BCI's Dunatov on the Limits of Diversification
Dunatov, who joined British Columbia Investment Management two years ago, said the most successful portfolios over the last 40 years invested in equities, real estate and infrastructure which were all just various plays on growth. Under his guidance, the $170 billion fund has increased its allocation to private assets and focused on buying investments with predictable income flows.So, it seems like Stefan Dunatov is the new public spokesperson as it pertains to BCI.
“We have to be honest with ourselves and admit that being long growth beta is the answer to investing in the long term,” Dunatov told a roomful of asset owners and consultants at a recent Conexus Financial conference. “It exposes what I call the fallacy of composition when it comes to portfolio theory. Diversification works at a portfolio level. Diversification doesn’t go up, it doesn’t work at the strategic level and at the strategic level you want to own growth beta.”
The former chief investment officer of Coal Pension Trustees Services said that with interest rates near zero, institutional investors had to think differently about monetary policy, which could mean the markets will have to contend with negative interest rates for the next 20 years. He said it was time to “think outside the box and think a little more laterally and unconventionally.”
“When you are sitting down to current long term strategy that you have, you have to disconnect current zero rates from what valuations are telling you,” he said. “How do you reconcile a zero rate world with valuations and equity risk premiums still telling you that you are probably going to get 6 or 8 per cent in the equities space? How does that work?”
Dunatov said the challenge for asset owners right now was figuring out how to invest in a zero rate policy world that was still growing, albeit slowly. He said BCI, which manage assets for British Columbia’s public sector, spends a lot of time focused on liquidity in the portfolio to make sure the strategy of owning growth assets is robust enough in the event of a downturn.
“That is probably the most important thing,” he said. “How do I know that I’m not going to sell them in a drawdown? We spend a lot of time on the liquidity aspect of that. Just imagine that there are only two sorts of bad worlds – a hard stop world like 2008 or a slow stop world like 1991,1992, 1993. We need to know that we will have the liquidity to get through both of them. As we are in net outflow mode, crystallising losses destroys wealth.”
Even so, one of Dunatov’s three key changes at BCI has seen the fund increase its allocation to private assets, a repeat of his strategy at Coal Pension where private assets had doubled by the time he left to make up closer to 45 per cent of the portfolio. The other changes include investing down the capital structure, particularly in private credit, as yields have rallied and a focus on owning assets with predictable income streams.
“Whether that is in equities, private credit, infra, real estate (we are looking for) more predicable income flows,” said Dunatov. “When it comes to equities, I would point that even in the crisis, lots of companies kept paying their dividends. Nestle still sold lots of milk products around the world and still kept paying dividends. So there are really good companies around that world that still do that.”
As a result, the strategy has seen BCI switch money into real estate, sell public equities in favour of private credit and real estate and buy more private equity, where the fund is “looking at deals that maybe (it) would not have done beforehand,” said Dunatov. He added that the fund had also sped up the reduction in exposure to the Canadian market to make the portfolio more global.
As for emerging markets, the investment strategist said while he was less convinced on the debt side the fund had made a “general push” into more peripheral markets. “We are not far off what you would call a benchmark position,” he added.
I read this article on Friday and reached out to Mr. Dunatov earlier today but I have not heard back from him and doubt I will.
BCI keeps a very low profile, I'd say abnormally low for a pension fund managing over $170 billion but I know BCI's CEO & CIO Gordon Fyfe very well, he was never really comfortable in front of a camera and prefers to focus on annual results.
The problem with this communications strategy -- and here I am not just criticizing BCI -- is it doesn't do much for BCI's global brand. In an age of social media, you need to own your brand, and BCI and others need to step up their game in terms of communications and follow leaders like CPPIB, OTPP and the Caisse. I'd also look at HOOPP's new website for a proper and relevant website (yours truly provided some insights but they did a great job revamping it).
Anyway, let me begin as to where the article got it wrong. Stefan Dunatov wasn't brought into BCI to diversify assets away from public markets/ Canadian focus to go into private markets/ global markets.
That's precisely why Gordon Fyfe was hired as the CEO and CIO of BCI. Gordon's strategy was to shift more assets into private markets and push to shift them globally across public and private markets.
If you see BCI's management team, you will see Mr. Dunatov is the EVP Investment Strategy & Risk, similar to what Barb Zvan is doing at Teachers'.
