With markets as turbulent as they have been – and with few signs that volatility is set to decrease any time soon – the question of risk within investment portfolios is foremost in the minds of many pension fund managers.
Typically, the focus on managing risk – particularly in volatile markets – has taken place at the level of tactical asset allocation. But in volatile markets, risk management becomes more complex. Advisers say that a more sophisticated approach to risk management should be taken at the strategic level, tactical asset allocation should become more dynamic – and, some argue, the whole approach to the latter should be reconsidered.
At the strategic level, the message from Sri Moorthy, a London-based vice president at State Street Associates (SSA), is that trustees have to consider both volatile and quiet markets, and changing correlations between asset classes, when deciding on asset allocation.
The problem for trustees is that decisions on strategic asset allocation can be overly influenced by the historical market data that goes into the models – either exaggerating or underestimating the volatility a portfolio is likely to face. And as portfolios will encounter both ‘quiet’ or ‘volatile’ periods over a longer-term investment horizon, overemphasising either can be inappropriate.
One answer, he suggests, is creating one portfolio that assumes volatile market conditions, and another ‘satellite’ portfolio – of anything between 1-2% and 10% of the total assets – predicted on relatively ‘normal’ market conditions. The former portfolio might be weighted 70:30 bonds to equities, with the latter weighted 30:70 to deliver outperformance against an overall low-risk asset allocation strategy.
But with most strategies set, largely, in stone, most investment managers have to rely on tactic asset allocation to attempt to reduce risk, or enhance returns, in volatile market conditions.
Institutional investors have long shied-away from using derivatives, either because they are explicitly banned from so doing, or because they are perceived to be high-risk instruments. However, they can prove to be an efficient – and low-risk – means to alter short-term asset allocation, either to manage risk or manage cashflows. And some fund managers are also turning to them to provide downside protection for the their portfolios (see box).
At the most basic level, derivatives can be employed to manage cashflows into a fund. Buying an equity index future can provide instant exposure to a stock market, either while the physical stocks are bought over a period of time, or until sufficient cash is accumulated to make cost-effective equity purchases.
They can also be used to alter asset allocation more efficiently than in the cash markets.
“Traditionally, asset allocation involves shifting between pools of money. This can be expensive, very disruptive to the underlying portfolio, and it can take up to a week to implement the asset allocation shift,” says Adam Seitchik, chief global strategist at Deutsche Asset Management in London.
He gives the example of a client with a long-term allocation of 40% in UK equities, and 2% in Asia-Pacific stocks. To overweight the Asia-Pacific portfolio to 2.5% would involve selling a slew of individual stocks, or executing a programme trade, as well as presenting the Asian manager with the challenge of substantially increasing the size of his or her portfolio.
“Transaction costs for the UK fund manager can be 25-30 basis points each way in the physical stocks, and the Asian manager could find themselves holding large amounts of cash that needs to be quickly invested in shares,” he adds.
Using exchange-traded equity index futures, however, significantly speeds up the process – and cuts costs. Positions can be put on almost instantly and, he says, to sell and buy back £1m (E1.57m) of UK equities costs as little as £200 using FTSE 100 futures listed on the Liffe derivatives exchange, as opposed to as much as £7,000 in the physical.
Deutsche has taken a more radical approach, however, to the use of derivatives in tactical asset allocation. Last summer, it created two new funds – its Equity Asset Allocation and Balanced Asset Allocation Funds – to more efficiently manage asset allocation for its balanced fund clients, using derivatives.
An investor would typically place, say, 97% of their assets against their benchmark, with the remaining 3% in one of the allocation funds. Deutsche is now telling balanced clients that they will no longer carry out traditional asset allocation – investors have to choose between neutral investment policies, or placing some of their assets in one of the two funds. Seitchik says that they’ve started offering clients the option this quarter, and has placed client money in the two funds, but declines to disclose how much.
He says “there are no fee implications” of the move, and that it increases transparency and Deutsche’s risk management, as all tactical asset allocation decisions now relate to just the two allocation funds. He adds that, while explaining the funds’ use of derivatives involves considerable work with clients, they can be reassured that they use only exchange-traded contracts, with no net leverage.
Other specialists, however, argue that the market’s general approach to risk in tactical asset allocation is fundamentally wrong-headed. Kerrin Rosenberg, is a London-based associate in the investment practice of consultancy and actuary Hewitt Bacon and Woodrow. He says that the problem is the emphasis on managing risk in relation to the tracking error against a predefined index. “If a UK equities fund manager zero-weights Vodafone, he might be running a relatively_high 3% tracking error. That’s bizarre – because not holding Vodafone may be less risky than holding it. The real risk may be that the Korean stock market goes through the roof.
“Lots of trustees only worry about this type of tracking-error risk. At the end of the day, the risk that trustees are running is against the fund’s liabilities,” he says. “They should think about absolute, rather than relative, risks.”
Rosenberg concedes that a shift away from index-tracking will require a radical change in how institutional investors monitor risk, and measure performance. “But we have to be willing to change the rules of engagement – we can’t hold managers to falling indexes,” he says.
Andrew Dyson, head of institutional marketing for Europe at Merrill Lynch Investment management, takes a similar view: “There’s a potential weakness if you compartmentalise things too much – you can lose sight of the bigger picture.”
Appointing a number of fund managers with very limited terms of reference can reduce the potential for the fund to benefit from opportunities between asset classes – thus increasing the risk a portfolio faces. “A number of funds are looking at ways to draw back from excessive specialisation, and creating mandates spread across asset classes, looking at absolute returns.”
He gives an example of a mandate with a long-term allocation in UK corporate bonds. Because of the current valuation of these assets, a more appropriate allocation would currently be to place 80% of the assets in UK Gilts, with the remainder in property or UK equities, he says. “Because corporate bonds’ valuations are currently looking very stretched, this allocation would benefit from lower downside risk.”
There is little doubt traditional approaches to tactical asset allocation need to be re-thought – closely tracking a falling benchmark clearly creates little value for beneficiaries. Whether fund managers will embrace a more holistic, absolute return-orientated approach remains to be seen.