A crisis survival guide for pension systems

By Allen Jones, TEXPERS Communications Manager

As more workers face shelter-in-place orders in their communities to reduce the spread of the new coronavirus, COVID-19, public pension systems are maintaining operations by having staff work remotely. 

Public pensions are busy operations. System staff work to administer defined benefit pension benefits to employees of state and local governments. They communicate with active and retired pensioners, work with vendors to fulfill client services, conduct board meetings, ensure retirement checks are issued, manage investments, and collaborate on various other projects aimed at securing retirement for public employees. That work isn’t over, even during a pandemic.

Remote working, or telecommuting, allows your fund’s professionals to continue doing their work outside of a traditional office setting. But these are unprecedented times that require some out-of-the-box thinking.

With today’s internet-based technology, remote employees can execute their projects and accomplish their goals practically wherever they please. During the current health crisis, that remote place is most likely their own home as they isolate themselves and loved ones from a new respiratory virus that has claimed upwards of 20,000 lives worldwide (as of March 25). Check here for the latest data.

Benefits of Remote Working

Remote working isn’t a new concept. Technology has allowed various industries around the world to reduce office expenses while claiming improved worker satisfaction. According to the results of a 2017 Gallup survey, more American employees are working remotely and doing so for more extended periods. At the time, 43 percent of 15,000 adults surveyed said they spent at least some time working remotely. It represented a 4 percent increase since 2012. 

Some studies have pointed to increased productivity, lower employee turnover, and even a reduction in auto emissions as people spend fewer hours commuting to and from offices. However, the exact impacts of remote work have yet to be measured across industries and for an extended length of time, according to a report on vox.com.  

Who Should be Working Remotely, Now?

Regardless if your pension fund’s staff were already taking part in the remote work lifestyle, most likely, they are doing it now as governments enact social distancing policy to combat COVID-19. The Dallas-area, the Houston-area, and Austin residents are among workers facing orders to stay home unless they are employed in businesses deemed essential such as emergency services, sanitation, trucking, and grocery industries. 

That’s because cases of COVID-19 are increasing in urban areas of Texas. As of March 22, many of the state’s more rural counties were reporting zero evidence of the disease. Because of that, Gov. Greg Abbott hasn’t implemented a statewide shelter-in-place order. 

“I am governor of 254 counties in the state of Texas,” Abbott said during a March 22 interview. “More than 200 of those counties in the state of Texas still have zero cases of people testing positive for COVID-19.”

For now, Abbott has left shelter-in-place orders up to counties and municipalities. This website is tracking states with shelter-in-place orders – click the state of Texas on the map to look for information about your county or city. 

Things to Consider While Remote Working During a Pandemic

If your staff is working remotely, it is necessary to have tools in place to ensure they can effectively communicate with each other, accomplish their goals, and stay healthy during a stressful time. Here are some tips to help your plan’s employees stay productive while social distancing:

