Head of Investment Solutions, Multi-asset Group
In the current volatile macroeconomic environment should investors focus on generating growth or hedging their liabilities against further unexpected shocks? While the implementation depends on the type of investor, there are multi-asset solutions that combine both objectives.
Whether an investor is seeking income in a low yield environment, equity exposure with structured downside protection or a structured solution to achieve a superannuation scheme’s objectives, there is most likely something each investor can do to improve their portfolio and its performance.
The recent AMP Capital Institutional Investor Report (in conjunction with Institutional Investor magazine) revealed a focus on asset/liability management, volatility management and hedging. These were three of the top five priorities for global investors in 2013.
Who are these investors who consider risk management as so important? In Australia with a predominantly defined contribution system for generating individual retirement wealth, does this have any relevance for trustees considering the upcoming My Super legislation? The answer to many of these risk management questions lies in the target time horizon of institutional investors’ investment strategy, particularly those that are investing to meet defined obligations (liabilities) and are faced with increasing regulatory focus on solvency and capital in 2013. A raft of new legislation including Stronger Super, Australian Prudential Regulation Authority (APRA) SPS 160, and APRA’s Life Assurance and General Insurance Capital (LAGIC) is currently impacting these fiduciaries.
Liability driven investing
Continued market volatility has prompted some investors to query whether the equity risk premium is worth their nerves being rocked, while low bond yields have suggested to others that they have no choice but to accept that volatility.
The Global Financial Crisis and subsequent monetary policy changes including quantitative easing in developed market economies have, together with greater “mark to market” accounting transparency for corporates, driven a perfect storm. First, investors query the degree of shorter-term volatility associated with diversified portfolios relying on the equity risk premium, or indeed the balance sheet capital required to be tied up in supporting those equity strategies. Second, long-term bond yields have declined to such a point that actuaries have to lower their discount rates and increase today’s value of future payment commitments (higher liabilities). This is challenging the viability and financial solvency of future benefit commitments.
The uncertainty of these market conditions has seen some investors move to a liability immunisation approach, reducing as much risk as they can. While others seek yield, such as bank dividends, as a means to obtain returns despite continued capital volatility. Some investors are taking a bar-bell approach, where a portion of their portfolio is focused on performance and return generation and another portion is focused on hedging against unexpected shocks. As funding, or solvency levels, change the optimal proportion of the risk hedging portfolio and the performance seeking portfolio change dynamically.
This is the basis of the traditional ‘balanced’ portfolio and the growth/defensive segments. This was driven by a theory that risk and performance are two conflicting objectives that are best managed when managed separately (the separation theorem), as suggested below.
Finding the ‘new’ and integrated balance
Recent academic research1 has suggested there are benefits to be gained in abandoning this distinct separation in favour of a more interactive and integrated approach.
Simply put, a liability hedging portfolio can be shifted to have a marginally greater focus on returns, while the performance seeking part of a portfolio should have a marginally greater focus on liabilities.
If the opportunity cost of considering liability hedging characteristics in the performance seeking portfolio is only a small reduction in the Sharpe ratio, then it is worthwhile in terms of overall risk reduction. In this way for any given level of financial surplus a fund can have a higher proportion in the performance seeking portfolio, and reduce costs. The question is, is this just academic theory or can these investment strategies really work in the real world?
Some asset class investment strategies, as shown below, can be additive to the two segment approaches.
It is suggested that defined contribution investing involves a transfer of investment risk from the sponsor to the individual - and the trustee or fiduciary has no explicit liability to meet. It is important that the individual is given the education to be able to accept that responsibility otherwise the trustee’s liability will be an unhappy membership likely to regularly raise a number of questions about their superannuation balances and provider. The default strategy bridges this gap.
To date, a majority of default investment strategies have resembled the ‘balanced fund’ investment strategy defined (and limited) by the strategic asset allocation mix usually 70% growth and 30% defensive assets. Peer comparison of these funds is easy given an ‘apples for apples’ approach. This raises several shortcomings.
