In appointing an active manager to undertake the day to day investment management of a pension scheme’s assets, the trustees or sponsoring company will be taking on two types of risk.
First there is the risk that the asset manager will underperform their benchmark through poor stock selection decisions – namely that the shares of the companies chosen for the portfolio will collectively underperform the respective index. The second area of risk is whereby the asset manager implements short-term switches between asset classes or investment markets, to take advantage of perceived short-term pricing anomalies.
For example, an asset manager may favour equities rather than bonds for a given period and will consequently hold a greater proportion than that in the benchmark and outperform, should the view prove correct. This process is commonly referred to as short-term, or tactical, asset allocation. Until a few years ago, the majority of asset managers would aim to get approximately half their added value through stock selection and half through tactical asset allocation.
More recently however, the trend has been for asset managers to aim to add the majority of value through stock selection as opposed to tactical asset allocation. It is important to examine the reasons behind this trend because they may influence trustees or companies when establishing their investment arrangements for the pension scheme.
When building their investment portfolio, asset managers will typically select upwards of 50 shares and usually for a multi-country portfolio the number of stocks and shares held will run into three figures. Within the portfolio the asset manager will be running with a number of ideas and themes. In any one quarter, the manager will aim for enough of these themes or ideas to come through in order that the portfolio outperforms. In reality, a pension scheme’s asset manager will probably achieve the outperformance target if more than 55% to 60% of the portfolio holdings prove beneficial. Therefore, most importantly in any one quarter, it is unnecessary for all the ideas to come to fruition. Consequently, the asset manager is able to invest in stocks ahead of the market and wait for performance to come through.
The situation for tactical asset allocation, however, is very different. An asset manager will take around half a dozen positions and of these, only a couple are likely to have any significant strength of conviction. Given the limited number of positions being implemented, their impact can be disproportionately large. In particular, timing becomes a key factor. Hence, it is no longer satisfactory for the asset manager to implement a decision and then have to wait a long time before it bears fruit. Perhaps partly due to this, historically asset managers have had difficulty in successfully implementing tactical asset allocation policies, with the majority of managers actually detracting rather than adding value.
Further complications are likely to arise, given potential significant changes to benchmarks currently being discussed. In particular, it is being considered whether to introduce a separate index monitoring the performance of global or multinational companies, which have dominated the movement in stock markets throughout the world in recent years.
Furthermore, many asset managers are currently restructuring the processes by which they research stocks, with a significant move towards research being undertaken by teams focusing on sectors across borders rather than with a country or regional based approach. It remains to be seen, therefore, whether under such revised arrangements, tactical asset allocation could return to favour. At this juncture, it seems unlikely.
We are, therefore, seeing many trustees and companies arranging their investment polices so that any active decisions taken by asset managers revolve around stock selection rather than tactical asset allocation.
In this type of arrangement, when the allocation to markets moves out of line with the benchmark (due to relative market or asset class movements) by greater than predetermined limits, monies may be reallocated to rebalance back to the underlying long-term benchmark.
Proponents of this type of rebalancing approach argue that it has the inherent benefit of disinvesting from markets that have just outperformed and reinvesting into markets that have recently underperformed. Clearly however, it has the potential of continually moving monies into a market that is perpetually underperforming and that faced some criticism during the significant falls in the Pacific Rim markets a couple of years ago.
Another option is to appoint a specialist manager with the sole remit of undertaking the tactical asset allocation role. Quantitative investment houses often specialise in this area and implement their decisions having modelled technical factors, rather than adopting a fundamental qualitative approach. The difficulty here is to be able to assess fully such managers’ capabilities given this type of “black box” approach.
We would always urge trustees and companies, when formulating their investment policies, to focus on the areas where they have the greatest likelihood of achieving an outperforming structure. For the above reasons, we believe these arrangements are most likely to place emphasis on the asset managers adding value through stock selection and not tactical asset allocation.
Adrian Swales is principal and actuary at Aon Investment Consulting in Leeds

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