Asset allocation – the beautiful game?

October, 2012 Print

David Crum, Director, 330 Consulting Limited.

Following the next triennial actuarial valuation in England and Wales (which will be undertaken as at 31 March 2012, and the year after in Scotland), it’s likely that most LGPS funds will turn their attention to reviewing their respective investment strategies. Of course some funds may well have “tweaked” them between valuations, but for most, the formal strategic review is also a triennial experience. Regardless of the extent to which you undertake modelling of different investment strategies, this task is arguably the most important piece of work that a pensions committee will undertake. Given that most LGPS funds have remained predominantly invested in equities, the poor investment returns experienced since the last valuation may well concentrate minds even more on how each fund’s assets could – or should – be allocated.

I quite like football, and every year dabble in Fantasy Football for the English Premiership. Having said I like football, I’m by no means an expert, and don’t follow it with the religious fervour that some of my ex-colleagues exhibit on this topic. For those who don’t know anything about Fantasy Football, here’s the five most important points to be aware of when playing:

  • Each participant in the fantasy league is given a notional £100 million to spend on players;
  • They have to select a team of 15 players (2 goalkeepers, 5 defenders, 5 midfielders and 3 forwards);
  • They can only select a maximum of 3 players from any single Premier League team;
  • Each player will “earn” points each week, depending on how well they perform in their relative positions, with the total of the entire fantasy team’s performance being recorded every week; and
  • The participant whose team has the highest number of points at the end of the season wins.
Fairly straightforward, I hope. Since I don’t really know which players are the best, I have to employ a different tactic when picking my team. Historically, forwards and midfielders tend to score the most individual points – well, the ones who can actually play well have! – and so this year I decided to spend the largest proportion of my £100 million on three really expensive forwards, and two expensive midfielders. The rest of my team could kindly be described as being filled with “place mats” (the cheapest players still have a minimum cost of about £4 million each, so it becomes an interesting exercise trying to trade off the cost vs. benefit of different team permutations).

 

Why am I telling you all this? When doing it, it reminded me (sadly!) of making asset allocation decisions in a pension fund framework. There are quite a few similarities:
  • Each pension fund has a limited amount of assets to invest (regardless of whether its measured in the £m or the £bn);
  • Most funds want to spread their cash across a selection of asset classes, with the standard approach being to focus mainly on equities, bonds and property (the historic good performers);
  • Diversification suggests that you shouldn’t concentrate too much of the fund in any one asset or asset class;
  • Historic performance of individual asset classes tends to feature heavily when deciding on the composition of the overall long-term investment strategy

 

At the moment, my fantasy football team seems to be suffering from the same kind of problem that pension funds have experienced over the last 10 or so years with equities – namely, past performance is no guide to the future! So far, my expensive assets are not performing as expected (thank you Mr Rooney), but it is early days.

 

I’d be really interested to know what LGPS funds are thinking, with regards long-term strategic asset allocation. Figure 1 opposite, kindly provided by WM Company, shows the changing asset allocation of the WM Local Authority Universe for the last 20 years.
As can be seen, equities have been slowly, but surely, declining over the last 20 years. Bonds and property have both slightly increased, but the most noticeable change has been the increased exposure to alternatives.

 

What does the next round of strategic reviews hold for the LGPS? Are funds sufficiently fed up with equities that they will continue to fall as an overall percentage share of asset allocations? If so, where will the money go? Conventional wisdom says that fixed interest assets are expensive by historic standards, and that the “safe haven” effect that has driven their values up and yields down will have to unwind sometime – but when? When will the property market recover, held back as it is by the limited availability of lending? The same problem is likely to make some parts of the private equity spectrum also struggle.

 

What does that leave? Hedge funds? Infrastructure? Alternative credit? Emerging market debt? Social housing? Long lease property? What, if anything, does the average pensions committee know about these areas? How much time are they willing to spend between now and the end of 2013/14 preparing for the strategic review by learning about possible new investment opportunities?

 

Maybe the historic star player, equities, will rally between now and next March. Maybe there will be a corresponding fall in the value of bonds, as investors move their cash back to risk assets. Either, or both, would be a welcome result for LGPS funds – but given the current economic environment, and the general view of a continuing bumpy ride for the global economy, how likely is either?

 

It’s still early days for my fantasy football team, but I am currently languishing at the foot of the league that I compete in with my friends. I’ll give my star players a few more months to perform – but if they don’t, I may have to take action and put my faith in some up and coming, less expensive talent. I wonder if my friends who look after LGPS funds will be having some not dissimilar thoughts in the coming months?

Figure 1: WM Local Authority Universe – Longer-term asset allocation(%)

Asset Allocation FOCUS

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