Pierre Kunkel, Vice President of Media for the McGill International Portfolio Challenge (MIPC), recently sat down with Ramy Rayes, Executive Vice President of Investment Strategy & Risk at British Columbia Investment Management Corporation (BCI), to discuss BCI’s approach to investing in the current market environment.

BCI is one of the largest institutional investors in Canada with C$233 billion in gross assets under management. Based in Victoria, British Columbia, with offices in Vancouver, New York City, and London, U.K., BCI manages a global portfolio of diversified public and private market investments on behalf of 32 British Columbia public sector clients. Ramy joined BCI in 2016 and is responsible for setting, implementing, and monitoring clients’ investment strategies and for providing independent advice to BCI’s stakeholders. 

1.  The challenge of inflation is one that most in developed markets have not had to deal with during their careers. Was BCI surprised by the advent of inflation? If so, how did you deal with the challenge?

Fortunately, BCI was not surprised and responded quickly. Our transformation over recent years into an active, well-diversified global investor has put us in a strong position with a portfolio built to withstand volatility.

Through our process, we were able to achieve a positive outcome for our clients by fundamentally understanding the unique risks they are exposed to. A significant portion of our clients are pension plans and, while BCI has an investment policy, each of our clients have their own benefit, funding, and investment policies.

Most of our clients are conditionally indexed as part of the risk management strategies within their benefits policies. On the funding side, the policy depends on the assumptions of your model. We adopted a higher inflation assumption of 2.5 per cent instead of the Bank of Canada’s 2 per cent target, providing a buffer and allowing for some margin of error.

With risk mitigation in place through the benefit and funding policy, there is less need to perfectly hedge inflation through assets such as real return bonds in the investment policy. Instead, you can identify assets that are correlated to inflation that offer higher returns, like regulated contracted utilities in our infrastructure portfolio. Although we do not invest directly in commodities, we have exposure to commodity-linked assets in our portfolios, particularly our Canadian equities, and have shifted from fixed to floating rates on the debt side. We have been able to evolve our approach to mitigate inflation risks without the need for perfect hedging thanks to our understanding of our clients’ risk profiles and other factors.

2.  You mentioned exposure to commodity-linked assets, given the positive correlations between inflation and these assets, how do you balance the need to generate returns with ESG concerns?

We don’t believe that broad-based divestment is an effective approach to risk management. Instead, BCI is focused on acting as responsible stewards of our clients’ capital and using our ownership rights to drive ESG performance improvements. For example, we use proxy voting to reinforce our expectations with public companies and can engage through board representation in private markets. By maintaining exposure to an asset, we can more effectively guide the company in the right direction. Our approach allows us to address ESG without compromising our investment objectives.

3.  When reading BCI’s three-year plan I noticed a portion on geopolitical risk. The market sometimes does not price in these risks correctly due to modeling difficulties and the sheer randomness of these events. Is geopolitical risk something that you take into account?

The basic investing process starts with understanding what is priced in and comparing return expectations to the market, then you consider risks. The biggest risk is that you are wrong, and you will be wrong. This is where you have to adjust risk measurement or mitigation accordingly. We have an emerging risk process that inventories and analyzes risks based on probability and severity. Geopolitical risk follows a similar process, where we assess exposure to global regions and model potential outcomes or scenarios.

The typical way to manage or measure these risks is to design Monte Carlo simulations and focus on higher probability outcomes. Next, you inventory your own risk mitigation strategies to determine if unintentional mitigation is already in place and decide if it is sufficient. This process allows us to stay aware of issues without exhausting our resources. BCI has a funnel process that involves detailed assessments as the probabilities or severity of the risks increases, ensuring that we tackle the most relevant emerging issues effectively.

4.  That is an interesting take. I have read that the market sometimes ignores geopolitical events because historically, it served market participants well. When looking at the number of political crises in the past, very few of them affect markets for long, but the ones that do tend to have major effects. How do you choose which ones to focus on?