1 - The strategy is defined by the strategic asset allocation and not the outcome it is seeking to achieve. What if a 70/30 investment strategy does not meet the return target on the product label of “inflation +4.5%” over five years? Some industry commentators say to extend the investment time horizon to increase the probability of achieving the goal, or it doesn’t matter as long as other peer funds are having the same issues say others.
2 - What if the investor has an explicit five year time horizon until taking a lump sum at retirement or even less than that? Choose a lower risk investment strategy say the same industry commentators with a shorter time horizon; for example a ‘conservative fund’ with a three year horizon. Peer focused conservative funds tend to be defined by a large strategic weighting to (government) bonds and cash. Is the industry really suggesting that investing in government bonds and cash over the next three years is a wise or prudent conservative investment strategy?
Trustee liability within accumulation schemes
The focus should be on goal-based investing. Trustees of defined or accumulation schemes do have an explicit liability to consider: it is that their members are expecting the scheme to provide a comfortable or at least sufficient inflation proof retirement income.
While investors in Australia are relatively well served by the superannuation guarantee system of mandatory contributions, it is clear that from contributions at 9% to 12% per annum of salary, most retirement expectations are not going to be met unless the individual stays engaged with their superannuation in working life and where possible looks to top-up contributions through salary sacrificing.
Meeting expectations and controlling extreme investment emotions is key to members staying engaged in the long-term.
Improving engagement through target date funds
Adjusting the investment strategy to match specific individual time horizons is key to maintaining engagement and changing circumstances through life. A negative return of -10% in the year before an individual’s planned retirement is not going to meet expectations however that performance compares to peer groups.
Target-date investing encapsulates the above risk factors to keep members focused on the end goal, incorporating dynamic asset allocation strategies and capital protection measures. This is key to solving the portfolio challenge in an ever-changing investment environment.
During the life of the strategy it cannot be defined by a specific strategic asset allocation, it can only be judged by its success at delivering the investment outcome at the time required, usually the approximate date of retirement for a certain age cohort of members. In the absence of peer group comparison, excellence in reporting, communication and transparency must be delivered.
We have shown that liability driven investing principles are relevant for all investors. Risk management determines the success of investment strategies achieving goals and more focus should be given to the strategies that govern risk management. This means diversification of portfolios towards variable betas, with the flexibility to control asset allocation to suit valuation and environmental conditions.
A multi-asset solution
By considering a broader range of assets (or risk factors) beyond the traditional bonds and equities and allocating dynamically, portfolio outcomes are greatly enhanced.
For example, investment grade corporate bonds, infrastructure and infrastructure debt as well as some commercial property, can provide longer duration liability related returns. Global listed infrastructure/REITs, single strategy absolute return funds and other lower beta equity strategies can provide yield and capital growth opportunities with reduced volatility potential.
To meet specific client outcomes however, portfolio construction philosophy must be more complex than simply adding uncorrelated asset classes and relying on an asset allocation framework.
We have found the following investment principles to be helpful in building robust portfolios for the current investment environment:
Asset allocation is the key determinant in delivering a client’s desired investment outcome
Good portfolio construction including the ability to protect capital is an important capability in a volatile world
Flexible portfolio management is important in order to adjust portfolios to a changing macro-economic market environment and respond to valuation changes
Absolute return and yield capabilities have an important role in portfolios to achieve specified goals (such as inflation plus, income etc)
Illiquidity premiums (for direct investments) can provide an attractive return source, but come with risks that need to be carefully managed.
Using these investment principles as a foundation, we can assist clients in the following areas:
Implementation of multi-asset solutions can take many forms dependent on the existing portfolio or in-house investment resources available. Our clients tend to use three broad methods to implement.
1 Managing pension assets from Surplus Optimisation to Liability Driven investment” Lionel Martellini, March 2009.
2 Does Asset allocation policy explain returns”, Ibbotson et al. Financial Analysts Journal January 2000.
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