Episode Transcript
Kingsley Ford: Hello, welcome to this session of FTSE Russell Convenes. I'm Kingsley Ford. I'm the Global Head of our Index Investments and Group at FTSE Russell. I have the pleasure today of being joined by Walter Kress, the Chief Investment Officer of Ernst & Young. Welcome, Walter.
Walter Kress: Kingsley, thanks very much for the opportunity.
Kingsley Ford: What's really your focus at the moment? Is there anything keeping you up at night?
Walter Kress: What's going on politically here in the US is something that I'm paying attention to.
Geopolitical stress is something that I spend a fair amount of my time researching and trying to find alternate sources of information beyond just the local media. Where we are with interest rates right now and inflation does concern me. Inflation has created a bigger chasm between the have-mores and the have-lesses, or have-fewers. And that really relates to the fact that risk-free rates are very attractive today. Those with capital actually have earned good returns. Those that are having to borrow are borrowing at much higher rates. And that's driven a bigger wedge between those two pieces. And so persistent high inflation is something that I worry about from that perspective and the impact on the consumer to be able to continue to spend.
Kingsley Ford: So given that inflation environments and the higher rates, perhaps higher-for-longer we're seeing, do you see how that can play through into the retirement plans or any adjustment to those to take that into account?
Walter Kress: If I look back over the last two years, as we've seen interest rates rise over that period, it's really changed the view on fixed income. And that's really been driven as much by, if you look at the long-term capital market assumptions in general, for equities remain at about six and three quarters bracketed by probably six and a half to seven, by and large. But they've come up rather dramatically for fixed income. And it depends on which piece of fixed income you're looking at, but it's not unusual to get to four and a half to five percent long-term capital market assumptions.
That’s collapsed the delta in return expectations between the two. I think as importantly as that, is the volatility, the measure of risk for those two categories. By and large, for the equities, they are somewhere in that fourteen to eighteen or nineteen range. For fixed income, they remain anywhere on the low side from about four or five to on the high side, around ten for things like high yield.
The return per unit of risk has risen rather dramatically over the last couple of years. So the role for fixed income in portfolios today, I think looks a lot different than it did a couple of years ago. I try to split that up between the pension side of the equation, where we're managing money against liabilities, and then the defined contribution side of the equation, where we are trying to provide appropriate investment vehicles for our participants.
Most plans today really don't have that much in the fixed income arena, especially as folks get closer to retirement or use in target date funds, would expect there to be some kind of change for the use of fixed income as a bigger piece of the solution set.
Kingsley Ford: Are you also thinking about different types of fixed income beyond the core, the vanilla holding?
Walter Kress: On the pension side of the equation, higher rates, higher discount rates have helped with better funded status, including obviously some pretty good returns, especially after 2022, which was quite a challenging year.
It’s a little bit different on the defined contribution side, because where we seek high active share, active managers and fixed income, perhaps more so on the defined benefit side, the pension side, than the defined contribution side, it would really be inappropriate to offer some of those solution sets as standalone options within the defined contribution space. Things that I know that folks are considering right now include things like emerging market debt, high yield, some of the extended credit.
Offset that by the statement that credit spreads are incredibly tight right now.
You're not getting paid for taking a lot of extra credit risk today, but you have had positive convexity creep back in. Given the carry that you're receiving from fixed income today, a fifty basis point decline in rates versus a fifty basis point increase in rates, a fifty basis point increase in rates for a lot of fixed income will still give you a positive return after a year, and gives you a better return if you have a rate decline. That's very different than where we were two years ago. A fifty basis point increase in rates two years ago would actually take you into a negative territory. So carry has been reset in that space.
Kingsley Ford: Certainly a new paradigm for everyone to get used to, I mean, having had their mind in the old world. You see that sort of increasing focus and potentially allocation to fixed income and maybe even more types of fixed income. Do you think then that leads to people focusing more, a bit more attention on what is the benchmark they're using? What is actually included in that benchmark when they're measuring their active managers and is it tradable, those kind of things?
Walter Kress: Absolutely. So when you talk about fixed income, that's a very big playground. And when you start to break it up into bits and pieces, investment grade, long-term, short-term, getting out to the high yield space, some of these bigger areas, emerging market debt, which can be local or dollar denominated, those all look very different today than they did a few years ago. And they all have their somewhat unique risk and return profiles.
If you look at the continuum and defined contribution plans, for instance, many people have either a money market or a stable value. Many plans offer to their participants a core or core plus offering.