Don't get me wrong, Fyfe leans on Dunatov to understand risks of the portfolio across public and private markets, but it wasn't Dunatov who came up with the initial strategy to shift more assets into private markets. I think he was hired to help them on strategy and explain BCI's strategy at global conferences which is what he's doing.
Keep in mind, Dunatov is the former chief investment officer of Coal Pension Trustees Services and he undoubtedly has helped shaped BCI's strategy, including introducing private debt as an asset class.
Now, let me delve into Dunatov's comments because they are interesting. According to him, being long growth beta is the answer to investing in the long term.
In particular, he exposes what he calls the "fallacy of composition" when it comes to portfolio theory, stating diversification works at a portfolio level but it doesn’t work at the strategic level where "you want to own growth beta."
He also states with interest rates near zero, institutional investors have to think differently about monetary policy, which could mean the markets will have to contend with negative interest rates for the next 20 years.
Stop right there. Dunatov isn't the only one who has said ultra low rates are here to stay but he raises an interesting prospect, what happens if rates go negative and stay negative for a very long time? What does that imply for the strategic asset allocation of a multi-billion pension fund like BCI?
Most pensions don't want to own negative yielding assets. In fact, I'd say all pensions don't but some are forced to even if it makes zero sense.
If rates stay zero-bound or go negative for a very long time, Dunatov is correct, pensions need to shift their asset allocation into "growth" assets with steady streams of income which he defines as real estate, infrastructure, private equity and private debt.
In a low growth, ultra-low rate world, this is exactly what all of Canada's large pensions have been doing over the last decade, especially over the last five years.
In this regard, BCI is following the rest of its large Canadian peers, just like BCI's record $7 billion real estate deal allowed it to diversify its real estate holdings outside of Canada, something I was urging Gordon Fyfe's predecessor Doug Pearce to do years ago. There too, BCI is just following its large Canadian peers and it took a great deal like that one to get the ball rolling.
And Dunatov is right, when it comes to public equities, even during the crisis, large well established companies were still paying their dividend.
BCI is also bolstering its private equity, doing more co-investments under the watchful eye of Jim Pittman, the EVP Private Equity. Lincoln Webb is the EVP Infrastructure & Natural Resources and he will have to find assets which are still reasonably priced and can grow over the long run.
What I found interesting in Dunatov's statements is his focus on liquidity risk:
“That is probably the most important thing,” he said. “How do I know that I’m not going to sell them in a drawdown? We spend a lot of time on the liquidity aspect of that. Just imagine that there are only two sorts of bad worlds – a hard stop world like 2008 or a slow stop world like 1991,1992, 1993. We need to know that we will have the liquidity to get through both of them. As we are in net outflow mode, crystallising losses destroys wealth.”Go back to read my recent interview with outgoing Teachers' CEO Ron Mock where he said Teachers' is ready for the next crisis and he told me that following the 2008 crisis, they moved the focus on liquidity and managing counterparty risk. "We borrow on 3 or 5 year terms and in different currencies. So, liquidity fundamentals, conditional inflation protection and bolstering our repo operations through central clearing making it less bilateral than is was are all critical." He added: "we conduct fire drills and recently did one a month ago where we scenario tested what happens if the S&P goes down and stays down for a few years."
Also, go back to read my comments on how CPPIB's CEO sees lower returns ahead and how CPPIB is preparing for the next downturn where its CEO Mark Machin brought up liquidity risk and how a lot of mature pension plans are taking on more liquidity risk than they can afford, putting a third or more of of their assets into illiquid asset classes. And if a major crisis hits them hard, they will be forced to sell their "liquid assets" at distressed prices or worse still, sell their private holdings too at distressed levels.
In fact, take the time once again to watch this clip of Mark Machin and Amanda Lang below, it's actually more relevant now than back in August.
I also embedded an older (2017) clip where Stefan Dunatov, the former CIO of Coal Pension Trustees and now EVP and Chief of Investment Strategy & Risk at BCI, moderated a panel discussion at the Milken Institute Global Conference on assessing US opportunities from an overseas perspective.
Smart man who obviously knows what he's talking about and offers interesting and much needed fresh perspectives to BCI. It also looks like he will be BCI's public spokesperson so expect to see him more often as the organization incrementally bolsters its communications strategy.
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