• Communicate Regularly: Workers under shelter-in-place restrictions no longer find themselves near coworkers. They can’t walk over to pop a question about a collaborative project. Their managers aren’t close by with doors open to address concerns. As a plan administrator, try and replicate as much of that as possible by setting up communication channels for employees and board members. Make sure staff have essential phone numbers and email addresses. Create a set place on your fund’s website for staff to access important updates about operations. Schedule regular calls for one-on-one meetings. Use apps for video meetups or schedule conference calls for team meetings. Treat your virtual and telephone meetings as you would any in-office meeting – be online on time, have a set schedule, and set clear parameters for requests. You want to establish manageable deliverables, considering the stressful circumstances of working during a health emergency. Don’t be overbearing. Remember to reach out to workers and board members for a quick chat to check in on them – it doesn’t always have to be about a specific project or to make a request. 
• Prioritize Safety: Pension fund employees are working during a health crisis. Make sure they are following recommended health guidelines such as frequent hand washing, social distancing, and not running errands for non-essential job duties. Check to see if they have access to food and supplies and that they are working from a safe environment. Direct them to resources that can assist them if needed, such as the U.S. Centers for Disease Control and Prevention, the Texas Department of State Health Services, and other public health resources at their county or municipal levels. 
• Support Tech: Does your staff have the proper equipment to work remotely, such as a personal computer, laptop, or smartphone? If not, consider letting staff borrow office equipment such as laptops, an extra monitor, or other equipment such as keyboards. Or, consider helping workers locate used yet reliable equipment from charities or to borrow from coworkers. Encourage remote workers to obtain reliable internet at home, if they don’t already have it set up. If your fund is large enough to have an IT department, make sure remote workers can communicate with that department for any assistance they may need in setting up their home office equipment. 
• Provide Tools: Office productivity tools are applications that allow workers to view, create and modify general office documents such as spreadsheets, memos, presentations, letters, personal database, form generation, and imaging editing. They also include applications that allow teams to collaborate on tasks and for managers to monitor productivity. These apps may be accessible on their personal computers or smartphones. Plan administrators should consider standardizing a set number of applications to ensure everyone is using the same platforms. Also, make sure you provide resources for remote workers to download the applications. Here are 10 free or low-cost apps to consider: 
1. Slack is a set of collaboration tools and services, allowing teams to easily communicate with each other.
2. Clockify helps workers keep track of their time and gives them insight into their productivity performance.
3. Beeminder is a motivation tool that helps users visualize goals and set measurable targets.
4. Evernote allows users to capture, organize, and find their information across multiple platforms. 
5. Google Drive allows you to create documents, slides, and spreadsheets and share them with team members.
6. Google Calendar is a simple online calendar that allows users to create and maintain a weekly schedule in just a few clicks. 
7. Dropbox offers a place to keep data secure and in one place. You can store all your documents on a cloud, and later access them from all your devices, anytime you want. 
8. TeamViewer is a software that allows teams to connect remotely, so they can hold online meetings, make online presentations, and engage in online teamwork. 
9. LastPass is perfect if you have accounts on multiple websites, and you keep forgetting and changing your passwords. 
10. Canva is cloud-based design software that offers easy to use templates to create a variety of projects such as social media posts, brochures, business cards, mailers, magazines, newsletters, and other communications collateral. 
• Encourage Mental Health Breaks: This is the first pandemic set in a social media world. It is an unprecedented and stressful time for remote working. Your fund’s staff are being bombarded with information, and much of it can be frightening. They are facing new ways of working while worrying about panic buying, staying healthy, and trying to communicate with loved ones they may be unable to visit. Give remote workers time to check on loved ones – even if by phone or email. Allow them flexibility in their schedules so they have time to go get the food and supplies they may need to restock their pantries. Some grocery stores are reporting long lines. And let them feel useful by encouraging them to give back during this crisis. Some studies show that feeling empowered to do something in times of crisis can help lower stress. Here are a few ways remote workers to give back while social distancing: 
1. Donate to nonprofits helping to respond to COVID-19 - Encourage remote workers to collect any extra supplies they may have, such as disinfectants, hand sanitizers, paper towels, toilet paper, and bottled water for those in need such as the elderly and the homeless. Several nonprofits are working during the pandemic to locate these items and have set up collection sites. 
2. Volunteer with organizations providing critical services – Many nonprofits are providing services to hard-hit and underserved communities impacted by COVID-19. If they are deemed essential services through a shelter-in-place order, they may need additional people to help distribute food and emergency supplies. 
3. Advocate for those in need – Public pension fund workers are often accustomed to advocating to secure retirements for public workers. Ask your staff to consider expanding on their advocacy efforts during this time by being a public voice for social distancing and proper handwashing. Also, as they learn about the immediate needs in their communities, they can advocate for additional resources such as food supply, economic support, and expanded access to medical care. They can advocate through letter-writing campaigns to area officials, through social media posts, and through everyday verbal communication with family and friends.

If there is anything this health crisis is teaching us, it is that the even as we distance ourselves physically from each other, there are plenty of ways to carry on with the work of ensuring dedicated police officers, firefighters, and other state and local government employees earn secure retirements. If technology is in place and employers understand the need for flexibility during this pandemic, a lot of great work can still be accomplished.

  

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Investment Insights

Revisiting emerging market smaller companies

by Osamu Yamagata/Guest Contributor 

We believe that, as an asset class, emerging markets, or EMs, are underappreciated. This is clear when we consider the outsized representation of global client allocation of 5% against a global GDP contribution of 37% as of 2019 year end. This is in light of the fact that about 65% of growth in the world economy has been driven by EMs over the last 10 years.

