Execs told to make use of every strategic tool

Institutional investors better fine-tune their multitasking capabilities.

“The next generation of best practice for enhancing returns involves pursuing several paths in parallel, instead of embracing one idea,” Antti Ilmanen, a portfolio manager at global macro hedge fund Brevan Howard Asset Management LLP, London, wrote in a forthcoming book, “Expected Returns.”

Timing investments based on valuations, using leverage and looking beyond allocations based on asset class are tools all institutional investors should consider implementing, Mr. Ilmanen states in the book.

Mr. Ilmanen has pulled together the leading thinking on how long-horizon investors can harvest top returns from diverse risk premiums that vary over time, making the book a must-read for officials at sovereign wealth funds and large pension funds, say industry experts who've previewed the book.

“This is a marvelous collection of knowledge from financial theory, empirical research and the understanding of investment subjects, all bound together in a way that will bring knowledge and understanding to pension funds,” said Knut N. Kjaer, CEO of financial advisory firm GCapm, Oslo. Mr. Kjaer was the founding CEO of Norges Bank Investment Management, which runs the assets of the 3.1 trillion Norwegian kroner ($525.8 billion) Government Pension Fund-Global, also of Oslo.

Regarding Mr. Ilmanen's thesis, which urges that investors understand asset allocation in terms of strategy style and risk-factor return drivers, Elroy Dimson, emeritus professor of finance at London Business School, said: “We don't know an awful lot about these risk premiums ... so one wants (to invest in) a number of them. It's a matter of getting a diversified exposure to risk premiums.”

Mr. Kjaer added: “We don't have any choice; we have to go in that direction” of understanding returns in terms of strategy styles and risk factors. “We have learned from the global financial crisis that the traditional way of diversifying portfolios doesn't work.”

Mr. Ilmanen said in an interview that the goal for investors with adequate governance and resources is to achieve greater diversification and position themselves to harvest the right risk premiums. The first step, he said, is to understand return drivers.

To do that, asset-class returns should be understood in the context of strategy styles (such as value, carry and momentum) and risk factors (such as growth, inflation and liquidity), he said.

And when estimating expected returns, Mr. Ilmanen said investors should look beyond historical performance and accept that expected returns for certain asset classes, strategy styles and risk factors vary over time. Therefore, broadening the inputs to include macroeconomic views and forward-looking indicators (such as the price-earnings ratio of stock markets or nominal or real yields on bonds) should improve forecasts, he said in the book. (Mr. Ilmanen noted that writing the book was a separate enterprise unrelated to his job at Brevan Howard.)

Mr. Kjaer and other experts expect to see more active managers create strategies based on single style and factor exposures to allow investors to control and measure their overall exposures to these underlying return drivers.

Another tool investors can use to boost returns is incorporating valuations and forward-looking indicators into investment decisions, which Mr. Ilmanen calls market-, style- and factor-timing.

“In some ways, what I'm recommending is contrarian global tactical asset allocation,” Mr. Ilmanen said in an interview. “I emphasize forward-looking valuation indicators but suggest that other timing indicators should not be ignored.”

That is, he recommends institutional investors (with sufficient resources and governance, he emphasizes) consider widely where the best opportunities are and where the biggest risks lie, then overweight opportunities and underweight risks.

Cliff Asness, managing principal at AQR Capital Management, Greenwich, Conn., said investors are warming somewhat to this type of market timing. Paraphrasing the late economist Paul Samuelson, he said, “Twenty-five years ago I thought market timing was a sin. I still think that, but my new doctrine is "sin, but only a little.'”

Some pension funds already have adopted this approach, including the £18.2 billion ($28.3 billion) Barclays U.K. Retirement Fund, Poole, England.

That fund's investment staff “actively and dynamically manages the fund's exposure to the underlying risk premia that we are looking to harvest, ensuring flexible but structured decision making, and timely entry and exit points,” Stergios Saloustros, director and head of dynamic asset allocation at the fund, said in an e-mailed response to questions.

The fund uses “a combination of forward-looking, contemporaneous and backward-looking indicators, mainly quantitative in nature (as well as) qualitative thoughts, analysis, and views (that aim) to capture non-quantifiable events and themes, along with providing early signs of fundamental and regime change that, naturally, most indicators either fail or are slow to pick up,” Mr. Saloustros said.

Tim Hodgson, London-based senior investment consultant and head of Towers Watson & Co.'s Thinking Ahead group, said any definition of market timing is “a gray area,” in that it's not static asset allocation, but that “this is not about swinging the portfolio around on weekly or even quarterly basis.”

“For those clients who have sufficient governance, they should worry about market valuations (and) at extreme valuations they should take action,” Mr. Hodgson said. He added that Towers Watson's hurdle for moving in or out of an asset class is 1.5 standard deviations from normal valuations, but that can be adjusted based on client preference and can be fluid based on what other opportunities exist.

Mr. Ilmanen pins responsibility for the shift in attitude on valuations-based allocation moves to the boom/bust cycles of equity markets in the past decade. “It makes people think it is silly to be holding static asset-class investments through these environments, especially with the hindsight that these forward-looking indicators have worked,” he said in the interview.

However, he and others warn that any type of timing investments to markets should be done cautiously. Perhaps counterintuitively, he particularly endorses his version of market timing for long-horizon investors with $100 billion or more in assets.

Long-horizon investors are able to withstand moving early on timing bets as they are able to wait for the move to pay off, and they're best placed to provide liquidity in market downturns, he said.

“The proactive contrarian approach works for them because it's a way to tap the illiquidity premium,” Mr. Ilmanen said, noting that other illiquid markets, such as private equity or frontier markets, often aren't big enough to accommodate huge investors. “For those guys, it seems like one of the most attractive ways they can take advantage of their long horizon.”

Mr. Ilmanen and other members of the Norwegian fund's Strategy Council last month made a similar recommendation to the Norwegian Ministry of Finance, which sets the strategy of the Government Pension Fund-Global (Pensions & Investments, Dec. 13).

But Mr. Ilmanen noted in the interview, “It is hard to take this long-term view in real life.” If a move is mistimed, the fund's management will likely incur increased scrutiny until the bet pays off.

Because asset-class, style and factor returns vary over time, long-run average returns can be misleading, especially after recent returns have been strong, according to Mr. Ilmanen and other experts.

In this way, expected returns and risk management can be seen as “two sides of the same coin,” said Mr. Kjaer, who is also former president of RiskMetrics Group Inc. “All the (risk management) models are based on history, but the real (investment) situation is forward-looking.”

Mr. Kjaer noted that during the latter part of the so-called Great Moderation — roughly defined as the two decades leading up to the credit crisis in 2007 — there was low volatility in major stock and bond markets. To risk management, that would appear to be a low-risk situation. However, when volatility is low, risk premiums are also low, and investors can't expect as high of returns, which indicates higher risk. In this way, expected returns presaged the two major stock market crashes in the 2000s.

If the global financial crisis made style- and factor-based allocations and market timing more palatable, it did the reverse for the use of leverage, another tool Mr. Ilmanen endorses, although not for huge funds.

Leveraging up low-volatility strategies, which tend to have good risk-adjusted returns, is a good way to diversify away from the equity risk premium, he argued in the interview. “Clearly it's (leverage) gotten more of a bad name because people had to delever at the wrong time (in the recent financial crisis, but) using some amount of leverage still can be a good strategy.”

“Expected Returns” is scheduled to be released Jan. 21 in Europe and March 22 in the U.S., according to publisher John Wiley & Sons Inc.