Beyond Category

Institutional investors seek shelter from a perfect storm for asset allocation
By Maha Khan Phillips

Institutional investors had to learn a hard lesson in 2008. their portfolios. They have to generate sufficient The widely held assumption that asset class diversifica- income while interest rates remain extremely low. They have to reduce portfolio risk at a time tion also provided risk diversification proved to be a fal- of public market uncertainty and high correlalacy. In fact, asset class diversification was most ineffec- tions. They also have to consider how they will tive when it was most needed. Five years ago, no coun- achieve growth when developed market econtry or sector was immune to the effects of the financial omies are so stunted. Finally, they need to be ready for inflationwhen it comes. crisis and recession. Globally, private pensions lost 23% of their valuea staggering US$5.4 trillion in assets The Great Rotation according to the OECD. Institutional investors recognize that decision
If you are in a financial crisis, no asset class serves as a diversifier. What investments all have in common are the investors themselves. You arent able to run away from yourself, says Frances Hudson, global thematic strategist at Standard Life Investments, explaining how human behavior drove market direction during the crisis. Thus, it is hardly surprisingly that institutional investors are now re-thinking their approach to asset allocation, not only from a risk management point of view but also from a performance perspective. The task is not an easy one, and it is complicated by an array of circumstances. The macro environment continues to remain challenging. Today, interest rates are lower than they have been in more than six decades. A great deal of global equity market uncertainty persists, and correlations between asset classes remain high. JP Morgan Asset Management warns that investors face a perfect storm of challenges in
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making about asset allocation has become more important than ever. There is an increased volatility in markets overall, and sometimes we see the extreme correlation of 1 between asset classes, with big risk-on/risk-off portfolios, says Wayne Bowers, chief investment officer of Northern Trust in the EMEA and APAC regions. In this environment, asset allocation can significantly affect the overall return and risk profile of the portfolio, and the ability to change your allocation on a frequent basis is important. For many strategists, 2013 was going to be the year of the Great Rotation out of costly and underperforming government bonds and into equities. Ted Scott, director of global strategy at F&C Investments, emphasizes that government bonds were in a bull market for more than 30 years. As quantitative easing diminishes, the major buyer of government bonds will be removed from the market. The U.S. Federal Reserve will sell its bonds back on the open market to reverse quantitative easing. When

the Fed confirmed that quantitative easing will in fact be coming to an end later this year or in early 2014, it triggered concerns about bond prices.

Exposure to Fixed Income

In Europe, the majority of pension schemes are still making allocations to bonds, as they have been doing since the crisis began. According to William de Vijlder, chief investment officer of strategy and partners at BNP Investment Partners, pension funds moving into bonds was understandable initially. At the start of 2009, it was a safe assumption that people should be defensively positioned. Once there was a conviction level about where the world economy was heading, you saw flows into fixed income, he says. Initially this was standard plain-vanilla sovereign markets. Then, there was the evolution towards the corporate and emerging bonds. So, that is why you end up with the counterintuitive [fact] that bonds have actually seen large inflows over these last four years, he says. In de Vijlders view, although bond yields make sense against the background of the consensus view of fundamentals over the next year, the story changes for a multiyear period. Bonds look expensive, and fears of bursting bond bubbles continue to raise their head. The inflows into bonds have been occurring for quite some time in Europe. Equity allocations for U.K. pension schemes fell from 61% in 2002 to 56% in 2007 and to 45% in 2012, according to data from global consultancy Towers Watson. Allocations to bonds have increased from 30% in 2007 to 37% in 2012. Investment consultants believe that a great rotation is not likely to occur in the rest of Europe, particularly because new regulations require pension funds to hold fixed income. We havent seen any evidence of a great rotation. What we have seen from pension schemes in the last two years is a continuation of the trend of the last decade, and that is a shift out of equities towards bonds and alternatives, says Phil Edwards, principal at investment consultancy Mercer in London. Because the majority of pension schemes in Europe are maturing, they have different priorities. Pension schemes are moving toward the long-term de-risking of the funds as they mature, says Edwards. They are looking to reduce risk by looking at fixed income and by looking at liabilities.

I think the key mistake people make around the great rotation is that they only look at the yield component of bonds and not the stability component or diversifying properties. If you sell all your bonds now and just go into equities, are you really going to see growth? China is slowing down, and Europe is not out of the economic crisis either, argues Nico Marais, global head of multi-asset investments at Schroders. European institutional investors reduced equity allocations in 2012 and used the assets to fund an increase in alternatives, with bond allocations remaining broadly flat, according to Mercer. This year, things are very different. Reductions to equity allocations have been used primarily to fund an increase in bond portfolios, with allocations to alternatives slightly down from the previous year. Despite the lack of attractiveness of bond yields, strategists expect more allocations along the yield curve. There are certain areas in the fixed-income curve where you can be more protected than others, says Bowers. If you have to own fixed income, you tend to be better off with a shortto mid-term duration profile. Even in a monetary tightening scenario, historical analysis suggests you tend to lose less than if you owned longer-duration securities. Patrick Moonen, equity strategist at ING Investment Management, believes that the different drivers of fixed income are very mixed. There are some elements that still favor investments towards fixed income, he says. Some of them

What investments all have in common are the investors themselves. You arent able to run away from yourself.
are longer term, like demographics. You have an aging population. You also have a wave of regulation in the financial sector. And in the current environment, real assets are really scarce. Moonen doesnt expect anything to change in the short and medium term. Safe assets are expensive and will continue to be so [going forwards]. There is no inflation, no immediate need for larger investors to switch out of fixed income and into equities. Some of the drivers behind the demand for fixed income are long-term drivers. The demographics are there to stay, as is the regulation behind Basel II and Solvency II.

