By Richard Batty
Lower mortality rates and unstable market conditions pose an issue for pension planning. These two factors need to be addressed to enable pension commitments to be realised going forward. Pension funds are looking for more sophisticated solutions than those offered by ‘standard’ multi-asset or diversified growth funds in order to meet their objectives.
For many pension funds these objectives are to meet their increasing liabilities but with an acceptable level of volatility. Industry trends show that pension funds are increasingly looking at multi-asset solutions. Mercer’s recent 2013 European asset allocation survey* showed that pension funds were most likely to increase their weight in the alternatives space rather than more traditional investment strategies and that a large part of this was expected to be in multi-asset.
Targeted return strategies can be used as a diversifier or a ‘return engine’, which is captured in the twin aims of delivering equity-like returns while maintaining volatility at a level less than half that of global equities over a three-year rolling period (there is no guarantee these targets will be achieved).
Multi-asset portfolios have historically looked for diversification through investing in three or four asset classes – typical balanced funds have used government bonds, corporate credit, cash – and perhaps real estate to offset exposure to equities in the expectation that one asset class will perform when the other doesn’t. However, balanced funds have not always achieved this in the past and correlations between asset classes are by no means stable. We have seen the diversification benefits of government bonds vary substantially over time. At times they have had a high positive correlation with equities, at other times a high negative correlation. Indeed, the diversification properties often prove most unreliable at precisely the time they are needed. For example, during the ‘taper tantrum’ in May/June 2013, bonds and equities fell together and corporate bonds, property and cash would not have made up for the shortfall. The correlation between bonds and equities is neither sufficiently strong nor reliable enough for bonds to be a suitable source of diversification in an equity portfolio. The most recent rolling 180-day correlation between US 10-year bonds and global equities is close to zero (actually just +9% according to Datastream as at 27 July 2014).
Multi-asset approaches looks to achieve genuine, more reliable diversification through good investment ideas rather than relying on asset classes. For example, we may look at an idea that is long in US large cap stocks and short small caps, or another which is long the US dollar and short the Canadian dollar. Both these ideas currently have a negative correlation with global equities and one which has been more stable over time. More importantly, we believe that both of these ideas have the potential to provide a positive return over our two- to three-year investment horizon – the primary reason we have adopted them for our portfolios.
The investment ideas also need to work well in combination so that adequate diversification is achieved. It is important that the ideas in the portfolios have sufficient volatility to have the potential to achieve equity-like returns yet, when they are combined, the diversification benefits of the ideas are such that the total estimated volatility of the portfolios is less than half the volatility of global equities.
The aims of targeted return multi-asset portfolios – equity-like returns in all market environments over a rolling, three-year period, but with managed levels of volatility – seek to meet clients’ requirements. We believe an emphasis on diversification through ideas not asset classes is essential in order to achieve these hard to come by characteristics within a sophisticated portfolio.
Richard Batty is a multi-asset fund manager at Invesco Perpetual
*Source: Mercer Asset Allocation Survey, European Institutional Marketplace Overview 2013.
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