Asset Allocation 101

This is a classic form of institutional investing and has proven successful over longer periods of time. As the industry continues to introduce new investment products/solutions, 2009 may prove to be an opportune time to evaluate and possibly reset your asset allocation risk management process before you consider any wholesale product or manager changes.

Sponsors may think that risks can be mitigated by utilizing new investment products/solutions (which will typically come with a higher price tag), however, as humans, we tend to think that future risks will somehow be more controllable simply because of what we learned, albeit painfully, from a recent event. I am no sage but my diverse field experience has taught me that it is dangerous to think that imperfect solutions that exist today can be completely replaced by untested solutions going forward.

The following are some fairly straight forward risk management approaches that are part of the classic asset allocation / manager structure framework. It is important to note that some of these strategies by design are ‘built in’ or ‘bottom-up’, which imply that the direct responsibilities of the sponsor are lessened although the sponsor is still responsible for monitoring and oversight. ‘Top down’ strategies require more direct involvement from the sponsor or an external force that will have discretion on altering the risk surrounding the plan’s target asset allocation.

Top Down Risk Mitigation
The most common approach here is an overlay strategy such as global tactical asset allocation (GTTA). The idea here is to over weight or under weight certain countries, asset classes and currencies to mitigate the risks inherent in a plan’s target asset allocation. This approach aims to mitigate the risk that is actually the result of the policy allocation—the policy allocation is expected to produce risk-return characteristics over the longer term and GTAA is intended to smooth some of the bumps that will occur along the way.

For example, the overlay manager may believe that equities will be under pressure in the next 6 months and as a result reduce your plan’s exposure to equities through the overlay strategy. Like any investment strategy, GTAA can be risky—particularly if the overlay manager effectively doubles down and amplifies your portfolio risk as opposed to mitigating it. The key search and selection factor for an overlay manager is to ensure that the strategy is designed to hedge the unique circumstances of your plan’s risks which means the manager must be able to partner with your plan to customize a quality solution and not necessarily provide an off the shelf turn-key pooled solution.

Bottom Up Risk Mitigation
Asset Allocation – the most common built-in approach to asset allocation risk management is rebalancing. There are three main types of approaches to rebalancing:
1) full rebalance to plan target allocation at pre-determined set periods of time,
2) partial rebalance specific asset classes that are above or below pre-determined tolerance levels, and
3) catch-up rebalancing whereby the sponsor is allocating contributions to specific asset classes or redemptions from specific asset classes.

All of these strategies are simple to implement and monitor and ensure that the sponsor is not actively making asset allocations decisions different than the plan’s target allocation.

Manager Structure – ultimately it is the skill of the manager, in the case of active investing, that provides the balance between the results and the level of volatility assumed versus the fees charged. Other factors include the style of the manager, the magnitude of the constraints placed on the manager in terms of permitted cash allocation (and the ability of the manager to use the cash allocations to protect against downside risk) and the use of performance based fees to ensure that the manager is being compensated for actual results and not the expectation of results.

An emerging area for risk control is the use of investment mandate insurance. Most managers have E&O insurance and other types of insurance coverage in the range of $5 million to $25 million. An emerging sponsor practice is to require managers to insure the entire principal under its mandate, which can often be much greater than the historical coverage maintained by managers. This is an expensive approach from the manager’s perspective. This approach is also interesting given that investing has not historically been viewed as a riskless exercise. Nonetheless, we can expect this type of approach to increase forcing managers to align their interests with those of the sponsor.

In summary, there are a number of risk management strategies that plan sponsors can utilize in their asset allocation and manager structures. A lesson learned from the defined contribution side (usually it’s the other way around) is that before you add an investment solution, think carefully about taking something away to reduce complexity and costs that may not be justified.

For example, if employing a GTAA strategy that has a significant component related to managing currencies then the suitability of maintaining a fully hedged currency program may not be optimal and may in fact increase correlations and reduce diversification instead of promoting it.

Peter Arnold leads the Canadian Investment Consulting Practice for Buck Consultants, an ACS Company.

To comment on this story, contact us.