Strategic allocation by asset class is a core element of the asset liability modelling (“ALM”) process for pension funds and increasingly it is being executed without input from asset managers. This is a worrying trend. The actuary is best placed to assess the future liabilities of pension funds, but the specific expertise of asset managers in identifying long term trends in asset classes is being overlooked. A partnership approach involving both the actuary and the asset manager would provide the optimal asset allocation strategy for funds. Involvement of the asset manager also ensures consistency in all investment decisions – otherwise the tactical allocation and stock selection strategies pursued by the investment team may disconnect with the underlying benchmark.
A further problem with actuarially driven asset allocation decisions is that there tends to be a reliance on historical returns to support the determined asset mix. However, the use of historical data to make judgements about the future is questionable and could lead to a misallocation of assets. Long-term returns from the various asset classes depend on many qualitative factors, including for example, the economic background, the political climate, and the advent of new technologies, demographic factors, the regulatory climate, not to mention investor psychology. A change in one or more of these can influence investment returns in the various asset classes for sustained periods of time.
A young, cash positive, pension fund should always devote a large portion of its assets to equities – they clearly dominate the returns of all other asset classes in the long run. Indeed, using US data one has to go back nearly 150 years to find a sustained 30-year period in which bonds produced a higher real return than equities. Equity returns are quite predictable over the long run because of mean reversion and the fact that the growth rates in earnings and dividends do not change very much over time. However, the exceptional long-term performance of stocks is not delivered with regularity – it is the result of good and bad years coming in clusters.
Consider the past 40 years. US stocks delivered nominal returns of more than 11% per annum. From 1961 to 1981 stocks returned 7.5% per annum in nominal terms, while from 1982-2000 the return was almost double – despite earnings growth being broadly equal in both periods. The disparity occurred because a changing investment climate meant that the amount that investors were willing to pay for earnings changed dramatically between the two periods.
Furthermore, oft-used valuation yardsticks have not been very useful in predicting stock returns in the intermediate term. Returning to the US example, the dividend yield fell below the bond yield for the first time in history in the summer of 1958 following nine years of exceptional returns, yet the stock market continued to move higher for the next eight years. Stock market returns in the next 12 months alone were more than 30%. Similarly, the dividend yield definitively broke below 3% for the first time in the mid-1990s, yet investors continued to enjoy extraordinary returns until the end of the decade.
An additional feature of ALM, which often involves the break up of a fund into specialist mandates, is a trend towards an arbitrary split of the equity portion of a fund by geographical region. But the increasing trend towards globalisation means that allocating assets simply on the basis of region or country is potentially counterproductive.
An asset manager today must not only understand the dynamics of a company’s country of origin but also the dynamics of the overseas markets in which it operates. In the US for example, roughly 40% of total sales of the S&P Index constituents are generated overseas. Additionally, the increase in cross-border acquisition activity means that a corporation’s country of origin may change. Academic studies confirm that globalisation has led to an increase in the importance of asset allocation by global industry sector, as well as by geographical region.
The asset manager should participate in decision-making at each stage of the investment process. Through continuous monitoring of the capital markets, frequent visits to potential investee companies and ongoing communication and debate the successful asset manager is well positioned to identify and exploit emerging long-term trends in a constantly changing world. Participation at every level of the asset allocation process leads to a more coherent investment strategy, which ultimately is to the long-term benefit of pension fund members.
Gavin Caldwell is chief executive of KBC Asset Management in Dublin