Market cycles must be managed dynamically and liabilities kept under control, says Paul Kemmer

“For every complex problem, there’s a solution that’s neat, elegant and wrong,” as HL Mencken is supposed to have said. For years, investors and advisers have relied on neat and elegant models of volatility and returns to make projections and design portfolios. But recent painful experience has led many pension funds to question these models. Markets and economies are complex things, not given to simplistic modelling. 

Diversification as a means of improving risk-adjusted returns is the first lesson of investment management. But over the past year, diversification alone has not appeared to work very well as asset prices have become more correlated. Will it work in the future and, if so, is it enough? 

As the liquidity crunch unfolded over the course of 2008, many investors were forced to sell assets to meet liquidity demands. This selling pressure affected all liquid assets regardless of their medium or long-term return prospects. The pervasive effects of this liquidity squeeze meant that asset prices moved downwards together in a highly correlated manner. 

But the liquidity squeeze will pass. Historically, there have been periods where correlation has increased, particularly within asset classes, but trends in correlation tend to stop or reverse in unpredictable ways. Despite occasional bouts of high correlation - remember 2002? - diversification has proven to be a powerful tool and will continue to improve investors’ risk and return profile over the long term.

Surveys and reports from the UK’s National Association of Pension Funds and Pension Protection Fund confirm that many pension schemes have endorsed the notion of diversification. But the effort to diversify has been marginal. Most schemes, despite the trauma of the liquidity crunch, maintain a rigid asset allocation stra tegy. The traditional approach is that you have a long-term strategy and you should stick with it. Sounds sensible, doesn’t it? 

Many market commentators foresee a period of high volatility and uncertainty in the years ahead. Can we expect a straight 10-year bull market to start next year, or will we see meandering markets? An inflexible, fixed strategy might serve you as badly over the next few years as it has over the last few. 

Diversification on its own cannot be the starting point. To close a funding gap, we need assets to appreciate and/or liabilities to shrink (or at least not grow).

We know that asset classes and market sectors perform differently depending on the macroeconomic environment. Falling interest rates can affect bonds and equities differently. But if we take the macroeconomic temperature, we can make value-added decisions in our investment portfolio. 

Whereas equities generally outperform bonds and commodities in an environment of decreasing inflation and increasing growth, bonds outperform equities and commodities in the opposite conditions. To take advantage of changing economic conditions, we must take an active approach to asset allocation, rotating major asset classes through a market cycle.

Pension schemes’ main concern is the funding gap rather than investment performance per se. Due to changing interest rates and inflation, the goal posts for managing the funding gap is constantly moving. Unlike, say equity risk, inflation and interest rate risks are unrewarded risks which offer, on average, no potential return to the scheme.

Fortunately, schemes can hedge these risks using swaps and matching bonds (or a combination thereof). The design of such a scheme’s hedge depends on, among other things, the funding level of the scheme, the duration and shape of the scheme’s liabilities.  

Our implemented consulting solution was conceived in 2003 when a group of clients fresh from the internet boom and bust asked if we could implement our advice for them. The solution goes beyond manager selection and asset allocation to implement risk management and governance for pension funds. 

What does this mean for trustees and sponsors? According to the traditional approach, we would assess a pension fund’s position and appetite for risk, choose a mix of equity and bonds in a fixed combination, leave it and hope things work out.

Alternatively, we can put an active strategy in place that diversifies, rotates among asset classes and hedges liability risk. Although normally this range of services is only available to the largest schemes, full delegation means that even a scheme of £30m can have the risk management and demonstrate the governance of a scheme of £1bn.

Diversification is an important tool for improving the risk/return position of institutional investors. But diversification alone is not enough: it is essential to diversify into assets that appreciate and take care that your liabilities don’t get away from you. The solution for pension schemes is not diversification pure and simple; it is an active approach to asset allocation, in which asset classes are rotated through the market cycle to take full advantage of changing investment opportunities and liability risk is hedged.

Paul Kemmer is head of implemented solutions at P-Solve