Ireland: Fixing a broken model
The era of the traditonal managed fund is over, writes David O'Connor
Managed funds have dominated pension fund investment in Ireland for over 20 years. The concept was an appealing one: an investment manager would allocate between equities, bonds and properties, offering diversification and professional oversight. Managed funds fell into two classes: active, where the manager made decisions on how much to allocate to the three asset classes based on their medium term asset allocation views, and passive, where the manager would allocate according to the average allocation of the peer group. The attraction of passive funds was that allocation represented the consensus view of the active managers; indeed the term ‘consensus' has been adopted as a generic term for such funds.
Investors naturally expected active managers to adjust their funds' allocations based on their views and expectations, responding dynamically to the market. However, over the last several years, a debate has ensued over how ‘active' the active managed funds turned out to be in practice. This was on the basis that very few varied their asset allocation significantly from the peer group average. For example, the vast majority of managed funds had an equity weight between 75% and 80% just prior to the credit crunch.
In addition, it seemed odd that in all but one of the active managed funds the Irish equity market - a small and concentrated market that comprised 1% of the global index - comprised between 17% and 22% of the total just before the market began its descent into oblivion. Similarly in more than half of funds, Irish property had crept up over the 5% mark in spite of the obvious unsustainability of Irish property performance (as cited in Hewitt inVision Q4 2007). If these funds were truly active, why was there such similarity in the asset allocations of the different funds? Accordingly employers, trustees and members have understandably been asking what the definition of ‘active' is.
The investment management community has often pointed to peer group surveys as the reason for unwillingness to actively manage their funds. They have argued that if they are to be judged each quarter by their standing in the survey, they cannot accept the business risk associated with deviating from the average, and potentially underperforming that average. Therefore, the unique asset allocation of the Irish managed fund, with its historical bias to Irish equities and property, remained fairly static without justification solely because few managers found differentiation palatable. Any major shifts in allocation were predominantly due to market movements rather than active allocation.
Following the fall in values in 2008, the competitive risk of underperforming a benchmark has diminished as investors focus more heavily on absolute rather than relative returns. A number of investment managers have created new products that differ significantly from the traditional managed fund. In many cases these have superior risk/return profiles and are better diversified than their managed fund counterparts.
In addition, a number of these new funds are truly active in their asset allocation, and offer better protection to investors on the downside. It is our strong view that these funds are better alternatives to managed funds and should be considered for any investors seeking long term real returns either for DB Schemes and also as an offering (or even the default) of a DC Scheme.
Diversification is not a new investment concept. The practice of reducing exposure to any one area is a widespread feature of portfolio construction and indeed was the rationale behind the development of managed funds in the first place. However, in recent years the scope of diversification opportunities has grown dramatically, as well as the need.
Previously, a portfolio was considered well diversified if it contained equities across different regions and sectors. However, as large-cap stocks across global equity markets demonstrate increasing levels of correlation, it is necessary to find other assets that can reduce the overall volatility of the portfolio and potentially offer excess return. New asset classes offer the potential to diversify a portfolio beyond traditional means. To optimise portfolios, investment managers are turning to alternative assets with low correlation to the existing portfolio, reducing the overall volatility. In other words, the return is delivered in a very different pattern to that of the traditional assets.
The spectrum of asset classes available to investors has broadened greatly in the last number of years. Many alternative assets, which had been seen as too illiquid or cumbersome to be of interest to any but the largest of funds, are accessible thanks to the growth and development of the derivatives and indexed markets. Investment opportunities such as commodities (including oil, gold and agricultural goods), emerging markets, hedge funds, infrastructure, active currency and private equity are just some of the options available to investors.
The graph illustrates performance of various asset classes against their correlation with
equities. The lower the correlation, the greater the diversification benefit. Any correlation of 0.5 or less will provide significant diversification benefits when combined with equities. The graph shows that many any of the alternative assets offer low correlations with the
global equity index. As such they would act as good diversifiers by reducing the overall volatility of the portfolio.
Indeed, over the past five years, assets such as gold, active currency and agricultural commodities would have offered both volatility benefits and returns in excess of equities. Other assets, such as emerging market equities, are highly correlated with global equities but offer excess returns compared to equities. The appropriate combination of these assets with equities and government bonds should provide a more efficient portfolio, offering an improved risk/return profile.
Investors looking to take advantage of these diversification benefits could construct a portfolio using a range of products that offer exposure to these asset classes. Alternatively, there are a growing number of diversified funds where investment managers combine traditional equity and bond funds with alternative assets to reduce the overall volatility of a fund while aiming to offer consistent long-term returns.
Undoubtedly, there is more to selecting a quality fund than simply choosing the one with the highest historical return, the lowest risk or even both. Detailed qualitative evaluation is as important as quantitative evaluation, particularly where trustees are considering one of the newer funds which, in some cases, are much more complicated than traditional funds. Trustees will need to be comfortable with any fund they choose. But one thing is clear - investors have never had so much choice. The era of the managed fund is well and truly over.
David O'Connor is a consultant at Aon Hewitt in Dublin