Asset Allocation Insights from State Street Global Advisors

The OCIO Solutions team at State Street Global Advisors (SSGA) manages over $150 billion in discretionary assets for their clients, making them one of the largest outsourced investment providers globally.

In this Q&A, Thomas Kennelly, Head of OCIO Investment Strategy for SSGA, shares his perspectives on asset allocation in today’s market.

What portfolio trends have you seen at both asset owners and asset managers considering the macro and rate regime shift over the past couple of years?

Now that the “income” is back in “fixed income” and robust equity markets are compressing the equity risk premium, long term asset class forecasts have shifted more demonstrably than recent past, raising the relative attractiveness of income-oriented assets. As a result, asset-liability studies (for pension/OPEB plans) and spending analysis (for nonprofits) are actively being reassessed across the industry given the sharp changes to the inflation, interest rate, and yield curve regime.  More defensive and income-oriented investors (i.e., better funded pensions, closer to retirement DC plan participants, insurance companies) have increased target allocations to fixed income, both public and private, within their overall strategic asset allocation and investment policy. Industry flows reflect the increased flows into fixed income across many asset managers.

Broad-based real asset strategies and various components within the real asset complex remain in focus due to persistent inflationary pressures, ballooning deficits, and heightened geopolitical instability which have had an impact on hard assets. These can include oil, gas, copper, gold/silver, agricultural commodities, and infrastructure, as well as crypto. The benefits of real assets and their potential diversification benefits to riskier growth-seeking assets were realized in 2022—and that trend seems to be continuing.

Elevated short rates garner further interest in absolute return, cash plus type strategies, certain hedge funds, fixed income arb, multi-sector or multi-asset credit. Private credit and direct lending continue to gain interest given their broader opportunity set.

With the upcoming U.S. elections, the role of volatility management continues to take primary importance. A focus on quality, value, and lower beta equities (which have lagged U.S. growth equities) potentially offer more attractive entry points to maintain equity exposure whilst reducing overall volatility and potential downside deviation. Additionally, for certain investors, synthetic (derivative) risk management solutions may offer more time dependent and path dependent based on positioning a portfolio to hedge against adverse outcomes. Refinements to liability-driven investment (LDI) solutions using completion overlay strategies to better manage yield curve exposure continues for well/over-funded corporate pensions.

What is something which you think allocators or investors are not focusing on enough?

We actively seek to assess and mitigate blind spots across our practice and, most importantly, within client portfolios. Markets often present unforeseen adverse events and as a result we allocate assets, construct portfolios, and select managers (public and private) to properly diversify portfolios and better weather potential unforeseen shocks or crisis. In terms of what allocators or investors are not focusing on enough, it could be the aforementioned U.S. elections and the role of the U.S. dollar. We make that comment through a lens of recent market volatility which remains quite low across equity and fixed income indicating a potential complacency in the market leading up to what is likely to be a challenging election cycle, regardless of the outcome. The increasing de-dollarization of global trade and formation of new trade partnerships, coupled with geopolitical risk and conflicts, warrants a closer look at currency exposure and client risk exposures.

We also believe asset owners and investors may be overly focused on fees, for both advice and investment management, and potentially not focusing enough on the strength, stability, and capabilities of advisors and investment managers. Fees are important, obviously, but there is a risk that sole focus on driving fees lower can compromise services provided and potentially be detrimental in the not-too-distant future. Striving for “the lowest possible fee” may compromise the value for money equation offered by the highest quality service providers with a depth of resources, experienced client relationship support, and a strong governance and risk management framework. Fiduciary risk remains one of the prominent risks across the spectrum for institutional asset owners. While the pace of outsourcing some or all of their investments has increased across the industry, it remains important to partner with a strong, stable, committed team and business practice, and not simply seek a low-cost provider or manager. A manager could ultimately be worth a marginally higher fee in times of crisis and future market challenges.

Data suggests that private equity capital deployment has slowed down in recent vintages. Are you seeing that with your managers and if so, how has that affected your asset allocation commitment pacing to the space?

