Is asset allocation objective? Why are rational, intelligent individuals able to produce two radically different asset allocations both seeking to fulfil a 20-year objective? The answer lies in the conflicts of interest that are embedded in the institutional fund management industry.
The fundamental point is that what the risk stakeholders are concerned about is the failure to meet their own objectives. Where the objectives of the participants are clearly different, their perceptions of risk are different.
Controversy arises when one or more stakeholders judge that their economic interests are not being met by strategies being adopted or suggested by the other players, even though each player may be acting in a rational manner to control or minimise their individual perception of risk.
On the other hand, controversy can be reduced or potentially turned into collaborative behaviour when each participant can see evidence that their own objectives can be fulfilled through the group behaviour.
Whilst funds themselves may have 20-year horizons, the managers who act as their agents have career horizons closer to five years, the sponsoring firms are driven by their reporting requirements to have an annual time horizon, whilst trustees feel performance should be measured. As a result, from a manager’s viewpoint, the upside of being right over a couple of years by being very different from your peer group is not much, whilst the downside means losing the contract.
A perfectly rational response for managers is to control their business risk by equating investment risk with the risk of deviation from the average of their peers. A popular variation, with the comfort of some theoretical justification for equities, is to use the world capitalisation weighted indices as the portfolio of minimum risk although, pension schemes often still have an irrational home country bias.
A pension scheme with, say, 70% in equities and a 60% allocation to UK equities and 40% overseas in March 2000, when Vodafone was over 13% of the FTSE 100, would have employed managers who believed they were controlling risk by reducing their weighting to say 10%. From the manager’s viewpoint, they were at risk because they were underweight Vodafone. From the scheme’s viewpoint they were at risk in being so heavily exposed to a single stock irrespective of index weighting.
In the case of bond benchmarks, a capitalisation weighting approach has no theoretical justification, so making an insistence on using one as a measure of risk even more perplexing. A fundamental difference between equities and debt indices is that the amount of an issuer’s debt represented in a bond index is not very sensitive to the market’s pricing of its debt.
In contrast, unsuccessful companies with decreasing equity prices will see their weightings automatically decrease in a capitalisation weighted equity index. The credit spread forms only a small part of a bond’s yield, except in the case of high yield or distressed debt portfolios. As a result, we have the perverse result that the weaker an entity becomes through the issuance of more debt, the more an index will weight that entity, even though its attractiveness is reduced.

In setting objectives for long-term mandates, there is a fundamental choice to be made: using approximate estimates of the real risks the fund faces to manage it, or setting a proxy benchmark and measuring investment risks accurately against the benchmark, even though it has no direct relationship with the liabilities of the fund. In making this choice, one needs to differentiate between good risk management and good risk measurement.
The debate over liability driven investment strategies reflects the complexities of an environment with many different stakeholders and a slow but inexorable tightening of legislation turning promises by pension sponsors into legal liabilities, without a detailed map of where such a road leads to.
Turning a pension promise into a legal liability leads to the argument that pension liabilities are no different from other corporate liabilities and should be brought onto the balance sheet as indicated by the accounting standard FRS17. Matching liabilities with assets that behave in a similar manner has led to some argue that there should be a complete replacement of equities by a combination of conventional and index-linked bonds.
However, there are theoretical and practical issues that will make such a move unlikely in the short term, whilst even in the longer term, there are strong reasons for ensuring a diversified portfolio, albeit with debt instruments having a major and probably better planned role. The key difference in the future should be that all stakeholders in a pension plan are aware of the role that the debt investments are filling, and the reasons why they are combined with investments in a range of other assets in a controlled and risk-budgeted manner.
One of the problems that exist in deciding how to match liabilities is in deciding what the minimum risk portfolio would actually be. The UK’s actuarial profession had a working party that produced the idea of a Liability Benchmark Portfolio (LBP) that acts as a proxy for accrued liabilities and suggested that this in most cases could be approximated by a portfolio of conventional and index-linked bonds, although even the working party itself was not able to agree on this.
Whilst a benchmark of liability cashflows can be constructed, they can involve cashflows going out to 80 years in the most extreme cases . There are few bonds over 30 years and whilst it is possible to trade nominal swaps out to 70 years, liquidity reduces after the 30-year mark and for inflation-linked swaps, 40 years is the absolute maximum. Constructing a benchmark minimum risk asset portfolio that does not adequately match cashflows beyond 30 years needs to be handled with great care if it is not to confuse trustees even more by giving a misplaced sense of objectivity and security. It also raises the issue as to whether it is possible at all to construct a matched portfolio of fixed interest and index-linked bonds that is the theoretical minimum risk portfolio.
Virtually an entire generation of fund managers has been brought up managing money in an environment during which asset allocation has not been particularly significant. For 20 years or so from the early 1980s, when Paul Volcker, the US Fed Chairman instigated a series of policies designed to crush inflation, returns from all asset classes apart from commodities were boosted by a disinflationary environment. Asset allocation was only a marginal activity when all assets gave similar and high returns over the period of time. This however, has been a once-in-a-lifetime scenario, a one-off boost that will not be repeated. What is clear now is that there has been a secular change in the economic environment that makes the issue of asset allocation and the diversification of risks through incorporating a much wider range of asset classes one of the central planks of any investment strategy. The key is to determine what assets will give extra return and diversification in an environment of reasonable economic growth and modest inflation.

The issue for trustees is who has the skill set to do this most effectively, particularly when fund managers have spent the last decade building up specialist capabilities, with few managers being incentivised to build up asset allocation capabilities. Even those that had tactical asset allocation products have often discovered that there are more fees to be made by repackaging them as macro hedge funds rather than upgrading the product to offer liability-driven portfolio construction.
How does this all fit together? The answers would lie somewhere along the lines of first deciding the liability-based benchmark cashflow, then deciding on an estimate of a ‘minimum risk market exposure’ likely to be a combination of index linked and conventional bonds taking into account the yield curve and reinvestment risk after the 30-year cut-off. Given a benchmark portfolio, is this likely to generate sufficient return, that is, be at a yield that is high enough to be acceptable? If not, then diversification would be required to get more return after determining a risk budget available to be invested in equities, property and alternatives.
The key to the systematic and structured incorporation of other asset classes within a well designed solution to a liability profile and return objective is to have an appreciation of four critical areas:
q First of all, how sensible are current valuations for the asset class?
q Secondly, how stable are the correlations with other asset classes and how could they change during an economic or market crisis?
q Thirdly, how liquid are the investments should the scheme have to change its investment stance quickly due for example, to a corporate restructuring.
q Finally and most importantly, when it comes to manager selection and fee negotiations are the returns generated from purely beta market risks, where no manager skill is involved, or alpha, by management skill or else some combination of the two?

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