During the last two decades there was an ongoing discussion in academia and the professional community concerning the relative importance of stock/bond picking (either bottom-up or top-down) versus asset and country allocation. What part of the overall investment decision adds most value?
Ever since the work of Gary Brinson and others some 10 years ago most people are convinced that the asset allocation decision is at least as important as stock/bond picking. Yes, it is probably even of much greater importance. However, in practice we see a huge reluctance of institutional investors to follow active asset allocation strategies, both internally or externally. They easily hire active managers for specialised stock picking mandates with huge tracking error allowances but at the same time refrain from actively allocating assets over asset classes or within asset groups among countries or do it at a scale comparable to what they are doing in the alternative investments arena. And strange but true, when doing it they do it in a lot of cases internally based on relatively simple or naive econometric or fundamental consensus models. How can this be?
First of all, there are some technical complications when actively allocating assets in an institutional setting. Asset allocation strategies have a tactical and a strategic component. When doing strategic asset allocation pension funds have to take their liabilities into account. Short term, tactical shifts in the asset-mix based on changing market conditions must always be embedded in a sound long term strategic framework. That is why we need strategic benchmarks and asset/liability management.
As a consequence short term shifts have to be relatively small. However, we should not forget that their added value can be huge since it involves the total portfolio of pension plan assets. Another technical complication is also related to this size issue. Shifts in asset class weightings within an overall portfolio of pension fund assets involve huge amounts of money. In many instances these sums are so large that market impact is really an issue. Besides that, many pension plans give specialised mandates for various asset classes to several managers. Shifting between asset classes is a tedious process that leads to a lot of administrative and legal complexities. As a result of these two factors, most of the time it is more convenient to use future overlay strategies. However, a lot of pension plans are still afraid to use derivative strategies and think that derivatives might increase the pension plan’s risk to unacceptable levels. This is true when derivatives are used in an improper way. Intelligent use of these strategies will actually reduce risks and may enhance returns. In many instances the downside risk of improper derivative strategies is not correctly compared with the risks and costs attached to refraining from any form of dynamic asset allocation at all or doing this on an ad hoc basis.
Secondly, it also seems as if there is some behavioural factor that explains the reluctance to pay as much attention to asset allocation as to stock picking. And besides that, (tactical) asset allocation mandates are normally much larger than individual asset class mandates, something that gives many boards the feeling that the dependence on manager X or Y will be unacceptable. Also a large mandate against a standard fee is considered “too expensive, because we pay our European equity manager much less.” Furthermore, pension plans prefer to run the allocation mandate themselves.
The aforementioned distinction between tactical and strategic asset allocation results in many instances in a lack of integration between the two. Strategic benchmarks are derived on the basis of so-called Monte Carlo simulations, or something similar, using historical data. The optimal strategic allocation is then a function of the fund’s downside risk tolerance and its liability position. The strong reliance on historical data in asset liability management is a result of a strange form of conservatism. The plan wants to avoid taking large bets since it does not want to overestimate its forecasting capabilities in the long run. The strange thing is though, that tactical asset allocation positions are first of all a result of active bets, and second of all of the aforementioned econometric or consensus models that in many instances are based on the fact that history does not repeat itself. However, a simple glance at market data learns that it is exactly the short term that is harder to predict. Return and risk patterns of volatile assets are more stable in the long run. This dichotomy creates a lack of integration between the two elements of the asset allocation decision. And this will lead to sub-optimal decision taking because the long run is of course a sequence of short term periods. In effect it means that important new information is solely used for tactical modification of existing portfolios, but not immediately used to analyse if the strategic benchmarks are still okay or need adjustment.