Similar to general risk, it is important to consider the normal distribution of events. While understanding the mean and median is important, the most significant actions occur in the tails of the distribution, where severe consequences can arise. Ignoring these risks isn’t the right answer, but putting all your resources into a specific issue is impractical. Instead, you need a process to understand your tail risks and implement mitigation strategies when they become relevant.

5.  The emerging narrative regarding the rates environment seems to be a “higher for longer” story. What is your view of the future macroenvironment? How are you positioning yourself according to this view?

We were at a point where inflation was out of control and central bankers were working to regain control. I tend to agree with the “higher for longer” perspective that implies easing will not happen soon or with the same magnitude as before, potentially signaling the end of the era of cheap money. Bankers who have been through this before are unlikely to want to make the same mistakes again.

The impact on investments starts with your expectations. Strategies that relied on cheap money and leverage will need to be adapted and made more agile. For example, borrowing short and investing long may no longer be effective. At BCI, we have implemented a range of new strategies to build further diversification, enabling us to weather different outcomes and scenarios. Our advantage is that our investment process is internal, which means we can be nimble and react quickly to new developments.

6.  I noticed the recent addition of private debt to BCI’s asset mix, was this addition spurred by the advent of inflation?

Private credit allows us to leverage our competitive advantages, namely our long-term outlook, liquidity, and network. While this asset has been beneficial in addressing interest rate and inflation risk, our primary motivation stems from diversification.

Recently, we have been ramping up private credit investments in both the corporate and real estate sectors to mitigate inflation and interest rate risk. We have significantly increased our exposure to floating-rate loans, which have the ability to outperform fixed-rate loans in rising-rate environments.

BCI began exploring private credit in the mid-2010s, during a period of falling rates and a “lower for longer” consensus outlook on growth and inflation. Pension funds were looking for returns, but there were pressures that put achieving their targets in jeopardy. Investors faced two choices: lower their return expectations or adjust their strategies.

The traditional fixed income landscape used to do everything. It provided good returns, diversification, and low volatility alongside collateral management, liquidity, and downside protection. This is no longer the case, and many funds reduced their fixed income allocations and reallocated to return-seeking assets like public equities. Investors that previously had a 60/40 portfolio shifted to an 80/20. However, this resulted in concentrated risk in public equities, which has its own potential issues.

We have been deliberate about our fixed income approach. If we want collateral and liquidity management, we invest in more government bonds. For return-seeking fixed income, we have developed strategies in corporate and private credit.

7.  Continuing with the same theme: There have been increased volumes in the private credit secondaries market recently, and many tout the benefit of J-Curve mitigation with secondaries. Would that be an asset class that would interest you?

Let us take a step back and think about secondary markets in general. The seller is sometimes putting their assets on the market because they are running out of liquidity or because they are over-allocated. Let us assume you have a target of 5 percent in private markets, but are now at 7 percent. This means that something else is short and you need to rebalance. BCI has had very prudent liquidity management, we are very mature, and our clients are very mature, so we have the liquidity and the investment horizon. If there is something exciting on the market, we will be buying.

It is important to note, however, that we probably would not invest due to J-Curve mitigation. We are long-term investors, and have the benefit of not chasing the most recent headline or thinking quarter-to-quarter.

8.  Finally, you mentioned that BCI liked to have a long-term outlook. Is there a risk of being too far ahead of the curve? Wouldn’t you want an edge but also one that others can recognize?

It is reasonable to think about both near-term successes and long-term outlooks for companies that you will have to exit one day. Investors must be aware of the current environment, but also question the extent to which they can capitalize on their competitive advantage. Many investors claim to be long-term oriented, but they often benchmark themselves against a universe of managers that are short-term.

For example, when we buy a private company, we leverage our competitive advantage of having a long-term perspective because we are not beholden to quarter-to-quarter results. This approach means we can drive sustainable, long-term value creation. If we need to go to market or refinance, we will adjust accordingly. However, it is crucial to always keep your competitive advantage in mind when making investment decisions.