21 November 2011

Pension funds need to embrace a 3D vision

Funds that have de-risked, through liability driven investments, and have diversified, allocating to alternative assets in addition to equities, bonds and property, have done better through the past few years of turmoil. There is a lot of confusion, but dynamism is broadly taken to mean the ability to be more fluid with assets in a two-way direction – the risk-on, risk-off trade. We see regular asset-class mispricing, which can and should be exploited by pension schemes in the medium term (one to three years). This can be done not just to reduce risk, but also to enhance returns.

There are barriers to this cultural change. The first is the received wisdom which leads to herding and anchoring. We are in a decade-long cycle of so-called abnormal volatility – assuming the preceding periods were normal.

Investment strategy is the dominant driver of risk and return, but deriving it from a three-yearly modelling exercise that uses assumptions rooted in past experience has not, of late, served investors well. Academic financial theory throws up a second barrier. The idea that rational investors make risk-driven decisions in efficient markets does not seem to describe our experience. This will give more academic credence to the need to be dynamic. Static allocations, in a world where intervention, fear, greed and emotion prevail, are not up to task.

The third element thwarting dynamism is that it is seen in some quarters as tactical trading; “not what trustees are allowed to do”. It remains much easier to be wrong through inaction than risk being wrong by action. Fiduciary solutions are therefore filling a gap created by trustee ambiguity.

Full article (FN subscription required)

© Financial News