This concluding article on a new survey argues that pragmatism dominates asset allocation
While dancing on the rim of a smoldering volcano, today’s artificially inflated equity markets appear far removed from reality, as do the ultra-low-yield bond markets. Trading and investing look indistinguishable. Political, market and investor horizons are out of sync owing to historical shifts described in our first article (IPE, December 2017).
In such an environment, it is all too easy to get preoccupied with the here-and-now while missing the bigger picture. Our survey shows that pension investors are all too alert to this danger*. If anything, they are resorting to an unusual degree of common sense in the face of too many variables that do not lend themselves to any credible form of modelling.
“We have to invest in the markets as they are, not as we wish them to be”, said one respondent. They went on to say that what has worked in the past has little relevance in today’s surreal world of investing. It demands a reappraisal of the principles that have guided long-term investors in the past.
The emerging approach starts with the historical risk-return features of different asset classes and reconfigures them within a scenario analysis that considers the most likely macro economic outcomes. These range from the normalisation of the global economy to a prolonged secular stagnation. Under each scenario, the risks and returns for different asset classes are predicted before allocating assets.
The list of risks include liquidity, manager skill, political events, economic outlook, credit spreads, inflation and real interest rates. Return expectations associated with these risks are calculated for different scenarios before allocating assets, recognising that asset prices will continue to rise in steps and fall in escalators.
This means that the sequence of returns will be as important as their size. As more and more pension plans advance into run-off phase owing to ageing membership, they cannot afford a big hit to the portfolio that may take a long time to recover from.
This granularity supports the construction of a more pragmatic portfolio that could also benefit from a robust reappraisal of the time-honoured investment principles that have previously guided asset allocation (see figure).
At least 40% of our survey respondents elevated the role of the following principles:
- market timing is difficult (identified by 81% of respondents)
- diversification is essential (77%)
- risk generates returns (77%)
- buy-and-hold investing works (50%)
- markets revert to their mean (49%)
- asset valuations revert to their mean (47%)
- value investing works (44%)
- following the herd is inadvisable (41%).
These principles are inter-related. They convey four messages about pension investors’ view of the markets over the rest of this decade.
First, high volatility will be the norm. Timing the market will remain a fool’s errand. Few pension plans have the skills to engage in it. Depending upon how the political risks pan out, markets could be as volatile as they did during 2011-13, when the euro-zone crisis roiled them for extended periods and left them directionless.
Second, diversification will remain essential. The key will be to identify new risks and hedge them via a broad palette of assets. Pension plans are in the crosshairs. Ageing member demographics call for rapid de-risking. But, that is not viable as so many pension plans have funding deficits. The key difference from the past will be a shift from asset classes to risk factors, as ever more pension plans resort to risk factor investing. The way diversification – based on asset classes – has been implemented over the past 30 years has rarely been consistent with the objective of adding value because of the rising asset class correlations. Good returns were often more luck than judgement.
Third, asset class returns will remain volatile and unpredictable. Hence, investors have to increase their holding periods to allow risk premia to materialise. This argument in favour of longer holding periods is supported by the belief that mean reversion is not dead. It will continue to apply to both markets as well as asset classes. The MiFiD II regime will lend fresh impetus to long-term investing via total transparency around fees and charges.
Interestingly, high conviction investing is unlikely to command more attention from only 30% of our survey respondents. That is because asset class returns will remain volatile. Additionally, the rise of systematic strategies like smart beta and ETFs will attract fresh assets from active investing.
Finally, our overall results imply a changing emphasis on different principles rather than on radical departures, as implied by the ‘some extent’ scores in the figure. Even momentum investing, long frowned upon, will be favoured to some extent by 60% – when it is working.
While putting more emphasis on certain principles, pension plans have not closed the door on others. It is all a matter of horses for courses: whatever works in a dynamic environment at a time when there are no all-weather strategies.
*Back to Long-Term Investing in the Age of Geo-political Risk, available from email@example.com
Pascal Blanque is CIO of Amundi Asset Management and Amin Rajan is CEO of CREATE-Research
Case study: a Norwegian pension plan
“John Maynard Keynes is often quoted as saying “When facts change, I change my views. What do you do?” Experience over the past 20 years has forced us to do just that. But as pension investors, we have to remain invested.
The 2008 collapse devastated our portfolio. Since then, we have been trying to devise a strategy that can deliver decent returns over a longer period, while offering protection. We have learnt lessons that now influence our asset choices.
The key one is that the world of investment is best considered in terms of 10-20 year cycles. There is no ‘old normal’ and ‘new normal’: just different ‘normals’ for different phases. It is time to ditch the nostalgia about the ‘old normal’ that never was.
In this current phase, our investing is based on four core beliefs: diversification still works if based on risk, not asset classes; risk generates returns, if you are a buy-and-hold investor; markets revert to their mean; and a degree of opportunism is essential.”