July-August 2011

ASSET ALLOCATION: The price of de-risking

CakeEurope’s pension schemes must transform their asset allocations if they are to balance de-risking with members’ needs, but George Mitton finds that they will struggle to manage the shift on their own.
Twenty years ago the average UK pension fund had three-quarters of its assets in equities and the rest in bonds, cash and real estate. Not any more. Today, equities make up less than half the average scheme’s allocation in the UK, a mere quarter of the average apportionment in Denmark and the Netherlands, and just 5% in heavily regulated Germany. The move away from equities is one of the great investment shifts of our time. But it has come at a price. Pension schemes are finding they must explore exotic new asset classes, invest more money overseas, and review their investment decisions with much greater frequency to compensate for their withdrawal from the stock market. What investors must realise is that these new strategies bring new risks, which many schemes do not have the expertise to manage themselves. In essence, the problem Europe’s pension schemes face is a trade-off: they have reduced risk by selling equities and buying bonds, but this has lowered their expected return. Incoming regulation is set to accelerate this trend. Changes to rule 19 of the International Accounting Standard (IAS 19) will encourage the switch from equities to bonds from 2013 onwards, while European Union regulators have signalled that they will apply the incoming Solvency II regime to pension schemes as well as insurers. This is expected to make investors more risk-averse by forcing them to state the market value of their assets in their solvency calculations. One of the ways in which pension schemes are responding is by increasing their allocation to alternatives, such as hedge funds, commodities and private equity. A recent survey of 1,100 European pension schemes by Mercer Investment Consulting says nearly a fifth are planning to increase their exposure to these non-traditional asset classes in the next twelve months. Another study by consultancy Towers Watson says pension schemes invested nearly $1trn (€0.7trn) in alternatives last year, up 16% compared with 2009. The schemes hope that alternatives will provide safety through diversification, while also maintaining healthy returns. But is this an appropriate strategy? One reason to be cautious is that alternatives cannot provide protection against crisis-style events, as Richard Urwin, head of investments for BlackRock’s Fiduciary Mandate Investment team (FMIT), explains. “The level of diversification that alternatives provide, in a period when the markets are going down a lot, is fairly minimal,” he says. The Yale Model
Some also fear that the risks outweigh the benefits. Take the example of the Yale Model, which is the strategy developed by David F Swensen, chief investment officer at Yale University since 1985. By investing in a diversified portfolio that included large allocations to alternatives such as private equity, Swensen’s team returned nearly 12% a year for the decade ending 2009. However, Urwin says the model is unlikely to be appropriate for pension schemes. “You have to have people who understand alternative strategies and you have to be able to live with the illiquidity,” he says, referring to the Yale Model. “It’s not clear that that is a sensible route to go down for the average UK pension scheme.” Part of the Yale Model’s success was it sought out illiquid assets, because they pay a premium. However, the strategy was challenged during the crisis when Yale’s illiquid assets were impossible to sell. Yale’s endowment fell $7bn in 2009, a 30% drop. This was painful for the institution, which was forced to cut 600 jobs and bring in austerity measures. It would have been lethal for the beneficiaries of a cash-strapped pension scheme. Patrick Rudden, head of blend strategies at Alliance Bernstein, says the problem is that investing in alternatives requires dedicated research staff, which many pension schemes cannot afford. For that reason, schemes should exercise caution. “Either keep it simple and own the well-understood liquid asset classes that pay you to own them, such as equities and bonds,” he says. “Or, if you want to get more complicated, you’d better up your resources.” Risks and responsiveness
Of course, if a pension scheme lacks the resources to do specialist investing in-house, it could rent the expertise, says Rudden. This could take the form of an outsourced chief investment officer. Another option is to put money in diversified growth strategies, which essentially means outsourcing elements of the asset allocation decision. What schemes must not do is imagine that putting money into alternatives is a risk-free way to make up for the shortfall in equity returns. “If your experience in equities wasn’t good – meaning, you didn’t like the risk and your manager underperformed – to think your experience in hedge funds is going to be that much better is optimistic,” he says. Another way pension schemes are trying to generate returns is by investing in fast-growing emerging markets. According to the Mercer survey, more than a third of European schemes have a specific allocation to emerging market equities, up from 28% last year, while the proportion of schemes that plan to invest in emerging market debt has doubled. Some analysts say investors should aim for an even split between developed and emerging markets, in which case a huge shift is still to come. But again, there are risks. The more foreign currency assets a scheme buys, the more it stands to lose from currency fluctuations. According to Adrian Lee, founder of Adrian Lee & Partners, the problem is significant. He claims that currency volatility accounts for 30% of the risk attached to a portfolio of foreign equities and up to 70% of the risk for an overseas bond portfolio. Lee says pension schemes should hedge their portfolios using swaps and consider bringing in specialists to actively manage their currency exposure to generate alpha returns. “Ninety per cent of people ignore currency risk and accept it’s part of the game. But that’s such sloppy thinking,” he says. Not everyone needs to hedge. Due to their position in the world economy, Canada and Australia tend to see their stock markets perform well when other currencies decline, says Lee. Investors in these countries do not need to hedge. But European pension schemes are much more vulnerable and should definitely hedge their foreign portfolios, he claims. If they do not, they will become more and more exposed to risk the more they increase their exposure to foreign currency assets. Dynamic acceleration
Yet another strategy for pension schemes is to make asset allocation more responsive. Since the crisis, pension schemes have begun assessing this on a quarterly or even monthly basis, in the hope that this will help them respond more quickly to threatening market conditions. In the past, trustees would review the allocation once every two or three years. “Asset allocation has become dynamic,” explains Sergio Focardi, professor of finance at Edhec business school. “And it has accelerated after the crisis. People are looking for new ways of doing business now.” This offers another way to reduce risk. The idea is that fund managers will move out of underperforming asset classes more quickly and so cut losses. Of course, this puts a greater burden on the researchers and analysts who provide market information to trustees. In future, this could lead to a greater demand for third-party consultants. Balance
It is important to note that different pension schemes have different needs. One important shift, which is particularly marked in the UK, is the trend to decommission defined benefit schemes. These are being replaced, if they are replaced at all, with defined contribution schemes. In effect, this means scheme sponsors have reduced the sums their pension plans need to pay out. For many, this means they can afford to take less risk. They can switch their volatile return-seeking assets to liability-matching bonds and swaps, for instance. “If it works, you get to a point where you’re fully funded and you can hand the whole thing over to an insurance company and it’s game over, job done,” says Rudden. But these schemes are the lucky ones. The rest must perform a tricky balancing act; satisfying regulators that they are de-risking while at the same time keeping their sponsors happy by generating adequate returns. “Some enlightened people will keep it simple,” adds Rudden, meaning that they will stick to traditional asset classes, which are well known and well understood. “Others will like the lure of complexity, including alternatives, but will probably outsource the problem to an implemented consultant or an asset manager.” Here is the key. As pension schemes embrace more exotic asset classes, they require more help to manage the risk they take on. Schemes could invest in diversified growth funds or they could hire fiduciary managers. Of course, this means extra costs, but these are the costs you must pay to invest safely in alternatives. In the same way, investors in overseas assets may need to seek advice on how to hedge their exposure to foreign currencies, and schemes engaging in dynamic asset allocation will need more data to inform their decisions. The result may be a rise in the number of third parties who advise the industry, because many pension schemes cannot do all the work themselves. ©2011 funds europe

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