UK pension funds could have improved their long-term investment performance by up to 3.5% per year if trustees applied forward looking, dynamic asset allocation to pension portfolios, according to Aviva Investors.
- A call to trustees to focus less on manager selection and more on asset allocation
UK pension funds could have improved their long-term investment performance by up to 3.5% per year if trustees applied forward looking, dynamic asset allocation to pension portfolios, according to Aviva Investors. The findings are the result of an analysis prompted by the recent market turmoil, which examined whether assessing market events in a timely and preventative manner can make a difference to investment returns.
Aviva Investors constructed two hypothetical portfolios based on the typical asset allocation weights of an average UK pension fund in the beginning of 2001 (71% equities; 20% fixed income; 4% cash; 5% property)*. Over the following 10 years, one portfolio was managed dynamically with a quarterly, forward-looking review of asset allocation and shifted its weights in relation to changing return, risk and correlation properties. The second portfolio was managed in a more static way and rebalanced its allocations once every 12 months in line with the average UK pension fund*.
The results show that the dynamic portfolio outperformed the static one by almost 3.5% per year over the back-testing period. Moreover, dynamic rebalancing helped to reduce the overall volatility of the portfolio and lowered the downside risk, as measured by maximum loss over one quarter which was approximately 4% lower than that of the static portfolio.
|
| Static portfolio | Dynamic portfolio |
| Average annual return | 5.10% | 8.52% |
| Cumulative return over testing period | 64.39% | 126.61% |
| Annualized volatility | 10.26% | 10.24% |
| Maximum loss over one quarter | -12.69% | -8.31% |
Mirko Cardinale, head of strategic asset allocation research at Aviva Investors, commented: “The recent market turmoil has once again put the spot light on returns and prompted us to look at just how important it is for a pension fund to act in a timely manner. In our view asset allocation is the most important driver of portfolio risk and return for a multi-asset fund.
"As the choice of strategic weights has such fundamental importance, you would expect asset allocation to be on top of trustees’ and consultants’ list of priorities when it comes to time and resources devoted to investment matters. Yet in my experience it is often the other way round: a lot of effort goes into beauty parades of fund managers and investment meetings are dominated by discussions on relative performance vs. benchmarks or the rationale for fund managers’ overweights and underweights.”
The analysis shows how forward looking models can help to determine optimal allocations to asset classes. Instead of extrapolating from historical returns, the dynamic portfolio used current metrics such as price earnings ratios or dividend yield (equities), price to rent ratios (real estate), yield to maturity (bonds) and purchasing power parity (foreign exchange) in order to forecast returns of the respective asset classes and suggest allocation adjustments in line with their changing long-term return prospects.
For example, the portfolio reached a peak allocation to equities (64%) in 2002 when valuations improved in the wake of a sharp market correction. However, by 2008 equities had become expensive relative to other risky assets and allocation was cut down to a trough of 44%.
While the average pension fund kept the overall equity exposure around a similar level, the dynamic portfolio improved performance by significantly reducing the home bias and diversifying into overseas equities, with a focus on high growth Asia-Pacific and emerging markets. Optimal exposure to overseas fixed income assets also varied over time in line with changes in yields and the relative attractiveness of sterling versus other currencies.
When sterling became overvalued in 2006/2007 the portfolio assumed an overweight position in international vs domestic assets. This was later significantly reduced when sterling depreciated upon the exceptional monetary stimulus being put in place during the financial crisis. The allocation to real estate also followed a counter-cyclical pattern with a reduction in relative exposure as prospective returns gradually became squeezed by lower rental yields and overstretched valuations in 2007.
Mirko Cardinale concluded: “Many pension funds review their asset allocation on a regular but infrequent basis, in some cases this can be only once every three years. In addition, many portfolio optimization models used by investors still rely on historical returns as the best estimate for future returns, in spite of overwhelming evidence against such an approach.
“By contrast, we believe the market provides adequate signals on prospective returns across different asset classes which can be employed to recommend dynamic shifts in the asset mix. Most of these indicators can move relatively quickly even in a short period of time, so it is imperative that trustees review their portfolio’s asset allocation at least once every six months. Although a daunting task, our analysis shows that, when applied correctly and systematically, a forward-looking approach to asset allocation can ultimately lead to a significant uplift in long-term portfolio returns.”
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* Asset allocation figures derived from UBS European Institutional Asset Management Survey 2011.
For more information contact:
Wendy Svirakova
Corporate Affairs
Aviva Investors
Telephone: +44 (0)20 7809 8810
Email: wendy.svirakova@avivainvestors.com
Louise Riordan
F T I Consulting
Telephone: +44 (0)20 7269 9308
Email: louise.riordan@fticonsulting.com
Notes to editors:
- This document is for investment professionals and institutional/qualified investors only. It is not to be viewed by or used with retail clients.
- Past performance is not a guide to the future
- This research has been produced for the internal use of Aviva Investors Global Services Limited only. It is no to be relied on by anyone else for the purpose of making investment decisions.
- Unless stated otherwise any opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors). They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature.
Aviva Investors
Aviva Investors is the global asset management business of Aviva plc. The business delivers investment management solutions, services and client-driven performance to clients worldwide. Aviva Investors operates in 16 countries in Asia Pacific, Europe, North America and the United Kingdom with assets under management of £269 billion at 30 June 2011.
Aviva plc
- Aviva is a leading provider of life and pension products in Europe (including the UK) with substantial positions in other markets around the world, making it the world's sixth largest insurance group based on gross worldwide premiums at 31 December 2010.
- Aviva's principal business activities are long-term savings, fund management and general insurance, with worldwide total sales* of £47.1 billion and funds under management of £402 billion at 31 December 2010.
* Based on 2010 published life and pensions PVNBP on an MCEV basis, total investment sales and general insurance and health net written premiums, including share of associates' premiums.