If top entrepreneurs were to hear that tactics and strategy are not fully integrated in our industry, they would link this information to shocking stories about underperforming active asset managers and pension plans. The lack of integration is a token of the emerging, still underdeveloped status of our (relatively young) industry. Palladyne and our senior research consultant Dr Harry Markowitz (1990 Nobel Prize laureate) believe things can be done differently. Using a framework in which short term global tactical asset allocation (GTAA) signals are embedded in an optimiser that bears similarity to Markowitz’ modern portfolio theory (MPT), but also includes liability projections, transaction costs data, etc, tactical signals are translated into “probabilities” concerning the economic state of nature in the coming period. Through iterative loops integration of short term and long term are accomplished. Does this mean we refrain from using historical data as is done in the long term Monte Carlo simulations? No, the historical information with respect to correlations between, returns, return levels, volatilities etc is combined with information concerning the likelihood of various economic states of nature and the correlations between two consecutive states of nature. In this way we are able to integrate the dynamic short term and long term asset allocation decisions.
We believe that this is not a revolutionary methodology. Most professionals would agree that an integration of tactical and strategic allocation is essential. It is just that it is currently not being done in an optimal way. It is a bit comparable to what we all think about the integration of risk and return when taking investment decisions. As long as people invest, they agreed on the added value of an integration of these two decision variables. However, not until Markowitz developed the MPT did we really know how to integrate the two in a structured manner. The integration discussion above may seem academic, but it is not. A good practical example is what happened in Japan during the last decade. First, we had a period during which the weight of the Japanese stock market in the world index rose to record heights (even higher than the US weight). And then we entered the Japanese “dark ages” during which more and more weaknesses in the Japanese economic and corporate model were discovered. The index-weight for Japanese equities fell sharply. It was a phase during which many pension plans downgraded their Japan allocation based on ad hoc feelings that the standard long term ALM optimisers were wrong. The subjectivity of this approach is not optimal. However, the pension plans were right that something was fishy about the standard long term optimisations. What could have done was simply to incorporate their negative short term signals about the Japanese market in the strategic framework. The result would be an integrated downgrading of the Japan weight, but this time in an objective manner. The advantage of the integration lies in the fact that its outcomes are not dependent on gut feeling and that they have no problems with sharp shifts in economic climates.
Of course, it is impossible to correctly forecast these shifts all the time. But that is not the issue in long term strategic allocation. You simply want to avoid being “too” late! The seemingly conservative assumptions underlying the current way of doing things are comparable to a Formula One racer driving around on the circuit with his eyes closed so as to concentrate better on the historic information about the track as studied the day before. He ignores the short term, real time signals because they are probably not completely correct. He is driving at such a high speed that 100% certainty cannot be reached. The last statement is probably correct, but even uncertain information can help to make better decisions. This holds also for asset allocation.
Does an integration of short term and long term signals imply that trading volume will go up or that active risk levels will rise? No, but what it will do is give signals with respect to changes in the optimal asset mix based on all information, short term and long term. Currently, too many pension plans are still taking these decisions based on gut feeling (isn’t it time to do another ALM study again? Our profession is constantly developing and we are still an emerging industry, not one in which tens or even hundreds of years of ongoing research have led to an extremely high level of sophistication. That is in itself not a problem, but a fact of life and a reassuring fact is that change is noticeable. The willingness to learn from and acknowledge previous mistakes is growing. This holds for all players in our industry: pension plans, consultants and asset managers. The average level of professional and academic education in our industry is rising.
Being open for new ideas, the willingness to put them to a test, critical analysis of one’s own performance, the construction of dynamic and coherent investment strategies, open communication between client/consultant and asset manager, etc are all elements of the same phenomenon: the trend towards maturity in our industry. Some may argue that these are all new, populist ideas and that our industry was mature and sophisticated already. However, the large amount of underperforming active managers and pension plans as well as the popularity of passive asset management seem to be tokens of the opposite. But we see that the majority of professionals are willing to explore new ways or modify existing ones to add more value in the future.
This plus the fact that asset allocation is so important for the success or failure of a pension plan to reach its own targets, we cannot deny that “more sophisticated asset allocation” is going to be one of the most important themes in the coming decade.
Erik van Dijk is CEO of Palladyne Asset Management in Amsterdam