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The roof only leaks when it’s raining, but it’s always impractical — and often impossible — to fix it during a storm. This concept makes right now a relatively auspicious time to address institutional asset allocation. While the improvement is far from linear, US economic data has turned more benign and asset values seem to be on a steadier path. The S&P 500 is in a respectable range (for now) and rates aren’t likely to fall significantly further than they have, meaning duration risk is less of an issue than it was at this time last year. Finally, more sponsors have made contributions to improve their pension-funded statuses in accordance with the Pension Protection Act (PPA).
So now that we’re out of survival mode, how important is asset allocation and what should institutional allocators be thinking about? The answer is different for each fund, foundation, or endowment. But the short answer is that allocation is all about managing risk: start by defining your destination, then, given your constraints, reverse engineer a path by which to reach it that accords with the level of risk you can tolerate along the way.
The asset allocation decision is (and always will be) the highest order for a portfolio manager. Indeed, depending on the measurement method, asset allocation determines more than 100% of aggregate returns. In case you need a refresher on Dr. Roger Ibbotson’s research from the 1990s, the percentage of aggregate return attributable to asset allocation can exceed 100 because timing and security selection are (in the long run) zero sum exchanges but exact fees on the investor. A great deal of the 100+% r-squared is attributable to a common market factor (beta). But still, it’s undeniable that the primary means by which we articulate our investment philosophies is through asset allocation decisions.
Sebastien Page, executive vice president and head of the client analytics group with PIMCO, believes the very framework for assessing asset allocation has undergone a fundamental shift. He says: “The traditional variance-based data-driven approach is being replaced by one that’s risk factor-based and more sensitive to macro economic regime changes.” For Page, “this is especially relevant considering that a lot of analytical models are
run on data from the last 10 to 20 years—a time when interest rates were falling and developed world sovereign debt was regarded as nearly risk-free. Going forward, interest rates could reverse their trajectory, and from a fundamental standpoint, emerging-market balance sheets may be seen as more attractive to creditors than those of a number of developed states.” Risks are therefore subject to change and the consideration of tail events takes on an elevated level of importance.
Page says a helpful way to think about allocation is that “asset classes are like containers for risk in the way that meals are containers for nutrients. It’s what’s underneath them that really affects results. Understanding this helps reveal more accurate levels of exposure, as well as unseen correlations between assets in a portfolio, such as the equity risk that is embedded in corporate bonds or sovereign risk that is present in numerous assets.” Allocating with this in mind, as well as being able to gauge performance in both risk-on and risk-off environments, can significantly improve results in the long run, Page believes.
Dr. Bradley Jones, an independent consultant who presented at aiCIO’s CIO Summit in New York, says: “Strategies have to be created with an understanding of the asset-liability structure of the parent corporate or sovereign behind the fund.” He points out that “in 2008 and 2009, many funds were forced to sell assets at a highly unfavorable time, in order to meet cash calls they were not banking on.” Evidently, they didn’t properly factor their liabilities into their allocations, Jones asserts.
Jones also says: “Investors should also be diversified across a number of uncorrelated risk factors and not simply asset classes. Given the idiosyncratic objectives, constraints, risk preferences, and comparative advantage of each institution, it makes sense to bias portfolios toward certain types of risk premiums. For institutions charged with the responsibility of growing intergenerational wealth, with a high pain tolerance and little need for contingent liquidity holdings, it would be appropriate to harvest certain types of risk premiums that many in the marketplace seek to avoid.” PPA regulations have shortened the investment horizon of many American defined benefit plans, but they are still in a relatively strong position to collect premiums for market and value risk, volatility, and to a certain degree lower levels of liquidity. Jones believes next-generation allocations are likely to incorporate more orthogonal risk exposures including intellectual property rights, carbon and water credits, catastrophe bonds, and longevity swaps.
For the time being, however, the most immediate question for the majority of real money managers remains to beta or not to beta? Equity risk accounts for upwards of 90% of variability in a 50/50 portfolio of stocks and bonds, and the drawdowns of 2008 are still fresh in the memory of many managers. Nonetheless, one has to maintain a dedicated forward-looking approach to asset allocation. Ibbotson, the Yale School of Management Professor and Chairman and CIO of Zebra Capital whose now famous research on asset allocation was mentioned at the top of this article, says: “Long term investors shouldn’t rely on the rearview mirror when making decisions.” Ibbotson’s view is that asset allocation won’t magically correct funding deficits for pension plans, especially those caused by actuarial inaccuracies, but overall it’s a good time to take on certain risks in a portfolio.
Broadly speaking, Ibbotson believes long-term investors, including those who are underwater or have suffered recent losses, should stake a bet on the global economy. More specifically, and following with the theme of risk factor allocation, he says: “Pension funds should seek out premiums for which they are better suited to hold than other market participants. These include equity, size, value, liquidity, and possibility momentum premiums.” He advises capturing all of these dimensions and says that while no premiums are truly orthogonal, “size and value are relatively so, as is liquidity.” Ibbotson says the payoff for accepting less liquidity in a portfolio is especially appealing and can be directly observed in the market for fixed income. “Yield spreads on less frequently traded debt is higher,” he points out, “so you go after higher yielding less liquid bonds if you can afford to hold them.” He argues the same principle should be applied in equity investing.
The expert consensus is that the asset allocation process is inseparable from risk analytics. PIMCO’s Page believes risk-factor analysis provides a flexible language with which investors can express their forward-looking economic views, adapt to regime shifts, and diversify their portfolios more effectively. Independent consultant Jones says: “Funds need to calibrate their exposure to different risks according to their unique long run objectives and constraints.” And finally, Ibbotson emphasizes that institutional investors with longer horizons should seek to capture returns from risk premiums in areas where they’re natural buyers, such as volatility and lower liquidity. So take a minute to consider these points and then go buy some risk assets that accord with your long-term strategy. A failure to do so may be the biggest danger of all.