In this context, emerging market smaller companies present an even smaller contribution — less than 1% of global client assets. To add further context, of the MSCI ACWI Smid Index, EM represents an 11% weighting, but global investor allocation is the lowest across the main regions at 6%.

Why have investors stayed clear of small caps in EMs? A simplistic explanation would be the divergence in the performance of the EM large-cap index over the last five years. The large-cap index experienced a total return of 34% against a return of 17% for the small-cap index.

But put into context, the large-cap index performance has been driven by strong performance of a narrow group of stocks. Just five companies contributed 20% of the total return of the benchmark. Namely, Chinese Internet giants Alibaba, Tencent and associated holding company Naspers, as well as semiconductor leaders Samsung Electronics and TSMC. However, by the cap-limited nature of the smaller-companies index with little concentration risk, return has been broader, with the largest benchmark constituent accounting for less than 1%.

So, while technology stocks have driven returns for larger companies, the smaller companies’ returns come from broader sources. For active managers, they may represent a wider pool of opportunities to build a portfolio. It is also worth noting that the 1,644 stocks in the index are still an under representation, with multiples of small-cap stocks yet to be included. A prime example is the Chinese market, which represents an under-penetrated market representing <10% of the index.

The wider opportunity set and lower quality of information provides a fertile hunting ground for active managers. In the smaller-company space, quality of information is often lower. This is because a quarter of index constituents have either one or zero analysts, which has led to a consistently higher dispersion of returns for smaller companies. This, however, optimizes the potential for active outperformance for those with strong research capabilities. 

Chart 1: Greater dispersion of returns within small caps

Source: Aberdeen Standard Investments, Factset, 31 December 2019/Click image to enlarge chart.

The chart above shows the discrete annual differences between the average top 20 performers and the average bottom 20 performers for each period. Indices: MSCI EM & MSCI EM Small Cap. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index. For illustrative purposes only. 

One other notable aspect of smaller companies is the higher domestic investor base and local ownership. Share prices reflect local economy dynamics as opposed to wider swings of global liquidity. To date, passive funds represent less than 5% of assets in the small-cap space, compared to 33% of assets in the large-cap space.

The outlook for EM is increasingly bright. We believe many economies have passed the inflection point, which means markets less geared toward global growth will contribute more as we see the benefits of lowering inflation, lower rates and recovery of growth. Brazil, for example, is enjoying the benefits of lower rates, firmer fiscal management, recovering growth and concurrent shift in local allocations toward equity. In this context, domestically oriented smaller companies in Brazil have far outperformed their larger-company peers with a total return of 37% against 7% for larger companies over the last year.

Chart 2: Brazilian small caps outperform large-cap peers

Source: Aberdeen Standard Investments, December 31 2019/Click image to enlarge chart.

In the chart above, indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index. For illustrative purposes only.

In general, equity markets today are trading on higher multiples globally. But in this context, EM small caps are trading on the lowest premium versus historical averages, which further supports the investment case.

Lastly, an overriding misconception has been to see smaller companies as a riskier asset class. Evidence doesn’t support this, however. Passive flows and concentration of super sector returns have led to a divergence in volatility and predicted that beta of small cap compared to the larger companies is 0.75x. Therefore, we see smaller companies as a means to generate better risk-adjusted returns toward emerging markets.

Chart 3: EM small-cap vs. EM large-cap beta

Source: Aberdeen Standard Investments, December 31, 2019. Click image to enlarge chart.

In the chart above, indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index. For illustrative purposes only.

Our conclusion therefore is that an allocation to small caps is complementary to larger companies, and, for active managers, the wider opportunity set and dispersion of returns provide a stronger platform for active returns in the coming years.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Aberdeen Standard Investments or TEXPERS, and are subject to revision over time.

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Investment Insights

Embracing change: Humans plus machines

Image by Pavlofox from www.pixabay.com.

by Ken McAtamney/Guest Contributor

Technology, for asset managers and their clients, is less about technology stocks and more about the way disruption affects corporate performance. But what are the implications for active equity asset managers and, by extension, their clients as asset allocators?

The role of the active equity manager has been called into question in recent years as undifferentiated performance, and high fees are compounded by allocators’ difficulty in identifying outperforming managers.