De-Risking
Equities and bonds continue to dominate European pension plans investment strategy, typically accounting for 80% 90% of assets, according to Mercers 2013 asset allocation survey, which covered 1,200 plans managing total assets of 750 billion in 13 European countries. Pension schemes in Ireland have the highest allocation to equities at 44%, with this figure unchanged from the previous years survey. Although U.K. plans historically have had higher equities allocations, U.K. schemes are continuing to reduce their allocations to equities. Swedish and Belgian plans now allocate more to equities, on average, than do U.K. plans. Average equity allocations in other countries vary from 10% to 30%.

Managing Liabilities, Budgeting Risk

Mercers 2013 survey of European pension funds also revealed that 26% of funds have specifically allocated a portion of their overall investment strategy to a liability-hedging or liability-driven investment (LDI) mandate. Of plans that lacked a specific mandate, 15% confirmed that they manage the duration of their bonds through an allocation to a longdated (greater than 10 years) bond mandate. According to
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Derivative Instruments Used to Hedge Interest Rate and Inflation Risk

Interest Rate Swaps Inflation Swaps Government Bond Total-Return Swaps Government Bond Repos Swaptions Other 65% 49% 37% 36% 9% 5%

Source: Based on data from Mercer European Asset Allocation Survey 2013.

larger allocation is that real assets provide strong income. Core real estate and infrastructure typically provide an annual yield of 5%7% (or 300500 bps above 10-year U.S. Treasuries). They also offer stability. JP Morgan research indicates that returns for real assets are less volatile than equities, particularly when they are part of a diversified real assets portfolio, because of low correlations among different real asset categories. In addition, real assets can provide a direct link to higher-growth Asian economies, giving investors a pure play on local GDP growth, and can enhance inflation sensitivity through their ability to provide positive real returns even during periods of rising or elevated inflation.

Mercer, although an explicit liability-hedging strategy is not in place for these plans, this pattern suggests some thought has been given to matching the long-term interest rate sensitivity to the liabilities. For those pension plans that use derivative instruments to hedge liabilities, interest rate swaps and inflation swaps are used most often, with use of government bond totalreturn swaps and repurchase agreements (repos) also being common. Investors changing their allocations to equities and bonds also have risk mitigation to consider. The traditional balanced portfolio of 60% bonds and 40% equities (invested in, say, the S&P 500 Index and 10-year U.S. Treasuries) is highly concentrated in terms of risk allocation. People might think that 40% or 30% in equities and the rest in bonds and credits means that you dont have high risk exposure, but most of your risk budget is still in equities. So, it is useful to think in risk terms rather than dollar terms, says Phil Tindall, senior investment consultant at Towers Watson.

Risk Approaches
Investors are also looking at risk-parity or risk-factor approaches to provide diversification. Speaking at the CFA UK Annual Conference in June 2013, Sbastien Page, CFA, executive vice president of PIMCO, argued that traditional asset allocation approaches are backward looking and statistically driven and underestimate the dynamic nature of the market. Instead, he advocated a new normal asset allocation approach that is forward looking and driven by macroeconomics, focuses on risk-factor diversification, and explicitly seeks (on both secular and cyclical horizons) to hedge fat-tail risk. Fat-tail risk is clearly an important concern for institutional investors, as shown by Allianz Global Investors fourth RiskMonitor survey, conducted in October 2012 in conjunction with Investment & Pensions Europe (IPE) magazine. According to survey results from 155 institutional investors in Europe with a total of 1.9 trillion in assets under management (or advisement), 14% of respondents felt that tail risk was a huge risk to their portfolios and another 40% labeled it a considerable threat to their financial targets over the next 12 months. More than four in five European institutions were concerned about volatility and its potential on their 12-month financial targets. Almost a quarter of the respondents named market volatility as their biggest financial risk. A sharp drop in equity markets remains a great worry for 7 of 10 investors, and concerns about sovereign debt (73.8%) are even more widespread. Almost twothirds view current interest rates as a major risk for their twelve-month targets. Pension funds are adapting risk-parity approaches into their investment frameworks. ATP, the largest pension fund in Denmark, reports that risk parity has been an important component of its investment decision making for the past seven years. The fund defines risk parity as an allocation exercise which aims to spread risk more or less evenly among risk factors in order to generate higher risk-adjusted returns than equity-centric institutional portfolios, according to IPE magazine. ATPs portfolio is invested in five risk asset classes with very different risk profiles: interest rates, credit, equities, inflation hedges, and commodities. And ATP is not alone. In the U.S., the Ohio Police & Fire Pension Fund began discussing a risk-parity approach in early 2009, according to news reports, and the board of

