The importance of the asset allocation decision has been highlighted by the market volatility of recent years. This has encompassed phases when both equities and bond have moved in the same direction, albeit at different paces (mid to late 1990s) and the more recent past where performance has diverged radically.
While the greatest focus has been on the equity bond split, there have at times been sizable differences within equity areas, both in the comparison between domestic and overall international returns, and within the main overseas regions. For instance, over the five year period to September 2003 as a whole, UK and European equities underperformed gilts by 5% per annum, but the gap narrows to 3% for US equities (in sterling terms), while Japanese equities have generated similar returns to gilts.
With the recovery in equities from their March 2003 lows there has been at least a temporary respite for schemes which, on average, have remained predominantly (65% or more) invested in equities throughout. In fact while there have been selective instances of high profile switches from equities to bonds, schemes in general appeared to have used weak markets to reaffirm established allocations and buy equities on what appears to be favourable terms – that is to average down both the absolute level and the relative switching terms (compared with bonds).
Nevertheless, the debate continues on the direction of the longer term asset allocation (whether to increase the bond exposure), the review and decision making process that should be applied to set investment strategy and finally how such decisions should be implemented. These pivotal decisions involve to varying degrees trustees, sponsors, consultants and asset managers.
At a theoretical level there is a clear distinction between strategic and tactical decisions. The former includes the broad overall asset mix, the split between equities and bonds, and then the key subsidiary decision of the domestic and international equity balance, including any currency hedging. Within bond portfolios, the main decisions are the split between government bonds, corporates, overseas and index linked securities. These decisions are the direct responsibility of the trustee, acting on comprehensive advice, and having consulted the sponsor. At a tactical level, decisions to take advantage of shorter term market trends have usually been delegated to the asset managers, generally operating within predefined ranges.
For schemes still utilising traditional balanced managers alone, and without a customised benchmark, these two dimensions effectively remain combined. There is an implicit acceptance that the strategic allocation will reflect balanced universe averages, with tactical divergence from this starting point dependent on the investment process and risk taking propensity of the balanced manager selected. Clearly, there are a wide range of investment styles and processes available in the balanced arena, with varying emphasis on asset allocation, and sector and stock selection, as sources of potential added value.
Most schemes have now moved to customised benchmarks which are set in the light of their overall financial position and the ongoing funding basis adopted (supplementing the minimal requirements of the outgoing minimum funding requirement in the UK and other standards elsewhere). These funding bases in turn reflect the key characteristics of the schemes, their maturity, cashflow and the risk-return preference of trustees, and the sponsoring companies.
In a structure where there is a scheme-specific strategic benchmark, there is scope for a clear division of roles. The trustees, increasingly applying Myners recommendations which include establishing an investment committee, set a benchmark to reflect the funding basis recommended by the actuary, within a risk framework that has been modelled through an ALM process. The sponsor is consulted in detail to ensure that the risk preferences of both key stakeholders are aligned to the extent possible.
The tactical asset allocation decision can then be delegated to the asset managers. There are numerous ways to structure these arrangements, both to set the overall level of potential divergence from the strategic benchmark and then to define how this flexibility may be applied on asset allocation rather than stock/sector type decisions.
The overriding principle should be to ensure that active managers have ample opportunity to apply their skills without being unduly constrained by the strategic asset allocation, which is always destined to fluctuate to some degree due to market movement alone, without undermining the strategy.

Thus a potential arrangement for a larger scheme would be to set an overall allocation, say 60% equities, 40% bonds. Specialist managers could then be employed, but at a sufficiently high level to leave scope for asset allocation, (for smaller schemes possibly through a manager-of-manager structure). Thus rather than invest the entire equity component through regional specialists at least part of the mandate may be awarded to a manager who has scope to vary the domestic and international mix. Similarly, in a bond portfolio, given the macro global focus of the decisions on interest rates and bond yields it is useful to have flexibility to switch from domestic to international bonds (possibly on a currency hedged basis), from government to corporate securities, and between index linked and conventional bonds.
These structures often provides ample opportunity to add value to second-order asset allocation changes, but leave an absence of a view on overall bond equity decisions. Moreover, while in recent years the focus has been on relative bond and equity allocation, currency movements have, at times, had a significant impact.
As a minimum, schemes need to define a process to respond to asset allocation drift which results from relative movements in markets and currencies. This can be effected by applying a decision rule, a formula which triggers an automatic rebalancing the portfolio and resultant realignment of funds between specialist managers when pre-set target levels are reached. Thus a fund with a target 60:40 equity bond allocation may tolerate drift to say 55:45 or 65:35 (these do not need to be symmetrical) but no further. However, routine rebalancing has the advantage of ensuring that the asset mix remains close to some broadly optimal match for the liabilities, but has two key drawbacks.
The first is the transaction costs and the dislocation that the manager of the outperforming asset class faces in having to realise securities, possibly at a disadvantageous time for the specialist strategy adopted. More significantly, if the rebalancing is consistently in one direction over an extended period the message of these transactions – that the forecast returns underlying central ALM outcomes and funding assumptions may be suspect, may not get the focus it deserves.
Hence, there may be benefit in complementing the structure which manages the scheme and sponsor risk through a strategic benchmark and overall risk constraints (set by defining asset ranges and tracking error targets) and seeks to add value through identifying specialist managers for individual asset classes. The application of similar expertise at an overall investment level may entail considering tactical asset allocation products and currency overlay management. Clearly this would not seek to tilt the overall fund allocation, but would seek to add value on a shorter term basis.
The most direct structures that achieve this top down approach are hedge funds with a global focus and a mandate to take sizable positions in currencies, bonds and equities. While clearly this flexibility has the potential to increase the risks to the scheme significantly, this can be contained by investing through a fund-of-fund structure and by limiting the hedge fund overall allocation. Thus while routine rebalancing will still take place, there will be dedicated resource within the specialist manager structure seeking to capitalise on the main trends generating the key divergences.
Clearly while a structure which broadly differentiates between strategic and tactical decisions should be robust enough, there will be a need at times to consider intermediate-type decisions, which are too significant, or are likely to extend for longer than a routine tactical decision, but fall short of a change in overall strategy. These types of decisions are best taken by an investment committee, with appropriate reporting arrangements and clearly limited delegation, acting on the advice of investment consultants and asset managers, which can respond quickly and flexibly to new ideas and market developments, while still operating within a set risk framework.
Ultimately the combination of the trustee, its investment committee with a mandate to respond flexibly to opportunities and a streamlined process for seeking advice from consultants and utilising the skills of asset managers should give funds the structure to implement an investment strategy which can benefit from market opportunities and help schemes to meet their funding objectives.
David Felder is director, Law Debenture Trust Corporation in London

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