Investment committees should consider wealth and risk premia
In this fourth paper (Dynamic Asset Allocation and Fund Governance), Alan Brown, member of the 300 Club and Senior Adviser at Schroders, makes the case for a practical alternative to today’s best practice model, which takes account of a fund’s individual characteristics, its regulatory environment and its risk preferences.
Brown highlights how, despite acceptance that the industry’s best practice model of the last three decades has not served us well and is arguably no longer fit for purpose, no new model has emerged to take its place.
The main difference between the 300 Club’s proposed model and today’s, is the more dynamic approach to asset allocation which is driven by valuation (price of risk assets, risk premia) and wealth. Whilst there is some understanding as to how to respond to risk, Brown considers there to be no single answer as to how we should respond to shifting wealth.
Today’s model revisited
Brown’s thesis starts from the perspective of the more simple world of investment management from 30 years ago that evolved around a five stage process, which on the face of it was an appealing model built on some apparently common sense principles.
Whilst sounding sensible, Brown argues that this model is “riddled with problems,” particularly since complexity and costs have crept into the asset management system.
Asset classes have boomed from four in the 1970s to now include private equity, infrastructure, hedge funds, currency, commodities, credit, emerging market debt and emerging market equity. However, this change has not been compensated as returns at the fund level suggests that any benefits being earned by specialist managers are being eroded through inflexible asset allocation and higher costs. Added to this, is our devotion to controlling a portfolio’s deviation from the benchmark which means that we have got the 80:20 rule back-to-front as this approach misses the point that you cannot pay pensions out of relative returns.
Brown argues, “We need to be much more focused on the benchmark that really matters – the liabilities.”
Brown notes that by following a static strategic benchmark, we are assuming that our risk appetite remains unchanged even as our wealth changes or as forward-looking risk premia (return expectations) change. Questioning whether our risk appetite should be governed by these two factors, Brown suggests this will depend partly on the risk preferences of individual pension fund trustees, which in turn is likely to be moulded on the preferences of the fund sponsor and the regulatory environment the fund operates in.
Asset/Liability modelling (A/L)
“The great risk with modelling is that it is all too easy to get caught up in the sophistication of the model and the precision of the numbers that emerge,” notes Brown.
Highlighted by Brown is that the returns assumptions used are critical. He cites that typically, equities will use a model similar to a Gordon Growth Model, with the problem being, that in every decade since the 1970s, a Gordon Model forecast would have been far from reality, but when taking a 40-year investment horizon, the Gordon Model forecast would have been much closer. For Brown, he believes that there is a lot to be said about returns over meaningful investment horizons of three, five or ten years as earnings and dividends do tend to grow in line with trends.
Whether or not we experience above or below average returns is largely determined by whether or not we are in a period of Price/Earnings multiple (P/E) expansion or contraction (the valuation effect). He notes that there are two challenges to forecasting in this way: the tendency for the P/E multiple to mean revert over long periods – if P/E multiples today are high, it stands to reason that they are more likely to fall than rise further, and vice versa; and secondly that there is a well-documented relationship between inflation and P/E multiples. When inflation is high, P/E multiples tend to be low, and vice versa.
Taking a view: a better best practice model
Taking into account his reasons for the flaws in the current system, Brown presents a model which allows us to take a more dynamic view of asset allocation. His proposition is neatly encapsulated in a formula where risk appetite equals function (risk premia, wealth). He represents this in a graph entitled “Risk premia, wealth and four corners” where each of the corners maps degrees of risk appetite versus wealth.
Brown cites corners one and four as the most interesting on his graph. In corner one, both risk premia and wealth are high – an enviable position to be in and one that presents choices. In corner four, the situation of most of the industry today, wealth is low but risk premia are high and as a result a fund’s response will be conditioned by a number of factors.
According to Brown there are compelling reasons as to why governing boards should consider their “corner” solutions well ahead of time. Of decisions made, Brown says, “Any decision taken in advance can be re-visited at the time, but at least the issues will be understood and the arguments, for and against, will have been rehearsed. Dynamic asset allocation necessarily means doing something different to other funds and the consensus, and that is an inherently uncomfortable act for many. It is also inevitable that, in doing something different to the typical fund, there will be periods when headline returns are worse. The governance structure needs to be able to withstand that pressure.”
To respond to this pressure, Brown identifies three components essential for robust, sustainable governance: 1) a highly skilled investment committee; 2) representation by all key stakeholders; and 3) detailed records which overcome inadequate memories.
“This kind of an interaction between stakeholders and particularly the collective nature of decision making is very different from the typical modus operandi of funds today. However, the prize, if properly conducted, is a strategy which responds to the highly cyclical returns from markets and is genuinely tailor made to the circumstances and risk appetite of the fund,” observes Brown.
Throughout the paper it is assumed that pension funds are considered holistically, with a conventional view of de-risking which focuses on the liability side of a pension fund’s balance sheet. However, Brown argues that de-risking is more complicated and more nuanced than one might at first think, meaning that once again governing boards should consider their policy well ahead of time.
Brown concludes his paper by observing that, “if risk appetite should be more dynamic then funds and their investment committees should consider ahead of time how their risk appetite should respond to the extremes of wealth and risk premia.”
This is the fourth paper published by members of the 300 Club. To read other papers, please visit: http://www.the300club.org/WhitePapers.aspx.
Members of the 300 Club:
Saker Nusseibeh – Hermes Fund Managers (Chairman of the 300 Club)
Zuhair Mohammed – Aon Hewitt
Prof. Amin Rajan – Create Research
Lars Dijkstra Kempen – Capital Management
Bob Maynard – Public Employee Retirement System of Idaho
Adriaan Ryder – QIC
Robert Talbut – Royal London Asset Management
Alan Brown – Schroders
Dylan Grice – Societe Generale
Yves Choueifaty – TOBAM
The mission of the 300 Club* is to raise awareness about the potential impact of current market thinking and behaviours, and to call for immediate action. For further information, please visit the 300 Club’s website: www.the300club.org.