Real Assets
Mike OBrien, global head of institutional business at JP Morgan Asset Management, has never seen such a huge amount of disparity across investors worldwide. You are seeing a large group of investors who are becoming much

People might think that 40% or 30% in equities and the rest in bonds and credits means that you dont have high risk exposure, but most of your risk budget is still in equities.
more risk orientated in their asset allocation decision making. That risk orientation is being heavily influenced by regulations. At the same time, there is a group of investors who are more return seeking in terms of risk. According to a recent report by JP Morgan Asset Management, investors will need to increase allocations for real assets to as much as 25% of portfolios. One argument for a
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ease of implementation, says de Vijlder. If you had a value and growth portfolio, you need to build a pure value portfolio and a growth portfolio that is as pure as possible as well. That means the portfolios are mathematically completely distinct from one another. That creates an interesting challenge. This point is why a core active and passive satellite approach works best for allocation, according to Bowers. If you have the majority of your assets in a highly active style, the pension scheme formally adopted a new asset alloca- either internally or externally managed, then the ability to tion plan in February 2010 that called for reducing equity make subtle changes can be quite difficult from an impleexposures while increasing allocations to fixed income, real mentation point of view, he says. From an implementation estate, private markets, and alternatives, including timber perspective, which manager would you take money from and commodities. The new plan called for the total portfo- and which would you give it to? These decisions take time and detailed analysis. They can also be very meaningful in lio to be levered 1.2 times. Even the largest U.S. public pension fund, the Califor- terms of transaction costs. With any scenario, whether adopting a risk-factor approach nia Public Employees Retirement System (CalPERS), has been evaluating the idea. Staff members at the fund have or deciding where to sit on the bond curve, institutional investors have their work cut out been pushing for the adoption of a for them. Our clients are widenrisk-factor asset allocation model, Keep Going ing their horizons to consider a arguing that it would make a more broad range of asset classes, says transparent portfolio with stable New Horizons in Asset Allocation: Combining Liquid Alternatives in Portfolios, CFA Institute OBrien. We are seeing diversificorrelations. The model under conwebcast [www.cfawebcasts.org] cation becoming a much more presideration would include five facWill My Risk Parity Strategy Outperform? Finandominant objective in asset class tors: real interest rates, realized cial Analysts Journal (November/December 2012) discussions. inflation rates, expected inflation [www.cfapubs.org] rates, volatility, and growth. Maha Khan Phillips is a financial Will My Risk Parity Strategy Outperform?: A ComBut managers say that such journalist based in London and author of ment and Author Response, Financial Analysts the novel Beautiful from This Angle. approaches are not without chalJournal (March/April 2013) [www.cfapubs.org] lenges. You have to look at the

From an implementation perspective, which manager would you take money from and which would you give it to?

Beyond Market-Cap Weightings

Since Standard & Poors introduced the first market-capitalization-weighted equity index in 1923, cap-weighted indices have dominated the investment universe. Almost all equity diversification has occurred along the lines of country, region, size, sector, or market capitalization. Things are changing, however. Mercer reports that investors are increasingly recognizing the drawbacks of strategies built around market-cap-weighted indices. Investors are considering buy and maintain approaches as an alternative to traditional active or passive corporate bond mandates, and alternative indexation in place of traditional index-tracking equities. They are also looking at unconstrained active strategies instead of benchmark-relative approaches. In the 2012 research paper Investing with Style: The Case for Style Investing, quantitative asset manager AQR Capital Management makes a case for investing in four intuitive investment strategies: value, carry, momentum, and defensive, which (the paper argues) can improve the riskreturn characteristics of traditional portfolios. Value means buying assets that are cheap relative to fundamental value and selling assets considered expensive. Momentum involves buying assets that recently outperformed their peers and selling those that recently underperformed. Carry implies buying high-yielding

assets and selling low-yielding assets, and defensive strategies buy low-risk, high-quality assets and sell high-risk, low-quality assets. Most funds have an excessive dependence on equity risk, according to the report, which argues that balanced risk contributions can be maintained with the help of dynamic position sizing to more accurately target volatility/risk. There are certain risk factors which have risk premia attached to them, whether it is momentum or value or size or carry. Illiquidity is one of them. If you are holding an illiquid asset for a certain holding period, you get paid for that, explains Mike OBrien, global head of institutional business at JP Morgan Asset Management. Style investing also creates other types of diversification from which investors can benefit, including time horizon, which occurs naturally in portfolios. Managers who use trend-following strategies based on mean reversion have always looked at time horizons, but other investors also can benefit. Investors could look at their short-term (110 days) and medium-term (612 months) allocations and use it to create diversification. A 2009 research paper by Albert Descle, Jay Hyman, and Simon Polbennikov at Barclays Capital argued that the combination of alpha strategies based on independent time horizons could reduce portfolio risk even when the returns of the underlying assets are correlated.

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