LONDON - British pension funds can have their equity "cake" and eat it, too.
According to research by First Quadrant Ltd., London, pension funds can enjoy improved returns while significantly reducing the risk of their equity portfolios.
Through "tactical rebalancing," funds can rebalance to their policy benchmark without surrendering the added value that can be obtained from major shifts by global equity and bond markets, the firm says.
The research is particularly important in light of the twin pressures of increasing maturity and the U.K. Pension Act's new minimum funding requirement. U.K. pension executives fear those pressures will force them to reduce their world-leading average 78% in equities and boost investment in gilts. Increasing bond investments will lower long-term returns and ultimately will increase corporate pension contributions, they worry.
In fact, the average weighted U.K. pension fund's investment in equities already has peaked from 82.4% in the third quarter of 1993. (The median pension fund allocation to equities, which favors smaller funds, was 86.3%.) Equity allocations largely had drifted upward largely because of stock market rises, not because of conscious decisions by trustees.
But First Quadrant's research shows pension funds could have won virtually the same returns as from the drift approach but at much lower levels of risk.
Last year, a First Quadrant report showed that from January 1986 through March 1994, a simple quarterly rebalancing for a pension fund with a 50% equity and 50% gilt policy mix would have returned 14.11%, or seven basis points better than the average fund in the WM All-Funds Universe (ex-property), with significantly lower risk (Pensions & Investments, Jan. 9).
Now, First Quadrant executives are saying U.K. trustees can go a step further, significantly improving returns while keeping risk at a low level, through "tactical rebalancing" - or "inadvertent active management," as Rob Arnott, First Quadrant's chief investment officer, said tongue-in-cheek.
What is significant here is that an active approach is taken to the rebalancing process.
While automatically rebalancing at the end of every month or quarter clearly reduces risk, it may not always be the best time to make the shift, explained Lisa Plaxco, quantitative research analyst.
"There are occasions when the market would continue with trending behavior," Ms. Plaxco said. First Quadrant managers say that sometimes there is a need to fully or partially rebalance toward the benchmark several times within a year - but sometimes not at all.
To gain added value from those periods when the market clearly is on the way up or down, First Quadrant managers apply the quantitative factors used in their global tactical asset allocation model to a passive rebalancing approach. The approach avoids using subjective factors but still avoids blindly rebalancing to the policy benchmark.
The result is a low-risk approach suitable for core portfolio investments, such as the indexed portion of a pension fund, Ms. Plaxco said. In terms of risk, the approach is far closer to passive rebalancing than an active global tactical asset allocation approach, explained Bill Goodsall, managing director.
The tracking error from a monthly passive rebalancing is comfortably under 100 basis points for a global portfolio, Ms. Plaxco said.
For example, from January 1986 through September 1995, a tactical rebalancing approach would have provided an annualized return of 15.54% - 38 basis points better than the 15.16% return available from a monthly rebalancing approach.
The standard deviation would have increased only to 14.66% from 14.27%.
"This is a good answer for a fund that is going to be forced into a fund-specific benchmark for the first time," Ms. Plaxco explained.
