How to allocate if the world has changed forever

Jonathan ArmitageThe financial crisis has challenged pension funds to rethink standard asset allocation models, but as Jonathan Armitage, head of US equities at Schroders observes, a lot of investors are questioning whether they need to react.

Jonathan Armitage head of US equities at Schroder Investment Management, believes funds are grappling with the decision of whether or not to react to the unprecedented events during the global financial crisis, or stick with long term asset allocations.

“I was talking to a client [recently] and they were discussing internally the fact that this particular organisation has
a broad swathe of managers, and they had been extremely surprised at the amount of correlation between different geographies, size; there had been no real differentiation between small and large cap, for example,” he says.

“They thought they’d built up a portfolio of diversified and relatively uncorrelated equities, and the last 12 months
have demonstrated that they’ve all performed the same way.

“The challenge for them is whether or not they need to react to what was a pretty unprecedented period in financial
markets, or whether or not it was a one in 100 year event? And if that’s the case, would they expect that correlations return to some sort of normal distribution?”

This is a question being asked by many pension funds on the back of extreme volatility and poor performance of some of their so-called “safer” and “uncorrelated” assets.

Earlier this year, Roger Urwin, London-based head of investment content at one of the world’s largest
consultants, Watson Wyatt Worldwide, said the firm was “supportive” of pension fund clients who did not want to rush into rebalancing their portfolios during the turmoil.

But after sitting on their hands for many months, anecdotal evidence suggests funds are now re-examining the way they balance their long term goals of outperformance with their short term desires for both liquidity and risk management.

Jane Ambachtsheer, global head of responsible investment at Mercer, says smaller funds with small allocations to
unlisted assets are trying to tap into the larger allocations of bigger pension funds.

As we see more strategic long-term thinking, she believes we will see greater allocations to alternative asset

While there’s been more talk than action when it comes to changing or selecting new managers, the heightened focus on
how portfolios are structured is forcing managers to be clearer about what exactly it is that they are offering – and the risks they will need to take to get there.

“You need to be very clear about what you’re selling to your clients and your investment process,” says Armitage.

“Clients are asking a lot harder questions than they have historically, and that’s probably no bad thing. There’s a much
greater focus on investment process. You’re probably going to see questions about the stress testing that you can do in your portfolios … and I think also you will see clients attempting to understand how the risk inherent in a particular product that you’re talking to them about fits into their overall risk budget.”

Adam E. Farstrup, product manager, global and international equities at Schroders, says funds are also struggling with
whether or not to go “back to basics” for investing.

He says the re-emergence of the passive versus active debate is part of this discussion.

“[They’re asking] one, how do I think about active managers, how many are taking active positions versus being
overconstrained and taking risks in the wrong places?” he says.

“Because you’ve seen some active managers really struggle, you’ve seen a much bigger dispersion of returns. [And] two, what is the right way and the right time horizon over which to evaluate active managers?”

In a momentum market, Farstrup says active managers are probably doing what they should do, but they generally

“Despite the fact that from an actuarial perspective we know that most institutional investors should be long-term [investors], the decision-making process for various reasons is not always able to be that long term,” he says.

When constructing US and global equity portfolios, Armitage says pension funds are still underweight US financials.

“We’ve moved on from a discussion about solvency and survival, to one where you’re looking at what normalised profit
would look like but also what the next 12 months of credit costs are going to look like,” he says.

“One of the things that we expect to happen in the US is you will see a fairly sharp rise in commercial real estate write-offs. It always tends to be the latter part of the provisioning cycle where those losses start appearing and we’ve not really seen a lot of banks focus on that yet, but we know that it’s coming.”