John Harrison: Rethinking asset allocation
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Photo: Federico Racchi,CC
With pooling on the horizon LGPS funds are entering a new era. John Harrison argues they’ll have a strategic role in asset allocation but with more underlying complexity.
In a little over a year from now the LGPS pools will become operational and quite quickly take responsibility for manager selection and monitoring. The only significant investment function retained by individual administering authorities will be asset allocation. But what will that mean in practice?
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It is widely recognised that asset allocation is important. Indeed, most academic studies conclude that investment returns are mostly driven by asset allocation (the choice of markets) rather than by security selection (the choice of assets within markets). It is over 30 years since the seminal paper by Brinson, Hood and Beebower determined that asset allocation accounted for over 90% of long-term investment returns. The exact proportion has been regularly disputed ever since — academics have always loved a good argument — but most subsequent analysis has supported the view that asset allocation is significantly more important than security selection in generating long-term investment returns.
In the context of LGPS funds, however, the distinction between asset allocation and security selection is not always clear cut. Historically, most funds have focused their time and effort on establishing and monitoring manager mandates. Where this is a mandate in a specific market — UK equities, for instance — it is clearly security selection rather than asset allocation. But what about multi-asset or even global equity mandates? They devolve the choice of markets to the manager, albeit within the constraints of the benchmarks and risk tolerances chosen.
Choices
In the new LGPS structure administering authorities will have relatively little input into the selection and monitoring of manager mandates on a day-to-day basis. However, they will have some influence on the range of choices available, especially at the outset. Participating funds will need to agree with their respective pools what types of investment option will be made available — that is a live debate at present. For example, will a participating fund only be allowed a single asset allocation decision for global equities, or will they have flexibility to invest in regional portfolios in the US, Europe and Asia?
The trade-off between cost effectiveness and required flexibility will determine the number of investment options that are offered and therefore the level of granularity available to authorities in asset allocation. The pools will need to decide whether the choices available should be differentiated by asset category or by target relative return.
For example, if a pool could only offer three global equity buckets, should they be “US, Europe and Asia” or “passive, active and unconstrained”? This will be even more important in alternatives, where the potential range of choices is enormous and there is far less consensus on what should be included. It will not be possible to deliver the expected cost savings without limiting the choices available.
It is probably too early to determine the optimal range of choices required and it seems likely each pool will take a different approach. However, in my personal view, a number of key factors will shape the eventual outcome.
Factors
First, the focus of asset allocation at the authority level will be strategic rather than tactical. Individual authorities will have neither the time nor the internal expertise to attempt “market timing”. The role of asset allocation will be to ensure the long-term structure of the investments remains consistent with the funding position and liability drivers of the underlying schemes.
Second, it will be increasingly important for authorities to enable each employer to tailor investment strategy to their individual needs. The number of employers within each authority has increased substantially in recent years with many having maturity profiles or funding positions markedly different from the dominant employer. A “one size fits all” approach is no longer desirable. While it is unlikely to be cost effective to offer bespoke strategies to most employers, a high/medium/low risk range of policy options could be provided.
Third, liability risk management will become more important, not just for a few employers with more mature schemes but for all. The political toxicity of pension deficits means that LGPS funds will need to be seen to have defined a robust strategy to manage liability risks, which will include being able to react quickly if de-risking opportunities arise in volatile markets.
Fourth, to the extent that each pool will only be able to support a finite range of investment options, it will become less important to have multiple variations of developed market equities. Administering authorities will increasingly regard this as a tactical decision for managers. Instead they will want to be provided with more options in alternative asset classes and in liability aligned bonds.
In this new world, administering authorities will have more time to devote to strategic asset allocation, but with more complexity in how this is applied to the underlying employer funds. Reporting processes will evolve to focus more on funding level volatility and less on returns in isolation. And officers and advisers will need to have access to better strategy modelling tools.
John Harrison, independent investment adviser, Surrey Pension Fund.
