The static long-term assumptions of past consulting methodologies are no longer fit for purpose. But Brendan Maton finds that developing new approaches is a tough intellectual and practical challenge
On the perils of relying on past performance, the Thinking Ahead group at Towers Watson last summer sketched a picture of an investor who could be relied upon to produce 15% outperformance of cash each year – not annualised over a longer period– for 10% volatility.
The puzzle set for readers was to determine how much of the time this investor’s (hypothetical, alas) portfolio is ahead of the market benchmark. The answer is just 50.71% of the time, or 241 minutes of an eight-hour day. The moral of this story is not how slim the majority of success over failure needs to be in active management, but how harrowing such a slender margin, it must be psychologically.
“Not only will our investor be emotionally drained, but we also know from behavioural finance, that they will feel the losses far more keenly than any boost they get from the gains,” the paper, ‘Past Returns are Not Even a Reliable Guide to the Past’, concludes.
There is a further insight that braving such thin differences between right and wrong is buffeted by cross-currents of frequent performance measurement which confuse ‘noise’ with ‘signal’.
“I’d like to get away from performance measurement towards a range of outcomes, including the wildly pessimistic and wildly optimistic,” says Tim Hodgson, leader of the Thinking Ahead group and author of the paper. The ethos of ranges rather than numbers set in stone is predicated on much more humility when it comes to investment decisions.
“We are professionals and we can bring great mathematical rigour to forecasts but we aren’t clairvoyants,” Hodgson says. As an example, he poses the question of whether 1% per annum GDP growth for the USA is the ‘new normal’. “If you believe it is, then that radically changes your assumptions for returns on assets and your asset allocation.”
Hodgson is attracted by the kind of investment strategy based on the acknowledgement that the future is uncertain, and adjust exposures to economic trends and assets through time. “Asset prices are reflexive, which means that they alter investment behaviour and are consequently altered themselves.”
To retain a margin of success, however slim, month on month, year on year, in such an unknowable, reflexive world would indeed be nerve-shredding. And complex, or multi-pronged as Hodgson puts it, because there will be a breadth of assets to consider, not one homogenous portfolio. Moreover, behaviour is not moved solely by current prices but also an investor’s internal compass of assets’ fair values.
It is all a far cry from the asset-liability modelling (ALM) of the past, where from a plentiful range of stochastic outcomes, hard numbers would be nailed up on a wall to represent return expectations – without risk expectations – and left there for the three years until the next assessment. What was lacking then, according to the consultants, was the dynamism necessary for negotiating the random path that events take into the future.
“The ALM report would be duly conducted and then left to gather dust on a shelf for three years until the next exercise,” says John Belgrove, head of UK consulting at Aon Hewitt.
For John Stannard, head of consulting EMEA at Russell, dynamism is one of the three big trends which mark the industry’s evolution over the past 10 years: “Dynamism means being aware of the factors that drive returns in asset classes across your portfolio and making adjustments based on medium-term views.”
This seems a sensible way to cope with the uncertainty of markets. Does it mean the fixed figures of ALMs are dead? Yes and no. Investment consultancies’ processes still begin with long-term assumptions for asset allocation. “Long-term views are those which are aimed at determining neutral long-term assumptions,” says Stannard. “So, these largely reflect expected risk-premia of major asset classes, expected volatility and the extent to which asset classes move together.” He claims that absent tactical or medium signals, the long-term allocation should prevail.
Belgrove agrees that these long-term capital market assumptions do not change much. “Of course they can and do change quarter on quarter with prevailing conditions, but typically not radically, even in these volatile times.”
If one looks at Aon Hewitt’s long-term forecasts for euro-zone fixed income from December 2010, however, the outlook for 10-year annualised nominal returns at five-years’ duration was 3.5%, and at 15-years’ duration it was 4%. Fewer than 24 months later, these expected returns had fallen to 2.4% and 2.8%, respectively. (Aon Hewitt uses French government bonds as its benchmark for these forecasts, for consistency with the fact that it uses French inflation-linked bonds to arrive at its euro-zone inflation expectations).
These are big changes during extraordinary times for sovereign European debt. Some might say radical. Which begs the question whether mean reversion is applied to these long-term forecasts. Belgrove claims Aon Hewitt threw out the textbook on long-term returns years ago and gives the trend in equity/bond correlations as one example why: “100 years of data averages a small positive correlation but these past 10 years have been high and negative. That’s what happens and long-run averages are often useless as guidance.”
Instead, those who devise the assumptions, led by Tapan Datta, global head of asset allocation at Aon Hewitt, use their own experience as well as market data to make more informed decisions. Like other leading consultancies, Aon Hewitt employs a diversity of people to bring experience from trading and fund management on board.
Would it matter so much if their long-term assumptions were mere palimpsests? After all, no one evaluates economists’ predictions or investment banks’ model portfolios a decade after the fact. As in these cases, there is no real money tracking consultants’ decisions and for those like Russell that use the same models for investment funds as consulting advice, these former tend to get subjected to much shorter-term analysis anyway (the two investable strategies Russell offered to demonstrate its tactical and dynamic asset allocation prowess date from 2009).
Consider long-term assumptions in the extent to which Gilt yield reversion should be embedded in discount rates for actuarial valuations. “Undoubtedly, there will be pressure on actuaries in determining valuations and funding plans to not fully reflect the current exceptionally low level of Gilt yields, believing them to be temporary and artificial,” says Nick Sykes, European director of consulting at Mercer. That course would lighten the reported liabilities for sponsors. Alas for them, for long-term investment strategy setting, Mercer has not embedded such yield reversion expectations in its assumptions. But in perfect consultant fashion, Sykes adds: “We do incorporate discussion of the possibility in setting ‘glide paths’ for clients in terms of funding level development.”
