In September this year, JPMorgan Fleming AM published a fascinating research report entitled New Sources of Return, a survey into the usage and understanding of the newer generation of investment ideas designed to enhance investment returns across Europe’s institutional investors.
The report looked at the extent to which institutional investors (or at least 193 of them) across continental Europe (they excluded the UK from the survey for some reason) were (as at May/
June this year) considering new investment strategies such as portable alpha, absolute-return strategies and tactical asset allocation overlay.
The report also looked at future expectations
of returns; trends in asset allocation; passive versus active equity management; how institutions measure performance and the institutions use of derivatives and leverage.
I don’t have the room to consider most of findings but a few things do stand out. For example, while 49% of European institutions already employed absolute-return approaches in their portfolio, only 27% of respondents said they measured the progress of their asset performance against their liabilities. I thought this was an interesting statistic in its own right but I was amazed to see that only 15% of Dutch pension funds owned up to using a liability-based benchmark. Clearly there is a lot of work to do in this area but I sense it won’t be long before just about all funds have to benchmark performance against liabilities. Certainly, regulators and international accounting standards are pushing this way.
Interestingly, while the difficulties of achieving a high enough return on assets is a European wide problem, the proposed solutions are not. The report indicates that although markets such as the Netherlands and the Nordic rgion appear to be eager to adopt new instruments and new strategies, others such as Switzerland, apparently retain much more conviction in existing, more conservative approaches to asset management; and I am sure we would have seen even more country differences had the UK been included in the survey. Maybe Swiss funds feel that their existing move into hedge funds is enough of a move to new strategies.

I found it fascinating that so many institutions (81%) seemed willing to consider tactical asset allocation (TAA) as the most likely source of additional return. I well remember the UK pension funds that adopted TAA mandates in the 1980s and early 1990s were very distinctly under-whelmed by the results. However, there is no doubting the importance of correct strategic asset allocation and the relatively new science of global tactical asset allocation seems to be producing some impressive returns. I suspect there are fewer good tactical asset allocators than the market requires. Many funds are going to end up being very disappointed.
I was particularly amused by the apparently big contrast between European pension fund return expectations of 6% annually as shown in this report and the future return assumptions of US pension funds of 8.5% annually as reported in a Financial Analysts Journal study conducted by Robert Arnott. Even allowing for changes in currency valuations (which are apparently going the other way anyway) this difference simply cannot be justified.
Indeed, Arnott has found that, stripping out valuation effects, the rolling 10-year equity return (measured from the year 1871) averaged 5.7%, with a standard deviation of only 1.3%. Given that bonds and other lower yielding assets exceed equity holdings even Europe’s 6% annually return assumption, sounds rather too optimistic in today’s low inflation economy.

N ow, if the US assumption is as silly as it looks (or in the words of Warren Buffett “heroic”) then the outlook for the US equity market (and almost by definition the rest of world’s developed equity markets) is very poor. As pointed out by the Financial Times’ Philip Cogan: “The inevitable consequence is that companies will have to increase their pension contributions, eating into profits and thus potentially hurting the stock market.”
I believe this may well be a dramatic understatement of the obvious as many commentators still believe the US stockmarket may well be overvalued by up to 40% anyway, so the effect of long-term profit reductions may well see a serious stockmarket slump. I do hope pension funds have better risk control measures in place than they did in 1999, thanks goodness most funds are not all as exposed to equities as they were then.
Obviously, history might not be repeated and pension funds might well achieve the returns they desire, but the chances of failure seem rather too high to me. At the end of the day, I still think we are going to have to accept the fact that we all need to either pay much more into our pension funds or reduce our expectations as to the benefits we can afford to pay future pensioners. Either solution is going to be very painful and the longer it is delayed the more expensive it will be!

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