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Witnesses to the shifting landscape

Pensions & Investments' annual survey of the largest U.S. retirement funds once again provided a portrait of changes in the investment of their huge asset pools.

The key takeaway is that the executives overseeing the largest defined benefit funds have taken steps to offset the volatility in the markets, particularly the equity markets, and still earn positive returns. They tried to become more defensive, but to do so in ways that protected long-term returns.

One of the most significant developments last year was a further shift to domestic fixed-income investing by defined benefit plans, suggesting serious concern about stock market volatility. Overall, domestic fixed-income assets increased 10% from the previous year, while the average asset allocation to fixed income by corporate DB plans in the top 200 during the same time jumped to 43.4% from 38.8%.

Much of that fixed-income investing was in liability-driven investing, often in the form of immunized or cash-matched portfolios as companies sought to offset the volatility of their equity portfolios and its effect on liabilities.

As further evidence of the efforts to reduce volatility in the asset values, companies also reduced their exposure to high-yield fixed-income assets.

The trouble with seeking reduced volatility is that could also reduce long-term return since risk and return are tied together. Funds have adapted to that by further diversifying their portfolios. They have accepted Harry Markowitz's dictum that diversification provides the only free lunch in investing. That is, by diversifying carefully it is possible to earn a higher return for any given level of risk than with a non-diversified portfolio.

The largest funds report shows that the defined benefit plans have increased their allocations to many alternative asset classes. They increased energy and infrastructure investments significantly, though from small bases. They also increased private equity and real estate, two more familiar asset classes with reduced correlation to the equity markets.

On the other hand, hedge fund allocations declined, especially in hedge funds of funds, and asset owners negotiated hard to reduce fees. Clients have realized that hedge fund gross returns are not what is important, but rather net fees. To quote another investment guru (Ben Franklin), a penny saved is a penny earned. The less they pay to hedge fund managers, the more accrues to the asset base.

There has also been a slight trend back toward active management, especially in equity investments. The thinking apparently is that timely shifts by active managers between sectors, to and from defensive stocks, or even to or from significant cash positions can add to the long-term equity returns.

Fund executives are staying flexible and positioning assets under their control to take what the capital markets give without taking excessive risk, and in fact by dialing down the risk. No two funds are alike in their asset mixes, but each has been positioned in ways appropriate to the structure of its liabilities.

Fund executives are using insights of capital market theory and research to generate the best possible long-term returns at a time when stock and bond markets have made efforts to earn excess returns much more difficult.

The survey of defined contribution plans did not show the same significant changes in investment approach, but it confirmed the continued strong growth of their assets, with the DC assets in the top 1,000 plans growing 10% in the year ended Sept. 30. Among the top 200 plans, the assets grew 10.7%.

The survey did show that the average defined contribution plan participant had a higher equity allocation than the average defined benefit plan, and allocated much less to fixed income. The participants appear to have taken to heart the message that equity investing offers the highest long-term return.