It's a question of returns
There is some acceptance among pension funds in Europe that tactical asset allocation (TAA) – today’s version of it, at least – can top up their investment returns. But it is only in the Netherlands that TAA is widely used and spoken about.
TAA, which can either be done by the in-house investment team or outsourced to one of the specialist managers, involves giving a little leeway to strategic asset allocation. That leeway is used to increase returns by making short-term investment moves. Tactically, a fund’s exposure to attractively priced markets is increased, while its exposure to expensive markets is reduced.
TAA can take the form of an overlay over the whole fund, or as a stand-alone investment fund.
The Blue Sky Group, which manages the KLM pension fund in the Netherlands, redesigned its investment process five years ago, and decided that its internal TAA should be part of the process, says Justus van Halewijn, head of investment strategy research.
“It’s attractive to add some extra return while the risk is very low correlated to the other risks,” he says.
Since then, the management group has not been unhappy with the results. But they were not easy to obtain, Halewijn points out. “It’s about alpha and you need to have skill to obtain this alpha,” he says. The management team scored very well on the sub-categories within equities – Europe, US both small and large caps, Japan and UK, and fixed income – inflation-linked bonds, emerging market debt, high yield, corporates and government bonds, he says.
“Asset allocation itself – equities versus bonds versus cash versus real estate – was much more difficult for us and very hard to reach some extra returns here,” says Halewijn. “At Blue Sky Group we have a TAA team of four people who dedicate a serious amount of time to TAA. We developed some models, did a lot of research on this topic.”
That, he says, is the choice you have to make with this investment type. You can’t do it a little bit,
“Another advantage of doing TAA internally is that we now have good knowledge of what’s going on in the short term in the financial markets,” he says. “We need that also for our long-term expectations for the different asset classes.” For example, if you want to say something about the long-term expected return on equities, you need to know what the current valuations are of equities compared to the long-term average valuation.
Although TAA is currently
being managed in-house, Blue Sky is considering outsourcing.
In terms of risk, Halewijn says all the risk of its TAA bets is part of the total risk budget. “This budget limits the active risk we are allowed to take,” he says. The overall active risk – TAA plus active managers – has a very low correlation with the strategic risk, so the final impact on the total risk profile of the pension funds is really very limited.
“So this makes it attractive to take active risk. Again, we don’t have high expectations to add huge alpha because it’s a skill game but we think that to add some small alpha every year is a good thing for the pension funds in the long rub.”
While TAA can be deployed by a pension fund as a stand-alone fund or as an overlay, some pension funds make use of both methods. Dutch pension fund ABP carries out TAA internally in overlay, as part of its central asset allocation process, and also via
several decentralised hedge fund mandates. These are managed both externally and internally, the
Central TAA, says ABP, has always been a part of the pension fund’s asset management business, and it has been using TAA types of hedge fund strategies since 1997.
While strategic asset allocation (SAA) is reviewed once every three years, the centrally managed TAA active positions are reviewed monthly. However, not much in the way of changes are made to the active positions from month to month. Michel Meijs of ABP says the fund emphasises consistency, and avoids the psychology of the moment.
TAA can add value, says ABP. But it is hard to outperform the long-term strategic benchmark consistently, because the markets concerned are highly efficient. The key, says Meijs – unless an investor has specific skills – is to look at the fundamentals, to be consistent and patient. In the short term, asset returns are unpredictable, so
short-term oriented TAA is senseless, he says.
ABP aims to produce an additional return of between five and 10 basis points per year through its central TAA.
The ING corporate pension fund uses TAA, participating in the TAA programme of ING Investment Management. At ING, TAA decisions are the result of a disciplined process in which the team compares the current and expected relative attractiveness of equities and bonds, with the aim of adding value by adjusting the allocation to each of these asset classes.
Empirical research has shown that TAA can be a significant source of added value, says the ING pension fund, particularly for longer-term investors. The fund targets an information ratio of 0.25 on rolling three-year periods, and the alpha objective is between 10 and 15 basis points a year.
Dutch fund Pensionsfonds Horeca & Catering, makes adjustments to its SAA within 10% bands through a TAA strategy. The fund describes the strategy as one of “smart passive rebalancing” which is handled internally.
The TAA is based on information received from its managers. On the basis of this, it allocates the new inflows to the fund to the different managers, and in some instances moves assets from some classes to others, taking a three- to six-month view. Allocations are to be reviewed on a monthly basis, with any changes made quarterly. But it all depends on the strength of cash flows.