Pension Funds Struggle With Asset Allocation?
It is a difficult time to be a pension fund manager. Few asset classes are generating strong performance, complicating asset allocation decisions to the point of paralysing investors.
Paul Jayasingha, senior investment consultant at Towers Watson, said: “Volatile markets and heightened risk awareness continue to make asset allocation very challenging as companies and trustees balance such priorities as long- term de-risking, short-term market opportunities, rebalancing and maintaining a strategic asset-allocation mix.”
Equity allocations for UK pension schemes fell from 61% in 2002 to 56% in 2007, and to 45% in 2012, according to data from Towers Watson. However, UK pension funds have increased their exposure to alternative assets from 3% to an average of 17% over the past decade and allocations to bonds have also increased over the past five years – from 30% in 2007 to 37% in 2012.
Risk-averse schemes have sought the relative safety of bonds. James Montier, member of the asset-allocation committee at fund manager GMO, said: “Governments, in their process of financial repression, are forcing everyone to try to buy bonds. Pension funds are told that they need to liability match, so they need bonds. They are forcing everyone into these incredibly low-yielding assets and dragging down the returns of other assets as well.”
Equities provide better value than bonds, according to Jayasingha, but convincing pension schemes to invest in stocks is far from easy. He said: “It is challenging to know what to do about it when the goal for many funds is to reduce risk overall and diversify from existing equity holdings.”
Poor investment returns also continue to be a problem for trustees. The FTSE 100 is down 9% since 2000, which equates to a cumulative loss of about 0.7% annually. Antti Ilmanen, managing director of AQR Capital Management, said: “Investors have figured out that in the last 10 years or so their portfolios have been driven by one source of risk, which is market direction. All portfolios move with market direction, even when they are supposed to be diversified. It was embarrassing – no matter what they had in their portfolios their returns were driven by the markets.”
DC silver lining
In spite of this increased correlation between asset classes and the investor paralysis that has followed, fund managers remain confident that equities will return to favour, particularly as defined-contribution assets grow.
Projections from market research firm Spence Johnson show growth in the DC market is expected to continue from £286bn in December last year to £800bn by 2022, overtaking defined-benefit plans.
Neil Walton, head of strategic solutions at Schroders, said: “Participants in defined-contribution schemes will need good solid long-term returns to grow into anything sensible, so equity investing is definitely here to stay, probably within diversified portfolios.”
Diversified growth or multi-asset style portfolios have proved popular with investors attracted by access to a wide range of asset classes within a single product. Assets managed by diversified growth funds in the UK and Ireland rose from £30bn to £50bn in the 12 months to the end of June, according to investment consultancy Aon Hewitt.
Cerulli Associates estimates that the number of European diversified growth funds range from 40 to 100, depending on their definition, and there are an estimated 50 managers offering multi-asset funds in the UK.
But investors should be wary of going back to the old days of balanced management, where a single fund manager was appointed to invest across an often pre-determined and limited range of asset classes, warned Deb Clarke, investment partner at investment consultancy Mercer, which recently launched its own diversified fund.
Clarke said: “The flexible funds are interesting. Some of them have attracted a lot of assets. There is some merit to them, but we wouldn’t like to see them become just like the old balanced funds. It has to be someone with a skill set that can move in and out quickly and be holistic, not the old fashioned case of 60% equities and 40% bonds.”
Low-risk returns
Exchange-traded funds, smart beta products and traditional passive investments have also attracted investors keen to reduce their active exposure in search of low-risk, cheaper sources of returns. ETF assets under management have risen from $800bn at the end of 2007 to $1.3 trillion four years later despite the crisis, a compound annual growth rate of 14%, according to Boston Consulting Group. If passive mandates are grouped with ETF assets, the penetration of passive products within the total asset management market grew from 7% in 2003 to 12% in 2011.
ETF assets exceeded the $2 trillion mark in January. For Jeff Molitor, chief investment officer at Vanguard, whose lower fees helped spark a price war among ETF providers last year, the rationale is clear: “One of the few things that investors can control is the costs, the prices they pay.”
