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January 30, 2011 10:02 am
Bob Prince, co-chief investment officer of Bridgewater Associates, the US fund management giant, likes to challenge the pension fund fraternity. In a recent study of 200 US public and private pension funds, he found that 98 per cent of them had a strategic asset allocation that was more than 75 per cent correlated to the S&P 500. In other words they had a portfolio of many assets, but with the risk concentrated in one asset class. Much the same probably holds true in the UK and elsewhere.
Why, he asks, do such people choose to hold a concentrated portfolio when they almost certainly understand the benefits of diversification? Are they unaware of their concentration of risk? Do they think it maximises their economic interest because the expected return is higher and return matters more than risk? How does “prudent man” and peer risk fit in? Do they not know of a better way? Or what?
These questions go to the heart of the asset allocation dilemma faced by many pension funds. When put to a group of Bridgewater clients in London last week, the rationalisation they offered was that many of those who are over-exposed to equities do indeed think that return matters more than risk, while worrying that diversification is expensive because it lowers the return unless they compensate by taking on leverage.
Even at today’s low real rates of interest, pension funds’ historic antipathy towards borrowing remains strong. Some UK trustees recall how the Unilever and Imperial Chemical Industries pension funds did themselves damage by borrowing to finance disastrous speculative property developments in France and Germany in the inflationary panic of the 1970s.
Whatever one thinks about leverage, there are other risks that are quite as dangerous – not least the failure to diversify, which in many cases amounts to a high risk bet to beat growing actuarial deficits. Trustees who go down this route are, in economic jargon, gambling for resurrection, which sits oddly with the requirement for prudence.
That makes another response offered at the London meeting all the more interesting. This was the suggestion that excessive concentration reflected peer group risk. In other words, trustees were observing the depressing investment maxim excoriated by John Maynard Keynes – namely, that it is better to fail conventionally than to succeed unconventionally.
That highlights the point that in countries where investment is governed by “prudent man” rules, the definition of prudence is established by the herd. How long, I wonder, before the concept is legally tested in court on the basis of losses resulting from excessive concentration?
There may be another factor at work in pension funds’ excessive exposure to equities. Many trustees want to shift to liability matching, but are worried about abandoning not particularly expensive blue chip equities for government bonds that are on the lowest yields in decades. Some who are progressively de-risking portfolios on a flight path to 100 per cent liability matching are, I suspect, looking to defer switching out of risk-seeking investments while bonds look so expensive.
Some sympathy is in order. Bill Gross of Pimco, the world’s biggest bond fund manager, says that investors should fear the loss of America’s AAA sovereign rating. Shrewd Wall Street commentator James Grant nominates UK government bonds for the title of “Worst Prospective Fixed Income Investment of 2011”.
A switch to mechanistic approaches to investment, such as liability matching, entails abandoning such good old-fashioned value rules as “buy low, sell high”. For many investors volatility measured by standard deviation is not the only measure of risk. Loss of capital is their preferred definition.
Yet for anyone who does not have the luxury of investing in perpetuity, the fact that risk is not just short term means that concentration is a problem. It might lead to wonderful outcomes for decades. But it can equally lead to the opposite, so that pension funds may be forced to liquidate securities at poor values to meet liabilities.
For those who like statistics about “rare” events, Mr Prince shows that the 1965-81 US bear market in bonds had a probability of one in 93m years; the sustained period of underperformance in US stocks from 2000-2009 was one in 120 years; and the 1990-2010 Japanese bear market in equities was one in 4,000 years.
There are, of course, ways of diversifying without sacrificing value. Bridgewater’s is the risk parity approach, which involves balancing risk exposures across many sources of return to achieve consistent performance in all weathers. This showed its strength in 2008 when many pension funds paid the price for excessive concentration and many long-short hedge funds turned out to be long-only funds in disguise. More of that on another occasion.
Today the message is that concentration risk can produce lethal capital loss. And that is as fundamental a principle as buy low, sell high.
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