2022 Perspectives for the Public Sector

6 This approach later became codified into style boxes (popularized by Morningstar), which help investors compare and evaluate managers and facilitate capital allocation. An investor might seek to allocate to large cap value stocks or high yield bonds, for instance. Eventually, indices were created linked to these style boxes: trading of these indices emerged as an alternative way to obtain market returns. This set the stage for the growth of passive investing, often through exchange traded funds (ETFs). Another important development during this period was the expansion of pension funds’ investment universe beyond liquid market securities. David Swensen, then chief investment officer at Yale University, pioneered the expansion of equity holdings into asset classes such as private equity and hedge funds. These assets were illiquid, with long lock-ups. They also used leverage and shorting to obtain equity-like returns with seemingly bond-like risk (though to some extent this lack of volatility is illusory). A seminal moment for this approach came during the dotcom bubble in the early 2000s. From June 1999 to June 2002, Yale University had annualized investment returns of +16% versus pension funds invested in 60/40 portfolios which had returns of -4% (assuming 60% in the S&P 500 Index and 40% in the World Government Bond Index). 1 As a result, large institutions began reallocating away from public markets to private market segments. Nowadays, around 20% of institutional portfolios are allocated to alternative assets. More recently, advances in technology have enabled a real-time utilization of risk factors while the range of indices has significantly increased in number. Industry consultants have identified an ever-growing set of exposures, such as sectors, geographies and styles, to enhance equity and bond allocations, and created indices to capture those return streams. Understanding a portfolio’s mix of exposures in this way is extremely time-consuming. But technology, such as BlackRock’s Aladdin (as well as solutions from Barra), have allowed investors to measure and rebalance factor exposures in real time. This ability has led to a way of looking at portfolios as a passive core that delivers diversified beta exposure – achieved via indices and ETFs – and a series of satellite investments focused on higher conviction, more concentrated alpha-seeking equity and bond funds. Whereas in the past, asset owners used to seek the best manager in each asset class in order to achieve alpha and beta exposure across their entire portfolio, now many separate the pursuit of alpha and beta, even if – in some instances – alpha and beta is derived from the same manager. One consequence of this approach, and the huge complexity of designing, selecting and managing a contemporary portfolio given the multiplicity of factors, is the growing importance of outsourced CIO (OCIO) capabilities offered by managers and consultants. In many instances, allocation decisions are no longer the preserve of asset owners. At the same time, more sophisticated asset owners are choosing to internalize capabilities where they can add value and reduce costs, for instance in some private market asset classes. Integrating ESG into Existing Portfolio Construction Frameworks The nature of ESG requires a significant shift in mindset on the part of public pension funds. It imposes both new constraints and objectives. Historically, value has been defined in narrow financial terms, such as absolute, or risk-adjusted return.