We have seen a slowdown in capital deployment since 2021. In addition, private equity hold periods for companies are now over six years (all time high) which is decreasing the amount of capital being distributed back to LPs. Deal counts have slowed and cash awaiting deployment (dry powder) was at a record high of almost $2.6 trillion¹ in 2023.

The slower deployment of capital being invested somewhat offsets the decrease in the capital being distributed back to LPs but not enough to completely negate the impact. In general, it means we are committing smaller amounts to private equity than what we had forecasted a few years ago. The illiquid nature and lag time between the commitment and drawdown of capital in private markets makes the implementation pacing plan particularly important. This includes how and where to fund capital calls, use of interim benchmark targets within a strategic allocation as capital is called more slowly, and whether currency hedging is needed in global mandates. Each of our clients has different structural considerations to balance when determining how best to implement these illiquid allocations which we support through a strong governance framework.

We are encouraging clients to stay with their commitment plans to mitigate vintage risk gaps and have diversified private market strategies to balance out the cycles within private credit, debt, and real assets.

¹ Source: S&P Global

How do you approach being opportunistic when there are notable dislocations in the markets as we saw across both equities and fixed income in 2022?

We are opportunistic in several ways. First, for our clients who utilize our Tactical Asset Allocation (TAA) rebalancing offering, we are able to position client portfolio over/under-weights across various asset classes and sub-asset classes that comprise their overall Strategic Policy (SAA) target weights. We have allowable ranges +/- around target allocations where we can utilize a risk budget (tracking error) to manage risk and deliver alpha (excess return) for our clients at the total Portfolio level. In addition, our TAA alpha (excess return) history shows itself to also be a diversifier to excess returns of underlying active equity/bond managers employed in many client portfolios. In short, our alpha exhibits very little correlation to active manager alpha providing further risk-adjusted benefits to client portfolios. The excess return also helps our clients achieve their return targets and meet spending needs and retirement obligations.

We were able to position portfolios into and throughout 2022 in a defensive way (notably an overweight to cash and select real assets) and corresponding underweights to fixed income and portions of the equity markets. In addition to alpha generation, this provided an opportunistic risk management benefit to client portfolios.

We moved opportunistically, and more aggressively, into risk assets throughout 2023, notably U.S. Large Cap equities, thereby taking advantage of the sell-off experienced in 2022 which has delivered further alpha (excess return) to our client portfolios. While the higher interest rate environment has provided strategic benefits to certain clients who sought to de-risk (i.e., better funded pension plans) for our total return, tactical clients, we remained underweight duration (core fixed income) in order to fund our overweight to growth assets, notably equities.

The other area where we are “opportunistic” on behalf of clients is where we employ select active managers who are less benchmark constrained and therefore better able to move across, and within, certain asset classes. For example, we engage active fixed income managers in what we consider “multi-asset credit” who target a certain return and risk budget (volatility) with flexibility around duration, yield curve, and sector an actively allocate across areas such as High Yield, Emerging Market Debt, Bank Loans, Securitized Product, Convertible Bonds, IG Credit and Currencies. Given the idiosyncratic nature of these sectors, as well as the potential credit risk/opportunity set at an issuer and issue level, allowing high quality multi-asset credit managers the flexibility to deliver target risk adjusted returns and attractive Sharpe ratios via more opportunistic credit positioning has been a valued solution for our clients. 

While Hedge Funds were often maligned due to muted returns during the ultra-low interest rate environment during the quantitative easing (QE) cycle and liquidity-driven market rally post GFC that persisted for many years, we view certain Hedge Fund, or Hedge Fund of Fund, allocations to be an opportunistic solution within portfolios. While diversification benefits were dormant during the QE driven beta rally, the post-COVID interest rate and inflation regime reflect the benefits of such diversifying, low correlation strategies. In addition, many Hedge Funds and Absolute Return strategies strive for “Cash Plus” return targets and the short-term yield environment of 5+% enables cash plus oriented hedge fund strategies to deliver higher long term expected returns that many Endowments, Foundations, and Public Pension plan seek (i.e., 7-8% EROA). Allocating to such strategies and high-quality managers provide opportunistic returns while dynamically managing risk.

