Superannuation

Since 2007, investment has been all about managing the risk in portfolios.

Most smart investors managing long-term superannuation investments have been grappling, for the past three or four years, with the question of how to cope with the risk/return trade-off.

In most cases, this has resulted in changes to asset mixes, often reducing risk by moving out of equities into cash or bonds.

Target date funds

One investment industry solution overseas has been the target date fund – portfolios managed with the investor’s retirement age in mind.

But by the time the financial crisis played out, US pension fund investors with target date funds found this semi-mechanical approach had produced unhappy results (mainly by missing gains from the recovery in equities).

Clearly, a lot of investors need a better solution than target date funds which attempt to put portfolios on a “glide path” towards a more acceptable mix of risk and return.

Major US funds manager Pimco, under its relatively new chief executive Mohamed El-Erian, has widened its former concentration on fixed-interest investments towards providing investors with solutions to cope with what Pimco calls the “new normal” of lower returns.

Which is why Sebastien Page was happy to make the switch from cold Boston on the east coast to sunny Newport Beach in California to head a new Pimco division. His title is head of client analytics; his function is to provide solutions for clients who want to sidestep the potential volatility of markets in portfolios aiming to provide retirement income.

Look through the windscreen

His real task, however, is to re-educate people into thinking about their portfolio’s risk by looking through the windscreen rather than the rear view mirror.

The Pimco thesis, as outlined by Page, is that in the new global climate, the asset allocation process has to take account of forecasts of macro-economic events.“Macro matters,” Page says.

Before the global meltdown, investors largely managed portfolios by looking at which asset classes looked dear or cheap. That might work in normal markets, Page says, “but such a focus on the rear view mirror can lead to disastrous investment outcomes when important macro-economic shifts take place”.

There are close relationships between macro-economic conditions and factors which are the main drivers of returns among investments. The earlier approach assumed that diversification across asset classes provided enough protection for investors. In fact, Page says, in the financial crisis diversification didn’t work – certainly on the downside.

Equity risk premium

In many Australian super funds, the so-called “balanced” portfolios contained up to (or above) 70 per cent of equities. This heavy reliance on the equity risk premium to generate returns was anything but balanced, he says.

Many investors in super who were nearing retirement learnt that they needed to reduce their exposure to volatility and to diversify their returns away from equity risk.

The investment industry’s response generally was to introduce the so-called target date funds, managing the portfolio mix with the investor’s likely retirement date in mind and reducing the exposure to riskier assets. The idea was to put the portfolio on a glide path that minimised risk.

But the big lesson from the crisis was that the apparent free lunch from diversification was affected by the risks which many people didn’t see lurking at the two extremes of the risk/return curve – the so-called “tails”.

A tasty lunch

The smart thing, Page says, is to hedge against these risks. “Tail risk hedging may not be a free lunch but it is definitely a tasty one,” he says.

“Shocks are shocks because they [are] unanticipated – otherwise they wouldn’t be as extreme,” he says.

So, for fund trustees, “it’s not about predicting the unpredictable, its about recognising the likelihood of unpredictable events and preparing” .

Page says rebalancing a portfolio to cope with risk has to happen more often and needs to alter as the macro-economic outlook changes.

Events are key

He says Pimco wants to move away from a three or five-year portfolio horizon to an event-driven view.

“The global financial crisis caused a lot of long-term investors with a set and forget approach to make a lot of very difficult decisions about rebalancing,” he says.

Whether investors like it or not, significant macro-economic changes will drive them away from their three-year horizons.

So even those who are not active investors will “have to recognise shifts in macro-economic conditions which are not driven [simply] by how many times the earth has gone around the sun”.