Investment innovations: a scorecard
Pension plans have an open mind about innovations, say Neeraj Sahai, Jim McCaughan and Amin Rajan
Since the 1980s, numerous innovations have come in dribs and drabs. But their substantive adoption gained traction in the wake of the 2002-03 bear market.
It shifted attention from relative to absolute returns, from mainstream to alternatives, and from asset investing to liability matching, according to the 2011 Citi/PGI/CREATE annual global survey*.
It shows that the 2008 crisis overwhelmed most innovations indiscriminately. Even a seen-it-all-investor was stunned. Yet, for the decade as a whole, five innovations have been identified as delivering most value (figure 1): emerging market equities (a stand out), emerging market bonds, high yield bonds, LDI and ETFs.
Those pension plans that benefited from these innovations single out three factors acting in their favour. They had clear investment beliefs that guided their choices; a disciplined approach to buying and selling that minimised behavioural biases, and the skills and governance that chased intrinsic worth via early mover advantage.
Innovations that delivered least value include leverage, structured products, currency funds, and portable alpha. They worked for some investors but not others.
Pension plans that lost out report three contributory factors. They relied on financial engineering to extract value where there was none; on external advice to the extent that often promoted a herd instinct that prevented buying on the dips, and were less aware of the conditions in which innovations work because of low engagement with their asset managers.
This assessment by pension plans is duly echoed by their asset managers, but with one caveat: innovations were not inherently unsound if their ‘health warnings’ were heeded.
Pension plans accept that innovations cannot deliver replicable outcomes - nor can they do without them. Both the size of their current deficits and the returns required to fix them seem daunting in today’s low return environment.
Hence, they want to be assured that their asset managers will seek ‘best endeavour’ outcomes via product integrity, process integrity, operational excellence and interest alignment.
The likelihood of such outcomes may increase if:
• There is greater client engagement that seeks new ideas as much as manages expectations of what can and cannot be achieved in today’s markets;
• Innovations stem from managers’ core skills as distinct from pure market opportunism;
• Innovations walk the fine line between revenue streams for asset managers and credible opportunity sets for their clients.
The pension promise was easy to make, hard to keep. The main lesson learned is that asset allocation is the alpha behind alpha. That means not adopting anything radically new without strong investment beliefs, having a disciplined approach to trading and the necessary skills to understand risky products.
Two changes will help in the future. First, pension plans want future innovations to improve two product features that directly hit their bottom line: the risk-return trade-offs and their fees and charges. A new asset class will not help while all the money is locked into the old.
Second, they want risk models and investment processes to have a strong overlay of human judgment, especially while the global economy remains exposed to systemic shocks. Investors can no longer rely on the rear-view mirror.
Service provider scorecard
We asked pension plans to assess the value added by managers and consultants in their 10 core activities since the crisis.
Taken as line items, asset managers are rated as ‘good’ or ‘excellent’ in five of them by at least 50% of respondents. The corresponding figure for pension consultants is only one.
Asset managers out-score consultants in 8 out of 10 categories. In the top six value added activities - strategic asset allocation, manager selection, portfolio construction, stock selection, risk management and investment returns - asset managers do better as well.
Notably, the ‘excellent’ rating is awarded by no more than 12% of respondents to any single item in figure 2. The scope for improvement is big. These numbers are symptomatic of the problems that pension plans have experienced as they have progressively switched to liability matching in the wake of past losses and changing accounting rules.
In the bull market of 1986-2000, defined benefit plans had targeted equity risk premium - typically 5% - as an end in itself in the hope that it would take care of their future liabilities.
In the last decade, as the risk premium dried up, there was a reversal: liabilities became the ends and investment the means.
This switch towards goal-oriented investing has also been evident in defined contribution plans where solutions have emerged in different forms in the last decade: eg, capital preservation, excess over cash, wealth accumulation and balanced funds.
It became inevitable as two traditional pillars of asset allocation were weakened by systemic forces over the past decade: the buy-and-hold strategy was not working, as equities were outperformed by bonds; nor was the core satellite model, as actual returns diverged markedly from expected returns for most asset classes.
As the risk universe expanded, asset allocation had to become dynamic. Paradoxically, the factors that caused it are also the ones making it hard to implement.
Neither asset managers nor pension consultants receive high plaudits for helping plans to manage the transition. Asset managers and pension consultants need fresh insights into three factors on which successful dynamic asset allocation now depends: the causes, symptoms and consequences of systemic risks; the risk-return profiles of different investments at granular level; and changing correlation between different asset classes. In this context, two points were repeatedly made by pension plans involved in our interviews, especially in Asia.
First, the current generation of risk models used by managers and consultants overly relies on the rear-view mirror. They can neither predict risks nor help mitigate them. Eloquent concepts like VaR, information ratio and tracking error have lost credence when decision speeds are compressed from calendar to real time.
Second, if they are to develop the necessary insights, asset managers need to focus on their core capabilities and not stray too far in their innovation efforts. That means putting a stick in the ground where they can deliver most value within a range encompassing high alpha at one end and commoditised beta at the other.
The credit crisis marked the end of a chapter in the history of investment innovations. It was more a moment of introspection than the mother of invention.
Pension plans have got wise. On their part asset managers have started a fresh narrative on what they can deliver. Time will tell whether their current efforts will fare better than previous ones.
Neeraj Sahai is global head, Citi Securities and Fund Services, Jim McCaughan is CEO of Principal Global Investors, and Amin Rajan is CEO of CREATE-Research
*Investment innovations: raising the bar is available free from firstname.lastname@example.org