By Bob Maynard
Once upon a time, up until about 15 years ago, pension investment was straightforward. Conventional wisdom was to have a portfolio that was simple, transparent, focused and patient.
Simple, in relying primarily on the public markets with a long-term investment time horizon; transparent, in being relatively easy to understand and explain; focused, in concentrating on a relatively small number of additional special strategies that would have material impacts on the portfolio; and patient in focusing on returns and actions over five-year and longer periods, rather than on the next quarter. It avoided significant leverage or non-transparent structures. Risk control relied primarily on the transparency of the portfolio as a whole and the use of extensive quantitative risk models was a secondary, and often unnecessary, consideration.
This uncomplicated approach followed from a few basic principles: 1. markets are generally rational and efficient; 2. prices are random in the commonly-understood “coin-tossing” sense; 3. return is largely proportionate to risk, expressed as volatility; and 4. diversification is a necessity for good portfolio structure.
For five or 10-year periods and longer, the behaviour of the capital markets has been generally consistent with these assumptions. But this orthodoxy came under fire from the late 1990s premised on the increasing divergence between the long-term needs of investors in these markets and those markets’ actual shorter-term (monthly to three-year) behaviour. It relied on five key observations: 1. on a shortterm basis, public markets were more volatile than coin-tossing randomness would expect; 2. on these time horizons, the markets often behaved in ways that were neither efficient nor rational and often exhibited “herd-like” behaviour; 3. return was often not proportionate with risk in time frames under three years; 4. higher returns could be sought through illiquid markets; and 5. diversification could be extended to a vast number of markets, vehicles, active management styles and illiquid investments.
As a result, the investment world moved on to a new model of investing often referred to as the “ endowment model” – or its new progeny, the “risk-centric” portfolios, including risk budgeting, risk parity, or risk sleeve and factor models. This places much less reliance on major public markets, instead focusing on intense active management and illiquid instruments, often using leverage.
The endowment model failed its first stress test – the global financial crisis – miserably. Markets are indeed extremely volatile, but there is no place to hide and many of the places where the new model had significant exposures turned out to be far worse. Capital markets are indeed inefficient in the short term – but they are even more unpredictable than assumed by the standard model, and active management faces even higher hurdles than previously imagined.
Even in a complex, non-linear, inefficient and turbulent world, the best approach is still to be found with a simple, transparent, diversified but focused portfolio.
Bob Maynard is chief investment officer at the Public Employee Retirement System of Iadaho and a member of the 300 Club
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