An EDHEC professor is developing an approach to asset allocation that would better tailor investments to each investor.
Similar to the way corporate pension funds take the employer's business risks into account when investing (Pensions & Investments, Nov. 2, 2009), public plans and sovereign wealth funds, endowments and foundations and even defined contribution participants should do the same, argues Bernhard Scherer, professor of finance at EDHEC Business School in London.
In a new paper, “Asset Allocation with Shadow Assets,” he contends allocations to shadow assets — defined as non-financial and non-tradable assets that are outside the investor's asset allocation decision — “can hardly be changed, and yet their existence will change the investor's perspective on total wealth at risk.” The paper is awaiting publication approval by the Financial Analysts Journal.
“Ignoring shadow assets is unfortunate” because they are what make various investors different, which “leads to different demands for risky securities,” according to the paper. They should influence the outcome of asset allocation decisions based on their relationships with financial assets and “create a unique hedging demand ... that leave(s) standard (financial asset-centric) asset allocation advice inadequate at best.”
In an interview, Mr. Scherer said investors need to understand how their shadow assets relate to their investments.
For example, the shadow assets of a public pension fund or sovereign wealth fund in China would be the present value of future tax payments (or, more specifically, the difference between future tax payments and future government spending). Because China's economy is very much export-oriented and dependent on U.S. consumer spending, it wouldn't make sense for Chinese pension or sovereign wealth funds to invest heavily in U.S. consumer-sector stocks.
“If you were the chief investment officer of a Chinese pension fund, you might not want to buy Wal-Mart or other similar stocks,” Mr. Scherer said.
Similarly, university endowments should think about how their shadow assets (the present value of future alumni contributions) might be exposed to financial markets. For example, a U.S. endowment might trim its U.S. equity allocation in favor of an international one because of the correlation between the U.S. stock market and alumni giving. Also, the endowment might avoid the engineering sector if many of its contributing alumni are engineers.
But the concept might have the widest application in defined contribution plans.
“If you look at DC plans, they're all treated the same” whether they're for autoworkers or bankers, family businesses or corporations, he said. But an individual's career, company and other personal circumstances all affect how you invest for retirement, Mr. Scherer said.
All DC participants are different. A banker with bonuses throughout her career has greater exposure to the stock market than a college professor, for example. A person who expects to inherit a large house should invest differently from someone who won't, he said.
“Because they own different shadow assets, the right asset allocation isn't the same for all of them,” Mr. Scherer said. “The breadth of asset allocation advice doesn't reflect that breadth of different investors.”
While the ability to adjust an individual's DC investments already exists, Mr. Scherer acknowledged the difficulty in getting most participants to understand their investments, much less how shadow assets might relate to those investments.