Our Focus

One of our key success factors has been the ability to focus on what matters.  To illustrate this, we thought it might be helpful to share an example of a broad area on which we are advising clients, without giving too much away!

It was conventional thinking ten years ago to represent investment strategy as an equity/bond split.  Thinking moved on, as people began to accept the potential benefits of diversification.  Also, as derivatives products developed, the concept of using these to hedge the liability risk exposure to bond prices rising has also developed.  It is probably fair to say that many schemes now either have or are migrating towards diversifying and using liability hedging as a means of controlling pension risk. 

This is a relatively recent innovation for the industry, although we pioneered the concept in the industry a few years ago, and our clients have been positioned for this development as a result.

However, there are circumstances where the strategy could break down and these also need to be considered.  There are two issues to consider here.  Firstly, the expected return typically reduces, as a wider range of lower-returning assets are used to achieve diversification.  This can be an issue if liabilities grow more quickly than expected.  Secondly, risk exposure still exists, in a static asset allocation strategy as, for example, even a wide range of risky assets may all fall at the same time.

Let’s look briefly at each of these in turn.  If we need to generate more return, there are two options.  The first is to use active management in underlying markets, such as employing an active equity manager.  The second is to manage the overall asset allocation more actively.  Both are valid options.

If there is a need to manage downside risks in the case that a wide range of risky assets all fall, there are two clear approaches.  The first is to rotate temporarily into more defensive asset classes and the second is to use some form of hedging using derivatives, typically for the equity component of the portfolio.

Just to be clear, a wide range of our clients use all of these measures – active management, asset allocation management and hedging.  But if you aren’t already well diversified and used to these techniques, you probably need to find a place to start.

Let’s now think about the future.  We had a strong bull market in equities from 2003-2007.  We then moved into a period of significant uncertainty, followed by a substantial market fall in 2008.  This period has created its investment challenges, for sure.  But probably more interesting is to consider whether the structure of markets has changed over this time.

We tend to believe that markets have changed and that there is more uncertainty in the system now.  While the extent of the uncertainty will reduce, it probably won’t go away, which we think means it is now less likely that we’ll be seeing the same type of protracted bull market we saw from 2002 to 2007.  Rather, we will probably return to shorter bull and bear markets, producing greater year on year variation in returns. 

If these conditions play out, this will change the game for many active managers, as strategies that have been developed in protracted bull markets won’t work as well.  We believe the most practical way to address these conditions will be by managing asset allocation more directly.

So, in a nutshell, if you haven’t implemented diversification or equity hedging but you need more return than static diversification gives you, and/or you need to worry about downside risks, then we suggest that you spend a reasonable amount of governance time thinking about how you manage asset allocation. Many other things also matter but they probably won’t be as important as this.