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© Copyright 2000 Rogers Media. The following article first appeared in the June 2001 edition of
BENEFITS CANADA magazine.
Asset allocation 101
The asset allocation process hasn't changed much in three decades. It's time for a fresh
look.
By Janet Campagna
only a year ago, a much-talked about topic in the asset management industry was the impact that pension
fund returns had on corporate earnings. The majority of plan sponsors benefited from the recent decade-long
equity bull market. Required rates of return were generally in the 8%-to- 10% range. Meanwhile, equity
markets were achieving annual returns in excess of 20%.
Robust pension fund returns allowed many organizations to enjoy years of contribution holidays and achieve
fully funded or even overfunded status in their plans.
What a difference a year makes. Today, poor equity market returns are eating away at pension funds'
capital. Low short- and long-term yields are driving up both the risk premium that must be attained to meet
the required rate of return as well as the present value of the liability. Without a major shift in current
economic conditions, many plan sponsors will have to make contributions while the slowdown puts pressure on
the bottom line.
This discouraging scenario emphasizes the need for institutional investors to shift their attention towards
asset allocation. Studies confirm that the most important driver of portfolio returns (whether total
return, return variation over time or performance relative to peers) lies with this decision.
TIME FOR CHANGE
The traditional approach to strategic asset allocation has not changed significantly since the 1970s. Most
plan sponsors continue to rely on historical data to forecast long-term returns and then determine the
optimal portfolio mix by feeding them through a mean-variance optimizer. The industry must now innovate to
reflect the impact that asset allocation has on the health of pension funds.
Three areas can benefit from advances in financial and operations research. First, the method of developing
inputs for the asset allocation process must move beyond reliance on historical data. Significant insights
into long-term market returns may be gleaned from several sources, including demographic and market forces.
These insights should be included in a dynamic, time-varying equilibrium asset allocation framework.
While it's important to focus on inputs and assumptions, the optimization process must also be scrutinized.
Too often key elements of mean variance optimization are forgotten.
The assumption that returns are normally distributed needs to be challenged. Second, the assumption that
the optimization process is always intended to maximize the expected return for a given level of risk, or
the converse, also needs to be revisited. This objective may not accurately reflect plan sponsors' goals,
as they may prefer to minimize the probability of making a contribution. Third, it's important to keep in
mind that when a mean-variance efficient solution is implemented, the expected probability of meeting the
objective is only 50%.
MOVING BEYOND
Overall, these factors illustrate the need for pension fund mangers to move beyond mean variance. The new
framework must work with non-normal distributions, explicitly reflect investor preferences and maximize the
likelihood of investors meeting their objectives.
The asset allocation process must also be matched to the dynamics and requirements of the real world.
Sponsors generally evaluate the policy mix on a three-to-five-year cycle, yet innovation in the financial
world is significantly faster.
There is a proliferation of sophisticated financial instruments and investment strategies that can help
address institutional investors' challenges. While the use of these instruments and strategies must be
tempered by the caution that fiduciary responsibility requires, they should not be neglected for lack of a
disciplined, robust framework in which to evaluate their appropriateness.
Once again, we are faced with the reality that business cycles inevitably bring market downturns. The
current slump may provide the impetus to devote resources to areas that really move the industry forward.
Janet Campagna is the managing director, global head of asset allocation with Deutsche Asset Management in
New York.
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