The current hostilities in the Middle East may have subsided by the time you read this. It is also highly likely that they will not.
Many long-term investors may still hope that this crisis will ebb away or even take its place in the collective memory as a buying opportunity. But the sudden spike in oil prices in the second week of March, and the resulting equity market reactions, will have swept aside any lingering hesitancy on the part of institutional investors and their investment committees about the seriousness of the situation.
Turbulent markets can put serious stress on portfolio values – but they can also cause a crisis of faith among investors in the precise mechanics of their own governance and asset allocation frameworks. Stressed markets knock strategic allocations out of kilter. Equity markets drop below their quota; private markets bust their strategic limits, even though the valuations haven’t changed.
As Adina Grigoriu, CEO of Active Asset Allocation put it recently: “Geopolitical uncertainty is exposing a structural tension in asset allocation. This is not a failure of portfolio models; it is a stress test of governance structures. Markets can reprice geopolitical risk in days, while many investment committees still move in months.”
In previous crises, discussions have often been around breaches of strategic policies. Do investors permit themselves the indulgence of tolerance? And for how long? Do they exercise a form of market timing in buying equities to bring their allocation back up to the strategic weight, or do they allow markets to do the job for them?
Portfolios in the 2000s and 2010s were often more liquid, making rebalancing more straightforward. The rise of illiquid allocations in recent years has changed the narrative, often leading to a conclusion that traditional strategic asset allocation approaches are ripe for revision.
These considerations explain why many institutions are seeking to adopt more holistic or adaptive asset allocation processes. The total portfolio approach – which attempts to break down traditional asset class silos and thinking – is probably generating more discussion than action and is mostly confined to the largest institutions.
However, a dynamic approach to asset allocation is also gaining traction. A recent survey conducted by CREATE-Research and supported by IPE, found that almost three-quarters of pension funds use some form of dynamic approach. This is likely to increase to 84% in coming years.
In 2008, Gordon Clarke and Roger Urwin published a paper in the Journal of Portfolio Management (‘Best-practice pension governance’), which found that better-governed institutions generate better risk-adjusted returns. Those better-governed institutions are likely to be on the larger side. More turbulent markets, unanchored from the benign backdrop of QE are more likely to favour such larger, better-governed institutional investors long into the future.
There is also a clear connection between size of institution, better governance and better long-term retirement outcomes. Policymakers should double down on efforts to foster pension fund consolidation – following models adopted in the Netherlands and the UK. Future pensioners may thank them.
Liam Kennedy, Editorial Director