But the solutions available to allocators have also changed, thanks to technology. The disaggregation of alpha and beta, cheap passive beta exposure, and the evolution of cheap factor exposures are just a few examples. 

A Perfect Era for Passive—But That Will Change

Passive, smart beta, and factor investing take a rules-based approach to varying degrees, and they have the ability to identify and exploit patterns at low to no cost.

But we have been in a perfect era for this. Volatility has been low since the global financial crisis, thanks to abundant capital. And a concentrated set of leaders has dominated the market as a result of winner-take-all economics aided by network effects.

So, while there is a clear role for these strategies, we must remember that passive is, by definition, unable to predict disruptions in economic outcomes and profit pools, and thus any index, however “smart,” is always lagging. 

Applications for AI

As for AI, we do see some applications—for example, to help exploit near-term market inefficiencies. Specifically, AI may remove investment manager biases, so implementation and execution improves. But for the foreseeable future, this appears to be effective only over the shorter investment horizons.

I also don’t see AI replacing humans. At William Blair, we use machine learning to test and modify the factor models that inform our discretionary process. For now, at least, AI cannot do a better job than humans when it comes to predicting big changes, such as future consumption habits and innovations.

If the next era differs from the past era (due to de-globalization, deconsolidation, and the break-up of big tech, for example), those changes will be better understood by humans than machines. Humans are better at strategy, while machines are better at tactics.

Consider Japan’s $1.34 trillion government pension fund, GPIF, which used AI not to predict manager performance but to monitor fund behavior. In other words, does a particular fund behave and react to the market or economy as predicted? Does the manager really do what it says it will do? That’s tactical, not strategic. 

Profit Pools Shift

As investors in quality growth companies, we are very interested in how technology has changed the nature of competitive advantages, created and destroyed new business models, transformed competition, and changed costs, capabilities, and convenience.

The 20-year history of the retail industry is a good example. In consumer retail, technology has changed how products are created, marketed, and sold. From fast fashion to the customer’s information advantage, the entire equation has changed.

It’s not a surprise that retail industry profits have grown slightly more than the overall market over the past 20 years, by 6.7% versus 6.5% (represented by the Russell 3000 Index narrowed down to the retail industry).

But the shifts within that growth are surprising. Internet sales now comprise 28% of total retail industry profits, up from nothing 20 years ago (a compound annual growth rate of more than 24% since 1999). Meanwhile, general merchandise and department stores have gone from 55% of total retail 20 years ago to 11% today.

IBM Watson can beat humans at the ancient and intricate game of Go, but could a machine have predicted Amazon’s ever-expanding total addressable market (TAM) better than humans could? Doubtful. This is the reality of the nature of the innovation and disruption cycle. It takes creativity, insight, and imagination to identify it. 

Click image to enlarge chart.

A Diversified Approach

What are the takeaways? How can we as asset managers do better? How can our clients do better?

The answer is not to change who we are. One financial behemoth has said it is not an investment bank, but a technology company in the financial services industry. I take issue with that. We don’t have to pretend to be technology companies in order to survive in our industry, or any industry.

We do, however, have to assess our organization’s culture and mindset toward technology. Sometimes in the asset management business, we consider change a dirty word. But evolution is imperative, and a proactive approach to understanding and utilizing technology is better than a reactive one. Success really is about change, and innovation more broadly.

The good news is that many trends—including reduced costs due to digitization, for example—are making things more accessible. But acquiring the capabilities and talent will be challenging, and will take time (not to mention discomfort) to adjust. We are all feeling that already. 

Internal Mindset and Culture Key

My framework for adapting to change is to consider the external solutions available, the internal forces necessary, and approaches that combine these elements.

There are many external solutions that provide businesses with the capabilities of bigger organization without the infrastructure and costs, including cloud computing and partnerships with start-up accelerator programs.

But most important may be business leaders taking responsibility. At William Blair, I chair our technology working group, and two years ago we created the role of technology leader within our business unit.

One of our goals is to create a borderless technology environment, bringing technology from the back office into the front office and blurring the boundaries of technology and investment skills.

And, our proprietary Summit research platform codifies our investment process. Specifically, it enables our portfolio managers and analysts to efficiently collaborate to identify high-conviction investment ideas in the pursuit of better client outcomes.

To reiterate, I also don’t see technology replacing humans. Humans will continue to have a role, which is why we believe so deeply in the role of active management. 

