A typical pension fund portfolio is so dominated by equity risk that returns will fluctuate widely according to economic conditions which affect equity markets. Amanda White spoke to Rob Zink, portfolio strategist and now consultant for Bridgewater Associates about why most investors have a flawed approach to asset allocation.
The global financial crisis has highlighted flaws in portfolio structuring with equities allocations far too dominant for a balanced portfolio that can endure in all economic conditions, according to Rob Zink, director of portfolio strategy at Bridgewater Associates.
He says typically pension funds allocate about 65 per cent of their capital to equities, but what they ignore is this translates to about 86 per cent of the portfolio risk. (see table)
Instead the approach Bridgewater takes, and one they advocate philosophically — not just through their All-Weather product — is to build a portfolio that will be resilient in all economic conditions.
“You can make tactical decisions based on your views of the world but this is a strategic asset allocation for the long-term which is independent of any specific view of the world,” he says.
“From our perspective there are two ways to make money in markets, you can hire a smart manager to make market-timing calls, or you can bet on markets. Most people are more comfortable with the strategic asset allocation approach, and the most important focus is a better diversified portfolio.”
To achieve this, he says, means more focus on risk allocation and not capital in setting the asset allocation of portfolios.
“The capital allocation by super funds is dominated by equities, but portfolios don’t earn returns on the money invested but on the risk we take. About 85 per cent of the risk is in equities,” he says.
To eliminate the equity dominance in asset allocation, he says investors need to look at the drivers of return, and the relationships between different asset classes changes with different economic conditions.
For example if growth is a driver, then equities and commodities will behave differently to nominal bonds and inflation-linked bonds. Similarly, if inflation is the driver, then inflation-linked bonds and commodities will behave differently to equities and nominal bonds.
“A typical portfolio now is dominated by equities so the portfolio will be dominated by economic environments [in which] equities do well or badly Funds need to position their portfolios to do well for all environments.”
He says a more balanced portfolio would allocate [according to risk] 24 per cent to equities, 33 per cent to nominal bonds and 22 per cent to inflation-linked bonds, 13 per cent to commodities, 4 per cent to emerging market debt spreads, and 4 per cent to corporate spreads.
Equities have dominated pension fund allocations because investors have been chasing returns, he says. But the global financial crisis has highlighted what may have been forgotten, that higher returns come with higher risk.
Some investors may review a decrease in the allocation to equities as a potential decrease in returns. But Zink says this can be achieved through leveraging the bond portfolio, or, if there is a fear of leverage, investing in longer duration bonds.
“Basically all asset classes have roughly similar risk/return ratio, for 1 per cent risk all asset classes return between 20 and 30 basis points so that the risk/return ratio is between 0.25 and 0.3 per cent. People chase equities because they generate higher returns, but the fact it also has higher risk is ignored,” he says. “The notion is that to increase the risk allocated to an asset class then you can increase return as well – you can still run a more diversified portfolio and get return.”
He says analysis has shown if you leverage a normal bond index 2.5 times, using futures contracts, it will return the same as equities over the period from 1970 to now, with a little bit less risk (although that may time frame sensitive).
“You don’t have to chase equities to generate returns. Using leverage in a prudent way, you can equalise the risk of the asset classes and unlock the power of diversification. There is a general thought that ‘leverage is bad’, I’m not sure that’s true, it is misunderstood,” he says.
“Leverage is a risk-adjustment vehicle, the problems are when leverage is used to take too much risk, but leverage of itself is not a high risk.”
Zink says there are other methods of increasing risk, and so return, if investors are uncomfortable with leverage.
“In the case of bonds you can move to a longer duration index, such as 10+ years, you’re increasing risk and capturing a larger portion of return,” he says.
“The logic behind this way of allocating assets is quite compelling and whatever risk I take this asset allocation is a far more efficient use of risk than what’s done today, which is return chasing by investing in equities.”
Zink also points out that, by investing in equities, institutions are investing in leverage, as all companies are leveraged, which is why returns are high.
He says the principles for building a more resilient portfolio include: allocating risk not capital because risk drives returns; building an allocation that is resilient to all economic environments; sizing exposures to target desired return and risk, and maintaining a liquidity buffer for contingencies.
The Bridgewater All Weather fund returned 32.9 per cent in the year to February, and 7.6 per cent for the past 10 years.
Â Typical Pension fund portfolio weights by asset class
||Capital allocation %||Risk impact %|
|Nominal government bonds||15||2|