Relatedly, what advice do you have for asset owners when it’s appropriate to be tactical (short-term) versus strategic (long-term) in asset allocation?

We are proponents of tactical asset allocation (TAA) across multi-asset class portfolios, particularly for our client base with higher return needs to achieve spending targets or EROA objectives and longer investment horizon. We employ TAA as an additional mechanism to deliver alpha (excess return) above the total portfolio Strategic Asset Allocation targets. TAA is also a valuable risk mitigation tool in that it allows us to underweight less attractive asset classes (equities, bonds, real assets) or sub-asset classes (U.S. Large Cap vs. Small, U.S. vs. EAFE or EM, or Govt debt vs. Credit vs. High Yield) and tilt the portfolio towards more attractively valued asset classes. While we assess markets and our models often, we often take a 3-12 month horizon view on our TAA, and do not look to “time the market”, but rather seek out and maintain positions based on our quantitative signals (alpha models), fundamental views and risk assessment. We size our positions and risk budget (total risk and tracking error targets) based on our proprietary market volatility regime indicator driven by equity, rates, spreads and currency volatility which allows us to adjust risk (tracking error) up or down based on volatility environments and deliver more sustainable and persistent alpha.

When employing a tactical process, it is very important to agree on alpha (excess return) and risk (total volatility and relative/tracking error) targets and allowable ranges (i.e., Total Equities +/- 15% vs. policy benchmark) and codify such constraints within the Investment Policy Statement. Attribution analysis to isolate active manager and TAA alpha is also critical. Assessing the benefits of TAA is quite similar to how one would assess an active manager in terms of delivering on expected risk and return targets and performance metrics such as the Sharpe Ratio and Information Ratio.

For longer term Strategic Asset Allocation, we engage with clients and update our ALM analysis (Pensions/OPEB), or Spending Analysis (Endowments and Foundations) supported by our Long-Term Asset Class forecasts. When we find more meaningful changes, across or within various asset classes, as has been these case in the most recent regime shift, we modify/adjust long term strategic weights accordingly and codify them within the Investment Policy Statement. Given the longer-term nature of a strategic policy target, we seek to mitigate abrupt or frequent changes to targets, but rather modest adjustments based on client objectives. For example, the recent interest rate regime change and higher starting yields in fixed income coupled with improved funded status for corporate pension clients has resulted in further de-risking via increased fixed income allocations. For Endowments and Foundations, the dislocations and compressed risk premia relationships across growth-oriented assets, cap weights (U.S. Large vs. Small Cap) or regional weights (Emerging Market vs. ROW) has resulted in adjustments to equity targets as well as private markets.

Have you seen changes in risk management processes and the solutions/tools utilized in these processes?

I would not say we have seen “changes” as we have always embraced a culture of Risk Excellence at SSGA and within our OCIO practice, but rather, we have seen the benefits to client accounts in hoe we measure, manage, monitor, and report risks to our client base. Moreover, we employ top quality systems and tools to allow us to assess portfolio risk from top down to bottom up in order to drive not only our long-term asset allocation framework but also how we construct portfolios across sub-asset classes and especially the managers we employ. We take a holdings-based approach looking through our portfolios to measure potential overlap or style bias across managers (at the broader portfolio and/or within sectors). We also look beyond simple asset class labels (e.g. Equities, Bonds, Real Assets, Alternatives) and design portfolio in and around potential economic cycle regimes, inflation regimes, and importantly, central bank policy regimes to construct portfolios with certain factors and attributes that may perform better in such regimes and conversely, seek to mitigate style or factor concentration that may detract from portfolio performance and desired outcomes.

While risk management should be at the core of all portfolios and governance models, the importance of a strong risk framework has certainly come to the forefront post-COVID and now through the sharp change in inflationary and central policy regime changes over recent years.