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The yin and yang of asset allocation

In the third article in a series on a new study, Amin Rajan and Jim McCaughan show that clients are testing contrasting approaches

Risk failed to generate returns in the 2000s. The straw that broke the camel's back was when several well-known US money market funds ‘broke the buck' in 2008, with net asset values falling below one dollar.

For DB clients, a combination of persistent losses, covenant risk, an ageing population and onerous accounting rules have been forcing plan closures or restructuring throughout this decade, according to our latest global survey of 225 pension plans and asset managers in 30 countries.*

New mantra of DB plans
‘Core and explore' is the new mantra for institutional clients. Under it, pension plans are adopting an asset allocation approach with diametrically opposite aims:
• To focus the medium-term strategic asset allocation choices on transparent and liquid asset classes;
• To dabble in short-term opportunism with respect to distressed as well as mainstream asset classes.

The latter aim has gained traction as forced sellers and re-financiers have emerged in the distressed assets space, after the index on solvency margin fell off the cliff in 2008. Apart from growing opportunism, four other noteworthy points emerged from our survey results.

First, equities will make a comeback. The excess premium placed on transparency and liquidity is one factor. There is also the belief that they are under-valued, especially in the deep liquid markets of the US and Europe. Besides, DB plans' fling with alternatives has not paid off in this decade. Finally, mainstream asset classes are increasingly viewed as tactical plays.

Second, the bond markets will change. The seismic shift from investment banking to traditional banking will drive down demand for structured products and leveraged buy-out-financed debt, and drive up the proportion of debt issuance of governments or government-backed institutions at the expense of private sector issuance. This might reduce asset managers' ability to generate excess returns solely from active management of corporate bonds.

Third, liability-driven investment will gather momentum. The recent adoption of mark-to-market rules in the US is one factor. The other is the growing acceptance by DB plan sponsors that neither the mainstream nor the alternative asset classes can help them meet their long-term contractual liabilities. They have to sterilise as many unrewarded risks as possible. In order to cope with the counterparty risk post the collapse of Lehman Brothers, the next generation of LDI mandates will have two new features: more cash-based long duration mandates; and more inflation-linked assets that have the potential to hedge the inflation risk while providing a ‘return kicker'. Derivatives are not dead, as long as they are regulated and exchange traded. Any derivatives-based products will be subjected to worst-case scenario tests.

Fourth, private equity and hedge funds will morph under the weight of deleveraging now in progress. The decision by large buy-out houses earlier this year to return uncalled capital — ‘dry powder', worth $1trn — is symptomatic of the trend that is shrinking the industry on the one hand and taking it back to its roots on the other. Most institutional investment in the near term will focus on distressed sales in the secondary market. Similarly, only those hedge fund managers with the skills to play the volatility card without excess leverage will survive and thrive.

The morphing of DC plans
Worldwide, DC plans have been at the vanguard of the pension revolution since the early 1990s. In such countries as Australia, Canada, Ireland, Japan, the Netherlands, Switzerland, the UK and the US, their growth became pronounced with the continuing closure of conventional DB plans over time.

Alongside this restructuring, DC plans also received an organic fillip as such countries as Denmark, Germany, Finland, France, Poland and Sweden started new DC systems to relieve the pressures on state retirement systems in response to ageing populations. Unlike the first generation of plans, which relied solely on traditional equities and bonds, the second generation have relied also on insurance contracts to provide a significant measure of capital protection.

However, the 2007-08 financial tsunami hit all plans. Fear now seems to rule, with plan members often exhibiting a Wall Street version of the fight-or-flight mechanism: they were selling first and asking questions later, to the extent that major changes are likely in their asset choices.

Some 61% of respondents to our survey expected the emphasis on equities and bonds to continue worldwide, but with an enhanced advice infrastructure. Plan members in English-speaking countries — who make their own investment choices — are now engaging in serious dialogue with their managers about their investment options, contribution rates and retirement dates.

In continental countries, which have hitherto relied on deferred annuities, a serious re-examination is in progress in response to the counterparty risks associated with long-term swaps and options after the collapse of Lehman.

One idea being considered by their governments is to encourage DC plan members to invest in hedge funds as well as the safest asset classes, while extending retirement age. As a quid pro quo, the state will pick up the tail end liabilities beyond a certain age.
Thus, everywhere, buy-and-hold investments and tactical opportunism are emerging as strange bedfellows.

Prof. Amin Rajan is CEO of CREATE-Research and Jim McCaughan is CEO of Principal Global Investors

*Future of investment; the next move? Available to download for free from www.create-research.co.uk

 

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