Alternative investments are in, traditional stocks and bond strategies are out.
And not just absolute-return strategies, but investments — such as currency overlay, private equities, real estate, emerging-market securities and even commodities — that have low correlations to traditional asset classes.
"Overall, the general theme people are looking for is uncorrelated returns," said Jeffrey Shen, vice president and head of asset allocation research in J.P. Morgan Fleming Asset Management's global multiasset group, New York.
But that's not all that's on the table for 2004, which is promising to be a watershed year across the spectrum of institutional investors. Continued fallout from the mutual-fund industry scandal and blowups over governance and pay practices at the bastion of capitalism, the New York Stock Exchange, have set the stage for sweeping changes.
The staff of Pensions & Investments has plumbed the prospects for the industry this year. Here are the key findings:
-- Plan sponsors will continue ramping up their allocations to alternatives in an effort to generate higher returns from asset classes with low corrections to traditional stocks and bonds.
-- Money managers will be held to tougher standards of fiduciary responsibility in the wake of the mutual fund market-timing scandal. Fees of all sorts will be on the table: soft-dollar arrangements, management fees and mutual fund sales practices.
-- The NYSE is ripe for change, with the installation of a new CEO well versed in electronic trading. It's bad news for the middlemen, but potentially good news for buyers and sellers.
-- Defined contribution plans are set for a major push toward managed accounts and the comeback of lifecycle funds, and away from do-it-yourself retirement planning. Earlier trading deadlines also could reduce daily valuation's importance.
-- Federal legislators are expected to finally replace the 30-year Treasury bond as the benchmark for calculating pension liabilities. In addition, the Bush administration is expected to unveil a new proposal clarifying the legal status of cash balance plans.
-- Consolidation may continue to hit asset servicing firms, such as custody banks. Meanwhile, money managers are expected to keep outsourcing back-office functions, while multinational companies will seek a single provider to consolidate custody of their overseas pension assets.
Despite the U.S. equity market returning 31% in 2003, pension executives are seeking ways to enhance returns and reduce overall portfolio risk, experts said.
There are two reasons for this major change in outlook. First, pension executives believe returns from traditional asset classes will be inadequate to meet their funding requirements for the foreseeable future. What's more, they're still upset by the volatility of markets over the past half-dozen years that first caused pension funding levels to go through the roof, only to collapse from 2000 through 2002.
In fact, pension funds, on average, are no better funded after 2003's strong stock market because asset values are smoothed over a five-year period, while liabilities are averaged over a four-year period.
The upshot: Standard & Poor's officials reckon that pension liabilities for S&P 500 companies soared to $1.3 trillion by Dec. 31, a 13.7% increase from the previous year (Pensions & Investments, Dec. 22, 2003).
The combination of lower long-term expected stock market returns and low interest rates are driving plan sponsors "to put more active risk in the portfolio," said Kurt Winkelmann, managing director and co-head of global investment strategies at Goldman Sachs Asset Management, New York.
General Motors Corp.'s pension fund is a case in point. To meet its 9% long-term expected return as well as to lower overall volatility, fund officials want to reduce exposure to domestic equities and global equities, while increasing allocations to "high alpha" asset classes, such as emerging market equity and debt, U.S. high-yield bonds, small-cap stocks, real estate and private equities.
GM's target ranges for U.S. stocks and global stocks are expected to fall by five percentage points each, while target ranges for real estate will go to 8% to 12% from 7% to 11%, and other alternatives will increase to 9% to 13% from 6% to 8%.