With asset class correlations no longer following their historic norms, a new form of diversification focused on risk is emerging, according to Jim McCaughan and Amin Rajan
Old-style diversification hit a brick wall in 2008 when correlation between asset classes went through the roof. Since then, it has been staging a fight back. Its newer form seeks to minimise risks more than maximise returns, according to the 2012 Principal Global Investors/CREATE Global Survey, Market Volatility: Friend or Foe*.
The emphasis on risks is dictated by the fact that they can often emerge from unfamiliar sources that are hard to model. The term ‘market risk’ now embraces all the things that can go wrong. That means going beyond the traditional risk factors to allow for various contingent events. These may or may not happen. But if they do, they can nullify the historical risk-premia and ravage any portfolio.
The second point of departure is the additional emphasis on goals. While seeking to minimise correlations at different phases of the market cycle, the new approach chooses asset classes to deliver a blend of goals: eg, capital growth, high income, steady cash flow, high liquidity and inflation protection. The old focus on returns is now augmented by other distinct outcomes within a dynamic asset allocation approach that responds to events.
The new approach has evolved from the previous ones, as now exemplified by large defined benefit plans in the UK and the US. In the 1990s, asset allocation followed a formulaic approach that favoured overweight positions in equities. After the losses in the 2000-02 equity bear market, there was a significant switch to alternatives and exotic beta - the latter targeted risk premia in new areas like commodities, forestry, currency and ETFs. However, the losses in 2008 led to another fundamental rethink.
By 2010, three clear distinctions emerged in the portfolio: between alpha and beta; between opportunistic investing and buy-and-hold investing; and between re-risking and smart risking. While the first two distinctions had been evolving in the last decade, the third came to the fore in this decade, as pension plans sought three options to cut their deficits.
The first involves increasing risk in search of higher yielding assets. Some of the plans with big deficits have been obliged to go down this route. The second option involves obtaining higher returns from the existing risk budgets. This is investors’ equivalent of the Holy Grail that seeks additional alpha without taking on further beta risks. Such smart risking has been done by using market indices and a more diverse asset base to create smart beta that deliver cheap alpha. The third option involves going down the LDI route by hedging out the unrewarded risks and using a variety of assets in the returns-enhancing portfolio. European plans have been active adopters of LDI.
In contrast, their US peers have focused more on re-risking and smart risking. Either way, there is a clear distinction between means and ends. One is about the principles guiding asset allocation, the other about their outcomes. The outcomes in question include capital growth, high income, cash flow, high liquidity and inflation protection. Such multi-outcome funds in the US resemble diversified growth funds in Europe, which also have a broader palette and, in many cases, daily liquidity to meet the needs of DC investors.
The percentages in each box are indicative, not definitive; being based on a sample of large plans in the UK and the US. They vary with the circumstances of the plan in question. But they do show that, in the face of wild variables that cannot be modelled on a spreadsheet, pension plans have been exploring a new approach consistent with new realities.
Jim McCaughan is CEO of Principal Global Investors and Amin Rajan is CEO of CREATE-Research
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