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Asset allocation takes centre stage
VIEWPOINT – As we pivot away from a lower-for-longer interest rate regime, institutional investors will still require more complex, scalable solutions to achieve their long-term investment objectives, argues the managing director and head of strategy and research, Asia-Pacific, at State Street Global Advisors, Thomas Poullaouec.
Thomas Poullaouec 22 Jun 2017
Thomas Poullaouec is managing director and head of strategy and research, Asia-Pacific, at State Street Global Advisors
Thomas Poullaouec is managing director and head of strategy and research, Asia-Pacific, at State Street Global Advisors

Investors have faced a daunting investment environment for the last decade, marked by sluggish growth, low interest rates and policy uncertainty. However, even as we pivot away from a lower-for-longer interest rate regime, institutional investors will still require more complex, scalable solutions to achieve their long-term investment objectives. The shift towards outcome-oriented, multi-asset class solutions rather than relative-performance objectives alone is not only changing how investors view the value drivers in their portfolios, it is also changing the nature of the relationship between asset owners and asset managers.

The challenge for a growing number of institutions in a resource-constrained world is doing more with less: finding ways to improve upon muted market returns, extracting more value from the fees they pay, and supplementing limited internal investment resources with fresh thinking and actionable perspectives from their asset managers.

Investors who are tied only to conventional, passive market cap-weighted benchmarks are unlikely to be well served in the future. This is partly because of a low-return environment that necessitates more innovative and varied ways of generating incremental return to build upon what we expect to be suboptimal beta returns. But it is also because when you start from an investor’s objective, whether it’s income, growth, protection, or something else, those goals might not align with conventional beta exposures. Getting active in asset allocation increasingly means moving away from those traditional approaches to create a very different risk and return profile for your portfolio.

As institutional investors face a low return and resource-constrained world, they want asset managers to move beyond just providing a return stream and become actively engaged with idea generation, portfolio construction, and solving problems. They want to get a better understanding of the risk make-up of their portfolios and how their different active managers are working together.

Getting the long-term positioning right for the portfolio is important, but we have found that an ability to be active in asset allocation is a real benefit, especially since those drivers might be different from what drives active stock or bond picking. So you might have a lower correlation of alpha between asset allocation calls and what you might get from an additional manager. Active asset allocation can be both an alpha generator and a risk mitigator. The ability to move quickly from risk-on to risk-off across the portfolio is a key part of that active asset allocation call.

For really large asset owners, our conversations are less around whether they should be active and more around where they should be active. We essentially say: maybe it’s time to stop looking for that 59th active developed, large-cap manager and start to think about your active exposures from a factor perspective. You can use smart beta to get a lot of that factor exposure, and add some incremental active on top of that for a much more capital-efficient portfolio.

More importantly, for those who are truly long-term providers of capital, we advise them to look for market dislocations and be nimble enough to exploit them opportunistically. For example, European real estate after the financial crisis or moving back into high yield at the appropriate time: leveraging those opportunities in a timely way can have a meaningful impact on the portfolio. You need to establish those active risk parameters up front by building that flexibility into the governance structure.

The shift away from products to an objectives-based multi-asset solution reinforces the need for deep asset allocation expertise. In many ways asset allocation has become the new model of active management, where understanding the drivers of risk across asset class exposures can help investors build more resilient portfolios and incremental return. Applying a factor lens to portfolios can also help investors reduce risk in more comprehensive, dynamic and capital-efficient ways.

As an example, despite the well-known shortcomings of today’s fixed income indices, most institutional investors continue to search for active fixed income managers benchmarked against the Bloomberg Barclays Aggregate Bond Index (the Agg) or the Global Aggregate Bond Index (the Global Agg). That search process typically involves an RFP, followed by on-site visits from managers, walking through investment philosophy, process and performance, hoping to convince the investor that their particular product is best poised to beat the index.

But this raises the question whether an investor should invest in the conventional investment-grade fixed income benchmarks to begin with. Given the current level of rates, the prospective yield on investment-grade bonds will not cover even the expenses of most public pension plans. With the duration of these conventional investment-grade indices at an all-time high and rates potentially on the rise, public funds prefer a more balanced solution that embraces credit risk in an equal proportion to interest rate risk.

This is the point at which a manager with a deeper understanding of factor-based asset allocation options can play a more consultative role with clients to examine other potential paths that will lead to a better outcome. This approach requires flexibility and customization, which can be a costly business model for some asset managers, but we believe this is the future of active management.

Each investor will have different preferences and parameters, which is why the consultative approach of an asset-allocation-driven solutions group must increasingly encompass all three critical areas of advice, design and implementation. This new model of engagement will be the way forward for institutional investors who need more than a one-size-fits-all solution to help them achieve their objectives. And the most productive partnerships will be those with aligned cultures and are sufficiently compatible to endure through the long term.

 

Thomas Poullaouec is managing director and head of strategy & research in Asia-Pacific, investment solutions group, State Street Global Advisors.

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