Defined contribution investment should not rely on the up and down of global stock markets alone, says AB’s Karen Watkin.
Proactive asset allocation
Offers scope to tap into alternative asset classes including illiquid assets
Allows for dynamic management of exposure to equity return factors
Focuses investment budgets towards assets that potentially add most value
But it would be naive to assume that this lull is going to last indefinitely. Huge Brexit-related uncertainties lurk beneath the surface calm – and have considerable scope to trigger renewed turbulence. And, as was the case back in June, this could quickly spread far and wide.
Greater risks… and lower returns?
Of course, Brexit-related volatility is not the only potential blot on the landscape. In today’s globally interconnected financial markets, localised surprises have a nasty habit of turning into tidal waves that rapidly engulf different asset classes across geographies.
This has created a ‘risk on/risk off’ world, where swings in investor risk appetite can be pervasive and return patterns extreme. During the past year or so alone, global markets have been troubled by many unexpected upsets, including China’s devaluation of its currency, Japan’s move to a negative interest rate policy and, of course, the UK’s Brexit vote.
More unwelcome surprises can be expected – and it looks like blanket shifts from risk on to risk off mode and back again are going to remain the new normal.
Periodic spikes in risk aversion are not the only problem. The prospect of long-term lower growth rates across the world poses significant challenges to future investment returns, even during periods when investor risk appetite is relatively robust.
And, of course, central bank policies aimed at fostering growth via ultra-low interest rates and asset purchase programmes are making it harder and harder to earn returns from the safest government bonds.
Getting proactive on DC investment
With these big challenges ahead on both the risk and the return front, the outlook for defined contribution savers is far from rosy. How can investment managers squeeze better long-term returns out of pension assets, without also exposing savers to unacceptable levels of risk?
Even within the constraints imposed by charge caps, we believe that proactive approaches can deliver return outcomes considerably in excess of market norms, while also helping savers weather outbreaks of volatility. That’s because proactive asset allocation strategies are much more nuanced and dynamic than simple index-based investing and traditional derisking models.
Proactive asset allocation can add value on the return-seeking front in several different ways:
It offers scope to tap into alternative asset classes, including relatively illiquid assets, like private equity and infrastructure. These can be marginally more costly to access, but, if used appropriately, can secure better diversification plus stronger investment returns and, therefore, potentially superior member outcomes.
Second, it allows for dynamic management of exposure to equity return factors (like value, quality, momentum, etc). Using fundamental insights, factors likely to perform well in the prevailing environment can be emphasised. Even more importantly, factors likely to prove less rewarding and which are more prone to drawdowns can be avoided. For example, factors like quality tend to do better in times of recovery when investors are looking for stability, but do less well during periods of expansion when investors are more optimistic.
And, finally, it allows for investment budgets to be focused towards those assets and approaches that may potentially add most value – for example, towards broad bond mandates with the flexibility to rotate across sectors and take highly selective approaches in subsectors such as high-yield bonds and emerging market debt.
At the same time, proactive risk management can secure more reliable downside risk protection than simple mechanistic derisking triggers.
There is no such thing as passive
“It sounds like they’re saying passive life is good, he thought. But there is no such thing as passive life. That’s a contradiction.” Philip K Dick, A Scanner Darkly
In a risk on/risk off world characterised by extreme return patterns, the effectiveness of extreme – and perfunctory – responses to market turbulence should be questioned.
Actively assessing the challenges ahead and identifying appropriate responses on a case-by-case basis may prove a much more rewarding route towards smoother DC outcomes over multi-year timeframes.
Karen Watkin is portfolio manager, multi-asset solutions at asset management company AB
