Declining yields globally over the last 15 to 20 years have severely impacted the funded status of pension funds. Further, weak potential global economic growth has greatly reduced the return expectations for all assets. These pressures are forcing US public pension funds to lower the 10-year expected returns and has dire consequences for the sponsor of the fund, because it requires additional contributions at an inopportune time.
We argue that things are not as dire and, if one wanted to be controversial, there is a case for even raising the expected returns. Fiduciaries may have overlooked a very simple and lucrative source of expected returns that innovative pension funds captured with no change in policy or manager lineup.
Forecasting expected returns involves projecting a static Strategic Asset Allocation (SAA) for a given level of risk. Today, that static SAA is generally expected to deliver a 6.5% to 7.5% p.a. return. To raise that SAA return would require increasing allocations to illiquid assets or adding leverage, resulting in a commensurate increase in risk—an unpopular choice in the current market environment. But this static approach ignores a simple, yet potentially lucrative, source of expected return that is already baked into the SAA of every fund, requires no policy changes, and that some innovative funds have been capturing for years–Policy Ranges.
Dynamic markets cause a portfolio to drift around its SAA, so when approving a SAA policy, a board also approves allowable policy ranges before a rebalancing is triggered. While this policy range is generally viewed from the standpoint of risk (potentially 0.5% to 1.5% annualized risk), it also represents an overlooked source of potential return. We argue that policy ranges offer positive expected returns, and that most funds have ignored this “proper value” when calculating expected return assumptions.
Traditionally, plans implement a calendar- or range -based approach to manage the risk of portfolio drift. Such traditional rebalancings are a coin toss and represent arbitrary, reactive decisions based on behavioral biases. Worse, they can actually serve to exacerbate drawdowns in bear markets as was the case in 2008.
Previous claims that traditional rebalancing approaches were actual strategies—buy low, sell high or a form of volatility pumping— and were also not market timing are all easily disproved. The percent change in an asset’s allocation caused by drift is not just a function of that asset’s performance since the last rebalancing—it must also be viewed against the performance of all other assets in the portfolio over that same time period. In short, was the fund tilted to the right asset classes at the right time? In reality, simplistic rebalancing approaches have missed that point and taken funds in the wrong direction.
Instead of letting a portfolio aimlessly drift until some happenstance trigger occurs, a clearly identified staff member could take ownership of the asset allocation decision and make adjustments in an explicit, rules-based, and informed manner. Such asset allocation decisions contribute 80-90% to total fund risk and should be actively measured, monitored, and managed. We call this informed rebalancing, different from traditional rebalancing. The responsible individual uses simple but detailed relative value analysis to determine when and which assets to over- and underweight, and specifically by how much, within ranges already approved by the board.
Utilizing an informed rebalancing approach can add anywhere from 0.5% to 1.0% p.a. to the entire fund. For example, it has been independently verified that for the nearly 12 years ending January 2018, an innovative public fund has added approximately 1.2% p.a. to total fund returns (or about $1 billion) from informed rebalancing. Moreover, this potential can be tapped by large and small funds alike, with small or large teams, and each fund can develop a bespoke approach to managing this decision. This is how proper value is extracted.
The informed rebalancing approach differs from GTAA and other market-timing strategies in that it is custom built for the fund’s SAA and objectives rather than the GTAA provider’s needs. Informed rebalancing requires a modest but steady series of portfolio adjustments, none of which requires the investor to bet the farm. It is also rules-based, objective, and separate from the manager’s emotional estimation of the state of capital markets.
The informed expected return of a fund equals static SAA (6.5%-7.5%) plus proper value (0.5% to 1.0% depending on ranges). Just as the static SAA will go through cycles and have good and bad years, so too will the proper value; but an innovative public fund and other funds that have adopted this approach have reaped its long-term rewards.
Fiduciaries must tap every opportunity to maximize fund results. Incorporating proper value analysis and informed rebalancing holds the promise of additional return without any change in investment policy or governance. Pension funds can (and should) raise their expected returns.