Never has asset allocation been more of a concern for pension schemes than in the aftermath of the longest and most protracted recession since the 1930s. With markets continuing to recover to pre-crisis levels, many schemes are starting to look again at their asset allocation to remove risks from their balance sheets or increase diversification and repair funding shortfalls.

One of the most headline-catching cases of asset allocation gone awry in recent years was the investment strategy chosen by the Church of England for one of its pension schemes, which made a heady 100 per cent allocation towards shares (also known as equities). Its rationale was that the scheme concerned – a fairly immature scheme with liabilities building up from 1998 onwards – would benefit from the higher returns that equities can bring in a rising market. But the severity of the crash left the scheme battered and nursing a £300m deficit.

Unsurprisingly, the Church has been forced to rethink its investment strategy and the scheme is now moving to a 70/30 split between equities and bonds. Reducing benefits and raising the retirement age also seem likely. But this allocation is still a far cry from the investment approaches taken by many other, more mature schemes. A survey of 700 schemes conducted in January by Mercer, showed that on average, pension funds had reduced their exposure to shares to 50 per cent from 54 per cent a year earlier.

The lesson the clergy has had to learn is that the vast majority of investment returns for a pension scheme come through effective asset allocation choices, rather than investment performance. Indeed, several academic studies looking at pension scheme returns all the way back to the mid-1970s have shown that as much as 90 per cent of a scheme’s performance is directly related to its choice of asset allocation and how these assets perform, and not the excess return above the market – or ‘alpha’ – that top managers claim to be able to generate.

But the Church of England’s allocation is still what investment professionals call ‘undiversified’, since it invests only in two asset classes – equities and bonds. As the popular phrase about eggs and baskets proves, putting everything in one or two asset classes and hoping for the best can be costly.

In light of the great financial crisis, consultants have renewed efforts to press home the message that schemes must hold a greater variety of assets in order to avoid – or at the very least minimise – the dangers of another market crash.

Bobby Riddaway, senior investment consultant at Buck Consultants says: “We are telling schemes it is a good time to diversify into riskier assets within equities such as to emerging markets. Emerging market capitalisation is underrepresented compared to the other major global economies.

He says Buck Consultants is also looking to hedge funds, which are able make money in a variety of economic situations, as well as recommending property.

Getting diversified

The benefits of diversification are long-understood, having first been put forward in the 1950s by Nobel prize-winning economist Harry Markowitz. His ‘modern portfolio theory’ combined mathematical variables to allow investors to theoretically maximise returns while minimising risk through the use of diversification.

Put simply, if diversification works properly, then while some asset classes in the portfolio fall in value, others would rise, with the desired effect that returns would be cushioned by this movement, like a see-saw, and leading to lower overall volatility.

It is now more common for schemes to hold a half dozen or more different types of assets in their portfolio, each of which has their own return characteristics.

Allocating assets

The percentage of a scheme’s investment portfolio that is invested in each asset class defines its asset allocation. The factors that determine the makeup of the portfolio will include the trustees’ appetite for risk, which will in turn be linked to the scheme’s need to generate returns. For example, a closed scheme that is close to fully funded will have very different asset allocation needs to an open scheme with a significant deficit.

Typically schemes might have only a few percent of their portfolio invested in assets such as commodities or hedge funds, but it could still make a significant difference to the portfolio overall if other, more traditional, asset classes such as equities fail to perform.

At the end of 2008 for example, the £31bn BT Pension Scheme, had only 35 per cent of its investments in equities and 27 per cent in fixed interest assets, such as bonds, while it had an 11 per cent allocation to property, a 14 per cent allocation to inflation-linked assets and over 12 per cent in alternatives, including hedge funds, commodities, private equity and infrastructure.

Consider correlation

But as well as picking assets, correlation also matters. Investment mangers talk about correlations between asset classes, often on a scale of 0 to 1. A low correlation (between and 0.01 and 0.25, for example) means the price or the movement of prices of assets have little or no relation. So if one asset falls in value, the other asset will either keep its value or possibly even rise, while a correlation of 1 means a perfect match between movements.

In times of extreme market events, such as those following the collapse of investment bank Lehman Brothers in September 2008, many investors found asset allocation did not perform as well as expected. This is because all virtually asset classes were badly hit by the fallout from the financial crisis.

Correlations between previously unrelated asset classes started to edge towards a value of 1, meaning assets that previously had little or no correlation between them suddenly became closely entwined. Luckily, the collapse of Lehman Brothers was a one-off event. Markets have calmed down since then and relationships between assets classes have returned closer to normal levels, but all investors should keep in mind the potential pitfalls of having all their eggs in one basket.

TYPES OF ASSETS:

Equities or shares, are essentially a small slice of a company which entitles the owner to a portion of a company’s future profits, often paid once or twice a year as a ‘dividend’.

Bonds are a form of debt issued by companies and governments to raise money. In effect, it is a loan to the issuer. In return, the issuer promises to pay a set rate of interest each year – known as the ‘coupon’ – and to repay the initial capital – the ‘principal’ – at a set date in the future. Not repaying a bond is known as ‘defaulting’. Bonds issued by the British Government, called gilts, are highly unlikely to default because the Government is unlikely to go bust, although the recent Greek bond crisis has shown that governments can be a risk (see page 57). Corporate bonds, issued by companies, are only as safe as the company that issues them. The safety of the loan is assessed by credit rating agencies, such as Fitch, Moody’s and Standard & Poor’s.

Commodities are raw materials used to create other products such as food, furniture or power. Commonly traded commodities include copper, crude oil and wheat. As the world economy grows, demand for these products rises, allowing investors to benefit from global growth.

Gold is commonly used as a ‘safe haven’ investment, as it tends to rise in value in times of economic crisis. It is often used as a hedge against movements in the world’s dominant currency the US dollar.

Property or real estate, is most commonly office blocks or other buildings such as shopping centres. As rental income is closely related to business activity, returns can be hit in times of recession, although it can protect investors in times of high inflation.

Infrastructure assets are usually large-scale projects such as roads, hospitals and utilities. As many assets are regulated – such as electricity or water companies – or contracts with the government – such as building and running hospitals – they provide a steady, predictable income (see page 55).

Swaps are commonly used as a form of insurance to hedge against certain risks, including inflation, interest rates and the risk of bond defaults. Swap contracts involve exchanging one set of payments – a ‘leg’ – for another. One leg will be a fixed amount, while the other varies, or ‘floats’. In an interest rate swap, for example, a scheme may pay a fixed sum to effectively insure against changes in the interest rate (see page 38 for more information on longevity swaps).

Hedge funds are investment vehicles which are able to make money in a variety of economic situations, by using various investment techniques and strategies. They often use short-selling – borrowing and selling shares the hedge fund manager believes will fall in value, then re-buying them at a lower price to make a profit – as a technique to hedge or minimise risk.