AI, Digital Currencies and the Bond Yield Revival: 3 Key Pension Themes Investment Counsel can Implement Through ETFs

Progress is not linear, and history is littered with periods when great leaps forward have occurred in a short time span. We may be living in such a moment now. Being long-term investors who manage liabilities, pension plans spend inordinate amounts of time examining themes which will have large influences on their investment outcomes. Below, we highlight a handful of emergent themes currently being studied closely. 

Not surprisingly, changes to the liability side of an asset/​liability model are more concerning than transient asset fluctuations. Imagine the frustrations a marathon runner would experience if their finish line were to be extended as they are expending their energy. The same is true for investment managers. 

For the marathon runner, changing environmental conditions – wind, rain, temperature – are all vital considerations which force them to adapt their strategy to drive an acceptable result. Pension plans are no different, and have at present identified several key themes that hold the potential to change the macro investment environment: 

• Artificial Intelligence & Machine Learning;
• Cryptocurrency, Blockchain & the Impending Rise in Central Bank Digital Currencies;
• The Impact Higher Rates Will Have on Asset Allocation / Re-examining Alternatives.

Each of these areas demand additional resources for all investors, requiring deep expertise to understand the theme and to gauge to what extent it should be incorporated into the asset mix. This is true for pensions plans, but also for investment counselling and multi-family offices.

Artificial Intelligence and Machine Learning

A speaker at a recent industry conference caused a stir when she mentioned the impending structural dislocation AI would have on the labour market. Milena Marinova, VP of Microsoft’s Open AI, commented that 80% of jobs would face 10-20% redundancy risk as AI is implemented in the labour market¹. To be blunt, averaging her estimate at 15%, that would equate to an unemployment rate of 12%, though we do not know yet if the numbers will be frictional or structural. 

This will be the first time that knowledge-based jobs will be imperilled, posing significant questions for people as they plan the rest of their careers or embark on new ones. Some decision-making jobs will be eliminated, though people who learn to use AI may be able to minimize the threat. People who have strong interpersonal skills may be less affected, though it is impossible to say with any certainty if some client relationship roles can or will be replaced by AI.

People at the conference discussed the significant challenges that AI’s consequent impact will have on society, the economy and on the tax system. AI is irreversible, but leading institutions are discussing how to implement AI into their own operations while also gauging its economic implications.

Applicable BMO ETF Listings:

• BMO MSCI Innovation Index ETF (Ticker: ZINN) 
• BMO MSCI Next Gen Internet Innovation Index ETF (Ticker: ZINT)
• BMO Nasdaq 100 Equity Index ETF (Ticker: ZNQ )

Cryptocurrency, Blockchain & the Impending Rise in Central Bank Digital Currencies

At the same conference, there was an animated discussion about the future of money. A stark distinction was made between money and technology, recognizing the foundation upon which a fiat currency is based. 

Tim Massad of the Kennedy School at Harvard University, and Neha Narula, Director at Digital Currencies Initiative at MIT’s Media Lab stated that cryptocurrencies, not backed by a government, cannot become money but they can be a very useful exchange mechanism in economies with unstable currencies².

In contrast, both stablecoins, which are pegged to a fiat currency’s value, and Central Bank Digital Currencies (CBDC), are already changing the landscape. Using either stablecoins or CBDC on blockchain technology will accelerate global payments and make transactions less expensive, boosting economic activity. 

Looking at where Central Bank Digital Currencies have advanced provides some very interesting perspectives³. The speakers spent considerable time discussing how CBDCs make it difficult to impose sanctions, which may explain why Russia had progressed to the Proof-of-Concept stage in 2019. Thus far, only Nigeria has launched a successful CBDC, but Japan, Brazil, New Zealand, Norway and Sweden are also at the Proof-of-Concept stage, far ahead of many other countries.

There was mixed discussion about the pros and cons a CBDC might have. Some were excited that a CBDC would promote financial inclusion, but others were wary that, in its very nature, a CBDC would also allow governments to gather more data on citizens and their activities.

