Their cups runneth over
The institutional market in the US has grown from a relatively small pool of assets to a dominant source of assets in today’s investment environment. As shown in Figure 1, pension assets have soared from $459bn (e490bn) in 1980 to over $6trn in total assets today. As a percentage of the total, public plan assets have increased from 36% in 1980 to 40% in 2000.
Asset allocation trends
Trends in asset allocation have been distinct and long lasting. We examine below historical trends and where the industry is heading, based on the current market environment and other important factors driving the asset allocation process.
q Current market environment Over the past two decades, the US has enjoyed a reasonably strong economy, supported by a secular decline in inflation and interest rates. Equity investors were rewarded as the US stock market recognised fundamental changes within corporate America. Investors forecast a strong economy, low interest rates, high productivity gains and, most importantly, strong corporate earnings growth. Given these expectations, we see high market risk and little room for disappointment, particularly in America’s largest and fastest-growing companies. More than ever, public fund sponsors need to expand their investments beyond the highly priced US equities.
q Historical allocation trends Figure 2 illustrates the upward trend in equity allocations over the past 15 years. Higher equity exposure (US and non-US) has come at the expense of fixed income allocations but more notably from the decline in balanced mandates that have all but disappeared from defined benefit pension plans. Currently, the median US equity allocation of public plans that we monitor is just under 50%, but aggressive funds with proactive staffs have 60–70% in diversified equity.
After two decades of strong investment performance, public funds have improved their financial condition. In many plans, current assets now match or exceed long-term pension liabilities. Some city, county and state governments have, therefore, been able to reduce their ongoing plan contributions. These plans now face the decision of whether to grow the surplus further with current equity exposure or to protect the surplus by shifting into a strategy with greater exposure to less risky fixed income. Thus far, most plans in this position appear to favour maintaining equity exposure at current levels.
q Risk management Public plans have also shown increased focus on risk management. Also referred to as risk budgeting, risk management is an allocation of risk relative to a liability structure. The fund sponsor’s risk management process takes pension risks (eg, increases in contribution levels, increases in expense levels, and decreases in funded ratios) as inputs to both determine an optimal asset mix and monitor the performance of a pension fund.
Whether or not fund sponsors devote dedicated resources to developing a risk management programme, most are spending increased time on risk. As previously mentioned, fund sponsors have seen a significant run-up in funded status over the past five years. As such, they are very interested in remaining fully funded and are seeking ways to minimise the chance of becoming underfunded and to minimise the need for future contributions (public plans). Traditional risk management techniques such as diversification guideline reviews and enhanced security oversight are very popular.
Manager structure issues
This section presents trends in investment manager structure, or the allocation to assets within broad asset classes.
q US equity The most predominant trend in the equity arena has been an increase in benchmark orientation or awareness in the large cap space. Much of the fund sponsor focus has shifted from an absolute to a relative return orientation, where risk, historically measured in terms of volatility or standard deviation, is now defined relative to the benchmark (eg, tracking error). The key drivers of this trend have been superior market performance and a greater acceptance of the market’s efficiency.
Large cap managers have experienced a particularly difficult environment, struggling to beat the market, as most indices have been increasingly driven by a few large cap growth stocks. Underperformance has been painful for fund sponsors, as it has occurred in the core portion of their equity portfolios. This problem has been further exacerbated by the spread of performance between large cap growth and large cap value managers.
In many cases, sponsors have responded by indexing some or all of this portion of the portfolio or moving towards portfolios that are structured to closely match the characteristics and volatility of the market while still offering some upside. These structured products have, in many cases, replaced the market’s demand for traditional large cap management focused on total return.
Sponsors continue to diversify US equity structures by style and capitalisation. While demand for small cap strategies remains strong, there is limited, although increasing, demand for mid cap strategies. In many cases, too much overlap is perceived between large and mid cap and between mid cap and small cap. However, larger public plans have shown interest in small/mid strategies to mitigate capacity constraints they run into with pure small cap mandates.
q Fixed income The most notable trend within fixed income manager structures has been the increased use of ‘core plus’ to complement or replace core mandates. In general, public plans have been active in expanding their guidelines to include below investment grade and non-US securities included in core plus mandates. Fund sponsors are increasingly using these strategies to capture better the fixed income opportunity set and/or to opportunistically allocate to higher yielding bond sectors.
The use of specialty products within fixed income structures has generally been limited to large plans. Large plans with sufficient dedicated investment staff often manage a portion of the fixed income assets internally in a passive and/or core style. This is particularly common among large public plans. These plans will typically break out the high yield and non-dollar segments, outsourcing these mandates to external managers to tap into specific areas of investment manager expertise.
Non-US equity When first implemented in the late 1980s and early 1990s, non-US equity structures were often built around regional allocations to offset active managers’ proclivity to underweight Japan. Over the more recent five-year experience, in which the Pacific region underperformed Europe and many regional managers in Europe underperformed their index, many public plans have moved away from the regional approach previously used in favour of broad-based EAFE strategies. Many of these same plans have also moved away from a dedicated emerging market specialist following the Mexican peso and Asian crises.
Similar to the fixed income arena, non-US equity structures today combine core and ‘core plus’ mandates. While core plus within the international arena is not well defined, it generally indicates the opportunistic use of emerging markets, a concentration of holdings, style extremity, or some other form of deviation from the benchmark.
Finally, style and capitalisation are factors included in non-US equity structure decisions but are not as predominant or well defined as in the US equity arena. There has been increased interest in style investing outside the US over the past few years but it has not translated into significant search activity. Likewise, there is some interest in small cap international from an academic perspective but little interest from a search standpoint.
q Alternative investments Public plans have used private equity to implement an alternative investments strategy. Larger funds will have a separate account approach using a gatekeeper to identify limited partnerships in the major corporate finance strategies (eg, venture capital, buyouts, special situations, subordinated debt and distressed debt). Smaller funds (ie, with allocations of less than $100m) have become active in private equity by using commingled fund of fund vehicles.
Outside of private equity, there is very little activity in other areas (eg, hedge funds, managed futures). There is periodic interest in timber as an income-producing asset.
Real estate Public funds have been active in real estate for many years. While some plans were reluctant to invest early on due to decreasing property values in the late 1980s, there has been renewed interest in the asset class following the more than seven-year recovery. Plans are now more comfortable with the perceived stable property values. Additionally, the asset class has matured providing increased transparency and improved information to its investors.
Most plans will invest 70–80% of the real estate exposure in core properties geared towards income generation. The remainder is typically invested in specialised properties (value-added or opportunistic), focused more on appreciation.
Inga Sweet and James McKee are vice presidents with Callan Associates