The lacklustre performance of some active managers compared with their passive counterparts has also made it harder to convince nervous investors to return to active investing. Passive fund managers outperformed active managers in 30% of fund sectors in the three years to August 2011, according to data from Cerulli Associates. When active strategies did outperform, the differences in returns ranged from as little as 0.4 percentage points for Japanese equities to 11.9 for hedge funds.
Consultants say that with active managers charging higher fees, investors are opting for a larger passive allocation with a smaller core of active. Clarke said: “I think the issue is that there are fewer assets to go around and perhaps what needs to change is the fee structure.”
But active managers point out that the cyclical nature of the markets means they can add value. Charlie Crole, institutional client director at Jupiter, said: “If you look at the oil sector and banks, together they account for 25% to 30% of the index. The oil and gas sector fell in aggregate by 7.5% last year and the bank sector was up 40%, so you had a performance differential of nearly 50%. Are you going to slavishly follow an index where one of the largest sectors can fall by 7% and another rises by 40%?”
High conviction
As a result, many active managers are hoping to attract investors by pursuing high conviction strategies, which are typically based on a narrowly focused portfolio of stocks or bonds, or are based on a particular investment thesis or macro overlay.
Scottish Widows Investment Partnership, for example, is creating high conviction active share portfolios, picking what it believes are outperforming companies, such as TripAdvisor, carpet manufacturer Mohawk Industries or Treasury Wine Estates, according to Will Low, director of equities at SWIP.
Others, such as Berenberg Bank, are pitching the use of more overlay strategies to their institutional clients. Matthew Stemp, head of investment management UK, said: “One of the ways we are engaging with clients is to talk about using more market overlays on existing asset classes in order to protect funds from market falls but allow them to maintain existing asset classes. Three or four years ago building an equity overlay would not have been talked about. Now we are discussing this.”
- Top tips for beating inertia
- Invite pension funds to pre-commit to begin investing at a specific time in the future and ask them to set the date for that action
- Work with pension funds to agree on the size and frequency of periodic investments
- Decide in advance the nature of the assets that need to be purchased.
Source: Allianz Global Investors Center for Behavioral Finance
Investors, reluctant to re-enter the market and saving record amounts of cash since the start of the financial crisis nearly five years ago, have become paralysed by what behavioural scientists call “loss aversion”.
- Investment paralysis : it’s all in the mind
But although loss aversion is the most important psychological factor in investment paralysis, it can be overcome by “fuzzy accounting”, according to Allianz Global Investors’ Center for Behavioral Finance, which was founded in 2010 with the goal of turning academic insights into actionable ideas.
The research, Invest More Tomorrow, argues that if an investor puts all his or her cash into the market in one large transaction, then any increase or decrease in the value of the investment as the market moves up or down is easy to see.I've already covered global pension allocations here. The research paper from Allianz Global Investors’ Center for Behavioral Finance, Invest More Tomorrow, is well worth reading. Using concepts from behavioral finance, it provides an action framework that eases anxiety for both clients and financial advisors by attending to the psychology underlying investor paralysis.
However, if an investor commits a specific portion of his or her portfolio – say, 25% – at regular intervals such as every three months, then he or she doesn’t have a single reference point or sum of money to focus on. So if the investments from the first entry into the market were to lose value, the investor would feel that he or she had only committed a small portion of cash, and would see an opportunity to buy cheap with his or her next purchase. This strategy is known as dollar – or pound – cost averaging.
Procrastination by investors is another issue facing fund managers and advisers. The Center’s research suggests investors should be asked if they are willing to commit to entering the markets at some point in the future. This puts the timing of the strategy into the hands of the investor, rather than having it imposed on them, and the investor feels more in control and more committed to following the agreed-upon action.
Investor paralysis is a dominant theme as the scars of 2008 are still fresh among retail and institutional investors reluctant to take on more risk in volatile equity markets. For large institutions, asset allocation decisions are much harder as correlations among all assets increase dramatically in an environment of record low bond yields and unprecedented quantitative easing by central banks.
Worse still, confusion over volatility strategies is hampering funds struggling to mitigate downside risk on a portfolio level. Many pensions are moving out of stocks and bonds and into private markets, investing in real estate, private equity and infrastructure, but they're just taking on illiquidity risk. Others are taking a smart beta approach or just focusing on low-volatility strategies in their equity portfolio, buying companies which provide stable dividends.
