Pensions are a bellwether for the health of a long-term investing mind set. And where the majority of liabilities do not fall due for decades, pension schemes should be the ultimate form of patient capital.
Today’s investment universe offers golden opportunities to reinforce such an approach but other trends have created challenges.
Historically, there were natural straitjackets for pension fund investing. Using simple building blocks, an investment portfolio designed around an equity-bond mix was perfectly understandable.
It aligned neatly with the academic idea of a “market portfolio” of risky assets diluted by defensive assets. The monochrome 60/40 portfolio became the generic basis for investing.
While equity broadly remains equity whatever its flavour, it is arguably the debt universe that has caused the greater disturbance to the old model, particularly in terms of understanding its place in the overall portfolio.
For many years it crudely equated to ‘defensive’; today investors can choose a variety of leverage points and therefore access a broadening array of cash flow generative assets with more equity-like returns.
Simplistic
The simplistic portfolio has therefore gone, and with it the old taxonomy of asset classes.
New asset classes, more acceptable illiquidity, asset owners taking more direct ownership with less intermediation all offer the potential for better outcomes, but also accumulated governance challenges. This is in part because there has also been a contrasting flow in the direction of accepting what you are given as active management has given way to passive investing. The world’s largest pension funds have had to deal with the negative effects of size.
While there are certainly more resources available for larger investors to be active, there are also constraints, especially given the growing concentration of listed market weights in fewer names.
Size leads to owning the market – by default you become a passive investor. Smaller pension funds too are feeling the lure of passive – as simplicity and costs have moved to the forefront of thinking. This contradictory blend of trends has led to the governance setting framework becoming strained.
Schemes are faced with a pressing need for governance frameworks that can make sense of the combination of new and old investment styles and opportunities.
Traditional strategic asset allocation benchmark setting feels unresponsive in this context. With investment opportunities becoming ever more granular, the simple ranking of returns from equity to risk-free into linear betas looks somewhat out of date; with passive investing taking on more of a core role, the modelling of alpha also becomes challenged.
In governance terms, historically, mandates handed out to asset managers were tightly restricted. The asset owner would give a specific mix of assets as a benchmark strategic asset allocation, with the manager formally monitored with respect to their benchmark –relative performance.
Since the global financial crisis, there has been an increasing trend for pension funds to give their managers “outcome orientated objectives”. For example, a goal, such as cash+x or CPI+y, that is aligned with the asset owner’s specific end requirements but with very wide discretion.
Binary
We believe asset owners should not have to make a binary choice between micro management and full delegation. Instead the asset allocation can be developed by first establishing a reference portfolio – a liquid, passively implementable portfolio which maps out a scheme’s long-term risk and return characteristics.
This then allows for a more dynamic and granular implemented portfolio to be assessed against this more straightforward but slower-moving comparator over longer-term investing periods.
This balances the complex reality of the investment universe against the simple reality of choice of investment approaches available, and offers a helpful way to reset the asset-owner and asset-manager dynamic.
None of this means that the job is done.
This is not a one-off reset of the 60/40 portfolio – governance can be enhanced, but can never stop.
The approach described aims to bring realignment and accountability to a pension scheme’s true long-term investment potential.
The focus can move back from the trees to the woods; to investment markets as they will be in five, 10, 20 years – a different balance of geographies; ownerships across capital structures and not simply within asset class buckets; active ownership of assets and not funds. By reflecting the changing nature of the world’s financing basket to maximise the opportunities available, portfolios will be better placed to work towards that end goal of being able to pay that last pensioner liability in 40 or 50 years’ time.
Leandros Kalisperas is head of pension solutions for Aberdeen Standard Investments
