A 1986 landmark study, focusing on 91 large pension plans and covering the period 1974-83, concluded that asset allocation was far more important than stock selection in determining a portfolio’s returns*.
The study gave rise to a new orthodoxy that gained fresh traction after the 2000-02 downturn. In the raging bull market that preceded it, pension plans worldwide were overweight equities. Hence, as their funding levels plunged, they turned the spotlight on asset allocation.
In fact, many took a leaf out of the Yale Endowment book. At that time, this iconic investor had consistently notched up handsome double-digit returns since the early 1990s by making large allocations to alternative investments, and the urge to emulate it proved irresistible.
Between 2003 and 2007, allocations to alternatives increased from 5% to 23%. This happened at a time when their peak returns were history, and the wall of new money only served to dilute returns before the 2008 market crash took its own toll. The Yale model soon lost its star appeal, forcing yet more introspection within the pension landscape.
One positive outcome is the recognition that few investment ideas survive the period in which they are born. As the Federal Reserve has pumped more liquidity into the global system with every market downturn since ‘meltdown Monday’ in October 1987, conventional investment wisdom has been progressively sidelined.
The current quantitative easing programme is only the latest central bank action that has divorced market valuations from their fundamental drivers.
The hunt for alpha
Another positive outcome is the widespread realisation that asset allocation is not the sole driver of good returns. Pension plans are now paying just as much attention to two other areas to improve their investment performance – governance practices and execution capabilities.
Together, these three factors are deemed essential for generating alpha. Indeed, a closer examination of the Yale model has shown its success owed as much to nimble governance and savvy execution as it did to asset allocation. The three are inextricably linked within a mutually reinforcing cycle (see figure).
In particular, asset choices must be underpinned by a governance structure that has well defined goals, strong investment beliefs and clear delegated authority essential for dynamic investing. Effective execution also needs the right managers, investment vehicles, financial engineering tools (shorting, derivatives and leverage) and the right fee structures.
This is a far cry from the days when pension plans largely relied on a formulaic 60/40 equity-bond portfolio executed via a balanced fund. Mistakes on the governance or execution side can now easily nullify gains from the asset side.
Indeed, anecdotal evidence shows that a holistic approach is emerging as pension plans implement changes in their asset allocation by blending buy-and-hold and opportunistic investing; asset classes and risk factors; asset growth and liability matching; relative and absolute returns; traditional and smart beta; and financial assets and real assets.
This marks a significant change, but just as important is the growing recognition that asset allocation changes require major improvements in plan governance and execution capabilities. Neither this relationship nor the forces driving them have been studied, and examples of good practice are not documented. The world of investing post-2008 bears little resemblance to that caricatured in modern academic studies.
Three factors are driving up the importance of governance and execution:
- First, capital markets have entered an era of fatter tails and more frequent bubbles. The number of ‘3-sigma’ days has shot up from an average of one in the 1960s, three in the 1980s, 12 in the 2000s to 14 in this decade. This exponential growth is set to continue until the debt crisis is over.
- Second, pension plans no longer manage risk, they manage uncertainty. One relies on known probabilities of expected returns, the other on guesswork. For most pension plans, asset allocation has perforce moved from calendar time to real time as buy-and-hold strategies have weakened and excessive leverage has ramped up the correlation between historically lowly-correlated asset classes.
- Third, ageing demographics are altering investment priorities. High returns are not the only goal and other targets have emerged as the ‘baby boomers’ head towards retirement. Ever more pension strategies are seeking time-based diversification as they increasingly move to a negative cash-flow position during the run-off phase. Their asset mix is influenced far more by liability obligations than esoteric asset maximisation techniques.
Prof Amin Rajan is CEO of CREATE-Research
*Gary Brinson, Randolph Hood and Gilbert Beehower, ‘Determinants of Portfolio Performance’, Financial Analysts Journal, Vol. 42, No.4
Asset allocation change: rhetoric or reality?
That pension plans are no longer willing to put blind faith in asset allocation is not in question, and neither is there any doubt about progress in other areas, but hard evidence remains scant.
For example, commentators have written much about asset allocation based on risk factors, risk parity and smart beta. Yet little is known about how many pension plans have adopted these approaches, the implications on the governance and execution side and what lessons have been learnt.
Examples of good practice are few and far between, and it is hard to differentiate between the rhetoric and the reality of asset allocation changes.
IPE and CREATE-Research are teaming up for a survey of European pension plans that will aim to:
- Bridge the gaps in our knowledge of the emerging symbiotic approach;
- Provoke discussion and debate on its positive and negative aspects;
- Identify examples of good practice.
Can you help us by participating in the survey? For details, please email firstname.lastname@example.org