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of William Blair or TEXPERS, and are subject to revision over time.

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Investment Insights

Remastering volatility: Reducing noise in equity allocations

By Christopher Hogbin, Christopher Marx and Nelson Yu/Guest Contributors

Volatility is a challenge that has vexed equity investors for decades, yet its root causes are often misunderstood. Understanding how a company’s business profile determines a stock’s risk can help investors prepare for uncertainty and make better decisions when market turbulence strikes.

Erratic market behavior often seems like a mystery. Bad economic news, political chaos, interest-rate moves or an industry crisis can trigger widespread anxiety among investors and inflict indiscriminate damage to equities. This volatility is the admission price that investors must pay to access the higher return potential of stocks and other risk assets. Yet volatility also reduces returns through risk drag, and often prompts emotional, financially destructive decisions that stem from the fear of loss.

Behind the headlines that incite volatility, market fluctuations are ultimately driven by the collective behavior of individual stocks. And the risk profile of a stock often stems from fundamental and researchable aspects of its business model and strategy.

Confidence in Cash Flows—the Source of Risk

For individual stocks, the source of volatility is derived from investor confidence in company cash flows. In finance textbooks, the value of an asset is defined as a function of its future cash flows and the discount rate, which itself is a function of interest rates. It’s also affected by the perceived variability of a company’s cash-flow potential; greater uncertainty around cash flows will raise the discount rate and lower a stock’s valuation. So, anything that can provoke uncertainty around a company’s cash flows may become a source of volatility. A company’s income statement may offer important clues about its resilience or underlying vulnerabilities.

Let’s start at the top, with revenues. Sales are an important driver of company earnings, but can be unpredictable. And sales volumes can be very sensitive to changes in economic cycles in industries like autos and retail; changes in supply/demand balances, which often get reflected in changing prices for commodities, for example; and changes in competition or technology, which can impact market shares. Other industries, such as consumer staples and utilities, typically see more stable demand and pricing, and thus more stable sales. Our research shows that sectors with more stable sales patterns tend to be less volatile (See chart below).

Click image to enlarge chart.

Within any sector, understanding a company’s business model and forecasting its cash flows is the cornerstone of active equity investing. Just as important, fundamental research must also identify the risks to a company’s cash flows. Our research shows that companies with a higher volatility of cash flows also tend to have more volatile stock returns (see left chart, below). This means that the structure of a company’s business model can also be a source of volatility—and its income statement may offer important clues about its resilience or underlying vulnerabilities.

Click image to enlarge charts.

Cost Structures Matter

Cash flows can also be profoundly affected by cost structures. Consider two companies with very different cost structures. One requires little capital to get started, so it has low operating leverage. The other requires a much bigger investment to get started and has high operating leverage. The company with lower operating leverage starts out in a much more profitable position, while the company with higher operating leverage starts off with losses and will need to sell more units to become profitable (see right chart, above).

So how the company makes money can have a material impact on its profitability and consistency. Industries that generally exhibit lower operating leverage include services and retail. Companies with higher operating leverage tend to have high fixed costs, either from large upfront capital requirements in industries like mining and autos, or a fixed labor force. These types of companies also tend to be more sensitive to the economic cycle and to the changing tastes and habits of consumers.

Taking Calculated Risks, Avoiding Unintended Exposures

Of course, business models aren’t the only thing that determines a company’s risk profile. Company debt positions (or leverage) and sensitivity to exogenous shocks from the macroeconomy or politics will also influence the volatility of its stock. In future blogs, we will examine other sources of volatility and how to manage them. But we believe that with a clearer grasp of the way company-specific risks are at the heart of a stock’s volatility, active managers can better assess the risk-taking needed to achieve desired returns and reduce noise that can undermine confidence in an allocation.

By understanding the sources of volatility, portfolio managers can better drive their outcomes through intentional views—taking risk where insight identifies an opportunity for improved returns, while controlling the volatility of unintended exposures. This helps reduce the noise that interferes with an investing plan, and is the key to remastering portfolios and realizing the benefits of long-term equity returns.

This blog post is based on a whitepaper that was published in October 2019 titled Remastering Volatility: Reducing Noise in Equity Allocations.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Alliance Bernstein or TEXPERS, and are subject to revision over time.

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