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Asset allocation - the forgotten investment tool Back  
With the only significant asset allocation change in Irish pension funds over the past number of years being a switch out of Irish equities into Eurozone equities, Pramit Ghose says it is time to change. He says that trustees will have to actively manage their asset and fund manager mix if they are to generate sufficient additional investment performance to persuade sponsoring employers that pensions can still be funded at an acceptable economic cost.
TThe perceived wisdom on asset allocation is that it is the most important step in the investment process. Studies indicate that asset allocation account for some 90 per cent of a portfolio’s return. Intuitively this seems to make sense it was far more important to be out of equities in the 2000-2002 period than to be with the best equity fund manager; similarly it was far more important to have bought equities in March/April in 2003 than to have been invested with the best fixed interest fund manager.

However, it is also perceived wisdom that asset allocation is the hardest part of fund management to get right. We are all aware of the statistics showing that if you had been out of equities on a certain 20 days over the past 15 years that your return would have shrunk significantly. Professional fund managers and advisers are loathe to move significantly into or out of equities vis a vis their clients’ benchmarks for fear of missing these ‘super’ days.

For institutional fund managers, to a certain extent this has been driven by pension consultants. Consultants feel generally uncomfortable with fund managers that have outperformed through large asset allocation moves, as it is perceived that, relative to outperformance through superior stock selection, this process is not repeatable. Asset allocation moves tend to be infrequent, usually done by one or two individuals, and have a large potential effect on fund performance (i.e. risky!), while a proven stock selection process is much more measurable, done by teams, and each decision tends to have a small potential effect on fund performance.

Investment managers are also reluctant to make large asset allocation decisions. As investment consultants don’t tend to rate outperformance by asset strategy, managers feel there is no business upside to getting a big strategy call right, while the business risk of getting such a call wrong could be catastrophic.

The outcome of all this is that asset allocation has become a forgotten investment tool. Looking at the mix of Irish pension fund assets over the past few years, the only significant change has been a switch out of Irish equities into Eurozone equities this at a time when the Irish economy was growing much faster than the EU average and Irish shares were at relatively undemanding ratings. More worryingly for pension trustees, despite the major bear market of 2000-2002 there was generally little selling of equities.

In addition, increasingly for larger investment funds, assets are parceled up into specialist mandates (e.g. European bonds, US equities, UK property) where fund managers are only responsible for managing their particular asset class and not required (or asked) for their overall view on asset strategy. In relation to personal reputation this is also borne out: a fund manager strives for the accolade ‘she’s a great stockpicker’ she is less enamored to be known as ‘a great asset allocator’.
But now with this group of specialist fund managers, each looking after his/her particular mandate, who is there in the middle managing the asset class and manager mix? Adding David Beckham to a football team is bound to improve its chances of winning matches, but when that team already has Ronaldo, Zidane and Raul, somebody is needed to manage all that talent and develop dynamic tactics/strategies for different opponents. I believe that managing the asset class and manager mix is going to be a very important part of the whole asset management strategy.

Large investment funds are coming round to the thought that it is simply not acceptable or defensible to ignore how asset classes are valued relative to each other and they are looking at how to take advantage of asset class valuation anomalies. They are increasingly using either asset allocation experts (such as Acuvest) to identify and exploit these valuation anomalies, or hiring sophisticated ‘overlay managers’ who don’t disturb the underlying assets of the fund, but use derivatives to tactically increase/decrease asset class weightings according to their models.

Interestingly a recent Morgan Stanley report on the European Asset Management industry found that continental European trustees and plan sponsors do not believe actuarial consultants ‘have necessarily aided returns on the Anglo-Saxons’, and that many funds have ‘dissatisfaction with the traditional consultants’.

And that is the problem you get when you fail to overlay market knowledge on theoretical models. I don’t have to tell this audience that markets often reach irrational levels in both directions.

This is not retrospective wisdom; we all knew that stock markets going into 2000 were very high. Shane Whelan wrote a book towards the end of the last millennium and made the statement ‘Seldom have we had it so good’. We also had a pretty good idea that late 2002/early 2003 was a good time to buy equities. In March 2003, Alastair Ross Goobey, one of the UK’s leading investment experts, wrote in the Financial Times, ‘Today equities are better value against equities than they have been for a generation’. In fact, there is increasing evidence that, at valuation extremes, sensible models developed by certain investment banks and academics have a strong certainty of making the correct asset allocation call on a 12 to 18 month view. Advisers or fund managers who can add value to pension funds in this area are going to be in big demand. It is interesting to note that in a recent major investment management competition sponsored by the giant Universities Superannuation Scheme, the winning and runner-up entries both included strategic asset allocation as a key feature of their offering.

The benefits of this commonsense, valuation-driven process can add dramatically to a fund’s return. One of our clients uses several fund managers, one of which has adopted this commonsense approach this manager has employed sensible asset allocation policies, hedge funds, protected instruments, high yield corporate bonds and attractively valued midcap equities. The result: a return of about 10 per cent p.a. over the past seven years versus an average return of some 5 per cent p.a. for an initial fund of €10 million, the difference in performance amounts to €5.4 million after the seven years.

So if I am to summarise it is to say very simply trustees will have to actively manage their asset and fund manager mix if they are to generate sufficient additional investment performance to persuade sponsoring employers that pensions can still be funded at an acceptable economic cost.

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