Duration of those is somewhere in the zip code of six percent, he yield on those is typically four, four and a half, you know, somewhere in that range. Quite different than where we were a couple of years ago. But that's still leaving out some other things that may be further diversifiers. And then a lot of plans will include TIPS as well. TIPS everybody thought were the magic solution on higher interest rates, and yet they didn't actually work that way specifically.
A multi-strategy platform could include something like TIPS, but they're typically not a big piece of the solution set out there today.
Kingsley Ford: You said it very nicely, sort of the additional opportunity set and how we can think about that. Do you think from what you see, sort of plan sponsors and target date funds are really going far enough? Is there more to go? Is there anything holding them back?
Walter Kress: So as you start adding some of these extended asset classes, things like emerging market debt, I think, into that category, into target date funds, what is the liquidity profile of those? How are they understood by the planned participants? The perfect target date fund could include all sorts of things, but explainability and tracking error become two critical pieces in evaluating an offering in a 401(k) defined contribution plan. To have those as standalone offerings is highly unlikely. To embed them within a target date or risk-managed offering can often be appropriate.
Going back to your benchmarking question from a couple of minutes ago, there are certain areas where benchmarks aren't necessarily representative of the opportunity set, as most people think about them today. Something that I know that y'all are working on, have done some great work on.
You know, high yield is a great example of that. So high yield is, many of the indices today have a good bit of CCC in them. Most managers are not overweight CCC that are managing against that index. A few of them are. And many managers are really trying to stay away from that and really try to keep their vol down. Can look as if they're underperforming their self-stated benchmarks, when in fact on a risk-return measure, as soon as you put the risk in there, they're actually doing pretty well. So there are some aberrations in the space that I think need to be more fully vetted and understood.
It becomes difficult as you put all these together in a multi-manager offering, a white label offering, and even more difficult within a target date fund, potentially, as well, that can include so many different asset classes.
Kingsley Ford: I think having been so long where there wasn't that much excitement or interest in fixed income, I wouldn't say stagnated quite, but it's a really fast evolving space now. The attention on that and the development, I think, as you say, there's a lot more development we're doing and the market's doing.
Just as a final point, would you think of any sort of final message for how people should think about this and sponsors should think about this, how it evolves potentially going forward, we might need more dynamic changes to asset allocation reacting to the markets, or any final thoughts there?
Walter Kress: It's a challenging area because it's dynamic. As far as putting something together that makes sense, not just for today and what we see here today, but for the future as well, that allows people to take advantage of that. It's the other reason why a multi-strategy offering may be appropriate to allow somebody selecting the managers to move those versus just trying to map an individual security or type of manager. The challenge becomes a committee's desire to add new offerings to a portfolio, but I certainly think it's worthwhile for discussing and exploring at this point.
Kingsley Ford: Absolutely. Well, thank you for that. It's been really insightful, and I think it has real-world implications on people's lives and outcomes with such a fast-growing area.
Walter Kress: The only other thing I'd mention is, again, credit spreads are incredibly tight right now If interest rates were to decline, it would probably be due to a more difficult economic environment that would likely have credit spreads widen, which would be adverse to the fixed income- pricing, but there, again, they're likely to have decline in rates if we head in that direction as well. So there may be some offset, but that's the one area that concerns me right now is chasing credit. For the sake of chasing credit, you're not really well compensated for that today.
If you look at the composition of some of the indices out there today, many of the core offerings have upwards of sixty percent in Treasury or US government securities in there today, and that's a lot. You know, they're great at an opportunity set beyond there, actually changed over time as well, I think it just helps make an argument for it looking more broadly as far as the solution set for DC participants specifically, but even in the pension space as well, the proper use of some of the tools that are out there, return seeking, fixed income.
There's some specialised things out there as well that wouldn't be appropriate and may not have the correct liquidity for a defined contribution plan, but can be useful tools within a pension plan.
Kingsley Ford: Wow, with all those things going on in mind, I hope you're not having too many sleepless nights to my very first question, but I think that's a great message to end on, the range of options, but then it's not easy to really sort of see what suits your participants.
Walter Kress: Right, and one of the key takeaways is the difference between somebody running a pension plan and creating an offering set for individual participants in the 401(k) marketplace.
Kingsley Ford: Well thank you for joining us today Walter.
Walter Kress: Thank you. It's been a pleasure.
Kingsley Ford: That's been very insightful. Thank you.
Walter Kress: Thank you.
