We’ve read a lot of reports over the past year about how institutional investors are eschewing equities in favour of fixed income and alternative investments. For example, back in February, Pensions & Investments reported:
“Consultants, managers and pension fund executives agree that European pension funds will settle at a much lower equity allocation — unlike the last time, when allocations recovered to previous levels.
In the long term, the allocation to equity will probably settle around 40% (of the total portfolio) rather than around 60%,” said Paul Price, Dublin-based global head of institutional business at Pioneer Investments, which had $213.7 billion in assets under management globally at year-end 2008.”
At around the same time, consultancy Watson Wyatt confirmed this forecast (see chart below from report available here with free registration):
While equity-phobia is understandable, there may also be a more fundamental reason for a shift away from equities and toward lower volatility assets such as bonds and alternative investments. The past 24 months have shown that a “60/40” equity/bond allocation amounts to a equity/bond risk exposure. In other words, the extreme volatility shown by equities has caused them to “punch above their weight” in a portfolio.
An article written earlier this year by Ed Peters of First Quadrant in Pasadena, California illustrates the point in spades. Writes Peters:
“From January 1986 – October 2008 the S&P 500 had an annualized volatility of 14.90% while the 10 year T-Note had an annualized volatility of 5.12% and a 60/40 balanced fund had a risk of 9.35%…if we look at the risk budget for stocks and bonds in this 60/40 “balanced” portfolio, stocks carry 91.31% of the total risk …From a risk budgeting stand-point, the “balanced” portfolio is not balanced at all. Most of the risk is still in stocks. In fact, during the January 1986 – October 2008 period, the 60/40 had a 97.6% correlation with stocks. The bonds had “watered down” the volatility of equities, but not the risk exposure.”
In order to balance the risk exposure of stocks and bonds, Peters argues that you need to change the allocation from “60/40” to “28/72”.
This will drop the overall volatility and return of the portfolio. But since the volatility drops proportionately faster than the return, the Sharpe ratio goes up and the portfolio is, technically, more optimal.
But who wants lower returns? Certainly not underfunded pension plans. So they can always move up the capital market line by adding leverage (note that 43% stocks over gross exposure of 157% is roughly the same as the 28/72 allocation).
By thinking of leverage not on the fund per se, but on the underlying components (equities and bonds), Peters is able to create a new efficient frontier. But the effect is the same. He found a more optimal (higher Sharpe) combination of equities and bonds and then levered it up to the previous risk level. The result is a portfolio with the same volatility with a higher return.
A free lunch? Not really. More of a lunch you already paid for, but have not yet been served. As Peters concludes:
“Modest leverage, in this case, can actually reduce the risk of the total portfolio by balancing the risk exposure between the asset classes. Rather than having a 91% risk exposure to stocks as we do in the 60/40 case, we can change the risk exposure to a more balanced 50% while at the same time maintaining the same risk profile as a traditional 60/40 and increasing the long term expected return.”
In practice this means that First Quadrant’s “Essential Beta” portfolio over weights fixed income. If others are doing the same – for the same reasons – the experts may be right that equities may never recover their lofty perch.
One final thought: Paul Price of Pioneer Investments (quoted above in February in P&I) said there was only one scenario that could force him to revisit his position:
“What might change that view in the short term is a rally — a sustained rally.”