The progressive move by pension funds from balanced to specialist management has been one of the dominant trends in the asset management industry over the past 10 years. The process, which began in the US, has extended to Europe and now seems irreversible.
The main reason for the move is that traditional balanced management offers too narrow a range of competencies. The consensus, backed by a growing body of research, is that no single investment manager can add value consistently across all asset classes and regions.
Yet to avoid future market shocks pension funds need to have well-diversified portfolios. The Myners report in the UK, notably, insisted that, “asset classes considered should include the full range of investment opportunities, not excluding private equity”.
The bear market also exposed the deficiencies of benchmark-driven investment strategies, and pension funds are now moving away from peer group benchmarks. Again this tallies with the Myners recommendation was that pension funds develop ‘fund-specific’ investment strategies. In other words, asset allocation should reflect the fund’s own characteristics, not the average of other funds.
So is balanced management dead? Not necessarily. In the past two years an undertow is detectable beneath the main flow from balanced to specialist mandates. Some consultants and asset managers say that it may be time to ‘re-invent’ balanced management.
The thinking behind this is that there is nothing in principle wrong with the idea of balanced management. It is simply that it has not been applied effectively.
Much of this thinking was revealed in the landmark long-term/ responsible investment mandate competition organised by the UK’s Universities Superannuation Scheme (USS) and consultant Hewitt Bacon and Woodrow. In particular, it revealed the need to take a longer-term approach to investment than traditional balanced management had taken in the past.
A blueprint of what a ‘new balanced’ mandate might look like was unrolled by Watson Wyatt in a research paper last year ‘Remapping our investment world’.
“The main problem with balanced was that the business subtly changed from one of absolute skill - using investment wisdom to generate absolute returns - to one of producing relative returns against a moving peer group target,” the authors observed. As a solution the paper proposed ‘re-inventing’ multi-asset management to encourage a return to the absolute return approach
In new balanced management managers would be able to exercise their skills to the full by exploiting investment opportunities outside traditional mandates. They would also be able to take positions in non-traditional asset classes and use modern investment management techniques such as derivatives.
New balanced managers would be set different performance objectives to avoid repeating the mistakes of their benchmark-driven predecessors. Managers would focus on absolute or liability-relative returns with targets of inflation plus X% or liabilities plus Y%.
The paper suggested that
three particular groups were equipped to implement a new multi-asset approach - asset allocators, existing multi-asset managers and in-house executives.
Asset allocators, such as macro hedge funds and asset managers offering global tactical asset allocation (GTAA) have the necessary asset allocation skills, while multi-asset investment managers have the stock selection skills. And in-house executives, such as the managers of the largest Dutch pension funds and the leading US endowment funds, have the total fund management skills.
However, the take up of the idea has been disappointing, says Jane Welsh, senior investment adviser at Watson Wyatt, who is currently researching the market for new multi-asset managers:
“There are a number of managers who are offering something along those lines, but the bottom line is that we’re a little disappointed with what’s out there at the moment.”
Multi-asset managers have not diversified their portfolios away from equities and bonds, she says. “In practice we’re not seeing very much of that. In many of the strategies we’ve researched the key decision is still equities versus bonds, They might throw a bit of something else, but they haven’t really captured this idea of a much broader range of asset classes. When it comes to actual asset allocation, it still in many cases looks like old fashioned balanced.”
Nor are managers widening their search for alpha. “Most of the products we looked at are very narrow because they’re restricted to the alpha strategies they have got in-house, the things they think they’re good at,” Welsh says.
“We would like to see more of an open architecture approach. If there’s something out there that’s really interesting – whether its hedge fund, emerging markets, private equity or whatever – then you should try to exploit that even if you don’t have it in-house.”
GTAA managers or macro hedge fund managers have made most of the running so far, she observes. “Multi-asset managers and in-house executives don’t seem to be stacking up against those.”
The problem is partly the deep disillusionment with traditional balanced management. “There’s still a lot of cynicism about balanced management generally among our clients, therefore there’s not a huge appetite for looking at new multi asset yet.”
On top of that, the features of new multi asset management – the amount of discretion given to the manager and the necessity for long mandates may have frightened off pension fund trustees.
Nicolas Moreau global chief executive officer of AXA Investment Managers says that the main requirements of new balanced management may be diametrically opposed to the objectives of pension fund managers.