Applicable BMO ETF Listings:

• BMO MSCI Fintech Innovation Index ETF (Ticker: ZFIN)
• BMO Brookfield Global Real Estate Tech Fund (Ticker: TOWR)

The Impact Higher Rates Will Have on Asset Allocation / Re-Examining Alternatives

Investing in 2022 was a difficult endeavour. Assets which were supposed to have low or negatively correlation to equities headed in the same direction, making a mockery of carefully diversified asset allocation models.

In the aftermath, however, bond yields look very attractive, providing reasonable yields for prospective investors. This is vital for pension plans who manage long-term liabilities, but it should also be sobering for investment counselling firms, most of whom have built their reputations on their stock-picking abilities.

As the table below outlines, conservative fixed income exposure now provides compelling yields:

Figures as at 20 June 2023. Yield to maturity (YTM): The total expected return from a bond when it is held until maturity – including all interest, coupon payments, and premium or discount adjustments. 

Cash Alternatives:

Figures as at 20 June 2023. Annualized distribution yield: The most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV. 

The pension 60/40 model was conceived in the 1980s when interest rates were much higher, but became less relevant as yields declined to paltry levels. In its stead, pension plans embraced Alternative investments because they provided broader diversification to traditional asset classes and because most do no mark-to-market, providing stability to reporting and funding decisions.

Now that bond yields have risen to attractive levels, bond allocations are rising once again (though not to the 40% level). In contrast to Alternative investments, listed fixed income provides a more robust data set to model risk and return as well as the scalability to execute more fluidly. 

Interestingly, pension plans are also re-evaluating how they allocate to Alternatives like Infrastructure and Real Estate. Listed investments in these asset classes are highly regarded as valuable complements to unlisted equivalents, providing scalability and, more importantly, highly prized liquidity. 

Some pensions are also evaluating ETFs on public securities as proxies for private debt or private equity, motivated by their low cost, liquidity and crunchable data. Combining ZBBB with ZEF accents investment-grade exposure (ZEF uses a debt-to-GDP weighting to create a portfolio that is 2/3^rds investment grade), with ZFH (floating rate high yield), and ZHY (high yield bonds), provides a diversified, less expensive and scalable solution to capture Alternative Yield. 

Applicable BMO ETF Listings:

Core Fixed Income:

• BMO Short Corporate Bond Index ETF (Ticker: ZCS)
• BMO High Quality Corporate Bond Index ETF (Ticker: ZQB)
• BMO BBB Corporate Bond Index ETF (Ticker: ZBBB)

Real Assets:

• BMO Global Infrastructure Index ETF (Ticker: ZGI)
• BMO Equal Weight REITs Index ETF (Ticker: ZRE)
• BMO Global Agriculture ETF (Ticker: ZEAT)

Alternative Debt Proxy Portfolio:

• BMO BBB Corporate Bond Index ETF (Ticker: ZBBB)
• BMO Emerging Markets Bond Hedged to CAD Index ETF (Ticker: ZEF)
• BMO Floating Rate High Yield ETF (Ticker: ZFH) 
• BMO High Yield US Corporate Bond Hedged to CAD Index ETF (Ticker: ZHY) 

Investment management is a dynamic exercise, requiring constant monitoring and measurement. Deciding which emerging trends present lasting investment opportunities is critical to running any investment platform, be it a pension fund or a counselling business. The difficulty lies in retooling for change, and deciding whether it is necessary or feasible to build internal expertise to harness new opportunities. 

Both pension plans and investment counselling firms are using ETFs to fill in the gaps, using effective low-cost, transparent tools to adapt their portfolios in a changing landscape.

¹ Milena Marinova, speaking at FTSE Russell World Investment Forum in Sea Island, Georgia, 5 June 2023.

² Tim Massad & Neha Narula, speaking at FTSE Russell World Investment Forum in Sea Island, Georgia, 5 June 2023.

³ https://cbdctracker.org/