office remained overweight equities, with an emphasis on domestic U.S. exposure. Senior Investment Strategist David Koh indicated that they maintained positions in both value and growth, rebalancing on an as needed basis. Their approach was driven by both technical and fundamental considerations, as well as data received from the broader enterprise.
Regarding rebalancing specifically, Koh stated, “Our approach to rebalancing is grounded in our overall investment philosophy of not trying to be excessively tactical, as such moves have tax consequences for many of our clients and we do not want to dismiss the importance of strategic asset allocation. As such, we will typically make two to four tactical adjustments across our multi-asset portfolios in any given year. For 2020 and 2021, our tactics, rebalancing and selection decisions provided meaningful incremental value in both our multi-asset and separately managed account (SMA) solutions. We anticipate using the same approach in 2022.”
The Hunt for Yield
The fixed income space overall will be challenged by expectations of a Fed interest rate tightening cycle. The Wall Street Journal recently ran a great article on the emergence of private credit as a growing fixed income alternative. As yields have marched lower for years, institutional investors have migrated an ever-larger portion of their fixed income allocation to alternative assets, with private credit being the latest beneficiary.
The team at Callan was able to articulate the challenges that their institutional clients are facing. “The phenomenon of alts isn’t new – low expectations for stocks and bonds has pushed portfolios to risky territories. If not equities, where are you going to get return? Plan sponsors, public funds in particular, are loathe to reduce overall return expectations. We can take on illiquidity risk, but we don’t want to lever bond portfolios at this point. Risk parity is not so attractive with yields where they are. It’s a challenge and conundrum for institutional investors and consultants everywhere,” said Andersen.
According to the Wall Street Journal analysis, the median allocation to U.S. bonds has declined from 36.27% in 2001 to 19.72% in 2021. Private credit AUM has risen to $1.5 Trillion in 2021, double the assets from five years prior. The team at J.P. Morgan indicated that specific asset classes within the private credit space were some of the areas they were more willing to allocate dollars to, further underscoring the attractiveness of a couple hundred basis points in a world starved yield. As monetary policy is methodically tightened over the next year or two, this will be an asset class they expect to follow closely. The health of the credits making up this asset class is still to be determined.
The End of COVID?
With the Omicron variant fast fading and developments in Eastern Europe now dominating page one, unimaginably, COVID is starting to become an afterthought for many. Unfortunately, this isn’t the case for the many healthcare institutions still struggling with the fallout from COVID.
The J.P. Morgan team was kind enough to give us some insight into how their healthcare clients are coping. “During portfolio reviews we’ve been getting the impression that our clients are feeling overwhelmed. From operational issues, like not enough beds, to staffing shortages and budgeting, the pandemic has been extremely challenging. Operating spend is the key focus, which is a pivot from two years ago when it was all about consolidation,” said Page.
Joshua White, Executive Director at J.P. Morgan, added; “Over the last year we’ve noticed CFOs wearing multiple hats, especially after M&A activity, they end up as the Head of the Investment Committee and running pools of assets – they are looking to outsource.” According to J.P. Morgan, a majority of these organizations are still utilizing a traditional advisory model. There should be ample opportunity for OCIO managers as a growing number of health systems look to outsource their investment functions.
As highlighted here, a favorable part of the OCIO model is the flexibility for the manager to respond to volatile and shifting market conditions more dynamically than traditional governance models. Given the current context, it is one of the advantages of an OCIO manager with a high-level of expertise to take advantage of the opportunities and manage the risks presented.