“My understanding of new balanced is that it requires a very long-term time horizon and big freedom for the manager. This is absolutely the contrary of what the sponsor of a pension fund needs today.
“Today if you are a sponsor of a defined benefit plan what you want to do is close the gap between your liabilities and your assets. You want to have certainty on the returns, and you want to avoid having to put money back into the funds.”
Yet many of the ideas contained in the concept of ‘new balanced’ have widespread support in the investment community. Robert Hayes, the head of Merrill Lynch Investment Managers Strategic Advice Service, says that at its broadest, new balanced management is simply a call for more diversification, more flexibility and more active management.
“New balanced covers a multitude of sins. At one level it is no more than saying that historically pension funds have far too much of their return aspirations on a single bet of equities. In that context new balanced is all about managing the assets so as to have the maximum possible sources of return.
“It is re-inventing the wheel, but the wheel as it was 20 years ago, when there was genuinely discretionary active management,” he says.
“At another level, new balanced means looking at markets and trying to achieve levels of available return which are acceptable - not necessarily extraordinary - but which will meet liability requirements.”
MLIM has developed a product, which it calls Target Return Investing, which has many of the features of the new multi-asset model. The product is designed to maximise diversification across the widest range of assets possible. It is also designed to meet a target rather than maximise returns. This target can be set on a cash-plus, bond-plus basis or RPI-plus basis.
“The amount of return a client is looking for and the risk implicit in that return target are crucial in setting up the return mandate. That is totally different from historically balanced or GTAA mandates which have typically been about return maximisation,” says Hayes.
“Target return investment is all about being happy to leave something on the table if you achieve the level that you want and also being happy if you marginally underachieve the target. Again, this is a very different mindset from GTAA, which is generally a relative mindset.”
The polarisation of ‘traditional’ balanced and ‘new ‘ balanced management may do neither justice, however. It is possible for a traditional balanced manager, managing to a benchmark, to adopt some of the features of a ‘new balanced’ manager; in particular by diversification of asset classes.
Midas Capital Partners, a balanced asset management team, works to a range of traditional and absolute return benchmarks and has diversified into non-traditional asset classes and structured products. Midas was formed two years ago by the team who managed the £3bn Merseyside Pension Fund (MPF). Since then its pension fund performance has outperformed the benchmark returning 20.1% over the year to September 2004, compared with 11.1% for the WM 2000 benchmark putting it in the top 1% of the WM 2000 over this period.
The team developed a wide range of competencies at MPF. They began investing in hedge funds in the early 1990s and structured products in the late 1990s. It also ran a large venture capital portfolio and property portfolio.
David Thomas, head of business development at Midas, says the team has tried carry over lessons learned managing the Merseyside Pension Fund. “The approach has been very much one of engaging with new products and new ideas that came on the market, principally to enhance the level of diversification and to help control risk.”
Midas invests directly in domestic equity and fixed markets but chooses third party products for other asset classes. It also uses tactical asset allocation to add value where it can find it: “We have a core allocation to each asset class but we have quite a wide band around that, within which we are able to add value through tactical asset allocation,” says Thomas.
“We’re very firm about not going outside these bands, but we are given a degree of freedom which is perhaps unusual compared with what used to happen in the 1980s in the traditional balanced world.”
Diversification is a key feature of the process, says Thomas. “The traditional balanced mandate is equities, bonds and cash, and we would still have the equity and bond elements. But we’d start off from the assumption that an asset allocation mix can be put together from a much wider range of assets - equities, bonds, property, venture capital, alternative investments and structured products.”
Midas also makes use of structured products to enhance returns. “Over and above looking for ways of increasing the diversification in the funds, and keeping down the volatility, we’re also looking for ways to weight the odds in our favour by using structured products,” says Thomas.
“Some are offering an element of guarantees return over a given period, Some are enabling us to access the same underlying assets but through different products, often with the support of strong counter party balance sheets to add a further degree of security.
“So we get either a degree of either capital protection on the downside or a degree of effectively geared exposure to the stock market on the upside without us or our clients taking on the direct gearing risk.”
The lesson here may be that the investment managers do not need to re-invent the wheel but simply ensure that it continues to turn, efficiently and profitably.