Sometimes, finding the right investment approach can feel like trying to get a book onto the bestsellers list: a bit of strategy, a bit of prediction and a whole lot of luck.
A recent article in Institutional Investor suggested there are three alternatives to the traditional 60/40 investment model for pension plans: the Yale model, the Norway model and the Canada model.
The Yale model, or endowment model, is defined as reducing reliance on the equity risk premium by diversifying into illiquid alternative assets and seeking hedge fund alpha. The Norway model is described as reliance on in-house management within the 60/40 structure. The Canada model is not specifically defined, but appears to be viewed as a combination of the two approaches.
It may be useful to think in terms of four investment strategies, any of which could use a combination of internal and external management—and might just land your plan on the pension equivalent of a bestsellers list.
As many plans implement an immunized approach to pension investment management, they are reverting “back to the future”—following the model used by the insurance industry in the 1950s and 1960s. However, while the insurance companies might have favoured risk-free government bonds, pension funds are being encouraged by accounting rules to consider corporate bonds as the hedging asset class, thus exchanging equity risk for credit risk. Using an immunized approach lowers return expectations, but may also give rise to a false sense of complacency that risk has been eliminated.
Book title: The Perfect Storm
The 60/40 model has fallen into disrepute recently due to its inherent surplus risk volatility and excessive reliance on equity risk. Of course, the equity bear market of the last 15 years has not helped matters either. However, many investment strategists have recently noted the attractive valuation levels in equity markets, and we may be poised to enter another long-term bull market within the next few years. The 60/40 model, which performed so well in the 1980s, could be the champion once again.
Book title: Captains Courageous
The pursuit of illiquid assets (real estate, direct infrastructure, private equity, hedge funds) as an alternative to traditional public equity risk appears to be turning into a crowded trade. One of the benefits of this approach is “sticky” valuations, satisfying the gods of mark-to-market accounting. These asset classes are attractive because they are portfolio diversifiers and reduce volatility relative to plan obligations. However, these asset classes may at best only deliver returns that are comparable to public equity These strategies may also attract higher fees, making them more profitable for the asset managers than for the asset owners.
Book title: Where are the Customers’ Yachts?
Leverage, leverage, leverage
Some pension plans have elected to include leverage in their investment approach as a means of enhancing return while reducing surplus risk—having their cake and eating it, too. The approach may use interest rate swap overlays to extend duration or use equity swap overlays to add equity risk back to a fixed income portfolio. Once again, this approach exchanges one type of risk for another, and requires strong governance, extensive infrastructure and customized skills to implement. When one considers that even world-class investment banks have been brought to heel by injudicious derivative use, this model should be approached with caution.
Book title: Life on the Wild Side
As has been noted many times before, in our industry the only perfect hedge is in the Emperor’s garden in Japan. Pension plans are fundamentally risk-pooling mechanisms, which is why they fall into the domain of actuarial science. In attempting to pursue lower risk strategies, pension funds may be exchanging one demon for another.
Book title: A Demon of Our Own Design