Whatever approach they use, these are not easy times and overreliance on historical correlations is pretty much useless. Had a chat with a buddy of mine on Friday afternoon, a retail broker here in Montreal. He's worried that Greece will default and that global deflation will ensue. "Everyone is buying stocks because the Fed and other central banks are pumping money in the system but this party can come to an abrupt end very quickly."
Indeed, as Ambrose-Evans Pritchard of the Telegraph notes, Eurozone risks Japan-style deflation trap as ECB stays tight:
The ECB expects inflation to fall to 1.3pc next year but the underlying rate is significantly lower given the distorting effects of austerity taxes. Any error would raise the risk of slow slide into a Japanese-style trap.As I warned last January, euro dithering will lead to global deflation. This is hardly inspiring news and yet the bull market that gets no respect keeps making new record highs, for now.
“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen from Danske Bank. “This already looks very similar to what happened in Japan in 1996 and 1997.”
The Japanese discovered that they were acutely vulnerable to an external shock once inflation had fallen below 1pc for a protracted period.In their case the East Asian crash of 1998 tipped them over the edge into a serious crisis.
Eurozone lending to companies has fallen by €100bn over the last six months, and small firms are struggling with a severe credit crunch across the Club Med bloc. Mr Draghi said there were no plans to introduce a variant of the Bank of England's Funding for Lending to channel money where it is most needed.
Critics say the ECB has persistently under-estimated the severity of the downturn, and has failed to offset drastic budget cuts with monetary stimulus. Both levers of policy are set on contraction, with bank deleveraging compounding the effect.
There is a risk that the bank may be caught out again this year. German industrial orders fell 1.9pc in January, dashing hopes of German-led rebound.
Christine Lagarde, head of the International Monetary Fund, said it is too early to assume that the worst is over. “Clearly the world economy avoided collapse last year. I am very concerned that, by moving into a semi-complacent mood, people risk a relapse,” she told the Irish Times.
The Catholic charity Caritas called for radical change in the eurozone’s whole crisis strategy, saying the current course was self-defeating and “putting the very legitimacy of the EU at risk”.
It said child poverty had reached dramatic levels in Ireland, Spain, Italy, Portugal and Greece, while deep cuts to welfare have left the most vulnerable stripped of a safety net. It said the chief victims bore no responsibility for the crisis, a breach of natural justice.
The crisis has engulfed France where a key gauge of the money supply -- six-month real M1 -- is contracting at an annual rate of 6.6pc and flashing graver warning signs than in Italy or Spain.
Figures out today showed that French unemployment rose to a euro-era high of 10.6pc in the fourth quarter, with the total looking for work near 3.7m.
France’s BVA confidence index plunged 12 points last month. Some 75pc of households fear that the economy will deteriorate over the next year. It is the worst reading since President Francois Hollande took power in May with a pledge to kick start growth and break the back of unemployment.
The Figaro said the French jobless rate is now higher than at any time in the 1930s, when farm ties and the empire acted as a safety valve.
“France is on the brink economic implosion,” said economist Christian Saint Etienne, warning that a state sector nearing 57pc of GDP rendered the country unfit for of EMU.
In a recent comment, Nobel Laureate Paul Krugman discussed why the US doesn't have deflation, concluding:
The bottom line is that we have a lot of evidence suggesting that the failure of deflation to materialize reflects wage rigidity, not absence of economic slack. And it is therefore frustrating to see supposedly well-informed people talk about this issue as if none of that work had been done.All true but the biggest deflation risk in the US is external, not internal. Risks of deflation and a new depression are why shorting bonds has thus far been the worst trade of the year.
Below, an epic debate about the creation and preservation of wealth featuring Rick Rule, Peter Schiff, John Mauldin and Grant Williams (h/t, Zero Hedge). The highlight is a classic faceoff between Peter Schiff and John Mauldin. I think John is absolutely right on the deficit, the US dollar, austerity and deflation.
And Vadim Zlotnikov, AllianceBernstein chief market strategist, explains why he believes there's a near-term downside risk to the markets, yet remains constructive. Good interview, listen to his comments carefully.