Informing scheme actuaries is an interesting strand of the work of central asset allocators in investment consultancies. The latter were all born from actuarial firms, with the exception of Russell, which offers no actuarial services. Scheme actuaries are not renowned for straying into capital market predictions. Some still believe there is not much science to the work of their colleagues in investment consulting and stick to long-run averages when setting assumptions. Sykes’ example shows, however, that such remoteness of actuarial assumptions from investment practice is not policy at the major firms.
Belgrove agrees that actuarial and investment consultants work much more closely together. “There was a time when I think the two had to be seen as separate [given the origins of investment consulting within actuarial firms]. That period is now over.”
Of course, for larger clients the scheme actuary is unlikely to be first port of call for discussions on funding strategy – the work assets have to do to meet liabilities as measured by the scheme actuary. Funding strategy is the investment adviser’s domain.
Here again we come up against the tension between centre and periphery; or policy and practice. Yes, all the senior interviewees believe there is healthy connectivity between the strategy department and individual scheme advisers. But one UK scheme said that each of its successive advisers – all from the same firm – brought their own idiosyncrasies.
“If they were in love with hedge funds, that was the advice you received,” she recalls. “One was an ex-bond manager, so he always gave us a thorough analysis of the bond markets.” After five different advisers in four years, this particular scheme had had one idiosyncrasy too many and changed firm.
It is this kind of anecdote that sprinkles a little dust on the senior executives’ polished summaries.
The anecdote also reminds us that advising a pension scheme is a relationship, and while investing often seems entirely numerical, scheme executives don’t seem to bother assigning hard numbers to investment advice because they occur within the flow of greater currents of market and scheme movements. Others warned of the temptation of binary outcomes.
“I get worried if I see in an investment consultant’s report a tag next to an asset class saying ‘undervalued’ or ‘overvalued’,” says David Adkins, CIO of the Pensions Trust, a £5bn (€5.8bn) umbrella scheme for the UK’s charitable and voluntary sector. “That can make trustees feel they must either act or do nothing, and they are more likely to do nothing.” Adkins prefers to use the full stochastic range of outcomes and model investment decisions. If this echoes the consultants’ ethos, that is no surprise. Until three years ago, Adkins was an investment consultant at Towers Watson.
“I don’t know the direction of nominal and real yields,” he continues. “But, I can model the consequences of hedging our liabilities. I describe using ranges as a dimmer instead of an on/off switch.”
In terms of ranges for asset allocation, some consultants are happy to talk about their preferences in recent years.
Gavin Orpin, head of trustee investment consulting at Lane Clark & Peacock (LCP), highlights its calls on credit as a great success: “Credit in this context means investment grade, high yield and/or loans. Taken together, this is where we’ve seen most opportunities in recent years. We often see this as an alternative to equities, although we have also been advising clients to take money out of liability-matching portfolios due to low yields,” he says.
“We’ve put credit risk on and off quite regularly. In 2009 we were sharply on. Mid 2010 to the start of 2011 we rowed back but at the beginning of 2012 we were back on. Now in 2013 we are starting to encourage clients to take some out of the portfolio.”
While every consultant will caveat any recommendations with reference to the specifics of any client scheme, Orpin says that LCP measures its universe of clients’ returns versus the UK overall and reckons the former have outperformed the latter with significantly reduced risk over the past five years.
For Aon Hewitt, Belgrove goes one better on credit. He reckons in 2006 (the then) Hewitt saw the sub-asset class as expensive and recommended clients divest. In a frank admission, he adds that the switch was nothing to do with the credit crisis – “we didn’t see it coming” – and everything to do with relative value. “Spreads were just too tight.” More boldly than LCP, AonHewitt was overweight credit December 2008 and reversed that recommendation a year later. In summer 2010 it was back in bullish opinion and held this view until last summer.
In real estate, Belgrove is most proud of holding off until the third quarter of 2009 to push clients to buy more of this asset class (primarily direct holdings). On equities, he reckons that AonHewitt called for a reduction in equities in 2008 well enough but was too cautious in 2009 when the rebound came.
At Mercer, Sykes points to a series of papers disseminated to clients in the wake of Lehman Brothers’ demise on how to benefit from market dislocation. These included Investment Grade Credit (March 2009), Convertibles (May 2009), Recovery UK Property (July 2009).
Sykes is phlegmatic about that period’s unusually abundant, “unlikely to be repeated” opportunities: “Since then, our guidance to clients has been more generic, reflecting the environment in which we find ourselves: record low interest rates and bond yields, anaemic economic growth, plentiful liquidity but high uncertainty.” He nevertheless pinpoints some specific opportunities in the area of private debt including mezzanine and real estate debt.
Adkins has no doubts about the ability of consultancies to generate worthwhile ideas. Where he feels opportunities have been lost is in their ordering and prioritisation. This is probably more a fault of their clients’ governance.
“When I came to the Pensions Trust, part of the remit was to put in place processes and personnel so that we could make the most of the ideas the consultant was giving us,” he says. In the past, the investment department had just one employee, concentrating on performance reporting and manager changes. This year the team will number eight. “It’s the investment department’s responsibility to implement strategy, as agreed with the investment committee, not the consultants’,” says Adkins.