“The only thing you get from sitting on the fence is splinters!”   This statement probably resonated well with many superannuation funds watching their returns plummet during the global financial crisis.  The uncomfortable feeling of inaction in the face of adversity is one of many catalysts for a change in the asset allocation approach of superannuation funds.  However, change by its very nature, gives rise to opportunities and risks that need careful management and attention. 

Prior to the advent of multi-manager investing, “balanced funds” dominated the portfolios of superannuation funds.   A single investment management organisation would be responsible for all investment decisions, right down to stock level and across all markets.  In terms of asset allocation, many investment managers employed a tactical approach.  That is, the investment manager would seek to position the asset allocation of the fund to take advantage of perceived under or over valuation in asset classes, both short term and long term.

As superannuation funds grew in scale they also sought to explore alternative investment approaches and have greater involvement in the investment process.  Investment consultants successfully argued the benefits of a multi-manager approach and the intuitive appeal of specialisation.  The other core argument was focused on the failure of investment managers in making tactical asset allocation decisions. 

The attack on tactical asset allocation, and balanced funds, included:

• The inability of committees of sector specialists with vested interests to make decisions
• The lack of breadth in decision making.  Essentially, with very few decisions, each decision was significant and one wrong call could dominate performance outcomes
• Evidence of poor performance

Ultimately, successful marketing by consultants leveraging the self-interest of trustees, resulted in the demise of balanced funds and this approach to investment management.  Tactical asset allocation became a dirty word in the industry, and something to avoid.

Whilst tactical asset allocation was taboo, and any consultant pursuing the approach would have been viewed as hypocritical, the concept of taking defensive positions away from strategic asset allocation or avoiding an asset class was supported by a couple of investment consultants.  However, like all investment decisions, the success of the strategy had a degree of cyclicality.

More recently, we have entered an interesting phase with a myriad of factors stimulating a greater interest in medium term asset allocation approaches.  In fact, just as tactical asset allocation became a dirty word in the 90’s, strategic asset allocation has suffered much the same fate.  “Set and forget” and “Slave to your asset allocation” are two of the ways that taking a strategic approach to asset allocation is now often derogatorily described.  This compares with terms such “dynamic”, “defensive” (a good thing in a bear market!) and “preservation of capital” which are all often used to describe the making of medium term asset allocation decisions to take advantage of perceived under or over valuation in markets.

Red flags are waving

There are some red flags emerging that need to be heeded as funds actively seek to deliver better returns for members via active asset allocation:

·         Investment philosophy or commercial relevance: For many years there was a clear divide amongst the investment consultants and their medium term asset allocation beliefs.  Today, all of the major consultants are offering some form of medium term asset allocation advice.  Funds need to ask whether this is driven by philosophically investment thinking or a focus on having a commercially relevant offer.  The truth is that it is always a blend of the two, and funds need to understand the investment philosophy that is guiding advice, and the commercial realities that may influence this advice.

·         Trustee obsession with peers: Regulatory and industry focus on consolidation, and the regular publication of superannuation fund performance, have resulted in an unhealthy pre-occupation with relative short and medium term performance.  Peer envy has contributed to demand for medium term asset allocation advice, and all the normal health warnings are relevant, with the most important one being that past performance is not a guide to future performance.

·         How different can you be:  Four consultants represent most of the Australian market.  If you are relying on their asset allocation advice, then you are unlikely to be materially different from your peers!

·         Fundamental laws of active management haven’t changed: Successful investment management is a combination of skill in making investment decisions, and the breadth of decisions.  The greater the breadth the less influence of a single decision, thus the greater the chance that your skill will over-ride luck (i.e. back luck) over time.  However, with medium term asset allocation (as is the case with tactical asset allocaiton), the lack of breadth puts a greater emphasis on skill and the need for high confidence decisions.  Bottom line, making medium term calls is not easy, and luck (good & bad) will have a significant influence on short and medium term results.

·         Chasing winners, not just avoiding losers: Historically, medium term asset allocation was very much about avoiding losers, in particular asset classes or strategies that were viewed as sub-optimal.  Today, the focus has changed to also picking winners.  Whilst this may be viewed as a natural extension, it could also be argued that this reflects over-confidence emerging both amongst consultants and funds, and certainly changes the risk profile of the activity.

·         Governance framework and operating capability must lead investment strategy: Thanks to Towers Watson, and other consultants, investment governance has received considerable attention and funds are spending more time thinking about how they apply their scarce resources to provide greatest impact on investment strategy.  However, what has been often overlooked is that operating capability must also lead investment strategy.  The GFC has certainly highlighted the failure of funds in understanding this point (liquidity management, valuation policies, counterparty risk are all examples).  Funds need to ensure that their operating capabilities are supportive of a more active approach to asset allocation.