By now, balanced management was expected to be extinct, having had its demise predicted several years ago. The poor returns of balanced pooled funds during the recent bear market, especially in 2002, seemed destined to hammer the last nail in the coffin. Yet as some managers lose multi-asset briefs - mainly to specialist managers - others are picking them up. What is going on here?
Multi-asset management is being reinvented. Whereas the old-style balance was essentially a market-timing approach between equities, cash and bonds, the new strategy draws on a wide variety of asset classes, including many that are non-traditional. And unlike ‘old’ balanced, the new multi-asset approach gives a manager greater freedom to make meaningful bets against a customised or absolute-return type of benchmark.
Yet while demand grows from pension funds for their managers to take on more asset allocation responsibility, progress in this area has been slow. The handful of pension funds that have so far ventured into ‘new’ multi-asset territory have allocated a small part of their portfolio as a diversifier.
A ‘next generation’ model
Traditional balanced management has been falling from grace for some time in Europe’s most sophisticated pension markets. However, it is still
the strategy of choice for many smaller funds, and in smaller European markets such as Spain, where regulations
allowing only one external manager have deterred the use of specialists.
Last year, our firm was involved in just five active multi-asset manager appointments for UK pension funds, down from 36 in 1998. The UK experience differs from that of continental European pension funds in several ways, the most important being its focus on peer group measurement. This more than anything else dealt a mortal blow to ‘old’ balanced in the UK, because it led managers to take positions relative to their competitors, and short-term thinking became rife.
The other major drawback is common to all European markets – ‘old’ balanced with its limited number of asset classes offers too few bets to be a good way of making money. Coupled with this basic problem, markets in the 1980s and 1990s were a one-way bet and asset allocation was not the place to reap big rewards.
Changed conditions for pension funds are the key driver of demand for multi-asset management. At a time when pension liabilities are changing rapidly, pension funds realise that a static asset allocation is not enough. Increasingly, they are looking to make medium-term adjustments to their long-term strategic framework, and are asking their consultants and managers for asset allocation advice. Also, in markets that are heading sideways rather than skywards, asset allocation as a strategy looks a lot more interesting than it did.
Several other trends are emerging in support of this mindset. Pension funds are looking to diversify their portfolios among multiple sources of risk - including property, private equity and emerging markets - and do not necessarily want the trouble and expense of hiring a whole raft of managers.
Pension funds are also shunning short-term thinking and returning to longer-term investment horizons. This attitude lends itself to greater diversification (more in less liquid or unlisted assets) as part of a multi-asset strategy. Finally, funds are looking to exploit manager skills to add alpha, and giving them more flexibility to allocate assets is one way of doing this.
Finding the right skills
It would be misleading to think of the ‘new’ multi-asset approach as a neatly defined, off-the-shelf product. There are many different approaches, which depend on the type of manager implementing the strategy and also how much freedom the client allows.
Setting a performance target of inflation or liabilities, plus an extra percentage gain, reinforces the message that managers are free to use their skill wherever they see the best opportunities. In Continental Europe, where absolute return is part of the investment culture, some big funds are starting to use customised benchmarks, including hedge funds and property.
These targets also lend themselves to a multi-asset approach as long as managers are not bound by tight tracking error restrictions. Some Swiss funds are looking to loosen tracking error limits and give their balanced managers more freedom to take active bets between currencies as well as asset classes.
In practice, we see three types of manager qualified to offer multi-asset mandates. The first two fall into the asset allocator camp: these are macro hedge funds and global tactical asset allocation (GTAA) managers. Hedge funds are experienced in scouring the world for the best opportunities in a wide range of instruments, but charge high fees and are not generally considered friendly to institutions.
GTAA managers offer more breadth in markets and currencies than old-style TAA, and can almost be thought of as a type of macro hedge fund, except that they are typically subject to more restrictions. On the plus side, their fees are lower and they are used to dealing with institutional investors.
The third group are the multi-asset managers, which are usually larger global firms. These far outnumber macro hedge or TAA managers, and tend to base their bets on longer-term valuation trends rather than shorter-term trading opportunities. The drawback is that their skills are generally in stock selection, in separate specialist areas. There is a question mark over their ability to allocate between these areas, though a small number of managers does have this skill.
This brings us to the chief drawback of new approach - the shortage of managers that are either able or willing to take on such mandates. This is work in progress for our manager research team and so far we have turned up a small number of interesting propositions.
Another problem is the difficulty of distinguishing between flexible allocation (which is appropriate to the strategy) and market timing (which may not be). It is important to set some form of risk budget for the mandate to discourage managers from trying to meet their targets by taking outsize risks. Clearly, returns will be ‘lumpy’ relative to the performance target, so it may take time before any meaningful measure of success emerges.
But despite the problems, and the lack of ‘live’ experience, we see ‘new’ multi-asset management as one solution to the problems of short-termism and a lack of diversity in pension portfolios. Giving managers broader freedom to roam across more asset classes and types of securities makes sense in many ways.